(1) With the Company’s adoption of SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” in 2003, the Company’s outstanding Deferrable Capital Securities are classified as liabilities in 2003 and 2004.
See Management’s Discussion and Analysis of Results of Operation and Financial Condition-Restatement of Previously Issued Financial Statements for a description of each accounting error resulting in the adjustments. See also Note B of Notes to Financial Statements.
The internal review has since been completed. As a result of the findings of the internal review, the Company has concluded that our prior financial statements should be restated. The restatement resulted in a cumulative reduction to stockholders’ equity of approximately $11.6 million, $9.5 million, and $9.5 million as of December 31, 2003, 2002 and 2001, respectively, and a (decrease) increase to the previously reported net losses available to common shareholders of approximately $(191) thousand and $247 thousand for the years ended December 31, 2003 and 2002, respectively. In addition, the restatement resulted in an increase (decrease) to total comprehensive loss of approximately $2.3 million and $(234) thousand for the years ended December 31, 2003 and 2002, respectively.
Details of Accounting Adjustments included in the Restatement. The restatement adjustments to previously issued financial statements relate primarily to the categories described below. Following the description of each transaction, accounting entry or entity category is a summary impact of the adjustments relating to that category.
Finally, the Company noted that previously reported net investment income did not reflect all investment income related expenses. Rather, these expenses were previously reported as a component of operating expenses. As such, the Company reduced net investment income and operating expenses by $1.4 million and $2.2 million in 2003 and 2002, respectively to correct this error.
$74 thousand, for the year ended December 31, 2003. Reflecting the correction of this error in the restated financial statements impacted our Consolidated Statements of Operations and total comprehensive loss as follows (in thousands):
Gain on extinguishment of debt-The Company determined that we reported an incorrect gain amount stemming from a debt for equity swap in 2002. The impact of correcting this error was to increase the reported gain by approximately $316 thousand.
Consolidation Differences-As part of our internal review, the Company revised the process for consolidating our balance sheet for the applicable periods, and as a result were able to identify certain intercompany asset and liability balances that were not properly eliminated during the previous consolidation. These balances primarily included (1) an investment in a subsidiary, that was appropriately classified as an other invested asset in the underlying books and records, but which should have been eliminated as part of our consolidation and (2) numerous intercompany reinsurance balances, which also should have been eliminated as part of our consolidation. The failure to eliminate these balances in our consolidation process during 2003 and prior periods, resulted in the Company’s inability to properly identify income statement aggregation and consolidation errors. As a result, over a period of several years, the Company had overstated its consolidated net income available to common shareholders and consolidated stockholders’ equity. In total, the identified errors overstated Consolidated Stockholders’ Equity by $7.4 million, $7.0 million, and $7.2 million as of December 31, 2003, 2002 and 2001 respectively.
Reinsurance Contract Realized Gains-One of the Company’s insurance subsidiaries, American Founders Life Insurance Company (“AFLIC”), entered into a reinsurance contract with a third party effective October 1, 2002. Under the terms of that agreement, AFLIC ceded the investment results, including realized gains and losses, on part of its investment portfolio to the third party reinsurer. Upon the termination of this
In addition, the Company identified that certain of AFLIC’s assumed and ceded reinsurance agreements were erroneously reflected on a net basis in the previously issued Consolidated Balance Sheet. The correction of this error as of December 31, 2003 increased reinsurance balances receivable by $70.1 million, increased policy liabilities by $10.4 million and increased reinsurance balances payable by $59.7 million. This error did not have an impact on Consolidated Stockholders’ Equity as of December 31, 2003.
The following table presents the impact of the aforementioned adjustments on our Consolidated Balance Sheet at December 31, 2003.
The following table presents selected consolidated statements of cash flows information for the Company showing previously reported and restated cash flows, adjusted for the effects of the errors mentioned above, for the years ended December 31, 2003 and 2002 (in thousands):
The aforementioned changes to the reported consolidated balance sheets as of December 31, 2003, 2002 and 2001 resulted in changes to the activity reflected in the consolidated statements of cash flows for the years ended December 31, 2003 and 2002. The most significant of these changes relates to the change in consolidated cash as of December 31, 2003 due to the Company’s aggregate cash overdraft balance.
We formerly conducted business in the non-standard automobile agency and non-standard automobile underwriting industries and reported the financial information of these business segments. On July 9, 2004, we completed the initial public offering of 8.2 million shares of Affirmative Insurance Holdings, Inc. (“Affirmative”), our non-standard auto holding company. We retained 7.2 million shares, or approximately 42.9% of the outstanding shares. Our remaining ownership in Affirmative is being accounted for using the equity method beginning in the third quarter of 2004. As such, we no longer consolidate the balance sheet and statement of operations of Affirmative. Rather, we reflect the pro rata ownership of our investment in the equity of Affirmative as an investment asset on our balance sheet and our pro-rata share of the operating results of Affirmative in the Company’s Consolidated Statement of Operations as equity in net earnings of investee, net of tax. The amounts recorded as equity in net earnings of investee are included in the Corporate and Other segment for business segment reporting purposes.
Since 2000, we have pursued a strategy (1) to grow our market share in certain capacity constrained markets in the standard property-casualty business, (2) to enhance profitability in our target markets through sound underwriting and premium rate levels, (3) to exit certain states in which recent results and projected future results do not fit our overall growth strategy, and (4) to participate in profitable opportunities in other industry segments such as the non-standard automobile business and life insurance business. We have also endeavored to streamline operations and divest business lines that were less profitable or did not complement our strategy.
While we experienced significant and profitable growth in various personal lines businesses during the years 2000 through 2002, we also experienced significant declines in our statutory capital and surplus during the same
period. These declines in capital and surplus were primarily attributable to unfavorable arbitration awards and changes in estimates of disputed reinsurance recoverable balances, reserve strengthening in our discontinued commercial and assumed reinsurance segments and increased policy acquisition costs associated with significant premium growth. This decline in statutory surplus coupled with our significant growth in premiums written are the primary reasons that A.M. Best Company (“A.M. Best”) adjusted the financial strength ratings of our property and casualty subsidiaries from B+ (Very Good) to B (Fair) in March of 2003.
Since the A.M. Best rating action, we have initiated several actions to improve our overall financial strength. Such actions have included the aforementioned initial public offering of Affirmative, increased utilization of reinsurance and the contribution of 1.47 million shares of Affirmative common stock from our holding company to our lead insurance subsidiary, Vesta Fire. However, significant losses from catastrophic weather in 2003 and 2004, coupled with additional unfavorable results from disputed reinsurance recoverable balances during the same period, have prevented us from improving our financial strength rating. In November of 2004, A.M. Best announced that our financial strength rating of “B” for both Vesta Fire and American Founders Life Insurance Company was under review with negative implications. A.M. Best cited the reduction in surplus levels due to our losses from the four hurricanes and the recorded estimated loss from the Muhl lawsuit as the basis for the rating action.
In March of 2006, A.M. Best announced that our financial strength rating would be lowered to “C + +”, or “Marginal” as defined by A.M. Best. The Company believes that this rating, if maintained, will greatly erode our current premium writings levels. See “Business Strategy and Recent Developments” for a discussion of the Company’s plans to address the downgrade.
Subject to competitive and market trends and regulatory approval, premium rates are generally within our control, and we continuously monitor and seek to adjust rates as appropriate. During 2004, we received approval for a weighted average premium increase of approximately 6.8% for our standard auto business in Alabama, Arizona, Connecticut, Hawaii, Rhode Island, Pennsylvania and West Virginia, on estimated annual gross written premiums of approximately $26.7 million. In regard to our residential property business, we received approval for 14 rate changes with a weighted average premium increase of approximately 20.5% on estimated annual premiums of $74.4 million. Rate increases were approved for business in Alaska, Alabama, Arizona, Massachusetts, New Jersey, New York, Pennsylvania, Rhode Island, South Carolina and West Virginia. During 2005, we received approval of 7 automobile changes for a weighted average 4.0% increase in Rhode Island, Pennsylvania, Hawaii and West Virginia on an estimated $55.3 million. In residential property we received approval of 14 changes with an average overall impact of 1.4% on estimated annual premiums of $314.4 million. In Texas, we took a 4.1% decrease that was done to more competitively align us in the newer home marketplace. Excluding the Texas change, the average increase was 11.4% with changes in South Carolina, Pennsylvania, Rhode Island, Alabama, Connecticut, Tennessee, Florida, New Jersey, Arizona and West Virginia.
Our ability to retain and attract new business depends largely on our statutory surplus relative to our net exposure to insured loss. This is most commonly measured by a surplus leverage ratio that relates our net premium written (after reinsurance) to our statutory surplus. During 2003 and 2004, we ceded 50% of our gross premiums written on our residential property business to reinsurers pursuant to a 50% quota share reinsurance contract, which we increased to 75% effective December 1, 2004. Although the use of quota share reinsurance limits our profit potential on the reinsured business, it also increases our statutory surplus and reduces our ultimate exposure to insured loss, thereby enhancing our surplus leverage ratio. When we implemented this quota share agreement, we believed that the increase in surplus and reduction of net writings, coupled with the decrease in net written premiums resulting from separation of our non-standard automobile underwriting segment, would enable us to maintain our then current gross written premium levels. However, the losses and changes in estimates experienced during 2004 and 2005 have more than offset the benefits of our reinsurance activity. Based on our current statutory surplus levels, we do not believe we will be able to maintain our current premium volume. To the contrary, in the absence of a transaction to enhance our surplus leverage ratio and improve our rating by A.M. Best, we believe we will experience a significant deterioration in premiums in 2006. For more information on these matters, please refer to the section titled “Business Strategy and Recent Developments” in this report.
Another key performance measure for insurance companies is the “combined ratio.” The combined ratio compares (i) the sum of loss, loss adjustment expenses, operating expenses and policy acquisition expenses; to (ii) total earned premiums and policy fees. A combined ratio of less than 100% indicates underwriting profitability, without regard to investment income earned from investing the premium received.
Our property and casualty insurance companies also earn investment income by collecting and investing premiums in advance of paying claims. In addition to investing operating cash flow, these insurance companies invest funds and earn investment income related to the required statutory surplus that we maintain in our insurance companies to support the premiums that we underwrite. We report investment income and realized investment gains or losses generated from the activities of our property and casualty insurance companies in our corporate and other segment.
AICPA Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” and related Technical Practice Aids; and
Our financial statements include as assets amounts we either (i) expect to collect from third parties, particularly reinsurance recoverables, or (ii) expect to benefit from in future periods, particularly deferred acquisition costs and deferred tax assets. In establishing these amounts, we have made significant judgments and estimates regarding the ultimate realization of each asset. Specifically, we have made critical assumptions and judgments in establishing assets for reinsurance balances receivable, reinsurance recoverables on paid losses, deferred policy acquisition costs and deferred income taxes. Changes in the assumptions, judgments or estimates we have made with respect to each of these assets would directly impact our financial results and financial condition.
As a matter of practice, we routinely cede risks associated with insurance policies we underwrite to reinsurers pursuant to contractual arrangements. We obtain reinsurance to provide protection for individual loss occurrences, including catastrophic losses, to stabilize the results of our underwriting activities and to reduce our net liability for individual risks. We report as assets the estimated reinsurance recoverable on paid losses, including an estimate for losses incurred but not reported, and amounts paid to reinsurers applicable to unexpired terms of policies in force.
In exchange for reinsurance coverage, we pay a portion of the policy premiums we receive to reinsurers who have assumed a specified level of risk pursuant to a reinsurance contract. Although a reinsurer is liable for losses to the extent of coverage to which it assumes, reinsurance arrangements do not legally discharge us as the principal insurer of a policy.
At December 31, 2004, we have recorded $25.5 million, captioned as “Reinsurance recoverable on paid losses” on our Consolidated Balance Sheet, for our estimate of amounts due Vesta from reinsurers for the payment of valid claims. Additionally, at December 31, 2004, we have recorded $674.8 million, captioned as “Reinsurance balances receivable” on our Consolidated Balance Sheet, for our estimate of amounts due Vesta from reinsurers for unpaid losses, and amounts paid to these reinsurers applicable to terms of policies in force. These amounts reflect the impact of our current reinsurance agreements including the impact from the Company’s current residential property quota share agreements and the Company’s excess of loss reinsurance agreements.
