Infinity’s insurance subsidiaries lease approximately 865,000 square feet of office and warehouse space in numerous cities throughout the United States. All but one of these leases expire within ten years. The most significant leased office spaces are located in Birmingham, Alabama (Infinity’s principal office), suburban Atlanta, Georgia, Irving, Texas, and suburban Los Angeles, California. See Note 15 of the Consolidated Financial Statements for further information about leases.
(a) During the years 2003 and 2004, Infinity ceded a portion of its automobile physical damage business through reinsurance agreements which were commuted 12/31/2004 and were not renewed or replaced. The majority of the increase in net written and earned premium in years 2004 and 2005 is a result of the discontinuation of the reinsurance agreements.
Total revenues increased 7.5% primarily due to an 8.7% increase in earned premium attributable to gross written premium growth during the last six months of 2006 and the first six months of 2007. Gross written premiums for the twelve months ended December 31, 2007 grew 3.3% compared to the same period of 2006. During the first six months of 2007, gross written premiums grew 14.6% primarily from growth in California as Infinity continued to benefit from the California
Department of Motor Vehicles implementation of electronic enforcement of compulsory auto insurance laws. However, during the last six months of 2007, gross written premiums declined 7.8% primarily as a result of slowing new business application counts in Arizona, California, Connecticut and Florida. See Results of Operations - Underwriting - Premiums for a more detailed discussion of Infinity’s gross written premium growth.
Effective April 3, 2007, California adopted amended rate approval regulations, which among other changes, establishes, for personal auto and most other lines of property and casualty insurance written in California, a maximum permitted after-tax rate of return on invested capital at an insurance company level, currently set at 9.66%. In response to these amended regulations, as well as regulations adopted in October 2006 restricting the use of territory as a rating variable, Infinity discussed over several months and came to an agreement with the California Department of Insurance to reduce base rates on its two principal programs by approximately 11.2%. In October, Infinity received approval for the base rate and class plan filings for its largest program in California and implemented the new filings effective January 1, 2008. Infinity expects to receive approval on the pending rate and class plan filings for its second program in California sometime during the first six months of 2008. Infinity believes that profitability in 2008 could be materially adversely affected to the extent that the reduction of base rates in California cannot be mitigated by improved risk selection within California, an increase in business at adequate margins in California, or an improvement in profitability in other states, or a combination of these factors.
The preparation of financial statements requires management to make estimates and assumptions that can have a significant effect on amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change and thus impact amounts reported in the future. Management believes that the establishment of insurance reserves, the determination of “other-than-temporary” impairment on investments and accruals for litigation are the areas where the degree of judgment required to determine amounts recorded in the financial statements make the accounting policies critical.
For each subset of the business evaluated, each test generates a point estimate based on development factors applied to known paid and incurred claims and claim counts to estimate ultimate paid claims and claim counts. Selections of factors are based on historical loss development patterns with adjustment based on professional actuarial judgment where anticipated
While the ultimate liability may be greater or lower than recorded loss reserves, the development period for personal auto coverage is shorter than that associated with many other property and casualty coverages and can therefore be established with less uncertainty than coverages developing over longer periods, such as environmental coverage.
Where deviations from historical trends in these key areas exist, when possible, quantitative and qualitative modifications to, or selections of, such factors are made to reflect such deviations. Management analyzes the adequacy of reserves using actuarial data and analytical reserve development techniques, including projections of ultimate paid losses, to determine the ultimate amount of reserves. The list of “key underlying assumptions” provided above are examples of major factors taken into account in developing these estimates.
Management believes that Infinity’s relatively low average policy limit and concentration on the nonstandard auto driver classification help stabilize fluctuations in frequency and severity. For example, approximately 92% of policies included within the nonstandard book of business include only the state-mandated minimum policy limits for bodily injury and property damage, which somewhat mitigates the challenge of estimating average severity. These low limits tend to reduce the exposure of the loss reserves on this coverage to medical cost inflation on severe injuries since the minimum policy limits will limit the total payout.
The Company’s management believes that the historical magnitude of adjustments to ultimate losses on an accident year basis are indicative of the sensitivity of currently held loss reserves to changes in underlying assumptions. Over the past six accident years (the years for which data is readily available), excluding the effect of corporate litigation costs, the combined effects of adjustments to the initial estimate for average ultimate claims frequency and severity have ranged from (5.4)% to 4.5% (averaging (0.5)%).
Applying the six-year historical variances calculated above to the current 2007 accident year’s estimate of ultimate losses, excluding corporate litigation losses, would yield an indication of sensitivity to held reserves from $(32.7) million to $27.1 million, or about (5.3)% to 4.4% of held reserves, generating an impact to after-tax income of $21.2 million to $(17.6) million, respectively. The final outcome may fall below or above these amounts.
Calendar year losses incurred for corporate litigation losses, net of reinsurance, over the past six calendar years have ranged from $8.2 million to $15.8 million, averaging $11.3 million per year. Gross of reinsurance, corporate litigation losses have ranged from $8.2 million to $18.8 million, averaging $13.9 million over the past six calendar years.
The following tables present the development of Infinity’s loss reserves, net of reinsurance, on a GAAP basis for the calendar years 1997 through 2007. The Infinity table includes the loss reserves of the NSA Group through December 31, 2002, the addition of the Assumed Agency Business on January 1, 2003, and those of Infinity combined for 2003 and all subsequent years. The top line of each table shows the estimated liability for unpaid losses and LAE recorded at the balance sheet date for the indicated years. The next line, captioned Liability for Unpaid Losses and LAE - as re-estimated at December 31, 2007, shows the re-estimated liability as of December 31, 2007. The remainder of the table presents intervening development as percentages of the initially estimated liability. The development results from additional information and experience in subsequent years. The middle line shows a cumulative deficiency (redundancy) which represents the aggregate percentage increase (decrease) in the liability initially estimated. The lower portion of the table indicates the cumulative amounts paid as of successive periods as a percentage of the original loss reserve liability.
During calendar year 2006, Infinity experienced $31.2 million of favorable reserve development. This development came primarily from a reduction in ultimate estimates for average claim severities from accident years 2003-2005 in physical damage and bodily injury coverages. For those years, estimates for ultimate claim frequencies increased slightly.
Management regularly evaluates for potential impairment each security position that either has a fair value of less than 95% of its book value, an unrealized loss that exceeds $100,000 or had one or more impairment charges recorded in the past. In addition, management reviews positions held related to an issuer of a previously impaired security. The process of evaluation includes assessments of each item listed above. Since it is not possible to accurately predict if or when a specific security will become other than temporarily impaired, total impairment charges could be material to the results of operations in a future period. However, management believes that it is not likely that such impairment charges will have a significant effect on Infinity’s liquidity.
Infinity continually evaluates potential liabilities and reserves for litigation using the criteria established by SFAS 5, “Accounting for Contingencies.” Under this guidance, reserves for loss may only be recorded if the likelihood of occurrence is probable and the amount is reasonably estimable. Management considers each legal action and records reserves for losses in accordance with this guidance. Infinity believes the current assumptions and other considerations used to estimate potential liability for litigation are appropriate. Certain claims and legal actions have been brought against Infinity for which, under the rules described above, no loss has been accrued. While it is not possible to know with certainty the ultimate outcome of these claims or lawsuits, management does not expect them to have a material effect on Infinity’s financial condition or liquidity.
The National Association of Insurance Commissioners’ (“NAIC”) model law for risk-based capital (“RBC”) provides formulas to determine the amount of capital that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2007, the capital ratios of all Infinity insurance subsidiaries exceeded the RBC requirements.
Infinity is organized as a holding company with all of its operations being conducted by its insurance subsidiaries. Accordingly, Infinity will have continuing cash needs for administrative expenses, the payment of interest on borrowings, shareholder dividends, share repurchases and taxes. Administrative expenses at the holding company have averaged approximately $7.0 million annually since 2003.
In October 2006, the Board of Directors announced a second share repurchase program expiring on the earliest of December 31, 2008 or the completion of all purchases contemplated by the program, whereby the Company may repurchase up to an aggregate amount of $100 million of its outstanding common shares. During 2007, Infinity repurchased 1,032,479 shares at an average cost, excluding commissions, of $43.03.
In August 2007, the Company announced that the Board of Directors approved a third program to repurchase an additional $100 million of outstanding common stock. On September 7, 2007, Infinity repurchased 2,554,932 shares through an accelerated share repurchase (“ASR”). The shares were purchased from a dealer at $39.14 per share for a total cost of $100 million. The dealer began purchasing shares on October 8, 2007, and is expected to purchase an equivalent number of shares by the end of May 2008. At the end of the ASR program, Infinity may receive or be required to pay a price adjustment to the dealer based on the volume weighted average price of Infinity’s common stock during the period of the ASR purchases. Infinity has the option to settle this price adjustment in either shares or cash. The price adjustment will be recorded as an adjustment to shareholders’ equity. The maximum number of shares Infinity could be required to issue to settle the ASR is 7,664,796. Had the ASR settled as of December 31, 2007, Infinity would have received from the dealer either $1.7 million or 46,060 shares. Infinity purchased a collar on a portion of the shares to provide some protection from a significant increase in Infinity’s stock price.
In August 2005, Infinity entered into an agreement for a $50 million three-year revolving credit facility that includes requirements to meet certain financial and other covenants. Under this agreement, there were no borrowings outstanding at December 31, 2007 or December 31, 2006. Infinity intends to enter into a new agreement for a revolving credit facility when the existing agreement ends in August 2008.
Infinity’s insurance subsidiaries generate liquidity to satisfy their obligations, primarily by collecting and investing premiums in advance of paying claims. Infinity’s insurance subsidiaries had positive cash flow from operations of approximately $74.0 million in 2007, $28.5 million in 2006, and $56.2 million in 2005. In addition, to satisfy their obligations, Infinity’s insurance subsidiaries generate cash from maturing securities from their combined $1.1 billion fixed maturity portfolio.
(a) The payout pattern for reserves for losses and LAE is based upon historical payment patterns and do not represent actual contractual obligations. The timing and amounts ultimately paid can and will vary from these estimates, as discussed above under “Critical Accounting Policies” and in Note 1 of the Consolidated Financial Statements, “Reporting and Accounting Policies”.
Additionally, Infinity leases fleet vehicles for a minimum term of 12 months. After the minimum term, the lease becomes month-to-month. As of December 31, 2007, the total remaining minimum lease payments under the fleet operating lease were approximately $0.6 million.
On September 7, 2007, Infinity repurchased 2,554,932 shares through an accelerated share repurchase (“ASR”). The shares were purchased from a dealer at $39.14 per share for a total cost of $100 million. The dealer began purchasing shares on October 8, 2007, and is expected to purchase an equivalent number of shares by the end of May 2008. At the end of the ASR program, Infinity may receive or be required to pay a price adjustment to the dealer based on the volume weighted average price of Infinity’s common stock during the period of the ASR purchases. Infinity has the option to settle this price adjustment in either shares or cash. The price adjustment will be recorded as an adjustment to shareholders’ equity. The maximum number of shares Infinity could be required to issue to settle the ASR is 7,664,796. Had the ASR settled as of December 31, 2007, Infinity would have received from the dealer either $1.7 million or 46,060 shares. Infinity purchased a collar on a portion of the shares to provide some protection from a significant increase in Infinity’s stock price.
On April 1, 2007, Infinity’s four-year agreement with its previous investment manager ended. At that time, Infinity engaged two unaffiliated money managers for its fixed income portfolio and a Vanguard publicly traded exchange traded fund designed to track the MSCI U.S. Broad Market Index for the equity portfolio. The investment managers conduct, in accordance with the Company’s investment guidelines, all of the investment purchases and sales for the Company and its subsidiaries. In the second and third quarters of 2007, the fixed income managers repositioned the investment portfolio to take advantage of opportunities identified in municipal and high quality, well collateralized mortgage-backed and CMO securities. The Company’s Chief Financial Officer and the Audit Committee, at least quarterly, review the performance of the portfolio management and compliance with the Company’s investment guidelines.
Infinity’s consolidated investment portfolio at December 31, 2007 contained $1.2 billion in fixed maturity securities and $49.7 million in equity securities, all carried at fair value with unrealized gains and losses reported as a separate component of shareholders’ equity on an after-tax basis. At December 31, 2007, Infinity had pretax net unrealized gains of $11.4 million on fixed maturities and pretax net unrealized gains of $0.6 million on equity securities. The average duration of Infinity’s fixed maturity portfolio was 3.5 years at December 31, 2007.
The fair value of Infinity’s fixed maturity portfolio is directly impacted by changes in market interest rates; generally, the fair value of fixed-income investments moves inversely with movements in market interest rates. Infinity’s fixed maturity portfolio is comprised of substantially all fixed rate investments with primarily short-term and intermediate-term maturities. This portfolio composition allows flexibility in reacting to fluctuations of interest rates. In addition, the risk of loss in fair value is partially mitigated by higher market rates available for new funds available for investment. The portfolios of Infinity’s insurance companies are managed to achieve an adequate risk-adjusted return while maintaining sufficient liquidity to meet policyholder obligations.
The following table shows Infinity’s fixed maturity securities, by NAIC designation and comparable Standard & Poor’s Corporation rating as of December 31, 2007 (in thousands).
During the second half of 2007, the mortgage industry experienced a rise in mortgage delinquencies and foreclosures, particularly among lower quality exposures (“sub-prime” and “Alt-A”). As a result of these increasing delinquencies and foreclosures, many MBS and CMOs with underlying sub-prime and Alt-A mortgages as collateral experienced significant drops in market value. Infinity has only modest exposure to these type investments. At December 31, 2007, Infinity’s fixed maturity portfolio included 13 CMOs, or 2.1% of the total market value of the fixed income portfolio, with exposure to sub-prime and Alt-A mortgages. Although these CMOs have sub-prime mortgages as underlying collateral, all but one of them have AAA ratings and are in well secured tranches. One security, with a market value of $0.9 million, has an AA rating.
In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” Infinity performs impairment test procedures for goodwill on an annual basis. These procedures require Infinity to calculate the fair value of goodwill, compare the result to its carrying value and record the amount of any shortfall as an impairment charge. Infinity performed this test as of September 30, 2007 using a variety of methods, including estimates of future discounted cash flows and comparisons of the market value of Infinity to its major competitors as well as the overall market. The September 30, 2007 test results indicated that there was no impairment charge required at that date. Additionally, there was no indication of impairment at December 31, 2007.
Offsetting gross written premium growth in Arizona, California, Nevada and Texas were declines in gross written premiums in Connecticut and Florida. Infinity raised rates 16.2% in Connecticut and 13.5% in Florida during the twelve months ending December 31, 2007, which slowed new business production. Gross written premiums in Florida were also negatively impacted by the sunset of the mandatory personal injury protection (“PIP”) coverage on October 1, 2007. Although the Florida legislature eventually reinstated PIP as a mandatory coverage, the new requirement did not go into effect until January 1, 2008 and Infinity believes as a result, fewer consumers were purchasing PIP coverage in the fourth quarter of 2007.
Although gross written premiums and policies-in-force in Florida declined 5.1% and 0.3%, respectively, during 2006 as compared to 2005, gross written premiums in Florida grew 7.9% during the last six months of 2006 as compared to the same period of 2005. During the last nine months of 2005, Infinity implemented rate increases, totaling 15%, to address increasing combined ratios in Florida. New business during the first six months of 2006 declined as a result of these rate actions. During the third quarter, several competitors in Florida also increased rates and as a result, Infinity’s programs became more competitive.
Gross written premiums and policies-in-force in the Classic Collector book of business grew 8.4% and 0.3%, respectively, during 2006 as compared with 2005. The gross written premium decline in Other premiums is a result of a substantial decline in premiums for the runoff Homeowners book of business. As of December 31, 2006, Infinity had completed the runoff of its homeowners in-force policies.
Ceded reinsurance declined 49.6% during 2006 as compared to 2005. Although Infinity maintained its 90% quota share agreement on its runoff Homeowners book of business during 2006, the amount of direct premium written in this program has substantially declined and, as a result, the amount ceded to reinsurers has also declined. In addition, Infinity maintains an excess of loss reinsurance treaty for higher limits personal auto liability coverages. Gross written premiums ceded under this treaty have declined as Infinity has sold the renewal rights on the GAI book of business in Connecticut, which consists predominantly of higher policy limits standard and preferred business.
While financial data is reported in accordance with GAAP for shareholder and other investment purposes, data is reported on a statutory basis for insurance regulatory purposes. Infinity evaluates underwriting profitability based on a combined ratio calculated using statutory accounting principles. The statutory combined ratio represents the sum of the following ratios: (i) losses and LAE incurred as a percentage of net earned premiums and (ii) underwriting expenses incurred as a percentage of net written premiums. Certain expenses are treated differently under statutory and GAAP accounting principles. Under GAAP, commissions, premium taxes and other variable costs incurred in connection with writing new and renewal business are capitalized as deferred policy acquisition costs and amortized on a pro rata basis over the period in which the related premiums are earned; on a statutory basis these items are expensed as incurred. Costs for computer software developed or obtained for internal use are capitalized under GAAP and amortized over their useful life, rather than expensed as incurred, as required for statutory purposes. Additionally, bad debt charge-offs on agent balances and premium receivables are included only in the GAAP combined ratios.
In the Maintenance States, the 2007 combined ratio improved 23.6 points compared to 2006. The 25.1 point improvement in the loss and LAE ratio is primarily a result of improving loss and LAE ratios in Alabama and South Carolina where Infinity has increased rates over the last two years to improve profitability. Included in the 2006 underwriting expense ratio is a one-time benefit of $1.9 million related to a refund from the South Carolina Reinsurance Facility. Excluding this amount, the 2006 underwriting ratio in the Maintenance States would be 26.6% compared to the 24.2% expense ratio for 2007. This decline in the underwriting expense ratio is primarily attributable to an increase in fee income in 2007 as compared with 2006.
The combined ratio in the Other States for 2007 improved substantially compared to 2006 primarily due to favorable development on prior year loss reserves in New York.
Other income for the twelve-month period ended December 31, 2006 declined $1.7 million from 2005, primarily due to the continued decline of finance charge income from the Assumed Agency Business that is in runoff. The other items included in other income of $1.1 million and $1.4 million in 2006 and 2005, respectively, primarily related to revenues from a majority owned captive agency. The business in this agency was discontinued at the end of 2007.
The Senior Notes carry a coupon rate of 5.50%, effective yield of 5.55%, and require no principal payment until maturity in February 2014. (See Note 3 of the Consolidated Financial Statements for additional information on the Senior Notes).
Corporate general and administrative expenses increased 10.6% in 2007 compared to 2006 primarily as a result of both an increase in fees paid to the Board of Directors and share based compensation expense related to the July 31, 2007 issuance of restricted stock. (See Note 6 of the Consolidated Financial Statements for additional information on the restricted stock issuance).
During the fourth quarter of 2006, Infinity recorded a $4.8 million, pretax, charge related to severance costs. The $1.7 million charge during 2007 is primarily related to losses on subleases from facilities affected by the restructuring. Infinity expects to incur additional charges of approximately $0.4 million during 2008 as additional facilities affected by the restructuring are sublet.
Other expenses increased $4.0 million for the twelve-month period ended December 31, 2006 as compared to 2005. The increase relates primarily to an increase in corporate litigation expense during 2006, partially offset by a smaller loss on sublease. The 2006 corporate litigation expense increase was due to a new reserve for a class action lawsuit compared to a reduction in the litigation reserve in 2005 due to favorable settlements of other class action lawsuits. (See Note 14 of the Consolidated Financial Statements “Legal Proceedings”.)
Consolidated Statements of Changes in Shareholders’ Equity: Years ended December 31, 2007, 2006 and 2005