Our headquarters is located in Southfield, Michigan in a building owned by FMIC and has approximately 25,000 square feet. CoverX also leases office space in California, Florida, Illinois, Massachusetts and Texas. We believe our current space is adequate for our current operations.
The table shown below presents our selected historical consolidated financial and other data for the five years ended December 31, 2006, which have been derived from our audited consolidated financial statements included in this Annual Report on Form 10-K. The historical consolidated financial data presented below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated annual financial statements and accompanying notes included elsewhere in this Annual Report on Form 10-K.
The selected historical consolidated financial and other data presented below for each of the years in the three-year period ended December 31, 2004 (Predecessor), for the period from January 1, 2005 through August 16, 2005 (Predecessor), for the period from August 17, 2005 through December 31, 2005 (Successor), and for the year ended December 31, 2006 (Successor) have been derived from our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
Net income per share and weighted average shares outstanding reflect a 925-for-1 stock split of our common stock which occurred prior to the completion of our initial public offering in October 2006.
CoverX produces and underwrites all of the insurance policies for which we retain risk and receive premiums. As a wholesale insurance broker, CoverX markets our insurance policies through a nationwide network of wholesale and retail insurance brokers who then distribute these policies through retail insurance brokers. CoverX also provides underwriting services with respect to the insurance policies it markets in that it reviews the applications submitted for insurance coverage, decides whether to accept all or part of the coverage requested and determines applicable premiums. CoverX receives commissions from affiliated insurance companies, reinsurers, and non-affiliated insurers as well as policy fees from wholesale and retail insurance brokers.
ARPCO provides third party administrative services for risk sharing pools of governmental entity risks, including underwriting, claims, loss control and reinsurance services. ARPCO is solely a fee-based business and receives fees for these services and commissions on excess per occurrence insurance placed in the commercial market with third party companies on behalf of the pools.
As a result of our shift from the fronting model to the direct writing model, fees we paid to fronting insurers and a portion of our administrative expenses related to interacting with fronting insurers were eliminated, which has reduced our expenses. As a result of the decrease in fronting and administrative expenses, the shift to the direct writing model has increased our profitability. We are no longer subject to the underwriting and claims oversight of fronting insurers nor are we required to fund collateral grantor trust accounts. In addition, we are not dependent on the availability, capacity or rating status of fronting insurers.
Net Written and Earned Premiums: The change in business model did not have a significant impact on our net written or earned premiums.
Insurance Underwriting Commissions: Under the fronting model, we received fixed rate commission income on all premiums produced by CoverX for fronting insurers, as well as profit sharing commission income on all premiums produced that were retained by fronting insurers or ceded to third party insurers. Under the direct writing model, we do not report commission income on premiums written by our insurance subsidiaries because they are eliminated for consolidated financial statement purposes. The change in our business model therefore resulted in a decrease of our insurance underwriting commission income from 2004 to 2006.
Ceded Reinsurance Commissions: Under the direct writing model, we earn ceding commissions on insurance risks ceded from FMIC to third party insurers under reinsurance treaties and earn ceded profit sharing commissions on ceded reinsurance. Under the fronting model, these ceding commissions were paid to the fronting insurer by the reinsurers who received the corresponding premiums. Both of these items are
reported as an offset to our other operating expenses. The change in our business model resulted in an increase in our ceded reinsurance commissions from 2004 to 2006.
The reserves for losses and loss adjustment expenses represent our estimated ultimate costs of all reported and unreported losses and loss adjustment expenses incurred and unpaid at the balance sheet date. Our reserves reflect our estimates at a given time of amounts that we expect to pay for losses that have been reported, which are referred to as Case reserves, and losses that have been incurred but not reported and the expected development of losses and allocated loss adjustment expenses on open reported cases, which are referred to as IBNR reserves. We do not discount the reserves for losses and loss adjustment expenses.
The estimation of ultimate liability for losses and loss adjustment expenses is an inherently uncertain process. Our loss and loss adjustment expense reserves do not represent an exact measurement of liability, but are our estimates based upon various factors, including:
actuarial projections of what we, at a given time, expect to be the cost of the ultimate settlement and administration of claims reflecting facts and circumstances then known;
We take into consideration the facts and circumstances for each claim filed as then known by our claims department, as well as actuarial estimates of aggregate unpaid losses and loss expenses based on our experience and industry data, and expected future trends in loss costs. The amount of unpaid losses and loss adjustment expense for reported claims, which we refer to as case reserves, is based primarily upon a claim by claim evaluation of coverage, including an evaluation of the following factors:
We apply these methods to net paid and incurred loss and loss adjustment expense and net earned premium information after ceding reinsurance to determine ultimate net loss and loss adjustment expense and net IBNR
For security classes where we have many years of historical experience data, we perform semi-annual analyses of the payment and reporting patterns of losses and loss adjustment expenses as well as reported and closed claims by accident year for security guard, alarm, and safety equipment sub-classes. We have generally relied primarily on the Loss Development Method in calculating ultimate losses and loss adjustment expenses for the more mature accident years, applying our historical loss and loss adjustment expense reporting patterns to paid and incurred losses and loss adjustment expenses reported to date by accident year to estimate ultimate loss and loss adjustment expense and IBNR reserves. Our reserve estimates for the more recent, less mature accident years have relied more on the Bornhuetter-Ferguson Method to calculate expected loss and loss adjustment expense ratios. Although we have calculated the results from the Expected Loss Ratio Method for the less mature years, we have not relied significantly on this method due to the more meaningful results of the other methods we have used for security classes.
During 2006, the Company experienced approximately $1.1 million in net prior year reserve development primarily in the 2000 accident year, offset somewhat by favorable development on prior years unallocated loss adjustment expense reserves. The development on accident year 2000 reserves was concentrated primarily in the safety equipment class as a result of obtaining new information on several high severity cases. See “- Year Ended December 31, 2006 Compared to Year Ended December 31, 2005”, “- Losses and Loss Adjustment Expenses”.
