We lease an aggregate of approximately 444,000 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States.
The following tables provide selected historical consolidated financial and operating data of Affirmative Insurance Holdings, Inc. as of the dates and for the periods indicated. We have restated our 2004 consolidated statement of operations to reflect the correction of an error in the application of consolidating elimination entries. The restated 2004 consolidated statement of operations conforms to the presentation of the 2005 consolidated statement of operations. A reconciliation of the previously reported 2004 consolidated statement of operations to the restated 2004 consolidated statement of operations follows the Selected Data table below.
In conjunction with the data provided in the following tables and in order to more fully understand our historical consolidated financial and operating data, you should also read “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the accompanying notes included in this report. We derived our selected financial data as of December 31, 2005, 2004, 2003, 2002 and 2001 and for the years then ended from our audited consolidated financial statements. The results for past accounting periods are not necessarily indicative of the results to be expected for any future accounting period.
On December 28, 2001, Vesta increased its ownership interest in us to 92% of the voting power of our capital stock. At that time, we adopted push down accounting. Our statements of operations data for the year ended December 31, 2001 is presented above on our historical basis, as push down accounting was not appropriate prior to December 28, 2001 and no material adjustments exist for the period from December 28, 2001 to December 31, 2001.
We have restated our 2004 audited consolidated financial statements and our 2005 quarterly unaudited consolidated statements of operations. The restated consolidated financial statements conform to the current presentation and reflect the correction of an error in the application of consolidating elimination entries. See Note 2 “Restatement” to our consolidated financial statements for a reconciliation of previously reported amounts to the restated amounts. The restatement has no impact on previously reported net income, earnings per share or shareholders’ equity.
On June 1, 2005, we purchased 2,000,000 of our shares of common stock from Vesta at a price of $14.00 per share.
On June 14, 2005, Vesta entered into a Stock Purchase Agreement with New Affirmative LLC , for the sale of 5,218,228 shares of our common stock. New Affirmative was formed for the purpose of acquiring, holding, voting and disposing of the shares of our common stock acquired in connection with the Stock Purchase Agreement and any shares of our common stock that New Affirmative may acquire in the future. New Affirmative is (i) 50% owned by DSC AFFM, LLC, an entity controlled by DSC AFFM Manager LLC, the sole managing member of DSC AFFM, and Andrew G. Bluhm, the managing member of DSC AFFM Manager, and (ii) 50% owned by Affirmative Investment LLC, an entity owned, in part, by the Enstar Group, Inc., and controlled by Affirmative Associates LLC, the sole managing member of Affirmative Investment and J. Christopher Flowers, the sole member and manager of Affirmative Associates. Simultaneously with the closing of the transactions contemplated by the Stock Purchase Agreement: (1) DSC AFFM contributed 1,459,699 shares of the Company’s Common Stock which were previously acquired in open market transactions by members of DSC AFFM and subsequently contributed to DSC AFFM, to New Affirmative and (2) Affirmative Investment contributed 1,183,000 shares of the Company’s Common Stock, previously acquired by it in open market transactions, to New Affirmative. The Vesta / New Affirmative transaction was subject to customary closing conditions and regulatory approval by the Illinois Department of Financial and Professional Regulation - Division of Insurance and other required filings. Vesta completed the sale to New Affirmative on August 30, 2005. New Affirmative now owns 7,860,927 shares of our common stock, or approximately 50.9%.
The following table displays our total controlled premium and gross premiums written by distribution channel for the years ended December 31, 2005 and 2004 (dollars in thousands):
The historical financial results of Vesta’s non-standard personal automobile insurance business for the years ended December 31, 2003 have been included in footnotes to Vesta’s audited financial statements, which are not included in this report.
Acquisitions. In 2001, 2002, 2004 and 2005, we acquired seven retail and/or underwriting agencies currently operating in seven states. Effective December 31, 2003, we acquired our two insurance companies from Vesta. Descriptions of each of these acquisitions are provided below. With the exception of the December 31, 2002 InsureOne transaction and the acquisition of our insurance companies, all of these transactions were accounted for as purchases and the purchase price was allocated to the assets purchased based on their fair values at the time of acquisition.
American Agencies and Harbor. On January 1, 2002, we acquired American Agencies General Agency, Inc., as well as certain non-standard personal automobile insurance assets of Harbor Insurance Group, Inc. As part of the transaction, the assets and business operations of Harbor Insurance Group, Inc. were transferred to American Agencies General Agency, Inc. The combined American Agencies operation is an underwriting agency that underwrites and services non-standard personal automobile insurance policies sold by independent agencies in the states of Texas and New Mexico.
Fed USA. In December 2004, we acquired certain assets of Fed USA Retail, Inc., which owns retail agencies that produce and service non-standard personal automobile policies sold in Florida by 24 owned and branded retail stores in three DMAs as of December 31, 2004. We also acquired certain assets of Fed USA Franchising, Inc., which produces and services policies sold in Florida through 42 franchised retail stores in four DMAs as of December 31, 2004.
IPA. On July 19, 2005, we acquired the assets of IPA, LLC, an underwriting agency with operations in Michigan. IPA generates approximately $20 million in premiums annually.
Revenue recognition. Our consolidated revenues are derived principally from premiums, commissions, fees, investment income and investment gains and losses. Premiums are earned over the life of a policy on a pro rata basis. Unearned premiums represent that portion of premiums written which is applicable to the unexpired terms of policies in force. Premium receivables are recorded net of an estimated allowance for uncollectible amounts.
Claims processing fees are received from insurance companies over the premium earning period of the underlying policies. These fees are recognized as revenue over the expected period during which processing services are performed and in amounts appropriate to the processing effort and related costs. The service period and related revenues are based upon historical and expected claims settlement data. All claims processing fees from our insurance companies are eliminated in consolidation.
At December 31, 2005, we had $28.1 million receivables from reinsurers, including $18.5 million gross recoverable from Vesta Fire. Vesta Fire is currently rated “C++” (Marginal) by A.M. Best. According to our reinsurance agreement, if Vesta Fire’s A.M. Best financial strength rating remains below “B+” we have the right to require Vesta Fire to provide a letter of credit or establish a trust account to collateralize the gross amounts due to us from Vesta Fire under the reinsurance agreement. On July 27, 2004, we notified Vesta to establish a trust account collateralizing the amount due to us, due to the fact that Vesta Fire’s A.M. Best rating was below a “B+” after the consummation of our initial public offering. We have $22.0 million currently in a trust account to collateralize the $18.5 million gross recoverable from Vesta Fire.
Reserving for unpaid losses and loss adjustment expenses. We maintain reserves in the amount of the estimated ultimate liability for unpaid losses and loss adjustment expenses related to incurred claims and our estimate of unreported claims. Management’s estimation of the ultimate liability for unpaid losses and loss adjustment expenses is based on projections developed by our actuaries using analytical methodology commonly used in the property-casualty insurance industry. The liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based on the following: (1) the accumulation of estimates of individual claims for losses reported prior to the close of the accounting period; (2) estimates received from ceding companies, reinsurers and insurance pools and associations; (3) estimates of unreported losses based on past experience; (4) estimates based on past experience of expenses for investigating and adjusting claims; and (5) estimates of subrogation and salvage collections. We periodically adjust our loss and loss adjustment expense reserves for changes in product mix, underwriting standards, loss cost trends and other factors. Our loss and loss adjustment expense reserves may also be impacted by factors such as the rate of inflation, claims settlement patterns, litigation and legislative activities. Unpaid losses and loss adjustment expenses have not been reduced for our reinsurance recoverables. Changes in estimates of the liabilities for unpaid losses and loss adjustment expenses are reflected in the consolidated statement of operations in the period in which determined. Ultimately, our actual losses and loss adjustment expenses may differ materially from the estimates we have recorded. As previously noted, our financial statements for periods before December 31, 2003 include the effects of a 100% quota share reinsurance contract with our affiliate, Vesta Fire. Accordingly, we retain none of the underwriting risks associated with the reserves established at December 31, 2003 for our insurance companies.
