The Company reported net income of $4.1 million for the year ended December 31, 2009, compared with net loss of $3.4 million for the year ended December 31, 2008. In 2009, the Company recorded total realized investment gains of approximately $2.4 million. In 2008, the Company recorded total realized investment losses of approximately $6.3 million, approximately $5.7 million related to write downs for other-than-temporary impairment losses including $4.0 million from auction preferred securities backed by the preferred stock of the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corp. (“Freddie Mac”). Net premiums earned were $185.2 million and $176.6 million in 2009 and 2008, respectively, and gross premiums written were $179.6 million and $181.8 million in 2009 and 2008, respectively.
The Company markets its policies through approximately 4,800 independent agency locations in Arizona, Florida, Georgia, Nevada, New Mexico, South Carolina and Texas and one general agency in California that markets through approximately 900 insurance broker locations.
A one-for-five reverse stock split of the Company’s Common Stock, which was approved by shareholders in May of 2009, became effective in June of 2009. See “Capital Transactions - 2009 One-for-Five Reverse Split of Common Stock.” All share amounts for all periods presented have been retroactively adjusted for the one-for-five reverse stock split.
We believe the primary reasons for the decrease in gross premiums written between the comparable periods is the result of planned reductions of unprofitable segments in Florida and cancellation of some large agencies in Arizona. We believe product enhancements, rate adjustments and expanding marketing efforts in the Southeast and Southwest regions during the first six months of 2009 are the main reasons for the increase in net premiums earned in 2009 over 2008. The increase in the C & CAE ratio between the comparable periods was mentioned previously.
The Company believes it is pursuing a strategy that has the potential to build a competitively distinctive and successful franchise in the nonstandard personal auto business over time and is endeavoring to manage its investments and risks to achieve this result. These risks and other challenges are occurring in rapidly changing economic, financial, competitive, regulatory and claims environments. The Company’s operating and financial results vary from period to period as a result of numerous factors inherent in the insurance business, many of which are affected by such changes.
Agency revenues increased $538,000 (4%) in 2009 primarily as a result of the increase in writings in the first six months of 2009 over the first six months of 2008. Agency revenues are primarily fees charged on insureds’ premiums due, as discussed previously.
New business and the entry into new territories and product lines, associated with the Company’s growth beginning in 2005, has generally produced higher claims and greater uncertainty in determining reserves than more seasoned in-force business; see ITEM 1A. Risk Factors. The favorable development for prior accident years for nonstandard personal auto in 2009 is primarily the result of projected and actual decreases in severity associated with the physical damage lines. In 2008, the Company incurred several “extra-contractual” claims totaling $993,000 primarily related to prior accident years which contributed to the unfavorable development in 2008 (see ITEM 1A. Risk Factors - “Litigation may adversely affect our financial condition, results of operations and cash flows”).
Index to Financial Statements Policy acquisition costs include commissions, premium taxes, marketing expenses and the amortization of any premium deficiency. The expenses are charged to operations over the period in which the related premiums are earned. The increase of $612,000 (2%) in 2009 was primarily due to a decrease in premium deficiency amortization in 2009 from 2008. Commissions are paid to the independent agents based upon premium writings. The marketing expenses are primarily salaries of our territory managers who oversee the efforts of the agents within a geographical area and underwriting reports. Their time is focused on the supervision, relationship management and support of existing agents and recruiting new agents, as well as actively soliciting new business from these agents. Accordingly, these costs vary with and are primarily related to the acquisition of new and renewal insurance policies. The ratio of Policy acquisition costs to Net premiums earned was 16.4% and 16.8% for 2009 and 2008, respectively.
A one-for-five reverse split of the Company’s Common Stock was approved by shareholders in May of 2009 and became effective in June of 2009. Each five shares of the Company’s outstanding Common Stock, par value $0.10 per share were converted into one share of Common Stock, par value $0.10 per share, and the number of authorized shares of Common Stock was reduced proportionately.
As a result of the one-for-five reverse split of Common Stock in June 2009, the number of shares of Common Stock outstanding at December 31, 2008 was retroactively adjusted to 4,786,820. Treasury stock held at December 31, 2008 was retroactively adjusted to 252,729. At December 31, 2009 and 2008, Goff Moore Strategic Partners, LP owned approximately 34% of the outstanding Common Stock, Robert W. Stallings owned approximately 23% and James R. Reis owned approximately 12%.
Deferred tax assets are evaluated and a valuation allowance is established if it is more likely than not that all or a portion of the deferred tax assets will not be realized. See note 1(j) “Federal Income Taxes” in Notes to Consolidated Financial Statement appearing under Part 1. Financial Information - Item 1. “Financial Statements” of this Annual Report for further discussion.
The Company considers available evidence, both objective and subjective, including historical levels of income, expectations and risks associated with estimates of future taxable income in assessing the need for the valuation allowance.