It is possible that the amounts we recover under reinsurance contracts could be materially less than the amounts we have recorded, which may result in a material adverse impact on our financial condition and results of operations. Some reinsurers may dispute our claims under reinsurance contracts, including our calculation of amounts recoverable and may pursue arbitration or litigation over these matters. During the years 2002 and 2003, we have recorded changes in our estimated reinsurance recoverables of approximately $106.3 million, collectively, primarily related to several reinsurance arbitrations including NRMA Insurance Ltd., Alfa Mutual Insurance Company and Dorinco Reinsurance Company related to our 1997 20% Whole Account Quota Share, F&G Re (on behalf of USF&G), CIGNA Property and Casualty Insurance Company, Hartford Reinsurance, and Delta Re.
obligations under personal injury protection auto policies of the Shelby insurance companies originating prior to their acquisition in 1997. Lumbermens and other members of the Kemper Insurance Companies, which operate under a business pooling arrangement, were assigned an A. M. Best’s rating of “D” (Poor) on June 30, 2003. The Company is closely monitoring the financial condition of Lumbermens, which has entered into a voluntary run-off plan with the Illinois Department of Insurance. Based on Lumbermens financial condition, management concluded that the recording of a valuation allowance was appropriate. As such, management recorded a valuation loss of approximately $10.2 million in the third quarter of 2004. Additionally management recorded a valuation allowance of $2.0 million in the third quarter of 2004 related to an outstanding arbitration as discussed in Note I. In the aggregate, the Company has recorded a valuation allowance of $12.2 million as of December 31, 2004.
In addition to reserves on balances due from Lumbermens, the Company has reserves on recoverables from New Cap Re and Transatlantic Re of $11.1 million as of December 31, 2004.
Deferred policy acquisition costs represent costs we incur in connection with acquiring new business or renewing existing business. Deferred policy acquisition costs are primarily comprised of commissions and other costs related to issuing insurance policies, net of amounts received from reinsurers as reimbursements of such costs. In accordance with GAAP, these costs are not expensed in their entirety upon their incurrence (as is the case for statutory accounting purposes); rather, they are initially recorded as assets in our financial statements and are subsequently amortized over the life of the insurance policies to which they relate or at a constant rate based upon the present value of the estimated gross profits to be earned from the underlying policies. This treatment is intended to match the expenses associated with issuing an insurance policy with estimated revenues to be earned on the policy over the life of the policy. At December 31, 2004, we had $28.3 million recorded as an asset for deferred policy acquisition costs in our financial statements.
A reduction in recorded deferred policy acquisition costs is recognized if the sum of the expected losses and loss adjustment expenses, unamortized acquisition costs, and maintenance costs exceed related unearned premiums and anticipated investment income. On an ongoing basis, management reviews the components of deferred acquisition costs and assesses their recoverability. At December 31, 2004, we determined that there was no premium deficiency and therefore, that no reduction in recorded deferred policy acquisition costs was required. Changes in our assumptions, estimates and judgments with respect to establishing deferred acquisition costs could materially impact our financial statements and financial condition. Such changes assessed by management that could negatively impact the recoverability of deferred acquisition costs on an ongoing basis include changes in estimated future loss ratios, changes in projected investment income, reduction of premium rates due to competitive factors or regulatory actions, or changes in our overall expense levels.
In connection with our evaluation as of December 31, 2003, we considered the combination of significant cumulative losses in recent years and the uncertainty with respect to our ability to achieve sufficient taxable income to fully realize our year-end deferred tax asset balances within a reasonable time frame. Based on these factors, we determined that the recording of a valuation allowance of $76.6 million was warranted for those companies included in the Vesta Insurance Group, Inc. consolidated tax group, resulting in an aggregate valuation allowance of $83.9 million as of December 31, 2003.
Our assessment of the valuation of goodwill and other indefinite intangibles is based upon (1) the historical financial performance of each reporting unit; (2) the most recent financial performance of each unit; (3) management’s financial forecast for each reporting unit; (4) information regarding publicly available financial terms of recent transactions in the insurance industry; and (5) other publicly available information. Additionally, we have historically engaged a third party to assist management in its assessment of the valuation of goodwill.
As of September 30, 2004, the date of our annual evaluation, we had recorded goodwill and other intangible assets with indefinite lives for our homeowners insurance operations of $57.7 million and $7.5 million for our
life insurance operations. In addition, our homeowners insurance operations had recorded intangibles of approximately $1.5 million as of September 30, 2004. Based on this evaluation, we concluded that there is no goodwill impairment for our life insurance operations. In performing our assessment of our homeowners insurance operations reporting unit, the Company noted that several key assumptions had deteriorated over the past year leading to an indication that the homeowners insurance operations reporting unit goodwill was impaired. Specifically, the reporting unit’s financial condition had deteriorated throughout 2004 primarily due to hurricane activity and adverse arbitration rulings. In addition, the Company’s projected cash flows for the homeowners insurance operations reporting unit were negatively impacted by an increase in the Company’s projected catastrophe losses. This increase was primarily driven by the Company’s recent catastrophe experience in Florida and Texas and projected increases in catastrophe reinsurance costs.
In accordance with guidelines established by our Board of Directors, our investment portfolio consists primarily of investment grade, fixed income securities. At December 31, 2004, our cash and investment portfolio was approximately $857.7 million, with 12.6% consisting of investments in equity securities, including our investment in Affirmative. Because of the nature of our investments, the fair value of our portfolio is not typically volatile, and the market value of our investments has generally been greater than or equal to their costs.
The determination of whether other than temporary impairment has occurred involves significant assumptions, estimates and judgments by management. Changing economic conditions-global, regional or related to industries of specific issuers-could adversely affect these values.
The aggregate unrealized losses approximate 1.4% of the fair value of the temporarily impaired securities at December 31, 2004. For those securities identified as having temporary impairments for less than twelve months, the temporary losses are due to recent increases in U.S. Treasury yields and are not due to deterioration in credit quality issues. While the 10-year U.S. Treasury yield ended 2004 nearly unchanged at 4.22%, the rate did fluctuate from 3.68% to 4.87% during the year. The fair value of bonds purchased at the lower end of the 10-year Treasury yield range were adversely impacted by the increase in the rate at the end of the year.
Reserves for traditional life contracts are generally calculated using the net level premium method, based on assumptions as to mortality, withdrawals, dividends, and investment yields ranging from 2.5% to 6.5%. These assumptions are generally made at the time the contract is issued or at the purchase date. These assumptions are based on projections from past experience, modified as necessary to reflect anticipated trends and to include allowance for possible unfavorable deviation. At December 31, 2004, we had recorded policy liabilities of $693.7 million.
As of December 31, 2004, the Company’s remaining 42.9% ownership of the outstanding shares of Affirmative is accounted for using the equity method. As such, beginning in the third quarter of 2004, we no longer consolidate the Consolidated Balance Sheets and statements of operations of Affirmative. Rather, we reflect our pro rata share of the equity of Affirmative as an investment asset in our balance sheet and our share of the operating results of Affirmative in our Consolidated Statement of Operations as equity in net earnings of investee, net of tax. The Company’s pro rata share of Affirmative’s operating results are included in the Corporate and Other segment for business segment reporting purposes.
We are subject to proceedings, arbitrations, lawsuits and other claims, including proceedings under laws and government regulations related to securities, labor, insurance contracts and other matters. In conjunction with our financial reporting process, we assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. A determination of the amount of reserves required, if any, for these contingencies is based upon an analysis of each individual issue with the assistance of outside legal counsel. Our judgments as to any reserves required in connection with these matters may change in the future because of new developments in each situation or changes in our approach in addressing these matters such as a change in settlement strategy. For more information concerning litigation and arbitration matters to which we are a party and the potential impact to the Company’s financial condition from these matters, please refer to “Item 3. Legal Proceedings” of this report and Note H to our Consolidated Financial Statements.
A standard property-casualty combined ratio of 155.9%, which included the recognition of $66.5 million of losses and loss adjustment expenses, $5.5 million in catastrophe reinstatement premiums related to a series of hurricanes impacting Florida and the Southeast United States and $59.2 million of expense related to the impairment of our homeowners reporting unit goodwill;
Favorable changes to liabilities related to litigation and billing dispute settlements of $12.5 million related to our 20% Whole Account Quota Share arbitration;
Reduction in investment income of $3.2 million resulting from a decline in average invested assets related to our increased use of reinsurance;
Charges to standard property-casualty operating expenses of approximately $17.8 million related to the recording of valuation allowances on ceded reinsurance balances;
The continued recording of a full deferred tax asset valuation allowance for the standard property-casualty and corporate segments and the recording of a full deferred tax asset valuation allowance on our life insurance operations in 2004;
In our standard property-casualty segment, we underwrite or sell personal automobile and residential property insurance through approximately 2,600 independent insurance sales agencies. In 2004, the standard property-casualty segment generated approximately $237.0 million in revenue, or approximately 50.1% of consolidated revenue. For the year ended December 31, 2004, net premiums written in our standard property-
The decrease in both net premiums written and net premiums earned was primarily attributable to our 2004 reinsurance activity. Effective September 30, 2003, we entered into a 50% quota share agreement on our residential property book of business in our Continuing States, excluding Texas (“2003 50% Quota Share Agreement”). Effective December 1, 2003, we added our residential property book of business in Texas to the agreement. Prior to December 1, 2003, the Texas residential property book of business was reinsured under the 2002 50% Quota Share treaty, which expired on November 30, 2003.
The increased level and duration of residential property quota share activity in 2004 resulted in an increase in ceded written and ceded earned premiums of $45.5 million and $93.0 million, respectively, as compared to 2003.
For the year ended December 31, 2004, policy acquisition expenses decreased by $38.6 million, or 60.2%, to $25.9 million from $64.5 million for the same period of the prior year. Improved terms under our current reinsurance agreements, as compared to those in place in the prior year. Specifically, the decrease of policy acquisition expenses from improved reinsurance terms predominately stems from an 11% increased provisional ceding commission on the quota share agreements on our Texas residential property business. In addition, the decrease in overall net premiums earned resulting from the increased use of reinsurance resulted in the remaining decrease. Policy acquisition costs as a percentage of net premiums earned for the year ended December 31, 2004 was 11.1% as compared to 21.2% in the prior year reflecting the improved reinsurance terms.
Realized gains in our life insurance segment remained at a relatively consistent level with realized gains of $2.2 million in 2004 versus $2.0 million of gains in 2003.
For the year ended December 31, 2004, net investment income related to our property-casualty underwriting operations decreased by $2.6 million to $9.4 million from $12.0 million in 2003. The decrease in interest income was primarily due to a decrease in average invested assets during 2004 reflecting the impact of the divestiture of Affirmative and the increased level of reinsurance during 2004. Average invested assets, excluding our investment in Affirmative, decreased from $300.7 million in 2003 to $229.6 million in 2004. In addition, the weighted average annual yield (excluding realized and unrealized gains and losses) on invested assets decreased in the current year, with the yield for the years ended December 31, 2004 being 3.8% compared to 4.1% in the prior year.
In 2004, our non-standard underwriting and agency operations generated aggregate revenues of $225.6 million compared to $338.3 million in 2003. Pre-tax income from continuing operations for the non-standard underwriting and agency operations was $19.9 million in 2004 compared to $27.8 million in 2003. The decrease in revenues and pre-tax income in 2004 as compared to 2003 stems from the Company’s accounting for these segments under the equity method subsequent to the initial public offering of Affirmative. See “Equity in net earnings of investee” below for a discussion of the Company’s accounting for its ownership of Affirmative.
For the year ended December 31, 2004, we recorded losses from discontinued operations of $33.5 million. The 2004 losses are comprised of the following items:
$8.7 million related to the increase in the Company’s remaining assumed and commercial reinsurance reserves
necessary for those companies included in the Vesta Insurance Group, Inc. consolidated tax group. As a result of the determination made in 2003 that a full deferred tax asset valuation allowance was warranted, the impact of our results of operations from taxes was significantly reduced in 2004. The most significant impact from income taxes on our results for the year ended December 31, 2004 was a $6.3 million benefit stemming from the reduction of $6.3 million of deferred tax liabilities associated with our previous goodwill balances.
For the year ended December 31, 2003, we reported a net loss available to common shareholders of $119.8 million or $3.43 diluted per share, compared with a net loss available to shareholders of $31.9 million ($0.94 diluted per share) reported for the previous year.