During 2005 the Company experienced approximately $12.8 million in net prior accident year development in its security classes, primarily in accident years 2000 to 2002, principally in the safety equipment sub-class. The prior year reserve development occurred due to new information which emerged during 2005 on a small number of high severity cases, causing increased net case reserve valuations or loss and loss adjustment expense payments of $7.4 million that were not anticipated in our prior years’ IBNR reserve estimates. This development was inconsistent with our historical loss and loss and loss adjustment expense reporting patterns. As a result, we also increased net IBNR reserves by $5.4 million in the affected accident years, and sub-classes, and we increased the expected loss and loss adjustment expense ratios and the reporting patterns used in our reserve estimates for subsequent accident years in those sub-classes. The impact of these increases on our more recent accident years’ IBNR reserves are mitigated somewhat by the purchase of excess reinsurance coverage for high severity cases beginning in June 2004, which was not in place during most of the accident year periods experiencing development on prior year reserves. In addition, our security classes were completely re-underwritten during 2001 and 2002, and large rate increases and extensive use of restrictive and exclusionary coverage policy forms were subsequently implemented, resulting in significant reductions in claims frequency and in reported incurred loss and loss adjustment expense ratios for subsequent accident years. See “- Year Ended December 31, 2005 Compared to Year Ended December 31, 2004”, “- Losses and Loss Adjustment Expenses”.
From 2000 through 2004, our reserve estimates for other specialty classes utilized industry loss and loss adjustment expense reporting pattern information that was included in actuarial circulars available from ISO in 2000. New, updated ISO industry loss and loss adjustment expense reporting pattern information became available during 2005 which was more detailed for each of the sub-class groupings within other specialty classes. The new industry information reflected higher and slower loss reporting patterns than the industry information that was previously available. This was due to a number of factors, including more recent data, additional data from different
sources and more detailed segmentation of the data. During 2005, we compared the new industry reporting pattern information to our actual loss experience and have determined that the new information more closely aligned with our emerging experience, coverage class groupings and limits profiles for other specialty classes. As a result, in the fourth quarter of 2005, we adopted usage of the new industry loss reporting pattern information in our reserve estimates for all accident years, resulting in increases in prior years’ reserves, and in higher 2005 and later accident year reserve estimates. This change in loss reporting pattern assumptions resulted in the majority of the $6.2 million in prior accident year development that occurred in specialty classes during 2005. See “- Year Ended December 31, 2005 Compared to Year Ended December 31, 2004”, “- Losses and Loss Adjustment Expenses”.
Our loss and loss adjustment expense reserves do not represent an exact measurement of liability, but are estimates. Although we believe that our reserve estimates are reasonable, it is possible that our actual loss experience may not conform to our assumptions. The most significant assumptions affecting our IBNR reserve estimates are expected loss and loss adjustment expense ratios, and expected loss and loss adjustment expense reporting patterns. These vary by underwriting class, sub-classes, and accident years, and are subject to uncertainty and variability with respect to any individual accident year and sub-class. Generally, the reserves for the most recent accident years depend heavily on both assumptions. The most recent accident years are characterized by more unreported losses and less information available for settling claims, and have more inherent uncertainty than the reserve estimates for more mature accident years. The more mature accident years depend more on expected loss and loss expense reporting patterns.
The following sensitivity analysis represents reasonably likely levels of variability in these assumptions in the aggregate. Individual classes and sub-classes and accident years have different degrees of variability in both assumptions and it is not reasonably likely that each assumption for each sub-class and accident year would vary in the same direction and to the same extent in the same reporting period. We believe the most meaningful approach to the sensitivity analysis is to vary the ultimate loss and loss adjustment expense estimates that result from application of the assumptions. We apply this approach on an accident year basis, reflecting the reasonably likely differences in variability by level of maturity of the underlying loss experience for each accident year, using variability factors of plus or minus 10% for the most recent accident year, 5% for the preceding accident year, and 2.5% for the second preceding accident year. There is minimal expected variability for accident years at four or more years’ maturity.
The following table includes net ultimate loss and loss adjustment expense amounts by accident year from our statutory filing for our insurance subsidiaries for the year ended December 31, 2006, which are equal to the net ultimate loss and loss adjustment expense amounts by accident year included in our loss and loss adjustment expense reserve estimates in the consolidated financial statements at December 31, 2006. The use of net of ceded reinsurance amounts is most meaningful since the vast majority of our ceded reinsurance is on a quota share basis. We have applied the sensitivity factors to each accident year amount and have calculated the amount of potential net reserve change and the impact on 2006 reported pre-tax income and on net income and stockholders’ equity at
December 31, 2006. We do not believe it is appropriate to sum the illustrated amounts as it is not reasonably likely that each accident year’s reserve estimate assumptions will vary simultaneously in the same direction to the full extent of the sensitivity factor.
Policy acquisition costs related to direct and assumed premiums consist of commissions, underwriting, policy issuance, and other costs that vary with and are primarily related to the production of new and renewal business, and are deferred, subject to ultimate recoverability, and expensed over the period in which the related premiums are earned. Investment income is included in the calculation of ultimate recoverability.
Premiums produced, which consists of all of the premiums billed by CoverX, for the year ended December 31, 2006, were $230.1 million, a $41.6 million or 22% increase over $188.5 million in premiums produced during the year ended December 31, 2005. This growth was primarily attributable to:
Direct written premiums increased $45.6 million, or 27% while direct earned premiums increased $80.2 million, or 63% in the year ended December 31, 2006 compared to the year ended December 31, 2005. The increases in direct written premiums and direct earned premiums were due primarily to the change in our business model as a result of which we ceased relying on fronting arrangements under which we assumed insurance from fronting insurers and instead began to write substantially all of the new and renewal policies produced by CoverX. As of December 31, 2006, we had the benefit of a full year of direct written premiums with minimal fronting, which resulted in direct earned premiums increasing at a higher rate than direct written premiums. As of December 31, 2005, while the change in business model had been in effect for a full year, the first six months after the change was more of a gradual shift away from fronting towards directly writing policies and as such, there were lower volumes of policies to be earned as of December 31, 2005.
