We lease space in the office building which houses our principal place of business, located at 3333 Lee Parkway, Suite 1200, Dallas, Texas 75219. The property is in good condition and consists of approximately 52,000 square feet. Our Southeast region leases office space in Miami, Florida of approximately 28,100 square feet and our Southwest region leases office space in Phoenix, Arizona of approximately 4,800 square feet both of which are in good condition. We have no material real estate properties which we own.
The following selected financial data is derived from our audited financial statements for the years ended December 31, 2006, 2005, 2004, 2003 and 2002. You should read selected financial data together with the more detailed information contained in the Financial Statements and associated Notes and ITEM 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Form 10-K.
(2) Based on 24,924,825 shares of Common Stock outstanding at the end of 2006, 21,843,620 shares of Common Stock outstanding at the end of 2005 and 6,687,520 shares of Common Stock outstanding at the end of 2004, 2003 and 2002. Outstanding amounts have been adjusted to reflect the November 2006 and August 2005 rights offerings and the November 2005 reverse stock split. This assumes redemption occurring on all Series of Preferred Stock. See Note 11 of Notes to Consolidated Financial Statements.
The Company’s current vision is to grow the nonstandard personal auto business in target states to establish a broader and more geographically diversified earnings base. Significant growth at higher levels of operating leverage could enable the Company to materially increase its profitability, if it is able to achieve that growth with favorable profit margins, but it also has the potential to cause material and adverse effects on our financial condition and results if not profitably managed.
The Company limited its nonstandard personal auto insurance business to Florida until the fourth quarter of 2003, when it began writing policies in Texas. The Company began writing policies in Arizona and Nevada in 2004, in California, with an independent managing general agency, in 2005, and in South Carolina in 2006, and we are entering New Mexico in the first quarter of 2007. The Company markets its policies through 3,360 independent agency locations in Arizona, Florida, Nevada, New Mexico, South Carolina and Texas and one general agency in California that markets through approximately 1,200 independent agency locations. Beginning in 2005, significant growth has been realized as a result of these expansion activities, which has increased the operating leverage, the claims ratio and the overall financial and operational risk profile of the Company.
(1) C & CAE is an abbreviation for Claims and Claims Adjustment expenses, stated as a percentage of net premiums earned.
The discussion below primarily relates to the Company’s insurance operations, although the selected consolidated financial data appearing elsewhere is on a consolidated basis. The expense item “Underwriting and operating expenses” includes the operating expenses of the holding company, GAINSCO, INC. (“GAN”).
Each of the major regions achieved significant premium growth in 2006 and 2005. For 2006 the contribution to the premium increase by region is: Southeast 44%, South Central 41%, Southwest 16% and West (2)%. For 2005, the contribution to the premium increase by regions was: Southeast 49%, South Central 21%, Southwest 16% and West 14%. Net premiums earned increased 109% in 2006 and 118% in 2005 primarily as a result of the growth in gross premiums written. Beginning in the fourth quarter of 2005, policy fees were recorded as premiums and recognized over the period of the policy; previously they were recorded in Agency revenues and recognized as written.
Net investment income increased $3,315,000 (90%) in 2006 primarily due to the 56% increase in investments and the increase in Bonds available for sale, which provide higher returns than Short-term investments. At December 31, 2006 Bonds available for sale comprised 57% of Investments versus 46% at December 31, 2005. The increase in investments was due to funds received from the issuance of the subordinated debentures (see “Capital Transactions - 2006 Subordinated Debentures”), the rights offering in 2006 (see “Capital Transactions - Rights Offering”) and positive cash flows from operations. Net investment income increased $1,360,000 (59%) in 2005 primarily due to the 24% increase in investments and the increase in Bonds available for sale, which provide higher returns than Short-term investments. At December 31, 2005 Bonds available for sale comprised 46% of Investments versus 20% at December 31, 2004. The increase in investments was due to funds received from the rights offering in 2005 and positive cash flows from operations.