The primary sources of the insurance subsidiary’s liquidity are funds generated from insurance premiums, net investment income and maturing investments. The short-term investments and cash are intended to provide adequate funds to pay claims without selling fixed maturity investments. At December 31, 2009, the insurance subsidiary held short-term investments and cash that the insurance subsidiary believes is at adequate liquidity for the payment of claims and other short-term commitments.
With regard to liquidity, the average duration of the investment portfolio is approximately 2.4 years. The fair value of the fixed maturity portfolio at December 31, 2009 was $317,000 below amortized cost, before taxes see note 2 and note 18 of Notes to Consolidated Financial Statements which appear in Item 8 of this Annual Report). Various insurance departments of states in which the Company operates require the deposit of funds to protect policyholders within those states. At December 31, 2009 and 2008, the balance on deposit for the benefit of such policyholders totaled $5,397,000 and $5,447,000, respectively.
Premiums receivable decreased primarily due to the decrease in premium writings for the six months ended December 31, 2009 from the six months ended December 31, 2008. This balance is comprised primarily of premiums due from insureds. Most of the policies are written with a down payment and monthly payment terms of up to four months on six month policies. The Company recorded an allowance for doubtful accounts of $1,084,000 and $1,029,000 as of December 31, 2009 and 2008, respectively, which it considers adequate. The increase in the allowance for doubtful accounts was due primarily to an increase in over thirty day receivables.
Reinsurance balances receivable decreased primarily as a result a decrease in ceded unpaid C & CAE under the reserve reinsurance cover agreement.
Ceded unpaid C & CAE increased primarily as a result of an increase in CAE reserves subject to the excess casualty and quota share reinsurance agreements on the runoff business. This balance represents unpaid C & CAE which have been ceded to reinsurers under the Company’s various reinsurance agreements, other than the reserve reinsurance cover agreement. These amounts are not currently due from the reinsurers but could become due in the future when the Company pays the claim and requests reimbursement from the reinsurers.
Property and equipment decreased primarily as a result of depreciation expense recorded in 2009.
Deferred Federal income taxes include temporary differences and the tax asset from net operating loss carryforwards less a valuation allowance that fully reserves these two items, see “Liquidity and Capital Resources - Net Operating Loss Carryforwards.” The decrease is primarily due to the decrease in unrealized losses on investments, excluding common stocks.
Unpaid C & CAE decreased slightly in 2009 from 2008. As of December 31, 2009, the Company had $72,545,000 in net unpaid C & CAE (Unpaid C & CAE of $75,368,000 less Ceded unpaid C & CAE of $2,823,000). This amount represents management’s best estimate of the ultimate liabilities. The significant operational changes we continue to make in the nonstandard personal auto claims adjustment process and changing claims trends increase the uncertainties which exist in the estimation process and could lead to inaccurate estimates of claim and claim adjustment expense.
Index to Financial Statements As of December 31, 2009 and 2008, in respect of its runoff lines, the Company had $3,115,000 and $7,118,000, respectively, in net unpaid C & CAE. Historically, the Company has experienced significant volatility in its reserve projections for its commercial lines. This volatility has been primarily attributable to its commercial automobile and general liability product lines. On February 7, 2002, the Company announced it had decided to discontinue writing commercial lines insurance due to continued adverse claims development and unprofitable results. The Company has been settling and reducing its remaining inventory of commercial claims. See “Business Operations-“Discontinuance of Commercial Lines.”
Cash overdraft increased primarily due to the higher level of claims paid in 2009 than in 2008.
Accumulated other comprehensive loss decreased as a result of an increase in the unrealized gains on investments, which is a result of improvements in the credit markets.
The Company’s statutory capital exceeds the benchmark capital level under the Risk Based Capital (“RBC”) formula for its insurance company. RBC is a method for establishing the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. As of December 31, 2009, the Company’s RBC authorized control level was $14,077,000 and the total adjusted capital was $96,112,000. This amounts to 6.8 times the minimum amount of RBC level as of December 31, 2009.
Investments are generally stated at fair value and are based on prices quoted in the most active market for each security, the fair value of comparable securities, discounted cash flow models or similar methods with changes in fair value recorded as a component of comprehensive income. The “specific identification” method is used to determine costs of investments sold. Provisions for possible credit losses are recorded only when the values have experienced impairment considered “other than temporary” by a charge to realized losses resulting in a new cost basis of the investment, while non-credit losses are recognized in accumulated other comprehensive income (loss). Our securities are issued by domestic entities and are backed either by collateral or the credit of the underlying issuer. Factors such as an economic downturn, disruptions in the credit markets, a regulatory change pertaining to the issuer’s industry, deterioration in the cash flows or the quality of assets of the issuer, or a change in the issuer’s marketplace may adversely affect our ability to collect principal and interest from the issuer. Both equity and fixed income securities have been affected over the past several years, and may be affected in the future, by significant external events. Credit rating downgrades, defaults, and impairments may result in write-downs in the value of the investment securities held by the Company. The Company regularly monitors its portfolio for pricing changes, which might indicate potential other than temporary impairments, and performs reviews of securities with unrealized losses. In such cases, changes in fair value are evaluated to determine the extent to which such changes are attributable to (i) fundamental factors specific to the issuer, such as financial conditions, business prospects or other factors, or (ii) market-related factors, such as interest rates. See Item 7A, “Quantitative and Qualitative Disclosures about Market Risk” for a discussion of variability of estimates.
For fixed maturity securities that are other-than-temporarily impaired, the Company assesses its intent to sell and the likelihood that we will be required to sell the security before recovery of its amortized cost. If a fixed maturity security is considered other-than-temporarily impaired, but the Company does not intend to and is not more than likely to be required to sell the security prior to its recovery to amortized cost, the amount of the impairment is separated into a credit loss component and the amount due to all other factors. The credit loss component of an impairment charge on a fixed maturity security is determined by the excess of the amortized cost over the present value of the expected cash flows. The present value is determined using the best estimate of cash flows discounted at (1) the effective interest rate implicit at the date of acquisition for non-structured securities or (2) the book yield for structured securities. The techniques and assumptions for determining the best estimate of cash flows varies depending on the type of security. The credit loss component of an impairment charge is recognized in net earnings while the non-credit component is recognized in accumulated other comprehensive income (loss).
The Company receives pricing from independent pricing services, and these are compared to prices available from sources accessed through the Bloomberg Professional System. The number of available quotes varies depending on the security, generally we obtain one quote for Level 1 investments, one to three quotes for Level 2 investments and one to two quotes, if available, for Level 3 investments. If there is a material difference in the prices obtained, further evaluation is made. Market prices and valuations from sources such as the Bloomberg system, TRACE and dealer offerings are used as a check on the prices obtained from the independent pricing services. Should a material difference exist, then an internal valuation is made. For purposes of valuing these securities management produces expected cash flows for the security utilizing the standard mortgage security modeling capabilities available on the Bloomberg Professional System. The key inputs are the default rate, severity of default, and voluntary prepayment rate for the underlying mortgage collateral. These are generally based at the start on the actual historical values of these parameters for the prior three months. These cash flows are then discounted by a required yield derived from market based observations of broker inventory offerings, or in some cases Bloomberg Indices of like securities. Management uses this valuation model primarily with mortgage backed securities where the matrix pricing methodology used by the independent pricing service is too broad in its categorizations. This often involves differences in reasonable prepayment assumptions or significant differences in performance among issuers. In some cases, other external observable inputs such as credit default swap levels are used as input in the fair value analysis.
Index to Financial Statements The Company uses the following hierarchy for each instrument in total invested assets:
Goodwill represents the excess of purchase price over fair value of net assets acquired. The goodwill recorded is related to the 1998 acquisition of the Lalande Group. In accordance with ASC 350-10-65, goodwill is not amortized but rather is subject to an annual impairment test, or earlier if certain factors are present, based on its estimated fair value. Therefore, impairment losses could be recorded in future periods. The Company conducts on at least an annual basis a review of its reporting units’ assets and liabilities to determine whether goodwill is impaired. The goodwill impairment test is a two-step test. Under the first step, fair value of the reporting unit is compared with its carrying value (including goodwill). If the fair value of the reporting unit is less than its carrying value, an indication of goodwill impairment exists for the reporting unit and the enterprise must perform step two of the impairment test. Under step two, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of the goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. Fair value of the reporting unit is determined using a variety of methods, including a discounted cash flow analysis. If the fair value of the reporting unit exceeds its carrying value, step two does not need to be performed. GAN performed this test as of December 31, 2009 and 2008. The test results indicated that there was no impairment loss at December 31, 2009 or 2008.
Index to Financial Statements The process of establishing claims reserves is imprecise and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. The actual emergence of claims and claim adjustment expenses may vary, perhaps materially, from the Company’s estimates thereof, because (a) estimates of liabilities are subject to large potential revisions, as the ultimate disposition of claims incurred prior to the financial statement date, whether reported or not, is subject to the outcome of events that have not yet occurred (e.g., jury decisions, court interpretations, legislative changes (even after coverage is written and reserves are initially set) that broaden liability and policy definitions and increase the severity of claims obligations, changes in the medical condition of claimants, public attitudes and social/economic conditions such as inflation), (b) estimates of claims do not make provision for extraordinary future emergence of new classes of claims or types of claims not sufficiently represented in the Company’s historical data base or which are not yet quantifiable, and (c) estimates of future costs are subject to the inherent limitation on the ability to predict the aggregate results of future events.
