Effective March 1, 2005, Federated National sold its interest in the Lauderdale Lakes property to 21st Century at the property's net book value of approximately $2.9 million.
We are an insurance holding company, which, through our subsidiaries and our contractual relationships with our independent agents, control substantially all aspects of the insurance underwriting, distribution and claims process. We underwrite personal automobile insurance, general liability insurance, homeowners' insurance and mobile home property and casualty insurance in Florida and Georgia through our wholly owned subsidiaries, Federated National and American Vehicle. We internally process claims made by our own and third party insureds through our wholly owned claims adjusting company, Superior Adjusting, Inc. We also offer premium financing to our own and third-party insureds through our wholly owned subsidiary, Federated Premium Finance, Inc.
The most significant events affecting our results of operations and financial condition in 2004 were the four hurricanes that struck the State of Florida in the third quarter. Since then, we have been receiving and processing claims made under our homeowners' and mobile home owners' policies, a process that is expected to be substantially completed during the first half of 2005. Federated National incurred significant losses relative to its homeowners' insurance line of business. As of December 31, 2004, approximately 8,500 policyholders had filed hurricane-related claims totaling an estimated $105.4 million, of which we currently estimate that our share of the costs associated with these hurricanes will be approximately $43.5 million, net of our reinsurance recoveries and amortized reinstatement premiums. For a further discussion of our reinsurance please see our section titled "REINSURANCE"
ANALYSIS OF FINANCIAL CONDITION AS OF DECEMBER 31, 2004 AS COMPARED TO DECEMBER 31, 2003
As a result of the adverse market conditions which occurred in 2002, management more carefully monitors its concentrations, industries and asset allocations. There were no other instances of large concentrations of investment securities requiring write-downs. We did not hold any non-traded investment securities during 2004 or 2003.
PREPAID REINSURANCE PREMIUMS. Prepaid reinsurance premiums decrease was $2.9 million, net or 34.5% to $5.5 million as of December 31, 2004 from $8.4 million as of December 31, 2003. The decrease in Federated National's and American Vehicle's ceded quota-share reinsurance totaled $4.0 million and $3.8 million, respectively. This decrease was mitigated by an increase in ceded unearned premiums relative to Federated National's homeowners' and mobile homeowners' insurance products.
REINSURANCE RECOVERABLE - NET. Reinsurance recoverable increased $14.4 million or 130.6% to $25.5 million as of December 31, 2004 from $11.1 million as of December 31, 2003. This increase is the result of the increase in loss and loss adjustment expenses incurred relative to the four hurricanes that affected Florida in August and September 2004 and, to a lesser extent, the timing of settlements with our reinsurers. All amounts are considered current and are primarily associated with the catastrophic weather events.
INCOME TAX RECOVERABLE. Income tax recoverable increased by 887.5% to $7.9 as of December 31, 2004 as compared to $0.8 million as of December 31, 2003 and is primarily due to the effects of the current year net operating loss. Income tax provisions allows us to carry back our current year net operating loss two years and receive a tax refund for taxes paid in profitable years. The tax benefit is recognized as a receivable for the refundable amount. Further, the tax benefit reduces the current year's tax expense based on the tax rates in effect in the carryback period.
OTHER ASSETS. Other assets increased by $2.5 million, or 108.7% to $4.8 million as of December 31, 2004 as compared to $2.3 million as of December 31, 2003. The largest contribution to the increase in other assets is associated with our receivable due in connection with our sale in December 2004 of our assets related to our non-standard automobile insurance agency business in Florida (please see "Recent Developments" and "Discontinued Operations" above and Note 24 to our Consolidated Financial Statements included under Item 8 of this Report on Form 10-K for a description of this transaction). Major components of other assets are as follows:
Federated National's reserves increased by $23.0 million in 2004 as compared to 2003 and American Vehicle's reserves decreased by $1.4 million in 2004 as compared to 2003. Factors, other than the four hurricanes that struck Florida in August and September 2004, that affect unpaid losses and loss adjustment expenses include the estimates made on a claim-by-claim basis known as case reserves coupled with bulk estimates known as "incurred but not reported" (IBNR). Periodic estimates by management of the ultimate costs required to settle all claim files are based on the Company's analysis of historical data and estimations of the impact of numerous factors such as (i) per claim information; (ii) company and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the awarding of damages, and changes in political attitudes; and (iv) trends in general economic conditions, including the effects of inflation. Management revises its estimates based on the results of its analysis. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for estimating the ultimate settlement of all claims. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of the reserves, because the eventual redundancy or deficiency is affected by multiple factors. For further discussion, see "Losses and LAE."