Ceded written premiums increased $5.0 million, or 7%, and ceded earned premiums increased $52.8 million, or 109%, for the year ended December 31, 2006 compared to the year ended December 31, 2005. This increase was due to the increase in premiums produced as well as elections to increase premiums ceded under our current quota share arrangement by 10% to 50% in January 2006. This increase was offset by the return to the Company of $39.6 million in ceded written premiums on December 31, 2006 as a result of the Company’s exercise of its election to terminate expiring quota share reinsurance contracts on a cut-off basis, in accordance with the terms of the reinsurance contracts. The $39.6 million in returned premiums will be earned by the Company and reported as net earned premiums during 2007. The time lag between ceded premiums being written and ceded premiums being earned resulted in a more substantial increase in the ceded earned premiums.
Interest expense increased $11.6 million, or 236%, from 2005 to 2006. This increase was principally attributable to a $3.9 million increase in interest expense, $0.7 million of amortization of debt issuance costs, a $3.3 million prepayment penalty, and $4.0 million in write-off of debt issuance costs related to the $65.0 million senior notes issued in August 2005 and repaid in October 2006. This increase was offset by our redemption of a $5.0 million promissory note, $1.9 million of subordinated notes and the cancellation of our bank credit facility that eliminated other interest expense. Interest expense on the junior subordinated debentures included the change in fair value of the interest rate swap on the junior subordinated debentures as discussed in “- Liquidity and Capital Resources.”
The following table summarizes our results for the year ended December 31, 2005 and 2004:
Approximately $24.5 million increase in premiums produced from other specialty classes underwriting operations in the Northeast that began in the year ended June 30, 2005;
For 2005, realized capital gains were $0.2 million versus realized capital losses of $0.1 million for 2004. These portfolio gains were driven by the sale of several convertible securities which occurred in an effort to manage the overall risk of the convertible exposure. In addition, throughout the year, we continued to reduce treasury and corporate bond exposure in favor of what we believe to be a more compelling value in the municipal and asset backed sectors.
Decreased assumed reinsurance commissions of $10.1 million and an increase in the deferral portion of acquisition expenses of $3.2 million, which were consistent with the change in our business model;
Increased general underwriting and operating expenses of $6.0 million due primarily to increased compensation expenses.
No dividends were paid to FMFC by our insurance subsidiaries during the year ended December 31, 2006 or the years ended 2005 or 2004. Our insurance subsidiaries retained all of their earnings in order to support the increase of their written premiums, and we expect this retention of earnings to continue. Our insurance subsidiaries are restricted by statute as to the amount of dividends that they may pay without the prior approval of their domiciliary state insurance departments. Based on the policyholders’ surplus and the net income of our insurance subsidiaries as of December 31, 2006, FMIC and ANIC may pay dividends in 2007, if declared, of up to $15.7 million without regulatory approval.
For 2005, net cash used in investing activities totaled $99.2 million resulting primarily from our investment of operating cash flows and cash payments in connection with the notes offering and the repurchase of shares of our minority stockholders, which we refer to as the Holdings Transaction. For 2004, net cash used in investing activities totaled $78.2 million resulting primarily from our net investment of operating cash flows, our investment of cash received from the issuance of debt and convertible preferred stock and the acquisition of the ARPCO Group. The
The $46.0 million of net cash provided by financing activities for the year ended December 31, 2006 was primarily attributable to the proceeds from our initial public offering, offset by the repurchase of common stock and the retirement of the senior notes. The $51.4 million of net cash provided by financing activities for the year ended December 31, 2005 was primarily the result of the issuance of $65.0 million aggregate principal amount of senior notes in August 2005, offset by the repayment of $2.0 million of bank debt, a $5.0 million promissory note and $1.9 million of subordinated capital notes. During 2004, net cash provided by financing operations was $49.6 million and included $36.2 million of net proceeds from the issuance of convertible preferred stock, $20.6 million of net proceeds from the issuance of junior subordinated debentures, the issuance of a $5.0 million promissory note and $1.7 million of cash received upon exercise of stock options. Net cash provided by financing activities in 2004 was offset in part by the $13.8 million repayment under a revolving credit facility and other debt payments.
We completed our initial public offering of common stock on October 23, 2006 in which we sold 11,161,764 shares of common stock for $189.7 million. In connection with the offering, on October 23, 2006, we repurchased all of our outstanding senior notes for $69.9 million, paid the holder of our convertible preferred stock $58.0 million pursuant to the terms of our convertible preferred stock, which was also converted into common stock in connection with the initial public offering, and repurchased 1,779,336 shares of common stock. We used the remaining $15.9 million of the net proceeds from the initial public offering, along with available cash of $4.1 million, to make a $20.0 million contribution to the capital of FMIC in October 2006.
Credit Facility. In October 2006, we entered into a credit facility which provided for borrowings of up to $30.0 million. Borrowings under the credit facility bear interest at our election as follows: (i) at a rate per annum equal to the greater of the lender’s prime rate and the federal funds rate less 0.5%, each minus 0.75%; or, (ii) a rate per annum equal to LIBOR plus an applicable margin which is currently 0.75% or 1.0% based on our leverage ratio. The obligations under the credit facility are guaranteed by our material non-insurance subsidiaries. The maturity date of borrowings made under the credit facility is September 2011. The credit facility contains covenants which, among other things, restrict our ability to incur indebtedness, grant liens, make investments and sell assets. The
Derivative Financial Instruments. Financial derivatives are used as part of the overall asset and liability risk management process. We use interest rate swap agreements with a combined notional amount of $45.0 million in order to reduce our exposure to interest rate fluctuations with respect to our junior subordinated debentures. Under two of our swap agreements, which expire in August 2009, we pay interest at a fixed rate of 4.12%; under our other swap agreement, which expires in December 2011, we pay interest at a fixed rate of 5.013%. Under all three swap agreements, we receive interest at the three month LIBOR, which is equal to the contractual rate under the junior subordinated debentures. At December 31, 2006, we had minimal exposure to credit loss on the interest rate swap agreements.