A standard property-casualty combined ratio of 101.0%, which included the recognition of $18.3 million of losses and loss adjustment expenses related to a series of April, 2003 hail storms in Texas and the Southeastern United States;
The recognition of a deferred tax asset valuation charge of $76.6 million.
Reduction in investment income as a result of an overall decline in interest rates and decline in average invested assets;
The execution of the 2003 50% Quota Share effective September 30, 2003 covering our residential property book of business in our Continuing States.
Continued growth in our non-standard agency and non-standard underwriting business lines resulting from agency acquisitions in 2001 and 2002; and
Charges to discontinued operations of $23.8 million related to the divestiture of our health operations, increases to our commercial and assumed reinsurance reserves, and the write-off of certain assumed reinsurance receivable balances.
The decrease in both net premiums written and net premiums earned was primarily attributable to our 2003 reinsurance activity. Effective September 30, 2003, we entered into a 50% quota share agreement on our residential property book of business in our Continuing States, excluding Texas. The terms of the 2003 50% Quota Share include a term of one year, with the option of terminating the treaty on a cut-off basis on June 30, 2004, and a sliding scale ceding commission due from/to the reinsurers based on net written premiums and the loss performance of the subject book of business. Effective December 1, 2003, we added our residential property book of business in Texas to this 2003 50% Quota Share Agreement. Prior to December 1, 2003, the Texas residential property book of business was reinsured under the 2002 50% Quota Share treaty, which expired on November 30, 2003.
The impact of the 2003 50% Quota Share and the 2002 50% Quota Share on the standard property-casualty net premiums written and net premiums earned and policy fees in fiscal year 2003 was a reduction of $104.3 million and $97.7 million, respectively. Additionally, the continuation of management’s initiative to exit certain states (Georgia, Arkansas, Illinois, Indiana, Maryland, North Carolina, New Mexico, Nevada, Ohio and Virginia), our Discontinued States, further decreased net written and net premiums earned in 2003 by $28.7 million and $15.8 million respectively.
Although we do not expect our net written premium will significantly increase in 2004, we have implemented rate increases to address emerging loss trends and to protect our net written premium relative to expenses, or underwriting margin. During 2003, we implemented six rate increases in our standard automobile business line in the states of North Carolina, Ohio, West Virginia and Pennsylvania, which represented a weighted average premium increase of approximately 5.5% on actual gross written premiums during 2003 of $45.4 million. During 2003, we also implemented 17 rate increases in our standard residential property line in the states of West Virginia, Ohio, Pennsylvania, Tennessee, South Carolina, Arizona, Florida and New York which represented a weighted average premium increase of approximately 18.6% on estimated gross written premiums of $126.7 million.
The combined ratio for the standard property-casualty segment was 101.0% as of December 31, 2003 as compared to 102.5%, resulting in the improvements in the segment’s pre-tax results from continuing operations year over year. The improvement in the combined ratio from 2002 to 2003 is primarily a result of a 5.9% improvement in the loss ratio resulting from improvements in claim severity. Offsetting the improvement in claim severity was an increase in loss and loss adjustment expenses related to the $18.3 million net loss related to a series of hailstorms in Texas and the Southeastern United States.
Commission income for the year ended December 31, 2003 was $80.4 million, an increase of $12.9 million or 19.1% as compared to commission income of $67.5 million for the prior year. Commission income for our affiliated underwriting agencies for the year ended December 31, 2003 was $73.4 million, an increase of $10.3 million or 16.3% as compared to the commission income of $63.1 million for our affiliated underwriting agencies during the prior year. The increase in commission income for our affiliated underwriting agencies in 2003 as compared to 2002 was principally due to more favorable commission rates and an increase in contingent commission income related to positive loss ratio development. In addition to the improved commission rates and increased contingent commissions, results in 2003 were favorably impacted from a full year of operating results of Drivers’ Choice, which we acquired on September 1, 2002. Commission income related to our retail agencies sales of unaffiliated insurance companies products was $7.0 million for the year ended December 31, 2003, an increase of $2.2 million or 45.8% as compared to commission income for unaffiliated insurance company of $4.8 million in the prior year.
Operating expenses for the year ended December 31, 2003 were $126.6 million, an increase of $8.2 million or 6.9% as compared to total expenses of $118.4 million for the prior year. Commission expenses for the year ended December 31, 2003 were $23.8 million, a decrease of $2.8 million or 10.5% as compared to $26.6 million for the prior year, principally due to a decline in commission rate to 15.1% in 2003 from 16.4% during the prior year. Workforce expense for the year ended December 31, 2003 was $57.7 million, increase of $3.5 million or 6.5% as compared to workforce expense of $54.2 million in the prior year. Depreciation, amortization and other operating expenses for the year ended December 31, 2003 were $44.7 million, an increase of $7.1 million or 18.9% as compared to $37.6 million for the prior year.
For the year ended December 31, 2003, net premiums earned were $167.4 million an increase of $5.9 million or 3.7% as compared to net premiums earned of $161.5 million in the prior year. Of our total net premiums earned of $167.4 million for the year ended December 31, 2003, the net premiums earned on policies written through our affiliated underwriting agencies were approximately $136.7 million, a decrease of $3.0 million or 2.2% as compared to the prior year. The decrease in net premiums earned during 2003 as compared to 2002 was principally due to reduction in our retention of business written through our affiliated underwriting agencies. For the year ended December 31, 2003 we retained $150.8 million of net premiums written or 54.8% of the gross premiums written through our affiliated underwriting agencies, as compared to $173.9 million of net premiums written or 61.5% of the gross premiums written in the prior year.
Net premiums earned on policies written through unaffiliated underwriting agencies were $30.7 million for the year ended December 31, 2003, an increase of $8.9 million or 40.8% as compared to net premiums earned of
$21.8 million for the prior year. The increase in net premiums earned during 2003 was principally due to an increase in premium volume from an unaffiliated underwriting agency where we retain 100% of the premium written by the agency.
Total policy acquisition and operating expenses for the year ended December 31, 2003 were $68.7 million, an increase of $1.6 million or 2.4% as compared to $67.1 million in the prior year. The increase in policy acquisition and operating expenses incurred was primarily attributable to the increase in premium volume during 2003 as compared to prior year and partially offset by a decrease in the expense ratio related to the business produced through our affiliated underwriting agencies.
At December 31, 2003, American Founders had approximately $2.0 billion (face value) of life and annuity products in force, and approximately $725.8 million in invested assets.
Life insurance premiums and policy fees decreased to $11.1 million from $14.0 million in the prior year as a result of normal declines on closed blocks and increased reinsurance. Investment income decreased from $33.8 million the prior year to $26.5 million in the current year. The decrease in investment income is attributed to several factors. First, average invested assets decreased, excluding policy loans from $590.6 million in 2002 to $561.7 million in 2003. Compounding the impact on investment income from the decrease in the overall size of the investment portfolio was higher levels of mortgage-backed security paydowns and decreases in overall interest rates in 2003. The weighted average annual yield (excluding realized and unrealized gains and losses) on invested assets for the year ended December 31, 2003 was 5.0% compared to 6.2% in the prior year.
In 2003, we incurred $66.7 million of litigation and arbitration settlement expenses related to our 1997 20 percent Whole Account Quota Share arbitrations with NRMA, Dorinco and Alfa and other disputed balances compared to a charge of $9.0 million in 2002. In 2002, we reduced our estimated recoverables from the 20% whole account quota share arbitrations by $23.6 million and received a $16 million gain, before expenses, in a litigation settlement with Cincinnati Insurance Company.
Our corporate interest expense includes interest payable on our 8.75% senior debentures due in 2025, interest on Federal Home Loan Bank borrowings and our commercial credit borrowings. Interest expense for the twelve months ended December 31, 2003 was $6.4 million compared to $8.6 million in the previous year. The decrease in interest expense is attributable to the repurchase of approximately $23.9 million face amount of our long-term debentures during 2002, which also resulted in a pre-tax gain of $9.5 million during 2002.
During 2003, we redeemed $2.2 million face amount of Deferrable Capital Securities in exchange for approximately 402 thousand shares of common stock resulting in a pre-tax gain of $0.6 million. Pursuant to the provisions of SFAS No. 150, the gain is reflected as a component of income from continuing operations.
$10.7 million related to settlement of the CIGNA arbitration and the Nichols lawsuit;
In the fourth quarter of 2002, we made the decision to exit the health insurance and consulting business lines. Accordingly, our health insurance and consulting lines results for all periods presented have been reclassified in our financial statements as part of discontinued operations and are classified as operations held for sale. We consummated the sale of Aegis Financial Corporation (Aegis) and its subsidiary States General Life Insurance Company (States General) effective September 30, 2003 for $4.6 million. The sales price was financed through a $5.0 million note issued by the buyer payable to Vesta Fire. The sale of Aegis resulted in the Company recording a loss of $2.3 million, which is reflected as a component of discontinued operations. For the year ended December 31, 2003, we recorded a loss of $6.7 million for our health operations and our consulting business, including the aforementioned loss on the sale of Aegis.
Transactions between Vesta and its insurance subsidiaries, including the payment of dividends, are subject to certain limitations under the insurance laws of those subsidiaries’ domiciliary states. The insurance laws of the
state of Illinois, where Vesta Fire is domiciled, permit the payment of dividends out of unassigned surplus in any year which, together with other dividends or distributions made within the preceding 12 months, do not exceed the greater of 10% of statutory surplus as of the end of the preceding year or the net income for the preceding year, with larger dividends payable only after receipt of prior regulatory approval. The Illinois Insurance Department has indicated that these dividend limitations prohibit the payment of dividends if the insurer has negative or zero “unassigned funds” at the end of the prior year, as reported on its statutorily required annual statement. Our lead insurance subsidiary, Vesta Fire, reported negative “unassigned funds” on its annual statement for 2004, and is expected to continue to report negative unassigned funds for the foreseeable future.
With the exceptions of Texas Select Lloyds Insurance Company and Florida Select Insurance Company, J. Gordon Gaines, Inc. provides administrative services to all of our property-casualty insurance subsidiaries in exchange for fees pursuant to a management agreement. Select Insurance Services, Inc., (SIS), a subsidiary of J. Gordon Gaines, Inc., provides services to Texas Select Lloyds Insurance Company as its attorney-in-fact. These agreements are subject to certain regulatory standards, which generally require their terms to be fair and reasonable, and regulatory approval. These agreements are reviewed from time to time by the appropriate departments of insurance and it is possible that the terms could be modified to reduce the amounts available to our holding company. Assuming these agreements are not modified in any material respect, we believe that the holding company will have sufficient amounts to fund its anticipated needs for at least the next twelve months. However, as of December 31, 2004, these non-regulated companies did not have sufficient cash balances to fund all of the anticipated cash needs for the holding company for 2005. See the “Intercompany obligations” section of “Contractual and Contingent Obligations-Consolidated” for a detailed discussion of the funding of intercompany debt.
In conjunction with the sale of our remaining stake in Affirmative in the third quarter of 2005, the Company fully repaid and terminated the revolving credit agreement. The Company was in violation of certain covenants associated with the revolving credit facility as of December 31, 2004. Proceeds from the sale of our remaining stake in Affirmative in the third quarter of 2005 were used to repay the outstanding balance on the revolving line of credit. The credit agreement was terminated on August 31, 2005.
(3) Loss and loss adjustment expenses and policy liabilities represent our best estimate of net losses from claims and related settlement costs. Because of the nature of insurance policies, there is typically no minimum contractual obligation associated with covered claims. Both the amounts and timing of such payments are estimates, and the inherent variability of resolving claims and changes in market conditions make the timing of cash outflows uncertain. The ultimate amount and timing of loss and LAE payments, as well as policy liability payments, could differ from our estimates.
We are also a party to an indenture related to our 8.525% Deferrable Capital Securities due 2027 (the Capital Securities) and the related Amended and Restated Declaration of Trust dated January 31, 1997 of Vesta Capital Trust I. These instruments contain similar provisions to those outlined above. As of the date of the filing of this report on Form 10-K, neither we or, to the best of our knowledge, the Trustees under this Indenture or related Trust Agreement had received any notice of default arising from the delinquency of these reports.
As discussed above, our subsidiary operations are also involved in ongoing reinsurance recoverable disputes that could result in an obligation to repay certain amounts to reinsurers from whom we have collected funds. In connection with these disputes, our principal operating subsidiary, Vesta Fire, has obtained letters of credit for the benefit of reinsurers for which it is contingently liable. At December 31, 2004, Vesta Fire was contingently liable for $11.7 million under the terms of letters of credit obtained in connection with these reinsurance disputes.
Effective February 28, 2005, our wholly owned subsidiary, Vesta Fire Insurance Corporation, which is the holder of 100% of our 12.5% Senior Notes due December 2005, principal amount $44.1 million, agreed to an amendment to the indenture governing such notes for the purposes of (i) extending the maturity date to December 2008 and (ii) decreasing the interest rate on such notes from 12.5% to 8% per annum. The
Supplemental Indenture reflecting these modifications, which has been approved by the California and Illinois Insurance Departments, was attached to a current report on Form 8-K filed March 2, 2005. In connection with this amendment, we paid $5.2 million principal amount of such notes by transferring to Vesta Fire approximately 305 thousand shares of the common stock of Affirmative Insurance Holdings, Inc. held at the holding company. As a result of these transactions, Vesta Fire holds $38.9 million principal amount of the registrant’s 8% notes due December 2008, and approximately 4.2 million shares, or approximately, 24.8%, of Affirmative Insurance Holdings, Inc.’s outstanding common stock as of February 28, 2005.
The holding company is dependent on dividends from SIS, Florida Select Insurance Agency, Inc. and J. Gordon Gaines, Inc. to pay the annual interest on its debt obligations and ultimately the principal amounts due. The source of these dividends is from the future operations of Florida Select and Texas Select Lloyds and ultimately from Vesta Fire as a result of the reinsurance agreements between the companies. At current premium levels, we believe that the future cash flows will be sufficient to pay the interest and principal on these obligations. However, with the Company’s A.M. Best financial strength rating being downgraded in 2006, no assurances can be given that the Company’s premium levels and resulting cash flows will be sufficient to repay the debt. Failure to repay these inter-company obligations could have a material adverse affect on the statutory capital of our subsidiaries.
On a consolidated basis, net cash (used in) provided by operations for the year ended December 31, 2004 and 2003, was $(14.2) million and $(24.1) million, respectively. Cash flow from operations was negative for the current period primarily due to decreases in reinsurance balances payable, increased cash outflows stemming from higher levels of reinsurance in 2004 and the impact from four hurricanes in third quarter of 2004. Net cash used in investing activities was $(10.4) million and $(6.5) million for the year ended December 31, 2004 and 2003, respectively, reflecting the increased reinvestment of investment maturities and investment sales as compared to the impact of acquisitions in the prior year offset by lower investment security purchases. Net cash provided by (used in) financing activities was $7.8 million and $(28.9) million for the year ending December 31, 2004 and 2003, respectively. In 2004, our financing activities generated cash through additional FLHB borrowings and our cash overdraft balances, offset by increased withdrawals from insurance liabilities.
In December 2003, the Financial Accounting Standards Board (“FASB”) issued FIN 46R “Consolidation of Variable Interest Entities- Revised” (“FIN 46R”). FIN 46R clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated support from other parties. The effective date of FIN 46R was March 31, 2004. However, FIN 46R was applicable to entities that are considered special-purpose entities as of December 31, 2003. The application of FIN 46R had no effect on our Consolidated Financial Statements as of December 31, 2003. The provisions of FIN 46R on entities not considered to be special-purpose entities was
In July 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (“SOP 03-1”). SOP 03-1 provides guidance on the reporting method and presentation of separate accounts, recognition of gains and losses on the transfer of assets from the general account to a separate account, as well as several liability valuation issues related to nontraditional long-duration contracts such as universal life and annuity contracts. The provisions of SOP 03-1 became effective for the Company on January 1, 2004. In applying the provisions of SOP 03-1 to our life insurance products offered through American Founders Financial Corporation (“American Founders”), the holding company for our life insurance operations, we changed our methodology for accruing reserves on our single premium deferred annuity product to accrue reserves at the enhanced fund rate as defined within the annuity contracts. As a result of this change in methodology, we recorded a loss of $8.0 million in 2004. The charge is classified as a cumulative effect of change in accounting principle in the accompanying Consolidated Statement of Operations. The recording of this loss increased both basic and diluted net loss available to common shareholders per share by $0.23 for the year ended December 31, 2004.
In March 2004, the Emerging Issues Task Force reached a consensus on Issue 03-1, “Meaning of Other Than Temporary Impairment” (Issue 03-1). The Task Force reached a consensus on an other-than-temporary impairment model for debt and equity securities accounted for under Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and cost method investments. The basic model developed by the Task Force in evaluating whether an investment within the scope of Issue 03-1 is other-than-temporarily impaired is as follows: Step 1: Determine whether the investment is impaired. An investment is impaired if its fair value is less than its cost. Step 2: Evaluate whether the impairment is other-than-temporary. Step 3: If the impairment is other-than-temporary, recognize an impairment loss equal to the difference between the investment’s cost and its fair value. The three-step model used to determine other-than-temporary impairments shall be applied prospectively to all current and future investments in interim or annual reporting periods beginning after June 15, 2004. On September 30, 2004, the FASB issued Financial Staff Position (“FSP”) EITF 03-1 which delayed the required implementation of guidance under paragraphs 10-20 of EITF 03-1. In September of 2005, the FASB issued FSP FAS 115-1 which nullified the requirements under paragraphs 10 through 18 of Issue 03-1 and directs companies to look to existing literature when evaluating whether the impairment is other than temporary. The Company recognized losses of approximately $0.7 million, $3.1 million and $8.0 million for the years ended December 31, 2004, 2003 and 2002, respectively, related to investment securities for which the difference between the book value and market value was deemed other than temporary.
Transition and Disclosure and a revision to SFAS No. 123, Accounting for Stock-Based Compensation.” SFAS No. 123R requires alternative methods of transition for the change to the fair value method of accounting for stock-based employee compensation and is effective as of the beginning of the first annual period that begins after June 15, 2005. The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25, to account for its fixed plan stock options. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price.
As previously permitted by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of these statements. The Company plans to expense stock options using the modified prospective transition method prescribed in SFAS 123R. The modified prospective transition method requires expense to be recognized for new grants or modifications issued in the period of adoption, plus the current period expense for non-vested awards issued prior to the adoption of this standard. No expense is recognized for awards vested in prior periods. The Company is currently evaluating the use of various models, as well as the necessary assumptions for calculating the impact from adoption of this standard. Based on current guidance, the Company intends to adopt SFAS 123R and begin expensing stock based compensation on January 1, 2006.
Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 2004, 2003 (Restated) and 2002 (Restated)
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Vesta Insurance Group and its subsidiaries (the Company) at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 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 accompanying index 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 discussed in Note A to the consolidated financial statements, effective January 1, 2004, the Company adopted Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts and, effective October 1, 2003, the Company adopted Derivative Implementation Group Issue No. B36, Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That are Unrelated or Only Partially Related to the Creditworthiness of the Obligor Under Those Instruments.
Also, we have audited management’s assessment, included in Management’s Report on Internal Controls over Financial Reporting appearing under Item 9A, that Vesta Insurance Group did not maintain effective internal control over financial reporting as of December 31, 2004, because of the effect of material weaknesses existing in the (1) control environment because the Company did not (a) effectively communicate the importance of controls throughout the Company or set an adequate tone around control consciousness, (b) maintain a sufficient complement of personnel with an appropriate level of accounting knowledge, experience and training, and (c) maintain effective anti-fraud programs and controls, (2) risk assessment function, (3) controls over the completeness and accuracy of the period end financial reporting and close processes, (4) controls over vendor
setup for the corporate accounts payable system, (5) controls over the review and evaluation of the recoverability of goodwill, (6) review and monitoring controls over the accuracy of ceded reinsurance balances, (7) controls over the accuracy of the aged ceded reinsurance balances, (8) controls over the evaluation of rights and obligations for certain reinsurance contracts at the Company’s life insurance subsidiary, (9) controls over the estimation and monitoring of gross insurance reserves for certain discontinued product lines, and (10) controls over access to programs and data, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. As of December 31, 2004, the following material weaknesses have been identified and included in management’s assessment.
1. The Company did not maintain an effective control environment because of the following material weaknesses:
(b) The Company did not maintain a sufficient complement of personnel with an appropriate level of accounting knowledge, experience and training to support the size and complexity of the Company’s current organizational structure and financial reporting requirements. Specifically, certain accounting and finance positions were staffed with individuals who did not have the appropriate skills, training, and experience to meet their responsibilities.
(c) The Company did not maintain effective anti-fraud programs and controls. In particular, the Company did not have a consistent process for conducting background checks, which contributed to fraud being perpetrated by a member of senior management.
This material weakness contributed to each of the material weaknesses discussed in 3 through 10 below.
6. The Company did not maintain effective review and monitoring controls over the accuracy of ceded reinsurance balances. Specifically, certain ceded reinsurance balances subject to manual input were not accurately and completely entered into the general ledger. This control deficiency resulted in an audit adjustment to correct ceded reinsurance balances in the third quarter of 2004.
8. The Company did not maintain effective controls over evaluating it rights and obligations for certain reinsurance contracts at its life insurance subsidiary. Specifically, management failed to establish effective controls over certain third party investments held by the Company under a funds held reinsurance agreement and incorrectly recorded realized gains and losses in its statements of operations related to the sale of investments that belonged to a third party. This control deficiency resulted in the restatement of the Company’s consolidated financial statements for the years ended December 31, 2003 and 2002, for each of the quarters in the year ended December 31, 2003 and for the first and second quarters of the year ended December 31, 2004, to correct realized gains and reinsurance balances payable.
10. The Company did not maintain effective controls over access to programs and data. Specifically, certain of the Company’s personnel had unrestricted access to various financial application programs and data beyond the requirements of their assigned responsibilities. Furthermore, there were no effective controls in place to monitor user access. This control deficiency did not result in an audit adjustment or material misstatement to the Company’s 2004 interim or annual consolidated financial statements.
Accordingly, management has concluded that each of the control deficiencies in items 1 through 10 above constitutes a material weakness.
These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2004 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.
In our opinion, management’s assessment that the Company did not maintain effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the COSO. Also, in our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the COSO.
In addition, the Company formerly conducted business in the non-standard automobile agency and non-standard automobile underwriting industries. On July 9, 2004, we completed the initial public offering of Affirmative Insurance Holdings, Inc. (“Affirmative”), the non-standard automobile holding company. We retained 7.2 million shares, or approximately 42.9% of the outstanding shares of Affirmative. Our remaining ownership in Affirmative is being accounted for using the equity method beginning in the third quarter of 2004. See “Investment in Unconsolidated Subsidiary” in Note A for further discussion of the Company’s application of the equity method to the remaining ownership in Affirmative. Also, see Note D for further discussion of the Affirmative initial public offering. Finally, see Note D for a further discussion of the disposition of our remaining ownership of Affirmative stock in 2005.
Principles of Consolidation: The accompanying Consolidated Financial Statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of Vesta Insurance Group, Inc. and its operating subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.
Use of Estimates in the Preparation of the Financial Statements: The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates. These estimates and assumptions are particularly important in determining premiums in course of collection, reserves for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance receivables and impairment of goodwill and investments.
Factors considered by management in determining whether an investment security is other than temporarily impaired includes our ability and intent to hold the security, the credit quality of the security, the severity of the decrease between the security’s cost and market value, the length of time of the security’s impairment and the likelihood that the impairment will reverse in the future. For the years ended December 31, 2004, 2003 and 2002, we recognized other than temporary impairment losses of $0.7 million, $3.1 million and $8.0 million, respectively.
Derivatives: The Company holds certain bonds and preferred stocks within the Company’s fixed maturities and equity securities portfolios that contain the option to convert into the common stock of the issuers and are considered embedded derivatives. These options are carried at current market values, as provided by a third-party broker, and are accounted for with their related host contracts. Unrealized gains and losses are reflected in income currently in realized gains and losses. For the years ended December 31, 2004 and 2003, $0.6 million and $0.9 million, respectively, have been recognized in income. Because of the limited liquidity of some of these instruments, the recorded values of these transactions may be different than the values that might be realized if the Company were to sell or close out the transactions prior to maturity. The Company believes that such differences are not significant to its results of operations, financial condition, or liquidity. Such differences would be immediately recognized when the transactions are sold or closed out prior to maturity.
Determination of Fair Values of Financial Instruments: Fair values for cash, short-term investments, short-term debt, receivables and payables approximate their carrying value. Fair values for investment securities are based on quoted market prices, if available. For fair value disclosure purposes, fair values for long-term debt are based on quoted market prices, if available. If quoted prices are not available, fair value is primarily determined based upon management’s assessment of the market value of comparable investments. Our determination of fair value also considers various factors, including time value and volatility issues, credit quality of the counterparty and existing conditions in the overall financial markets.
Premiums on traditional life contracts are recognized as income when due;
Deferred Policy Acquisition Costs: Commissions and other costs that vary with and are primarily related to the production of new and renewal business are deferred and amortized over the terms of the policies to which they relate. Anticipated investment income is considered in determining recoverability of deferred acquisition costs. For the years ended December 31, 2004, 2003 and 2002, amortization expense for deferred policy acquisition costs was $0.7 million, $0.9 million and $0.6 million, respectively. The unamortized deferred policy acquisition costs as of December 31, 2004 and 2003 was $9.4 million and $6.7 million, respectively.
The average discount rate for the value of business acquired was approximately 15.25%.
See Note E for a discussion of the impairment of the homeowners and life insurance operations reporting unit goodwill in 2004.
Investment in Unconsolidated Subsidiary: The Company’s remaining 42.9% ownership of the outstanding shares of Affirmative is accounted for using the equity method. As such, beginning in the third quarter of 2004, we no longer consolidate the balance sheet and statement of operations of Affirmative. Rather, we reflect the pro rata ownership in the equity of Affirmative as an investment asset and our pro rata share of the operating results of Affirmative in the Company’s Consolidated Statement of Operations as “equity in net earnings of investee, net of tax.” The Company’s pro rata share of Affirmative’s operating results are included in the Corporate and Other segment for business segment reporting purposes.
With respect to reported claims, we establish reserves in our standard property-casualty segment based upon our historical loss experience. Reserve amounts are determined by taking into account the circumstances surrounding each claim and policy provision relating to the type of loss. Reserves are reviewed on a regular basis, and as new data becomes available, the reserves are adjusted appropriately to reflect estimated ultimate losses.
Stock Based Compensation: During 1995, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”. The Statement defines a fair value based method of accounting for an employee stock option. It also allows an entity to continue using the intrinsic value based accounting method prescribed by the Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Vesta has continued to use this method to account for its stock options and other forms of stock based compensation. However, SFAS No. 123 requires entities electing to remain with the intrinsic method of accounting to provide pro forma disclosures of net income and earnings per share as if the fair value based method of accounting had been applied as well as other disclosures about Vesta’s stock-based employee compensation plans.
Pro forma information regarding net income and earnings per share is required by SFAS No. 123 and has been determined as if Vesta had accounted for its employee stock options under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions for 2004: risk free interest rates between 3.96% to 4.38%; dividend yields in the range of 2.60% to 3.03%, volatility factor of the expected market price of Vesta’s common stock in the range of 76.0% and 76.1% and a weighted-average expected life of the options of eight years. The following assumptions were made in the Black Scholes option pricing model for 2003 and 2002, respectively: risk-free interest rates of 3.55% and 4.03%; dividend yields of 4.35% and 2.36%; volatility factor of the expected market price of Vesta’s common stock of 60.67% and 79.10%, and a weighted-average expected life of the options of ten years.
In December 2003, the Financial Accounting Standards Board (“FASB”) issued FIN 46R “Consolidation of Variable Interest Entities-Revised” (“FIN 46R”). FIN 46R clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have
In April 2003, the Derivatives Implementation Group of the FASB issued DIG B36. DIG B36 requires the bifurcation of potential embedded derivatives within modified coinsurance and funds withheld coinsurance agreements in which the terms require the future payment of a principal amount plus a return based on a specified proportion of the ceding company’s return on either its general account assets or a specified block of those assets. The effective date of the implementation guidance in DIG B36 was for the first fiscal quarter beginning after September 15, 2003 and was to be applied on a prospective basis. On October 1, 2003, the Company adopted DIG B36. In connection with the adoption of DIG B36, the Company elected to reclassify to trading securities the investments, which are held in a separate trust, supporting a funds withheld treaty. In addition, the Company recognized a cumulative effect from the adoption of DIG B36 in 2003 of $(1,167) (net of $628 in taxes) in connection with recording the derivatives embedded in its modified coinsurance and funds withheld coinsurance arrangements. The recording of this loss increased both basic and diluted net loss available to common shareholders per share by $0.03 for the year ended December 31, 2003.
In March 2004, the Emerging Issues Task Force reached a consensus on Issue 03-1, “Meaning of Other Than Temporary Impairment” (Issue 03-1). The Task Force reached a consensus on an other-than-temporary impairment model for debt and equity securities accounted for under Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and cost method investments. The basic model developed by the Task Force in evaluating whether an investment within the scope of Issue 03-1 is other-than-temporarily impaired is as follows: Step 1: Determine whether the investment is impaired. An investment is impaired if its fair value is less than its cost. Step 2: Evaluate whether the impairment is other-than-temporary. Step 3: If the impairment is other-than-temporary, recognize an impairment loss equal to the difference between the investment’s cost and its fair value. The three-step model used to determine other-than-temporary impairments shall be applied prospectively to all current and future investments in interim or annual reporting periods beginning after June 15, 2004. On September 30, 2004, the FASB issued Financial Staff Position (“FSP”) EITF 03-1 which delayed the required implementation of guidance under paragraphs 10-20 of EITF 03-1. In September of 2005, the FASB issued FSP FAS 115-1 which nullified the requirements under paragraphs 10 through 18 of Issue 03-1 and directs companies to look to existing literature when evaluating
whether the impairment is other than temporary. The Company recognized losses of approximately $0.7 million, $3.1 million and $8.0 million for the years ended December 31, 2004, 2003 and 2002, respectively, related to investment securities for which the difference between the book value and market value was deemed other than temporary.
In December 2004, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 123R, “Accounting for Share Based Payment, an amendment to SFAS No. 148, Stock-Based Compensation - Transition and Disclosure and a revision to SFAS No. 123, Accounting for Stock-Based Compensation.” SFAS No. 123R requires alternative methods of transition for the change to the fair value method of accounting for stock-based employee compensation and is effective as of the beginning of the first annual period that begins after June 15, 2005. The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25, to account for its fixed plan stock options. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price.
In connection with the preparation of the Company’s Consolidated Financial Statements and the filing of the Quarterly Report on Form 10-Q for the period ended September 30, 2004, the Company identified an error related to the consolidation of one of its subsidiaries. As a result of this finding, the Company delayed the filing of its Form 10-Q for the period ended September 30, 2004. Management initiated an internal review of all of its books and records, including those of its subsidiary companies, to determine the period, nature and amount of the error. The internal review was conducted under the direction of senior management with oversight of the Audit Committee of the Board of Directors.
As part of its internal review, the Company thoroughly evaluated its financial reporting consolidation and elimination process and the resulting financial statements. The financial consolidation process was a focus of the internal review due to a number of acquisitions during the years 2000 through 2004 and the complexities of the integration of accounting processes of the newly acquired entities into Vesta’s financial statement consolidation process. The Company also reviewed its ceded reinsurance processes.
In regards to the consolidation process component of the internal review, the Company determined that it was necessary to essentially reperform the consolidation of the financial statements in prior periods beginning with the consolidated balance sheet as of December 31, 2000. The reperformance of the consolidation of the financial statements was a time consuming process due to the multiple general ledger systems in place during this period, the number of acquisitions and dispositions during that time, turnover of key accounting personnel and
the volume and complexities of intercompany transactions. Furthermore, the ceded reinsurance process component of the internal review required extensive time and effort due to system conversions during the period and the fact that many of the reinsurance treaties involved in the process were put into place several years ago.
Reinsurance Contract Realized Investment Gains-One of the Company’s insurance subsidiaries, American Founders Life Insurance Company (“AFLIC”), entered into a reinsurance contract with a third party effective October 1, 2002. Under the terms of that agreement, AFLIC ceded the investment results, including realized gains and losses, on part of its investment portfolio to the third party reinsurer. Upon the termination of this contract on December 31, 2004, it was determined that certain realized investment gains and losses had been recorded as income in full by AFLIC instead of reflecting a portion of these gains as being due to the third party reinsurer, as required by the reinsurance contract. As such, the Company overstated its realized gains by $430 thousand and $309 thousand, net of a tax benefit of $151 thousand and $108 thousand for the years ended December 31, 2003 and 2002, respectively, in its Consolidated Statements of Operations and total comprehensive loss by the following amounts in the following periods (in thousands):
Other Differences-For the year ended December 31, 2003, the Company identified errors in the allocation of income taxes between comprehensive loss, continuing operations, deferrable capital security distributions, and discontinued operations. The allocation errors stem from the application of the intra-period tax allocation provisions of SFAS No. 109, “Accounting for Income Taxes”. These errors decreased the consolidated net loss available to common shareholders by $2.8 million, predominately related to adjusting the tax effect on other comprehensive income and correctly reflecting the tax benefit in continuing operations. In addition, the income tax benefit of $335 thousand and $8.7 million previously reflected in deferrable capital security distributions and loss from discontinued operations, respectively, are now reflected as a component of the income tax (benefit) expense line item.
Since the aforementioned $2.8 million adjustment was a correction of the intra-period tax allocation between other comprehensive income and continuing operations and not a change to tax expense in total, the restated total comprehensive loss and consolidated stockholders’ equity were not affected by this error.
Policy acquisition costs and operating expenses-In conducting our internal review, the Company noted errors in the elimination of policy acquisition costs and operating expenses allocated to its subsidiaries. As such, the Company understated these expense captions by $1.5 million and $1.0 million for the years ended December 31, 2003 and 2002, respectively.
Consolidation Differences-As part of our internal review, the Company revised the process for consolidating our balance sheets for the applicable periods, and as a result were able to identify certain intercompany asset and liability balances that were not properly eliminated during the previous consolidation. These balances primarily included (1) an investment in a subsidiary, that was appropriately classified as an other invested asset in the underlying books and records, but which should have been eliminated as part of our consolidation and (2) numerous intercompany reinsurance balances, which also should have been eliminated as part of our consolidation. The failure to eliminate these balances in our consolidation process during 2003 and prior periods, resulted in the Company’s inability to properly identify income statement aggregation and consolidation errors. As a result, over a period of several years, the Company had overstated its consolidated net income available to common shareholders and consolidated stockholders’ equity. In total, the identified errors overstated Consolidated Stockholders’ Equity by $7.4 million, $7.0 million, and $7.2 million as of December 31, 2003, 2002 and 2001 respectively.
Life Insurance Reinsurance Adjustments-For the year ended December 31, 2003 the Company identified errors in the recording of ceded losses to certain external reinsurers of AFLIC. Specifically, we identified that the Company had erroneously ceded too many losses to these reinsurers. As a result, the Company’s reinsurance balances receivable was overstated by $213 thousand as of December 31, 2003. In recording the correction of these errors, the Company also recorded a $73 thousand reduction of deferred income taxes to reflect the tax impact of the errors. The net impact of these errors reduced Consolidated Stockholders’ Equity by $139 thousand as of December 31, 2003.
The Company has experienced substantial losses over the past four years. Aggregate losses from continuing operations during this period, including catastrophe, intangible impairment and arbitration losses, were $210.6 million. In addition, losses from discontinued operations totaled $101.4 million during this period. The combination of these losses has resulted in a significant deterioration in the Company’s financial condition. As of December 31, 2004, the Company had a consolidated stockholders’ deficit of $45.8 million.
These losses have also negatively impacted the financial condition of the Company’s lead insurance company, Vesta Fire. As of December 31, 2004, Vesta Fire’s statutory surplus was $50.0 million, which was below “Company Action Level” as defined by the National Association of Insurance Companies (“NAIC). Approximately $40.0 million of Vesta Fire’s surplus is Vesta Fire’s investment in bonds issued by our holding company. Vesta Fire’s ability to fund its future operations and meet future claims liabilities is largely dependent upon the Company’s ability to repay these bonds. The Company did not have the liquid assets available to repay the $40.0 million of bonds held by Vesta Fire as of December 31, 2004. If these bonds were unable to be repaid, it could result in regulatory action by various departments of insurance, including placing the insurance subsidiaries under supervision.
alternative financing, asset sales or capital raising activities. There can be no assurances that the Company could raise the necessary cash to pay the Debentures and/or Capital Securities or that it could on terms acceptable to the Company.
In response to Vesta Fire’s financial condition as of December 31, 2005, A.M. Best announced in March of 2006 that Vesta Fire’s financial strength rating would be lowered to “C + +”, or “Marginal” as defined by A.M. Best. Management believes that this rating, if maintained, will greatly erode our current premium writing levels and will negatively affect the Company’s ability to service its debt obligations. Thus, no assurances can be given that the Company’s premium levels and resulting cash flows will be sufficient to meet the Company’s obligations.
- Renewal rights transactions-The Company is considering possible renewal rights transactions that would allow the Company to reduce the level of writings in certain product lines. Specifically, the Company is considering a renewal rights agreement for its standard automobile policies in West Virginia. The Company’s standard automobile policies in West Virginia, which represents approximately $20 million of annual written premiums, was excluded from the July, 2005 renewal rights transaction with Donegal. The possible consummation of this transaction would complete the Company’s exit of the multi-line market and would further reduce the Company’s overall premium writing levels.
The Company is also evaluating possible renewal rights transactions involving certain states/regions in our homeowners portfolio.
- Raising capital-The Company is pursuing possible capital raising initiatives in the private sector geared towards improving our overall financial condition. The evaluation of these possible transactions is in the preliminary stages.
- Expense reductions-In 2004, the Company began implementing certain operational consolidation initiatives aimed at reducing policy maintenance and claims adjustment costs. While these consolidation initiatives continue to be implemented, the Company is also reviewing other expense reduction initiatives, including, but not limited to, the delaying of certain information technology initiatives and facility cost reductions.
Despite the Company’s current financial condition and the consideration of certain transactions which could reduce the Company’s current premium volumes in certain states/regions, the Company continues to pursue its current business strategy of being a provider of homeowners insurance in capacity constrained states/regions. Management continues to believe that the Company is well positioned in certain capacity constrained markets to take advantage of market conditions. However, the success of pursuing this strategy is largely dependent upon
In addition, the Company’s on-going segments remain exposed to various external factors such as further catastrophic weather events, regulatory oversight, and continued access to affordable reinsurance and competition from other insurance companies. Such factors could have a material adverse impact on our financial condition and could impact our current financial ratings and greatly hamper the Company’s ability to obtain an improved rating.
Summarized financial information regarding Affirmative as of and for the year ended December 31, 2004, was as follows (in thousands):
The Company executed a definitive agreement on March 12, 2004 to sell American Founders Financial Corporation, our life insurance subsidiary, for a total purchase price of approximately $63.5 million, consisting of $25 million in cash at closing and a promissory note in the amount of approximately $38.5 million. The buyer failed to close the transaction as required by the terms of the contract, and we terminated the definitive agreement in the fourth quarter of 2004 due to a breach of the agreement by the purchaser.
On September 30, 2005, our wholly owned subsidiary, American Founders Financial Corporation, sold 100% of the stock of its subsidiary, Laurel Life Insurance Corporation for $55.8 million, net of closing costs, to Sagicor, USA, Inc. The sale of Laurel Life Insurance Company included all of Vesta’s life insurance operations. Vesta will report a gain of approximately $4.5 million in the third quarter of 2005 related to this transaction.
As of September 30, 2004, we had recorded goodwill and other intangible assets with indefinite lives for our homeowners insurance operations of $57.7 million and $7.5 million for our life insurance operations. In addition, our homeowners insurance operations had recorded amortizable intangibles of approximately $1.5 million as of September 30, 2004. Based on our evaluation as of September 30, 2004, we concluded that there was no goodwill impairment for our life insurance operations. In performing our assessment of our homeowners insurance operations reporting unit, the Company noted that several key assumptions had deteriorated over the past year leading to an indication that the homeowners insurance operations reporting unit goodwill was impaired. Specifically, the reporting unit’s financial condition had deteriorated throughout 2004 primarily due to hurricane activity and adverse arbitration rulings. In addition, the Company’s projected cash flows for the homeowners insurance operations reporting unit were negatively impacted by an increase in the Company’s projected catastrophe losses. This increase was primarily driven by the Company’s recent catastrophe experience in Florida and Texas and projected increases in catastrophe reinsurance costs.
The consummation of the initial public offering of Affirmative resulted in a decrease to the Company’s consolidated goodwill and other intangibles by $79.5 million.
Other intangible assets at December 31, 2004 and 2003 are as follows (in thousands):
The changes in the carrying amount of goodwill and other intangible assets for the years ended December 31, 2004 and 2003 are as follows (in thousands):
Vesta’s insurance subsidiaries are required to file statutory financial statements with state insurance regulatory authorities. Accounting principles used to prepare these statutory financial statements differ from accounting principles generally accepted in the United States of America (“GAAP”). The most significant differences between GAAP and statutory accounting principles are as follows: (a) under GAAP acquisition costs of obtaining new business are deferred and amortized over the policy period rather than charged to operations as
incurred; (b) under GAAP certain items are reported as assets (property and equipment, agents’ balances, prepaid expenses) rather than being charged directly to surplus as nonadmitted items; (c) statutory accounting disallows reserve credits for reinsurance in certain circumstances; (d) under GAAP bonds classified as available-for-sale are recorded at their market values instead of amortized cost; (e) under GAAP benefit liabilities are computed using a net level method and are based on realistic estimates of expected mortality, interest, and withdrawals as adjusted to provide for possible unfavorable deviation from such assumptions rather than under statutory prescribed assumptions; (f) under GAAP the Asset Valuation Reserve and Interest Maintenance Reserve established for statutory accounting purposes are restored to stockholders’ equity and (g) under GAAP other assets such as deferred income taxes and goodwill are not limited to statutory prescribed percentages of equity with any excess charged directly to surplus as nonadmitted items.
Restrictions on Dividends to Stockholder and Transactions between Affiliates: Transactions between Vesta and its insurance subsidiaries, including the payment of dividends and management fees to Vesta by such subsidiaries, are subject to certain limitations under the insurance laws of those subsidiaries’ domiciliary states. The insurance laws of the state of Illinois, where Vesta Fire is domiciled, permit the payment of dividends out of unassigned surplus in any year which, together with other dividends or distributions made within the preceding 12 months, such dividends do not exceed the greater of 10% of statutory surplus as of the end of the preceding year or the net income for the preceding year, with larger dividends payable only after receipt of prior regulatory approval. On October 29, 2001, the Illinois Insurance Department published a Company Bulletin that indicates that the Department interprets these dividend limitations to prohibit the payment of dividends if the insurer has negative or zero “unassigned funds” at the end of the prior year, as reported on its statutorily required annual statement. Our lead insurance subsidiary, Vesta Fire, reported negative “unassigned funds” in its annual statement for 2004.
Risk-Based Capital Requirements: The NAIC adopted risk-based capital requirements that require insurance companies to calculate and report information under a risk-based formula which attempts to measure statutory capital and surplus needs based on the risks in a company’s mix of products and investment portfolio. The formula is designed to allow state insurance regulators to identify potential weakly capitalized companies. Under the formula, a company determines its “risk-based capital” (“RBC”) by taking into account certain risks related to the insurer’s assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer’s liabilities (including underwriting risks related to the nature and experience of its insurance business). Risk-based capital rules provide for different levels of regulatory attention depending on the ratio of a company’s total adjusted capital to its “authorized control level” of RBC. Pursuant to the formula described above, there are no issues with respect to a company’s risk-based capital as long as risk-based capital as a percentage of authorized control level is in excess of 200%. At December 31, 2004, the total adjusted risk-based capital as a percentage of authorized control level for our principal insurance subsidiaries was 158% for the Vesta Fire
Based on our statutory results for 2003 and 2004, we have seen our IRIS ratios unfavorably vary from the normal range. The unfavorable variances were predominantly a result of (i) significant declines in surplus levels due to unfavorable arbitration charges and significant catastrophe activity over the last two years, (ii) the significant decline in net writings in the current year due to the divestiture of Affirmative, and (iii) Vesta Fire’s level of investment in its subsidiary statutory insurance companies.
During 2004, we recorded $5.3 million of other realized losses related to a $5.0 million note received in connection with the sale of Aegis. Additionally, we recorded an other realized loss of $1.2 million related to our arbitration with Employers Reinsurance Corporation. See Note I for more details regarding the Employers Reinsurance Corporation arbitration.
During 2002, we actively pursued collection of approximately $27 million in loans held as assets by American Founders. As of December 31, 2002, we had seen no indications that these loans would perform. Accordingly, we concluded that these loans were impaired and recorded an estimated loss on these loans equal to their entire balance.
A summary of fixed maturities and equity securities available-for-sale by amortized cost and estimated fair value at December 31, 2004 and 2003 is as follows (in thousands):
Gross gains (losses) realized on the sale of equity securities were $0.9 million, $6.1 million and $(0.6) million in 2004, 2003 and 2002, respectively. Gross gains realized on the sale of fixed maturities were $5.4 million, $6.5 million and $10.5 million in 2004, 2003 and 2002, respectively. Gross losses on the sale of fixed maturities were $1.6 million, $6.0 million and $10.3 million in 2004, 2003 and 2002, respectively.
As part of our investment in a limited partnership, whose purpose is to invest funds in the private equity markets, we are contractually obligated to contribute an additional $5.7 million. As of December 31, 2004, we had contributed $4.3 million to the partnership. The Company contributed approximately $2.7 million in 2005. Although we do not expect the entirety of the remaining funding requirement to occur in 2006, there are no contractual annual limitations to the funding requirement.
Vesta discontinued all commercial and assumed reinsurance lines of business in 1999 and 2000, respectively. The variability in reserves is largely due to the ultimate disposition of individual claims associated with these lines of business. The absence of other risk factors from this listing does not imply that additional factors will not be identified in the future that will have a significant influence on our reserves.
On March 1, 2004 the NRMA panel ruled in favor of NRMA and as a result, the Company incurred a charge of $33.5 million to its 2003 fourth quarter earnings. While the NRMA ruling did not set a binding precedent regarding Vesta’s other arbitrations and while there are distinct facts and circumstances underlying and affecting our billing disputes with the other participants, for financial reporting purposes, the Company incurred a charge
to its recoverable from the other treaty participants of $30.1 million in the fourth quarter of 2003 to record the recoverable at the Company’s best estimate of realizable value. On March 4, 2004, Vesta filed a motion to vacate this arbitration award in the United States District Court for the Northern District of Alabama, Southern Division. The grounds for this motion was the evident partiality of the neutral umpire. On May 5, 2004, the court issued an order granting Vesta’s request for limited discovery and set an evidentiary hearing on Vesta’s motion to vacate the arbitration award for August 25, 2004. During the second quarter of 2004, this matter was settled by the parties for a payment of $25 million by Vesta to NRMA. As a result of the settlement, the Company recorded a reduction to litigation and billing dispute settlements of $3.8 million in the second quarter of 2004. Vesta made such payment in July of 2004 and cancelled the letters of credit of $29.8 million related to the NRMA arbitration.
The hearing on the merits of the arbitration with Alfa was scheduled for May, 2003, however on April 21, 2003, Alfa filed a lawsuit against Vesta Fire in the state court in Montgomery, Alabama seeking a declaration from the court on certain procedural and organizational matters and requesting that the court stay the arbitration proceedings during the pendency of the litigation in state court in Alabama. On April 24, 2003, the court issued a temporary restraining order staying the proceedings in the on-going arbitration in order to maintain the status quo until the merits of Alfa’s petition could be heard and determined. After the hearing in the Circuit Court of Montgomery County on December 8 and 9, 2003, the court decided the procedural and organizational matters partially in favor of the Company and partially for Alfa. The hearing was rescheduled for the weeks of March 7th and March 14th, 2005. However, on February 25, 2005, the dispute was settled by the parties for a payment of $4.1 million to Alfa. As a result of the settlement, the Company recorded a $5.6 million favorable change in the previously recorded liability in the third quarter of 2004.
Based on the ruling on the existence of Pool III, the agreement of the parties to enter formal mediation and advice of outside counsel, the Company originally recorded a loss of $14.5 million in the third quarter of 2004. While settlement was not reached at the mediation, the parties settled the case on December 8, 2004 by Vesta agreeing to pay $16.5 million to Midland Insurance Company to fully settle Pool I and III. It was agreed that the payment would be made on the later of 45 days from December 8, 2004 or 15 days after the settlement is approved by the court hearing jurisdiction of the liquidation of Midland. Court approval was received on February 23, 2005 and the payment was made on March 10, 2005. The $16.5 million settlement, net of $2.0 million of reinsurance, is reflected as a loss from discontinued operations in the third quarter of 2004.
Liberty National Life Insurance Company (“LNL”) vs. Vesta Fire was a breach of a contract and declaratory judgment action brought by LNL claiming recoveries for 7.5% of premiums collected, commissions paid to their agency force, and approximately $27 thousand in expenses incurred by LNL for conversion of the industrial fire business to in-house handling by Vesta Fire, under a marketing and administrative services agreement. The Court granted summary judgment in favor of LNL which was appealed by Vesta Fire. After the summary judgment was upheld by the appeals court, Vesta Fire paid the part of the judgment that stated a monetary amount. LNL filed an action to enforce the entire judgment and after a ruling adverse to Vesta Fire in that case the parties agreed to settle the case in the second quarter of 2005 by Vesta Fire agreeing to pay approximately $4.0 million to LNL. As a result of the settlement, the Company recorded a loss from discontinued operations of $3.6 million in the third quarter of 2004.
Vesta Fire vs. Employers Reinsurance Corporation (“ERC”) is an arbitration filed in July, 2005 by Vesta Fire against ERC for its failure to pay balances properly owed Vesta Fire pursuant to several Excess of Loss Reinsurance Agreements (“Reinsurance Agreements”). Vesta Fire is seeking recovery of approximately $2.0 million, plus costs and attorneys fees. ERC claims certain offset amounts under the terms of the 1999 acquisition of the management agreement for Vesta County Mutual Insurance Company (“Acquisition Agreement”), specifically under a Loss Portfolio Transfer (“LPT”) Agreement attached to the Acquisition Agreement. The Company contends the LPT Agreement is not a reinsurance agreement, so any offset against ERC’s reinsurance obligations is improper.
resolve the threshold issue of whether the LPT is a reinsurance agreement that would support ERC’s claim for offset. Discovery has begun for that hearing which is currently scheduled for November 2006. Management recorded a realized loss of $1.2 million in connection with this arbitration in the third quarter of 2004 to reflect the uncertainty regarding this case.
Insurance Ventures, Inc. (“IV”) vs. Vesta Fire Insurance Corporation, et al. is a lawsuit brought against Vesta Fire in Sacramento County, California for $20 million in damages. In late 2003, Vesta Fire conducted an audit of accounts of IV who, at the time, was a managing general agent of Vesta Fire. The audit discovered a premium deficiency of approximately $2.5 million. In January 2004, Vesta Fire sent written notice to IV suspending their authority to conduct business on behalf of Vesta Fire and demanding payment of approximately $2.5 million in missing policyholder premiums. IV responded by filing suit against Vesta Fire and two corporate officers asserting fraud, constructive trust, unjust enrichment, misrepresentation, negligence, breach of contract and accounting. Their lawsuit alleges that Vesta Fire knew that a downgrade of the financial strength rating of Vesta Fire by A.M. Best was imminent and that Vesta Fire concealed that knowledge at the time it signed a General Agency Agreement with IV. IV further contends that Vesta Fire intended to take IV’s book of business when it suspended its authority and continued to collect premiums from policyholders in the program. Management believes that IV’s lawsuit in state court is without merit, and is merely an attempt to divert attention from its own breaches of fiduciary duty and breaches of contract which are the subject of a federal lawsuit filed by Vesta, discussed below. Pretrial motions in this case were heard during the week of May 15th, and the trial commenced on May 22nd. We expect the trial to continue into June of 2006.
In February 2004, Vesta Fire filed suit against IV and certain of its principals in the United States District Court for the Eastern District of California alleging fraud, breach of contract, breach of the implied covenant of good faith and fair dealing, breach of fiduciary duty, mishandling of fiduciary funds, conversion and failure to account for commingled funds. Vesta Fire is seeking approximately $2.5 million in missing premiums, $1.3 million for losses on policies produced by IV without authority, plus punitive damages, attorney fees and costs. IV filed an answer and counterclaim alleging the same facts and circumstances that gave rise to its lawsuit against Vesta Fire in state court, discussed above. On February 9, 2006, the District Court granted Vesta’s motion for partial summary judgment, finding that IV had breached its fiduciary duties to Vesta in a number of respects
Pursuant to Delaware law and our by-laws, we are obligated to indemnify our current and former officers and directors for certain liabilities arising from their employment with or services to Vesta, provided that their conduct complied with certain requirements. Pursuant to these obligations, we have been advancing costs of defense and other expenses on behalf of certain current and former officers and directors, subject to an undertaking from such individuals to repay any amounts advanced in the event a court determines that they are not entitled to indemnification. During the year ended December 31, 2004 and 2003, funding of such expenses was less than $0.1 million per year.
unfavorable finding by a jury in the trial of this case could result in an award of significant damages which could have a material adverse effect on our financial position, statement of operations and cash flows.
Vesta and two former officers of Vesta are defendants in a lawsuit styled James H. Cashion, Jr. d/b/a American Health Underwriters v. Vesta Insurance Group, Inc., et al. Plaintiff, a former general agent of our subsidiary States General Life Insurance Company, which we purchased in 2001 and disposed of in 2003, alleges that the defendants engaged in an actionable civil conspiracy to tortiously interfere with his agency contracts. The civil conspiracy claim is premised, in part, on certain payments made to these two former officers of Vesta by another agent who replaced Mr. Cashion. The plaintiff is seeking actual and punitive damages. Vesta denies tortiously interfering with plaintiff’s agency contract, believes the claims asserted against it have no merit, and is vigorously defending this lawsuit. The trial court denied the Company’s motion to compel arbitration, which decision was appealed to the Texas Supreme Court. The Texas Supreme Court recently ruled in the Company’s favor and has compelled arbitration. The plaintiffs have petitioned the Texas Supreme Court for reconsideration of their ruling. Discovery has been stayed pending resolution of this appeal. In the opinion of management, resolution of this lawsuit is not expected to have a material adverse effect on our financial position statement of operations or cash flows.
On February 10 2006, the Company’s board of directors replaced Norman W. Gayle, III as President and CEO. Mr. Gayle, who continues to be a director and employee of the Company, has notified the Company that he may proceed with a claim that his employment has been terminated by the Company without cause and that he is entitled to certain compensation and benefits under his employment agreement. No litigation has been yet filed.
Our holding company owes contractual obligations to certain of our subsidiaries that are eliminated in consolidation of our financial statements. As of December 31, 2004, our insurance company subsidiaries held $13.2 million face amount of our 8.75% Senior Debentures due 2025 and $44.1 million face amount of our 12.5% Senior Notes due in December of 2005. Our holding company paid these subsidiaries approximately $6.8 million in interest payments in 2004, 2003 and 2002 which was eliminated in consolidation.
Effective February 28, 2005, our wholly owned subsidiary, Vesta Fire Insurance Corporation, which is the holder of 100% of our 12.5% Senior Notes due December 2005, principal amount $44.1 million, agreed to an amendment to the indenture governing such notes for the purposes of (i) extending the maturity date to December 2008 and (ii) decreasing the interest rate on such notes from 12.5% to 8% per annum. The Supplemental Indenture reflecting these modifications, which has been approved by the California and Illinois Insurance Departments, was attached to a current report on Form 8-K filed March 2, 2005. In connection with this amendment, we paid $5.2 million principal amount of such notes by transferring to Vesta Fire approximately 305 thousand shares of the common stock of Affirmative Insurance Holdings, Inc. held by us at the holding company level. As a result of these transactions, Vesta Fire holds $38.9 million principal amount of the registrant’s 8% notes due December 2008, and approximately 4.2 million shares, or approximately, 24.8%, of Affirmative Insurance Holdings, Inc.’s outstanding common stock. In addition, our holding company made a $5.0 million principal payment in December of 2005 related to these bonds.
We lease office space for our home office and subsidiary offices and other equipment under operating lease arrangements. Rental expense for operating leases was $9.0 million, $11.1 million, and $13.9 million for the years ending December 31, 2004, 2003 and 2002 respectively.
Future payments for operating lease obligations at December 31, 2004 are as follows (in thousands):
In January of 2002, the Company completed three transactions to purchase InsureOne Agency, Harbor Insurance Group and Old American Investments. The Company financed $20.2 million of the total purchase price.
Effective June 30, 2004, the Company commuted the 2003 50% Quota Share Agreement on a cut-off basis. Under the terms of the commutation, the Company’s insurance subsidiaries received payment for all reserves previously ceded to the reinsurers and will be responsible for any adverse development on losses that occurred on or prior to June 30, 2004 from policies subject to this agreement.
Effective December 31, 2003, the Company’s insurance subsidiaries executed certain internal reinsurance contracts, the results of which were to cede all future non-standard auto earned premiums and losses and loss adjustment expenses incurred after December 31, 2003 to the insurance companies owned by Affirmative. Based on the terms of these reinsurance contracts, the Company’s insurance subsidiaries retained their non-standard auto loss and loss adjustment expense reserves as of December 31, 2003 and remain liable for any losses incurred on or prior to December 31, 2003 as well as any subsequent development of loss and loss adjustment reserves related to those losses. The accompanying Consolidated Statement of Operations for the year ended 2004 does not reflect any significant losses related to losses occurring on or prior to December 31, 2003.
The Company’s 2004 catastrophe excess of loss reinsurance program, which covers the period July 1, 2004 to June 30, 2005, provides a maximum of $200 million of reinsurance for risks in Hawaii, $270 million in Texas, and $150 million for other nationwide risks in excess of our retention of $15 million. These retention levels do not include the expenses that the Company would incur in the event the Company exceeds the retention, most notably reinstatement premiums. In Florida, the Company’s current program provides $238 million of reinsurance in excess of our retention of $15 million of risk. Included in the reinsurance protection for Florida is an estimated $84.7 million of coverage in excess of $22.8 million of losses, with a 10% co-insurance requirement, from The Florida Hurricane Catastrophe Fund (the “FHCF”). This catastrophe excess of loss reinsurance program, combined with other inuring reinsurance contracts, provides reinsurance coverage sufficient to cover the probable maximum loss, or “PML,” from a 1-in-100 year weather event based on estimates of probable losses provided by Risk Management Solutions, Inc.’s RiskLink v4.2 sp1 run with demand surge, excluding storm surge.
Effective July 1, 2005 to June 30, 2006, our catastrophe excess of loss reinsurance program covers losses in excess of $20 million up to $150 million per event in every state except Florida, Texas and Hawaii. In Florida, we have coverage of $75.8 million, with a 10% coinsurance requirement, from the FHCF in excess of $21.3 million, bringing the total coverage to $218.2 million. In Hawaii and Texas, we have coverage up to $200 million. Additionally, the 2005 quota share reinsurance agreement provides coverage for catastrophes for up to 25% of the subject earned premium, which is estimated to be $42.5 million without any per event limits.
Simultaneous with the commutation of the 2004 50% and 2004 25% Quota Share Agreements, the Company’s insurance subsidiaries entered into a new 50% quota share agreement (“2005 50% Quota Share Agreement”). The 2005 50% Quota Share Agreement is effective for residential property business in our Continuing States, and retains similar economic terms, including ceding commissions and profit sharing commissions.
As further discussed in Note T, we exited the assumed reinsurance line of business in 1999. The premiums disclosed here as assumed premiums represent non-standard automobile premiums which were fronted for Vesta by another carrier. The above amounts in 2004 related to non-standard automobile premiums only reflect activity through July 7, 2004 as this was the date of the divestiture of Affirmative.
The Company has ceded reserves of $37.6 million to Lumbermens Mutual Casualty Company (“Lumbermens”), a member of the Kemper Insurance Companies, primarily related to long-term care obligations
The components of Vesta’s income tax (benefit) expense from continuing operations consisted of the following (in thousands):
Vesta’s effective income tax rate on continuing operations differed from the statutory income tax rate as follows:
Vesta has a Shareholders’ Rights Plan that provides for the payment of a dividend of one preferred stock purchase right to be attached for each outstanding share of common stock. Each Right, if and when it becomes exercisable, will entitle the registered holder to purchase from Vesta one one-hundredth (1/100) of a share of Vesta’s Series B Junior participating Preferred Stock at a price of $30.00 per one one-hundredth of a share. The Rights will be exercisable only if a person or group acquires a beneficial ownership of 10% or more of the common stock. The Rights entitle the holder to purchase one one-hundredth of a share of a new series of preferred stock at an exercisable price of $30.00 and will expire on June 15, 2010.
The standard property-casualty segment consists of two principal lines of business: (1) underwriting only residential property insurance in capacity constrained states; and (2) underwriting residential property and automobile insurance in states where we can profitably offer both products through independent agents. Vesta’s insurance products are distributed primarily through approximately 2,600 independent agencies. Our residential property lines target families (1) with multiple insurance policies; (2) who own more than one automobile; and (3) who live in a home valued between $100,000 and $350,000. Our standard personal auto line targets drivers over age thirty-five with above average driving records.
As discussed in Note D, we consummated an initial public offering of Affirmative, our non-standard underwriting and non-standard agency holding company during the third quarter of 2004. Based on this transaction and our post-IPO ownership of Affirmative, we will no longer consolidate the operating results of the non-standard underwriting and agency operations. Rather, our remaining ownership in Affirmative is accounted for under the equity method. As such, beginning in the third quarter of 2004, our pro-rata share of the net income of Affirmative is reflected as “Equity in net earnings of investee, net of tax” on the accompanying Consolidated Statement of Operations. The historical results of our non-standard agency and underwriting segments remain unchanged.
Our corporate and other business segment is primarily comprised of (1) investment income related to our property-casualty underwriting operations; (2) corporate and property-casualty interest expense; (3) general
Long-term debt and Deferrable Capital Securities at December 31, 2004 and 2003 consists of the following (in thousands):
Company did not file its September 30, 2004 Form 10-Q and its 2004 Form 10-K within the required time, we were in violation of the covenant under this indenture. In addition, we have not filed our periodic reports for 2005 with the Securities and Exchange Commission in the time required by the Commission’s rules, and, therefore, are in technical default under the terms of this Indenture. Such default will not constitute an Event of Default, as defined in the indenture, unless and until the Indenture Trustee delivers notice of default to the Company, and the Company fails to cure or otherwise remedy this default within sixty days of receipt of the notice. If such a notice were to be delivered, we believe the Event of Default could be remedied by the filing of the delinquent reports. We intend to file such reports with the SEC as soon as practicable. However, we can give no assurance that the reports could be filed within the sixty day cure period. As of the date of the filing of this report on Form 10-K, neither we or, to the best of our knowledge, the Indenture Trustee had received any notice of default arising from the delinquency of these reports.
If notice of default were delivered to the Company on the Debentures or the Capital Securities, or both, the Company does not have the funds necessary to repay these obligations. The Company would have to pursue alternative financing, asset sales or capital raising activities. There can be no assurances that the Company could raise the necessary cash to pay the Debentures and/or Capital Securities or that it could on terms acceptable to the Company.
During the year ended December 31, 2002, we exchanged 69 thousand shares of common stock for $805 thousand face amount of Deferrable Capital Securities. The resulting after-tax gain of $209 thousand was recorded directly to retained earnings in accordance with EITF 86-32. The after-tax gains from these transactions have been included in the respective computations of income available to common shareholders and related earnings per share computations in accordance with EITF Topic No. D-42, “The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock.”
During 2003, we redeemed $2.2 million face amount of Deferrable Capital Securities in exchange for approximately 402 thousand shares of common stock resulting in a gain of $0.6 million. Pursuant to the provisions of SFAS No. 150, the gain is reflected as a component of income from continuing operations.
Vesta’s outstanding balance of the line of credit at December 31, 2004 and 2003 is as follows (in thousands):
In conjunction with the sale of our remaining stake in Affirmative in the third quarter of 2005, the Company fully repaid and terminated the revolving credit agreement. Proceeds from the sale of our remaining stake in Affirmative in the third quarter of 2005 were used to repay the outstanding balance on the revolving line of credit. The credit agreement was terminated on August 31, 2005.
The terms of the capital securities and the underlying debenture permit us to defer interest payments on the debentures, and, therefore, distributions on the capital securities, for up to ten years. We exercised this right of deferral with respect to the semi-annual payment originally due July 15, 1999. While we have elected to resume payment on these capital securities effective January 15, 2000, including all accrued amounts due since July 15, 1999, we may elect to defer payments again in the future. In the event we elect to defer such payments again in the future, we will not be permitted to pay any dividends on our common stock or other equity securities.
We are required to maintain a collateral deposit with FHLB. At December 31, 2004 and 2003 respectively, investments having a market value of approximately $172.2 million and $178.8 million, respectively, were pledged to the FHLB. For the years ended December 31, 2004 and 2003, interest expense was approximately $5.7 million and $6.2 million, respectively.
Annual maturities of borrowings from FHLB as of December 31, 2004 are as follows (in thousands):
During the third quarter of 2005, the Company repaid $28.0 million of outstanding advances from the FHLB. Proceeds from the commutation of the 2004 50% and 25% Quota Share Agreement were used to repay these balances. In addition, with the divestiture of Laurel Life Insurance Company in the third quarter of 2005, those advances from the FHLB related to our life insurance operations no longer were a liability of the Company. As such, the Company had no outstanding Federal Home Loan Bank advances as of September 30, 2005.
Prior to completion of our initial public offering, our stockholders approved the Vesta Insurance Group, Inc. Long Term Incentive Plan (“Plan”), which provided for grants to our executive officers of restricted stock, stock
options, stock appreciation rights, and deferred stock awards, and in certain instances grants of options to directors. Our stockholders approved certain amendments to the Plan effective August 27, 1999 and May 16, 1995, including an amendment to increase the shares of common stock available for awards to 2,221,998 shares and an amendment to delete the provision for the grant of options to non-employee directors. Of the shares authorized under the Plan, approximately 782 thousand shares remain available for future awards. On May 7, 2001, stockholders approved the 2001 Incentive Compensation Plan (“Incentive Compensation Plan”) as a means of continuing our ability to attract, retain and motivate directors and employees through equity based compensatory awards. Under the Incentive Compensation Plan, the Compensation Committee of the Board of Directors has the discretion to issue stock options, restricted stock awards, and unrestricted stock awards in recognition of past services or other valid consideration. The aggregate number of shares of Vesta common stock that may be issued under the Incentive Compensation Plan may not exceed 2,000,000; provided, however, that no more than 750,000 shares may be awarded under the Incentive Compensation Plan in the form of awards other than options. Of the shares authorized under the Incentive Compensation Plan, approximately 1.1 million shares remain available for future awards. The maximum number of shares with respect to which awards may be granted to any individual in any one-year under the Incentive Compensation Plan is 350,000. The stockholders also approved the Vesta Insurance Group, Inc. Non-Employee Director Stock Plan (“Director Plan”) effective May 16, 1995, which provides for grants to Vesta’s non-employee directors of stock options and restricted stock. The aggregate number of Vesta common stock that may be issued under the Non-Employee Director Stock Plan may not exceed 780,000 and approximately 439 thousand shares remain available for future awards.
Of the 1,568,811 outstanding options at December 31, 2004, 550,311 were exercisable.
At December 31, 2004, Vesta has issued 767 thousand shares of restricted stock. In addition, Vesta issued 74 thousand shares to officers of Vesta in exchange for promissory notes. The common stock is being held by Vesta as security for the repayment of the notes. The balance of the unamortized restricted stock and unpaid note receivable at December 31, 2004 and 2003, was $5.2 million and $6.1 million, respectively, and are shown as reductions to stockholders’ equity. The restrictions on these shares expire in 2005-2011. Total expense related to the issuance of the restricted stock was $2.1million, $2.0 million and $3.1 million for the years ended December 31, 2004, 2003 and 2002, respectively.
Vesta has set forth below selected quarterly financial data for the years ended December 31, 2004 and 2003 (as restated). Because certain of the data set forth in the following tables has been restated from amounts previously reported on Form 10-Q for the applicable period, the following tables reconcile the quarterly information presented with those previously reported.
See Note B herein for a description of the adjustments reflected in the restated financial statements.
The following table presents the impact of the financial statement adjustments on our Consolidated Statements of Operations for our four restated quarters in 2003.
Equity Securities-The carrying value of unaffiliated common stock, except for stock of FHLB, approximates fair value. Because FHLB shares are not publicly traded, the market value of the stock was considered to be equivalent to its cost due to the fact that FHLB has historically redeemed the shares at the original cost.
Other Invested Assets-The carrying value of certain other invested assets approximates fair value because existing rates of return approximates the current rates of return required on similar investments.
Borrowings-Fair values for the advances from FHLB were calculated using interest rates in effect as of each year end with the other terms of the advances unchanged. Carrying values of short-term debt approximate fair value as effective rates approximate current rates. Fair values of long-term debt and deferrable capital securities, were determined based on recent transactions involving the applicable
In the fourth quarter of 2002, we made a decision to exit the health insurance business line, which we entered in December 2000 through the acquisition of Aegis Financial Corporation and its subsidiary States General Life Insurance Company. In connection with this decision, we recognized a charge of $9.9 million in the fourth quarter of 2002, which included a charge of $7.9 million to write-off goodwill associated with this business line. In December 2002, in connection with our decision to exit the health insurance business, we (1) terminated our exclusive agent that was generating new business; (2) began actively marketing efforts to sell the health business, including its platform; and (3) hired an investment banker to advise us with respect to a sale. Accordingly, in accordance with the requirements of SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets,” our health operations have been segregated from continuing operations herein for all periods presented.
Also in the fourth quarter of 2002, we elected to exit the consulting business. In connection with this decision, we wrote-off goodwill associated with the consulting business of $1.2 million. In accordance with the requirements of SFAS No. 144, the consulting operations have been segregated from continuing operations herein for all periods presented.
We consummated the sale of Aegis Financial Corporation and its subsidiary States General Life Insurance Company (States General) effective September 30, 2003 for $4.6 million. For the year ended December 31, 2003, we recorded a loss of $6.7 million, net of tax, for our health operations and our consulting business, including the aforementioned loss on the sale of Aegis.
In 1999, we elected to exit the assumed reinsurance business line and stopped accepting new contracts. We sold the majority of our reinsurance assumed operations, including most renewal rights to Hartford Fire Insurance Company in the first quarter of 1999 for $15 million. In the fourth quarter of 2000, the last active reinsurance contract was commuted. Such commutation represented the measurement date for treatment of the reinsurance assumed business as a discontinued operation under APB Opinion No. 30. Therefore, the reinsurance assumed operations have been segregated from continuing operations herein for all periods presented. Vesta will continue to pay losses on policies with coverage periods prior to the measurement date as those losses become due.
For the year ended December 31, 2004, we recorded a loss from discontinued operations of $33.4 million. The current year loss primarily related to a $14.5 million loss related to the Muhl litigation, $15.8 million of losses related to reserve adjustments and reinsurance contract commutation losses related to our commercial and assumed reinsurance books of business, and $3.1 million related to the settlement of the Liberty National lawsuit.
In June of 2001, the Company settled a contingent liability with three of its executives under the Executive Officer Incentive Compensation Plan by issuing 1.25 million shares of restricted stock and giving the executives total loans of $5.0 million. The restricted stock, which is recorded as Unearned Stock at December 31, 2004, vests over a 10-year period under certain circumstances. The loans, which are recorded as Other Assets at December 31, 2004 may be forgiven over a 10-year period. The Company will record the vesting of the restricted stock and any forgiveness of the loans as compensation expense in the appropriate periods.
During 2005, the Company incurred losses from several hurricanes. The following is a summary of the estimated gross and net losses incurred by the Company related to these events in 2005 (in thousands):
The above amounts exclude the estimated catastrophe reinsurance reinstatement premiums of $10.2 million incurred by the Company during 2005 related to these hurricanes. In addition, the Texas Windstorm Insurance Association levied a $3.5 million guaranty fund assessment on Texas Select Lloyds Insurance Company related to Hurricane Rita in September of 2005.