DEFERRED INCOME FROM SALE OF AGENCY OPERATIONS. Deferred income from sale of agency operations was $2.5 million as of December 31, 2004 as compared to zero as of December 31, 2003. This reflects the contractual provisions associated with the December 31, 2004 sale of our non-standard automobile insurance agency business in Florida that provide for a post-closing payment of up to $2.5 million provided that certain performance criteria are met. The company believes it will meet these criteria during 2005. For further information about this transaction, please see "Recent Developments" above and Note 24 to our Consolidated Financial Statements included under Item 8 of this Report on Form 10-K.
SUBORDINATED DEBT. On September 30, 2004, we completed a private placement of 6% Senior Subordinated Notes due September 30, 2007 (the "September 2004 Notes"). These notes were offered and sold to accredited investors as units consisting of one September 2004 Note with a principal amount of $1,000 and warrants to purchase shares of our Common Stock (the "2004 Warrants"), the terms of which are similar to our subordinated notes and warrants sold in our July 2003 private placement described below. We sold an aggregate of $12.5 million of units in this placement, which resulted in proceeds (net of placement agent fees of $700,000 and offering expenses of $32,500) to us of $11,767,500. By comparison, the subordinated notes that we sold in 2003 (the "July 2003 Notes") resulted in net proceeds to us of $6,938,498. Please see Note 22 to our Consolidated Financial Statements included under Item 8 of this Report on Form 10-K, for further discussion.
RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDED DECEMBER 31, 2003
This table reflects the success of our efforts to expand our line of insurance products to include products other than automobile insurance.
INCREASE (DECREASE) IN PREPAID REINSURANCE PREMIUMS. Prepaid reinsurance premiums decreased $0.5 million or 15.3%, to ($2.9) million as of December 31, 2004, from ($3.4) million for the year ended December 31, 2003. The decrease is due primarily to our decreased reliance on quota-share reinsurance on its automobile insurance products.
MANAGING GENERAL AGENT FEES. Managing General Agent Fees decreased modestly by $0.2 million or 11.0% to $2.1 million as compared to $2.3 million as of December 31, 2003. The decrease reflects an overall decrease in the production of insurance policies mitigated by policies with higher rates and volume of one-year term policies.
NET INVESTMENT INCOME. Net investment income increased by $1.6 million or 95.3% to $3.2 million for the year ended December 31, 2004, as compared to $1.6 million for the year ended December 31, 2003. The increase in investment income is a result of the additional amounts of invested assets. Our overall investment yield increased by ..35%, from 4.47% for the year ended December 31, 2003 to 4.82% for the year ended December 31, 2004.
NET REALIZED INVESTMENT GAINS (LOSSES). Net realized investment gains decreased by $1.5 million, or 69.1%, to $0.7 million for the year ended December 31, 2004 as compared $2.2 million for the year ended December 31, 2003. The table below reflects the gains and losses by investment category.
21st Century Holding Company Management's Discussion and Analysis of Financial Condition and Results of Operations
For the year ending December 31, -------------------------------- 2004 2003 ---- ---- Automobile 73.24% 79.51% Home owners 166.54% 21.30% Commercial liability 18.74% 18.50% Mobile home owners 238.79% 28.74% All Product Lines 113.21% 61.30%
(in millions) Gross Reinsurance Net Hurricane Losses Recoveries Losses --------- ------ ---------- ------ Charley (August 13) $ 44.2 $ 34.2 $ 10.0 Frances (September 3) 37.7 27.7 10.0 Ivan (September 14) 13.7 -- 13.7 Jeanne (September 25) 9.8 -- 9.8 ------------- ------------- ------------- Total Loss Estimate $ 105.4 $ 61.9 $ 43.5 ============= ============= =============
Furthermore, as a result of the 2004 hurricanes, we incurred a net reinstatement insurance premium of $3.0 million that is amortized through operations from the reinstatement date of August 13, 2004 to June 30, 2005.
POLICY ACQUISITION COSTS, NET OF AMORTIZATION. Policy acquisition costs, net of amortization, increased by $9.3 million, charging earnings by $8.4 million for the year ended December 31, 2004, as compared to a credit of $0.9 million as of December 31, 2003. 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.
Year eneded December 31, ------------------------ 2003 2002 ---- ---- Automobile $49,297,915 67.5% $52,586,436 83.4% Homeowners' 16,804,497 23.0% 8,669,642 13.8% Commercial liability 5,149,944 7.1% -- 0.0% Mobile home owners' 1,739,078 2.4% 1,780,390 2.8% ----------- ----- ----------- ----- Gross written premiums $72,991,434 100.0% $63,036,468 100.0% =========== ===== =========== =====
GROSS PREMIUMS CEDED. Gross premiums ceded decreased $5.7 million or 25.8% to $22.1 million for the year ended December 31, 2003, from $25.3 million for the year ended December 31, 2002. The decrease is primarily due to the decline in our ceded quota-share reinsurance associated with our automobile insurance.