The above table includes all interest payments through the stated maturity of the related long-term debt. Variable rate interest obligations are estimated based on interest rates in effect at December 31, 2006, and, as applicable, the variable rate interest included the effects of our interest rate swaps through the expiration of those swap agreements.
The majority of our portfolio consists of AAA or AA rated securities with a Standard and Poor’s weighted average credit quality for our aggregate fixed income portfolio of AA+ at December 31, 2006. The majority of the investments rated BBB and below are convertible securities and were rated higher at the time of purchase. Consistent with our investment policy, we review any security if it falls below BBB- and assess whether it should be held or sold. The following table shows the ratings distribution of our fixed income portfolio as of December 31, 2006 as a percentage of total market value.
At December 31, 2006 the total unrealized loss of all impaired securities totaled $2.7 million. This represents approximately 0.9% of year-end invested assets of $297.8 million. This unrealized loss position was the result of the continual increase in short term and intermediate term interest rates that has taken place over the past approximately 3 years. These unrealized losses have persisted due to the series of tightenings by the Federal Reserve resulting in a significant increase in interest rates of approximately 200 basis points in the intermediate part of the yield curve
monitored and may be classified in the future as being other than temporarily impaired. The balance, or 99.5% of those securities trading at a loss, is investment grade. The majority of these securities are “AAA” or “AA” rated.
For 2006 and 2005, we sold approximately $33.5 million and $37.4 million, respectively, of market value of securities, which were trading below amortized cost while recording a realized loss of $0.8 million and $0.6 million, respectively. This loss represented 2.4% for 2006 and 1.6% for 2005 of the amortized cost of the positions. We sold U.S. government securities to purchase other securities. We also sold some isolated positions of corporate, convertible and municipal bonds. These sales were unique opportunities to sell specific positions due to changing market conditions. These situations were exceptions to our general assertion regarding our ability and intent to hold securities with unrealized losses until they mature or recover in value. This position is further supported by the insignificant losses as a percentage of amortized cost for the respective periods.
We defer a portion of the costs of acquiring insurance business, primarily commissions and certain policy underwriting and issuance costs, which vary with and are primarily related to the production of insurance business. For the year ended December 31, 2006, $25.1 million of the costs were deferred. Deferred policy acquisition costs totaled $18.5 million, or 22.7% of unearned premiums (net of reinsurance), at December 31, 2006.
On December 31, 2006 we elected the cut-off termination option available to us on the expiration of our 50% quota share contracts expiring that day in accordance with the termination provision of the quota share contracts. As a result, we effectively eliminated the 50% quota share reinsurance on the December 31, 2006 unearned premiums that had been ceded 50% up until contract expiration. The amount of the previously ceded net unearned premium reserve that was returned to the Company as a result of the cut-off termination election is $39.6 million. As those premiums are earned during 2007, they will be reported in the Company’s net earned premiums. We had previously recorded the related $12.8 million in ceded commissions as a reduction in deferred acquisition costs. Those commissions are included in deferred acquisition costs reported at December 31, 2006, and will be amortized during 2007 as the related unearned premiums are earned.
Our loss experience on policies that we wrote for the safety equipment installation and service class during 1999 to 2001 has been significantly worse than on policies written for other security classes, with an average loss and loss adjustment expense ratio of approximately 188% during those accident years. We have written the safety equipment class throughout our history on a profitable basis, and we expanded our writings in this class dramatically from 1999 through 2001, primarily through writing new policies for former customers of several competitors who exited the property casualty markets during that period. Our underwriters relied on loss history data provided by the former competitors and increased premium rates accordingly on these policies, and we expected the new policies to be profitable.
While we increased the prices on new policies from those charged by the previous insurers, the historical loss information we used to underwrite some of the new policies was based on information provided by previous insurers who left the market, and much of that information was later found to be inaccurate or incomplete. In retrospect, premium rates for new policies written for the safety equipment installation and service class during this period ultimately proved to be inadequate. The impact of the inadequate premium rates was compounded by our growth in the safety equipment installation and service class during that period. In reaction to the observed deterioration in the loss experience of the safety equipment installation and service class, we implemented a number of changes in both the safety equipment installation and service class and other security classes, many of these changes coincided with and were facilitated by the “hard market” conditions that emerged during this period, and include the following:
Implementation of many coverage exclusions, restrictions, endorsements, and higher deductibles in 2002 and 2003;
In addition, we increased our reserves applicable to policies written for other specialty classes by approximately $6.2 million, principally as a result of using updated industry loss development factors, which became available to us during 2005, in the calculations of ultimate expected losses and reserves on those classes. These updated factors indicate that losses are expected to emerge more slowly than what was reflected in the previous industry development factors that we used. We began writing for other specialty classes in 2000 and have six years or less of our own historical loss experience for these classes. Consequently, we have relied significantly on industry development factors in our reserve estimates. As our historical experience increases, we will be able to give more weight to our own experience and reduce the amount of weight given to industry experience in our reserve estimates.