Statutory accounting practices. The Company is required to report its results of operations and financial position to Insurance Departments of Insurance based upon Statutory accounting practices (“SAP”). Certain key differences under SAP, unlike GAAP are as follows: the Company is required to expense all sales and other policy acquisition costs as they are incurred rather than capitalizing and amortizing them over the expected life of the policy. The immediate charge off of sales and acquisition expenses and other conservative valuations under SAP generally cause a lag between the sale of a policy and the emergence of reported earnings. Because this lag can
Valuation of investments. Our investments are recorded at fair value and are typically based on publicly available quoted prices. From time to time, the carrying value of our investments may be temporarily impaired because of the inherent volatility of publicly traded investments. We do not adjust the carrying value of any investment unless management determines that its value is other than temporarily impaired.
Our Investment Committee reviewed our investment portfolio in December 2005 and decided to sell a portion of our investment portfolio in order to better align our portfolio with our historical claims life. Specifically, the Investment Committee determined that all securities with a maturity after December 31, 2008 should be sold. We determined that the identified securities to be sold would not fully recover (fair market value would not equal or exceed amortized cost) prior to the expected sale date, therefore the securities were deemed other than temporarily impaired in December 2005 when the decision to sell was made and we recorded a charge to earnings of $1.7 million in the fourth quarter of 2005. The identified securities were in compliance with our investment guidelines prior to the realignment decision by the Investment Committee.
The following table shows our investments with gross unrealized losses (after giving effect to the $1.7 million charge in December 2005) and fair value, aggregated by type of fixed maturity investment and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2005 (dollars in thousands):
Overview. As described in more detail below, our agency segment is comprised of our underwriting agencies and our retail agencies. Our underwriting agencies primarily design, distribute and service policies issued or reinsured by our insurance companies or another unaffiliated insurance company. In our insurance segment, we issue non-standard personal automobile insurance policies through our two Illinois-domiciled insurance company subsidiaries. Our insurance companies possess the certificates of authority and capital necessary to transact insurance business and issue policies, but they rely on both affiliated and unaffiliated underwriting agencies to design, distribute and service those policies.
Our retail agencies earn commissions and fees from the sale of non-standard personal automobile insurance policies administered by our underwriting agencies, which are substantially eliminated in consolidation, as well as commissions and fees from the sale of other insurance policies and products of unaffiliated companies. For the year ended December 31, 2005, the total commissions and fees earned by our retail agencies were $48.9 million, of which approximately $14.2 million, or 29.1%, was paid to us by unaffiliated companies and not eliminated in consolidation.
commissions generated by our underwriting agencies from designing, distributing, servicing and selling insurance policies issued or reinsured by our insurance companies and by unaffiliated insurance companies;
claims processing fees paid to our underwriting agencies for the administration of claims for policies issued or reinsured by our insurance companies and by an unaffiliated insurance company.
Our underwriting and retail agencies have substantial fixed-cost components to their operating structures enabling them to significantly increase premium volume while only marginally increasing operating expenses. The principal operating expenses of our underwriting and retail agencies include:
For the year ended December 31, 2003, our insurance companies’ revenues consisted primarily of policy fees, comprised primarily of origination and installment fees charged to our policyholders, and a small amount of investment income earned on invested assets and realized gains and losses. Beginning January 1, 2004, our insurance companies’ revenues include:
net premiums earned, which is the sum of the premiums earned on direct and assumed premiums written less premiums earned on premiums we cede to reinsurers;
policy fee revenues, which are comprised primarily of origination and installment fees charged to our policyholders.
For the year ended December 31, 2003, our insurance companies’ expenses consisted primarily of policy acquisition expenses, less ceding commissions that we received under reinsurance contracts, and a small amount of operating and general expenses. Because our insurance companies received ceding commissions from Vesta Fire that exceeded their policy acquisition expenses, our insurance company segment reported negative expenses during the year ended December 31, 2003. Beginning January 1, 2004, our insurance companies’ expenses include:
policy acquisition fees, including commissions and fees paid to our underwriting agencies and unaffiliated underwriting agencies and premium taxes, less ceding commissions that we receive under reinsurance contracts; and
We have restated our 2004 audited consolidated financial statements and our 2005 quarterly unaudited consolidated statements of operations. The restated consolidated financial statements conform to the current presentation. See Note 2 “Restatement” to our consolidated financial statements for a reconciliation of previously reported amounts to the restated amounts. The restatement of the audited 2004 financial statements has no impact on previously reported net income, earnings per share, invested assets or shareholders’ equity for 2004. The restatement of the 2005 unaudited quarterly statements of operations has a cumulative effect of reducing net income by $555,000 through the nine months ended September 30, 2005.
Comparison of the Year Ended December 31, 2005 to December 31, 2004
Consolidated. Total revenues for the year ended December 31, 2005 were $381.5 million, an increase of $58.1 million, or 18.0%, compared to total revenues of $323.3 million for the prior year. The increase in total revenues was principally due to our retention of gross premiums written in our insurance companies following the termination of the reinsurance agreements with Vesta, which allowed us to start retaining premiums beginning January 1, 2004 that were previously ceded to Vesta.
For the year ended December 31, 2005, our consolidated financial statements reflect $79.6 million in commission income and fees, as compared to $126.7 million in the year ended December 31, 2004. This significant decrease on a reported consolidated basis is directly related to our significantly increased retention of business written and assumed by our insurance companies. In our agencies, we earn commission income and fees that are based on written premiums. In consolidation, we eliminate the commission income and fees based on business that our insurance companies retain against our agency segment expenses. Therefore, when we retain a higher percentage of our written premiums, as we did in 2005 as compared to 2004, we eliminate a greater portion of the agency segment’s commission and fees income, thereby reducing our reported consolidated commission income and fees. Our net premiums earned increase to reflect the revenue on the greater proportion of the business retained by us.
As more fully described in Note 8 “Reinsurance” to our consolidated financial statements, in 2005 we ceded to non-affiliates only 1.7% ($5.5 million) of gross written premiums (direct and assumed premiums written) of $321.2 million, as compared to 23.6% ($66.5 million) of the $281.7 million gross premiums written in 2004. As described in the discussion of our agency segment below, the total commission income and fees for 2005 before consolidating eliminations was $169.6 million (52.8% of 2005 gross written premiums) as compared to $165.7 million (58.8% of 2004 gross written premiums) in the prior year.
In 2005, the losses and loss adjustment expenses represented 64.2% of net premiums earned (our “loss ratio”), as compared to 66.4% in 2004. See discussion of consolidated trade ratios below.
For the year ended December 31, 2005, selling, general and administrative expenses of $153.8 million represented 40.8% of the sum of the year’s net premiums earned and commission income and fees compared to 46.1% for the year ended December 31, 2004. Selling, general and administrative expenses increased by 3.9% from $148.1 million in 2004 to $153.8 million in 2005 largely due to the growth in our business.