The Company recorded net realized capital gains of $137,000, $73,000 and $1,910,000 in 2006, 2005 and 2004, respectively. Variability in the timing of net realized capital gains and losses should be expected.
Claims and claims adjustment expenses increased $75,199,000 in 2006 and increased $30,740,000 in 2005. The C & CAE ratio was 71.2% in 2006 versus 64.7% in 2005 and 65.9% in 2004. The increase in the ratio for 2006 was primarily due to higher estimated ultimate liabilities in the nonstandard personal auto line (which included a provision for extra-contractual obligations on known claims), offset by favorable development of $4,938,000 in estimated ultimate liabilities in the runoff lines. The decrease in the C & CAE ratio in 2005 was primarily related to favorable development in estimated ultimate liabilities of approximately $4,600,000 in the runoff lines. The C & CAE ratio for nonstandard personal auto was 73.8%, 69.8% and 66.8% for 2006, 2005 and 2004, respectively. The increase in this ratio from 2005 to 2006 was primarily due to higher estimated ultimate liabilities on business written in 2006. Generally, new business initially produces higher claim ratios than more seasoned in-force business; see ITEM 1A. Risk Factors. The higher C & CAE ratios occurred primarily in the Southeast and South Central regions. During 2006, the Company began implementing improved claim practices in each of the major regions’ claims departments in order to ultimately decrease the average time from when a claim occurs to when it is settled. The Company believes that, over the long term, timeliness in the settlement of claims is likely to produce the most favorable claim results for the Company. However, when this practice is initially implemented, it can cause an increase in the C & CAE and introduce greater uncertainty into the process of setting reserves. The increase in C & CAE ratio from 2004 to 2005 was primarily due to favorable development in estimated ultimate liabilities in 2004 which recurred at a lower level of magnitude in 2005 than in 2004 and to generally higher ratios on new business. With regard to environmental and product liability claims, the Company has an immaterial amount of exposure. The Company did not provide environmental impairment coverage and excluded pollution and asbestos related coverages in its policies. A portion of the Company’s remaining claims are related to construction defects. Inflation impacts the Company by causing higher claim settlements than may have originally been estimated. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results.
Policy acquisition costs include commission expense, change in deferred policy acquisition costs, premium taxes and regulatory fees and assessments. The increase in 2006 and 2005 is primarily due to the increase in premium writings. The ratio of Policy acquisition costs to Net premiums earned was 17%, 14% and 13% for 2006, 2005 and 2004, respectively. The increase in 2006 was primarily due to the Southeast region, which generally has a lower policy acquisition costs ratio than the other regions, comprising a smaller portion of the mix in 2006 than in 2005 as a result of significant growth in the South Central region.
In November 2005, a one-for-four reverse split of the Company’s Common Stock was approved by shareholders and became effective. Each four shares of the Company’s outstanding Common Stock, par value $0.10 per share were converted into one share of Common Stock, par value $0.10 per share.
As a result of the recapitalization in January 2005, the rights offering in August 2005, the one-for-four reverse split of Common Stock in November 2005 and the rights offering in November 2006, the number of shares of Common Stock outstanding increased from 6,687,520 as of December 31, 2004 to 21,843,620 shares as of December 31, 2005 (adjusted to reflect the transactions described below).
In August 2005, the Company completed a rights offering which raised approximately $14.6 million in net proceeds. Approximately 97% of the maximum shares of Common Stock available through the rights offering were exercised. There was no over-subscription privilege in connection with this offering.
In January 2006, the Company organized GAINSCO Capital Trust I, which issued $25 million of 30-year capital securities. The capital trust is not consolidated with the Company. The capital securities require quarterly payments of interest at a floating interest rate equal to the 3-month LIBOR (London interbank offered rate for U.S. dollar deposits) plus a margin of 3.85%. The capital securities will mature on March 31, 2036 and are redeemable at the Company’s option beginning after March 31, 2011, in whole or in part, at the liquidation amount of $1,000 per capital security. Taken together, the Company’s obligations provide a full, irrevocable and unconditional guarantee of payments of distributions and other amounts due on the capital securities, subject to the subordination provisions of the agreements.
