The office space of approximately 543,851 square feet includes a new lease that was entered into in 2006 for approximately 56,875 square feet of office space in Burr Ridge, Illinois. We officially occupied the office space on January 1, 2007, while simultaneously moving from our Bedford Park, Illinois location, where we leased approximately 96,722 square feet of office space. The Burr Ridge lease has a term of 10 years and provides for escalating rents during the lease term. The lease for the office space in Bedford Park was terminated on January 1, 2007. We continue to lease approximately 56,888 square feet of office space in Addison, Texas with three years remaining in the lease term.
Affirmative Insurance Holdings, Inc. was incorporated in 1998 and completed an initial public offering of its common stock in July 2004. We are a distributor and producer of non-standard personal automobile insurance policies for individual consumers in targeted geographic markets. Non-standard personal automobile insurance policies provide coverage to drivers who find it difficult to obtain insurance from standard insurance companies due to their lack of prior insurance, age, driving record, limited financial resources or other factors. Non-standard personal automobile insurance policies generally require higher premiums than standard automobile insurance policies for comparable coverage.
We are currently active in offering insurance directly to individual consumers through retail stores in 8 states, (Illinois, Texas, Missouri, Indiana, South Carolina, Florida, Kansas and Wisconsin) and distributing our own insurance policies through independent agents in 9 states (Illinois, Texas, Missouri, Indiana, South Carolina, Florida, California, Michigan and New Mexico). Today, the 11 states in which we operate collectively represent approximately 51% of the non-standard personal automobile insurance market. These combined states accounted for $14.6 billion in direct written premium in 2005, based on information from A. M. Best and our company analysis. We believe the states in which we operate are among the most attractive non-standard personal automobile insurance markets due to a number of factors, including size of market and existing regulatory and competitive environments.
On January 31, 2007, we completed the acquisition of USAgencies in a fully-financed all cash transaction valued at approximately $200.0 million. USAgencies is a non-standard automobile insurance provider headquartered in Baton Rouge, Louisiana. It has 92 sales offices in Louisiana, Illinois and Alabama selling its products directly to consumers through its own retail stores, virtual call centers and internet site. In 2006, USAgencies had gross written premium of approximately $177.1 million, an increase of 12.6% from 2005 gross written premiums of $157.3 million. The purchase of USAgencies was financed through $200.0 million in borrowings under a $220.0 million senior secured credit facility that was entered into concurrently with the completion of the acquisition.
Our three operating components often function as a vertically integrated unit, capturing the premium and associated risk and commission income and fees generated from the sale of an insurance policy. There are other instances, however, when each of our operations functions with unaffiliated entities on an unbundled basis, either independently or with one or both of the other two operations. For example, as of December 31, 2006, our insurance companies had relationships with two unaffiliated underwriting agencies that design, distribute and service our policies through their approximately 4,200 independent agencies, and our underwriting agencies distributed insurance policies through approximately 3,200 independent agencies in addition to our 158 owned and 33 franchised retail stores. In addition, our retail stores earn commission income and fees from sales of third-party policies.
The Sales Process. We are an insurance holding company engaged in the underwriting, servicing and distributing of personal non-standard automobile insurance policies and related products and services. We distribute our products through three distinct distribution channels: our owned retail stores, independent agents and unaffiliated managing general agencies. We generate earned premiums and fees from policyholders through the sale of our insurance products. In addition, through our owned retail stores, we sell insurance policies of third-party insurers and thereby earn commission income from those third-party insurers and fees from the customers.
In response to the market conditions that have existed for the past several years, our owned insurance carriers have been developing and introducing new and better segmented products to serve our target markets, resulting in a slightly lower overall aggregate rate level and improving the competitiveness of our insurance products offered through our distribution channels. Management of our insurance carriers is responsible for developing and pricing our products, while maintaining and improving our insurance margins.
that we are generally competitive in the markets we serve and we constantly evaluate our products relative to those of other carriers. As shown below, sales of our products through independent agencies have remained at about the level of the prior year despite competitive market conditions largely due to the incremental business in Michigan during 2006 resulting from an acquisition in mid-2005.
In our independent agency distribution channel, gross premiums written were $158.8 million, a decrease of $1.0 million, or 0.6%, as compared to $159.8 million for the same period in 2005, principally due to decreased production in our Texas underwriting agencies offset by an increase in production in Michigan.
Gross premiums written for our unaffiliated agencies were $40.6 million, a decrease of $4.1 million, or 9.1%, as compared to $44.7 million in the prior year. The change was primarily due to $14.1 million of gross premiums written on new programs in California and Arizona, offset by run-off of two of our programs in California, and programs in Utah, Alabama and Georgia.
Commission income and fees earned by our underwriting agencies on business that is not written or retained by us. We only earn this income when we reinsure a portion of our insurance business to other parties. Over the past several years we have substantially eliminated our reinsurance contracts and, as a result, this income source has been almost eliminated. Instead, we generate additional premium on the retained business, increasing our earned premiums. Had we continued to utilize reinsurance, our earned premiums would have been reduced but we would have earned greater commission income and fees for servicing the policies. In the future, we may choose to increase the use of reinsurance, which could result in an increase in this type of commission income and fees.
Policy, installment, and agency fees earned for business written or assumed by our insurance companies both through independent agents and our retail agencies. These policy, installment and agency fees are fees charged to the customers in connection with their purchase of coverage from our insurance carriers. We can increase or decrease agency and installment fees at will, but policy fees must be approved by the applicable department of insurance. In the second quarter of 2006, we reduced or eliminated our agency fees in our retail stores to reduce the cost to the customer of purchasing coverage from us. This increased the overall level of sales and thereby increased our commission income (when the product sold is a third-party carrier’s coverage) and earned premiums (when the product sold is our own insurance carrier’s coverage). We believe that this change in our agency fee implementation reduced our near-term commission income and fees but increased our long-term profitability as those incremental commissions from third-party carriers and earned premiums at our own insurance carriers are earned into revenue over the service life of the incremental policies sold. In the fourth quarter of 2006, we reinstituted certain agency fees but at a moderate level as compared to the first half of the year.
The commissions earned on sales of unaffiliated (third-party) insurance companies’ products sold by our retail agencies. As described above, in our owned retail stores, there has been a shift in the relative proportion of the sales of third-party insurance products as compared to sales of our own carriers’ products due to the relative competitiveness of our insurance products. This has resulted in an increase in our commission income and fees from non-affiliated third-party insurers. We negotiate commission rates with the various third-party carriers whose products we agree to sell in our retail stores. As a result, the level of third-party commission income will also vary depending upon the mix by carrier of third-party products that are sold.
Losses and Loss Adjustment Expenses. Since the single largest expense of an insurance company are the losses and loss adjustment expenses, another measurement of our insurance carriers’ performance is the level of such expense, specifically as a ratio to earned premiums. Our losses and loss adjustment expenses are a blend of the specific estimated and actual costs of providing the coverage contracted by the purchasers of our insurance policies. We maintain reserves to cover our estimated ultimate liability for losses and related loss adjustment expenses for both reported and unreported claims on the insurance policies issued by our insurance companies. The establishment of appropriate reserves is an inherently uncertain process, involving actuarial and statistical projections of what we expect to be the cost of the ultimate settlement and administration of claims based on historical claims information, estimates of future trends in claims severity and other variable factors such as inflation. Due to the inherent uncertainty of estimating reserves, reserve estimates can be expected to vary from period to period. To the extent that our reserves prove to be inadequate in the future, we would be required to increase our reserves for losses and loss adjustment expenses and incur a charge to earnings in the period during which such reserves are increased. We have a limited history in establishing reserves and the historic development of our reserves for losses and loss adjustment expenses is not necessarily indicative of future trends in the development of these amounts.
Overall, we continue to see favorable frequency trends and moderating severity trends on an aggregate basis. In a period of stable premium rates, these trends would have resulted in generally stable loss ratios (the ratio of losses and loss adjustment expenses to earned premiums). However, the current competitive environment has led management of our insurance carriers to selectively reduce rates in certain markets and on certain products. Such rate decreases constrict our insurance margins and increase our loss ratios.
Deferred policy acquisition costs represent the deferral of expenses that we incur in acquiring new business or renewing existing business. Policy acquisition costs, consisting of primarily commission, premium taxes, underwriting and retail agency expenses, are initially deferred and then charged against income ratably over the terms of the related policies through amortization of the deferred policy acquisition costs. Thus, the amortization of deferred acquisition costs is correlated with earned premium and the ratio of amortization of deferred acquisition costs to earned premium in an accounting period is another measurement of performance.
related commission expense associated with these policies, while our agencies recognize commission income and fees. The amount of commission that our insurance companies pay our agencies is recorded as insurance - level commission expense that becomes part of the insurance companies’ deferred acquisition costs. In addition, the agencies record agency - level policy acquisition expenses such as independent agent commissions, workforce and operating expenses. Our agencies incur policy acquisition expenses because our underwriting operation is accounted for as a function of our agencies.
Since both the insurance companies and the agencies have recorded revenue and expenses related to selling our own insurance policies, we eliminate the internal commission income and fees and policy acquisition expenses recorded on our agencies.
The historical financial results of VIG’s non-standard personal automobile insurance business for the years ended December 31, 2003 have been included in footnotes to VIG’s audited financial statements, which are not included in this report.
In May 2006, we received our insurance license for AIC - Michigan and we funded that company with an initial capital contribution of $9.0 million from AIC.
Fees for Accenture’s services include a fixed component and a smaller variable component. The fixed component is expected to, at its maximum amount, reach approximately $12.0 million per annum and ultimately decrease to $4.5 million per annum by 2016, based on the parties’ current expectations of service usage. The variable component will be charged on an hourly basis depending on the skill level and location of the resource. The fees are subject to adjustments for discounts based on usage in previous years, cost of living increases, currency fluctuations for off-shore resources, and for service level failures or improvements customary in the IT outsourcing industry. Through the first half of 2007, the cost of our IT operations has been and will be borne by Affirmative through internal staffing and contractors. We believe that within a few quarters this arrangement with Accenture
will be less expensive than managing our own IT department would have been. However, the initial costs of implementing this arrangement are significantly higher than our cost of IT would normally be - particularly in the fourth quarter of 2006 and the first quarter of 2007 when we will have both our usual costs as well as the costs associated with the transition and implementation of the arrangement. In the fourth quarter of 2006, we expensed $6.5 million of transition expenses related to the Accenture outsourcing contract and the cost of incomplete IT projects eliminated by outsourcing.
During 2006, we expensed $378,000 in severance for internal IT employees that were terminated due to our outsourcing agreement with Accenture.
During the fourth quarter of 2005, we determined that the outside vendor used to develop our new enterprise system had not met the terms of the development and license agreement and had breached the contract. We also determined that we would not be able to obtain any benefit from our investment in this project. We have since initiated litigation and are seeking relief to the full extent possible (See “Legal Proceedings” contained elsewhere in this report). As a result, the $2.4 million invested in this project was written down to zero in 2005.
Termination of lease agreement in Michigan. During 2006, we terminated a lease for our office in Michigan that had approximately 18 months remaining in the lease contract, resulting in $125,000 in accelerated lease expense.
Acquisitions. In the fourth quarter of 2006, we expensed $697,000 to write off previously capitalized legal, accounting and other investigatory costs related to a potential acquisition that ultimately was not completed.
Fed USA. In December 2004, we acquired certain assets of Fed USA Retail, Inc., which owns retail agencies that produce and service non-standard personal automobile policies sold in Florida by owned and branded retail stores in three DMAs as of December 31, 2004. We also acquired certain assets of Fed USA Franchising, Inc., which produces and services policies sold in Florida through franchised retail stores in four DMAs as of December 31, 2004.
Reinsurance transaction with VIG. Effective December 31, 2003, VIG restructured its internal reinsurance arrangements relating to non-standard personal automobile insurance policies to transfer to our insurance companies all of the future economic interest in VIG’s non-standard personal automobile insurance business. Under this transaction, which was effected through a quota share reinsurance agreement, VFIC retained all losses and loss
The commission rate paid to our underwriting agencies is established annually in contractual agreements between our underwriting agencies and our insurance companies and the unaffiliated insurance companies that our retail agencies represent. Provisional commissions are paid to our underwriting agencies based upon a contractually established provisional commission rate multiplied by the premiums that they produce. Our underwriting agencies also can earn profit-sharing commissions from our insurance companies and the unaffiliated insurance company they represent if the loss ratio on the business they produce is lower than a contractually established provisional loss ratio. Profit-sharing is recorded when we conclude it is probable that estimates of losses will result in loss ratios that are lower than the provisional loss ratios. These loss ratio estimates are based on various actuarial assumptions and determinations by our internal actuaries regarding potential future losses. If the actual loss experience is less favorable than the estimates used, income may be reduced in subsequent periods.
At December 31, 2006, we had $24.8 million receivables from reinsurers, including $20.2 million gross recoverable from VFIC. Under the reinsurance agreement with VFIC, AIC had the right, under certain circumstances, to require VFIC to provide a letter of credit or establish a trust account to collateralize the gross amount due
losses and loss adjustment expenses may differ materially from the estimates we have recorded. As previously noted, our financial statements for periods before December 31, 2003 included the effects of a 100% quota share reinsurance contract with our affiliate, VFIC. Accordingly, we retained none of the underwriting risks associated with the reserves established at December 31, 2003 for our insurance companies.
In the fourth quarter of 2006, management determined that a reclassification would provide improved presentation for the liability for reserves for loss adjustment expenses that had previously been classified as deferred revenue liability. We reduced our consolidated deferred revenue liability for the years ended December 31, 2005 and 2004 while increasing our reserve for losses, loss adjustment expenses and deposits. This reclassification resulted in an adjustment to our statements of cash flows for the years ended December 31, 2005 and 2004. However, the reclassification does not affect “net cash provided by operating activities” because the reclassification was between two components of “net cash provided by operating activities”. The reclassification as of December 31, 2005 and December 31, 2004 was $16.0 million and $5.8 million, respectively.
Our losses, loss adjustment expense reserves and deposit liabilities were $162.6 million on a gross basis and $138.4 million on a net basis, which were our best estimates as of December 31, 2006. The analysis provided by our independent opining actuaries, as of December 31, 2006, indicated that the expected range for the ultimate liability for our losses and loss adjustment expense reserves was between $139.1 million and $168.8 million on a gross basis and between $121.1 million and $145.9 million on a net basis.
We conduct regular reviews to assess whether the amortized cost of our investments are impaired and if any impairment is other than temporary. Factors considered by us in assessing whether an impairment is other than temporary include the credit quality of the investment, the duration of the impairment, our ability and intent to hold the investment until recovery and overall economic conditions. If we determine that the value of any investment is other-than-temporarily impaired, we record a charge against earnings in the amount of the impairment.
The following table shows our investments with gross unrealized losses and fair value, aggregated by type of fixed maturity investment and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2006 (dollars in thousands):
Accounting for business combinations, goodwill and other intangible assets. We adopted SFAS No. 141 and SFAS No. 142, Goodwill and Other Intangible Assets, effective January 1, 2002. With the exception of our acquisitions of our insurance companies and InsureOne from VIG, which were accounted for as a pooling of interests, we have accounted for all of our acquisitions using the purchase method of accounting. In acquisitions using the purchase method of accounting, the purchase price for the acquisition is allocated to the assets acquired, including identified intangible assets and liabilities assumed based on their estimated values. The excess of cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed is an asset referred to as goodwill. Indirect and general expenses related to business combinations are expensed as incurred.
Principally, all of our goodwill and intangible assets relate to our agency acquisitions. We test our goodwill and intangible assets for impairment annually, or more frequently if impairment indicators arise. We test for impairment based upon the following: (1) the historical financial performance of the unit; (2) the most recent financial performance of the unit; (3) management’s financial forecast for the unit; (4) information regarding publicly available financial terms of recent transactions in the insurance industry; and (5) other publicly available information. We perform impairment tests annually as of September 30. The test performed as of September 30, 2006 indicated there was no goodwill or indefinite life intangible asset impairment.
As of December 31, 2006, our financial statements include $65.3 million of goodwill, $14.7 million of indefinite life intangible assets and $3.4 million of finite life intangible assets having estimated lives of between two and 20 years.
The following table summarizes our consolidated results of operations (dollars in thousands except share data and ratio computations).
Comparison of the Year Ended December 31, 2006 to December 31,
Total revenues for the year ended December 31, 2006 were $357.1 million, a decrease of $24.4 million, or 6.4%, as compared to total revenues of $381.5 million for the same period in 2005. The decrease in revenues was primarily due to a 23.4% decrease in commission income and fees as well as a 3.3% decrease in earned premium. Earned premium decreased primarily as a result of the 10.9% decrease in gross premiums written in the current period. As discussed below, the decrease in commission income and fees is due to our insurance companies’ retaining more premiums as well as a change in the amounts of our fees charged.
Total commission income and fees for the year ended December 31, 2006 were $61.0 million, a decrease of $18.6 million, or 23.4%, as compared to $79.6 million in the same period of the prior year. This decrease is primarily related to our increased retention of business written and assumed by our insurance companies. In our agencies, we earn commission income and fees that are based on premiums earned in the current period but written in both current and prior periods. In consolidation, we eliminate our agencies’ commission income and fees based
In connection with our strategy of operating our retail stores as independent agencies, in many of our markets we reduced or eliminated the agency fee charged to a customer when a policy was written. This allowed us to offer our customers a more affordable down payment on the insurance product that best met their needs and, in some cases, improved the competitiveness of our product offerings as compared to the products of unaffiliated insurance companies. By foregoing these fees, we believe that we gained new customers and increased premiums written. This resulted in a reduction of approximately $3.2 million in agency fees for both affiliated and non-affiliated business in 2006 as compared to 2005. We believe that this reduction will be largely or completely offset by an increase in the commission income earned on incremental sales of third-party products and earned premiums on incremental sales of our own insurance products. Commission income from sales of third-party business is earned over time as the customers pay their premiums to the third-party carriers. In the fourth quarter of 2006, we reinstituted certain agency fees but at a moderate level as compared to the first half of the year. For the year ended December 31, 2006, commission income and fees for sales of third-party products were $14.9 million, an increase of $1.9 million, or 14.8%, compared to $13.0 million in the same period of the prior year.
The following table summarizes the components of other selling, general and administrative expenses and the impact of significant events that impact comparability for the years ended December 31, 2006 and 2005:
Write down of amounts capitalized on the enterprise system development and license agreement
Our expense ratio for the year ended December 31, 2006 increased to 32.6%, as compared to 26.3% for the same period in 2005 even though our total selling, general and administrative expenses declined in the current year. The expense ratio calculation treats all commission income and fees as a reduction in the dividend, with the divisor consisting of earned premium only. Therefore, the increase in our expense ratio is due, in part, to the decision to reduce or eliminate agency fees for policies sold in our retail locations as discussed above, thereby reducing the amount of the revenue offset against expenses. Agency fees are a direct component of commission income and fees.
Depreciation and amortization expenses for the year ended December 31, 2006, were $4.4 million, an increase of $191,000, or 4.5% as compared to $4.2 million in 2005. Depreciation expense decreased by $374,000 to $2.9 million for the year ended December 31, 2006 from $3.3 million for the year ended December 31, 2005. Our amortization expense in 2006 was $1.5 million as compared to $887,000 million in 2005. Included in the increase of amortization expense was a net increase of $565,000 associated with several non-competition agreements. In the fourth quarter of 2005, we completed non-competition agreements with two former executives that resulted in amortization expense of $885,000 in 2006 as compared to only $122,000 in 2005. Conversely, the cost of a non-competition agreement negotiated in 2004 was fully amortized in the first quarter of 2006, resulting in amortization expense of only $39,000 in 2006 as compared to $233,000 in 2005. Other amortization expense is related to amortization of intangible assets for acquired agency relationships.
Interest expense for the year ended December 31, 2006 was $4.3 million, an increase of $827,000, or 23.5%, as compared to $3.5 million in 2005. Interest expense is primarily related to our $56.7 million notes payable, which were issued in December 2004 and June 2005 following our private placements of $30.0 million and $25.0 million, respectively, of trust preferred securities. Our weighted average interest cost during the years ended December 31, 2006 and December 31, 2005 was 7.66%.
Pretax income for the year ended December 31, 2006 was $12.5 million, a decrease of $16.3 million, or 56.6%, as compared to $28.7 million for the same period in 2005. In 2006, $16.5 million of expenses for significant events that impact comparability was included in selling, general and administrative expenses, as described above, and impacted comparability. Pretax net income for 2006, excluding the significant events, would have been $26.2 million. In 2005, $5.3 million of costs for significant events were included in selling, general and administrative expenses, as described above, resulting in pretax income that would have been $34.0 million in 2005.
Comparison of the Year Ended December 31, 2005 to December 31,
Total revenues for the year ended December 31, 2005 were $381.5 million, an increase of $58.1 million or 18.0%, as compared to total revenues of $323.3 million for the year ended December 31, 2004. The increase in total revenues was primarily due to our retention of gross premiums written in our insurance companies following the termination of the reinsurance agreements with various reinsurers, which allowed us to retain more of our written premiums.
Commission income and fees consists of (a) the commission income and fees earned by our underwriting agencies on business that is not written or retained by us, (b) policy, installment, direct bill and agency fees earned for business written or assumed by our insurance companies (affiliated) both through independent agents and our retail agencies and (c) the commissions earned on sales of unaffiliated (third-party) insurance companies’ products sold by our retail agencies. The table below displays the components of consolidated commission income and fees earned for the specified periods (dollars in thousands):
Commission income from sales of third-party business is earned over time as the customers pay their premiums to the third-party carriers. For the year ended December 31, 2005, commission income and fees for sales of third-party products were $13.0 million, an increase of $4.7 million or 55.9%, compared to $8.3 million in the prior year.
Net investment income for the year ended December 31, 2005 was $5.7 million, an increase of $3.4 million, or 146.2%, compared to $2.3 million in the same period in 2004. The increase was primarily a result of a 32.0% increase in total invested assets to $210.8 million at December 31, 2005 from $159.7 million at December 31, 2004. The increase in invested assets is primarily the result of increased cash flows from operations. The average investment yield was 3.3% (4.5% on a taxable equivalent basis) in 2005 compared to 3.1% (3.8% on a taxable equivalent basis) in 2004 primarily as the result of the higher interest rates available for new investments in 2005.
Our investment committee reviewed our investment portfolio in December 2005 and decided to sell a portion of our investment portfolio in order to better align our portfolio with our historical claims life. Specifically, the Investment Committee determined that all securities with a maturity after December 31, 2008 should be sold. We determined that the identified securities to be sold would not fully recover (fair market value would not equal or exceed amortized cost) prior to the expected sale date, therefore the securities were deemed other than temporarily impaired in December 2005 when the decision to sell was made and we recorded a charge to earnings of $1.7 million in the fourth quarter of 2005. The identified securities were in compliance with our investment guidelines prior to the realignment decision by the Investment Committee. Net realized losses for the year ended December 31, 2005, included the $1.7 million related to the realignment of the investment portfolio. Our investment portfolio had not included securities with values that were other than temporarily impaired in previous fiscal periods.
Losses and loss adjustment expenses for the year ended December 31, 2005 were $191.2 million, an increase of $62.2 million, or 48.3%, as compared to $129.0 million for the same period in 2004. Our overall loss and loss adjustment expense ratio for the year ended December 31, 2005 was 64.2% as compared to 66.4% for the year ended December 31, 2004. The decrease in our overall loss and loss adjustment expense ratio was primarily due to greater favorable loss development on prior years’ business than we experienced in the prior year for the current period. The impact from the favorable loss ratio development on our losses and loss adjustment expense ratio was 5.0% for the year ended December 31, 2005 as compared to 1.5% in the prior year. The following table displays the impact of favorable loss development on prior years’ business on our overall loss and loss adjustment expense ratio for the years ended December 31, 2005 and December 31, 2004:
Depreciation and amortization expenses for the year ended December 31, 2005 were $4.2 million, unchanged relative to the prior year. Depreciation expense decreased by $160,000 for the year ended December 31, 2005 as compared to the prior year. This decrease was offset by an increase of $148,000 in amortization expense primarily due to non-competition agreements with two former executives.
Interest expense for the year ended December 31, 2005 was $3.5 million, as compared to $588,000 for the prior year. Interest expense in 2005 is primarily related to our $56.7 million notes payable, which were issued in December 2004 and June 2005 following our private placement of $30.0 million and $25.0 million, respectively, of trust preferred securities. Interest expense for the prior year was primarily related to a note payable associated with a prior acquisition that was repaid in full in the third quarter of 2004.
Pretax income for the year ended December 31, 2005 was $28.7 million, a decrease of $12.7 million, or 30.7%, as compared to $41.5 million in the prior year. In 2005, $5.3 million in expenses related to significant events that impact comparability was included in selling, general and administrative expenses, as described above. Excluding these expenses, pretax income would have been $34.0 million in 2005.
Income tax expense for the year ended December 31, 2005 was $9.8 million, or an effective rate of 34.0%, as compared to income tax expense of $15.3 million, or an effective rate of 36.9% for the same period in 2004. In the fourth quarter of 2005, we recorded an adjustment to our deferred tax asset for state taxes. This adjustment reduced our income tax expense by $500,000 in the fourth quarter of 2005, resulting in an effective tax rate of 34.0% for 2005. Excluding the effect of this item, our effective tax rate would have been 35.7%. The decrease in the effective tax rate in year ended December 31, 2005 excluding the effect of the adjustment to our deferred tax asset, as compared to prior year, was principally due to the favorable impact of tax exempt income from our investment portfolio following our initial public offering in July 2004.
There are no restrictions on the payment of dividends by our non-insurance company subsidiaries other than state corporate laws regarding solvency. As a result, our non-insurance company subsidiaries generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends to the holding company, and we expect to use those revenues to service our corporate financial obligations, such as debt service and stockholder dividends. As of December 31, 2006, we had $16.9 million of cash and invested assets at the holding company level and $856,000 of cash and invested assets at our non-insurance company subsidiaries. As of March 8, 2007, our cash and invested assets at the holding company level was approximately $7.2 million. In January 2007, we paid $2.2 million in closing costs for the USAgencies acquisition, $0.6 million to Accenture under the outsourcing agreement, $0.6 million for payment of accrued construction costs for our new Chicago office, $0.2 million for the purchase of new premium finance software, with the remaining difference being attributed to every day operating expenses.
The National Association of Insurance Commissioners’ model law for risk-based capital provides formulas to determine the amount of capital that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2006, the capital ratios of our insurance companies substantially exceeded the risk-based capital requirements, as well as the highest level for regulatory action under the risk-based capital guidelines.
Net cash provided by operating activities was $34.7 million for the year ended December 31, 2006, as compared to $91.2 million for the year ended December 31, 2005, and $52.1 million for the year ended December 31, 2004. The decrease in cash provided by operating activities for the year ended December 31, 2006 as compared to the prior year was primarily due to a net decrease in insurance related items of $65.7 million such as collections of premiums and commissions receivable, payments of losses and loss adjustment expenses and unearned premiums, including $18.7 million that was collected as part of the novation and commutation agreements executed in 2005. In addition, we paid $6.0 million to Accenture in relation to our outsourcing contract in 2006, $0.7 million for an unsuccessful acquisition and $0.9 million for costs related to moving to our new Burr Ridge office and the closing of offices in Florida and Michigan. The decrease in cash provided was offset by a decrease in taxes paid during 2006 of approximately $14.5 million and tax refunds received for approximately $6.0 million. The increase in cash flow generated from operations for the year ended December 31, 2005 compared to the prior year was principally due to a net increase in insurance related items of $57.3 million such as collections of premiums and commissions receivable, payments of losses and loss adjustment expenses and unearned premiums, of which $18.7 million was collected as part of the novation and commutation agreements executed in 2005. This increase in cash flows was offset by $12.8 million in increased federal income tax payments over the prior year.
Net cash used in investment activities was $26.3 million for the year ended December 31, 2006, as compared to $66.6 million for the year ended December 31, 2004 and $129.2 million for the year ended December 31, 2004. The decrease in cash used in investment activities for the year ended December 31, 2006 as compared to the prior year is primarily due to a net decrease of $45.8 million in bonds acquired offset by $4.8 million in cash used for property, plant and equipment in 2006 as compared to the prior year. The decrease in cash used in investment activities for the year ended December 31, 2005 compared to the prior year is primarily due to a net decrease in bond purchases in the investment portfolios of our insurance companies of $59.5 million, as well as a decrease in cash used for acquisition in 2005 of $3.8 million as compared to the prior year.
Net cash used in financing activities was $4.0 million for the year ended December 31, 2006, as compared to $0.7 million for the year ended December 31, 2005 and $85.9 million in cash was provided by financing activities in the year ended December 31, 2004. Cash used in financing activities for the year ended December 31, 2006 included $4.1 million used to purchase outstanding shares of common stock and $1.2 million used to pay dividends offset by $1.3 million received from the issuance of common stock due to the exercise of stock options. Cash used in financing activities for the year ended December 31, 2005 included $28.0 million used to purchase outstanding shares of our common stock, offset by $24.4 million received from the private placement of trust preferred securities, net of fees, in June 2005, to fund this purchase. In addition, dividends of $1.3 million were paid in 2005 offset by $4.2 million received from the issuance of common stock in connection with the exercise of stock options. In 2004, $67.5 million was received from our initial public offering and $29.1 million was received in December 2004 from the private placement of trust preferred securities, partially offset by a $10.0 million principal payment on a note payable.
Initial Public Offering. We completed our initial public offering of our common stock effective July 9, 2004. We issued 4,420,000 additional shares of our common stock and VIG sold 3,750,000 shares of our common stock that they owned, at an initial public offering price of $14.00 per share. On July 26, 2004, our underwriters exercised their option to purchase an additional 663,000 shares from us, and an additional 562,500 shares from VIG. The combined net proceeds to us from these transactions were approximately $65.3 million, of which $64.3 million was contributed to our insurance companies in order to increase their policyholder’s surplus.
Senior secured credit facility. On January 31, 2007, we entered into a $220.0 million senior secured credit facility (the “Facility”) provided by a syndicate of lenders, including Credit Suisse, Cayman Islands Branch, as Administrative Agent and Collateral Agent. The Facility provides for a $200.0 million senior term loan facility and a revolving facility of up to $20.0 million, depending on our borrowing capacity. On March 8, 2007, we added The Frost National Bank, N.A. to the Facility when we received approval of the First Amendment to the Facility and executed a joinder agreement whereby Frost became the provider of an initial revolving credit commitment of $15.0 million. The revolving portion of the Facility includes an option to increase the $20.0 million principal amount of revolving loans available thereunder by up to an additional $20.0 million and a $2.0 million sublimit for letters of credit. Our obligations under the Facility are guaranteed by our material operating subsidiaries (other than our insurance companies) and are secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than our insurance companies), including a pledge of 100% of the stock of AIC. The facility contains certain financial covenants, which include capital expenditure limitations, minimum interest coverage requirements, maximum leverage ratio requirements, minimum risk-based capital requirements, maximum combined ratio limitations, minimum fixed charge coverage ratios and a minimum consolidated net worth requirement, as well as other restrictive covenants.
In connection with the closing of the Facility on that date, we terminated our existing Credit Agreement with The Frost National Bank dated July 30, 2004, as amended (the “Prior Credit Agreement”). At the time of the termination of the Prior Credit Agreement , there were no borrowings or other amounts outstanding under the Prior Credit Agreement. As of December 31, 2006, there were no outstanding loan amounts due under the Prior Credit Agreement, and we were in compliance with all of our financial and other restrictive covenants.
Trust Preferred Securities. On June 1, 2005, our newly formed trust entity, Affirmative Insurance Holdings Statutory Trust II (“Trust Entity II”), completed a private placement of $25.0 million of 30 year floating rate trust preferred securities. Simultaneously, we borrowed $25.0 million from Trust Entity II and the net proceeds from this borrowing, along with cash from operations, were used to purchase the 2.0 million shares of our common stock as discussed in Note 13 of our consolidated financial statements. The trust preferred securities, which can be redeemed in whole or in part by the issuer after five years, bear an initial interest rate of 7.792% until June 15, 2010, at which time they will adjust quarterly to the 90-day LIBOR rate plus 355 basis points.
We and our subsidiaries are named from time to time as defendants in various legal actions arising in the ordinary course of our business and arising out of or related to claims made in connection with our insurance policies, claims handling and employment related disputes. We believe that the resolution of these legal actions will not have a material adverse effect on our financial position or results of operations. However, the ultimate outcome of these matters is uncertain. For detailed information concerning legal actions, please refer to “Legal Proceedings” contained elsewhere in this report.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Affirmative Insurance Holdings, Inc. and subsidiaries as of December 31, 2006, and the results of its operations and its cash flows for the year ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Affirmative Insurance Holdings, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2006, 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 16, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)1 present fairly, in all material respects, the financial position of Affirmative Insurance Holdings, Inc. and its subsidiaries at December 31, 2005 and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)1, present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As described in Note 2 to the consolidated financial statements included in the 2005 Form 10K (not separately presented herein), the Company restated its 2004 and 2003 consolidated financial statements.
Our consolidated financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”) and include our accounts and the accounts of our operating subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.
Our preparation of financial statements in con formity with GAAP requires us to make estimates and assumptions that affect our reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of our financial statements and our reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates. These estimates and assumptions are particularly important in determining revenue recognition, reserves for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance receivables and impairment of assets.
Intangible assets consist of brand names, agency relationships, non-competition agreements and goodwill. Goodwill represents the excess cost over the fair value of identifiable net assets acquired. Goodwill and indefinite
life intangible assets are not amortized but are subject to periodic impairment testing. Finite life intangible assets are amortized on a prorata basis over their expected useful lives, ranging from two to twenty years (Note 9).
We maintain reserves in the amount of the estimated ultimate liability for unpaid losses and loss adjustment expenses related to incurred claims and our estimate of unreported claims. Our estimation of the ultimate liability for unpaid losses and loss adjustment expenses is based on projections developed by our actuaries using analytical methodology commonly used in the property-casualty insurance industry. Our liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based on: (1) the accumulation of estimates of individual claims for losses reported prior to the close of the accounting period; (2) estimates received from ceding companies, reinsurers and insurance pools and associations; (3) estimates of unreported losses based on past experience; (4) estimates based on past experience of expenses for investigating and adjusting claims; and (5) estimates of subrogation and salvage collections. We periodically adjust our losses and loss adjustment expense reserves for changes in product mix, underwriting standards, loss cost trends and other factors. Our losses and loss adjustment expense reserves may also be impacted by factors such as the rate of inflation, claims settlement patterns, litigation and legislative activities. Unpaid losses and loss adjustment expenses have not been reduced for reinsurance recoverable. Changes in estimates of our liabilities for unpaid losses and loss adjustment expenses are reflected in our consolidated statement of operations in the period in which determined. Ultimately, our actual losses and loss adjustment expenses may differ materially from the estimates we have recorded.
Certain previously reported amounts have been reclassified in order to conform to current year presentation. Such reclassification had no effects on net income, stockholders’ equity or cash flows from operating, investing and financing activities.
Profit sharing commissions, which enable us to collect commission income and fees in excess of provisional commissions, are recorded when we conclude it is probable that estimates of loss ratios will be below the levels stated in our agency contracts.
For long-term real estate leases, we estimate future rate increases to compute a straight-line monthly expense over the term of the lease.
As permitted by SFAS 123, until December 31, 2005, we accounted for stock-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognized no compensation cost on grants of employee stock options. Had we adopted SFAS 123R in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described below.
The following table illustrates the effect on our net income and net income per share if we had applied SFAS 123 to stock-based compensation for the years ended December 31, 2005 and 2004 (dollars in thousands, except per share amounts):
On May 9, 2006, the board of directors approved a share repurchase program for up to $15 million of our common stock over the subsequent 12 months. From time to time, repurchases may be made in the open market or through privately negotiated transactions at the discretion of management based on management’s assessment of market conditions and other relevant factors. We expect to fund the purchases initially through internally available funds. In May and June 2006, we repurchased a total of 302,400 shares of our common stock at an average cost of $13.67 per share.
We paid (recovered) the following amounts for the years ended December 31(dollars in thousands):
Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. Our amortized cost and estimated fair value of fixed income securities at December 31, 2006 by contractual maturity are as follows (dollars in thousands):
As of December 31, 2006, we own approximately $16.0 million of pre-refunded municipal bonds. These pre-refunded municipal bonds have contractual maturities in excess of ten years. However, due to pre-refunding, these
securities will be called by the issuer generally within three years or less. Pre-refunded municipal bonds are created when municipalities issue new debt to refinance debt issued when interest rates were higher. Once the refinancing is completed the issuer uses the proceeds to purchase U.S. Treasury securities and places these securities in an escrow account. These proceeds are then used to pay interest and principal on the original debt until the bond is called.
Our investment committee reviewed our investment portfolio in December 2005 and decided to realign a portion of our investment portfolio in order to better align our portfolio with our historical claims life. We determined that the identified securities to be sold would not fully recover prior to the expected sale date, therefore the securities were deemed other than temporarily impaired in December 2005 when the decision to sell was made. The identified securities were in compliance with our investment guidelines prior to the realignment decision of the investment committee.
The following table shows our investments with gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2006 and 2005 (dollars in thousands):
At December 31, 2006 and 2005, investments in fixed maturity securities with an approximate carrying value of $52.7 million and $54.3 million, respectively, were on deposit with regulatory authorities as required by insurance regulations.
Effective July 9, 2004, the date of our initial public offering, we terminated our tax allocation agreement with VIG and began filing separate federal income tax returns on a go forward basis. Prior to July 9, 2004, we were included in a consolidated income tax return filed by VIG. Under the tax allocation agreement with VIG, a company with taxable income pays tax equal to an amount that would have been paid had the company filed a separate return. A company with a taxable loss is paid a tax benefit currently to the extent that affiliated companies within the consolidated group utilizes that loss.
The provision for income taxes for the years ended December 31 consists of the following (dollars in thousands):
Our effective tax rate differs from the statutory rate of 35% for the years ended December 31 as follows (dollars in thousands):
Tax effects of temporary differences that give rise to significant portions of our deferred tax assets and deferred tax liabilities at December 31, 2006 and 2005 are as follows (dollars in thousands):
At December 31, 2006, we have available approximately $2.1 million capital loss carryforward resulting primarily from sales of securities executed in 2006 to realign a portion of our investment portfolio to better align our portfolio with our historical claims life. This capital loss carryforward, which may be carried forward for five years, may only be used to offset future realized capital gains. We recorded a valuation allowance of $725,000 for the full amount of the deferred tax asset resulting from this capital loss carryforward. We believe the available objective evidence, principally the capital loss carryforward being utilizable to offset only future capital gains, our current investment strategy, and a lack of significant historical realized capital gains, creates sufficient uncertainty regarding the realizability of its capital loss carryforward. As a result, it is more likely than not, that substantially all of the capital loss carryforward is not realizable.
On December 31, 2004, we acquired certain assets of the retail agency and franchise operations of 21st Century Holding Company. The acquisition added 24 company owned retail stores and franchise operations consisting of 42 franchise locations operating in Florida. We paid $7.0 million at closing and up to an additional $2.5 million subject to certain performance criteria being met. The retail agency and franchise operations operate under the FED USA brand. Summarized below is an allocation of assets and liabilities acquired (dollars in thousands):
For the year ended December 31, 2006, we have paid $1.1 million in contingent purchase price adjustments related to prior acquisitions, $225,000 for the acquisition of two retail stores and $63,800 for the purchase of a franchise.
As of December 31, 2005, AIC had two quota share reinsurance agreements in place for active programs where the cession ranged from 25% to 100%. In Florida, our underwriting agency, Space Coast Underwriters, produces business on behalf of AIC, and 25% of the business is ceded to FolksAmerica. In Georgia, AIC serves as direct front for an unaffiliated underwriting agency to which 100% of the business is ceded to their insurance company.
VIG transferred our insurance company subsidiaries to us on December 31, 2003. Before this time, these insurance companies had ceded 100% of the business that they wrote to VFIC as part of an intercompany reinsurance agreement. In connection with a reinsurance restructuring agreement, VFIC retained all liability with respect to any losses and allocated loss adjustment expenses occurring on or prior to December 31, 2003 on policies issued by our insurance companies, and retained all corresponding losses and loss adjustment expense reserves as of December 31, 2003. As a result, as of December 31, 2003, our insurance companies had no net loss or loss adjustment expense reserves. In connection with the acquisition of our insurance companies from VIG, this reinsurance agreement was terminated as of December 31, 2003, and our insurance companies began accruing losses and loss adjustment expenses, subject only to third-party reinsurance arrangements, for reported and incurred but not reported losses for insurance policies issued or assumed by our insurance companies after December 31, 2003. Therefore, due to the termination of this 100% reinsurance agreement as of December 31, 2003, our insurance companies have recorded losses and loss adjustment expenses in their respective statements of operations beginning January 1, 2004. Although VFIC remains liable as a reinsurer for all of our insurance companies’ losses and loss adjustment expenses associated with these policies occurring on or prior to December 31, 2003, we are subject to primary liability with respect to these policies. Consequently, we face exposure to credit risk with respect to VFIC’s ability to satisfy its obligations to us.
In June, 2006, the Texas Department of Insurance placed VFIC, along with several of its affiliates, into rehabilitation and subsequently into liquidation. Due to VFIC’s liquidation status, AIC is working through certain procedures to effect its right to withdraw funds from the VFIC Trust. AIC has been working with the Special Deputy Receiver (the “SDR”) and his staff on this matter since VFIC was placed into liquidation. To date, the SDR has not taken issue with the validity of the VFIC Trust; however, we currently are negotiating with the SDR the manner in which the funds will be withdrawn from the VFIC Trust, which must then be approved by the Special Master of the Receivership Court. We have $23.1 million currently in a trust account to collateralize the $20.2 million gross recoverable from VFIC.
We are continuing to transition the non-standard personal automobile business written on all VIG insurance company subsidiaries to AIC and Insura. During this transitional period AIC or Insura will reinsure the new and
For the year ended December 31, 2006, we have ceded $5.9 million of paid losses and $6.8 million of incurred losses and loss adjustment expense to various reinsurers. For the year ended December 31, 2005, we ceded $29.2 million of paid losses and $6.1 million of incurred losses and loss adjustment expense to various reinsurers. These amounts are included as loss and loss adjustment expenses in our statements of operations for the years ended December 31, 2006 and 2005.
Effective January 1, 2005, we reduced the amount of business we ceded to our reinsurers on all business written through our underwriting agencies in Illinois, Indiana, Missouri, New Mexico and South Carolina to zero. Our insurance companies retained 100% of this business.
All of our quota share reinsurance agreements contain provisions for sliding scale commissions, under which the commission paid to us varies with the loss ratio results under each contract. The effect of this feature in the quota share reinsurance agreements is to limit the reinsurer’s aggregate exposure to loss and thereby reduce the ultimate cost to us as the ceding company. These features also have the effect of reducing the amount of protection relative to the quota share amount of premiums ceded by us. Before entering into these reinsurance agreements, and based on our prior operating history, we concluded that each agreement met the risk transfer test of SFAS No. 113 (“SFAS 113”), Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts as the reinsurers assume significant risk and have a reasonable possibility of significant loss.
We have ceded premium to the Michigan Catastrophic Claims Association (“MCCA”), a mandatory facility in that state. In 2006, we ceded $1.8 million in written premiums and $735,000 in earned premium to MCCA.
On January 31, 2006, Judge Bigelow absolved Hawaiian and SCJ of all counts plaintiff filed against them in this litigation on the trial court level by virtue of court order on motions for summary judgment that were submitted by both Hawaiian and SCJ. A partial dismissal without prejudice was entered as to defendant Paul Ruelas. Plaintiff filed a notice of appeal on April 18, 2006. On September 22, 2006, Hawaiian moved to stay appellate proceedings pursuant to an Order of Liquidation entered on August 21, 2006, in the Circuit Court for the State of Hawaii. Hawaiian and the other defendants thereto believe plaintiff’s allegations in this lawsuit are without merit and will continue to vigorously contest the claims brought by the plaintiff, and intend to exercise all available rights and remedies against them; however, the ultimate outcome of this matter is uncertain.
On October 2, 2006, The Court of Appeal of the State of California, Second Appellate District, Division Five, granted the stay order requested by Hawaiian, which effectively stayed the entire litigation proceeding. On December 11, 2006, the court modified its October 2, 2006 stay order by lifting it as to SCJ, causing the suit to proceed with SCJ as the sole defendant. Hawaiian filed a status update with the court on March 7, 2007 indicating that the liquidation proceeding for Hawaiian remains pending and that the August 21, 2006 Order of Liquidation entered by the Circuit Court of the State of Hawaii remains in full force and effect.
Effective August 1, 2005, we entered into novation agreements with several unaffiliated reinsurers related to an assumed aggregate excess of loss reinsurance agreement for business produced in the state of Texas by one of our underwriting agencies, written by Old American and ceded to the reinsurers. These novation agreements eliminated excess of loss coverage that was not necessary so these agreements had no financial impact on us.
VIG transferred our insurance company subsidiaries to us on December 31, 2003. Before this time, these insurance companies had ceded 100% of the business that they wrote to VFIC as part of an intercompany reinsurance agreement. In connection with a reinsurance restructuring agreement, VFIC retained all liability with respect to any losses and allocated loss adjustment expenses occurring on or prior to December 31, 2003 on policies issued by our insurance companies, and retained all corresponding losses and loss adjustment expense reserves as of December 31, 2003. As a result, as of December 31, 2003, our insurance companies had no net loss or loss adjustment expense reserves. In connection with the acquisition of our insurance companies from VIG, this reinsurance agreement was terminated as of December 31, 2003, and our insurance companies began accruing losses and loss adjustment expenses, subject only to third-party reinsurance arrangements, for reported and incurred but not reported losses for insurance policies issued or assumed by our insurance companies after December 31, 2003.
We had favorable reserve development relating to prior year losses of $5.2 million in 2006 and $8.7 million in 2005. These reserve redundancies resulted from decreased estimates of the ultimate liability for losses and related loss adjustment expense for claims reported in previous periods.
Our recorded loss, loss adjustment expense reserves and deposit liabilities of $162.6 million on a gross basis and $138.4 million on a net basis are our best estimates as of December 31, 2006.
Policy acquisition expenses, primarily commissions, premium taxes and underwriting expenses related to issuing a policy, are deferred and charged against income ratably over the terms of the related policies.
On January 1, 2002, we ceased goodwill amortization. We test annually for impairment or more frequently if impairment indicators arise. Intangible assets with finite lives are amortized over their useful lives and are periodically reviewed to ensure that no conditions exist indicating the recorded amount of intangible assets is not recoverable from future undiscounted cash flows.
(3) our financial forecast for the unit; (4) information regarding publicly available financial terms of recent transactions in the industry; and (5) other publicly available information. We perform an impairment test annually as of September 30. The test performed as of September 30, 2006 indicated there was no goodwill impairment.
As of December 31, 2006, our financial statements include $65.3 million of goodwill, $14.7 million of indefinite life intangible assets and $3.4 million of intangible assets having estimated lives of between two and 20 years and a weighted average life remaining of approximately 12 years. We expect $46.7 million of our goodwill and other intangible assets to be fully deductible for tax purposes.
Other intangible assets at December 31, 2006, 2005 and 2004 are as follows (dollars in thousands):
Amortization expense was $1.5 million, $887,000, and $738,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
As of December 31, 2005, other adjustments to goodwill included the valuation allowance for NOLs of $10.2 million offset by changes to the contingent purchase consideration on certain acquisitions and final adjustments to purchase price allocations.
A summary of property and equipment at December 31, 2006 and 2005 is as follows (dollars in thousands):
For the year ended December 31, 2006 we recognized a realized loss on disposal of assets of $432,000 and recognized a realized gain of $13,000 for the year ended December 31, 2005.
As of August 30, 2005, we and our subsidiaries are no longer affiliated with VIG (See Note 1). As a result, there are no amounts related to contracts with VIG and its subsidiaries included in our consolidated balance sheet that would be considered related party.
Any failure by one of our insurance company subsidiaries to meet the applicable risk-based capital or minimum statutory capital requirements imposed by the laws of Illinois or other states where we do business could subject it to further examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require us to increase our statutory capital levels, which we may be unable to do. As of December 31, 2006 each of our insurance company subsidiaries maintained a risk-based capital level in excess of an amount that would require any corrective actions on our part.
On December 31, 2004, our newly formed trust subsidiary, Affirmative Insurance Holdings Statutory Trust I (“Trust Subsidiary I”), completed a private placement of $30.0 million of 30 year floating rate trust preferred securities. Simultaneously, we borrowed $30.9 million from Trust Subsidiary I and contributed $29.0 million to AIC’s policyholders’ surplus. The trust preferred securities, which can be redeemed in whole or in part by the issuer after five years, bears an initial interest rate of 7.545 percent until December 15, 2009, at which time the securities will adjust quarterly to the 90-day LIBOR rate plus 3.6 percentage points. As of December 31, 2006 the note balance was $30.9 million.
Service agreements. On October 16, 2006, we entered into a master services agreement with Accenture LLP under which we will outsource substantially all of our IT operations to Accenture, including our data center, field support and application management. The initial term of the agreement is ten years, although it may be terminated for convenience by us at any time upon six month’s notice after the first two years, subject to the payment of certain stranded costs and other termination fees.
The office space of approximately 543,851 square feet includes a new lease that was entered into in 2006 for approximately 56,875 square feet of office space in Burr Ridge, Illinois. We officially occupied the office space on January 1, 2007, while simultaneously moving from our Bedford Park, Illinois location where we leased approximately 96,722 square feet of office space. The lease for the office space in Bedford Park was terminated on December 31, 2006.
Legal proceedings. We and our subsidiaries are named from time to time as defendants in various legal actions arising in the ordinary course of our business and arising out of or related to claims made in connection with our insurance policies, claims handling and employment related disputes. We believe that the resolution of these legal actions will not have a material adverse effect on our financial position or results of operations, however, the ultimate outcome of these matters is uncertain.
In December 2003, InsureOne Independent Agency, LLC (“InsureOne”), American Agencies General Agency, Inc. and Affirmative Insurance Holdings, Inc. (collectively “Affirmative”) brought action in the Circuit Court of Cook County, Illinois to enforce non-compete and non-solicitation agreements entered into with James Hallberg, the former president of InsureOne, a wholly-owned subsidiary, and eight former employees of InsureOne and two of Hallberg’s family trusts. The court entered interim orders prohibiting all defendants, including Hallberg, from hiring any employees of InsureOne or of plaintiffs’ other underwriting agencies. On November 9, 2005 upon the close of Affirmative’s case, the court ruled that the following counts from our 5th Amended Verified Complaint would remain in the case to be considered until the close of trial: 1) breach of contract by James P. Hallberg; 2) breach of contract by James P. Hallberg Gift Trust and Patricia L. Hallberg Gift Trust; and 3) breach of contract by William Hallberg. James Hallberg’s currently pending counterclaims include breach of contract, fraud, and breach of fiduciary duty. The Hallberg family gift trusts have also asserted a single counterclaim that alleges fraud and breach of fiduciary duty in relation to the purchase of that same 20% minority interest in InsureOne in 2003. We are seeking between $15 and $23 million in damages for lost profits and diminution in value. James Hallberg and the Hallberg family gift trust are seeking combined damages of at least $4,530,482. The trial and post-trial briefing of this matter are complete. The court is expected to render judgment in the case in the first half of 2007.
Affirmative Insurance Holdings, Inc. and Affirmative Property Holdings, Inc. brought action against Business Risk Technology, Inc. and Steven M. Repetti (“BRT”) in the Circuit Court of the 17th Judicial Circuit, Broward County, Florida on January 6, 2006 for fraudulent inducement, breach of contract, breach of the covenant of good faith and fair dealing, and for declaratory and supplemental relief arising from the defendant’s wrongful conduct and contractual breaches. The details of such allegations are set forth in the petition. This action involves our enforcement of certain rights under a software license agreement we entered with BRT wherein BRT agreed to develop and provide us with a complete, turnkey software system for use by our various affiliates. Among the requested relief, we are seeking declaratory relief, a return of confidential and proprietary information, monetary damages, attorneys’ fees, reasonable pre-judgment and post-judgment interest, and any other relief the court deems just. On April 27, 2006, BRT counterclaimed for breach of contract, unjust enrichment, fraud, unfair and deceptive trade practices and libel. Subsequently, the court dismissed the unfair and deceptive trade practices and libel claims without prejudice and provided BRT with leave to amend its complaint in ten (10) days; however, BRT did not
amend. The case is in discovery at this time. We are vigorously prosecuting the claims against the defendants and are exercising all available rights and remedies against them.
One of our insurance subsidiaries, AIC, was the subject of a purported class action in the Circuit Court of the 3rd Judicial Circuit, Madison County, Illinois in a second-amended complaint wherein Plaintiff alleged that AIC committed fraud and misrepresentation by 1) falsely stating “it would pay only a stated fee for a rental car when, in fact, it would pay more than the stated fee;” 2) falsely stating “that a car could be rented for this stated fee when, in fact, a car was not available for rental at this amount;” 3) falsely stating “the facts of the obligation of it and its insureds when one of its insureds was involved in an accident with a third-party such as plaintiff and the members of the Class in that it stated that its obligation with respect to a rental car was limited to the stated fee per day it said it would pay when, in fact, its insured might be liable for a greater amount;” and 4) falsely stating “that it would not pay an amount for rental that would allow Illinois consumers to rent a car of the same or similar kind and quality as that which was damaged, when, in fact, it sometimes did pay such an amount.” The plaintiff sought declaratory relief as to the underlying action, specific relief concerning the class action in the form of various court orders; reasonable attorneys’ fees, compensatory damages in an amount less than $75,000 per class member, and pre-judgment and post-judgment interest. The case concluded on December 18, 2006, when AIC obtained a motion for summary judgment in its favor on the grounds of mootness. Plaintiff did not appeal.
Assessments. Recently, two of our owned underwriting agencies were subject to a routine sales and use tax audit conducted by the State of Texas. The examiner for the State of Texas has now completed his audit report and delivered an audit assessment to us. The examiner’s report asserts that, for the period from January 2002 to December 2005, we should have collected and remitted approximately $2.9 million in sales tax derived from claims services performed by our underwriting agencies for policies sold by these underwriting agencies and issued by Old American County Mutual Insurance Company, an unaffiliated insurance company, through a fronting arrangement. The assessment includes an additional $412,000 for accrued interest and penalty for a total assessment of $3.3 million. We believe that these services are not subject to sales tax, are vigorously contesting the assertions made by the state, and are exercising all available rights and remedies available to us. On October 19, 2006, we responded to the assessment by filing petitions with the Comptroller of Public Accounts for the State of Texas requesting a redetermination of the tax due and a hearing to present written and oral evidence and legal arguments to contest the imposition of the asserted taxes. As a result of the timely filing of these petitions, an administrative appeal process has commenced and the date for payment is delayed until the completion of the appeal process. Such appeals routinely take up to three years and much longer for complex cases. As such, the outcome of this tax assessment will not be known for a commensurate amount of time. At this time, we are uncertain of the probability of the outcome of our appeal. Additionally, we cannot reasonably estimate the ultimate liability at this time. We have not made an accrual for this as of December 31, 2006, as we do not believe this meets the requirements of FAS 5, Accounting for Contingencies.
On January 31, 2007, we entered into a $220.0 million senior secured credit facility (the “Facility”) provided by a syndicate of lenders, including Credit Suisse, Cayman Islands Branch, as Administrative Agent and Collateral Agent. The Facility provides for a $200.0 million senior term loan facility and a revolving facility of up to $20.0 million, depending on our borrowing capacity. On March 8, 2007, we added The Frost National Bank, N.A. to the Facility when we received approval of the First Amendment to the Facility and executed a joinder agreement whereby Frost became the provider of an initial revolving credit commitment of $15.0 million. The revolving portion of the Facility includes an option to increase the $20.0 million principal amount of revolving loans available thereunder by up to an additional $20.0 million and a $2.0 million sublimit for letters of credit. Our obligations under the Facility are guaranteed by our material operating subsidiaries (other than our insurance companies) and are secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than our insurance companies), including a pledge of 100% of the stock of AIC. The facility contains certain financial covenants, which include capital expenditure limitations, minimum interest coverage requirements, maximum leverage ratio requirements, minimum risk-based capital requirements, maximum combined ratio
On March 12, 2004, we issued 19,886 shares of our common stock to VIG in connection with the exercise of warrants, with an exercise price of $0.08 per share, which were originally purchased by VIG in 2000.
On September 28, 2004, we issued 80,837 shares of our common stock to VIG in connection with the exercise of options, with an exercise price of $7.59 per share, which we originally issued to VIG on June 30, 2000.
In January 2005, we issued 6,734 shares of restricted common stock to certain members of our board of directors, in lieu of cash as their annual retainer. In both February and May 2005, we issued 7,500 shares of restricted common stock to certain members of our board of directors for compensation related to services performed. In November 2005, 7,000 shares of restricted common stock that had been issued were cancelled due to the resignation of certain board members. We are expensing the amount to compensation expense over the service period for the remaining issued shares. Total compensation expense recognized for the years ended December 2006 and December 2005 was zero and approximately $108,000, respectively.
In December 2005, we issued 3,000 shares of restricted common stock to Mark E. Pape, Executive Vice President and Chief Financial Officer, which vested immediately. Total compensation recorded at the date of the grant was $42,480.
In May 2006, we issued 2,925 shares of our common stock upon the exercise of options.
In August 2006, we issued 2,104 shares of our common stock upon the exercise of options.
In October 2006, we issued 70,000 shares of restricted stock to Kevin R. Callahan, Chief Executive Officer, which vests ratably over five years. Total compensation recorded for the year ended December 31, 2006 was approximately $34,000.
In October 2006, we issued 37,285 shares of our common stock upon the exercise of options.
In November 2006, we issued 20,000 shares of restricted stock to Joseph G. Fisher, Senior Vice President and General Counsel, which vests ratably over five years. Total compensation recorded for the year ended December 31, 2006 was approximately $5,000.
In November 2006, we issued 61,804 shares of our common stock upon the exercise of options.
During the year ended December 31, 2006, we paid dividends to holders of our common stock in an aggregate amount of $1.2 million.
In December 2004, the FASB issued SFAS 123R, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25 (“APB25”), Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. This standard was effective for public companies at the beginning of the first annual period beginning after June 15, 2005. In March 2005, the SEC issued Staff Accounting Bulletin 107 (“SAB 107”) to assist preparers by simplifying some of the implementation challenges of SFAS 123R. In particular, SAB 107 provides supplemental implementation guidance on SFAS 123R, including guidance on valuation methods, classification of compensation expense, inventory capitalization of share-based compensation cost, income tax effects, disclosures in Management’s
For the year ended December 31, 2006, we have recognized approximately $595,000 before income taxes ($468,000 after income taxes) in share-based compensation expense under the requirements of SFAS 123R resulting in a negligible impact on earnings per share.
As permitted by SFAS 123, until December 31, 2005, we accounted for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognized no compensation cost on grants of employee stock options. Had we adopted SFAS 123R in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net income and earnings per share in Note 2.
In connection with our initial public offering, on May 25, 2004, our board of directors adopted and our stockholders approved the 2004 Stock Incentive Plan (“2004 Plan”) to enable us to attract, retain and motivate eligible employees, directors and consultants through equity-based compensatory awards, including stock options, stock bonus awards, restricted and unrestricted stock awards, performance stock awards, stock appreciation rights and dividend equivalent rights. The maximum number of shares of common stock reserved for issuance under the 2004 Plan, as amended, is 3,000,000, subject to adjustment to reflect certain corporate transactions or changes in our capital structure.
Under the 2004 Plan, the board or committee may fix the term and vesting schedule of each stock option, but no incentive stock option will be exercisable more than ten years after the date of grant. Vested stock options generally remain exercisable for up to three months after a participant’s termination of service or up to 12 months after a participant’s death or disability. Typically, the exercise price of each incentive stock option must not be less than 100% of the fair market value of our common stock on the grant date, and the exercise price of a nonqualified stock option must not be less than 20% of the fair market value of our common stock on the grant date. In the event that an incentive stock option is granted to a 10% stockholder, the term of such stock option may not be more than five years and the exercise price may not be less than 110% of the fair market value on the grant date. The exercise
A summary of activity under the 1998 and 2004 Plans for the years ended December 31 is as follows:
A summary of activity for our nonvested restricted stock grants for the year ended December 31, 2006 is as follows:
The following table identifies the states in which we operate and the gross premiums written by state by our affiliated and unaffiliated underwriting agencies for the years ended December 31, 2006 and 2005 (dollars in thousands):
In 2006, our affiliated and unaffiliated underwriting agencies utilized approximately 7,400 independent agencies and, as of December 31, 2006, 158 owned retail stores and 33 franchised retail stores to sell the policies
Fixed maturities and short-term investments - The fair values of fixed maturities and short term investments are calculated using quoted market prices by third-party organizations.
National Association of Insurance Commissioners Accounting Principles and Procedures Manual subject to any deviations prescribed or permitted by the insurance commissioner in each state of domicile.
Insura and AIC of Michigan are wholly owned by AIC and are included as common stock investments on AIC’s balance sheet in its statutory surplus.
The following is a summary of our unaudited quarterly consolidated results of operations for the years ended December 31, 2006 and 2005:
On January 31, 2007, we completed the acquisition of USAgencies. Pursuant to the terms of a Purchase and Sale Agreement that was effective as of October 12, 2006 (the “Purchase Agreement”), among the Company and the unit holders (the “Sellers”) of USAgencies, we acquired all of the issued and outstanding membership interests of USAgencies from the Sellers for an aggregate purchase price of approximately $196.3 million in cash after giving effect to deductions based on the estimated indebtedness and book value of USAgencies and the estimated expenses of the transaction (the “Purchase Price”). The transaction is effective January 1, 2007 for accounting purposes. Of the Purchase Price, $20.0 million was deposited into an escrow fund to satisfy any indemnification obligations of the Sellers under the Purchase Agreement. The Purchase Price is subject to a post-closing adjustment based on the actual indebtedness and book value of USAgencies and the actual expenses of the transaction, in each case as finally determined within a specified period following closing.
On January 31, 2007, we entered into a $220.0 million senior secured credit facility (the “Facility”) provided by a syndicate of lenders, including Credit Suisse, Cayman Islands Branch, as Administrative Agent and Collateral Agent. The Facility provides for a $200.0 million senior term loan facility and a revolving facility of up to $20.0 million, depending on our borrowing capacity. On March 8, 2007, we added The Frost National Bank, N.A. to the Facility when we received approval of the First Amendment to the Facility and executed a joinder agreement whereby Frost became the provider of an initial revolving credit commitment of $15.0 million. The revolving portion of the Facility includes an option to increase the $20.0 million principal amount of revolving loans available thereunder by up to an additional $20.0 million and a $2.0 million sublimit for letters of credit. Our obligations under the Facility are guaranteed by our material operating subsidiaries (other than our insurance companies) and are secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than our insurance companies), including a pledge of 100% of the stock of AIC. The facility contains certain financial covenants, which include capital expenditure limitations, minimum interest coverage requirements, maximum leverage ratio requirements, minimum risk-based capital requirements, maximum combined ratio limitations, minimum fixed charge coverage ratios and a minimum consolidated net worth requirement, as well as other restrictive covenants.