In 2005, we expensed a total of $3.1 million for external auditing and external compliance consulting in connection with our year end financial statement audit and compliance with the Sarbanes-Oxley Act of 2002, including $1.2 million in the fourth quarter of 2005, as compared to $600,000 in 2004, including $200,000 in the fourth quarter of 2004. While we will remain subject to the requirements of
the Sarbanes-Oxley Act of 2002 in future periods, we believe that the level of costs incurred in the fourth quarter of 2005 is not reflective of the recurring level of such costs in future periods.
As noted in more detail in the discussion of our agency segment below, consolidated selling, general and administrative expenses for the year ended December 31, 2005, included (a) $2.7 million incurred in the fourth quarter of 2005, related to separation and non-competition agreements with three former executives, (b) $200,000 incurred for a retained search for a replacement executive and (c) $2.4 million related to the write down of amounts capitalized on the enterprise system development and license agreement. Consolidated depreciation and amortization expenses included $122,000 in amortization on the same non-competition agreements. There were no expenses of a similar nature incurred in the fiscal year ended December 31, 2004.
Income tax expense for the year ended December 31, 2005 was $9.8 million, or an effective rate of 34.0%, as compared to income tax expense for the year ended December 31, 2004 of $15.3 million, or an effective rate of 36.9%. In the fourth quarter of 2005, we recorded an adjustment to our deferred tax asset for state taxes. This adjustment reduced our income tax expense by $500,000 in the fourth quarter of 2005, resulting in an effective tax rate of 34.0% for 2005 and a fourth quarter effective tax rate of 49.3% due to the loss incurred in the quarter. Excluding the effect of this item, our effective tax rates would have been 35.72% and 32.8% for the year and the quarter, respectively. This adjustment is a non-recurring event and we anticipate that our future effective tax rates will be more similar to the effective tax rate for the year 2005 when this item is excluded. The decrease in the effective tax rate in year ended December 31, 2005 excluding the effect of the adjustment to our deferred tax asset, as compared to prior year, was principally due to the favorable impact of tax exempt income from our investment portfolio following our initial public offering in July 2004.
For the year ended December 31, 2005, our expense ratio was 26.3% as compared to 13.2% in the prior year. This increase in our expense ratio reflects the effect of the computational method that offsets our expenses with our commission income and fees in the dividend of the widely used industry calculation, with the divisor consisting of only net premiums earned. As described above, commission income and fees included in our consolidated financial statements decreased $47.1 million in 2005 to $79.6 from $126.7 million in 2004 as a result of the elimination entries related to our increased retention of business produced.
Using an alternative financial computational method whereby commission income and fees are included in the divisor and total expenses (other than losses and loss adjustment expenses and interest expense) are the dividend, the total expenses (other than losses and loss adjustment expenses and interest expense), which increased to $158.0 million in 2005, represented 41.9% of revenues (excluding investment income and realized losses) as compared to $152.3 million in 2004, representing 47.4% of revenues (excluding investment income and realized losses). The increase in expenses in 2005 includes certain expenses related to severance and non-competition agreements with three former executives and the write off of the costs associated with an outside vendor’s software development, as more fully discussed in the segment analysis below.
Provisional commission income for our underwriting agencies for the year ended December 31, 2005 was $72.6 million, a decrease of $3.6 million, or 4.7%, as compared to provisional commissions of $76.1 million in the prior year. The $72.6 million in provisional commission was favorably impacted by our recent acquisitions of Fed USA and IPA. IPA recorded provisional commission of $3.0 million over the last six months of 2005, while Fed USA contributed $629,000 of provisional commission to our Florida underwriting agency. Excluding these acquisitions, provisional commissions decreased $7.1 million, or 9.4% as compared to the prior year. Our provisional commission is derived from the total controlled premium produced by our underwriting agencies which decreased 8.4% from the prior year. Excluding the above acquisitions, total controlled premium produced decreased 13.4% from the prior year. Slightly offsetting this decrease was an overall increase in provisional commission rates which increased to 26.5% for the year ended December 31, 2005 from 25.5% in the prior year.
Commission income related to our retail agencies’ sales of unaffiliated insurance companies’ products was $10.0 million for the year ended December 31, 2005, an increase of $3.3 million, or 48.5%, as compared to commissions related to our retail agencies’ sales of unaffiliated insurance companies’ products of $6.7 million for the prior year. This increase is primarily due to our December 2004 acquisition of Fed USA, which accounted for $3.7 million of commissions for the year ended December 31, 2005, offset by a decrease in commissions from sales of unaffiliated insurance companies’ products in our Midwest operation due to increased competition.
caused an increase of $4.1 million as compared to prior year as well as $2.7 million in severance related expenses paid or accrued to three former executives during 2005. In addition, these acquisitions, as well as increased medical costs, were the primary cause in the increase in healthcare expense of $920,000 as compared to the prior year. During 2005, normal salary increases and increases in incentive compensation caused an increase of $1.3 million in employee compensation as compared to the previous year. We also had increases in human resource related expenses such as recruiting and relocation of $483,000 as compared to the prior year, primarily due to the increased headcount as well as $200,000 incurred for a retained search for our permanent chief executive officer.
Operating expenses for the year ended December 31, 2005 were $54.9 million, an increase of $5.6 million, or 11.3%, as compared to $49.3 million in the prior year. The increase in operating expenses was primarily a result of contractual changes, expansion through acquisitions, and legal and professional expenditures. Our acquisitions of Fed USA and IPA caused increases in expenses in areas such as advertising, rent and premium taxes and fronting fees. In total, operating expenses increased $3.3 million from the prior year due to these acquisitions. During 2005 we experienced continued increases in allocated loss adjustment expenses over the prior year of $3.8 million. The increase in allocated loss adjustment expense payments is a result of changes in contractual terms where our payment of allocated loss adjustment expenses is included in all of our claims administration contracts in 2005, where in 2004, this additional expense was not in all our contracts for the full year. In addition we incurred increases in legal and professional fees of $2.6 million, primarily due to increased audit fees and fees associated with the Sarbanes-Oxley Act of 2002. During the fourth quarter of 2005, management determined that the outside vendor used to develop our new enterprise system had not met the terms of the development and license agreement and had breached the contract. We have since initiated litigation and are seeking relief to the full extent possible. At present, however, we do not expect to be in a position to introduce this system before the end of 2006, if at all, therefore we have written off the amounts capitalized on this project in the fourth quarter of 2005, which caused an increase in expense over the prior year in the amount of $2.4 million. These increases were partially offset by decreases in areas such as licenses, taxes and fees and underwriting reports as well as bank charges and other miscellaneous expenses in the amount of $2.5 million, as well as $4.2 million increase in expenses allocated to our insurance segment in 2005 due to increased efforts in this segment.
Insurance company segment. Total revenues for the year ended December 31, 2005 were $327.9 million, an increase of $102.8 million, or 45.7%, as compared to total revenues of $225.1 million for the prior year. The increase in total revenues was principally due to our continued increased retention of gross premiums written by our insurance companies. The increased capitalization of our insurance companies from the proceeds of our initial public offering in July 2004 and the issuance of trust preferred securities in December 2004, enabled us to increase retention amounts at July 2004 and, again, at January 2005. We retained approximately 93.4% of our total controlled premium for the year ended December 31, 2005, as compared to 52.8% in the prior year.
Net investment income for the year ended December 31, 2005 was $5.5 million, an increase of $3.3 million, or 145.1%, from net investment income of $2.3 million in the prior year. The increase in investment income is attributable to the increase in the size of our investment portfolio due to the capital contributions into our insurance companies after our initial public offering and the issuance of trust preferred securities, as well as operating cash flow resulting from the increased retention of gross premiums written.
