During 2011, the company’s management discovered an error in its stated accounts receivables. The error arose as a result of the process used to record transactions to the accounting system for insufficient funds on policy payments from insureds. This process, which in certain instances required manual adjustments to the accounts receivable system for insufficient funds transactions, resulted in a duplicate booking of certain transactions to the accounting systems in years 2007 through 2010. The process for recording and reconciling insufficient funds transactions was changed in 2011. Additionally, the company’s management strengthened its internal controls as a result of this error.
As a result, the Company’s accounts receivable were overstated by $1.8 million as of December 31, 2010. The effect of the overstatement is a cumulative charge to earnings, after giving effect to taxes, of $1.2 million over the four-year period from 2007 through and including 2010. Of this aggregate charge to earnings after giving effect to taxes, $254,623 related to fiscal year 2007; $397,818 related to fiscal year 2008; $269,634 related to fiscal year 2009; and $312,583 related to fiscal year 2010.
Based on the foregoing, on April 2, 2012, the Company’s Board of Directors, after consultation with the Company’s management, concluded that the Company’s financial statements for the fiscal years 2009 and 2010, the interim periods contained therein, and the quarterly statements for the first three quarters of 2011 must be restated to the extent of the overstatements listed above. See Note 3 within the Consolidated Financial Statements for further information.
The pre-tax loss from continuing operations for the year ended December 31, 2011 compared to the same period last year, resulted primarily from lower earnings in the wholesale operation (AAIC and MGA) in 2011 and a $3.5 million gain on extinguishment of debt recognized in 2010. Total revenue declined by $6.9 million or 11% from the prior year. This reduction reflects both the challenging economic environment as well as actions taken by the Company to address underwriting results. The loss and loss adjustment expenses increased $6.0 million compared to the prior year. This increase included $4.1 million of adverse loss development from prior accident years, primarily 2009 and 2010.
The Company sold its TrustWay retail agencies in 2011. The TrustWay business is reported as discontinued operations in the Consolidated Financial Statements and 2010 results for this business was reclassified as discontinued operations for comparative purposes. The Company reported a net after-tax loss from discontinued operations of $2.6 million for the year ended December 31, 2011, compared to a net after-tax loss of $2.2 million for the year ended December 31, 2010. The Company reported basic and fully diluted losses per common share from discontinued operations of $0.040 for the year ended December 31, 2011, compared to losses of $0.033 in the same period in 2010. The pre-tax loss from discontinued operations was $2.7 million for the year ended December 31, 2011 and $3.2 million for 2010, respectively.
Policies in-force of 68,663 as of December 31, 2011 decreased 16.7% from policies in-force at December 31, 2010.
Our MGA operations receive managing general agent commissions for agency, underwriting, policy administration, and claims adjusting services performed on behalf of insurers. Commission income for the year ended December 31, 2011 was $12.2 million compared to $14.8 million in 2010. The decrease in commission income was driven by the reduction in premium volume and a lower ceding commission rate. AAIC pays the MGA commission on premium, which AAIC retains and this amount is subsequently eliminated upon consolidation.
Insurance losses and loss adjustment expenses include payments made to settle claims, estimates for future claim payments and changes in those estimates for current and prior periods, as well as loss adjustment expenses incurred in connection with settling
claims. Insurance losses and loss adjustment expenses are influenced by many factors, such as claims frequency and severity trends, the impact of changes in estimates for prior accident years, and increases in the cost of medical treatment and automobile repairs. The anticipated impact of inflation is considered when we establish our premium rates and set loss reserves. During 2011, our outside actuarial firm performed quarterly analyses of accident year results to update reserve requirements. The estimate of ultimate loss and loss adjustment expenses is evaluated by accident quarter and by major coverage group (e.g., bodily injury, physical damage). The quarterly analyses are gross of reinsurance and then reinsurance terms are applied to calculate indicated net reserves.
Effective May 15, 2011, the Company entered into a twelve month catastrophe agreement with Shelter Mutual Insurance Company (“SMIC”). SMIC shall be liable for private passenger automobile physical damage coverage with respect to each loss occurrence, for the ultimate net loss over and above an initial ultimate net loss of $400,000 each event such as a storm or flood, subject to a limit of liability to the reinsurer of $1,600,000 each event, and further subject to a limit of liability to SMIC of $3,200,000 with respects to all events commencing during the term of this contract.
Effective April 1, 2011, the Company entered into a new quota share agreement with Greenlight Reinsurance Ltd. (“Greenlight”) for premium written in the state of Florida for the period of April 1, 2011 to March 31, 2012. The Company ceded 50% of premiums and losses for bodily injury liability, physical damage and other automobile liability coverages to Greenlight. The Company will receive a 19% ceding commission on ceded premiums earned if the loss and loss adjustment expense ratio as a percentage of earned premium is 75.5% or greater. If the loss ratio is less than 75.5%, but not less than 71.5% then the ceding commission shall be 19.0%, plus one half of the difference in percentage points between 75.5% and the actual loss ratio. If the loss ratio is 71.5% or less, then the ceding commission rate will be 21.0%. The Company receives a provisional commission rate of 20% in advance, which is subject to adjustment once the final loss ratio is known.
As a result of the reinsurance agreements, the Company is currently ceding to its reinsurers approximately 67% in 2011 and 72% in 2010 of its direct loss and loss adjustment expenses incurred. The Company ceded approximately 65% of its direct premiums written to its reinsurers during 2011 compared to 67% in 2010.
Selling, general and administrative expenses were $30.9 million for the year ended December 31, 2011 and $32.3 million for the same period of 2010. The decrease of $1.4 million in 2011 expenses relates to a $1.7 million decrease in selling expenses due to lower premium volume in the wholesale division and a $1.5 million goodwill impairment loss reflected in the prior year, partially offset by increases in personnel costs of $0.6 million, boards and bureau assessments of $0.6 million and $0.4 million in other administrative costs. Depreciation and amortization expenses increased $223 thousand related to investment in a proprietary web-based quoting and policy issuance platform. Interest expense was $344 thousand lower than the prior year, primarily due to the extinguishment of the trust preferred debt in late 2010.
As of December 31, 2011, the Company’s assets included two promissory notes secured by real estate mortgages, in the amount of $2.5 million and $1.5 million, respectively. The two notes were subsequently assigned by the Company as a capital contribution to its subsidiary AssuranceAmerica Insurance Company. The assigned promissory notes are secured by mortgages and real estate deeds owned by Guy Millner the Chairman of the Company and a related party. See Note 6 of the Consolidated Financial Statements for further details regarding the notes.
Receivable from insureds as of December 31, 2011, decreased $5.7 million to $25.1 million compared to $30.8 million as of December 31, 2010. The balance represents amounts due from AAIC’s insureds and the majority of the decrease is directly attributable to the decline in AAIC’s premium writings during 2011. The Company’s policy is to write off uncollected receivable balances within 60 days of cancellation or expiration, and the Company does not consider an allowance for doubtful accounts to be necessary.
Prepaid reinsurance premiums as of December 31, 2011, decreased $4.2 million to $19.5 million compared to $23.6 million as of December 31, 2010. The decrease results from AAIC’s decline in premium during the year of 2011 and represents premiums ceded to its reinsurers which have not been fully earned.
Other receivables as of December 31, 2011 increased $0.9 million to $1.6 million when compared to December 31, 2010. The increase mainly relates to $0.2 million note receivable due from the purchaser of the TrustWay Alabama agencies, $0.3 million due from the purchaser of the TrustWay Florida agencies and $0.4 million increase for balances related to the managing general agency agreements.
Index to Financial Statements Prepaid income taxes decreased $107 thousand as of December 31, 2011, when compared to the balance at December 31, 2010. Deferred tax assets decreased $2.4 million as of December 31, 2011 compared to the balance as of December 31, 2010. A valuation allowance of $4,851,743 was established based on the “more likely than not” threshold for the Company’s net deferred income tax asset as of December 31, 2011. See Note 10 of the Consolidated Financial Statements.
Accounts payable and accrued expenses as of December 31, 2011, increased $0.6 million to $7.3 million from the balance of $6.7 million as of December 31, 2010. The increase is due to $1.6 million of unclaimed property, offset by a decrease of $0.3 million in lower premium tax accruals, $0.5 million in general and administrative expense accruals, and amounts due to agents of $0.2 million.
Provisional commission reserves represent the difference between the minimum ceding commission and the provisional amount paid by the reinsurers. These balances as of December 31, 2011 decreased $0.8 million to $2.5 million, compared to the balance on December 31, 2010 of $3.3 million. The decrease is related to the reduction in ceded written premium in 2011 and a reduction in the commission rate.
The Company’s revolving line of credit of $1.5 million was fully paid during 2011. The line was not renewed by the Company.
Notes and interest payable as of December 31, 2011 decreased $58 thousand due to principal payments on a note with a third party.
Financing activities for the year ended December 31, 2011, used cash of $1.5 million, primarily due to the $1.5 million payment of the line of credit.
Index to Financial Statements The First Amendment extended the maturity date for the credit facility to July 16, 2011. However, the lender extended the agreement through September 30, 2011. The facility was fully paid in July 2011 and upon expiration, the facility was not renewed. The proceeds of the facility was used for funding certain permitted acquisitions, funding short-term loans to the Company’s wholly owned subsidiary, AAIC, or for working capital or general corporate needs in the ordinary course of business. The credit facility was secured by a pledge of the Company’s ownership interests in two of the Company’s subsidiaries, TrustWay and MGA, and was guaranteed by the same entities.
On December 30, 2010, AAIC issued a dividend in-kind to the Company of all the capital securities issued by AssuranceAmerica Capital Trust in the amount of $1,001,089 and the Company extinguished the related junior subordinated debentures of $4,988,513, which resulted in a gain of $3,509,845. On March 10, 2009, AAIC purchased all of the capital securities issued by the trust at a discounted price of $1,000,000 from the non-affiliated holder of those securities. The discount was accreted to interest income over the remaining life of the capital securities using the interest method. The purchase resulted in an increase in AAIC’s investment portfolio for redeemable preferred stock in the amount of $1,001,089.
The Company is required to make certain estimates and assumptions when preparing its financial statements and accompanying notes in accordance with GAAP. One area which requires estimations and assumptions is the establishment of loss and LAE reserves. Loss and LAE reserves are established to reflect the estimated costs of paying claims and claims expenses under insurance policies we have issued. These reserves are an approximation of amounts necessary to settle all outstanding claims, including known claims and claims that have been incurred but not reported (“IBNR”) as of the financial statement date.
Legal and regulatory trends affecting claims settlements and average legal defense costs by state and other geographical regions.
The following table presents the gross reserves by line of business as of December 31, 2011 and December 31, 2010:
The increase in gross reserves was $8.8 million mainly representing an increase in the bodily injury and personal injury protection coverages of $8.3 million and $0.5 million in physical damage coverages.
AssuranceAmerica estimates liabilities for the costs of losses and LAE for both reported and unreported IBNR claims based on the historical trends and assumptions set forth above. When possible, where deviations from historical trends in these key areas exist, quantitative and qualitative modifications to, or selections of, such factors are made to reflect such deviations. Management analyzes the adequacy of reserves using actuarial data and analytical reserve development techniques, including projections of ultimate paid losses, to determine the ultimate amount of reserves. The key assumptions and factors previously discussed under the “Critical Accounting Policies” Section are taken into account in developing these estimates. AssuranceAmerica reviews loss reserve adequacy quarterly by accident year at a line of business level. Reserves are adjusted as additional information becomes known. Such adjustments are reflected in current year operations. Loss and LAE reserves are also certified to state regulators annually.
The Company’s claims costs represent payments made and estimated future payments to be made to or on behalf of our policyholders, including expenses needed to adjust or settle claims. These costs relate to current costs under our non-standard state-mandated automobile insurance programs. Claims costs are impacted by loss severity and frequency and are influenced by inflation and driving patterns, among other factors. Accordingly, anticipated changes in these factors are taken into account when we establish premium rates and loss reserves.
During the year ended December 31, 2011, our loss and LAE ratio increased 17.9%, as compared to 1.7% in the same period a year ago, which reflects reserve strengthening for prior year loss development. We continuously monitor internal and industry-wide severity trends and adjust rates as appropriate to compensate for the higher loss costs.
The table below presents the development experienced in the following periods:
The Company cedes a significant portion of its personal automobile premium and losses to reinsurers. The Company’s reinsurance strategy is to use quota share reinsurance to mitigate the financial impact of losses on its operations, while enabling premium growth within the limits of its capital base. Historically, the Company’s reinsurance contracts have been one or two years in duration, subject to renewal.
The impact of reinsurance on the balance sheets as of December 31 is as follows:
The Company’s reinsurance recoverable balances amounted to $36.7 million and $34.0 million as of December 31, 2011 and 2010, respectively. The reinsurance recoverable includes ceded unpaid losses and loss adjustment expenses of $27.6 million and $23.4 million for the same periods, respectively. The ceded reserves from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies ceded. Reinsurance recoverable assets include paid loss balances due from other reinsurers under the terms of reinsurance agreements in the amount of $9.1 million and $10.6 million as of December 31, 2011 and 2010, respectively. The paid loss recoverables are current as of December 31, 2011.
The Company’s ceded prepaid premium relates to policies in force and is earned ratably over the policy period. As of December 31, 2011 and 2010, the ceded prepaid premiums amounted to $19.5 million and $23.6 million, respectively. Reinsurance payable of $20.5 million and $29.4 million as of December 31, 2011 and 2010, respectively, represents the amounts due to reinsurers for ceded premiums net of commissions. The Company pays its reinsurers on a collected premium basis. Effective for the 2011 treaty year, the Company receives ceding commissions on ceded collected premiums, whereas for prior treaty years ceding commissions were based on ceded written premiums. The Company does not have any balances that are in dispute as of December 31, 2011.
The Company’s quota share reinsurance facility has a significant impact on its cash flows. Since the Company cedes a significant amount of its premium and losses, the Company relies heavily on its reinsurers to settle outstanding reinsurance balances due for loss payments net of ceded premiums collected. The Company paid ceded premiums net of commissions of $55.1 and $51.5 million for the years ended December 31, 2011 and 2010, respectively, and received reinsurance recoverables on paid loss and loss adjustment expenses of $60.0 million and $71.3 million during the same periods.
When we determine that the carrying amount of intangible assets or goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure the impairment based on the pro forma sustainable earnings capacity and discounted cash flows. This review is based upon our historical earnings, industry comparisons, and the underlying risks inherent in Trustway’s current business model.
The intangible asset carrying value as of December 31, 2010 relates to the TrustWay division, which was sold during 2011 and the value was reduced to zero as of December 31, 2011 (see Note 9 of the Consolidated Financial Statements for additional information).
The Company reviews its deferred tax assets for recoverability at each interim reporting date. The Company’s ability to realize deferred tax assets depends on the ability to generate sufficient taxable income within the carryforward period provided for in the tax law. The Company considered the following possible sources of taxable income when assessing the possible realization of deferred tax assets: future reversals of existing taxable temporary differences, future taxable income exclusive of reversing temporary differences and carryforwards; taxable income in prior carryback years; and tax planning strategies. As of December 31, 2011, a valuation allowance of $4.9 million was established based on the “more likely than not” threshold for the Company’s net deferred income tax asset.