NET INVESTMENT INCOME. Net investment income increased by $0.3 million or 29.5% to $1.6 million for the year ended December 31, 2003, as compared to $1.3 million for the year ended December 31, 2002. The increase in investment income is a result of the additional amounts of invested assets. Although the Company's net investment income has increased during 2003 compared to 2002, our overall investment yield declined by 1.5%, from 4.9% for the year ended December 31, 2002 to 3.4% for the year ended December 31, 2003.
2003 2002 ---- ---- Realized gains: Fixed securities $ 1,590,937 $ 774,931 Equity securities 1,230,118 123,232 ------------- -------------
Loss and loss adjustment expenses increased by $11.5 million, or 72.1%, to $27.5 million for the year ended December 31, 2003, as compared to $16.0 million as of December 31, 2002. The increase is predominantly due to the increase in net premiums earned. The Company's loss ratio, as determined in accordance with GAAP, for the year ended December 31, 2003 was 60.8% compared with 54.4% for the same period in 2002. The table below reflects the loss ratios by product line.
Losses and loss adjustment expenses, the Company's most significant expense, represent actual payments made and changes in estimated future payments to be made to or on behalf of its policyholders, including expenses required to settle claims and losses. Management revises its estimates based on the results of its 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 Company attributes the overall increase in the loss ratio primarily to its liability lines of insurance associated with automobile claims and the related estimates of the costs necessary to settle the claims. The estimated cost to close all claim files, for accidents that occurred in years other than the accidents that occurred in the current year ended December 31, 2003 and net of reinsurance recoveries, has increased by a total of $1.2 million over the ultimate estimates made as of December 31, 2002, primarily due to a decrease of claim frequency and claim severity and periodic estimates made by management of the ultimate costs required to settle all claims, both reported and not yet reported.
SALARIES AND WAGES. Salaries and wages increased $0.8 million, or 18.9%, to $5.4 million for the year ended December 31, 2003, as compared to $4.6 million for the year ended December 31, 2002. Management believes that the increase in salaries and wages is consistent with retaining quality management and increased premium production.
POLICY ACQUISITION COSTS, NET OF AMORTIZATION. Policy acquisition costs, net of amortization, increased by $1.2 million, or 58.6%, to a credit of $0.9 million for the year ended December 31, 2003, as compared to a credit of $2.1 million as of December 31, 2002. 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.
Our primary sources of capital in 2004 were revenues generated from operations, including our investment portfolios, issuance of debt securities, sale of certain assets related to our non-standard automobile agency insurance business in Florida, and borrowings under our Revolving Loan Agreement (the "Revolving Agreement"), as described below. Because we are a holding company, we are largely dependent upon fees from our subsidiaries for cash flow.
Operations for the year ended December 31, 2004 used $32.9 million of gross cash flow primarily for a $14.4 million increase to reinsurance recoverable, net and a $7.1 million increase income taxes recoverable, and $5.2 million gain on sale of agency operations. Additionally, $5.2 million was used to pay agent commissions where the underlying policy term is unexpired as of December 31, 2004.
In addition, our investment portfolio is highly liquid as it consists almost entirely of readily marketable securities. Cash flow used in net investing activities was $30.9 million for the year ended December 31, 2004, as we invested the cash flow from operating and financing activities. While in a period in which written premiums are increasing, it is reasonably expected that cash from premiums will be used for investing activities. In the future, we expect a continued cash flow deficit from investing activities, as we invest cash from operations.
The 2003 Warrants issued to the purchasers of the July 2003 Notes and to the placement agent in the offering, J. Giordano Securities Group ("J. Giordano"), each entitle the holder to purchase 3/4 of one share of our Common Stock at an exercise price of $12.7435 per whole share (as adjusted for the Company's three-for-two stock split) until July 31, 2006. The total number of shares issuable upon exercise of 2003 Warrants issued to the purchasers of the July 2003 Notes and to J. Giordano totaled 408,050. GAAP requires that detachable warrants be valued separately from debt and included in paid-in capital. Based on the terms of the purchase agreement with the investors in the private placement, management believes that the July 2003 Warrants had zero value at the date of issuance.
The 2004 Warrants issued to the purchasers of the September 2004 Notes and to the placement agent in the offering, J. Giordano, each entitle the holder to purchase one share of our Common Stock at an exercise price of $12.75 per share and will be exercisable until September 30, 2007. The number of shares issuable upon exercise of the 2004 Warrants issued to purchasers equaled $12.5 million divided by the exercise price of the warrants, and totaled 980,392. The number of shares issuable upon exercise of the 2004 Warrants issued to J. Giordano equaled $500,000 divided by the exercise price of the warrants, and totaled 39,216. GAAP requires that detachable warrants be valued separately from debt and included in paid-in capital. Based on the terms of the purchase agreement with the investors in the private placement, management believes that the September 2004 Warrants had zero value at the date of issuance. The terms of the 2004 Warrants provide for adjustment of the exercise price and the number of shares issuable thereunder upon the occurrence of certain events typical for private offerings of this type.
