Our executive offices are located at 3661 West Oakland Park Boulevard, Lauderdale Lakes, Florida in a 39,250 square feet office facility. All of our operations are consolidated within this facility.
The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with management’s evaluation of the determination of liability for unpaid loss and LAE, the amount and recoverability of amortization of deferred policy acquisition costs. In addition, significant estimates form the bases for our reserves with respect to finance contracts, premiums receivable and deferred income taxes. Various assumptions and other factors underlie the determination of these significant estimates.
Please see Note 2 of the Notes to Consolidated Financial Statements for additional discussions regarding critical accounting policies.
In September 2005, the AICPA issued Statement of Position 05-1, "Accounting by Insurance Enterprises for Deferred Acquisition Costs in connection with Modifications or Exchanges of Insurance Contracts" (“SOP 05-1”). This statement provides guidance to insurance entities that incur deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. SOP 05-1 defines internal replacements as modifications in product benefits, features, rights, or coverage that occur by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage with a contract. The accounting treatment for such replacements depends on whether, under the provisions of the SOP, the replacement contract is considered substantially changed from the replaced contract. A substantial change would be treated as the extinguishment of the replaced contract, and all unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement assets from the replaced contract would no longer be deferred in connection with the replacement contract. A replacement contract that is substantially unchanged should be accounted for as a continuation of the original contract. SOP 05-1 will be effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. The Company adopted this statement beginning with the fiscal quarter beginning January 1, 2006. There was no impact on our consolidated financial statements with respect to the adoption of SOP 05-1.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS, No. 123, Share-Based Payments (revised 2004) (“SFAS No. 123R”). This statement eliminates the option to apply the intrinsic value measurement provisions of APB No. 25 to stock compensation awards issued to employees. Rather, SFAS No. 123R requires companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award - the requisite service period (usually the vesting period). SFAS No. 123R will also require companies to measure the cost of employee services received in exchange for employee stock purchase plan awards. SFAS No. 123R became effective for 21st Century’s fiscal quarter beginning January 1, 2006. The effect on operations for the year ended December 31, 2006 was a pretax charge totaling $539,000 or a $0.05 per share basic and $0.04 per share on a fully diluted basis.
APB Opinion No. 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. This Statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. When it is impracticable to determine the period-specific effects of an accounting change on one or more individual prior periods presented, this Statement requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period rather than being reported in an income statement. When it is impracticable to determine the cumulative effect of applying a change in accounting principle to all prior periods, this Statement requires that the new accounting principle be applied as if it were adopted prospectively from the earliest date practicable. This Statement shall be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS 154 did not have a significant effect on our financial statements.
As of December 31, 2006 as Compared to December 31, 2005
Investments classified as held-to-maturity include debt securities wherein the Company’s intent and ability are to hold the investment until maturity. The accounting treatment for held-to-maturity investments is to carry them at amortized cost without consideration to unrealized gains or losses. Investments classified as trading securities include debt and equity securities bought and held primarily for the sale in the near term. The accounting treatment for trading securities is to carry them at fair value with unrealized holding gains and losses included in current period operations. Investments classified as available-for-sale include debt and equity securities that are not classified as held-to-maturity or as trading security investments. The accounting treatment for available-for-sale securities is to carry them at fair value with unrealized holding gains and losses excluded from earnings and reported as a separate component of shareholders’ equity, namely “Other Comprehensive Income”.
Total Investments increased $24.7 million, or 24.7%, to $124.8 million as of December 31, 2006, as compared to $100.1 million as of December 31, 2005. The increase is primarily a result of our investment of the proceeds from an increase in written insurance premiums.
The fixed maturities and the equity securities that are available for sale and carried at fair value represent 84.2% of total investments as of December 31, 2006, as compared to 80.3% as of December 31, 2005.
Below is a summary of net unrealized gains and (losses) at December 31, 2006 and December 31, 2005 by category.
In reaching a conclusion that a security is either other than temporary or permanently impaired we consider such factors as the timeliness and completeness of expected dividends, principle and interest payments, ratings from nationally recognized statistical rating organizations such as Standard and Poor’s and Moody’s as well as information released via the general media channels.
All of our securities are in good standing and are not impaired as defined by FASB 115. We have determined that none of our securities qualify for other than temporary impairment or permanent impairment status. Our rational for this determination includes, but is not limited to, Standard and Poor’s rating of no less than BB++, no delinquent interest and dividend payments, near term maturity dates and our ability and intent to hold these securities for a period sufficient to allow for an anticipated recovery in market value.
Prepaid reinsurance premiums increased $26.8 million, or 220.8%, to $38.9 million as of December 31, 2006, as compared to $12.1 million as of December 31, 2005. The increase is due to our payments and amortization of prepaid reinsurance premiums associated with our homeowners’ book of business.
Our homeowners’ insurance premiums receivable increased $0.9 million, or 47.4%, to $4.2 million as of December 31, 2006, as compared to $1.9 million as of December 31, 2005. The increase can be attributed to the seasonality of the purchasing patterns of our policy holders.
Deferred income taxes, net, increased $0.9 million, or 33.5%, to $3.6 million as of December 31, 2006, as compared to $2.7 million as of December 31, 2005. The increase is comprised primarily of $1.5 million related to regulatory assessments and $0.9 million in connection with the sale of our property in Lauderdale Lakes, offset by $0.8 million in connection with deferred policy acquisition costs, $0.4 million related to allowance for credit losses and $0.3 in connection with our investment portfolio.
Property, plant and equipment, net, decreased $2.6 million, or 66.8%, to $1.3 million as of December 31, 2006, as compared to $3.9 million as of December 31, 2005. Effective on or about March 1, 2006, 21st Century sold its interest in the Lauderdale Lakes property to an unrelated party for approximately $5.0 million cash and a $0.9 million six year 5% note, generating a gain on sale totaling approximately $2.9 million. As part of the transaction, 21st Century has agreed to lease the same facilities for a six year term. Our lease for this office space expires in December 2011. The Company recognized a deferred gain in connection with the sale totaling approximately $2.8 million.
Unpaid losses and LAE decreased $114.4 million, or 74.3%, to $39.6 million as of December 31, 2006, as compared to $154.0 million as of December 31, 2005. The decrease in unpaid losses and LAE relates to our payment patterns primarily relative to the settling of hurricane related claims. The composition of unpaid loss and LAE by product line is as follows:
Funds held under reinsurance treaties were returned to our reinsurer as of December 31, 2006, as compared to $1.5 million balance as of December 31, 2005. During its regularly scheduled meeting on August 17, 2005, the Board of Governors of Citizens determined a 2004 plan year deficit existed in their High Risk Account. Citizen’s Board decided that a $515 million Regular Assessment was in the best interest of Citizens and consistent with Florida Statutes. On this basis, Citizen’s Board certified for a Regular Assessment. Federated National’s participation in this assessment totaled $2.0 million. Provisions contained in our excess of loss reinsurance policies provided for their participation totaling $1.5 million of our $2.0 million assessment.
Subordinated Debt decreased $6.0 million, or 59.2%, to $4.2 million as of December 31, 2006, as compared to $10.2 million as of December 31, 2005. The decrease is in connection with the retirement of the 2003 notes on July 31, 2006 and the scheduled quarterly principal payments on the 2004 notes.
Deferred gain from sale of property increased to $2.5 million as of December 31, 2006 as compared to nothing as of December 31, 2005. In accordance with the provisions of FASB No. 13, we will amortize the deferred gain over the term of the lease-back which is scheduled to end in December 2011.
Accounts payable and accrued expenses increased $1.6 million, or 37.5%, to $5.7 million as of December 31, 2006 as compared to $4.2 million as of December 31, 2005. This increase is due to our cash management efforts and timing of payments with our trade vendors.
Year Ended December 31, 2006 as Compared to Year Ended December 31,
Gross premiums written increased $33.2 million, or 27.8%, to $152.7 million for the year ended December 31, 2006, as compared to $119.4 million for year ended December 31, 2005. The following table denotes gross premiums written by major product line.
Gross premiums ceded increased to a debit balance of ($67.5) million for the year ended December 31, 2006, as compared to a debit balance of ($31.4) million for year ended December 31, 2005. The increase is associated with the change in our prepaid reinsurance premiums in connection with our 2006-2007 hurricane season. For further discussion please see Footnote 6 titled “Reinsurance Agreements”.
The increase in prepaid reinsurance premiums was $20.2 million for the year ended December 31, 2006, as compared to $6.6 million for year ended December 31, 2005. The increased credit to written premium is primarily associated with the timing of our reinsurance payments measured against the term of the underling reinsurance policies.
Finance revenue decreased $1.9 million, or 52.7%, to $1.7 million for the year ended December 31, 2006, as compared to $3.6 million for year ended December 31, 2005. The decrease is primarily due to the sale in December 2004 of our assets related to our non-standard automobile insurance agency business in Florida and the finance revenue derived there from. We expect a continuing decline in finance revenue over the near future.
Other income increased $1.8 million, or 129.7%, to $3.3 million for the year ended December 31, 2006, as compared to $1.4 million for year ended December 31, 2005. Major components of other income for the year ended December 31, 2006 included approximately $1.4 million of commissions in connection with the acquisition of our current reinsurance program, $0.5 million in partial recognition of our gain on the sale of our Lauderdale Lakes property, $0.3 million of commissions in connection with our prior sale of agency operations, $0.3 million of commissions in connection with the national flood insurance program, $0.2 million in connection with a legal settlement, $0.2 million of business interruption recovery, $0.1 million in connection with FIGA fees, $0.1 million of rental income and $0.2 million of miscellaneous other sources.
Loss and LAE, our most significant expense, represent actual payments made and changes in estimated future payments to be made to or on behalf of our policyholders, including expenses required to settle claims and losses. We revise our estimates based on the results of analysis of estimated future payments to be made. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events.
The table below reflects a recovery to operations of $0.1 million during the year ended December 31, 2006 from the four hurricanes that occurred in July, August, September and October of 2005.
Our loss ratio, as determined in accordance with GAAP, for the year ended December 31, 2006 was 49.7%, as compared to 58.3% for the year ended December 31, 2005. The table below reflects the loss ratios by product line.
Operating and underwriting expenses increased $4.9 million, or 60.1%, to $13.2 million for the year ended December 31, 2006, as compared to $8.2 million for year ended December 31, 2005. The change is primarily due to a charge to operations of $3.9 million in connection with a FIGA assessment and premium tax expense which increased $1.0 million. Approvals by the OIR to recoup the assessment through an average 1.0% policy surcharge on all of our policies written in Florida over a twelve month period for new and renewal business have been granted. Premium tax expense is directly correlated to written premium, which experienced an increase in 2006.
Salaries and wages increased $0.6 million, or 9.8%, to $7.0 million for the year ended December 31, 2006, as compared to $6.4 million for year ended December 31, 2005. As a result of the adoption of SFAS No. 123R on January 1, 2006, salaries and wages for the year ended December 31, 2006 include a $0.5 million charge, representing approximately 85.9% of the 2006 overall increase. The remaining increase in salaries and wages was due in part to the increased labor costs in connection with additional claims loss adjusters added to our staff. We believe that salaries and wages are consistent with retaining quality management and increased premium production.
Policy acquisition costs, net of amortization, increased $2.8 million, or 19.5%, to $17.4 million for the year ended December 31, 2006, as compared to $14.6 million for year ended December 31, 2005. Policy acquisition costs, net of amortization, consists of the actual policy acquisition costs, including commissions, payroll and premium taxes, less commissions earned on reinsurance ceded and policy fees earned.
The provision for income tax expense for continuing and discontinued operations increased $2.1 million, or 39.9%, to $7.4 million for the year ended December 31, 2006, as compared to $5.3 million for the year ended December 31, 2005. The effective rate for income tax expense is 34.7% for the year ended December 31, 2006, as compared to 30.4% for the year ended December 31, 2005.
As a result of the foregoing, the Company’s net income for the year ended December 31, 2006 was $13.9 million compared to net income of $12.1 million for year ended December 31, 2005.
As noted above, the Company’s efforts to expand commercial general liability lines of insurance products are coming to fruition, as reflected by increased premiums written of $22.6 million for the year ended December 31, 2005, as compared to $12.5 million for the same period in the prior year. Furthermore, these policies reflect an increased percentage of the Company’s total gross premiums written, increasing to 18.9% of total premiums written in the year ended December 31, 2005, as compared to 12.42% in the same period of fiscal 2004.
In 2004, the Company made a conscious decision to decrease its sale of mobile home policies and consequently, its sales of these policies have decreased to $0.4 million in the year ended December 31, 2005, representing 0.37% of total premiums written.
The increase in unearned premiums was $11.7 million for the year ended December 31, 2005, as compared to $16.0 million for the year ended December 31, 2004. The increase in unearned premiums of $11.7 million for the year ended December 31, 2005 was due to an $11.5 million increase in unearned homeowners’ insurance premiums, a $4.4 million increase in unearned commercial liability premiums, a $3.7 million decrease in unearned automobile premiums, and a $0.5 million decrease in unearned mobile home insurance premiums. These changes reflect our continued growth along our homeowners’ and commercial general liability lines of business. For further discussion, see “Unearned Premiums” above.
Net investment income increased $0.7 million, or 21.1%, to $3.8 million for the year ended December 31, 2005, as compared to $3.2 million for the year ended December 31, 2004. The increase in investment income is primarily a result of the additional amounts of invested assets, offset by a modest decrease in overall yield to 4.16% for the year ended December 31, 2005, as compared to a yield of 4.82% for the year ended December 31, 2004.
Net realized investment gains decreased by $0.2 million, or 33.5%, to $0.5 million for the year ended December 31, 2005, as compared $0.7 million for the year ended December 31, 2004. The table below reflects the gains and losses by investment category.
Loss and LAE decreased by $26.7 million, or 35.5%, to $48.3 million for the year ended December 31, 2005, as compared to $75.0 million as of December 31, 2004. The decrease is due primarily to the Company’s reinsurance retention philosophy in connection with the frequency and severity stemming from the four hurricanes that occurred in July, August September and October of 2005, and the four hurricanes that occurred in August and September of 2004 which were partially offset by the impact of the improved automobile loss experience due to management’s efforts to migrate from predominately liability only policies to full-coverage type automobile policies.
The table below reflects a charge to current year earnings of $10.6 million, net of reinsurance recoveries of $27.8 million, stemming from the four hurricanes that occurred in August and September of 2004.
Our loss ratio, as determined in accordance with GAAP, for the year ended December 31, 2005 was 58.26% compared with 113.21% for the same period in 2004. The table below reflects the loss ratios by product line.
For further discussion, see the Note 7 to the Consolidated Financial Statements included under Part II, Item 8, of this Report.
A summary of long-term contractual obligations as of December 31, 2006 follows. The amounts represent estimates of gross undiscounted amounts payable over time.
For the year ended December 31, 2006, our primary sources of capital were revenues generated from operations, including decreased amounts due from reinsurers, net, increased unearned premiums and decreased finance contracts receivable. Operational sources of capital also included, decreased other assets, increased premium deposits and customer credit balances, increased accounts payable, net realized investment gains, non-cash compensation, premiums receivable, depreciation and amortization, common stock issued for interest on notes, and an increased provision for credit losses. Also contributing to our liquidity were proceeds from the sale of investment securities, exercised warrants, the sale of assets, exercised employee stock options and a tax benefit related to non-cash compensation. Because we are a holding company, we are largely dependent upon fees and commissions from our subsidiaries for cash flow.
For the year ended December 31, 2006, operations generated $184.6 million of gross cash flow, due to a $140.9 million decrease in amounts due from reinsurers, net, a $16.0 million increase in unearned premiums, a $5.5 million decrease in finance contracts receivable, a $2.5 million decrease in other assets, a $1.6 million increase in accounts payable and accrued expenses, a $1.6 million increase in premium deposits and customer credit balances and $1.1 million of net realized investment gains.
For the year ended December 31, 2006, operations used $156.9 million of gross cash flow primarily due to a $114.4 million decrease in unpaid losses and LAE, a $26.8 million increase in prepaid reinsurance premiums, a $4.1 million decrease in bank overdrafts, a $3.0 million decrease in income taxes payable, a $2.4 million increase in deferred gain on sale of our building, a $2.0 million increase in policy acquisition costs, net of amortization, a $1.5 million decrease in funds held under reinsurance treaties, a $0.9 million increase in deferred income tax expense, $0.8 million increase in income taxes recoverable, a $0.6 million increase in recognized gain in connection with the sale of our building, $0.3 million in amortization of investment discount, net and a $0.1 million recovery of uncollectible premiums receivable.
For the year ended December 31, 2006, investing activities generated $276.9 million and used $296.6 million from the maturity several times over of our very short municipal portfolio. Sources of cash flow from investing activities included the sale of property with net book value of $2.7 million, for which we received $5.6 million in proceeds and recorded a $2.9 million deferred gain. The Company also used $0.4 million for the purchase of equipment.
Outstanding borrowings under the Revolving Agreement as of December 31, 2006 were approximately $0.01 million, as compared to $0.2 million as of December 31, 2005.
Federated National’s and American Vehicle’s statutory capital surplus levels as of December 31, 2005 were approximately $11.2 million and $18.0 million, respectively, and their statutory net income (loss) for the year ended December 31, 2005 were ($2.2) million and $2.9 million, respectively.
As of December 31, 2006, 2005, and 2004, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as “structured finance” or “special purpose” entities, which were established for the purpose of facilitating off-balance-sheet arrangements or other contractually narrow or limited purposes. As such, management believes that we currently are not exposed to any financing, liquidity, market or credit risks that could arise if we had engaged in transactions of that type requiring disclosure herein.
On July 31, 2006, we made the final principal payment of $625,000 on the July 2003 notes and the July 2003 warrants expired. Of the 612,074 shares that could have been issued in connection with the July 2003 warrants, 301,430 were exercised, 225,000 were reacquired in the open market by us and 85,644 were unexercised. The unexercised warrants were cancelled as of July 31, 2006.
The consolidated financial statements and related data presented herein have been prepared in accordance with GAAP which requires the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation. Our primary assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on performance than the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or with the same magnitude as the inflationary effect on the cost of paying losses and LAE.
For the years ended December 31, 2006 and 2005, there were no off balance sheet transactions.
We have audited the accompanying balance sheets of 21st Century Holding Company as of December 31, 2006 and 2005, and the related statements of income, stockholders equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of 21st Century Holding Company as of December 31, 2006 and 2005 the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of 21st Century Holding Company’s internal control over financial reporting as of December 31, 2006, 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 16, 2007 expressed an unqualified opinion on management’s assessment of internal control over financial reporting and an adverse opinion on the effectiveness of internal control over financial reporting.
We have audited management’s assessment, included in the accompanying Evaluation of Disclosure Controls and Procedures, that 21st Century Holding Company did not maintain effective internal control over financial reporting as of December 31, 2006 because of the effect of (i) the recognition and accounting of unrecorded premium transactions and (ii) an income tax issue relating to computing the Company’s income tax liability where the Company failed to consider a prior year tax refund applied to the current year, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organization of the Treadway Commission (COSO). 21st Century Holding 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. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
21st Century is an insurance holding company, which, through our subsidiaries and our contractual relationships with our independent agents and general agents controls substantially all aspects of the insurance underwriting, distribution and claims process. We are authorized to underwrite personal automobile insurance, commercial general liability insurance, homeowners’ property and casualty insurance and mobile home property and casualty insurance in various states with various lines of authority through our wholly owned subsidiaries, Federated National and American Vehicle.
Federated National is authorized to underwrite homeowners’ property and casualty insurance and personal automobile insurance in Florida as an admitted carrier. American Vehicle is authorized to underwrite personal automobile insurance and commercial general liability coverage in Florida as an admitted carrier. In addition, American Vehicle is authorized to underwrite commercial general liability insurance in Georgia, Kentucky, South Carolina, Virginia, Missouri and Arkansas as a surplus lines carrier and in Texas, Louisiana and Alabama as an admitted carrier. American Vehicle operations in Florida, Georgia, Kentucky, Louisiana, Texas, South Carolina and Virginia are on-going. American Vehicle operations in Alabama, Arkansas and Missouri are expected to begin this year. American Vehicle has an application pending authorization as a surplus lines carrier in the state of California, and applications pending submission to the states of Mississippi and Nevada.
During the year ended December 31, 2006, 74.4%, 21.6%, and 4.0% of the premiums we underwrote were for homeowners’ property and casualty insurance, commercial general liability insurance and personal automobile insurance, respectively. During the year ended December 31, 2005, 63.8%, 18.9%, and 17.3% of the premiums we underwrote were for homeowners’ property and casualty insurance, commercial general liability insurance and personal automobile insurance, respectively. We internally process claims made by our own and third-party insureds through our wholly owned claims adjusting company, Superior. We also offer premium financing to our own and third-party insureds through our wholly owned subsidiary, Federated Premium.
Accounting for loss contingencies pursuant to SFAS No.5 involves the existence of a condition, situation or set of circumstances involving uncertainty as to possible loss that will ultimately be resolved when one or more future event(s) occur or fail to occur. Additionally, accounting for a loss contingency requires management to assess each event as probable, reasonably possible or remote. Probable is defined as the future event or events are likely to occur. Reasonably possible is defined as the chance of the future event or events occurring is more than remote but less than probable, while remote is defined as the chance of the future event or events occurring is slight. An estimated loss in connection with a loss contingency shall be recorded by a charge to current operations if both of the following conditions are met: First, the amount can be reasonably estimated; and second, the information available prior to issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements. It is implicit in this condition that it is probable that one or more future events will occur confirming the fact of the loss or incurrence of a liability.
Financial instruments, which potentially expose us to concentrations of credit risk, consist primarily of investments, premiums receivable, amounts due from reinsurers on paid and unpaid losses, finance contracts. We have not experienced significant losses related to premiums receivable from individual policyholders or groups of policyholders in a particular industry or geographic area. We believe no credit risk beyond the amounts provided for collection losses is inherent in our premiums receivable or finance contracts. In order to reduce credit risk for amounts due from reinsurers, we seek to do business with financially sound reinsurance companies and regularly review the financial strength of all reinsurers used. Additionally, our credit risk in connection with our reinsurers is mitigated by the establishment of irrevocable clean letters of credit in favor of Federated National.
In February 2006, FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments”. This accounting standard permits fair value re-measurement for any hybrid financial instrument containing an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify them as freestanding derivatives or as hybrid financial instruments containing an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument pertaining to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year beginning after September 15, 2006. There was no impact on our consolidated financial statements with respect to the adoption of SFAS No. 155.
In November 2005, the FASB released FASB Staff Position Nos. FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP 115-1”), which effectively replaces EITF Issue No. 03-1. FSP 115-1 contains a three-step model for evaluating impairments and carries forward the disclosure requirements in EITF Issue No. 03-1 pertaining to securities in an unrealized loss position is considered impaired; an evaluation is made to determine whether the impairment is other-than-temporary; and, if an impairment is considered other-than-temporary, a realized loss is recognized to write the security’s cost or amortized cost basis down to fair value. FSP 115-1 references existing other-than-temporary impairment guidance for determining when impairment is other-than-temporary and clarifies that subsequent to the recognition of other-than-temporary impairment loss for debt securities, an investor shall account for the security using the constant effective yield method. FSP 115-1 is effective for reporting periods beginning after December 15, 2005, with earlier application permitted. There was no impact on our consolidated financial statements with respect to the adoption of FSP 115-1.
In April 2005, the Securities and Exchange Commission’s Office of the Chief Accountant and its Division of Company Finance has released Staff Accounting Bulletin (“SAB”) No.107 to provide guidance regarding the application of FASB Statement No. 123 (revised 2004), Share-Based Payment. Statement No. 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. SAB 107 provides interpretative guidance related to the interaction between Statement No. 123R and certain SEC rules and regulations, as well as the staff’s views regarding the valuation of share-based payment arrangements for public companies.
Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123R using the modified-prospective-transition method. Under that transition method, compensation cost recognized during the year ended December 31, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of Statement 123, and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair-value estimated in accordance with the provisions of SFAS No. 123R. Results for prior periods were not required to be restated.
During the year ended December 31, 2006, 65,446 non-qualified and 40,550 qualified stock options were issued with an average option price of $19.09 per share. Like all other outstanding stock options, these stock options contain service conditions and do not contain any performance conditions. For a further discussion regarding the provisions of SFAS No. 123R and its effect on our operations, please refer to footnote 16, Stock Compensation Plans.
Certain 2005 financial statement amounts have been reclassified to conform to the 2006 presentations.
During December 2005 we reclassified $19.7 million of our bond portfolio as held-to-maturity. These bonds secure a $15.0 million irrevocable letter of credit in order to facilitate business opportunities in connection with our commercial general liability program.
We have determined that all of these securities do not qualify for other than temporary impairment or permanent impairment status. Our rational includes, but is not limited to, Standard and Poor’s rating of no less than BB++, no delinquent interest and dividend payments, near term maturity dates and our ability and intent to hold these securities for a period sufficient to allow for an anticipated recovery in market value.
Below is a summary of fixed maturities at December 31, 2006 and 2005 by contractual or expected maturity periods. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
United States Treasury Notes with a book value of $1,000,000, each, and maturing in 2012 were on deposit with the Florida OIR as of December 31, 2006, as required by law for both Federated National and American Vehicle and are included with other investments held until maturity.
Proceeds from sales of fixed maturities and equity securities for the years ended December 31, 2006, 2005 and 2004 were approximately $271.3 million, $122.5 million and $81.2 million, respectively.
At December 31, 2006 prepaid reinsurance premiums of $6.6 million were associated with a single reinsurer. The Company holds collateral under related reinsurance agreements in the form of letters of credit totaling $3.6 million that can be drawn on for amounts that remain unpaid for more than 120 days.
Outstanding borrowings under the Revolving Agreement as of December 31, 2006 and December 31, 2005 were $10,081 and $196,943, respectively. Interest expense on this revolving credit line for the years ended December 31, 2006, 2005 and 2004 totaled approximately $8,000, $75,000, and $178,000, respectively.
In assessing the net realizable value of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. At December 31, 2006 and 2005, based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences.
To retain our certificate of authority, the Florida Insurance Code (the "Code") requires Federated National and American Vehicle to maintain capital and surplus equal to the greater of 10 percent of their liabilities or a statutory minimum capital and surplus as defined in the Code. In 2006, 2005 and 2004, Federated National and American Vehicle were required to have capital surplus of $4.0 million. At December 31, 2006, 2005 and 2004, Federated National’s statutory capital surplus was $15.2 million, $11.2 million and $7.6 million, respectively. At December 31, 2006, 2005 and 2004, American Vehicle had statutory capital surplus of 26.7 million, $18.0 million and $17.1 million, respectively.
The insurance companies are also required to adhere to prescribed premium-to-capital surplus ratios. As of December 31, 2006 and 2005, both Federated National and American Vehicle were in compliance with the prescribed premium-to-surplus ratio.
Under Florida law, a domestic insurer may not pay any dividend or distribute cash or other property to its shareholders except out of that part of its available and accumulated capital surplus funds which is derived from realized net operating profits on its business and net realized capital gains. A Florida domestic insurer may not make dividend payments or distributions to shareholders without prior approval of the Florida OIR if the dividend or distribution would exceed the larger of (i) the lesser of (a) 10 percent of capital surplus (b) net income, not including realized capital gains, plus a two-year carryforward, (ii) 10 percent of capital surplus with dividends payable constrained to unassigned funds minus 25 percent of unrealized capital gains or (iii) the lesser of (a) percent of capital surplus or (b) net investment income plus a three-year carryforward with dividends payable constrained to unassigned funds minus 25 percent of unrealized capital gains. Alternatively, a Florida domestic insurer may pay a dividend or distribution without the prior written approval of the Florida OIR (i) if the dividend is equal to or less than the greater of (a) percent of the insurer's capital surplus as regards policyholders derived from realized net operating profits on its business and net realized capital gains or (b) the insurer's entire net operating profits and realized net capital gains derived during the immediate preceding calendar year, (ii) the insurer will have policyholder capital surplus equal to or exceeding 115 percent of the minimum required statutory capital surplus after the dividend or distribution, (iii) the insurer files a notice of the dividend or distribution with the Florida OIR at least ten business days prior to the dividend payment or distribution and (iv) the notice includes a certification by an officer of the insurer attesting that, after the payment of the dividend or distribution, the insurer will have at least 115 percent of required statutory capital surplus as to policyholders. Except as provided above, a Florida domiciled insurer may only pay a dividend or make a distribution (i) subject to prior approval by the Florida OIR or (ii) days after the Florida OIR has received notice of such dividend or distribution and has not disapproved it within such time. No dividends were declared or paid in 2006, 2005 or 2004 by the insurance companies. Under these laws, neither Federated National nor American Vehicle would be permitted to pay dividends to 21st Century in 2007.
While Federated National and American Vehicle were scheduled to have their statutorily required triennial examination during 2006, the OIR limited its examination to American Vehicle. American Vehicle’s examination was for the three years ended December 31, 2005. The last regulatory examination of American Vehicle covered the three-year period ended on December 31, 2002. A loss reserve deficiency totaling approximately $1.3 million (net of income taxes) was recorded in the fourth quarter of 2006 in connection with the OIR examination.
As of December 31, 2006, Federated National was outside NAIC’s usual ranges with respect to its IRIS tests on six out of thirteen ratios. There was one exception in connection with surplus growth, one exception in connection with liabilities to liquid assets and four exceptions in connection with adverse homeowner claims in connection with the 2004 hurricanes.
The table below reflects the range and test results for both Federated National and American Vehicle for the years ended December 31 2006 and 2005, respectively.
American Vehicle’s statutory capital and surplus was $26.7 million and $18.0 million as of December 31, 2006 and 2005, respectively. American Vehicle’s statutory net income was approximately $6.2 million, $2.9 million and $2.03 million for the years ended December 31, 2006, 2005 and 2004 respectively. American Vehicle’s statutory non-admitted assets were approximately $0.4 million and $2.9 million as of December 31, 2006 and 2005, respectively.
The 2004, 2003 and 2002 consolidated Federal Income Tax Returns filed by the Company have been examined by the Internal Revenue Service (“IRS”) during 2006 and 2005. We have concurred with certain IRS conclusions and have appealed other conclusions. Irrespective of the ongoing appellate process, we do not believe that a material adjustment will occur.
During its regularly scheduled meeting on August 17, 2005, the Board of Governors of Citizens determined a 2004 plan year deficit existed in the High Risk Account. Citizens decided that a $515 million Regular Assessment was in the best interest of Citizens and consistent with Florida Statutes. On this basis, Citizens certified for a Regular Assessment. Federated National’s participation in this assessment totaled $2.0 million. During a subsequent regularly scheduled meeting on or about December 18, 2006, Citizens board determined an additional 2004 plan year deficit existed in the High Risk Account. Citizens decided that a $515 million Regular Assessment was in the best interest of Citizens and consistent with Florida Statutes. On this basis, Citizens certified for a Regular Assessment. Federated National’s participation in this assessment totaled $0.3 million. Provisions contained in our excess of loss reinsurance policies provide for their participation totaling $1.5 million.
Pursuant to Section 627.3512, Florida Statutes, insurers are permitted to recoup the assessment by adding a surcharge to policies in an amount not to exceed the amount paid by the insurer to Citizens. Federated National is currently underwriting the recoupment in connection with this assessment and has recouped approximately $1.2 million during 2006. As noted above, Federated National has subrogated $1.5 million to our reinsurers.
Effective on or about March 1, 2006, the Company sold its interest in the property located at 3661 West Oakland Park Boulevard, Lauderdale Lakes, Florida to an unrelated party for approximately $5.0 million cash and a $0.9 million six year 5% note. As part of the transaction, the Company has agreed to lease the same facilities for a six year term; in accordance with FASB 13, the lease will be treated as an operating lease. The expected future five year payout schedule is as follows:
Effective December 31, 2004 we sold our interest in our agency operations which relieved us from these lease obligations. Until then we leased office space under various lease agreements with expiration dates through September 2007. Rental expense associated with operating leases was charged to expense in the period incurred. Rental expenses for 2006, 2005 and 2004 were approximately $0, $0 and $840,000, respectively, and are included in discontinued operations in the accompanying consolidated statements of operations.
Net income (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock and common stock equivalents outstanding during the periods presented. Options granted in accordance with the stock option plan were anti-dilutive for the year ended December 31, 2004 and were not taken into account in the computation.
FASB Statement No. 131, Disclosures About Segments of an Enterprise and Related Information, requires that the amount reported for each segment item be based on what is used by the chief operating decision maker in formulating a determination as to how many resources to assign to a segment and how to appraise the performance of that segment. The term chief operating decision maker may apply to the chief executive officer or chief operating officer or to a group of executives. Note: The term of chief operating decision maker may apply to a function and not necessarily to a specific person. This is a management approach rather than an industry approach in identifying segments. The segments are based on the Company’s organizational structure, revenue sources, nature of activities, existence of responsible managers, and information presented to the Board of Directors.
Accordingly, we have discontinued our segment disclosures for the finance segment, as it did not exceed the 10% threshold for revenues, earnings or assets.
In 2002, we implemented the 2002 Option Plan. The purpose of this Plan is to advance our interests by providing an additional incentive to attract, retain and motivate highly qualified and competent persons who are key to the Company, including key employees, consultants, independent contractors, Officers and Directors, upon whose efforts and judgment our success is largely dependent, by authorizing the grant of options to purchase Common Stock to persons who are eligible to participate hereunder, thereby encouraging stock ownership by such persons, all upon and subject to the terms and conditions of the Plan. Options outstanding under the plan have been granted at prices which are above the market value of the stock on the date of grant, vest over a five-year period, and expire six years after the grant date. Under this plan, we are authorized to grant options to purchase up to 1,800,000 common shares, and, as of December 31, 2006, we had outstanding exercisable options to purchase 637,358 shares.
Options outstanding as of December 31, 2006 are exercisable as follows:
At December 31, 2006, the Company has two stock-based employee compensation plans and one stock-based franchise compensation plan, which are described above. Prior to January 1, 2006, we accounted for those plans under the recognition and measurement provisions of stock-based compensation using the intrinsic value method prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by FASB Statement No. 123, Accounting for Stock-Based Compensation. Under these provisions, no stock-based employee compensation cost was recognized in the Statement of Operations for the years ended December 31, 2005 or 2004 as all options granted under those plans had an exercise price equal to or less than the market value of the underlying common stock on the date of grant. Effective January 1, 2006, the Company adopted the fair value recognitions provisions of FASB Statement No. 123R using the modified-prospective-transition method. Under that transition method, compensation cost recognized during the year ended December 31, 2006 includes:
Compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair-value estimated in accordance with the provisions of SFAS No. 123R. Results for prior periods have not been restated, as not required to by the pronouncement.
The weighted average fair value of options granted during 2006, 2005 and 2004 estimated on the date of grant using the Black-Scholes option-pricing model was $3.62 to $5.73; $2.81 to $10.75 and $6.13 to $18.26 respectively. The fair value of options granted is estimated on the date of grant using the following assumptions:
We have established a profit sharing plan under Section 401(k) of the Internal Revenue Code. This plan allows eligible employees, except key and highly compensated employees, to contribute up to 100 percent of their compensation on a pre-tax basis, not to exceed statutory limits. For the years ended December 31, 2006, 2005 and 2004, we did not contribute to the plan. Our contributions, if any, are vested incrementally over five years.
The September 2004 Notes pay interest at the annual rate of 6%, mature on September 30, 2007, and rank pari passu in terms of payment and priority to the July Notes. Quarterly payments of principal and interest due on the September 2004 Notes, like the July 2003 Notes, may be made in cash or, at our option, in shares of our Common Stock. If paid in shares of Common Stock, the number of shares to be issued shall be determined by dividing the payment due by 95% of the weighted-average volume price for the Common Stock on Nasdaq as reported by Bloomberg for the 20 consecutive trading days preceding the payment date.
As indicated on the table below, we paid, pursuant to the terms of the September 2004 Notes and in accordance with the contractual computations, the quarterly payments of principal and interest due in shares of our Common Stock.
On December 22, 2004 we announced our intention to sell our interest in Express Tax and EXPRESSTAX Franchise Corporation for approximately $2 million cash. This transaction closed with an effective date of January 1, 2005. The book value of Express Tax and EXPRESSTAX Franchise Corporation on January 1, 2005 was approximately $0.6 million.