From 2000 through 2004, we had used an earlier set of available industry development factors from a study published in 2000 for other specialty classes. We adopted the industry development factors that became available during 2005 because they reflected more recent industry experience, were separated into losses and loss adjustment expenses and in more class and coverage limit segments that aligned more closely with our classifications and coverage limits, and were more closely aligned with our actual emerging experience. The increases and decreases in incurred losses related to prior accident years, as reflected in the preceding table for 2004 and 2003, primarily resulted from differences in actual versus expected loss development.
The next section of the table sets forth the re-estimates in later years of incurred losses, including payments, for the years indicated. For example, as reflected in that section of the table, the original reserve of $48.0 million was re-estimated to be $32.3 million at December 31, 2006. The increase/decrease from the original estimate would generally be a combination of factors, including:
The “cumulative redundancy (deficiency)” represents, as of December 31, 2006, the difference between the latest re-estimated liability and the reserves as originally estimated. A redundancy means that the original estimate was higher than the current estimate for reserves; a deficiency means that the current estimate is higher than the original estimate for reserves. For example, because the reserves established as of December 31, 1996 at $48.0 million were reestablished at December 31, 2006 at $32.3 million, it was re-estimated that the reserves which were established as of December 31, 1996 included a $15.7 million redundancy.
From 1996 through 1998, our insurance subsidiaries experienced significant favorable development of their reserves, reflecting redundancies in all years. This development was significantly influenced by the police and public officials classes of business which FMIC’s predecessor organization, First Mercury Syndicate (“FMS”) began writing in 1991, and FMIC stopped writing in 1996. Early reported losses and loss adjustment expense emergence in those classes was worse than industry experience, and estimated ultimate losses and loss adjustment expenses and related reserves were based on a continuation of the adverse trend and use of industry development factors. In addition, FMS’s loss and loss adjustment experience data only went back to FMS’s formation in 1985, so greater weight was given to industry data compared to our claims experience in establishing IBNR. As our policies in the accident years matured, the loss trends moderated and ultimate losses and loss adjustment expenses emerged lower than the industry data indications.
In June 2004, following the investment in our convertible preferred stock, FMFC contributed additional capital to FMIC, resulting in an increase in FMIC’s statutory surplus of $26.0 million. Shortly thereafter, A.M. Best raised FMIC’s financial strength rating to “A−” and size rating to “VII,” thus qualifying it to be the direct writer of substantially all of the premiums produced by CoverX. On May 1, 2005, the prior assumed reinsurance contracts terminated. By December 31, 2005, substantially all premiums produced were written directly by FMIC.
FMIC entered into ceding reinsurance contracts effective June 2004, ceding per occurrence coverages in excess of $500,000 per risk, and ceding 39% of its net retention to an unaffiliated reinsurer (30%) and to ANIC (9%), increasing the combined net retention of our insurance subsidiaries to 70% of the first $500,000 per occurrence. We increased the premiums ceded under quota share agreements with unaffiliated reinsurers to 40% in July 2005 and 50% in January 2006.
We have historically adjusted our level of quota share reinsurance based on our premiums produced and our level of capitalization, as well as our risk appetite for a particular type of business. We believe that the current
The following table illustrates our direct written premiums and ceded for the years ended December 31, 2006, 2005 and 2004:
Our net cash flows relating to ceded reinsurance activities (premiums paid less losses recovered and ceding commissions received) were approximately $48.7 million net cash paid for the year ended December 31, 2006 compared to net cash paid of $48.4 million for the year ended December 31, 2005. We paid approximately $12.8 million for the year ended December 31, 2004. As a result of the above described election to exercise the cut-off termination option with respect to the 2006 50% ceded quota share reinsurance contracts, $26.8 million is due to the Company from the quota share reinsurers. This amount is reported in premiums and reinsurance balances receivable in our December 31, 2006 balance sheet, and receipt of the cash is due during the first quarter of 2007 in accordance with the reinsurance contract terms.
On December 31, 2006 and December 31, 2005, FMFC had a net amount of recoverables from reinsurers of $99.6 million and $49.2 million, respectively, on a consolidated basis. The following is a summary of our insurance subsidiaries’ net reinsurance recoverables by reinsurer:
- all other reinsurers carry an A.M. Best rating of “A” and above
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments.” Under current generally accepted accounting principles, an entity that holds a financial instrument with an embedded derivative must bifurcate the financial instrument, resulting in the host and the embedded derivative being accounted for separately. SFAS No. 155 permits, but does not require, entities to account for financial instruments with an embedded derivative at fair value, thus negating the need to bifurcate the instrument between its host and the embedded derivative. SFAS No. 155 is effective for fiscal periods beginning after September 15, 2006. The Company does not expect that SFAS No. 155 will have a material impact on its consolidated financial statements.
In September 2006, the SEC Staff issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements” (“SAB No. 108”). SAB No. 108 requires the use of two alternative approaches in quantitatively evaluating materiality of
misstatements. If the misstatement as quantified under either approach is material to the current year financial statements, the misstatement must be corrected. If the effect of correcting the prior year misstatements, if any, in the current year income statement is material, the prior year financial statements should be corrected. SAB No. 108 was effective for the fourth quarter of 2006 and did not have any impact on the Company’s financial statements.
We have audited the accompanying consolidated balance sheets of First Mercury Financial Corporation and Subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity and cash flows for the year ended December 31, 2006 (Successor Company), the periods August 17, 2005 through December 31, 2005 (Successor Company), January 1, 2005 through August 16, 2005 (Predecessor Company), and for the year ended December 31, 2004 (Predecessor Company). We have also audited the schedules listed in the accompanying index. These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Mercury Financial Corporation and Subsidiaries as of December 31, 2006 and 2005, and the results of its operations and its cash flows for the year ended December 31, 2006 (Successor Company), the periods August 17, 2005 through December 31, 2005 (Successor Company), January 1, 2005 through August 16, 2005 (Predecessor Company), and for the year ended December 31, 2004 (Predecessor Company) in conformity with accounting principles generally accepted in the United States of America.