The net proceeds of the offering were used by GAINSCO Capital Trust I to acquire subordinated debentures of the Company that have the same maturity and bear interest at the same rate as the capital securities. The Company acquired 100% of the common securities of GAINSCO Capital Trust I. The Company used the proceeds to (i) redeem its outstanding Series A Preferred Stock held by GMSP, (ii) to provide $5 million of capital to its insurance companies and the balance will be used for general corporate purposes.
The net proceeds of the offering were used by GAINSCO Statutory Trust II to acquire debt securities of the Company that have the same maturity and bear interest at the same rate as the capital securities. The Company acquired 100% of the common securities of GAINSCO Statutory Trust II. The Company, in turn, used the proceeds for general corporate purposes.
GAN provides administrative and financial services for its wholly owned subsidiaries. GAN needs cash during 2007 primarily for administrative expenses and interest on the Subordinated debentures and the Note payable. GAN raised approximately $17.4 in net proceeds as a result of its issuance of $18 million in Subordinated debentures in December 2006, which it intends to use for general corporate purposes. Another source of cash to meet obligations is statutorily permitted dividend payments from its insurance subsidiary, General Agents, an Oklahoma corporation. Statutes in Oklahoma restrict the payment of dividends by the insurance company to the available surplus funds. The maximum amount of cash dividends that General Agents may declare without regulatory approval in any 12-month period is the greater of net income for the 12-month period ended the previous December 31 or ten percent (10%) of policyholders’ surplus as of the previous December 31. For 2007, the maximum amount of cash dividends that General Agents may pay without regulatory approval is approximately $9,559,000. In addition, we have a credit arrangement with a commercial bank which can be used to provide for holding company funds. GAN believes its cash and short-term investments should be sufficient to meet its expected obligations for 2007.
As a result of losses in prior years, as of December 31, 2006 the Company has net operating loss carryforwards for tax purposes aggregating $61,721,000. These net operating loss carryforwards of $13,451,000, $33,950,000, $13,687,000 and $633,000, if not utilized, will expire in 2020, 2021, 2022 and 2023, respectively. The tax benefit of the net operating loss carryforwards is $20,985,000, which is calculated by applying the Federal statutory income tax rate of 34% against the net operating loss carryforwards of $61,721,000. The Company currently has a partial valuation allowance for its net operating loss carryforwards of $15,516,000 based on management’s analysis of available evidence, both objective and subjective.
In certain circumstances, Section 382 of the Internal Revenue Code may apply to materially limit the amount of the Company’s taxable income that may be offset in a tax year by the Company’s net operating losses carried forward from prior years (the “§ 382 Limitation”). The annual § 382 Limitation generally is an amount equal to the value of the Company (immediately before an “ownership change”) multiplied by the long-term tax-exempt rate for the month in which the change occurs (e.g., 4.22% if the ownership change occurred in December 2006). This annual limitation would apply to all years to which the net operating losses can be carried forward.
In general, a 5% shareholder is a person who directly or indirectly owns 5% or more of the total value of the instruments that constitute stock for Section 382 purposes. The term 5% shareholder also refers to a group of shareholders that individually own less than 5% of the total value of the outstanding stock and are referred to as a “public group.” If a 5% shareholder is an entity (i.e., a corporation, partnership or trust), then the corporation who has the NOL carryforward (referred to as a “loss corporation”) is required to look through the entity (and through any higher-tier entity) in order to determine which owners of the entity are indirectly 5% shareholders. It is the ownership of these ultimate 5% shareholders, including public groups, that is considered when determining whether a greater than 50 percentage point increase has occurred.