Net realized losses for the year ended December 31, 2005 were $1.7 million as compared to net realized losses of $11,000 for the same period in 2004. The increase in the net realized losses is due to our decision to sell a portion of our investment portfolio in order to better align our portfolio with our historical claims life. Specifically, the investment committee determined that all securities with a maturity after December 31, 2008 should be sold. We determined that the identified securities would not fully recover (fair market value would not equal or exceed amortized cost) prior to the expected sale date, therefore the securities were deemed other-than-temporarily impaired in December 2005 when the decision to sell was made.
Our agreements with our owned and non-owned underwriting agencies contain sliding scale commission schedules that may change our ultimate loss and loss adjustment expense ratio and our expense ratio based upon ultimate performance of each agency. The impact from favorable loss ratio development in current periods decreases our losses and loss adjustment expense ratio due to lower selected loss ratios and increases our expense ratio due to increased commissions due to our owned and non-owned agencies in the form of profit sharing commissions.
Losses and loss adjustment expenses for the year ended December 31, 2005 were $191.2 million, an increase of $62.2 million, or 48.3%, as compared to $129.0 million for the prior year. Our insurance segment loss ratio for the year ended December 31, 2005 was 59.0%, as compared to 57.9% in the prior year. The increase in our loss and loss adjustment expenses was due to our increased retention of gross premiums written as previously discussed, offset by decreases in our overall loss
ratio for both our owned and non-owned programs due to favorable prior year loss ratio development in the current period. The impact from the favorable loss ratio development on our loss and loss adjustment expense ratio was 4.6% for the year ended December 31, 2005 as compared to 1.3% in the prior year, related to both our owned and non-owned agencies underwriting agencies.
Policy acquisition and operating expenses for the year ended December 31, 2005 were $119.4 million, an increase of $39.7 million, or 49.8%, as compared to $79.7 million for the prior year. The increase in policy acquisition and operating expenses was due to our increased retention of gross premiums written as previously discussed, as well as increases in our expense ratio for both our owned and non-owned programs. Our insurance segment expense ratio for the year ended December 31, 2005 was 36.8%, as compared to 35.8% in the prior year, primarily as a result of increased expense allocations of $4.4 million over prior year from our agency segment due to increased efforts in this segment. The expense ratio was also unfavorably impacted due to favorable loss ratio development in the current year, which increases profit sharing commissions due to our owned and non-owned underwriting agencies. The impact from the favorable loss ratio development on our expense ratio was 4.1% for the year ended December 31, 2005 as compared to 1.4% in the prior year.
Pre-tax income for the year ended December 31, 2005 was $17.3 million, an increase of $858,000, or 5.2%, as compared to pre-tax income of $16.4 million in the prior year. The increase in pre-tax income was principally a result of the increased retention of the business as previously discussed. Our insurance segment combined ratio for the year ended December 31, 2005 was 95.8%, as compared to 93.6% in the prior year.
Total expenses for the year ended December 31, 2004 were $281.9 million, an increase of $208.7 million, or 285.11%, as compared to total expenses of $73.2 million for the prior year. The increase in total expenses was principally due to increases in expenses related to our retention of premiums that were previously ceded to Vesta.
For the year ended December 31, 2004, minority interest net of income taxes was $804,000 as compared to $403,000 in the prior year. The increase in minority interest was a result of improved profitability of our Space Coast underwriting agency, where our ownership interest was 73.0% in the periods presented.
For the year ended December 31, 2003, we had no earned premiums so the loss ratio, expense ratio and combined ratio are not applicable for that year.
Commission income related to our retail agencies’ sales of unaffiliated insurance companies’ products was $6.7 million for the year ended December 31, 2004, a decrease of $211,000, or 3.0%, as compared to $6.9 million for the prior year.
Total expenses for the year ended December 31, 2004 were $139.6 million, an increase of $14.0 million, or 11.2%, as compared to total expenses of $125.6 million in the prior year.
Depreciation and amortization expenses for the year ended December 31, 2004 were $4.2 million, an increase of $643,000, as compared to $3.6 million in the prior year. The increases in depreciation and amortization expenses were principally due to the acceleration of the depreciable lives of certain policy and claims processing systems to match their remaining expected lives due to the expected implementation of a new policy and claims system in 2005 as well as increases in depreciation as a result of increases in software and hardware purchases related to the integration of our acquisitions.
Net premium earned for the year ended December 31, 2004 was $194.3 million as compared to zero in the prior year. The increase was due our retention of gross premiums written in our insurance companies following the termination of the reinsurance agreements with Vesta that allowed us to start retaining premiums beginning January 1, 2004 that were previously ceded to Vesta.
Loss and loss adjustment expenses for the year ended December 31, 2004 were $129.0 million as compared to zero for the prior year. Our insurance segment loss and loss adjustment expense ratio for the year ended December 31, 2004 was 57.9%. The increase in our loss and loss adjustment expenses was due to our termination of reinsurance agreements with Vesta.
Policy acquisition and operating expenses for the year ended December 31, 2004 were $79.7 million as compared to a negative $544,000 for the prior year. Our insurance segment expense ratio for the year ended December 31, 2004 was 35.8%. The increase in our policy acquisition and operating expenses was due to our termination of reinsurance agreements with Vesta. The negative expense reported for the prior year is a result of our insurance companies receiving ceding commission in an amount greater than their policy acquisition and operating expenses.
There are no restrictions on the payment of dividends by our non-insurance company subsidiaries other than state corporate laws regarding solvency. As a result, our non-insurance company subsidiaries generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends, and we expect to use those revenues to service our corporate financial obligations, such as debt service and stockholder dividends. As of December 31, 2005, we had $12.2 million of cash and invested assets at the holding company level and $3.9 million of cash and invested assets at our non-insurance company subsidiaries.
Net cash provided by operating activities was $91.2 million for the year ended December 31, 2005, as compared to $52.1 million for the year ended December 31, 2004, and $40.7 million for the year ended December 31, 2003. The increase in cash flow generated from operations for the year ended December 31, 2005 compared to the prior year was principally due to a net increase in insurance related items of $78.1 million such as collections of premiums and commissions receivable, payments of losses and loss adjustment expenses and unearned premiums, of which $18.7 million was collected as part of the novation and commutation agreements executed in 2005. This increase in cash flows was offset by $12.6 million in increased federal income tax payments over the prior year. The increase in cash flow generated from operations for the year ended December 31, 2004 compared to the prior year was principally due to an increase in our net income as well as increases in cash flows due to the timing of collections and payments of losses and unearned revenue as well as increased collections on amounts due reinsurers.
Initial Public Offering. We completed our initial public offering of our common stock effective July 9, 2004. We issued 4,420,000 additional shares of our common stock and Vesta sold 3,750,000 shares of our common stock that they owned, at an initial public offering price of $14.00 per share. On July 26, 2004, our underwriters exercised their option to purchase an additional 663,000 shares from us, and an additional 562,500 shares from Vesta. The combined net proceeds to us from these transactions were approximately $65.3 million, of which $64.3 million was contributed to our insurance companies in order to increase their policyholder’s surplus.
