Insurance Underwriting leases facilities with an aggregate square footage of approximately 68,563 at six locations in six states. The latest expiration date of the existing leases is in December 2017.
Kingsway is a holding company and is engaged, through its subsidiaries, in the non-standard property and casualty insurance business. The Company conducts its business through the following two reportable segments: Insurance Underwriting and Insurance Services.
Kingsway, like many insurance companies, analyzes performance based on underwriting ratios such as combined, expense and loss ratios. The loss ratio is derived by dividing the amount of net loss and loss adjustment expenses incurred by net premiums earned. The expense ratio is derived by dividing the sum of commissions and premium taxes and general and administrative expenses by net premiums earned. The combined ratio is the sum of the loss ratio and the expense ratio. A combined ratio below 100% demonstrates underwriting profit whereas a combined ratio over 100% demonstrates an underwriting loss.
In the year-end actuarial review process, an analysis of the provision for unpaid loss and loss adjustment expenses is completed for each insurance subsidiary. Unpaid losses, allocated loss adjustment expenses and unallocated loss adjustment expenses are separately analyzed by line of business or coverage by accident year. A wide range of actuarial methods are utilized in order to appropriately measure ultimate loss and loss adjustment expense costs. These methods include Paid Loss Development, Incurred Loss Development, Paid Bornhuetter-Ferguson, Incurred Bornhuetter-Ferguson, Berquist-Sherman Paid Method, Berquist-Sherman Reported Method and frequency-severity method. Reasonability tests such as average outstanding provision for loss and loss adjustment expenses, ultimate loss trends and ultimate allocated loss adjustment expense to ultimate loss are also performed prior to selection of the final provision. The provision is indicated by line of business or coverage and is separated into case reserves, IBNR reserves and a provision for unallocated loss adjustment expenses.
Objective positive evidence is necessary to support a conclusion that a valuation allowance is not needed for all or a portion of a company's deferred income tax asset balances when significant negative evidence exists. Cumulative losses are the most compelling form of negative evidence considered by management in this determination. To the extent a valuation allowance is established in a period, an expense must be recorded within the income tax provision in the consolidated statements of operations. As of December 31, 2011, the Company maintains a valuation allowance of $260.1 million, $258.9 million of which relates to its U.S. deferred income taxes. The largest component of the U.S. deferred income tax asset balance relates to tax loss carryforwards that have arisen as a result of the continued losses of the Company's U.S. operations. Uncertainty over the Company's ability to utilize these losses over the short-term has led the Company to record a valuation allowance.
Goodwill and intangible assets with an indefinite life are assessed for impairment annually as of December 31, or more frequently if events or circumstances indicate that the carrying value may not be recoverable, by applying a fair value-based test. In determining fair value, valuation models such as price-to-earnings ratios and other multiples are used. Management must make estimates and assumptions in determining the fair value of a reporting unit that may affect any resulting impairment write-down. This includes assumptions regarding fluctuations in future earnings from the reporting units. Management then compares the fair value of a reporting unit to the carrying amount. If the carrying amount of a reporting unit exceeds the fair value of that reporting unit, a second step of impairment is performed to compare the implied fair value of the reporting unit with the carrying amount. In connection with the annual impairment assessment performed as of December 31, 2011, all reporting units were tested. Based on the assessment, an impairment provision of $2.8 million has been recorded against the goodwill of the Company related to the Itasca acquisition described in the "Acquisitions, Discontinued Operations and Dispositions" section in Item 1 of this 2011 Annual Report. The Company concluded that the carrying amount of goodwill related to the Itasca acquisition exceeded its fair value and, therefore, was not recoverable. The determination that the fair value of the goodwill was less than its carrying value resulted primarily from a decline in the quoted value of Kingsway's common stock as compared to the book value per share of the Company at December 31, 2011. Additional information regarding our goodwill and intangible assets accounting is included in Note 10, "Goodwill and Intangible Assets," to the Consolidated Financial Statements.
Deferred policy acquisition costs represent the deferral of expenses that we incur acquiring new business or renewing existing business. Policy acquisition costs, primarily commissions, advertising, premium taxes and underwriting and agency expenses related to issuing policies, are deferred and charged against income ratably over the terms of the related policies. Management regularly reviews the categories of acquisition costs that are deferred and assesses the recoverability of this asset. A premium deficiency and a corresponding charge to income is recognized if the sum of the expected losses and loss adjustment expenses, unamortized acquisition costs and maintenance costs exceeds related unearned premiums and anticipated net investment income.
Our LROC preferred units, senior unsecured debentures and subordinated debt are measured and reported at fair value. The fair value of the LROC preferred units is based on quoted market prices, and the fair value of the subordinated debt is estimated using an internal model based on significant market observable inputs. The fair values of senior unsecured debentures, for which no active market exists, are derived from quoted market prices of similar instruments or other third-party evidence. Any change in the estimated fair value of our debt is reflected in the gain or loss on the change in fair value of debt we record in the consolidated statements of operations and in the carrying value for our debt on our consolidated balance sheets.
Loss from Continuing Operations, Net Loss and Diluted Loss Per Share
In 2011, we incurred a loss from continuing operations of $26.1 million ($0.50 per diluted share) compared to a loss of $184.5 million ($3.54 per diluted share) in 2010. The loss from continuing operations in 2011 is attributable to operating losses in Insurance Underwriting and corporate general expenses, partially offset by the gain on the change in fair value of debt. The loss in 2010 is largely due to Insurance Underwriting operating loss, unrealized loss on fair value of debt and corporate general expenses. In 2010, these factors have been partially offset by net realized gains on investments and the buy-back of the Company's debt which resulted in a gain and lowered interest expense. The Company also recorded a gain on the consolidation of debt in 2010.
In 2011, we incurred a net loss of $27.4 million compared to $161.6 million in 2010. The diluted loss per share was $0.52 for 2011 compared to a diluted loss per share of $3.10 for 2010.
For the year ended December 31, 2011, Insurance Underwriting gross premiums written were $138.4 million compared to $211.6 million for the year ended December 31, 2010, representing a 34.6% decrease. Net premiums written decreased 37.0% to $126.9 million for the year ended December 31, 2011 compared with $201.3 million for the year ended December 31, 2010. Net premiums earned decreased 28.9% to $156.4 million for the year ended December 31, 2011 compared with $220.0 million for the year ended December 31, 2010.
it continues to actively produce business and discontinued unprofitable programs and unaffiliated managing general agent relationships. Also contributing to the reduction in non-standard automobile premium is the continuing poor economic conditions in much of the United States. The non-standard automobile insurance market tends to contract during periods of high unemployment as was experienced in the United States throughout 2011.
The Insurance Underwriting operating loss decreased to $37.1 million for the year ended December 31, 2011 compared with $60.3 million for the year ended December 31, 2010. The decrease is primarily attributed to a decrease in loss and loss adjustment expenses, as reflected in the loss ratio, against a smaller volume of net premiums earned.
The Insurance Underwriting loss ratio for 2011 was 91.5% compared to 97.3% for 2010 due to decreasing ultimate loss estimates for current and prior accident years. This improvement was primarily driven by two factors. First, unfavorable development of $7.9 million recorded during 2011 in the provision for unpaid loss and loss adjustment expenses for losses incurred as of December 31, 2010 was less than the unfavorable development of $14.4 million recorded during 2010 for losses incurred as of December 31, 2009. Second, the increased premium rate adequacy which Insurance Underwriting implemented throughout 2011 is having a positive influence on the loss ratio for losses incurred during 2011.
The Insurance Underwriting expense ratio was 38.1% in 2011 and 36.3% in 2010. This deterioration is a derivative effect of the 28.9% decrease in net premiums earned cited above which has made it more difficult for Insurance Underwriting to cover its fixed overhead expenses. In response to the shrinkage in its volume of business, Insurance Underwriting has been reducing its fixed overhead expenses.
The Insurance Underwriting combined ratio was 129.6% in 2011 compared with 133.6% in 2010, reflecting the dynamics which affected the loss and expense ratios.
The Insurance Services operating income increased to $1.7 million for the year ended December 31, 2011 compared with an operating loss of $15.9 million for the year ended December 31, 2010. This improvement reflects, in part, the inclusion of ARS for the full year of 2011, as noted above. Also, 2010 operating income was adversely affected by several one-time charges, including $4.5 million to adjust the Insurance Services deferred revenue liability, $3.7 million to charge off receivables deemed uncollectible at NEA, and $1.5 million to terminate a legacy contract at NEA related to its policy and claim administration system.
Net investment income decreased to $4.1 million in 2011 compared to $12.8 million in 2010. The decrease is a result of several factors. First, the Company's total investments, cash and cash equivalents have declined approximately 40% since December 31, 2009 as a result of reduced volumes of business and acceleration of claim payments in Insurance Underwriting as well as corporate debt buy-backs and other corporate initiatives. Second, the percentage of the Company's total investments, cash and cash equivalents which is comprised of cash and cash equivalents, which carry lower investment yields, has increased from approximately 15% to approximately 42% since December 31, 2009 as a result of the sales of investments to realize gains and an intention to maintain higher liquidity given the planned shrinkage of business in Insurance Underwriting and other corporate needs. Third, yields on fixed maturities remain at historically low levels such that reinvestment of maturing investments occurs at yields lower than the yields on the maturing investments.
The Company incurred net realized gains in 2011 of $1.1 million compared to $9.3 million in 2010. The net realized gains in each year primarily resulted from the liquidation of fixed maturities in Insurance Underwriting. Most of the material unrealized gains in the fixed income portfolios were realized in 2010. Because of the relatively flat interest rate environment throughout 2011, few additional material unrealized gains developed in the fixed income portfolios, leaving far less to realize when fixed maturities were liquidated during the third and fourth quarters of 2011. There were no impairments recorded during 2011 and 2010 for other-than-temporarily impaired investments.
The gain on change in fair value of debt amounted to $25.9 million in 2011 compared to a loss of $107.3 million in 2010. The 2010 loss reflects an increase in the fair values, primarily during the first two quarters of 2010, applicable to the larger debt balances outstanding prior to significant debt buy-backs that occurred later in 2010. The 2011gain reflects a decrease in fair values primarily during the second and third quarters of 2011, of the Company's outstanding debt.
Interest expense for 2011 was $7.5 million compared to $14.8 million in 2010. The decrease is due to the repurchase of debt during 2011 and 2010. Refer to "Gain on Buy-Back of Debt" discussion below.
Amortization expense for 2011 was $0.1 million compared to $4.4 million in 2010. The decrease was primarily related to the Company's decision to reclassify certain intangible assets which had been subject to amortization to be treated as intangible assets with indefinite useful lives not subject to amortization. See Note 10, "Goodwill and Intangible Assets" to the Consolidated Financial Statements for further details.
During 2011, Kingsway 2007 General Partnership purchased and canceled $11.4 million par value of its senior unsecured debentures with a carrying value of $11.3 million for $10.7 million, recording a gain of $0.6 million. During 2010, KAI and Kingsway 2007 General Partnership purchased and canceled $143.3 million par value of its senior unsecured debentures with a carrying value of $127.2 million for $124.1 million, recording a gain of $3.1 million.
Income tax benefit on continuing operations for 2011 was $0.2 million compared to $6.1 million in 2010. The decrease in income tax benefit is primarily attributable to the establishment, in 2011, of a $2.7 million deferred tax liability related to indefinite life intangible assets and a $1.3 million lower income tax benefit recorded in 2011 than in 2010 related to the Company's Canadian operations. See Note 15, "Income Taxes" to the Consolidated Financial Statements for further details.
All of our investments are classified as available-for-sale and are reported at fair value. At December 31, 2011, we held cash and cash equivalents and investments with a fair value of $202.9 million. As of December 31, 2011, we held an investments portfolio comprised primarily of fixed maturities issued by the U.S. Government, government agencies and high quality corporate issuers. Investments held by our insurance subsidiaries must comply with applicable domiciliary state regulations that prescribe the type, quality and concentration of investments. Our U.S. operations typically invest in U.S. dollar-denominated instruments to mitigate
TABLE 2 Fair value of investments, including cash and cash equivalents
Table 3 below summarizes the fair value by contractual maturities of the fixed maturities portfolio, excluding cash and cash equivalents at December 31, 2011 and 2010.
TABLE 3 Fair value of fixed maturities by contractual maturity date
At December 31, 2011, 84.8% of fixed maturities, including treasury bills, government bonds and corporate bonds, had contractual maturities of five years or less. Actual maturities may differ from contractual maturities because certain issuers have the right to call or prepay obligations with or without call or prepayment penalties. The Company holds cash and high-grade short-term assets which, along with fixed maturities, management believes are sufficient in amount for the payment of unpaid loss and loss adjustment expenses and other corporate obligations on a timely basis. In the event that additional cash is required to meet obligations to our policyholders, we believe that the high quality, liquid investments in the portfolios provide us with sufficient liquidity.
Because the investments portfolio is comprised of primarily fixed maturity instruments that are usually held to maturity, periodic changes in interest rate levels generally impact our financial results to the extent that the investments are recorded at market value and reinvestment yields are different than the original yields on maturing instruments. During periods of rising interest rates, the market value of the existing fixed maturities will generally decrease and realized gains on fixed maturities will likely be reduced. The reverse is true during periods of declining interest rates.
At December 31, 2011, the gross unrealized losses amounted to $0.2 million, and there were no unrealized losses attributable to non-investment grade fixed maturities.
At each of December 31, 2011 and December 31, 2010, all unrealized losses on individual investments were considered temporary. Fixed maturities in unrealized loss positions continued to pay interest and were not subject to material changes in their respective debt ratings. We concluded that default risk did not exist at the time and, therefore, the declines in value were considered temporary. As we have the capacity to hold these investments to maturity, no impairment provision was considered necessary.
Tables 5 and 6 include a segmentation of the provision for unpaid loss and loss adjustment expenses on gross and net of external reinsurance bases by line of business.
TABLE 5 Provision for unpaid loss and loss adjustment expenses - gross
At December 31, 2011 and 2010, the gross provisions for unpaid loss and loss adjustment expenses for our non-standard automobile business were $93.5 million and $140.1 million, respectively. The decrease is due to the reduction in the volume of non-standard automobile premium written and an acceleration of claim payments, partially offset by unfavorable development described below.
Information with respect to development of our provision for prior years' unpaid loss and loss adjustment expenses is presented in Table 7.
For the year ended December 31, 2011 (in millions of dollars)
The net movements in prior years' provisions for unpaid loss and loss adjustment expenses, net of reinsurance, for the years ended December 31, 2011 and 2010 were increases of $7.9 million and $14.4 million, respectively. Table 7 identifies the relative contribution of the increases / (decreases) in the provisions for unpaid loss and loss adjustment expenses attributable to the respective lines of business and accident years.
During 2011, the net cash provided by investing activities as reported on the consolidated statements of cash flows was $29.0 million. This source of cash was driven by proceeds from sales and maturities of fixed maturities in excess of purchases of fixed maturities. As previously explained, the Company's insurance subsidiaries hold investments portfolios comprised primarily of fixed maturities issued by the U.S. Government, government agencies and high quality corporate issuers which are of generally short duration and are highly liquid which enables the insurance subsidiaries to meet their liquidity needs.
During 2011, the net cash used in financing activities as reported on the consolidated statements of cash flows was $7.9 million. This use of cash is explained by the Company's repurchase of senior unsecured debentures for $10.7 million. See Note 13, "Debt" to the Consolidated Financial Statements for further details. See also Table 8 below for a schedule of remaining debt maturities by period.
The Company's insurance subsidiaries fund their obligations primarily through premium and investment income and maturities in the investments portfolio. As a holding company, Kingsway derives cash from its subsidiaries generally in the form of dividends and management fees to meet its obligations, which primarily consist of interest payments on debt as well as holding company operating expenses. The operating insurance subsidiaries require regulatory approval for the return of capital and, in certain circumstances, prior to the payment of dividends. At December 31, 2011, the insurance subsidiaries of the Company were restricted
from making any dividend payments without regulatory approval pursuant to the domiciliary state insurance regulations. In the event that dividends and management fees available to the Company are inadequate to service its obligations, the Company would need to raise capital, sell assets or restructure its debt obligations. The Company believes that it has the flexibility to obtain the funds needed to meet its obligations and satisfy regulatory capital requirements.
Beginning in 2009, KFS Capital began purchasing LROC preferred units. On June 9, 2010, KFS Capital commenced the take-over bid ("the KLROC Offer") to acquire up to 750,000 LROC preferred units at a price per unit of C$17.50 in cash. On July 9, 2010, KFS Capital increased the size and price of its previously announced KLROC Offer to 1,500,000 units at a price per unit of C$20.00 in cash. The KLROC Offer expired on Friday, July 23, 2010, and 1,525,150 units were tendered, of which 1,500,000 were purchased on a pro-rata basis. The tender was paid for using available cash. As a result of these acquisitions, the Company beneficially owns and controls 2,333,715 units, representing 74.8% of the issued and outstanding units. This repurchase resulted in a realized gain of $17.8 million during 2010.
In the United States, a risk based capital (“RBC”) formula is used by the National Association of Insurance Commissioners (“NAIC”) to identify property and casualty insurance companies that may not be adequately capitalized. The NAIC requires that capital and surplus not fall below 200% of the authorized control level. Most states, including the domiciliary states of our insurance subsidiaries, have adopted the NAIC RBC requirements. Insurers not meeting the RBC requirements are subject to varying levels of regulatory action, including discontinuation of operations. As of December 31, 2011, surplus as regards policyholders of all our insurance subsidiaries exceeded the minimum required RBC levels.
In May 2009, the Company placed all of Lincoln General Insurance Company ("Lincoln General") into voluntary run-off, and subsequently on October 19, 2009, with the objective of protecting the interests of the Company's stakeholders, KAI disposed of its entire interest in its wholly owned subsidiary, Walshire Assurance Company ("Walshire"). Walshire was the sole shareholder
of Lincoln General. All of the stock of Walshire was donated to charities, and with this disposition Lincoln General ceased being a member of the Kingsway group of companies. The disposition led to litigation with the Pennsylvania Insurance Department ("DOI"), as discussed in the 2010 Annual Report. On October 17, 2011, Kingsway reached a settlement and release ending all legal disputes with the DOI. At closing, Kingsway also obtained releases from Walshire, Lincoln General, and the charities.
Between December 4, 2002 and December 16, 2003, six subsidiary trusts of the Company issued $90.5 million of 30-year capital securities to third-parties in separate private transactions. In each instance, a corresponding floating rate junior subordinated deferrable interest debenture was then issued by KAI to the trust in exchange for the proceeds from the private sale. The floating rate debentures bear interest at the rate of the London interbank offered interest rate for three-month U.S. dollar deposits ("LIBOR"), plus spreads ranging from 3.85% to 4.20%, but until dates ranging from December 4, 2007 to January 8, 2009, the interest rates will not exceed 12.45% to 12.75%. The Company has the right to call each of these securities at par value any time after five years from their issuance until their maturity. During the first quarter of 2011, the Company gave notice to its trustees of its intention to exercise its voluntary right to defer interest payments for up to 20 quarters, pursuant to the contractual terms of its outstanding indentures, which permit interest deferral. This action does not constitute a default under the Company's indentures or any of its other debt indentures. At December 31, 2011, deferred interest payable of $3.8 million is included in accrued expenses
and other liabilities in the consolidated balance sheets. The cash interest due in 2016 at the end of the 20-quarter deferral period is subject to changes in LIBOR over the deferral period.
Table 8 summarizes certain payments projected by period, including debt maturities, future minimum payments under operating leases and the provision for unpaid loss and loss adjustment expenses. Our provision for unpaid loss and loss adjustment expenses does not have contractual payment dates. In Table 8 below, we have included a projection of when we expect our unpaid loss and loss adjustment expenses to be paid, based on historical payment patterns. The exact timing of the payment of unpaid loss and loss adjustment expenses cannot be predicted with certainty. We maintain an investments portfolio with varying maturities and a substantial amount in short-term investments to provide adequate cash flows for the projected payments in Table 8. The unpaid loss and loss adjustment expenses in Table 8 have not been reduced by amounts recoverable from reinsurers.
Prior to July 23, 2010, the Company entered into an off-balance sheet transaction through the KLROC Trust transaction which is more fully described in Note 4, "Acquisitions" and Note 13, "Debt" to the Consolidated Financial Statements. As of December 31, 2011 and 2010, the Company does not engage in any off-balance sheet financing arrangements.
Consolidated Statements of Operations for the Years Ended December 31, 2011 and 2010
Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 2011 and 2010
Consolidated Statements of Cash Flows for the Years Ended December 31, 2011 and 2010
We have audited the accompanying consolidated balance sheets of Kingsway Financial Services Inc. as of December 31, 2011 and 2010, and the related consolidated statements of operations, shareholders’ equity, comprehensive loss and cash flows for the years then ended. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedules listed in the accompanying index. These consolidated financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits.
We conducted our audits 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 consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements and schedules. We believe that our audits provide a reasonable basis for our opinion.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Kingsway Financial Services Inc.'s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 30, 2012 expressed an unqualified opinion thereon.
As discussed in Note 2 to the consolidated financial statements, the Company was required to change its accounting framework from Canadian Generally Accepted Accounting Principles to accounting principles generally accepted in the United States of America (U.S. GAAP). The comparative figures in respect of 2010 were restated to reflect the adoption of U.S. GAAP.
We have audited Kingsway Financial Services Inc.'s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Kingsway Financial Services Inc.'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, included in the accompanying “Item 9A, Management's Report on Internal Control Over Financial Reporting”. Our responsibility is to express an opinion on the company's internal control over financial reporting based on our audit.
Kingsway Financial Services Inc. (the "Company" or "Kingsway") was incorporated under the Business Corporations Act (Ontario) on September 19, 1989. Kingsway is a holding company and is engaged, through its subsidiaries, in the property and casualty insurance business.
The accompanying information in the 2011 Annual Report has been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"). The Company previously presented its consolidated financial statements for the year ended December 31, 2010 in accordance with Canadian Generally Accepted Accounting Principles ("Canadian GAAP"). The comparative figures in respect of 2010 were restated to reflect the adoption of U.S. GAAP.
Other investments include mortgage loans and are reported at their unpaid principal balance. Short-term investments, which consist of investments with original maturities between three months and one year, are reported at cost which approximates fair value.
The Company accounts for all financial instruments using trade date accounting.
The Company defers commissions, premium taxes, and other underwriting and marketing costs that vary with and are directly related to the acquisition of premiums written to the extent they are considered recoverable. These costs are then expensed as the related premiums are earned. The method followed in determining the deferred policy acquisition costs limits the deferral to its realizable value by giving consideration to estimated future loss and loss adjustment expenses to be incurred as premiums are earned. Changes in estimates, if any, are recorded in the accounting period in which they are determined. Anticipated investment
The Company and its non-U.S. subsidiaries file separate foreign income tax returns. Kingsway America II Inc. and its eligible U.S. subsidiaries file a U.S. consolidated federal income tax return (KAI Tax Group). The method of allocating federal income taxes among the companies in the KAI Tax Group is subject to written agreement, approved by each company's Board of Directors. The allocation is made primarily on a separate return basis, with current credit for any net operating losses or other items utilized in the consolidated federal income tax return. The Company's U.S. subsidiaries which are not included in the KAI Tax Group file separate federal income tax returns.
The Company follows the asset and liability method of accounting for income taxes, whereby deferred income tax assets and liabilities are recognized for (i) the differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases and (ii) loss and tax credit carryforwards. Deferred income tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the date of enactment. Future tax benefits are recognized to the extent that realization of such benefits is more likely than not and a valuation allowance is established for any portion of a deferred tax asset that management believes will not be realized. Current federal income taxes are charged or credited to operations based upon amounts estimated to be payable or recoverable as a result of taxable operations for the current year.
Goodwill is tested at least annually for impairment to ensure that it's fair value is greater than or equal to the carrying value. Any excess of carrying value over fair value is charged to the consolidated statements of operations in the period in which the impairment is determined.
When the Company acquires a subsidiary or other business where it exerts significant influence or acquires certain assets, intangible assets may be acquired, which are recorded at their fair value at the time of the acquisition. An intangible asset with a definite useful life is amortized to income over its defined useful life. The Company writes down the value of an intangible asset with a definite useful life when the undiscounted cash flows are not expected to allow for full recovery of the carrying value.
Intangible assets with indefinite useful lives are not subject to amortization and are tested at least annually for impairment to ensure that fair values are greater than or equal to carrying values. Any excess of carrying value over fair value is charged to the consolidated statements of operations in the period in which the impairment is determined.
The Company's LROC preferred units, senior unsecured debentures and subordinated debt are measured and reported at fair value. The fair value of the LROC preferred units is based on quoted market prices, and the fair value of the subordinated debt is estimated using an internal model based on significant market observable inputs. The fair values of senior unsecured debentures, for which no active market exists, are derived from quoted market prices of similar instruments or other third-party evidence. Changes in fair value are reported in the consolidated statements of operations as gain (loss) on change in fair value of debt.
Service charges on installment premiums are recognized as income upon receipt of related installment payments and are reflected in other income. Revenue from policy service fees is deferred and recognized over the terms of the respective policy contracts, with revenue reflected in other income.
Service fee and commission income represents policy and claim service fee income based on terms of various agreements with insurance partners and state agencies. These policy and claim service fees are earned over the period of the administration of the related policies and claims. This earning pattern is based on actuarial data and historical experience. The assumptions and methodologies used are continually reviewed and any adjustments are reflected in the consolidated statements of operations in the period in which the adjustments are made.
In September 2011, the FASB issued ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment. The standard is effective for the first interim or annual period beginning on or after December 15, 2011, with early adoption permitted. The standard amends Accounting Standards Codification Topic 350, Intangibles-Goodwill and Other, and gives companies the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Except for the option to perform the qualitative assessment, the Company does not anticipate that the adoption of the new standard will have a material impact on the Company.
recognized related to retention of buyout customers and contract renewals. Subsequent to the acquisition, JBA was renamed Assigned Risk Solutions Ltd. ("ARS"). Refer to Note 10, "Goodwill and Intangible Assets" for further disclosure on intangible assets related to this acquisition.
KN Trust lent funds to Kingsway ROC GP ("ROC GP") and combined with its partnership capital of C$8.3 million, ROC GP subscribed for common shares in Kingsway ROC LLC ("ROC LLC") totaling C$82.1 million. With these proceeds, ROC LLC purchased a promissory note from KAI, with the principal amount of $66.2 million bearing interest at 7.37% per annum and due June 30, 2015.
As a result of the disposition, the Company recognized an after-tax gain of $0.6 million in 2011 and an after tax loss of $0.9 in 2010. The Company's revenues from discontinued operations relating to Atlas companies were zero and $53.9 million for December 31, 2011 and December 31, 2010, respectively. In total, the Company reported income from discontinued operations, net of taxes, related to American Country, American Service and Southern United of $0.6 million and a loss of $19.1 million for the years ended December 31, 2011 and December 31, 2010, respectively.
On October 19, 2009, with the objective of protecting the interests of the Company's stakeholders, KAI disposed of its entire interest in its wholly owned subsidiary, Walshire. Walshire is the sole shareholder of Lincoln General. All of the stock of Walshire was donated to charities, and, with this disposition, Lincoln General ceased to be a member of the Kingsway group of companies.
On October 30, 2009, the Company completed its previously announced sale of Zephyr, a specialty property insurance company founded specifically to protect Hawaii homeowners and residents from catastrophic loss due to hurricanes, for $31.5 million plus a settlement of pre-closing earnings and other post-closing adjustments of $5.5 million.
As a result of the disposal, the Company recognized an after-tax gain of $0.9 million in 2010. In total, the Company reported income from discontinued operations relating to Zephyr, net of taxes, of zero and $0.9 million in 2011 and 2010, respectively.
On October 9, 2009, specific assets of Avalon were sold for $1.5 million pursuant to an Asset Purchase agreement with FMG Specialty Insurance Agency LLC.
On January 25, 2010, the Company entered into a definitive purchase agreement with The Westaim Corporation (“Westaim”) to sell all of the issued and outstanding shares of Jevco to Westaim. On March 29, 2010, after receipt of all required regulatory approvals, the sale was completed for a purchase price of C$263.3 million subject to certain future contingent adjustments. The contingent adjustments included up to a C$20.0 million decrease in the purchase price relating to specific future adverse development in Jevco's provision for unpaid loss and loss adjustment expenses at the end of 2012. On March 31, 2011, the Company settled the C$20.0 million contingent adjustments related to the Jevco transactions for C$17.8 million, recording a pre-tax loss of $2.3 million. As a result of the disposal of Jevco, the Company realized an after-tax loss of $1.9 million and an after-tax gain of $30.4 million for the years ended December 31, 2011 and 2010, respectively. Included in the 2010 gain is a $34.1 million foreign currency exchange gain previously recorded in accumulated other comprehensive income and now recognized as a result of the disposal of Jevco.
The Company's revenues from discontinued operations relating to Jevco were zero and $84.9 million in 2011 and 2010, respectively. In total, the Company reported a loss from discontinued operations relating to Jevco, net of taxes, of $1.9 million and a gain of $41.4 million, net of taxes, for the years ended December 31, 2011 and 2010, respectively.
On March 30, 2011, KAI sold all of the issued and outstanding shares of its wholly owned subsidiary Hamilton and its subsidiaries, including Amigo, to HRM Acquisition Corp., a wholly owned subsidiary of Acadia, in exchange for a $10.0 million senior promissory note due March 30, 2014, a $5.0 million junior promissory note due March 30, 2016 and a Class B partnership interest in Acadia representing a 40% economic interest. A third-party and members of the Hamilton management team hold Class A partnership interests in Acadia representing a 60% economic interest. KAI acts as the general partner of Acadia. As general partner, KAI has control of the policies and financial affairs of Hamilton; therefore, Kingsway will continue to consolidate the financial statements of Hamilton. During the second quarter of 2011, HRM Acquisition Corp. merged into Hamilton. As a result
The amortized cost, gross unrealized gains and losses, and estimated fair value of the Company's investments at December 31, 2011 and December 31, 2010 are summarized in the tables shown below:
The table below summarizes the Company's fixed maturities at December 31, 2011, by contractual maturity periods. Actual results may differ as issuers may have the right to call or prepay obligations, with or without penalties, prior to the contractual maturity of these obligations.
Gross realized gains and losses on fixed maturities, equity instruments and short-term investments for the years ended December 31, 2011 and 2010 were as follows:
The following tables highlight the aggregate unrealized loss position, by investment type, of fixed maturities, equity investments and short-term investments in unrealized loss positions as of December 31, 2011 and December 31, 2010. The tables segregate the holdings based on the period of time the investments have been continuously held in unrealized loss positions.
Fixed maturities, equity instruments and short-term investments contain approximately 22 and 19 individual investments that were in unrealized loss positions as of December 31, 2011 and 2010, respectively.
As a result of the above analysis performed by the Company to determine declines in market value that are other-than-temporary, there were no write-downs related to fixed maturities and equity investments for other-than-temporary impairments for the years ended December 31, 2011 and 2010.
Net investment income for the years ended December 31, 2011 and 2010, respectively, is comprised as follows:
Investment in investees includes investments in the preferred and restricted voting common stock of Atlas as well as the member's capital of each of Oak Street Real Estate Capital GP II, LLC ("Oak Street") and LGIC Holdings, LLC ("LGIC Holdings"). Investment in investees is accounted for under the equity method. Investment in Atlas is recorded on a three-month lag basis. The carrying value, fair value and approximate voting and equity percentages at December 31, 2011 and December 31, 2010 were as follows:
The fair value of the Company's investment in Atlas at December 31, 2011 in the table above is calculated based on the published closing price of Atlas at September 30, 2011 to be consistent with the three-month lag in reporting its carrying value under the equity method. The fair value of the Company's investment in Atlas based on the published closing price of Atlas at December 31, 2011 is $39.1million. The Company's investment in Atlas at December 31, 2010 approximates carrying value due to the investee not being actively traded at December 31, 2010. During 2011, the Company performed an impairment review of its investment in Atlas, which considered the current valuation and operating results of Atlas. Based upon this review, the Company concluded the decline in fair value of its investment in Atlas is other than temporary and is not impaired.
The fair value of the Company's investment in Oak Street at December 31, 2011 approximates carrying value due to the investee not being actively traded at December 31, 2011.
During 2011, the Company acquired a 49.0% equity investment in LGIC Holdings. During 2011, the Company performed an impairment review of its investment in LGIC Holdings, which considered the current valuation and operating results of LGIC Holdings. Based upon this review, the Company recorded an impairment charge of $0.2 million during the fourth quarter of 2011.
Summarized financial information for Atlas at September 30, 2011 and December 31, 2010 is presented below:
The Company's reinsurance includes excess of loss reinsurance to reduce its exposure to loss related to events which may affect only one of our policyholders as well as catastrophic events which may simultaneously affect many of our policyholders. We also purchase quota-share reinsurance to increase our capacity to underwrite additional insurance risks.
The Company's reinsurance limits net exposure to a maximum amount on any one loss of $0.5 million with respect to commercial automobile liability claims. For most of the personal non-standard automobile business, the liability is limited to the minimum statutory liability limits, which are typically not greater than $50,000 per occurrence, depending on the state. The Company's reinsurance protects against awards in excess of our policy limits above a retention of $2.0 million. Catastrophe reinsurance provides $5.5 million coverage in excess of a $0.5 million retention for certain books of business. One of the Company's insurance subsidiaries also entered into a quota-share reinsurance arrangement during the fourth quarter of 2011 under which it cedes 25% of certain portions of its book of business to a third-party reinsurer.
Ceded premiums, loss and loss adjustments expenses, and commissions as of and for the years ended December 31, 2011 and 2010 are summarized as follows:
Policy acquisition costs, consisting primarily of commissions, premium taxes and other underwriting and marketing costs, are deferred and expensed as the related premiums are earned. The components of deferred policy acquisition costs and the related amortization expense were as follows:
The Company tested goodwill associated with each of its reporting units for recoverability at December 31, 2011.
The Company's intangible assets with indefinite useful lives are not amortized. The Company's intangible assets with definite useful lives are amortized over their estimated useful lives. Accumulated amortization for these intangibles as of December 31, 2011 and 2010 was $18.3 million and $18.2 million, respectively. As of December 31, 2011, the Company's intangible assets with definite useful lives are fully amortized.
All intangible assets are reviewed at least annually by the Company for impairment. No impairment charges were taken on intangible assets in 2011 or 2010.
During 2010, KAI contributed its building to American Service which was disposed of as part of the Atlas transaction.
Consequently, the process of determining the provision necessarily involves risks that the actual results will deviate, perhaps substantially, from the best estimates made.
The Company's evaluation of the adequacy of unpaid loss and loss adjustment expenses includes a re-estimation of the liability for unpaid loss and loss adjustment expenses relating to each preceding financial year compared to the liability that was previously established. The results of this comparison and the changes in the provision for unpaid loss and loss adjustment expenses, net of amounts recoverable from reinsurers, as of December 31, 2011 and December 31, 2010 were as follows:
The results for the year ended December 31, 2011, were adversely affected by the evaluation of unpaid loss and loss adjustment expenses related to prior years.
The Company reported unfavorable development on unpaid loss and loss adjustment expenses of $7.9 million in 2011 compared to an unfavorable development of $14.4 million in 2010. Non-standard automobile business contributed $6.0 million of the prior years' adverse development in 2011 compared to $15.2 million in 2010. Business other than non-standard automobile contributed $1.9 million of the prior years' adverse development in 2011 compared to favorable development of $0.8 million in 2010.
During 2011 and 2010, the Company repurchased zero and $73.5 million of par value, respectively, of this offering. The Company realized a gain on the repurchases of zero in 2011 and $0.3 million in 2010. As of December 31, 2011 and 2010, $27.0 million of par value of this issue remains outstanding.
Beginning in 2009, KFS Capital began purchasing LROC preferred units. On June 9, 2010, KFS Capital commenced the take-over bid (“the KLROC Offer”) to acquire up to 750,000 LROC preferred units at a price per unit of C$17.50 in cash. On July 9, 2010, KFS Capital increased the size and price of its previously announced KLROC Offer to 1,500,000 units at a price per unit of C$20.00 in cash. The KLROC Offer expired on Friday, July 23, 2010, and 1,525,150 units were tendered, of which 1,500,000 were purchased on a pro-rata basis. The tender was paid for using available cash.
As a result of these acquisitions, the Company beneficially owns and controls 2,333,715 units, representing 74.8% of the issued and outstanding LROC preferred units. The Company has determined that the consolidated financial statements of KLROC Trust should be consolidated with the financial statements of the Company beginning July 23, 2010. Refer to Note 4, "Acquisitions" to the consolidated financial statements for further discussion.
Income tax benefit varies from the amount that would result by applying the applicable Canadian income tax rate (28.25% for the year ending December 31, 2011 and 30.99% for the year ending December 31, 2010) to loss from continuing operations before income tax benefit. The following table summarizes the differences:
The income taxes recoverable of $8.1 million and $18.0 million at December 31, 2011 and December 31, 2010, respectively, primarily relate to tax receivables of the Company's Canadian operations.
The federal income tax returns of the Company's U.S. operations for the years through 2007 are closed for Internal Revenue Service ("IRS") examination. The Company's U.S. operations federal income tax returns are not currently under examination by the IRS for any open tax years. The Company's 2009 Canadian federal income tax return is currently under examination by the Canada Revenue Agency ("CRA"). No material audit adjustments have been proposed by the CRA. The federal income tax returns of the Company's Canadian operations for the years through 2005 are closed for CRA examination.
Net loss per share is based on the weighted-average number of shares outstanding. Diluted weighted-average shares is calculated by adjusting basic weighted average shares outstanding by all potentially dilutive stock options. Stock options outstanding of 1,591,500 and 1,768,000 as of December 31, 2011 and 2010, respectively, were not included in the computation of diluted loss per share because the exercise prices of the options was greater than the average market price of the common stock and thus the inclusion would have been anti-dilutive.
The Company has established a stock option incentive plan for key officers of the Company and its subsidiaries. Historically a stock option incentive plan was also available for directors. The director's plan was canceled during 2010. At December 31, 2011, the maximum number of common shares that may be issued under the plan was 4,800,000 common shares. The maximum number of common shares available for issuance to any one person under the stock option plan is 5% of the common shares outstanding at the time of the grant.
The Company determines the fair values of options granted using the Black-Scholes option pricing model. Fair value of options granted in January 2010 was C$1.55 and September 2010 was C$1.57.
The Black-Scholes option valuation model was developed for use in estimating fair value of traded options that have no vesting restrictions and are fully transferable. As the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in
The Company had an employee share purchase plan where qualifying employees could choose each year to have up to 5% of their annual base earnings withheld to purchase the Company's common shares. The Company matched one half of the employee contribution amount, and its contributions vested immediately. All contributions were used by the plan administrator to purchase common shares in the open market. The Company's contribution was expensed as paid and for the years ended December 31, 2011 and 2010 totaled zero and $0.1 million, respectively. This program was canceled effective June 30, 2010.
The total number of DSUs held, for the years ended December 31, 2011 and 2010 was zero. The program was terminated effective January 1, 2010, and all outstanding DSUs held were redeemed effective August 26, 2010. The Company made a lump sum cash payment (net of any applicable withholdings or deductions) equal to the number of DSUs credited to the director's account as of the filing date of the notice of redemption of the DSUs multiplied by the fair market value per share.
In February 2009, the Company announced a corporate restructuring plan to concentrate on its core lines of business and to improve the Company's financial stability. The Company consolidated operations in the United States and Canada, simplified the management structure, and reduced costs through synergies and operational efficiencies. As the Company exited businesses and streamlined operations, a significant number of employees were removed from the total workforce. The restructuring plan concluded in 2010.
Since all restructuring activities were completed in 2010, the provision balance was reduced to zero in 2011.
There were no dividends declared for the 2011 or 2010 year.
Accumulated other comprehensive income is a component of shareholders' equity on the consolidated balance sheets.
The Company's property and casualty insurance business operations are conducted primarily through the following subsidiaries: Mendota, Mendakota, UCC, Amigo, Kingsway Reinsurance Corporation and Kingsway Reinsurance (Bermuda) Ltd. (collectively,
"Insurance Underwriting"). Insurance Underwriting provides non-standard automobile and other types of property and casualty insurance to individuals and commercial automobile insurance to businesses and actively conducts business in 17 states.
Insurance Services includes the following subsidiaries of the Company: ARS, NEA and Advantage Auto, (collectively, "Insurance Services").
The operating loss of each segment is before income taxes and includes revenues and direct segment costs. Segment net loss for the years ended December 31, 2011 and 2010 were:
Net premiums earned by line of business for the years ended December 31, 2011 and 2010 were:
Fair value amounts represent estimates of the consideration that would currently be agreed upon between knowledgeable, willing parties who are under no compulsion to act. Fair value is best evidenced by quoted bid or ask price, as appropriate, in an active market. Where bid or ask prices are not available, such as in an illiquid or inactive market, the closing price of the most recent transaction of that instrument subject to appropriate adjustments as required is used. Where quoted market prices are not available, the quoted price of similar financial instruments or valuation models with observable market based inputs are used to estimate the fair value. These valuation models may use multiple observable market inputs, including observable interest rates, foreign exchange rates, index levels, credit spreads, equity prices, counterparty credit quality, corresponding market volatility levels and option
volatilities. Minimal management judgment is required for fair values calculated using quoted market prices or observable market inputs for models. Greater subjectivity is required when making valuation adjustments for financial instruments in inactive markets or when using models where observable parameters do not exist. Also, the calculation of estimated fair value is based on market conditions at a specific point in time and may not be reflective of future fair values. For the Company's financial instruments carried at cost or amortized cost, the book value is not adjusted to reflect increases or decreases in fair value due to market fluctuations, including those due to interest rate changes, as it is the Company's intention to hold them until there is a recovery of fair value, which may be to maturity.
Fair values of equity investments are considered to approximate quoted market values based on the latest bid prices in active markets. Fair value of fixed maturities for which no active market exists are derived from quoted market prices of similar instruments or other third-party evidence.
The Company employs a fair value hierarchy to categorize the inputs it uses in valuation techniques to measure the fair value. The extent of use of quoted market prices (Level 1), internal models using observable market information (Level 2) and internal models without observable market information (Level 3) in the valuation of the Company's financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2011 and December 31, 2010 was as follows:
On January 4, 2010, the Company and its subsidiary, KAI, acquired certain assets of Itasca, a property and casualty insurance industry advisory firm, owned and controlled by Mr. Larry G. Swets, Jr., a former director and the current Chief Executive Officer and President of the Company. As of the date of the transaction, Mr. Swets was not a director and did not hold any position within the Company. The consideration for the assets purchased was equal to $1.5 million cash and one million restricted common shares of the Company as described in the Note 4, "Acquisitions," to the consolidated financial statements.
In March 2010, the Company signed an agreement with American Physicians Assurance Corporation ("AP Assurance") to provide investment management and investment accounting services to the Company, commencing April 1, 2010. Two of the members of the Company's Board of Directors sat on the board of AP Assurance in March 2010, making it a related party.
In connection with its operations in the ordinary course of business, the Company and its subsidiaries are named as defendants in various actions for damages and costs allegedly sustained by the plaintiffs. While it is not possible to estimate the loss, or range of loss, if any, that may be incurred in connection with the various proceedings at this time, it is possible that some of the actions may result in a loss with a material adverse effect on its financial condition or results of operations.
Under SAP, deferred policy acquisition costs are expensed as they are incurred rather than capitalized and amortized over the expected life of the policy as required by U.S. GAAP.
Under SAP, the realizability of deferred tax assets is determined utilizing an admissibility test whereas under U.S. GAAP, the realizability of deferred tax assets is evaluated utilizing a "more likely than not" standard. A valuation allowance is established for deferred tax assets deemed not realizable using this standard. Under SAP, any gross deferred tax assets determined to be not realizable are non-admitted. Additionally, changes in the balances of deferred tax assets and liabilities result in increases or decreases in net income under U.S. GAAP, whereas under SAP, these changes are charged or credited directly to surplus.
In 2004, KAI issued $125.0 million 7.5% senior notes due in 2014 through a private offering. These notes are redeemable at KAI's option on or after February 1, 2009 and are fully and unconditionally guaranteed by the Company. On July 10, 2007, the Company through its newly formed, wholly-owned subsidiary Kingsway 2007 General Partnership ("K2007GP"), issued C$100.0 million 6% senior unsecured debentures with a maturity date of July 11, 2012, unconditionally guaranteed by Kingsway Financial Services Inc. ("KFSI") and KAI (each a "Guarantor"). The debentures will be redeemable, in whole or part, at the option of K2007GP and are not subject to repayment by the holders prior to maturity. Interest on the debentures is payable semi-annually in arrears in equal installments on January 10 and July 10 each year beginning January 10, 2008. The following tables show condensed consolidating financial information for the Company as of December 31, 2011 and 2010 and for the years ended December 31, 2011 and December 31, 2010, with a separate column for each Guarantor, the issuer and the other businesses of the Company combined ("Non-Guarantor subsidiaries").
On January 27, 2012, the Company announced that it is implementing an action to effect a reverse stock split of the Company's common stock. The action is intended to ensure that Kingsway remains in compliance with the New York Stock Exchange ("NYSE") continued listing standards. The action has been approved in principal by the Company's Board of Directors and remains subject to final Board action and shareholder approval. The Company has notified the NYSE of its intention to address through a reverse stock split its non-compliance with the NYSE continued listing requirement that the average closing price of a security not be lower than $1.00 per share over a consecutive 30 trading-day period, which is the minimum share price requirement. The Company's common stock continues to be listed on the NYSE and trades as usual subject to the NYSE's continued listing standards and monitoring. The Company plans to submit the reverse stock split for shareholder approval at its Annual Meeting of Shareholders to be held May 31, 2012.