Also, in our opinion, the schedules present fairly, in all material respects, the information set forth therein.
The consolidated financial statements include the results of FMFC and its subsidiaries. FMFC’s subsidiaries are First Mercury Insurance Company (“FMIC”), All Nation Insurance Company (“ANIC”), CoverX Corporation (“CoverX”), Quantum Direct Service Corporation (“QDSC”), Questt Agency, Inc. (“Questt”), Quantum Insurance Agency, Inc. (“QIA”), Van-American Insurance Services, Inc. (“VAIS”) and ARPCO Holdings, Inc. and its subsidiaries (“AHI”), collectively referred to as “the Company.” All significant intercompany transactions have been eliminated upon consolidation. Minority interest in consolidated subsidiaries is insignificant and is reflected as part of other liabilities and other expenses.
AHI’s subsidiaries are American Risk Pooling Consultants, Inc., Public Entity Risk Services of Ohio, Inc., a 67.8% equity interest in Public Entity Risk Services of Iowa, Inc. and a 50% equity interest in Integrated Risk Management, Inc., collectively referred to as the “ARPCO Group.” The ARPCO Group is a third party administrator and service provider for five public entity risk pools and an excess reinsurance pool. They provide or coordinate accounting, finance, claim handling, loss control, underwriting, investments and general welfare services for the pools and their members.
The consolidated financial statements also include earnings on investment in First Mercury Financial Capital Trusts I, II and III; wholly-owned, unconsolidated subsidiaries of the Company (see Note 7).
Holdings was formed on July 28, 2005 and on August 17, 2005, issued $65.0 million of Senior Floating Rate Notes due 2012 (“Notes”). Holdings used the net proceeds from the issuance to purchase certain outstanding shares of FMFC common stock, while at the same time issuing convertible preferred shares and common shares to certain former shareholders and option holders of FMFC in exchange for their convertible preferred and common shares. On December 15, 2005, Holdings formed First Mercury Merger Corporation (“FMMC”), and on December 29, 2005 merged FMMC with and into FMFC, with FMFC being the surviving entity (the “Merger”). The remaining common shares of FMFC that were not sold to Holdings under the August 17, 2005 transaction were cancelled and converted into rights for those shareholders to receive cash for their shares from FMFC. At the completion of the December 29, 2005 merger, Holdings owned 100% of the common shares and the convertible preferred shares of FMFC.
Interest Rate Risk is the risk that interest rates will change and cause a decrease in the value of an insurer’s investments or an increase in the Company’s interest expense due on its long-term debt. The Company mitigates this risk related to investments by attempting to match the maturity schedule of its assets with the expected payout of its liabilities. To the extent that liabilities come due more quickly than assets mature, the Company would have to sell assets prior to maturity and recognize a gain or loss. At December 31, 2006 and 2005, the estimated market value of the Company’s bond portfolio was lower than its cost. The Company mitigates this risk related to its junior subordinated debentures by entering into interest rate swap agreements, which fix the interest rate on long-term debt (see Note 8).
The exception of this rule relates to investments with embedded derivatives, primarily convertible debt securities (see “Derivative Instruments and Hedging Activities”).
Federal income taxes are calculated using the liability method as specified by SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”).
On January 1, 2006, the Company adopted SFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). SFAS 123(R) eliminates the option of accounting for share-based payments using the intrinsic value method and making only pro forma disclosures of the impact on earnings of the cost of stock options and other share-based awards measured using a fair value approach. SFAS 123(R) requires that companies measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award (i.e., the requisite service period) which is usually equal to the vesting period. Prior to adopting SFAS 123(R), the Company recorded stock option expense under SFAS 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure - An Amendment to FASB Statement No. 123” (“SFAS 148”).
Certain of the Company’s financial instruments contain embedded derivatives where the economic characteristics of the embedded instrument do not closely relate to those of the host contract. The Company bifurcates these embedded derivatives under SFAS 133 and recognizes the change in the embedded derivatives in realized gains and losses on the income statement. The fair value of these embedded derivatives, primarily related to investments in convertible debt securities, is included in investments on the balance sheet.
The fair value of the derivative is derived by allocating the fair market value of the host contract in excess of the calculated fair market value of the bond portion of the host contract. At December 31, 2006 and 2005, the fair value of the embedded derivatives was $5.2 million and $3.4 million, respectively.
The Company has also entered into three interest rate swap agreements. Two of these agreements have not been identified as hedging transactions. For these agreements, the change in the fair value is included in Change in Fair Value of Derivative Instruments in the consolidated statements of income. For the agreement that has been designated and qualifies as a cash flow hedge, to the extent the hedge is effective, the change in fair value is included in comprehensive income until earnings are affected by the variability of cash flows of the hedged transaction. Any hedge ineffectiveness is recorded in the statement of income. There was no such ineffectiveness since inception of this hedge in 2006. The fair value of the interest rate swaps are included in Other Assets or Other Liabilities on the balance sheet and represent the estimated amount that the Company would receive (pay) to terminate the derivative contract at the reporting date.
The Company’s operations are conducted throughout the United States of America. The Company’s net earned premiums are derived from substantially similar products.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. This statement is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing the potential impact that the adoption of SFAS 157 will have on its financial statements.
Subsequently, on June 11, 2004, FMFC became the 100% owner of AHI in exchange for 150 shares of voting convertible preferred stock (see Note 12).
On June 14, 2004, AHI acquired 100% of the common stock of the ARPCO Group for $20.0 million, funded with $15.0 million in cash and the issuance of a $5.0 million promissory note by FMFC (See Note 7). The former majority owner of the ARPCO Group also owned, at the date of the acquisition, common stock of FMFC representing a 34% voting interest in FMFC. Direct costs related to the acquisition totaling $0.5 million were also capitalized as part of the purchase price.
The acquisition of the ARPCO Group was accounted for in accordance with SFAS No. 141, “Business Combinations” (“SFAS 141”). The cost of the acquisition was allocated to the assets acquired and liabilities assumed based on estimates of their respective fair values at the date of acquisition. Fair values were determined by internal analysis and an independent third party appraisal.
On August 17, 2005, Holdings acquired 96.12% of FMFC through a Stock Contribution Agreement among Holdings and the stockholders of FMFC and through Holdings assumption of obligations of the FMFC stock option plan. FMFC stockholders and option holders received either cash, Holdings preferred or common stock, or Holdings options in exchange for their shares or options of FMFC. On December 29, 2005, the remaining outstanding shares of FMFC common stock were cancelled and converted to stockholder rights to receive cash through a merger of Holdings wholly owned subsidiary, FMMC with and into FMFC (the “Merger”). The estimated amount payable of $5.1 million was reflected as shareholder rights payable at December 31, 2005. As a result of these transactions, Holdings acquired 100% of FMFC (the “Acquisition”). In the second quarter of 2006, the Company made its final payment related to the former shareholder’s rights to receive cash of $6.4 million resulting in a $1.3 million increase in purchase consideration. In addition, the Company completed its evaluation of the tax bases of its net assets in connection with the acquisition. As a result of these events, the Company adjusted its purchase accounting to reflect an increase in its intangible assets of $8.5 million and a decrease in its net deferred tax assets of $7.2 million.
The Acquisition was accounted for as a purchase in accordance with SFAS 141 and Emerging Issues Task Force (EITF) Issue No. 88-16, “Basis In Leveraged Buyout Transactions.” (“EITF 88-16”). Because the transaction resulted in a “change in control” as described in EITF 88-16, the total purchase price was allocated to the acquired assets and liabilities based on their estimated fair values at the Acquisition date to the extent of the new investors ownership of 28%. The remaining 72% ownership was accounted for at the continuing investors’ carrying basis in FMFC. The resulting purchase price was $120.2 million. Cash consideration, including the accrual of shareholders rights amounts, of $61.4 million was financed by Holdings issuance of the $65.0 million in Senior Floating Rate Notes discussed in Note 7. Approximately $27.6 million of the cash consideration was paid to a common stockholder that had a 33% voting interest before the transaction and a 28% voting interest after the transaction. Financing costs of $4.8 million were being amortized over the seven year term of the notes as interest expense. Immediately following the Company’s initial public offering and full payoff of the $65.0 million senior notes in October 2006, all remaining financing costs were written off.
The following table summarizes both the cash and non-cash consideration related to the Acquisition (in thousands):
Components of intangible assets at December 31, 2006 (Successor) consist of the following:
Our non-amortizing intangible assets consist of the trade name for CoverX and the state/jurisdiction licenses to conduct insurance operations, as it is expected that these intangibles will contribute to cash flows indefinitely. The trade name and the state/jurisdiction licenses have been in existence for many years and there is no foreseeable limit on the period of time over which they are expected to contribute cash flows. Aggregate amortization expense related to intangible assets was $1.3 million and $0.4 million for the year ended December 31, 2006 and for the Successor period August 17, 2005 through December 31, 2005, respectively. The weighted-average remaining useful life is 11.7 years. Estimated amortization expense for each of the next five years is as follows:
FMIC and ANIC maintain trust accounts for the protection of reinsureds, pursuant to the assumed reinsurance contracts. These funds are to be used to pay or reimburse the reinsureds for FMIC’s and ANIC’s share of any losses and allocated loss adjustment expenses paid by the reinsureds if not otherwise paid by FMIC and ANIC. At December 31, 2006 and 2005, investments held in the trust accounts totaled approximately $85.3 million and $93.2 million, respectively. In addition, CoverX maintains premium trust accounts, which represent premiums collected by CoverX but not yet remitted to the corresponding insurance carriers. The balances in the premium trust accounts as of December 31, 2006 and 2005 were approximately $3.3 million and $4.0 million, respectively.
At December 31, 2006 and 2005, FMIC had marketable securities approximating $7.0 million on deposit with various states for regulatory purposes.
The Company recognized a loss of $0.6 million for the year ended December 31, 2006 for securities identified as other than temporarily impaired. There were no such losses incurred during the periods August 17, 2006 to December 31, 2005, January 1 through August 16, 2005, or for the year ended December 31, 2004.
The following is a summary of fixed assets, included in other assets, as of December 31, 2006 and 2005:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are presented below:
The Company has arranged for the sale of trust preferred securities (“Trust Preferred Securities”) through First Mercury Financial Capital Trust I, First Mercury Financial Capital Trust II, and First Mercury Financial Capital Trust III (each a “Trust”; collectively the “Trusts”). Each trust was created solely for the purpose of issuing Trust Preferred Securities. In accordance with FASB Interpretation No. 46, “Consolidation of Variable Interest entities, an interpretation of ARB No. 51”, “FIN 46”, the Trusts have not been consolidated with the Company in these financial statements.
At December 31, 2006, the three months LIBOR was equal to 5.36%.
In connection with the Company’s initial public offering, the Company repurchased all of its outstanding senior notes for $69.9 million, including a $3.3 million redemption premium and $1.6 million of accrued interest.
On June 14, 2004, the Company issued $5.0 million of unsecured promissory notes to certain stockholders of the Company in connection with its acquisition of the ARPCO Group, which could be repaid, in whole or in part, at the Company’s option, with no penalty or premium. In September 2005, the Company elected to pay off this note in full.
The Company has entered into a third interest rate swap agreement in order to fix the interest rate on its First Mercury Financial Corporation Trust III and thereby reduce the exposure to interest rate fluctuations. At December 31, 2006, this interest rate swap had a notional amount of $25.0 million. Under this agreement, the Company will pay the counterparty interest at a fixed rate of 5.013%, and the counterparty will pay the Company interest at a variable rate equal to three months LIBOR until expiration in December 2011. The notional amount does not represent an amount exchanged by the parties, and thus is not a measure of exposure of the Company. The variable rate is subject to change over time as LIBOR fluctuates.
The Company accounts for this third interest rate swap as a cash flow hedge whereby the change in fair value of the interest rate swap is recorded in other comprehensive income, net of taxes. The fair value of the interest rate swap was not significant as of December 31, 2006.
Neither the Company nor the counterparty, which is a major U.S. bank, is required to collateralize its obligation under these three swap agreements. The Company is exposed to loss if the counterparty should default. At December 31, 2006, the Company had minimal exposure to credit loss on the interest rate swaps. The Company does not believe that any reasonably likely change in interest rates would have a materially adverse effect on the financial position, the results of operations or cash flows of the Company.
FMIC assumes liability business on a quota share basis from primary insurers who write business produced through CoverX. Beginning in June 2004, and concurrent with an upgrade in the Company’s AM Best Rating to A−, the Company, to a much greater extent than before, directly writes this same business. As of December 31, 2006, the Company is writing essentially all of this business directly. FMIC retains, at varying percentages, the first $0.5 million or $1.0 million per occurrence, depending on the underwriting year and program. The Company, as well as the other primary insurers, retain a portion of the quota share and cede excess and remaining quota share to others. For the year ended December 31, 2006 (Successor), the period August 17 to December 31, 2005 (Successor), the period January 1 to August 16, 2005 (Predecessor), and the year ended December 31, 2004 (Predecessor), FMIC retained 54.2%, 42.0%, 51.8%, and 41.1%, respectively, of the aforementioned liability business.
The Company manages its credit risk on reinsurance recoverables by reviewing the financial stability, A.M. Best rating, capitalization, and credit worthiness of prospective and existing risk-sharing partners. The Company customarily collateralizes reinsurance balances due from non-admitted reinsurers through funds withheld trusts or stand-by letters of credit issued by highly rated banks. The largest unsecured reinsurance recoverable is due from an admitted reinsurer with an A.M. Best rating of “A+” and accounts for 66.2% of the total recoverable from reinsurers.
First Home Insurance Agency (FHIA), formed in 2005, is considered a related party to the Company due to common ownership of FHIA and FMFC. The Company provides systems support, accounting, human resources, claims and regulatory oversight for FHIA under an administrative services and cost allocation agreement. Under the terms of this agreement, FMFC charges a fee of 1.5% of premium from FHIA’s agency-produced business for systems usage, and allocates actual expenses and costs related to the activities discussed above. For the year ended December 31, 2006 and for the periods August 17 to December 31, 2005 and January 1 to August 16, 2005, costs related to this agreement and other allocated expenses were $0.6 million, $0.3 million and $0.7 million, respectively. As of December 31, 2006 and 2005, the Company had a receivable for these charges and other advances of approximately $20,000 and $1.2 million, respectively, from FHIA.
The Company has entered into a consulting agreement with its founder, who currently serves as a director. The agreement has a three year term and provides for an annual consulting fee of $1.0 million.
In connection with the Company’s initial public offering, all of the shares outstanding of the Preferred Stock were converted into 6,435,140 shares of common stock. On conversion, the Company paid the former holders of the Preferred Stock $8.3 million in accrued dividends, $49.7 million in cash in lieu of 2,926,544 shares of common stock, and $30.3 million for the repurchase of an additional 1,779,339 shares of common stock.
The aggregate intrinsic value of fully vested options outstanding and exercisable under the 1998 Plan was $19.7 million at December 31, 2006. The aggregate intrinsic value of options expected to vest under the Omnibus Plan was $1.6 million at December 31, 2006.
The total intrinsic value of stock options exercised was $1.3 million, $0.2 million, $0, and $4.2 million for the year ended December 31, 2006 (Successor), for the period August 17 through December 31, 2005 (Successor), for the period January 1 through August 16, 2005 (Predecessor), and for the year ended December 31, 2004 (Predecessor), respectively.
The number of stock option awards outstanding and exercisable at December 31, 2006 by range of exercise prices was as follows:
As of December 31, 2006, there was approximately $1.2 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Omnibus Plan and related to non-vested restricted stock. That cost is expected to be recognized over a weighted-average period of 2.8 years.
For 2006, the expected term of options was determined based on historical exercise behavior and the period of time that the options are expected to be outstanding. Expected stock price volatility was based on an average of the volatility factors utilized by companies within the Company’s peer group. Prior to the adoption of SFAS 123R, expected term was based on the contractual term of the award and price volatility was not utilized in the Company’s
FMIC was originally formed in 1996 as an Illinois Domestic Stock Property and Casualty Insurer operating on an admitted basis in Illinois, which required maintaining minimum capital and surplus of $2.0 million. On July 15, 2004, FMIC received approval from the Illinois Department of Insurance and became an Illinois Domestic Stock Surplus Lines Insurer. With this change in status Illinois now requires a minimum $15.0 million in surplus of which $1.0 million must be paid in capital to qualify for domestic surplus lines status. FMIC was in compliance with the applicable requirements at December 31, 2006, 2005, and 2004.
The State of Minnesota requires ANIC to maintain a minimum of $1.5 million in capital stock and surplus, which they were in compliance with at December 31, 2006, 2005, and 2004.
The National Association of Insurance Commissioners (NAIC) has established risk-based capital models to measure the adequacy of capitalization for insurance companies. The model calculates minimum capital requirements for each insurer based on certain criteria, including investment risk, underwriting profitability and losses and loss adjustment expense risk. As of December 31, 2006, 2005, and 2004, FMIC and ANIC exceeded the minimum capital requirements determined by the NAIC’s risk-based capital models.
The statutory net income and stockholder’s equity of the Company’s insurance subsidiaries were as follows: