The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions when applying our accounting policies. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. Our critical accounting policies are described below. For a detailed discussion on the application of these and other accounting policies, see note 2 of Notes to Consolidated Financial Statements which appears in Item 8 of this Annual Report.
Reserving for unpaid losses and loss adjustment expenses. On a quarterly basis at the end of each financial reporting period, we record our 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 that occurred through the current financial statement date, as well as the amount we expect to expend for all claim settlement expenses. The overall reserve for losses and loss adjustment expenses estimate that we record is the difference between (1) our point estimate of the ultimate loss and ultimate loss adjustment expenses, and (2) the amount of losses and loss adjustment expenses paid through the current financial statement date. Our point estimate of ultimate loss consists of a point estimate for incurred but not reported (IBNR) losses and case reserves. The point estimate of ultimate loss adjustment expenses consists of a separate point estimate for adjusting and other expenses and for defense and cost containment expenses.
Paid Bornhuetter/Ferguson - We use a combination of paid development methods and expected loss and loss adjustment expense methods. Expected loss ratio methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss and loss adjustment expense ratios are typically developed based upon the information used in pricing and are multiplied by the total amount of premiums earned to calculate ultimate loss and loss adjustment expense which is then proportionately added to the actual paid to date.
Incurred Bornhuetter/Ferguson - We use a combination of incurred development methods and expected loss adjustment expense methods. Expected loss ratio methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss and loss adjustment expense ratios are typically developed based upon the information used in pricing and are multiplied by the total amount of premiums earned to calculate ultimate loss and loss adjustment expense which is then proportionately added to the actual incurred to date.
There can be no assurance that actual future loss and LAE development variability will be consistent with any potential variation indicated by our historical loss and LAE development experience. It is expected that the final outcome for the accident years will lie within the range of estimates and should be centered around the selected value if normal development comes to pass.
At December 31, 2011, our receivables from reinsurers included $10.1 million net recoverable (net of $2.9 million payable) from VFIC. At December 31, 2011, the VFIC Trust held $16.8 million to collateralize the $10.1 million net recoverable from VFIC. We have, with the approval of the VFIC Special Deputy Receiver and the District Court, Austin, Texas, withdrawn $8.7 million through December 31, 2011 from the trust securing our reinsurance recoverables from VFIC, which represented 100% of the amount we paid in losses as of the date of the withdrawal covered by the VFIC reinsurance. We have made arrangements with the VFIC Special Deputy Receiver to submit quarterly statements for approval to withdraw additional funds from the trust based upon losses paid.
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-sale investment securities were considered temporary in nature as of December 31, 2011 and 2010, respectively. Accordingly, unrealized losses are recorded in other comprehensive income on our consolidated balance sheet.
Valuation of goodwill and other intangible assets. We evaluate goodwill for impairment annually as of September 30, or more frequently if events or circumstances indicate that the carrying value may not be recoverable. We report under a single reporting segment and, as such, the goodwill analysis is measured at the consolidated company level. Consistent with prior assessments, the fair value of the Company was determined using an internally developed discounted cash flow methodology and other relevant indicators of value available in the market place such as market transactions and trading values of similar companies. Management considered its market capitalization in relation to its book value and believes that our market capitalization is not representative of the long-term value of the Company. In arriving at this conclusion, management considered the limited daily trading volume of the Company’s stock, lack of liquidity in our Company’s stock and the impact on our Company’s stock from being a controlled company.
ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment, permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. Additionally, if the carrying amount of a reporting unit is zero or negative, the second step of the impairment test shall be performed to measure the amount of the impairment loss, if any, when it is more likely than not that a goodwill impairment exists. In considering whether it is more likely than not that a goodwill impairment exists, a qualitative assessment will be performed. If an entity concludes it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it need not perform the two-step impairment test. This standard is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. We do not expect the adoption of this standard to have a material impact on our consolidated financial position, results of operations or cash flows.
ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, will require companies to present the components of net income and comprehensive income in either one or two consecutive financial statements. Companies will no longer be permitted to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. This standard is effective for interim and annual periods beginning after December 15, 2011, and should be applied retrospectively. The adoption of this standard will not impact our consolidated financial position, results of operations or cash flows.
ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, provides identical guidance with concurrently issued international financial reporting standard (IFRS) 13, Fair Value Measurements. Most of the changes in the new standard are clarifications of existing guidance, but it expands the disclosures about fair value measurements, and will require the categorization by level of the fair value hierarchy for items that are not measured at fair value in the statement of financial position, but for which the fair value is required to be disclosed, which would consist of our debt. In addition, for fair value measurements categorized as Level 3 within the fair value hierarchy, the valuation processes and sensitivity of the fair value measurements to changes in unobservable inputs shall be disclosed. This standard is effective for interim and annual periods beginning after December 15, 2011, and should be applied prospectively. Early adoption is not permitted. The adoption of this standard will not impact our consolidated financial position, results of operations or cash flows.
ASU 2010-26, Financial Services-Insurance (Topic 944), modifies the types of costs incurred by insurance entities that can be capitalized in the acquisition of new and renewal insurance contracts. The Task Force reached a final Consensus that requires costs to be incremental or directly related to the successful acquisition of new or renewal contracts to be capitalized as a deferred acquisition cost. This standard is effective for interim and annual periods beginning after December 15, 2011 and may be early adopted as of the beginning of an annual reporting period using either the prospective or retrospective method. The Company will adopt this guidance on January 1, 2012 using retrospective application. Upon adoption, a cumulative effect adjustment will be recorded, based on amounts that would have been recognized if this guidance had been applied from the beginning of 2010. As a result of retrospective adoption of this standard, the Company will write off against the retained deficit previously deferred acquisition costs of $13.3 million, net of tax, as of January 1, 2010. If the Company had been under the new guidance from the beginning of 2010, selling, general and administrative expenses would have been lower by $1.6 million for 2011 and $2.0 million for 2010, on a pretax basis, and deferred acquisition costs, net of ceding commission, as of December 31, 2011 would have been lower by $9.7 million.
ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses (Topic 310), an amended guidance for disclosures about the credit quality of financing receivables and the allowance for credit losses. This update amends existing guidance by requiring more robust and disaggregated disclosures by an entity about the credit quality of its financing receivables and its allowance for credit losses. These disclosures will provide additional information about the nature of credit risks inherent in a company’s financing receivables, how a company analyzes and assesses credit risk in determining its allowance for credit losses, and the reasons for any changes a company may make in its allowance for credit losses. This update was effective for interim and annual reporting periods ending on or after December 15, 2010. The adoption of the new guidance had no effect on the Company’s consolidated financial position, results of operations or cash flows as the requirements are disclosure only.
ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820), requires additional disclosures about fair value measurements, including transfers in and out of Levels 1 and 2 and activity in Level 3 on a gross basis, and clarifies certain other existing disclosure requirements including level of disaggregation and disclosures around inputs and valuation techniques. The provisions of the new standard were effective for interim or annual reporting periods beginning after December 15, 2009, except for the additional Level 3 disclosures which became effective for fiscal years beginning after December 15, 2010. This standard is disclosure-only in nature and does not change accounting requirements. Accordingly, adoption of the new standard had no impact on the Company’s consolidated financial position, results of operations or cash flows.
Our policies produced by our retail agencies decreased $26.1 million, or 14.1%, compared with 2010 primarily due to the pricing and underwriting actions. Third-party policies for 2011 increased $6.1 million, or 12.6%, compared with 2010. The overall net reduction in premium volume produced by our retail agencies in 2010 is primarily due to the shift in policies sold to shorter periods of coverage. Gross premiums written in our retail distribution channel for 2010 decreased $21.7 million, or 10.5%, when compared with 2009. This decrease was due to more of our retail customers choosing third-party products.
In our independent agency distribution channel, gross premiums written for 2011 decreased $92.9 million, or 62.4%, compared with 2010. The decrease was primarily due to the suspension of new business production from unprofitable independent agent relationships, which included our withdrawal from the Michigan market, as well as our pricing and underwriting actions. Gross premiums written for 2010 increased $12.7 million, or 9.3%, compared with 2009. The increase was due to an initiative to target the expansion of certain independent agent relationships, which was primarily in Michigan.
Gross premiums written by our unaffiliated underwriting agencies for 2011 decreased $5.7 million, or 27.6%, compared with 2010. Gross premiums written by our unaffiliated underwriting agencies in 2010 decreased $4.9 million, or 19.3%, compared with 2009. This decline was primarily due to a decision to reduce the writings of one of the agencies.
The following table sets forth net premiums earned by distribution channel (in thousands):
The largest component of revenue is net premiums earned on insurance policies. Total net premiums earned for 2011 decreased $156.7 million, or 47.0%, compared with 2010. The decrease was primarily due to the decline in gross written premium and the effects of reinsurance purchased for the fourth quarter of 2010 and year ended December 31, 2011.
Since insurance premiums are earned over the service period of the policies, the revenue in the current period includes premiums earned on insurance products written through our three distribution channels in both current and previous periods. Net premiums earned during 2011 on policies sold through our affiliated underwriting agencies (including retail and independent agencies) decreased by $147.8 million, or 47.2%, compared with 2010. Net premiums earned during 2011 on insurance products sold through the unaffiliated underwriting agencies distribution channel decreased by $9.0 million, or 44.4%, compared with 2010.
Net premiums earned for 2010 decreased $32.1 million, or 8.8%, compared with 2009. This decrease was primarily due to the overall reduction in gross premium volumes and the effect of a quota-share reinsurance agreement put in place during the fourth quarter of 2010. Net premiums earned during 2010 on policies sold through our affiliated underwriting agencies (including retail and independent agencies) decreased by $26.9 million, or 7.9% compared with 2009. Net premiums earned during 2010 on insurance products sold through the unaffiliated underwriting agencies distribution channel decreased by $5.3 million, or 20.8%, compared with 2009.
Effective October 1, 2010, we entered into a quota-share reinsurance agreement with a third-party reinsurance company ceding 40% of premiums and losses on policies in-force in all states other than Michigan on October 1, 2010 and policies written through December 31, 2010 on a run-off basis. Written premiums ceded under this agreement totaled $60.8 million through December 31, 2011.
A quota-share reinsurance agreement was put in place effective January 1, 2011 ceding 28% of gross written premium in all states other than Michigan through December 31, 2011. Our quota-share ceding commission rate structure for both quota-share agreements varies based on loss experience for both agreements. Written premiums ceded under this agreement totaled $66.7 million during 2011.
The amount of recoveries pertaining to reinsurance contracts that were deducted from losses and loss adjustment expenses incurred during 2011, 2010 and 2009 was approximately $40.6 million, $75.2 million and $7.1 million, respectively. The amount of loss reserves and unearned premium we would remain liable for in the event our reinsurers are unable to meet their obligations was as follows (in thousands):
The following table summarizes the ceded incurred losses and loss adjustment expenses (consisting of ceded paid losses and loss adjustment expenses and change in reserves for loss and loss adjustment expenses ceded) to various reinsurers (in thousands):
The following sets forth the components of consolidated commission income and fees earned for the years ended December 31, 2011, 2010 and 2009 (in thousands):
customers. Commissions and fees have increased due to the increase in third-party policies sold and the expansion of ancillary product offerings in all of our retail stores.
At December 31, 2011, our fixed-income investments were invested in the following: corporate debt securities 50.1%; FDIC-insured certificates of deposit 17.2%; states and political subdivisions securities 14.0%; U.S. Treasury and government agencies securities 9.8%; and mortgage-backed securities 8.9%. The average quality of our portfolio was A+ at December 31, 2011. 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, 2011, the effective duration of our fixed-income investment portfolio was 1.8 years.
For the year ended December 31, 2011, other income included $0.2 million for a business interruption insurance settlement related to Hurricane Gustav.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses for 2011 decreased $175.0 million, or 56.0%, compared with 2010. Losses and loss adjustment expenses for 2010 increased $24.5 million, or 8.5%, compared with 2009.
The gross cumulative redundancy in 2010 was primarily due to a reduction of Michigan case reserves for 2010 due to revised estimates of losses. The gross cumulative deficiency in 2009 increased as a result of revised case reserves on our Michigan business due to increased estimates of ultimate losses.
As a result of the 100% quota-share reinsurance contract with VFIC, all losses and loss adjustment expense reserves of our insurance companies as of December 31, 2003 were reinsured by VFIC.
Amortization of deferred policy acquisition costs is a major component of SG&A expenses. The following table sets forth the impact that amortization of deferred acquisition costs had on SG&A expenses and the change in deferred acquisition costs (in thousands):
Additions to deferred acquisition costs in 2011 decreased by $35.7 million and additions to the related amortization decreased by $39.7 million compared with 2010. The decrease in additions is primarily due to a decline in gross written premium and an increase in ceded deferred policy acquisition expenses. The decrease in amortization is due to a decline in net written premium and lower policy acquisition expenses.
Net expenses, defined as the sum of selling, general and administrative expenses and depreciation and amortization less commission income and fees, as a percentage of net premiums earned (the net expense ratio) increased to 30.7% in 2011 compared with 27.9% in 2010. The increase was primarily due to a 47.0% decrease in net premiums earned and a 32.7% decrease in SG&A expenses, which were partially offset by an 18.7%
Depreciation and Amortization. Depreciation and amortization expenses for 2011 were comparable to 2010.
Depreciation and amortization expenses for 2010 increased $0.1 million, or 1.6%, compared with 2009.
Sources and uses of funds. We are a holding company with no business operations of our own. Consequently, our ability to pay dividends to stockholders, meet our debt payment obligations and pay our taxes and administrative expenses is largely dependent on dividends or other distributions from our subsidiaries.
There are no restrictions on the payment of dividends by our non-insurance company subsidiaries other than state corporate laws regarding solvency. As a result, our non-insurance company subsidiaries generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends and we have and expect to continue to use those revenues to service our corporate financial obligations, such as debt service and stockholder dividends. As of December 31, 2011, we had $0.1 million of cash and cash equivalents at the holding company level and $5.4 million of cash and cash equivalents at our non-insurance company subsidiaries.
The National Association of Insurance Commissioners’ model law for risk-based capital provides formulas to determine the amount of capital that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2011, each of our insurance subsidiaries maintained a risk-based capital level that was in excess of an amount that would require any corrective actions.
Senior secured credit facility. In 2007, we entered into a $220.0 million senior secured credit facility (the facility) provided by a syndicate of lenders, that provide for a $200.0 million senior term loan facility and a revolving facility of up to $20.0 million, depending on our borrowing capacity. The principal amount of the term loan is payable in quarterly installments, with the remaining balance due January 31, 2014. Beginning in 2008, we were also required to make additional annual principal payments that are calculated based upon our financial performance during the preceding fiscal year. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments. During 2011, we made $9.8 million in principal payments. The revolving portion of the facility expired in January 2010.
At every quarter end, we will make a payment to the lenders equal to the excess of cash at the non-regulated entities of $12 million at December 31 and March 31 and $10 million at June 30 and September 30.
In addition, we paid a 0.25% fee to all lenders that approved the amendment.
(2) In May 2010, we entered into a capital lease obligation related to certain computer software, software licenses, and hardware currently used by and on the books of Affirmative Insurance Company and received cash from the financing in the amount of $28.2 million.
convenience by us at any time upon six month’s notice after the first two years, subject to the payment of certain stranded costs and other termination fees. These amounts represent our minimum future IT outsourcing commitments.
We have audited the accompanying consolidated balance sheets of Affirmative Insurance Holdings, Inc. and subsidiaries (the Company) as of December 31, 2011 and 2010, and the related consolidated statements of income (loss), stockholders’ equity (deficit), comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2011. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
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, 2011 and 2010, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Affirmative Insurance Holdings, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 30, 2012 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
We have audited Affirmative Insurance Holdings, Inc. and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying section of Item 9A. titled Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Affirmative Insurance Holdings, Inc and subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of income (loss), stockholders’ equity (deficit), comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2011, and our report dated March 30, 2012 expressed an unqualified opinion on those consolidated financial statements.
Affirmative Insurance Holdings, Inc. (the Company), formerly known as Instant Insurance Holdings, Inc., was incorporated in Delaware in June 1998. The Company is a distributor and producer of non-standard personal automobile insurance policies and related products and services for individual consumers in targeted geographic areas. The Company currently offers insurance directly to individual consumers through retail stores in 9 states (Louisiana, Texas, Illinois, Alabama, Missouri, Indiana, South Carolina, Kansas and Wisconsin) as well as through 5,000 independent agents or brokers in 8 states (Louisiana, Texas, Illinois, Alabama, California, Missouri, Indiana and South Carolina).
Basis of Presentation • The consolidated financial statements include the accounts of Affirmative Insurance Holdings, Inc. and its subsidiaries (together the Company), and have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). All material intercompany transactions and balances have been eliminated in consolidation.
Certain prior year amounts have been reclassified to conform to the current presentation.
Fiduciary and Restricted Cash • In the Company’s capacity as an insurance agency, it collects premiums from customers and, after deducting authorized commissions, remits these premiums to the appropriate insurance companies. Unremitted insurance premiums are held in a fiduciary capacity until disbursed to third parties or to the Company’s consolidated insurance subsidiaries. In certain states where the Company operates, the use of investment alternatives for these funds is regulated by various state agencies. The Company invests these unremitted funds only in cash and money market accounts and reports such amounts as restricted cash on the consolidated balance sheet. The Company reports the unremitted portion of these funds as amounts due to reinsurers on the consolidated balance sheet. Interest income earned on these unremitted funds is reported as investment income in the consolidated statement of income (loss).
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, the 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. The Company also considers potential adverse conditions related to the financial health of the issuer based on rating agency actions.
Deferred Acquisition Costs, net of ceding commission • Deferred acquisition costs represent the deferral of expenses that the Company incurs to acquire new business or renew existing insurance policies. Acquisition costs, consisting primarily of commissions, advertising, premium taxes, underwriting and agency expenses, are deferred and charged against income ratably over the terms of the related policies. The Company regularly reviews the categories of acquisition costs that are deferred and assesses the recoverability of this asset. A premium deficiency, and a corresponding charge to income, is recognized if the sum of the expected losses and loss adjustment expenses, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums and anticipated investment income. Amounts received as ceding commissions on reinsurance contracts are recorded as reductions of deferred acquisition costs and are recognized into income ratably as the related ceded premium is earned. Amortization of deferred policy acquisition costs is recorded in SG&A expenses in the consolidated statements of income (loss).
Affirmative Insurance Holdings Statutory Trust II (“Trust II”), is an unconsolidated trust subsidiary, for the sole purpose of issuing $25.0 million trust preferred securities in 2005. Trust II used the proceeds from the sale of these securities and the Company’s initial capital contribution to purchase $25.8 million of subordinated debt securities from the Company. The debt securities are the sole assets of Trust II, and the payments under the debt securities are the sole revenues of Trust II.
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
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.
Statutory accounting practices • The Company’s insurance subsidiaries are required to report results of operations and financial position to insurance regulatory authorities based upon statutory accounting principles (SAP). The more significant differences between SAP and GAAP are as follows:
Recently Issued Accounting Standards • ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment, permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. Additionally, if the carrying amount of a reporting unit is zero or negative, the second step of the
ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, will require companies to present the components of net income and comprehensive income in either one or two consecutive financial statements. Companies will no longer be permitted to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. This standard is effective for interim and annual periods beginning after December 15, 2011, and should be applied retrospectively. The adoption of this standard will not impact the Company’s consolidated financial position, results of operations or cash flows.
ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, provides identical guidance with concurrently issued international financial reporting standard (IFRS) 13, Fair Value Measurements. Most of the changes in the new standard are clarifications of existing guidance, but it expands the disclosures about fair value measurements, and will require the categorization by level of the fair value hierarchy for items that are not measured at fair value in the statement of financial position, but for which the fair value is required to be disclosed, which would consist of the Company’s debt. In addition, for fair value measurements categorized as Level 3 within the fair value hierarchy, the valuation processes and sensitivity of the fair value measurements to changes in unobservable inputs shall be disclosed. This standard is effective for interim and annual periods beginning after December 15, 2011, and should be applied prospectively. Early adoption is not permitted. The adoption of this standard will not impact the Company’s consolidated financial position, results of operations or cash flows.
ASU 2010-26, Financial Services-Insurance (Topic 944), modifies the types of costs incurred by insurance entities that can be capitalized in the acquisition of new and renewal insurance contracts. The Task Force reached a final Consensus that requires costs to be incremental or directly related to the successful acquisition of new or renewal contracts to be capitalized as a deferred acquisition cost. This standard is effective for interim and annual periods beginning after December 15, 2011 and may be early adopted as of the beginning of an annual reporting period using either the prospective or retrospective method. The Company will adopt this guidance on January 1, 2012 using retrospective application. Upon adoption, a cumulative effect adjustment will be recorded, based on amounts that would have been recognized if this guidance had been applied from the beginning of fiscal year 2010. As a result of retrospective adoption of this standard, the Company will write off against the retained deficit previously deferred acquisition costs of $13.3 million, net of tax, as of January 1, 2010. If the Company had been under the new guidance from the beginning of 2010, selling, general and administrative expenses would have been lower by $1.6 million for 2011 and $2.0 million for 2010, on a pretax basis, and deferred acquisition costs, net of ceding commission, as of December 31, 2011 would have been lower by $9.7 million.
ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses (Topic 310), an amended guidance for disclosures about the credit quality of financing receivables and the allowance for credit losses. This update amends existing guidance by requiring more robust and disaggregated disclosures by an entity about the credit quality of its financing receivables and its allowance for credit losses. These disclosures will provide additional information about the nature of credit risks inherent in a company’s financing receivables, how a company analyzes and assesses credit risk in determining its allowance for credit losses, and the reasons for any changes a company may make in its allowance for credit losses. This update was
effective for interim and annual reporting periods ending on or after December 15, 2010. The adoption of the new guidance had no effect on the Company’s consolidated financial position, results of operations or cash flows as the requirements are disclosure only.
The Company’s available-for-sale investment securities are carried at fair value with unrealized gains and losses, net of income taxes, reported in accumulated other comprehensive income (loss), a separate component of stockholders’ equity (deficit). Gains and losses realized on the disposition of investment securities are determined on the specific-identification basis and credited or charged to income.
Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. The Company’s amortized cost and estimated fair values of fixed-income securities at December 31, 2011 by contractual maturity were as follows (in thousands):
The Company’s portfolio contained approximately 34 and 64 individual investment securities that were in an unrealized loss position as of December 31, 2011 and 2010, respectively.
The unrealized losses at December 31, 2011 and 2010 were 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, the 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. The Company also considers potential adverse conditions related to the financial health of the issuer based on rating agency actions. At December 31, 2011 and 2010, management performed its quarterly analysis of all securities with an unrealized loss and concluded no individual securities were 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. In addition, the Company assumes reinsurance from other insurance companies.
In 2011, the Company entered into an additional 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 $22.9 million during 2011.
In June 2011, the Company entered into a one-year reinsurance agreement with third-party reinsurers which provides $7.0 million in excess of the first $3.0 million of losses coverage for catastrophic events that may involve multiple insured losses.
Under certain of the Company’s reinsurance transactions, the Company has received ceding commissions. The ceding commission rate structure varies based on loss experience. The estimates of loss experience are continually reviewed and adjusted, and the resulting adjustments to ceding commissions are reflected in current operations. Ceding commissions recognized, reflected as a (reduction) increase of selling, general and administrative expenses follows (in thousands):
Effective January 1, 2009, the Company terminated its quota-share reinsurance contract on a cut-off basis and received $10.5 million of returned unearned premiums, net of $2.6 million returned ceding commissions.
The Company assumes reinsurance from a Texas county mutual insurance company (the county mutual) whereby the Company has assumed 100% of the policies issued by the county mutual for business produced by the Company’s owned general agents. The county mutual does not retain any of this business and there are no loss limits other than the underlying policy limits. AIC has established a trust to secure the Company’s obligation under this reinsurance contract with a balance of $34.4 million and $52.0 million as of December 31, 2011 and 2010, respectively.
Premium finance receivables (related to policies of both the Company and third-party carriers) were as follows at December 31, 2011 and 2010 (in thousands):
Premium finance receivables are secured by the underlying unearned policy premiums for which the Company obtains assignment from the policyholder in the event of non-payment. When a payment becomes past due, the Company cancels the underlying policy with the insurance carrier and receives the unearned premium to clear unpaid principal and interest. The loan is closed by writing off any uncollected amounts or refunding any overpayment to the customer. An insignificant amount of finance receivables are past due in excess of thirty days. Losses due to non-realization of premium finance receivables were $0.6 million and 0.4% of total premiums financed for 2011, $0.7 million and 0.4% of total premiums financed for 2010 and $0.8 million and 0.5% of total premiums financed for 2009.
Amortization of deferred policy acquisition costs was $76.3 million for 2009. At December 31, 2010, the Company determined a premium deficiency existed and recorded a $0.5 million reduction of deferred acquisition costs.
The Company completed its annual goodwill and indefinite lived intangible asset impairment analysis as of September 30, 2011. The Company reports under a single reporting segment and, as such, the goodwill analysis is measured at the consolidated company level. Consistent with prior assessments, the fair value of the Company was determined using an internally developed discounted cash flow methodology and other relevant indicators of value available in the market place such as market transactions and trading values of similar companies. Based upon the results of the assessment, the Company concluded that the carrying values of goodwill and other intangible assets were not impaired as of September 30, 2011. Due to prior period adverse loss development on the Company’s Michigan business recorded in the fourth quarter of 2011 and recent negative premium production trends, the Company revised its five-year forecast and updated its discounted cash flow model to assess the recoverability of recorded goodwill at December 31, 2011. A discount rate of 14.5% was used at December 31, 2011, which the Company believes remained an appropriate risk-adjusted discount rate based on its overall cost of capital. Based on this updated analysis, the Company concluded that the carrying amount of goodwill was not recoverable. 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. The resulting implied fair value was compared to the carrying value of goodwill with the excess carrying value resulting in an impairment. The step two analysis resulted in the recognition of a non-cash, pretax goodwill impairment charge of $140.1 million.
Other intangible assets at December 31, 2011 and 2010 were as follows (in thousands):
In 2011, the percentage of calendar year losses and loss adjustment expense to net premiums earned (the loss ratio) was 78.0% compared with 93.8% in 2010. The accident year loss ratio for 2011 decreased 13.7 points compared with the current 2010 accident year loss ratio of 88.8%. The decline in the loss ratio for 2011 compared with the 2010 accident year was due to the pricing and underwriting actions that were taken as well as additional process changes implemented in the handling of claims to mitigate the significant increases in severity that occurred due to the claims initiatives. Also, there was $10.1 million of unfavorable prior period development primarily related to our Michigan business and $5.0 million of favorable prior period development in 2011 due to Vesta-related reserves, compared with 2010’s adverse loss development of $28.0 million primarily related to our 2009 Texas and Michigan business. The accident year decline was even more significant when the impact of the quota-share treaties that were entered into for the fourth quarter of 2010 and for all of 2011 are taken into account. As such, the quota-share treaties’ impact on the calendar year loss ratio was to increase it by 3.1 points for 2011 and 1.7 points for 2010. We ceased writing new business in Michigan in March 2011 and renewal business in June 2011.
In 2010, the increase in the accident year loss ratio was due to increased losses on the Texas and Michigan businesses as well as significantly increased severity, which was primarily due to the claims transformation project that began in the third quarter of 2009. Significant pricing and underwriting actions were taken to address Texas and Michigan profitability in 2010 and in 2011. Also, additional controls were instituted in the handling of claims to mitigate the significant increases in severity that occurred.
In 2009, adverse development on reserve estimates for prior accident years was $14.8 million. This was primarily due to the Florida business due to a decision to promote the Company’s full coverage product, which had inadequate pricing and product management. The Company ceased writing business in Florida in May 2010.
The Company’s long-term debt instruments and balances outstanding at December 31, 2011 and 2010 were as follows (in thousands):
In March 2011, the Company entered into an amendment to the facility. The amendment included the following significant items:
The quarterly requirements for the interest coverage ratio covenant calculation were changed for the first two quarters of 2011.
The quarterly requirements for the loss ratio covenant calculation were changed from December 31, 2010 through March 31, 2012.
The Company has the option to capitalize interest that is in excess of the prior payment terms to the loan balance.
In accordance with ASC 470-50 Debt Modifications and Extinguishments, the Company evaluated the present value of the cash flows under the terms of the amended credit agreement to determine if they were at least 10 percent different from the present value of the remaining cash flows under the terms of the existing credit agreement. It was determined that the terms were not substantially different and therefore should not be accounted for as a debt extinguishment. Accordingly, lender consent fees of approximately $0.3 million were capitalized and will be amortized, along with remaining unamortized debt issuance costs from the March 2009 debt modification, over the remaining term of the senior secured credit facility. Fees paid to other parties of approximately $0.7 million were expensed as incurred in 2011.
The consolidated net worth covenant calculation was changed to a covenant that excludes goodwill and includes subordinated debt;
A sale and leaseback transaction of capitalized technology assets is allowed for up to $30.0 million;
requirements, minimum risk-based capital requirements, maximum loss ratio limitations, minimum fixed charge coverage ratios and a minimum consolidated net worth requirement, as well as other restrictive covenants. As time passes, certain of the financial covenants become increasingly more restrictive.
Property under capital lease consisted of the following as of December 31, 2011 and 2010 (in thousands):
Tax effects of temporary differences that give rise to significant portions of the Company’s deferred tax assets and deferred tax liabilities at December 31, 2011 and 2010 were as follows (in thousands):
At December 31, 2011, the Company’s 2007 and prior tax years were either closed or under final exam review by the IRS. There were no significant issues outstanding for 2007 and prior tax years.
As of December 31, 2011, the Company leased office space for its agencies, insurance companies and retail stores in various locations throughout the United States. The Company’s operating lease rental expenses were $7.8 million, $9.1 million and $8.8 million for the years ended December 31, 2011, 2010 and 2009, respectively.
The following table summarizes the Company’s minimum future IT outsourcing and operating lease commitments at December 31, 2011 (in thousands):
The Company recognized total compensation expense related to the stock options of $378,000, $472,000 and $666,000 during 2011, 2010 and 2009, respectively. Compensation expense is included in selling, general and administrative expenses in the consolidated statements of income (loss). Total unrecognized compensation expense related to unvested stock options was $987,000 at December 31, 2011, which will be recognized over a weighted-average period of approximately 2.5 years.
Stock options outstanding and exercisable at December 31, 2011 were as follows (shares in thousands):
The Company recognized total compensation expense related to the restricted stock awards of $159,000, $553,000 and $379,000 during 2011, 2010 and 2009, respectively. Compensation expense is included in selling, general and administrative expenses in the consolidated statement of income (loss). As of December 31, 2011, there was an insignificant amount of total unrecognized compensation cost related to unvested restricted stock awards, which will be recognized over a weighted average period of approximately 0.1 years.
The aggregate fair value of restricted stock awards vested during 2011, 2010 and 2009 was $15,000, $141,000 and $101,000 at the date of vesting, respectively.
The Company has entered into certain transactions with a partnership that is affiliated with J. Christopher Flowers. Mr. Flowers is affiliated with New Affirmative LLC, the majority shareholder of the Company.
As part of the terms of the acquisition of AIC and Insura, VIG has indemnified the Company for any losses due to uncollectible reinsurance related to reinsurance agreements entered into with unaffiliated reinsurers prior to December 31, 2003. As of December 31, 2011, all such unaffiliated reinsurers had A.M. Best ratings of “A-” or better. The Company had reinsurance recoverable of $2.8 million and $3.0 million as of December 31, 2011 and 2010, respectively.
The Company’s Level 3 financial liabilities are interest rate swaps. The fair value of these swaps was determined by quotes from brokers that are not considered binding. The interest rate swaps expired during the first half of 2011.
Fair value measurements for assets in category Level 3 for the year ended December 31, 2010 were as follows (in thousands):
Insura, AIC of Michigan, Casualty, and Direct are wholly-owned subsidiaries of AIC and are included as common stock investments on AIC’s balance sheet in its statutory surplus. The following table summarizes selected statutory information of the Company’s insurance subsidiaries ended December 31 (in thousands):
The following is a summary of the Company’s unaudited quarterly consolidated results from continuing operations for the years ended December 31, 2011 and 2010 (in thousands, except per share data):
The aggregate sales price increased by $0.2 million to $4.2 million in the third quarter of 2009 upon the failure by the purchaser to make a scheduled payment of $0.2 million. This also increased the secured 10% note to the principal amount of $2.9 million payable over five years. The sales price also included cash at closing of $0.3 million as well as a deferred payment of $1.0 million, subject to certain adjustments, due within 18 months of closing, which may be converted to a secured note at the purchaser’s option. Due to the uncertainty surrounding the financial viability of the debtor, the note and deferred payment were recorded with no estimated net realizable value.
The condensed financial information of the parent company, Affirmative Insurance Holdings, Inc. as of December 31, 2011 and 2010, and for each of the three years ended December 31, 2011, 2010 and 2009 is presented as follows (in thousands, except share data):