The annual interest rate on advances under the Revolving Agreement is the prime rate plus additional interest varying from 1.25% to 3.25% based on the prior month's ratio of contracts receivable related to insurance companies with an A. M. Best rating of B or worse to total contracts receivable. The effective interest rate on this line of credit, based on our average outstanding borrowings under the Revolving Agreement, was 5.71%, 4.83% and 6.23% for the years ended December 31, 2004, 2003 and 2002, respectively.
As an alternative to premium finance we offer direct billing where the insurance company accepts from the insured, as a receivable, a promise to pay the premium, as opposed to requiring the full amount of the policy, either directly from the insured or from a premium finance company. The advantage of direct billing a policyholder by the insurance company is that we are not reliant on our credit facility, but remain able to charge and collect interest from the policyholder.
At December 31, 2004 and 2003, 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.
We have audited the accompanying consolidated balance sheets of 21st Century Holding Company and Subsidiaries (the "Company"), a Florida corporation, as of December 31, 2004 and 2003, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2004. 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.
21st Century Holding Company and Subsidiaries CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
21st Century Holding Company and Subsidiaries CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS) YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
21st Century Holding Company and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
We are an insurance holding company, which, through our subsidiaries and our contractual relationships with our independent agents, control substantially all aspects of the insurance underwriting, distribution and claims process. We underwrite personal automobile insurance, general liability insurance, homeowners' insurance and mobile home property and casualty insurance in Florida, Georgia and Louisiana through our wholly owned subsidiaries, Federated National Insurance Company ("Federated National") and American Vehicle Insurance Company ("American Vehicle"). American Vehicle has recently been authorized to write commercial general liability policies in Kentucky and expects to begin writing policies in that state in the near future. American Vehicle is a fully admitted insurance carrier in Florida, Louisiana and Texas and is admitted as a surplus lines carrier in Georgia and Kentucky.
We also offered other services at our Company-owned and franchised agencies, including tax return preparation and electronic filing and the issuance and renewal of license tags. In August 1999, we acquired an 80% interest in Express Tax Service, Inc ("Express Tax"). Express Tax licenses tax return preparation software to business locations throughout the United States and also earns fees on all electronically filed returns. Express Tax licenses its software to the Company's agencies. On January 13, 2005, with an effective date of January 1, 2005, we sold our 80% interest in Express Tax Service, Inc.
Year Ended December 31, ----------------------- 2004 2003 2002 ------------ ------------ ------------ Balance, beginning of year $ 1,739,685 $ 7,721 $ 11,952 Acquisition costs deferred 13,640,291 877,685 (2,068,545) Amortization expense during year (8,422,808) 854,279 2,064,314 ------------ ------------ ------------ Balance, end of year $ 6,957,168 $ 1,739,685 $ 7,721 ============ ============ ============ (E) PREMIUM DEPOSITS
Unpaid losses and loss adjustment expenses are determined by establishing liabilities in amounts estimated to cover incurred losses and loss adjustment expenses. Such liabilities are determined based upon our assessment of claims pending and the development of prior years' loss liability. These amounts include liabilities based upon individual case estimates for reported losses and loss adjustment expenses and estimates of such amounts that are incurred but not reported. Changes in the estimated liability are charged or credited to operations as the estimates are revised. Unpaid losses and loss adjustment expenses are reported net of estimates for salvage and subrogation recoveries, which totaled approximately $889,000, $859,000 and $550,000, net of reinsurance, at December 31, 2004, 2003 and 2002, respectively.
There can be no assurance that our unpaid losses and loss adjustment expenses will be adequate to cover actual losses. If our unpaid losses and loss adjustment expenses prove to be inadequate, we will be required to increase the liability with a corresponding reduction in our net income in the period in which the deficiency is identified. Future loss experience substantially in excess of the established unpaid losses and loss adjustment expenses could have a material adverse effect on our business, results of operations and financial condition.
Commission income consists of fees earned by the Company-owned agencies placing business with third party insurers and third party premium finance companies. Commission income is earned on a pro rata basis over the life of the policies. Unearned commissions represent the portion of the commissions related to unexpired policy terms. During 2002 Assurance MGA completed its program for underwriting insurance for an unaffiliated insurance company.
Provisions for credit losses are provided in amounts sufficient to maintain the allowance for credit losses at a level considered adequate to cover anticipated losses. Generally, accounts that are over 90 days old are written off to the allowance for credit losses. We have been increasing our reliance on the direct billing our policyholders for their insurance premiums. Direct billing is when the insurance company accepts from the insured, as a receivable, a promise to pay the premium, as opposed to requiring payment of the full amount of the policy, either directly from the insured or from a premium finance company. We believe that the direct billing program does not increase our risk because the insurance policy, which serves as collateral, is managed by our computer system. Underwriting criteria are designed with down payment requirements and monthly payments that create policyholder equity, also called unearned premium, in the insurance policy. The equity in the policy is collateral for the extension of credit to the insured. The increase in the allowance for credit losses can be primarily attributed to homeowner and mobile homeowner policyholders and a cancellation moratorium in effect for non-payment of insurance premiums.
Our reinsurance contracts provide ceding commissions for premiums written which are subject to adjustment. The amount of ceding commissions is determined by the loss experience for the reinsurance agreement term. The reinsurer provides commissions on a sliding scale with maximum and minimum achievable levels. The reinsurer provides us with the provisional commissions. We have recognized the commissions based on the current loss experience for the policy year premiums. This results in establishing a liability for the excess of provisional commissions retained compared to amounts recognized, which is subject to variation until the ultimate loss experience is determinable. There were no contingent ceding commissions recognized for the year ended December 31, 2003 due to the provisions contained in the reinsurance contract allowing for a flat rate commission schedule. For the year ended December 31, 2002 there was $369,000 of contingent ceding commissions recognized.
In May 2003, the FASB issued Statement of Financial Accounting Standard Number 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity and it requires that an issuer classify a financial instrument that is within its scope as a liability because the financial instrument embodies an obligation of the issuer. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective in the first interim period beginning after June 15, 2003. On July 31, 2003 , we completed a private placement of our 6% Senior Subordinated Notes (the "July 2003 Notes"), and on September 30, 2004 , we completed another private placement of our 6% Senior Subordinated Notes (the "September 2004 Notes"), both of which were offered and sold to accredited investors as units consisting of one Note with a principal amount of $1,000 and warrants (the "Warrants") to purchase shares of our Common Stock. These Notes which fall within the definition of financial instruments as described in Financial Accounting Standard Number 150 are presented as a liability in conformity with Statement of Financial Accounting Standard Number 150. As such, the adoption of this Statement did not have any impact on our Consolidated Financial Statements.
As a result of the hurricanes striking Florida in August and September 2004, we are not in compliance with certain regulatory requirements. To retain our certificates of authority, Florida insurance laws and regulations require that our insurance company subsidiaries, Federated National and American Vehicle, maintain capital surplus equal to the greater of 10% of its liabilities or the 2004 statutory minimum capital and surplus requirement of $4.00 million as defined in the Florida Insurance Code. As of December 31, 2004, Federated National was not in compliance with its requirement to maintain minimum capital surplus primarily based on the incurred losses associated with the four hurricanes that occurred in August and September 2004. Under the provisions afforded Federated National according to Statement of Statutory Accounting Principles No 72 titled "Surplus and Quasi-reorganizations," compliance with this provision was restored by way of a surplus infusion from 21st Century. American Vehicle remains in compliance with statutory minimum capital and surplus requirement. The insurance companies are also required to adhere to prescribed premium-to-capital surplus ratios. As of December 31, 2004, Federated National did not comply with the prescribed premium-to-capital surplus ratio, primarily based on the incurred losses associated with the four hurricanes that occurred in August and September 2004. Under the provisions afforded Federated National according to Statement of Statutory Accounting Principles No. 72, compliance with this provision was also restored. American Vehicle remains in compliance with statutory premium-to-capital surplus ratios.
(II) CREDIT RISK--the risk that issuers of securities owned by us will default or that other parties, including reinsurers to whom business is ceded, which owe us money, will not pay. We attempt to minimize this risk by adhering to a conservative investment strategy, maintaining reinsurance agreements with financially sound reinsurers, and by providing for any amounts deemed uncollectible.
(IV) CATASTOPHIC EVENT RISK--the risk associated with writing insurance policies covering automobile owners, home owners, and business owners for losses that result from catastrophes, including hurricanes, tropical storms, tornadoes or other weather related events. We mitigate our risk of catastrophic events through the use of reinsurance, forecast modeling techniques and the monitoring of concentrations of risk, all designed to protect the statutory surplus of the insurance companies.
We account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees". Compensation cost for stock options, if any, is measured as the excess of the quoted market price of our stock at the date of grant over the amount an employee must pay to acquire the stock.
The FASB Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (FAS 123) establishes financial accounting and reporting standards for stock-based compensation plans. As permitted by FAS 123, we use the accounting method prescribed by Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" (APB 25) to account for our stock-based compensation plans. Companies using APB 25 are required to make pro forma footnote disclosures of net income and earnings per share as if the fair value method of accounting, as defined in FAS 123, had been applied. See Note 2(e) "Accounting Changes" and Note 16 "Stock Compensation Plans" for more information.
Property, plant and equipment are stated at cost less accumulated depreciation. Depreciation on property, plant and equipment is calculated on a straight-line basis over the following estimated useful lives: building and improvements - 30 years and furniture and fixtures - 7 years. We capitalize betterments and any other expenditure in excess of $500 if the asset is expected to have a useful life greater than one year. The carrying value of property, plant and equipment is periodically reviewed based on the expected future undiscounted operating cash flows of the related item. Based upon our most recent analysis, we believe that no impairment of property, plant and equipment exists at December 31, 2004.
Below is a summary of fixed maturities at December 31, 2004 and 2003 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 Office of Insurance Regulation as of December 31, 2004, as required by law for both Federated National and American Vehicle.
Proceeds from sales of fixed maturities and equity securities for the years ended December 31, 2004, 2003 and 2002 were approximately $81.2 million, $168.0 million and $41.3 million, respectively.
Net unrealized losses: Fixed maturities $ 18,701 $ (321,514) Equity securities (315,964) 27,712 ----------- -----------
Years Ended December 31, ------------------------ 2004 2003 --------- --------- Mortgage receivable beginning of year $ 137,571 $ 145,043 New mortgages -- -- Principal payments received (137,571) (7,472) --------- --------- Mortgage receivable end of year $ -- $ 137,571 ========= =========
As of December 31, 2004, approximately $2.6 million, or 28.8%, of the gross premium finance receivables (before the allowances for credit losses and unearned premium finance charges) that represent policies from an unrelated insurer. This unrelated insurance company currently is rated "B-" (Fair) by A.M. Best.
Years Ended December 31, ------------------------ 2004 2003 ----------- ----------- Land $ 625,000 $ 632,144 Building and improvements 3,114,300 2,823,400 Furniture and fixtures 2,562,971 2,385,083 ----------- ----------- Property, plant and equipment, gross 6,302,271 5,840,627 Accumulated depreciation (2,029,538) (1,686,984) ----------- ----------- Property, plant and equipment, net $ 4,272,733 $ 4,153,643 =========== ===========
We reinsure (cede) a portion of written premiums on a quota-share basis to nonaffiliated insurance companies in order to limit our loss exposure. We also maintain coverages to limit losses from large exposures, which we believe are adequate for current volume. To the extent that reinsuring companies are unable to meet their obligations assumed under the reinsurance agreements, we remain primarily liable to our policyholders.
We earned approximately $1.5 million, $6.7 million and $6.8 million in commissions on premiums ceded during the years ended December 31, 2004, 2003 and 2002, respectively. Had all of our reinsurance agreements been cancelled at December 31, 2004 we would have returned no reinsurance commissions to our reinsurers and in turn, our reinsurers would have nothing to return to us from unearned premiums. Had all of our reinsurance agreements been canceled at December 31, 2003, we would have returned a total of approximately $2.5 million in reinsurance commissions to our reinsurers; in turn, our reinsurers would have returned approximately $7.8 million in unearned premiums to us.
The Revolving Agreement contains various operating and financial covenants, with which we were in compliance at December 31, 2004 and December 31, 2003. Outstanding borrowings under the Revolving Agreement as of December 31, 2004 and December 31, 2003 were $2.1 million and $4.1 million, respectively. Outstanding borrowings in excess of the $2.0 million commitment totaled $148,542 as of December 31, 2004. The excess amount, permissible by reason of a compensating cash balance of $156,070 for December 31, 2004, was held for the benefit of FPF and is included in other assets. Outstanding borrowings in excess of the $4.0 million commitment totaled $98,786 as of December 31, 2003. The excess amount, permissible by reason of a compensating cash balance of $200,430 for December 31, 2003, was held for the benefit of FPF and is included in other assets. Interest expense on this revolving credit line for the years ended December 31, 2004, 2003 and 2002 totaled approximately $178,000, $203,000 and $342,000, respectively.
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 2004, 2003 and 2002, Federated National and American Vehicle were required to have capital surplus of $4.0 million, $3.60 million and $3.25 million, each, respectively. At December 31, 2004, 2003 and 2002, Federated National's statutory capital surplus was $7.6 million, $16.7 million and $9.2 million, respectively. At December 31, 2004, 2003 and 2002, American Vehicle had statutory capital surplus of $17.1 million, $10.7 million and $4.0 million, respectively. Further, the companies were also required to adhere to a prescribed net premium-to-surplus ratio.
As of December 31, 2004, Federated National was not in compliance with its requirement to maintain minimum capital surplus primarily based on the incurred losses associated with the four hurricanes that occurred in August and September 2004. Under the provisions afforded Federated National according to Statement of Statutory Accounting Principles No 72 titled "Surplus and Quasi-reorganizations," compliance with this provision was restored. American Vehicle remains in compliance with statutory minimum capital and surplus requirement. The insurance companies are also required to adhere to prescribed premium-to-capital surplus ratios. As of December 31, 2004, Federated National did not comply with the prescribed premium-to-capital surplus ratio, primarily based on the incurred losses associated with the four hurricanes that occurred in August and September 2004. Under the provisions afforded Federated National according to Statement of Statutory Accounting Principles No 72, compliance with this provision was also restored. American Vehicle remains in compliance with statutory premium-to-capital surplus ratios.
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 Office of Insurance Regulation 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) 10 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 Office of Insurance Regulation (i) if the dividend is equal to or less than the greater of (a) 10 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 Office of Insurance Regulation 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 Office of Insurance Regulation or (ii) 30 days after the Florida Office of Insurance Regulation has received notice of such dividend or distribution and has not disapproved it within such time. No dividends were declared or paid in 2004, 2003 or 2002. Under these laws, neither Federated National nor American Vehicle would be permitted to pay dividends to 21st Century in 2004.
for corrective action and is currently in discussions with the Florida Office of Insurance Regulation regarding the merits of the action plan points. The regulatory action level permits the insurance regulators to perform an examination or other analysis and issue a corrective order. Federated National is scheduled to have its statutorily required triennial examination during 2005 for the three years ended December 31, 2004 to be performed by the Florida Office of Insurance Regulation. We may be subject of additional targeted examinations or analysis. These examinations or analysis may result in one or more corrective orders being issued by the Florida Office of Insurance Regulation.
The NAIC has also developed Insurance Regulatory Information Systems ("IRIS") ratios to assist state insurance Department of Financial Services in identifying companies which may be developing performance or solvency problems, as signaled by significant changes in the companies' operations. Such changes may not necessarily result from any problems with an insurance company, but may merely indicate changes in certain ratios outside the ranges defined as normal by the NAIC. When an insurance company has four or more ratios falling outside "usual ranges," state regulators may investigate to determine the reasons for the variance and whether corrective action is warranted.
As of December 31, 2004, Federated National was outside NAIC's usual ranges with respect to its IRIS tests on seven out of twelve ratios. With the exception of two of these test results, all of test results can be attributed to the significant degradation of Policyholders' Surplus stemming from the losses incurred relative to its homeowner s' line of business as a result of the four hurricanes that affected Florida in August and September of 2004. Change in Net Writings and Two-Year Reserve Development to Policyholders' Surplus was the results of test ratios that do not employ Policyholders' Surplus.
As of December 31, 2004, American Vehicle was outside NAIC's usual ranges for three out of twelve ratios. The first ratio relates to a larger than anticipated change in net writings, the second ratio relates to higher surplus growth that stemmed from the Parent company's capital contributions totaling $4.3 million during the year and the third ratio relates to an investment yield that was slightly less than expected.
The table below reflect the range and test results for both Federated National and American Vehicle for the years ended December 31 2004 and 2003, respectively.
GAAP differs in some respects from reporting practices prescribed or permitted by the Florida Office of Insurance Regulation. Federated National's statutory capital and surplus was $7.6 million and $16.7 million as of December 31, 2004 and 2003, respectively. Federated National's statutory net income (loss) was ($25.4) million, $2.9 million and ($2.1) million for the years ended December 31, 2004, 2003 and 2002, respectively. Federated National's statutory non-admitted assets were approximately $8.9 million and $504,000 as of December 31, 2004 and 2003, respectively.
American Vehicle's statutory capital and surplus was $17.1 million and $10.7 million as of December 31, 2004 and 2003, respectively. American Vehicle's statutory net income was approximately $2,032,000, $848,000 and $135,000 for the years ended December 31, 2004, 2003 and 2002 respectively. American Vehicle's statutory non-admitted assets were approximately $167,000 and $161,000 as of December 31, 2004 and 2003, respectively.
In June 2000, a lawsuit was filed against us, our directors and our executive officers seeking compensatory damages in an undisclosed amount on the basis of allegations that our amended registration statement dated November 4, 1998 was inaccurate and misleading concerning the manner in which we recognized ceded insurance commission income, in violation of Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The lawsuit was filed in the United States District Court for the Southern District of New York. The plaintiff class purportedly included purchasers of our common stock between November 5, 1998 and August 13, 1999. The Court granted the plaintiffs class status. Specifically, the plaintiffs alleged that we recognized ceded commission income on a written basis, rather than amortized on a pro rata basis. The plaintiffs allege that this was contrary to the Statement of Financial Accounting Concepts Nos. 1, 2 and 5. We believe, however, that the lawsuit is without merit and we have vigorously defended the action, because we reasonably relied upon outside subject matter experts to make these determinations at the time. We have also since accounted for ceded commission on a pro rata basis and have done so since these matters were brought to our attention in 1998. Nevertheless, we have also continued to actively participate in settlement negotiations with the plaintiffs and have agreed to settle the case. The parties have negotiated the final terms of a Memorandum of Understanding, which was executed by the parties and then approved by the court in late February 2005. We have reserved and charged against forth quarter 2003 earnings $600,000 for the potential settlement and associated costs. During 2004, and through the date of the auditor's report, no adjustment to the original reserve has been deemed necessary.
During the year ended December 31, 2004 Federated National and American Vehicle were assessed $362,121 and $120,009, respectively. These charges are contained in Operating and Underwriting Expenses in the Statement of Operations. Future assessments by this association are undeterminable at this time.
Effective December 31, 2004 we sold our interest in our agency operations which relieved us from our 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 2004, 2003 and 2002 were approximately $840,000, $733,000 and $756,000, respectively, and are included in operating and underwriting expenses in the accompanying consolidated statements of operations.
One of our directors is a partner at a law firm that handles the Company's claims litigation. Fees paid to this law firm amounted to approximately $327,000, $219,000 and $266,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
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 years ended December 31, 2004 and 2002 and were not taken into account in the computation.
We operate principally in two business segments consisting of insurance and financing. The insurance segment consists of underwriting through Federated National and American Vehicle, managing general agent operations through Assurance MGA, claims processing through Superior Adjusting and marketing and distribution through independent agents. The insurance segment sells primarily standard and nonstandard personal automobile insurance, homeowners' insurance, mobile home property and casualty insurance, and general liability insurance. This segment includes substantially all aspects of the insurance, distribution and claims process. The financing segment consists of premium financing through Federated Premium Finance. The financing segment provides premium financing to our insureds and third party carrier insureds, and is marketed through our distribution network.
Supplemental segment information as of and for the year ended December 31, 2004, 2003 and 2002 follows:
Activity in our stock option plans for the period from January 1, 2002 to December 31, 2004 is summarized below:
The weighted average fair value of options granted during 2004, 2003 and 2002 estimated on the date of grant using the Black-Scholes option-pricing model was $6.13 to $18.26; $4.21 to $8.31 and $1.45 to $5.37, respectively. The fair value of options granted is estimated on the date of grant using the following assumptions:
Reclassification adjustments related to the investment securities included in comprehensive income (loss) for the years ended December 31, 2004, 2003 and 2002 are as follows:
On July 31, 2003, we completed a private placement of our 6% Senior Subordinated Notes (the "July 2003 Notes"), which were offered and sold to accredited investors as units consisting of one July 2003 Note with a principal amount of $1,000 and warrants (the "2003 Warrants") to purchase shares of our Common Stock. We sold an aggregate of $7.5 million of July 2003 Notes in this placement, which resulted in proceeds to us (net of placement agent fees of $450,724 and offering expenses of $110,778) of $6,938,498.
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 2003 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 July 2003 Notes, the quarterly payments of principal and interest due in shares of our Common Stock and in accordance with the contractual computations issued common stock as follows:
For the period - -------------- Year ending December 31, 2005 $2,500,000 Year ending December 31, 2006 1,875,000 ---------- Total $4,375,000 ==========
For the period - -------------- Year ending December 31, 2005 $ 4,166,668 Year ending December 31, 2006 4,166,668 Year ending December 31, 2007 4,166,664 ----------- $12,500,000 ===========
The company has recognized a $2.5 million receivable relating to this transaction and it is reflected in Other Assets. Concurrently, the company has also recognized a $2.5 million deferred gain relating to the same transaction and it is reflected as a liability titled Deferred income on discontinued operations.
Subsequent to December 31, 2004 and the date of presentation the Company received notice from the Alabama Department of Insurance that American Vehicle has been admitted and licensed to underwrite personal automobile and commercial general liability lines of insurance.
In connection with the transaction, the Company has extended the expiration dates for the 75,000 outstanding stock options previously granted to Kluba and the 30,000 outstanding stock options previously granted to Kluba's wife, such that 80% of such stock options shall expire, if not exercised, on the first anniversary date of the closing and the remaining 20% of such stock options shall expire on the second anniversary date of the closing; none of these options shall be exercisable for the six-month period following the closing.
Effective March 1, 2005, Federated National sold its interest in the Lauderdale Lakes property used by the company as its headquarters to 21st Century at the property's net book value of approximately $2.9 million.