Our Credit Agreement requires us to provide the bank with written notification and documents related to certain events. On August 12, 2005 we entered into a First Amendment to Credit Agreement and Waiver of Defaults to the credit facility which amended and waived
certain notice requirements of the Credit Agreement and waived all existing defaults and all events of default related to written notice requirements related to certain acquisitions of business in December 2004 and January, February, and July 2005, the repurchase of shares in June of 2005, and the issuance of trust preferred securities in December of 2004 and June of 2005. As of December 31, 2005, there were no outstanding loan amounts due under our credit facility, and we are in compliance with all of our financial and other restrictive covenants.
Under the terms of our Credit Agreement with Frost Bank dated July 30, 2004, as amended (“Credit Agreement”), we were required to file our Annual Report on Form 10-K on or before March 31, 2006. Frost Bank has waived, for a certain period of time, our compliance with the above covenant of the Credit Agreement, and we have filed our Annual Report on Form 10-K within the waiver period. All other terms of the Credit Agreement are unaffected by this waiver.
Trust Preferred Securities. On June 1, 2005, our newly formed trust subsidiary, Affirmative Insurance Holdings Statutory Trust II (“Trust Subsidiary II”), completed a private placement of $25.0 million of 30 year floating rate trust preferred securities. Simultaneously, we borrowed $25.0 million from Trust Subsidiary II and the net proceeds from this borrowing, along with cash from operations, were used to purchase the 2.0 million shares of our common stock as discussed in Note 17 of our consolidated financial statements. The trust preferred securities, which can be redeemed in whole or in part by the issuer after five years, bear an initial interest rate of 7.792% until June 15, 2010, at which time they will adjust quarterly to the 90-day LIBOR rate plus 355 basis points.
The payout pattern for reserves for loss and loss adjustment expense is based upon historical payment patterns and do not represent actual contractual obligations. The timing and amount ultimately paid can and will vary from these estimates.
We and our subsidiaries are named from time to time as defendants in various legal actions arising in the ordinary course of our business and arising out of or related to claims made in connection with our insurance policies, claims handling and employment related disputes. We believe that the resolution of these legal actions will not have a material adverse effect on our financial position or results of operations, however, the ultimate outcome of these matters is uncertain. For detailed information concerning legal actions, please refer to “Legal Proceedings” contained elsewhere in this report.
The examiner for the State of Texas has now completed his field work and delivered a summary of tentative audit adjustment to us. The examiner’s report asserts that, for the period from January 2002 to August 2005, we should have collected and remitted approximately $2.5 million in sales tax derived from claims services provided for Old American County Mutual Insurance Company, an unaffiliated insurance company. We believe that these services are not subject to sales tax, are vigorously contesting the assertions made by the state, and are exercising all available rights and remedies available to us; however, the ultimate outcome of this matter is uncertain.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)1 present fairly, in all material respects, the financial position of Affirmative Insurance Holdings, Inc. and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)1 present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As described in Note 2 to the consolidated financial statements, the Company restated its 2004 and 2003 consolidated financial statements.
(a) The Company did not maintain effective controls over access to, and changes in, their information technology systems, financial applications and underlying financial data. Specifically, the Company lacked adequate controls over: (i) the design, documentation and enforcement of internal access security policies and procedures, and (ii) changes to masterfile or standing data to prevent errors and irregularities in financial information. Changes to tables and standing data did not follow the approved change management process and lacked user approval and/or testing. Furthermore, access to financial applications and underlying financial data was not adequately restricted or monitored to ensure unauthorized individuals do not have access to add, change or delete the underlying premiums, commissions and fee income, claims, commission expense, accounts payable, or general accounting data. This control deficiency did not result in any adjustments to the Company’s 2005 annual or interim consolidated financial statements. However, this deficiency could result in a material misstatement to significant accounts and disclosures including premium revenue, claims expense and the related receivables and reserves that would result in a material misstatement to the Company’s annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management has determined that this control deficiency constitutes a material weakness.
(b) The Company did not maintain effective internal controls over the elimination of intercompany transactions. Specifically, effective controls were not designed and in place over the review and approval of manual intercompany elimination journal entries. This control deficiency resulted in the restatement of the Company’s 2004 annual and interim consolidated financial statements and the interim consolidated financial statements for each of the three quarters in 2005, to correct commissions, fee income, policy acquisition expenses, operating expenses, premiums and fees receivable, commissions receivable, amounts due reinsurers and other liabilities. Additionally, this control deficiency could result in a misstatement of the aforementioned accounts that would result in a material misstatement to the Company’s annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management has determined that this control deficiency constitutes a material weakness.
Certain of the control deficiencies described above resulted in the restatement of the Company’s previously issued audited consolidated financial statements as of December 31, 2004 and December 31, 2003 and for the years then ended and the previously issued 2005 and 2004 unaudited interim consolidated statements. Furthermore, these control deficiencies could result in other misstatements in financial statement accounts and disclosures that would result in a material misstatement to the annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management has concluded that these control deficiencies constitute material weaknesses. These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2005 consolidated financial statements, and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements.
We completed an initial public offering of our common stock effective July 9, 2004. We issued 4,420,000 additional shares of our common stock and Vesta sold 3,750,000 shares of our common stock that they owned, at an initial public offering price of $14.00 per share. On July 26, 2004, our underwriters exercised their option to purchase an additional 663,000 shares from us, and an additional 562,500 shares from Vesta. On June, 2005, we purchased 2,000,000 of our shares of common stock from Vesta at a price of $14.00 per share.
On June 14, 2005, Vesta entered into a Stock Purchase Agreement with New Affirmative LLC, for the sale by Vesta of 5,218,228 shares of our common stock. New Affirmative was formed for the purpose of acquiring, holding, voting and disposing of the shares of our common stock acquired in connection with the Stock Purchase Agreement and any shares of our common stock that New Affirmative may acquire in the future. New Affirmative is (i) 50% owned by DSC AFFM, LLC, an entity controlled by DSC AFFM Manager LLC, the sole managing member of DSC AFFM, and Andrew G. Bluhm, the managing member of DSC Manager, and (ii) 50% owned by Affirmative Investment LLC, an entity owned, in part, by the Enstar Group, Inc., and controlled by Affirmative Associates LLC, the sole managing member of Affirmative Investment, and J. Christopher Flowers, the sole member and manager of Affirmative Associates. Simultaneously with the closing of the transactions contemplated by the Stock Purchase Agreement: (1) DSC AFFM contributed 1,459,699 shares of our common stock which were previously acquired in open market transactions by members of DSC AFFM and subsequently contributed to DSC AFFM, to New Affirmative and (2) Affirmative Investment contributed 1,183,000 shares of the Company’s Common Stock, previously acquired by it in open market transactions, to New Affirmative. Vesta completed the sale to New Affirmative on August 30, 2005. As of December 31, 2005, New Affirmative owned 7,860,927 shares of our common stock, or approximately 50.9% of our common stock outstanding.
In addition, we corrected a misallocation of commission income and fees among the first three quarterly periods of 2005. This resulted in increasing commission income and fees in the third quarter of 2005 by $483,000 and reducing commission income and fees for the first and second quarters of 2005 by $344,000 and $138,000 respectively. This had no effect on commission income and fees reported for the year ended December 31, 2005 since it was an allocation among quarters within the first nine months of the year.
All applicable amounts relating to the restatement have been reflected in the consolidated financial statements and these notes to the consolidated financial statements.
The effect of the restatement on line items of the previously reported unaudited consolidated balance sheets as of the periods ended March 31, 2005, June 30, 2005, and September 30, 2005 is presented below (dollars in thousands):
Management believes the accompanying financial statements are representative of our costs of doing business on a stand-alone basis. The accompanying income statements include charges for expenses allocated to us by Vesta for various services until 2004. These charges were based upon specific identification when available or were allocated based upon estimated usage. Management believes the methods used to identify and allocate these costs are reasonable.
We conduct regular reviews to assess whether the amortized cost of our investments are impaired and if any impairment is other than temporary. Factors considered by us in assessing whether an impairment is other than temporary include the credit quality of the investment, the duration of the impairment, our ability and intent to hold the investment until recovery and overall economic conditions. If we determine that the value of any investment is other than temporarily impaired, we record a charge against earnings in the amount of the impairment and the investment is adjusted to net realizable value.
Deferred policy acquisition costs represent the deferral of expenses that we incur acquiring new business or renewing existing business. Policy acquisition costs, consisting of primarily commission, premium taxes, underwriting and agency expenses, are deferred and charged against income ratably over the terms of the related policies. At December 31, 2005, we had $24.5 million of deferred policy acquisition costs. We regularly review the categories of acquisition costs that are deferred and assess the recoverability of this asset. A premium deficiency, and a corresponding charge to income is recognized, if the sum of the expected loss and loss adjustment expenses, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2005, we determined that there was no premium deficiency. Amounts received as expense allowances on reinsurance contracts that represent reimbursement of acquisition costs are recorded as reductions of deferred acquisition costs.
standards, loss cost trends and other factors. Our loss and loss adjustment expense reserves may also be impacted by factors such as the rate of inflation, claims settlement pattern, litigation and legislative activities. Unpaid losses and loss adjustment expenses have not been reduced for reinsurance recoverable. Changes in estimates of our liabilities for unpaid loss and loss adjustment expenses are reflected in our consolidated statement of operations in the period in which determined. Ultimately, our actual losses and loss adjustment expenses may differ materially from the estimates we have recorded.
Commission income - Commission income and related policy fees, written for affiliated and unaffiliated insurance companies, are recognized at the date the customer is initially billed or as of the effective date of the insurance policy, whichever is later. Commissions on premium endorsements are recognized when premiums are processed. Our allowance for policy cancellations, presented as deferred revenue in our consolidated balance sheet, is periodically evaluated and adjusted as necessary. All commission and policy fee revenue and our related allowance for policy cancellations from our insurance companies is eliminated in consolidation.
We utilize various advertising mediums such as yellow pages, television and radio campaigns and print advertisements. We account for advertising costs in accordance with Statement of Position 93-7 (“SOP 93-7”), Reporting on Advertising Costs. SOP 93-7 requires all advertising costs not meeting the
criteria for direct response advertising be expensed as incurred or at the first time the advertising takes place. Our advertising process does not meet the criteria for direct response advertising and therefore we expense all advertising costs as incurred or at the first time the advertising takes place.
As of December 31, 2003, we had $928,000 classified as other invested assets, consisting of investments in three limited partnerships. Effective March 1, 2004, we sold our three limited partnership investments to Vesta in settlement of an intercompany payable balance. No gain or loss was recognized in connection with this transaction.
As permitted by SFAS 123, until December 31, 2005 we accounted for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognized no compensation cost on grants of employee stock options. Accordingly, the adoption of SFAS 123R may have a significant impact on our results of operations that cannot be predicted at this time because the impact will depend on the future levels of share-based grants. However, had we adopted SFAS 123R in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net income and earnings per share in Note 2 to our consolidated financial statements.
In June 2005, the FASB issued Statement No. 154, Accounting Changes and Error Corrections (“SFAS 154” ), which replaces APB 20 and SFAS 3. SFAS 154 applies to all voluntary changes in accounting principles. The statement requires that voluntary changes in accounting principles be applied retrospectively to prior periods unless doing so is impracticable. SFAS 154 is effective for fiscal years beginning after December 15, 2005. We applied SFAS 154 to our presented financial statements and in Notes 2, 24 and 26 to our consolidated financial statements.
In November 2005, the FASB issued Staff Position (FSP) FAS115-1 and FAS 124-1, which nullifies certain provisions of EITF Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments", and completely supersedes EITF Topic D-44, “Recognition of Other Than Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value”, addresses (1) determining when an investment should be considered impaired, (2) determining whether an impairment should be deemed other than temporary, and (3) measuring impairment loss. Combined FSP Nos. FAS 115-1 and FAS 124-1 were applied to the realignment of a portion of our investment portfolio as discussed in Note 4 to our consolidated financial statements.
As of December 31, 2005, the $210.3 million in fixed maturities includes $135.2 million in securities that had been identified by the Investment Committee of the Board of Directors as securities to be sold. The $135.2 million reflects the fair market value of such securities after $1.7 million in losses were recognized in December 2005.
Proceeds from sales, maturities, and principal receipts of bonds were $7.8 million, $20.6 million, and $5.0 million for the years ended December 31, 2005, 2004, and 2003, respectively.
Our Investment Committee reviewed our investment portfolio in December 2005 and decided to realign a portion of our investment portfolio in order to better align our portfolio with our historical claims life. We determined that the identified securities to be sold would not fully recover prior to the expected sale date, therefore the securities were deemed other than temporarily impaired in December 2005 when the decision to sell was made. The identified securities were in compliance with our investment guidelines prior to the realignment decision of the Investment Committee.
If a decline in the fair market value of investments is determined to be other than temporary, the investment is written down to fair value and the amount of the write-down is accounted for as a realized loss.
The following table shows our investments with gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2005 (dollars in thousands):
On July 19, 2005, we acquired the assets of IPA, LLC, an underwriting agency with operations in Michigan. IPA generates approximately $20 million in premiums annually. We paid $600,000 at closing to the owners of IPA, assumed certain liabilities for processing of claims and providing of customer service from existing business, and may pay up to an additional $1.3 million if certain performance criteria are met. During 2005, we paid $246,000 of the $1.3 million to the previous owners of IPA for meeting certain performance criteria.
As of December 31, 2005, Affirmative Insurance Company had two quota share reinsurance agreements in place for active programs where the cession ranged from 25% to 100%. In Florida, our underwriting agency, Space Coast Underwriters, produces business on behalf of Affirmative Insurance
The effect of reinsurance on premiums written and earned is as follows (dollars in thousands):
The amount of unpaid loss and loss adjustment expenses and unearned premium we would remain liable for in the event our reinsurers are unable to meet their obligations at December 31 are as follows (dollars in thousands):
Effective January 1, 2005, we entered into two quota share reinsurance agreements with Old American County Mutual Fire Insurance Company, where we will assume 100% of the business written through our underwriting agencies in the state of Texas.
Affirmative Insurance Company, a wholly-owned subsidiary, is a party to a 100% quota share reinsurance agreement with The Hawaiian Insurance & Guaranty Company, Ltd. (“Hawaiian”), which is ultimately a wholly-owned subsidiary of Vesta. On November 4, 2004, Hawaiian was named among a group of four other named defendants and twenty unnamed defendants in a complaint filed in the Superior Court of the State of California for the County of Los Angeles alleging causes of action as follows: enforcement of coverage under Hawaiian’s policy of an underlying default judgment plaintiff obtained against Hawaiian’s former insured, who was denied a defense in the underlying lawsuit due to his failure to timely pay the Hawaiian policy premium; ratification and waiver of policy lapse and declaratory relief against Hawaiian; breach of implied covenant of good faith and fair dealing against Hawaiian with the plaintiff as the assignee of the insured; intentional misconduct as to the defendant SCJ Insurance Services; and professional negligence as to the defendants Prompt Insurance Services, Paul Ruelas, and Anthony David Medina. SCJ Insurance Services, Prompt Insurance Services, Paul Ruelas, and Anthony David Medina are not affiliated with Affirmative. The plaintiff sought to enforce an underlying default judgment obtained against Hawaiian’s insured on September 24, 2004 in the amount of $35,000,643 and additional bad faith damages including punitive damages in the amount of $35,000,000. Affirmative Insurance Company, as a party to a 100% quota share reinsurance agreement, is sharing in the defense of this matter.
On August 8, 2005, we were served a copy of plaintiff’s Second Amended Complaint, which added a cause of action for fraud and deceit against all defendants, and a cause of action for negligent misrepresentation against Hawaiian and SCJ Insurance Services.
The entry above includes approximately $2.9 million of contingent commission that is payable to our MGA and is therefore eliminated in consolidation.
Effective August 1, 2005, we entered into novation agreements with several unaffiliated reinsurers related to an assumed aggregate excess of loss reinsurance agreement for business produced in the state of Texas by one of our underwriting agencies, written by Old American and ceded to the reinsurers. During 2005, we had executed letters of credit under our credit facility of approximately $2.3 million with these reinsurers, all of which were released on December 1, 2005 (See Note 17).
Vesta transferred our insurance company subsidiaries to us on December 31, 2003. Before this time, these insurance companies had ceded 100% of the business that they wrote to Vesta Fire as part of an intercompany reinsurance agreement. In connection with a reinsurance restructuring agreement, Vesta Fire retained all liability with respect to any losses and allocated loss adjustment expenses occurring on or prior to December 31, 2003 on policies issued by our insurance companies, and retained all corresponding loss and loss adjustment expense reserves as of December 31, 2003. As a result, as of December 31, 2003, our insurance companies had no net loss or loss adjustment expense reserves. In connection with the acquisition of our insurance companies from Vesta, this reinsurance agreement was terminated as of December 31, 2003, and our insurance companies began accruing losses and loss adjustment expenses, subject only to third-party reinsurance arrangements, for reported and incurred but not reported losses for insurance policies issued or assumed by our insurance companies after December 31, 2003.
Our recorded loss, loss adjustment expense reserves and deposit liabilities of $126.9 million on a gross basis and $106.5 million on a net basis are our best estimates as of December 31, 2005. The analysis provided by our independent opining actuaries indicated that their expected range for the ultimate liability for our loss and loss adjustment expense reserves, as of December 31, 2005, was between $111.5 million and $130.9 million on a gross basis and between $92.8 million and $108.1 million on a net basis.
Policy acquisition expenses, primarily commissions, premium taxes and underwriting expenses related to issuing a policy are deferred and charged against income ratably over the terms of the related policies.
The changes in the carrying amount of goodwill as of December 31, 2005 and 2004 and for the years ended December 31, 2005 and 2004 are as follows (dollars in thousands):
Other adjustments to goodwill include the valuation allowance for NOLs of $10.2 million offset by changes to the contingent purchase consideration on certain acquisitions and final adjustments to purchase price allocations.
Depreciation expense was $3.3 million, $3.5 million, and $2.6 million for the years ended December 31, 2005, 2004 and 2003, respectively.
During the fourth quarter of 2005, we determined that the outside vendor used to develop our new enterprise system had not met the terms of the development and license agreement and had breached the contract. We have since initiated litigation and are seeking relief to the full extent possible (See “Legal Proceedings” contained elsewhere in this report). At present, however, we do not expect to be in a position to introduce this system before the end of 2006, if at all. As a result, we have written down to zero the amounts capitalized on this project in 2005, in the amount of $2.4 million.
As of August 30, 2005, we and our subsidiaries are no longer affiliated with Vesta (See Note 1).
State insurance laws limit the ability of our insurance company subsidiaries to pay dividends and require our insurance company subsidiaries to maintain specified minimum levels of statutory capital and surplus. In addition, for competitive reasons, our insurance companies need to maintain financial strength rating which require us to maintain minimum capital and surplus requirements in those subsidiaries. Without regulatory approval, the aggregate maximum amount of dividends that can be paid in 2006 to us by our insurance company subsidiaries is approximately $7.2 million. During 2005, our insurance companies paid $5.0 million in dividends to us.
On December 31, 2004, our newly formed trust subsidiary, Affirmative Insurance Holdings Statutory Trust I (“Trust Subsidiary I”), completed a private placement of $30.0 million of 30 year floating rate trust preferred securities. Simultaneously, we borrowed $30.9 million from Trust Subsidiary I and contributed $29.0 million to Affirmative Insurance Company’s policyholders’ surplus. The trust preferred securities, which can be redeemed in whole or in part by the issuer after five years, bears an initial interest rate of 7.545 percent until December 15, 2009, at which time the securities will adjust quarterly to the 90-day LIBOR rate plus 3.6 percentage points. As of December 31, 2005, the note balance was $30.9 million.
We and our subsidiaries are named from time to time as defendants in various legal actions arising in the ordinary course of our business and arising out of or related to claims made in connection with our insurance policies, claims handling and employment related disputes. The plaintiffs in some of these lawsuits have alleged bad faith or extra-contractual damages and some have claimed punitive damages. We believe that the resolution of these legal actions will not have a material adverse effect on our financial position or results of operations, however, the ultimate outcome of these matters is uncertain. For detailed information concerning legal actions, please refer to “Legal Proceedings” contained elsewhere in this report.
The examiner for the State of Texas has now completed his field work and delivered a summary of tentative audit adjustment to us. The examiner’s report asserts that, for the period from January 2002 to August 2005, we should have collected and remitted approximately $2.5 million in sales tax derived from claims services provided for Old American County Mutual Insurance Company, an unaffiliated insurance company. We believe that these services are not subject to sales tax, are vigorously contesting the assertions made by the state, and are exercising all available rights and remedies available to us; however, the ultimate outcome of this matter is uncertain. We have not made an accrual for this as of December 31, 2005 as we do not believe this meets the requirements of FAS 5.
On August 6, 2004, we entered into a senior secured credit facility with The Frost National Bank. Under this credit facility, the maximum amount available to us from time to time is $15.0 million, which may include up to $15.0 million under a two-year revolving line of credit, up to $10.0 million in five-year term loans and up to $10.0 million in five-year stand-by letters of credit. The borrowings under our credit facility will accrue interest based on the 90-day LIBOR rate plus 150 basis points and we will pay letter of credit fees based on an annual rate of 75 basis points. Our obligations under the facility are guaranteed by our material operating subsidiaries (other than our insurance companies) and are secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than our insurance companies), including a pledge of 100% of the stock of Affirmative Insurance Company. The facility contains certain financial covenants, which include combined ratio, risk-based capital requirement, fixed charge coverage ratio, consolidated net worth and consolidated net income requirements and other restrictive covenants governing distributions and management changes. The proceeds are available to issue letters of credit securing our obligations under reinsurance agreements, to fund general working capital for our agency operations, capital surplus for our insurance companies and to finance acquisition activities. During the twelve months ended December 31, 2005, we executed letters of credit under this credit facility of approximately $2.3 million to collateralize an assumed reinsurance contract with certain of our reinsurers, all of which were released on December 1, 2005 (See Note 8). Total fees were approximately $13,000.
On February 14, 2003, we issued 53,615 shares of our common stock to E.B. Lyon, III, a minority stockholder for $407,000.
order to increase their statutory surplus. This additional capital allowed us to reduce our reinsurance purchases and retain more gross premiums. The remaining $1.0 million of net proceeds were held for general corporate purposes.
In January 2005, we issued 6,734 shares of restricted common stock to certain members of our Board of Directors, in lieu of cash as their annual retainer. In both February and May 2005, we issued 7,500 shares of restricted common stock to certain members of our Board of Directors for compensation related to services performed. In November 2005, 7,000 shares of restricted common stock that had been issued were cancelled due to the resignation of certain board members. We recorded net prepaid expense for these grants of approximately $221,000 in 2005 and are amortizing the amount to compensation expense over the service period for the remaining issued shares. Total compensation expense in connection with restricted stock recorded for the twelve months ended December 31, 2005 was approximately $108,000.
In August and September 2005, we issued 3,657 shares of our common stock due to the exercise of options.
In November 2005, we issued 623,610 shares of our common stock to Thomas E. Mangold due to the exercise of options. In addition, we purchased 50,963 shares of treasury stock from Thomas E. Mangold for $14.63 per share, which was market value on the date of the transaction.
A “modified prospective” method in which compensation cost is recognized beginning with the adoption date (a) based on the requirements of SFAS 123R for all share-based compensation payments granted after the adoption date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the adoption date that remain unvested on the adoption date.
As permitted by SFAS 123, until December 31, 2005 we accounted for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognized no compensation cost on grants of employee stock options. Accordingly, the adoption of SFAS 123R may have a significant impact on our results of operations that cannot be predicted at this time because the impact will depend on the future levels of share-based grants. However, had we adopted SFAS 123R in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net income and earnings per share in Note 3 to our consolidated financial statements.
Weighted average risk-free interest rate: 1998 Plan 4.5%, 2004 Plan 4.1%
In addition, the 2004 Plan provides for awards for restricted stock, unrestricted stock, performance stock, and dividend equivalent rights. As of December 31, 2005, we have issued 20,533 shares of restricted stock awards to our Directors and Chief Financial Officer. These awards have varying vesting periods ranging from immediate to five years.
On December 27, 2005, our board of directors approved certain amendments to our 2004 Stock Incentive Plan, subject to approval and adoption by New Affirmative LLC, our majority stockholder. New Affirmative approved by written consent the amendments and adopted the Amended and Restated 2004 Stock Incentive Plan on December 27, 2005. The written consent of New Affirmative represented 50.9% of the shares of common stock eligible to vote. The amendments made to our original stock incentive plan are as follows:
To increase the maximum aggregate number of shares of common stock which may be issued upon exercise of all awards under the our original stock incentive plan, including incentive stock options, by 1,500,000 shares, such that the new maximum aggregate number of shares of common stock which may be issued upon exercise of all awards under our Amended and Restated Plan, including incentive stock options, is 3,000,000
To modify transfer restrictions to permit transfer of stock options to a stockholder/principal by a director who is serving as the designated representative of a significant stockholder.
To adjust deferral election timing provisions and add a safe harbor exercise/distribution date provision to conform to Section 409A of the Internal Revenue Code if an option or other award is determined to constitute nonqualified deferred compensation that is subject to the requirements of Section 409A of the Internal Revenue Code.
To eliminate the ability to grant nonqualified stock options with an exercise price that is less than fair market value of the underlying common stock on the date of grant.
The following table identifies the thirteen states in which we operate and the total controlled premium and gross premiums written by state by our affiliated and unaffiliated underwriting agencies for the year ended December 31, 2005 (dollars in thousands):
We sponsor a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code. The plan covers substantially all employees who meet specified service requirements. Under the plan, we may, at our discretion, match 100% of each employee’s contribution, up to 3% of the employee’s salary, plus 50% of each employee’s contribution for the next 2% of the employee’s salary. We made $1.0 million in contributions to the plan during 2005 and $1.1 million in each of the years 2004 and 2003.
The carrying amount of and estimated fair values of our financial instruments at December 31, 2005 and 2004 are as follows (dollars in thousands):
The fair values presented represent our best estimates and may not be substantiated by comparisons to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Certain financial instruments and all non-financial instruments are not required to be disclosed. Therefore, the aggregate fair value amounts presented do not purport to represent our underlying value.
We have reflected the requirements of SFAS 131 for the years ended December 31, 2005, 2004 and 2003 in the following tables for our three operating segments: agency segment, insurance segment, and corporate segment.
Insura is wholly owned by Affirmative Insurance Company and included as a common stock investment within Affirmative Insurance Company at its statutory surplus basis.
The following is a summary of our unaudited quarterly consolidated results of operations for the years ended December 31, 2005 and 2004:
The condensed financial information of the parent company, Affirmative Insurance Holdings, Inc. only as of December 31, 2005 and 2004, and for the years ended December 31, 2005, 2004, and 2003 is presented as follows:
We have been named as a co-defendant in a complaint which alleges breach of contract, breach of fiduciary duty, waste, fraud, fraudulent conveyance and an accounting. The complaint alleges that Clarendon National Insurance Company (“Clarendon”) and Harbor Insurance Group, Inc. (“Harbor”) had an agreement whereby Clarendon became a 5% shareholder in Harbor. The complaint alleges that the Majority Shareholders of Harbor breached its shareholder agreement with Clarendon when it sold certain of Harbor’s assets to Instant Insurance Holdings, Inc. now known as Affirmative Insurance Holdings, Inc. (“Affirmative”), and such alleged breaches are detailed as follows: 1) failing to notify Clarendon of the sale, 2) selling assets at a reduced market value, 3) fraudulently conveying Harbor’s assets to a related party, 4) diverting Harbor’s assets, 5) selling assets for personal shareholder gain to the exclusion of Clarendon, 6) transacting to receive diverted assets for non-compete promises in favor of Affirmative, 7) preventing Harbor from generating income and preventing Clarendon from receiving preferred returns of $2,800,000, 8) violating their fiduciary duties to Clarendon as minority shareholder, 9) failing to act in Harbor’s best interests, and 10) breaching their contract with Clarendon. Clarendon also alleges that Harbor has breached its contract by diluting Clarendon’s ownership of Harbor, and that such dilution cuts off Clarendon’s ability to receive further value and profits from Harbor. Plaintiffs seek $5,942,750.00, attorneys’ fees incurred through trial and appeal, pre- and post-judgment interest, litigation costs, and any other relief the Court deems proper. The action is pending in the United States District Court for the Northern District of Texas, Dallas Division. This matter, filed January 30, 2006, is still in the early procedural stages. We believe these allegations are without merit, are vigorously contesting the claims brought by the plaintiff, and are exercising all available rights and remedies against them; however, the ultimate outcome of this matter is uncertain.
From time to time, we and our subsidiaries are subject to random compliance audits from federal and state authorities regarding various operations within our business that involve collecting and remitting taxes in one form or another. Recently, two of our owned underwriting agencies were subject to a sales and use tax audit conducted by the State of Texas. The examiner for the State of Texas has now completed his field work and delivered a summary of tentative audit adjustment to us. The examiner’s report asserts that, for the period from January 2002 to August 2005, as agent, we should have collected and remitted approximately $2.5 million in sales tax derived from claims services provided for Old American County Mutual Insurance Company, an unaffiliated insurance company. We believe that these services are not subject to sales tax, are vigorously contesting the assertions made by the state, and are exercising all available rights and remedies available to us; however, the ultimate outcome of this matter is uncertain.
In March, 2006, we completed the acquisition of the 27% minority ownership interest of Space Coast. Consequently, our current ownership interest in Space Coast is 100%.