We may not have historical results for new markets, or the historic development of reserves for claim and claim adjustment expense may not accurately reflect future trends. For example, these estimates are subject to:
new classes or types of losses not sufficiently represented in historical data or not discernible from the data available to us; and
We rely on several key assumptions regarding the existence of consistency or a discernible trend in the following factors:
Index to Financial Statements The key assumptions identified above are in turn based on additional underlying assumptions regarding numerous internal and external factors, which often vary for different states, programs and coverage groups, for different accident periods and for different actuarial estimation methodologies. Internal factors include, but are not limited to, the experience level of our claims department personnel, changes in claims department processes, and changes in underwriting standards and rules. External factors include, but are not limited to, claim severity, claim frequency, inflation in costs to repair or replace damaged property, inflation in the cost of medical services, legislative activities, regulatory changes, judicial changes, and litigation trends.
When we reviewed claims data to make estimates for 2008, the following variances were found. Based on the analysis of these variances, we made adjustments described below:
During our review of data for 2008, we continued to notice that the average case reserve per claimant in bodily injury coverages had increased. We attempted to take the increase in case reserves into consideration by selection of loss development factors and use of actuarial judgment.
Index to Financial Statements When we reviewed claims data to make estimates for 2009, some of the same variances were found. Based on the analysis of these variances, we made the following adjustments:
For our runoff lines, the remaining number of claims has declined to the point that conventional actuarial methods are of less utility than during the period in which the number of active claims provided more complete statistical data. Accordingly, during 2009 we ceased using conventional actuarial methods in our estimates for runoff claims and relied exclusively on evaluations of individual claim files. This methodology is not used for our personal lines business.
In both personal lines and commercial runoff business, we utilize the same procedures for estimating reserves on a quarterly basis as we do annually. Historically, the independent actuarial consulting firm that we retained had the responsibility for making the reserve estimate used in our financial statements. However, we changed our procedures beginning with the financial statements for the third quarter of 2007 and subsequent quarterly and annual periods. In our revised procedures, the reserve estimates are made for each period by our in-house actuarial staff, and we do not rely upon the review by the independent actuarial firm to estimate the amount of our GAAP reserves. However, an actuarial consulting firm provides analysis to management as requested.
The actuarial procedures we follow are described in detail below. The reserve estimates are developed based on review and analysis of accident quarter data. Once the reserve levels have been estimated, management makes appropriate entries.
Commercial auto - most states in which we wrote policies have two-year statutes of limitation. Because we ceased writing new business in 2002, no new claims are expected to be incurred.
Development patterns in the personal auto business are somewhat unique by state, since each state has varying policy limits, laws establishing liability, and litigation environments. Development patterns also vary by line of coverage, as liability claims traditionally take longer to settle than physical damage claims.
Unpaid claims department expenses are estimated using a cost per claim approach. Under this approach historical paid claims department expense data are divided by the historical number of claim activity transactions. It is assumed that the expense associated with settling a liability claim is twice that of settling a physical damage claim, since liability claims are typically more complex. It is also assumed that there are two activities creating expenses associated with pure IBNR claims - the cost to open the claim and the cost to settle and close the claim, while only one activity is associated with claims already open - the cost to settle and close the claim. The cost per activity is multiplied by the total estimated future activities to arrive at an estimate of future claims department expense for all claims that have occurred prior to the evaluation date.
We believe it is reasonably likely that our loss costs could increase or decrease by 2% from current estimates, as remaining claims are recorded and resolved. Loss costs reflect the incurred loss per unit of exposure and are the product of frequency and severity. A 2% increase or decrease in our loss costs would result in unfavorable or favorable development of $10.6 million (assuming the size of the Company remains constant). This estimate of sensitivity is informational only, is not a projection of future results and does not take into account possible effects of extraordinary litigation events (such as class action claims).
The Company has evaluated tax contingencies in accordance with ASC 740-10-65, Income Taxes - Overall - Transition and Open Effective Date Information. At December 31, 2009 and 2008, the Company does not have any significant uncertain tax positions.
Index to Financial Statements Effective April 1, 2009, we adopted ASC 855-10, Subsequent Events - Overall (“ASC 855-10”), which sets forth general standards of accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The adoption of ASC 855-10 did not have a material impact on our condensed consolidated financial condition or results of operations. On February 24, 2010, the FASB issued Accounting Standards Update (“ASU”) 2010-09, Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements (“ASU 2010-09”). The amendments in ASU 2010-09 remove the requirement in ASC 855-10 for a SEC filer to disclose a date through which subsequent events have been evaluated in both issued and revised financial statements.
Consolidated Statements of Operations for the Years Ended December 31, 2009 and 2008