On September 30, 2005, the Company entered into a credit agreement with a commercial bank providing for term loans of up to $10 million in the aggregate. Proceeds from the term loan advances may be used for working capital. The Company may request advances until September 30, 2007. Interest, payable monthly, will accrue on any outstanding principal balance at a floating rate equal to the 3 month London Interbank Offered Rate plus a margin (currently 2.00%) to be determined by the consolidated net worth of the Company and earnings before interest, taxes, depreciation and amortization for the preceding four calendar quarters. The outstanding principal balance will be payable in equal quarterly installments commencing on October 1, 2007 based on a 60-month amortization schedule, with the balance of the loan payable in full on or before September 30, 2010. The outstanding balance at December 31, 2006 was $2,000,000.
The primary sources of the insurance subsidiaries’ liquidity are funds generated from insurance premiums, net investment income and maturing investments. The short-term investments and cash are intended to provide adequate funds to pay claims without selling fixed maturity investments. At December 31, 2006, the insurance subsidiaries held short-term investments and cash that the insurance subsidiaries believe are at adequate liquidity for the payment of claims and other short-term commitments.
Unpaid C & CAE decreased primarily as a result of the settlement of claims in the normal course and favorable development in 2006 from the runoff lines. As of December 31, 2006, the Company had $63,537,000 in net unpaid C & CAE (Unpaid C & CAE of $77,898,000 less Ceded unpaid C & CAE of $14,361,000). This amount represents management’s best estimate, as derived from the actuarial analysis and was set at a higher level than the selected reserve estimate as established by an independent actuary to reflect additional potential claims liability identified after completion of the independent actuary’s analysis. The independent actuary identified that significant risk factors in its evaluation included the runoff status of the commercial lines, exposure to construction defect claims, exposure to directors and officers liability and personal umbrella claims on an excess of loss basis and recent changes in the nonstandard personal auto claims operation. In consideration of these risk factors the independent actuary believes that there are significant risks and uncertainties that could result in material adverse deviation in the unpaid C & CAE. Management has reviewed and discussed the results of the actuarial analysis with the actuary and believes the reserve estimate selected by the independent actuary, with the addition referred to above, to be the best estimate of reserves at this time, see “Item 1. Business - Reserves.”
Subordinated debentures of $25 million and $18 million were issued during the first quarter and the fourth quarter of 2006, respectively. See “Capital Transaction - 2006 Subordinated Debentures.”
The general partner of Crescent Funding is CRE Management VIII, L. P., a Delaware limited liability company, of which Crescent Real Estate Equities, Ltd., a Delaware corporation (“Crescent”), is the Manager. Crescent is also the owner of the building. Two of the directors of the Company, Robert W. Stallings (the executive Chairman of the Board of Directors) and John C. Goff, are members of the Board of Managers of Crescent. Mr. Goff is also the Chief Executive Officer and Vice Chairman of the Board of Managers of Crescent. The Lease was unanimously approved by the members of the Company’s Board of Directors other than Messrs. Stallings and Goff, who did not vote on the Lease, and the amendments were each approved by the Corporate Governance Committee.
Stallings Racing is owned and controlled by Robert W. Stallings, the Executive Chairman of the Company. The Company’s Board of Directors authorized the agreement at a meeting in December, 2006. In authorizing the agreement, the Board of Directors considered Mr. Stallings’ role and concluded that, under the circumstances, the Sponsorship Agreement is fair to, and in the best interests of, the Company. The Sponsorship Agreement contains provisions protecting the Company’s interests, including a termination provision that permits the Company unilaterally to terminate the agreement at any time and thereby cease making installment payments of the sponsorship fee.
The discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements 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 from those estimates under different assumptions or conditions.
Deferred policy acquisition costs are principally commissions, premium taxes, marketing and underwriting expenses which are deferred. Policy acquisition costs are principally commissions and premium taxes and the change in deferred policy acquisition costs that are charged to operations over the period in which the related premiums are earned. The Company utilizes investment income when assessing recoverability of deferred policy acquisition costs. Recoverability is based upon assumptions as to claims ratios, investment income and maintenance expenses and would vary with changes in these estimates.
Goodwill represents the excess of purchase price over fair value of net assets acquired. The goodwill recorded is related to the 1998 acquisition of the Lalande Group. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized but rather is subject to an annual impairment test, or earlier if certain factors are present, based on its estimated fair value. Therefore, impairment losses could be recorded in future periods. These procedures require the GAN to calculate the fair value of goodwill, compare the results to its carrying value and record the amount of any shortfall as an impairment charge. GAN performed this test as of December 31, 2006, using a variety of methods, including estimates of future discounted cash flows and comparisons of the market value to its major competitors as well as the overall market. The test results indicated that there was no impairment loss at December 31, 2006.
The process of establishing claims reserves is imprecise and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. The actual emergence of claims and claim adjustment expenses may vary, perhaps materially, from the Company’s estimates thereof, because (a) estimates of claims and claim adjustment expense liabilities are subject to large potential errors of estimation as the ultimate disposition of claims incurred prior to the financial statement date, whether reported or not, is subject to the outcome of events that have not yet occurred (e.g., jury decisions, court interpretations, legislative changes (even after coverage is written and reserves are initially set) that broaden liability and policy definitions and increase the severity of claims obligations, subsequent damage to property, changes in the medical condition of claimants, public attitudes and social/economic conditions such as inflation), (b) estimates of claims do not make provision for extraordinary future emergence of new classes of claims or types of claims not sufficiently represented in the Company’s historical data base or which are not yet quantifiable, and (c) estimates of future costs are subject to the inherent limitation on the ability to predict the aggregate course of future events.
The Company considers available evidence, both objective and subjective, including historical levels of income, expectations and risks associated with estimates of future taxable income in assessing the need for the valuation allowance. As a result of available evidence, both objective and subjective, as of the end of the fourth quarter of 2005, it was considered more likely than not that a full valuation allowance for deferred tax assets was not required, resulting in the release of a portion of the valuation allowance previously recorded against deferred tax assets and generating a $3.6 million tax benefit in the fourth quarter of 2005. In the fourth quarter of 2006, management’s analysis of available evidence, both objective and subjective, concluded it was more likely than not that additional portions of this asset would be used in future periods so the valuation allowance was reduced by $5.5 million, producing a tax benefit of $5.5 million in the fourth quarter of 2006.
In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of Statement No. 115”. Statement No. 159 permits a company to choose, at specified election dates, to measure at fair value certain eligible financial assets and liabilities that are not currently required to be measured at fair value. The specified election dates include, but are not limited to, the date when an entity first recognizes the item, when an entity enters into a firm commitment or when changes in the financial instrument causes it to no longer qualify for fair value accounting under a different accounting standard. An entity may elect the fair value option for eligible items that exist at the effective date. At that date, the difference between the carrying amounts and the fair values of eligible items for which the fair value option is elected should be recognized as a cumulative effect adjustment to the opening balance of retained earnings. The fair value option may be elected for each entire financial instrument, but need not be applied to all similar instruments. Once the fair value option has been elected, it is irrevocable. Unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. Statement No. 159 is effective as of the beginning of fiscal years that begin after November 15, 2007. Management is currently evaluating the impact, if any, the adoption Statement No. 159 will have on our consolidated results of operations.
In November 2005, the FASB issued FASB Staff Position (“FSP”) 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” This FSP provides additional guidance on when an investment in a debt or equity security should be considered impaired and when that impairment should be considered other-than-temporary and recognized as a loss in earnings. Specifically, the guidance clarifies that an investor should recognize an impairment loss no later than when the impairment is deemed other-than-temporary, even if a decision to sell has not been made. The FSP also requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. Refer to Note 1(c) for these disclosures. Management has applied the guidance in this FSP.
The following Consolidated Financial Statements are on pages 63 through 106:
Consolidated Statements of Shareholders’ Equity and Comprehensive Income for the Years Ended December 31, 2006, 2005 and 2004
Notes to Consolidated Financial Statements December 31, 2006, 2005 and 2004
The following Consolidated Financial Statements Schedules are on pages 107 through 117: