Excludes premiums of $35,000 in 2003, $1,727,000 in 2002, $16,627,000 in 2001, $26,973,000 in 2000 and $58,137,000 in 1999 from the Company’s fronting arrangements, the commercial automobile plans of Arkansas, California, Louisiana, Mississippi, and Pennsylvania under which the Company was a servicing carrier and the reinsurance arrangement in Florida whereby MGAI premiums are ceded to a non-affiliated reinsurer and assumed by General Agents.
On February 7, 2002, the Company announced its decision to cease writing commercial insurance, due to continued adverse claims development and unprofitable results. As a result, the Company had only 31 commercial policies remaining in force at December 31, 2003. The discontinuance of writing commercial lines has resulted in the Company ceasing to be approved to write insurance in several states, however, this state action has not materially restricted the geographic expansion of the Company’s personal auto lines thus far.
The Company continues to settle and reduce its inventory of commercial lines claims. At year-end 2003, there were 525 claims associated with the Company’s overall runoff book outstanding, compared to 1,062 a year earlier. Due to the long tail and litigious nature of these claims, the Company anticipates it will take substantial number of years to complete the adjustment and settlement process with regard to existing claims and the additional claims it expects to receive in the future from its past business writings. Most of the remaining claims are in suit and the Company’s future results may or may not be impacted either negatively or positively based on its ability to settle the remaining claims and anticipated new claims within its established reserve level. In the course of reducing its employee count, in the first quarter of 2003 the Company outsourced certain of its information technology operations related to the run-off of its commercial lines to an unaffiliated third party provider with which Richard A. Laabs, a former senior executive of the Company, and three other former employees of the Company are affiliated.
Personal lines increased 2% in 2003 but decreased 34% in 2002. The increase in 2003 was primarily due to slight growth in nonstandard personal auto in Florida. The decrease in 2002 was primarily related to the Company’s decision to discontinue writing nonstandard personal auto in the upper Midwest and to discontinue writing personal umbrella. Also contributing to the decrease in 2002 was the fact that most nonstandard personal auto policies written in 2002 were six month policies, whereas in 2001 a significant amount were twelve month policies. A six-month policy gives the Company greater flexibility in managing the business with regards to underwriting selection and rate adequacy.
Claims and claim adjustment expenses (“C & CAE”) decreased $30,897,174 in 2003 from 2002 and decreased $31,012,337 in 2002 from 2001. The C & CAE ratio was 74.2% in 2003, 93.6% in 2002 and 127.2% in 2001. The decrease in the C&CAE ratio in 2003 is due to smaller increases in estimated ultimate liabilities recorded in 2003 than was recorded in 2002. The commercial general liability lines recorded increases in the 2000 and 2001 accident years, but this was offset to some extent with decreases recorded in the commercial auto and personal auto lines for the 1999 and 2002 accident years. The decrease in the C & CAE ratio in 2002 is primarily due to smaller increases in estimated ultimate liabilities recorded in 2002 for commercial lines than was recorded in 2001. The commercial general liability lines recorded increases in the 2000 and 2001 accidents years. With regard to environmental and product liability claims, the Company has an immaterial amount of exposure. The Company does not provide environmental impairment coverage and excludes pollution and asbestos related coverages in its policies. 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.
The ratio of commissions and the change in deferred policy acquisition costs and deferred ceding commission income to net premiums earned was 13% in 2003, 15% in 2002 and 18% in 2001. The progressive decrease in this ratio is primarily due to the shift in the mix of business to nonstandard personal auto, which has lower acquisition costs than commercial lines.
Commissions are comprised of commission expenses (which vary with gross premiums written), offset by commission income, (which varies with ceded premium written). Commission expenses are paid to agents to produce the business for the Company. Commission income is received by the Company from reinsurers as compensation to the Company for business the Company cedes to the reinsurers. Commissions decreased in 2003 and in 2002 primarily as a result of the decrease in gross premiums written discussed previously.
Change in deferred policy acquisition costs (“DPAC”) and deferred ceding commission income (“DCCI”) represents the change during the period in the asset “Deferred policy acquisition cost”. This asset item is comprised of commission expenses, premium taxes and certain marketing and underwriting expenses, which are deferred, offset by commission income received from reinsurers, which is also deferred. This net asset DPAC is amortized into the results of operations through “Change in deferred policy acquisition costs and deferred ceding commission income,” as the underlying gross premiums written and ceded premiums written are earned. Change in DPAC and DCCI resulted in a charge in 2003 of $382,861, a charge in 2002 of $1,513,880 and a credit in 2001 of $886,282. The charge in 2002 is primarily attributable to the amortization of previous DPAC and DCCI exceeding DPAC and DCCI incurred for 2002 as a result of the decision to discontinue writing commercial lines in 2002. The credit in 2001 is primarily the result of the DPAC and DCCI incurred in 2001 exceeding the amortization of previous DPAC and DCCI. The amortization of previous DPAC and DCCI included a significant amount of DCCI recorded in the 2000 year.
There is no amortization expense in 2003 and 2002 due to the adoption of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (see Note 1(h) of Notes to Consolidated Financial Statements).
Underwriting and operating expenses were down 25% in 2003 and they were down 39% in 2002. The decrease in 2003 was primarily due to continued expense reductions, primarily salaries and salary related expenses, and a decrease in the allowance for doubtful reinsurance balances receivable. The decrease for 2002 was primarily due to expense reductions implemented as a result of the decision to discontinue writing commercial lines.
Goodwill impairment in 2002 is a result of the Company positioning itself for an exit from the personal auto business in the second quarter of 2002 and the consideration of a sale of the Lalande Group. A re-evaluation of goodwill for the Lalande Group was made during this period and an additional impairment of $2,859,507 was recorded. This re-evaluation was based upon market indications of value contained in a proposal from a potential acquirer and upon the uncertainty of achieving value levels. Goodwill impairment in 2001 was a result of the Company’s decision to no longer pursue a long-term geographic expansion strategy in nonstandard personal auto beyond that of its core operation in Florida and to sell its Tri-State agency subsidiary. Tri-State was acquired by the Company in the first quarter of 2000, but ultimately it proved marginally unprofitable under the Company’s ownership. Because of the profitability issues surrounding the Lalande Group, (see below), the Company decided in the second quarter of 2001 to sell Tri-State to its former owner so that the Company could focus all of its nonstandard personal auto efforts solely on the Lalande Group. As a result, the remaining goodwill associated with the Tri-State acquisition was written off in the second quarter of 2001. In December 2001 the Company recorded an impairment of $13,360,603 on the goodwill associated with the 1998 acquisition of the Lalande Group. The Company acquired the Lalande Group in the fourth quarter of 1998, it produced a small profit in 1999, but in 2000 it produced a loss. At the end of 2000 the Company was expecting a significant improvement and profitability from the Lalande Group in 2001. During 2001 the Company continued to implement actions throughout the year to return this business to profitability. While results in 2001 showed improvement, they remained unprofitable. In the fourth quarter of 2001 the Company concluded that the value of this operation was significantly below what the Company had paid and accordingly recorded the impairment against goodwill based upon then current estimated market valuation levels of agencies in the nonstandard personal auto marketplace.
The Company recognized a current tax benefit of $2,607,796 in 2002 as a result of a carry back of alternative minimum tax losses. A change in the tax law during 2002 extended the carry back period for losses to offset income in earlier periods. As a result, the Company was entitled to a tax refund, which it received in October 2002. The Company recorded deferred tax expense during the first quarter of 2002 due to an increase in the deferred tax asset valuation allowance, as a result of excluding the effects of unrealized gains in the deferred tax asset. The Federal income tax expense for 2001 is a result of the Company recording a valuation allowance of $31,534,712 against its deferred Federal income tax asset offset by the income tax benefit generated by the net loss from operations. Establishing the valuation allowance was necessary because of the uncertainty of future profitability levels. The Company does not lose the right to utilization of its net operating loss carry forwards for Federal income tax purposes in the future. During 2001 the Company continued to implement actions to return to profitability, both in commercial lines and the personal lines. However, earnings in 2001 did not materialize and in the first quarter of 2002 the Company announced it was discontinuing the writing of its largest line of business, commercial lines, due to continued adverse claims development and unprofitable results. At that time the prospects for significant profits in personal lines, its only remaining line of business, were unclear. Because the Company had no near-term expectation of profitable results, it was necessary to fully reserve the deferred tax asset due to uncertainty of future taxable results, which could utilize this asset. In 2002 the Company continued to record taxable losses and had no expectation of significant taxable income at that time. In 2003 the Company recorded a small taxable loss. Current expectations are that the Company will begin to record taxable income in 2004 and into the future, at which time the reserve for the deferred tax asset will be re-evaluated. However, as of December 31, 2003 the deferred tax asset remains fully reserved. A reconciliation between income taxes computed at the Federal statutory rates and the provision for income taxes is included in Note 6 of Notes to Consolidated Financial Statements.
The cumulative effect of change in accounting principle recorded in 2001 was a result of EITF 99-20, which became effective April 1, 2001. This amount represents the write down of an investment that was considered temporarily impaired and was written down in the first quarter of 2001 through accumulated other comprehensive income. EITF 99-20 changed the definition of impairment which resulted in this asset being reclassified as an impairment other than temporary which requires recognition through the statement of operations.
In the normal course of its operations, the Company has been named as defendant in various legal actions seeking payments for claims denied by the Company and other monetary damages. In the opinion of the Company’s management the ultimate liability, if any, resulting from the disposition of these claims will not have a material adverse effect on the Company’s consolidated financial position or results of operations. The Company’s management believes that unpaid claims and claim adjustment expenses are adequate to cover liabilities from claims that arise in the normal course of its insurance business.
1999 GMSP Transaction. On October 4, 1999, the Company sold to Goff Moore Strategic Partners, L.P. (“GMSP”), for an aggregate purchase price of $31,620,000, (i) 31,620 shares of Series A Preferred Stock (stated value $1,000 per share), which are convertible into 6,200,000 shares of Common Stock at a conversion price of $5.10 per share (subject to adjustment for certain events), (ii) the Series A Warrant expiring October 4, 2004 to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise price of $6.375 per share and (iii) the Series B Warrant expiring October 4, 2006 to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise of $8.50 per share.
At closing the Company and its insurance company subsidiaries entered into Investment Management Agreements with GMSP, pursuant to which GMSP manages their respective investment portfolios. Completion of these transactions (the “1999 GMSP Transaction”) concluded a strategic alternatives review process that the Company initiated in 1998. Proceeds from the 1999 GMSP Transaction were available for acquisitions, investments and other corporate purposes.
2001 GMSP Transaction. On March 23, 2001, the Company consummated a transaction with GMSP (the “2001 GMSP Transaction”) pursuant to which, among other things, the Company issued 3,000 shares of its newly created Series C Preferred Stock (stated value of $1,000 per share) to GMSP in exchange for an aggregate purchase price of $3 million in cash. The annual dividend rate on the Series C Preferred Stock is 10% until March 23, 2004 and 20% thereafter. Unpaid dividends are cumulative and compounded. The Series C Preferred Stock is redeemable at the Company’s option after March 23, 2006 and at the option of the majority holders after March 23, 2007 at a price of $1,000 per share plus accrued and unpaid dividends. The Series C Preferred Stock is not convertible into Common Stock.
2002 Amendment to Investment Management Agreements. In August 2002, the Company’s Investment Management Agreements with GMSP were amended to reduce, effective as of October 1, 2002, the minimum aggregate monthly payment to GMSP from $75,000 to $63,195 (with respect to each calendar month from October 2002 through September 2003), $53,750 (with respect to each calendar month from October 2003 through September 2004), and $45,417 (with respect to each calendar month after September 2004). The amendment also extended the date upon which either party to each of the investment management agreements can terminate such agreements at its sole option from October 4, 2002 to September 30, 2005.
Obligation to Redeem Series A Preferred Stock on January 1, 2006. On March 23, 2001, the Series A Preferred Stock was called for redemption so that on January 1, 2006 the Company will be obligated to pay $31,620,000 to the holder of the Series A Preferred Stock, subject to the conditions described below. The Company’s obligation to redeem the Series A Preferred Stock generally is conditioned upon (i) the redemption not contravening any credit or financing arrangement in excess of $3,000,000 and approval by at least one director nominated by the Series A Preferred Stock (no such indebtedness is now outstanding); (ii) the holder of the Series A Preferred Stock not receiving a purchase offer to purchase shares of the Series A Preferred Stock prior to January 1, 2006 from a financially responsible unaffiliated third party for a price equal to or greater than the liquidation value of the Series A Preferred Stock; and (iii) the payment of the redemption price not contravening the provisions of Article 2.38 of the Texas Business Corporation Act (which generally prohibits the amount to be paid to the holder of the Series A Preferred Stock in respect of the redemption from exceeding the net assets of the Company or leaving the Company insolvent) or any other applicable federal and state laws. The Board of Directors is contractually obligated to use its best efforts to take such actions as will cause the redemption to not contravene Article 2.38 or other applicable law. To the extent that the Company is restricted from redeeming the Series A Preferred Stock because of the conditions described above, the Company will be obligated to pay quarterly an amount equal to 8% interest per annum on any unpaid balance.
Dividends on Series B and Series C Preferred Stock. The Company declared dividends aggregating $2,111,267 in respect of the Series B and Series C Preferred Stock to be paid on April 1, 2004, which would bring dividends current to that point. From and after April 1, 2004, dividends accrue at the rate of 20% per annum, of which at least half (or at least $150,000 in the aggregate in respect of the Series B and Series C Preferred Stock) must be paid quarterly.
Board Focus. The Board of Directors has been focusing on the Company’s obligations to the holders of the Preferred Stock, which are affiliates of three of the Company’s eight directors, recognizing that the Company does not have, or expect that its operations will generate, sufficient funds to redeem the Series A Preferred on January 1, 2006. Also, the Board of Directors has considered how the need for capital to satisfy those obligations may limit the Company’s ability to pursue opportunities to further expand the Company’s nonstandard personal auto business. The interests of the holders of the Preferred Stock in assuring that these obligations are met in a timely manner may differ from those of other shareholders. As a result, the Board of Directors formed a Special Committee of independent directors to address the alternatives for providing for these obligations. The Special Committee consists of director Joel C. Puckett, Chairman, and directors Harden H. Wiedemann and John H. Williams, with director Sam Rosen acting as an advisory member. The Special Committee first considered, with the assistance of an investment banking firm, proposals from holders of Preferred Stock for the recapitalization of the Company, including a proposal that would have involved an investment by two consultants and the President of the Company. No agreement was reached with the holders of the Preferred Stock, and all recapitalization proposals were withdrawn. The Board of Directors then expanded the mandate of the Special Committee to consider alternatives that might be available with unaffiliated third parties. The Special Committee intends to engage an investment banking firm to advise it as to any such alternatives that may be available to the Company. No prediction can be made at this time as to the outcome or length of this process.
In general, a 5% shareholder is any person who owns 5% or more of the stock (by value) of the Company at any time during the testing period. The determination of whether an ownership change has occurred is made by the Company as of each “testing date.” For this purpose, a testing date generally is triggered whenever there is an “owner shift” involving any change in the respective stock ownership of the Company and such change affects the percentage of stock owned (by value) by any person who is a 5% shareholder before or after such change. A testing date also may be triggered by the Company’s issuance of options in certain limited circumstances. Examples of owner shifts that may trigger testing dates include a purchase or disposition of Company stock by a 5% shareholder, an issuance, redemption or recapitalization of Company stock that affects the percentage of stock owned (by value) by a 5% shareholder, and certain corporate reorganizations that affect the percentage the percentage of stock owned (by value) by a 5% shareholder.
Net cash used for operating activities was $1,000,446 in 2003, $62,050,686 in 2002 and $61,384,654 in 2001. The cash used in 2002 was primarily attributable to the transfer of trust assets to the reinsurer for the reserve reinsurance cover agreement in the first quarter of 2002. The cash used in 2001 was primarily related to the decrease in premium writings and the ongoing payment of claims and claim adjustment expense related to the commercial lines business.
Investments decreased primarily due to principal payments on the note payable of $3,700,000 and negative cash flows from operations due to commercial claim payments and declining premiums written. At December 31, 2003, 91% of the Company’s investments were investment grade with an average duration of approximately 1.2 years, including approximately 62% that were held in short-term investments. On a taxable equivalent basis the return on average investments was 2.8% in 2003, 3.9% in 2002 and 4.3% in 2001. The Company classifies its bond securities as available for sale. In February 2002 GMSP purchased the equity investments and the note receivable, classified as “Other investments” for approximately $2,087,000 which was their carrying value at December 31, 2001. In March 2002, the Company reduced the carrying value of a non-rated security to $0 resulting in a write down of $2,010,670 as a result of a significant increase in the default rate in January and February of 2002 in the underlying collateral, which had disrupted the cash flow stream sufficiently to virtually eliminate future cash flows. The unrealized gain associated with the investment portfolio was $1,955,141 (net of tax effects) at December 31, 2003. The duration of the bonds available for sale approximates the average expected payout of claims.
Premiums receivable increased primarily as a result of the increase in writings in nonstandard personal auto. This balance is comprised primarily of premiums due from insureds for nonstandard personal auto. The nonstandard personal auto premiums are written with a down payment of 34% and monthly payment terms of up to four months. The Company has recorded an allowance for doubtful accounts of $275,000, which it considers adequate at the present time.
Ceded unpaid claims and claim adjustment expenses (C&CAE) decreased as a result of the decrease in unpaid claims and claim adjustment expenses with regard to commercial claims subject to the commercial quota share reinsurance agreement. This balance represents unpaid claims and claim adjustment expenses which have been ceded to reinsurers under the Company’s various reinsurance agreements, other than the reserve reinsurance cover agreement. These amounts are not currently due from the reinsurers but are expected to become due in the future when the Company pays the claim and requests reimbursement from the reinsurers.
Funds held by reinsurers decreased as a result of a decrease in assumed paid and unpaid C&CAE and a decrease in commissions payable both of which are due to reinsurers. Funds held by reinsurers collateralize obligations of the Company to the reinsurers.
Goodwill of $609,000 is associated with the 1998 acquisition of the Lalande Group and reflects a value no less than the estimated fair valuation levels of combined agency and claims handling operations of this type in the personal automobile marketplace. Effective in 2002, goodwill is no longer amortized but is subject to an impairment test based on its estimated fair value. Additional impairment losses could be recorded in future periods.
As of December 31, 2003, in respect of its commercial and runoff lines, the Company had $64,894,298 in reserves for unpaid claims and claim adjustment expenses. Historically, the Company has experienced significant volatility in its reserve projections for its commercial lines. This volatility has been primarily attributable to its commercial automobile and general liability product lines. See Item 1 “Business Operations - Unpaid Claims and Claim Adjustment Expenses.” On February 7, 2002, the Company announced it had decided to discontinue writing commercial lines insurance due to continued adverse claims development and unprofitable results. The Company has been settling and reducing its remaining inventory of commercial claims. See “Business Operations -Recent Developments - Discontinuance of Commercial Lines.” As of December 31, 2003, 525 commercial and runoff claims remained. Included in these claims are 69 product liability claims, 27 construction defect type claims, and 1 environmental claim. The Company has no asbestos related claims. The average commercial lines claim at December 31, 2003 was approximately $123,608 per claim, at December 31, 2002 the average commercial lines claim was approximately $78,779 per claim.
As of December 31, 2003, in respect of its nonstandard personal auto line, the Company had $11,675,102 in unpaid claims and claim adjustment expenses. These claims generally are shorter tailed than the Company’s commercial and runoff lines claims. At December 31, 2003, the Company had 1,370 nonstandard personal auto claims. The average nonstandard personal auto claim at December 31, 2003 was approximately $8,522 per claim, at December 31, 2002 the average nonstandard personal auto claim was approximately $7,276.
The Company considers the unpaid claims and claim adjustment expenses to be adequate; they are set to equal the selected reserve estimate determined by an independent actuarial firm.
In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 141, “Business Combinations” (“Statement 141”) and Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“Statement 142”). Statement 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. Statement 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill, noting that any purchase price allocable to an assembled workforce may not be accounted for separately. Statement 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of Statement 142. Statement 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.”
The Company adopted the provisions of Statement 141 effective July 1, 2001 and Statement 142 effective January 1, 2002. The adoption of Statement 141 had no impact on the consolidated financial statements. The adoption of Statement 142 resulted in the Company no longer amortizing goodwill.
Goodwill of $609,000 is associated with the 1998 acquisition of the Lalande Group and reflects a value no less than the estimated fair valuation levels of combined agency and claims handling operations of this type in the personal automobile marketplace.
In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“Statement 149”). This statement clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. This statement is generally effective for contracts entered into or modified after September 30, 2003, and all provisions should be applied prospectively. The Company adopted Statement 149 on October 1, 2003. Statement 149 did not have a material effect on the Company’s financial statements.
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“Statement 150”). This statement does not have an impact on the current accounting by the Company as all of the Company’s series of Preferred Stock are not considered “mandatory redeemable financial instruments” based on Statement 150’s definition, and therefore are not subject to the accounting treatment under paragraph 9 of Statement 150. All three series of Preferred Stock are currently classified as temporary equity pursuant to SEC ASR 268 and EITF Topic No. D-98. Rule 5-02.28 of SEC Regulation S-X requires preferred securities that are redeemable for cash or other assets to be classified outside of permanent equity if they are redeemable (1) at a fixed or determinable price on a fixed or determinable date; (2) at the option of the holder; or (3) upon the occurrence of an event that is not solely within the control of the issuer.
In December 2003, the FASB issued a revision to Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” that was originally issued in January 2003. This interpretation as revised addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003. This Interpretation requires certain disclosures in financial statements issued after January 31, 2003. The Company adopted FASB Interpretation No. 46 as revised January 2003. FASB Interpretation 46 as revised did not have a material effect on the Company’s financial statements.
The following Consolidated Financial Statements Schedules are on pages 92 through 103