We lease approximately 23,000 square feet of office space in an office project at 1301 Capital of Texas Highway., Suite C-300, Austin, Texas as our principal executive offices.
APS Capital engages in the trading, clearing and settlement of trades involving syndicated bank loans, trade claims and distressed private loan portfolios. Trade claims are private debt instruments representing a pre-petition claim on a debtor’s estate. We recognize commission revenue and the related compensation expense when the transaction is complete and fully funded.
The accompanying financial statements have been prepared in accordance with Generally Accepted Accounting Principles ("GAAP"). The preparation of our consolidated GAAP financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates, including those related to: reserve for losses and loss adjustment expenses; death, disability and retirement reserves; reinsurance premiums recoverable/payable; premiums ceded; deferred policy acquisition costs, impairment of assets; bad debts; income taxes; and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Revenue Recognition. Historically, our Insurance Services segment recognized revenues in accordance with Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition. Prior to April 1, 2007, our Insurance Services revenues were historically related to management fees based on the earned premiums of API and included a profit sharing component related to API’s annual earnings. Management fees equaled 13.5% of API’s earned premiums before payment of reinsurance premiums plus profit sharing equal to 50% of API’s pre-tax earnings up to a maximum of 3% of earned premiums before payment of reinsurance premiums. Management fees were recorded, based upon the terms of the management agreement, in the period the related premiums are earned by API. API recognizes premiums as earned ratably over the terms of the related policy. The profit sharing component was historically recognized in the fourth quarter when it was certain API would have an annual profit. In 2007, however, since the management contract ended March 31, 2007, we recognized the quarter’s profit in March, based on our ability to fully determine the profit sharing base.
SFAS 157 describes three levels of inputs that may be used to measure fair value:
Level 1 consists of instruments whose values are based on quoted market prices in active markets. We receive quoted market prices from a third party, independent, nationally recognized pricing service (pricing service). The Company utilizes the pricing service, either for market values obtained based on quoted, actively traded market prices (Level 1) or quoted prices for similar assets in active markets or market prices obtained from third-party pricing services for identical or comparable assets (Level 2). Of our investment portfolio of $208,110,000 as of December 31, 2008 approximately 99% of our fixed-income securities are priced either as Level 1 or Level 2. The fair value estimate for our equity portfolio of $10,044,000 and our U.S. Treasury fixed income securities of $30,993,000 are based on Level 1 pricing provided by this pricing service since there is an active, readily tradable market value based on quoted prices, as of December 31, 2008, or the measurement date. Active markets are those in which transactions occur in significant frequency and volume to provide pricing information on an on-going basis. Valuation of Level 1 securities does not entail a significant degree of judgment since an active market exists and quoted prices are readily and regularly available.
With the exception of U.S. Treasury securities, very few of our fixed-income securities are actively traded. Most of our fixed-income securities, such as government or agency mortgage backed securities, tax-exempt municipal securities and corporate securities are valued using a pricing service and fall within Level 2. Level 2 pricing in our fair value hierarchy comprises $164,414,000 or 79.0% of our investment portfolio which as of December 31, 2008 includes our U.S. Government agency bonds/notes of $24,415,000; U.S Government agency mortgage backed bonds of $30,428,000; U.S. Government agency collateralized mortgage obligations (“CMO’s”) of $50,531,000; Government tax-exempt bonds of $25,446,000; corporate bonds of $7,808,000 and non-agency CMO’s of $25,730,000. Five Alt-A securities with a fair value estimate of $2,659,000 or 1.3% of our investment portfolio are classified as Level 3 since the securities are priced based on non-binding indications provided by dealers and the professional judgment of our investment professionals in our asset management subsidiary, APS Asset Management (Asset Manager) upon review of the specifics of the security, including class, maturity, credit rating, durations, collateral and comparable markets for similar securities. Alt-A securities are CMO’s generally considered to have underlying mortgages with underwriting characteristics that are stronger than “Subprime” mortgages but less stringent than “Prime” mortgages.
In regards to Level 2 pricing, fair values are used and are based on the market prices from the pricing service where valuations are based on quoted market prices for identical or similar assets and/or valuations using industry-standard models such as matrix pricing. The pricing service evaluates each asset based on relevant market information, credit information, perceived market movements and sector news. The market inputs utilized in the pricing evaluation include, benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets benchmark securities, bids and offers, quoted forward prices, time value, volatility factors, current market and contractual prices for the underlying instrument, and industry news and economic events. For mortgage related products, the pricing service uses an Option Adjusted Spread model to develop prepayment and interest rate scenarios. Depending on the security, the priority of the use of inputs may change or some market inputs may not be relevant. The pricing service we utilize has indicated that they will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation.
The deepening national housing crisis and its potential impact on the underlying collateral of our Alt-A securities has resulted in a significant and rapid decline of their fair market value, especially in relation to the market prices provided by the outside pricing service. Consistent with our approach to pricing our entire portfolio, we initially received market pricing on these securities from the pricing service. We then reviewed the pricing of our Alt-A securities based on the market environment and the specific characteristics including the overall structure of the instrument; default rates; demographic and geographic characteristics of the underlying mortgages; support levels; and loan to value ratios. As a result of this review, as of December 31, 2008, we have adjusted five of the seven Alt-A securities to lower fair market value from those indicated by the pricing service, (a market-corroborated observable input) based on non-binding indications received from dealers and the judgment of our Asset Manager (unobservable inputs). We obtain two to three indications from dealers who actively trade in these or similar securities, but are not binding offers. Because the approach to valuing these securities involves significant professional judgment and the expertise of our Asset Manager including the use of unobservable inputs from non-binding dealer indications, we classify securities valued in this manner as Level 3.
The financial condition and near-term prospects of the security’s issuer, taking into consideration the economic prospects of the issuer’s industry and geographical region, to the extent that information is publicly available;
The extent to which the decline in fair value is attributable to credit risk specifically associated with an investment or its issuer;
Our internal assessments and those of our external portfolio managers regarding specific circumstances surrounding an investment, which can cause us to believe the investment is more or less likely to recover its value than other investments of similar characteristics;
For asset backed securities; the origination date of the underlying loans, the remaining average life, the probability that credit performance of the underlying loans will deteriorate in the future, and our assessment of the quality of the collateral underlying the loan; and,
Asset Impairment. We periodically review the carrying value of our assets to determine if events and circumstances exist indicating that assets might be impaired. If facts and circumstances support this possibility of impairment, our management will prepare undiscounted and discounted cash flow projections, which require judgments that are both subjective and complex. We may also obtain independent valuations. In accordance with SFAS No. 142, “Goodwill and Other Intangibles” intangible assets with indefinite lives are not amortized but are subject to annual tests for impairment or more often if events or circumstances indicate they may be impaired. Other identified intangible assets are amortized over their estimated useful lives and are subject to impairment if events or circumstances indicate a possible inability to realize the carrying amount.
Based on our review of the fair value of assets acquired in the acquisition of API on April 1, 2007, there was no goodwill and we recorded an extraordinary gain of $2,264,000 during the three months ended June 30, 2007 for the excess of net assets received over cost to acquire.
In December 2007, the FASB issued Statement of Financial Accounting Standards, or SFAS No. 141 (Revised December 2007) “Business Combinations” (SFAS 141R). SFAS 141R replaces SFAS Statement No. 141, “Business Combinations” but retains the fundamental requirement in SFAS 141 that the acquisition method (referred to as the purchase method in SFAS 141) of accounting be used for all business combinations. SFAS 141R provides new and additional guidance with respect to business combinations including: defining the acquirer in a transaction, the valuation of assets and liabilities when non-controlling interests exist, the treatment of contingent consideration, the treatment of costs incurred to effect the acquisition, the treatment of reorganization costs, and the valuation of assets and liabilities when the purchase price is below the net fair value of assets acquired. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We have adopted the Statement on its effective date.
For both claims-made and occurrence policies, a significant amount of time can elapse between the occurrence or reporting of an insured event and the final settlement of the claim. The time period between the occurrence of a loss and its resolution by an insurer is referred to as the claims tail. Short tail claims are reported and settled quickly, resulting in less reserve estimation variability. The longer the tail or time before the final resolution of a claim, the greater the exposure to estimation risk and hence, greater estimation uncertainty. Although our predominance of claims-made policies has a positive impact in terms of reducing claim tails, most of our policies are nonetheless regarded as having a longer tail than other lines of property and casualty insurance. This is because medical professional liability claims frequently involve litigation which may take years before a judgment or settlement is reached. Medical liability claims are typically resolved over an extended period of time, often five years or more.
In addition to case reserves, we also maintain reserves for claims incurred but not reported, commonly referred to as IBNR. IBNR is the estimated liability for (1) the ultimate cost of claims that have been reported but not yet settled, and (2) claims that have occurred but have not yet been reported. IBNR reserves are established to cover additional exposure on known and unknown claims using various actuarial loss projection models. Included in our IBNR loss reserve are estimates of the aggregate difference between our individual estimated case reserves and the amount for which they will ultimately be settled. This provision, which is included in our total IBNR reserves, comprises the majority of such reserves given our predominately claims-made coverage. Since each claim reported is settled individually based on its merits, and it is not unusual for a claim to take years after being reported to settle, an IBNR reserve is established for this uncertainty in ultimate claim cost. An additional provision in our IBNR loss reserves is included for our small percentage of occurrence policies where claims have occurred but have not yet been reported. While actuarial loss projection models vary, our general approach for calculating IBNR reserves involves calculating ultimate losses and LAE costs by each accident year and reducing that amount by the amount of cumulative claims paid and by the amount of our case reserves.
As part of its evaluation, our outside consulting actuary develops a point estimate and a range of reserves it believes is reasonable. The point estimate represents our actuaries' estimate of the most likely amount that will ultimately be paid to settle unpaid claims at a particular point in time. The upper end of the range reflects their higher estimates of future loss and loss adjustment expenses while the lower end of the range reflects their lower estimates of future loss and loss adjustment expenses. In general, the width of a range reflects the level of variability in the underlying projections. These range determinations are based on estimates and actuarial judgments and are intended to encompass reasonably likely changes in one or more of the variables that were used to determine the point estimate.
Because of the nature and complexities of this line of insurance and expectations about future claim results and trends, our best estimate may differ from the selected reserve estimate of our independent actuary. Even minor changes in assumptions regarding these factors can have a substantial impact on the projection of the ultimate liability, especially with a long-tailed, low-frequency, high-severity line of business such as medical professional liability insurance. While our assessment may differ, our carried reserves remain within the actuarial range of the independent actuary’s selected reserve estimate. The data and analysis performed by our independent actuarial firm serves as an objective confirmation of the adequacy of our carried reserves and we utilize the actuarial point estimate and reserve ranges to monitor the adequacy and reasonableness of recorded reserves. The reserve opinions of our independent actuary for the years ended December 31, 2008 and 2007 have been filed with state insurance regulators along with API’s statutory financial statements.
We have established a net reserve for loss and LAE at $78,257,000 as of December 31, 2008 or what we believe to be the upper end of the reserve estimates, as projected by actuarial review; however, there is no assurance that such reserves will ultimately prove adequate. We have established a position of conservatively reserving to the upper-end of the reserve estimate due to the inherent judgments and uncertainties in estimating ultimate claims losses and management’s philosophy that this is the appropriate approach to reserving at the current time.
Loss frequency and severity trends are important assumptions in the estimation of ultimate liability of losses and loss adjustment expenses. Claims frequency is measured in various ways. The most common measure is the number of claims reported, which is then typically adjusted for the relative exposure, either in terms of the number of insureds or earned premiums. Claims frequency is also measured in terms of the number of claims reported to us on which we make loss payments as opposed to claims on which we pay only expenses or those that we close with no payment to claimants. Claim frequency impacts not only our projection of the number of IBNR claims associated with our occurrence or tail business but is also evaluated to determine the cause of changes in frequency. In periods where claims frequency is declining, we determine the nature of the claims in decline. A drop in non-meritorious claims, for example, could have an impact on the percentage of claims that will ultimately have loss payments and could impact the projection of ultimate losses.
Our incurred loss and loss adjustment expense for the most recent accident year of $39,134,000 in 2008 is reflective of the relative decreases in reported claim count as compared to prior accident years of $40,682,000 in 2007 and $42,354,000 in 2006. In 2008 and 2007, we decreased our incurred loss and loss adjustment expense for prior year development by $20,565,000 in 2008 and $16,023,000 in 2007, which was primarily the result of loss severity for the 2002 through 2006 report years developing favorably compared to prior period estimates.
The following tables, known as the reserve development tables, show the development of the net liability for unpaid loss and loss adjustment expenses. The top line of the table shows the original estimated liabilities at the balance sheet date, including losses incurred but not yet reported. The upper portion of the table shows the cumulative amounts subsequently paid as of successive year-ends with respect to the liability. The lower portion of the table shows the re-estimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimates change as claims settle and more information becomes known about the ultimate frequency and severity of claims for individual years. A (deficiency) or redundancy exists when the re-estimated liability at each December 31 is greater (or less) than the prior liability estimate. The cumulative (deficiency) or redundancy depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years. The volatility of medical professional liability claim frequency and severity makes the prediction of the ultimate losses very difficult. Likewise, the long period of time necessary for medical professional liability claims to develop and be paid further complicates the reserving process.
The following summarizes our reserve development since our acquisition of API on April 1, 2007. Since we acquired API on April 1, 2007, reserve development data for API prior to that date is not directly applicable for us.
Prior to the passage of Texas tort reform in 2003, API saw a significant increase in the number claims reported as claimants were attempting to beat the filing deadline prior to tort reform going into effect. This has resulted in significant adverse development from the originally reported net liability for 2003.
The table below shows our recorded net reserves at December 31, 2008 and December 31, 2007, the actuarial point estimates and the high and low ends of the actuarial reserve range, as determined by our independent actuaries:
Under API’s primary medical professional liability reinsurance contract or excess of loss treaty, certain premiums are ceded to other insurance companies under the terms of the reinsurance agreement. The excess of loss treaty provides coverage for losses in excess of API’s retention of $250,000 on individual claims and beginning in 2002, $350,000 on multiple insured claims related to a single occurrence. The 2006 reinsurance contract provides for these same terms with API retaining 10% of the risk above the aforementioned $250,000 and $350,000 retention levels. The 2007 reinsurance contract provides for the same terms with API retaining 20% of the risk above the $250,000 and $350,000 retention levels. The 2008 reinsurance contract provides for the same terms with API retaining 40% of the risk above the $250,000 and $350,000 retention levels. The reinsurance contracts for 2002 through 2008 contain variable premium ceding rates based on loss experience and thus, a portion of policyholder premium ceded to the reinsurers is calculated on a retrospective basis. The variable premium contracts are subject to a minimum and a maximum premium range to be paid to the reinsurers, depending on the extent of losses actually paid by the reinsurers. A provisional premium is paid during the initial policy year. The actual percentage rate ultimately ceded under these contracts will depend upon the development of ultimate losses ceded to the reinsurers under their retrospective treaties.
There are several factors that can directly affect the ability to accurately forecast the reinsurance recoverables. Many of the factors discussed above related to the sensitivities of forecasting total loss and loss adjustment expense reserves also apply when analyzing reinsurance recoverables. Since we cede excess losses above $250,000 on individual claims and $350,000 on multiple insured claims plus additional retention levels above those amounts, the trends related to severity significantly affect this estimate. Current individual claims severity can be above or fall below our retention level over the period it takes to resolve a claim.
Deferred Policy Acquisition Costs. The costs of acquiring and renewing insurance business that vary with and are directly related to the production of such business are deferred and amortized ratably over the period the related unearned premiums and maintenance fees are earned. Such costs include commissions, premium taxes and certain underwriting and policy issuance costs. Deferred acquisition costs are recorded net of ceding commissions. Deferred policy acquisition costs are reviewed to determine if they are recoverable from future income, including investment income. If such costs are estimated to be unrecoverable, they are expensed in the period the determination is made.
Income Taxes. We compute income taxes utilizing the asset and liability method. We recognize current and deferred income tax expense, which is comprised of estimated provisions for federal income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all or some portion of the benefits related to the deferred tax assets will not be realized. We have not established a valuation allowance because we believe it is more likely than not our deferred tax assets will be fully recovered. In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 ("FIN 48"), which we adopted on January 1, 2007. FIN 48 clarifies the accounting for income tax uncertainties. We have developed and implemented a process based on the guidelines of FIN 48 to ensure that uncertain tax positions are identified, analyzed and properly reported in the company’s financial statements in accordance with SFAS 109. Based on all known facts and circumstances and current tax law, we believe that the total amount of unrecognized tax benefits as of January 1, and December 31, 2008, is not material to our results of operations, financial condition or cash flows. We also believe that the total amount of unrecognized tax benefits as of January 1, and December 31, 2008, if recognized, would not have a material effect on our effective tax rate. We further believe that there are no tax positions for which it is reasonably possible that the unrecognized tax benefits will significantly increase or decrease over the next 12 months producing, individually or in the aggregate, a material effect on our results of operations, financial condition or cash flows.
The pro forma adjustments are based upon available information and assumptions that each company’s management believes are reasonable. The unaudited pro forma condensed consolidated financial statements are presented for illustrative purposes only and are based on the estimates and assumptions set forth in the notes accompanying these statements, which should be read in conjunction with these unaudited pro forma condensed consolidated financial statements. The companies may have performed differently had they always been combined. You should not rely on this information as being indicative of the historical results that would have been achieved had the companies always been combined or the future results that the combined company will experience. The unaudited pro forma condensed consolidated financial information is not comparable to our historical financial information due to the inclusion of the effects of the API acquisition. The unaudited pro forma condensed consolidated financial statements and the related notes thereto should be read in conjunction with the audited consolidated financial statements of the Company for the years ended December 31, 2007 and 2006, and the related notes thereto and other information in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the unaudited financial statements of API for the quarter ended March 31, 2007 filed in our Form S-1 dated, June 19, 2007.
Each share of Series A redeemable preferred stock of API was converted into the right to receive one share of our Series A redeemable preferred stock. The shares of our common stock and Series A redeemable preferred stock issued in the acquisition are subject to a 180-day lock-up period in which the holders of such shares are prohibited from transferring their shares. This lock-up period expired on September 28, 2007.
Records commissions expense incurred by API that is currently reimbursed by the Company. There is no reimbursement following the acquisition. The reimbursement was eliminated in our financial statements.
Our Financial Services segment suffered its first net operating loss since 1996 as a result of the 2008 collapse of the investment, mortgage and banking markets. This segment experienced significant declines in commission revenue from security trading in both investment grade and non-investment grade securities, along with similar revenue percentage declines in our investment banking and bank debt trade claim businesses. Though the size of monthly losses eased in the final months of the year as a result of continued efforts to cut costs, it is apparent that a return to profitability for this segment will be dependent to a great extent upon the recovery of the U.S. economy as a whole and the investment markets in particular
The following table sets forth selected historical financial and operating data. Our results of operations for the year ended December 31, 2007 include the historical financial and operating results prior to and subsequent to the acquisition of API on April 1, 2007. The selected historical financial and operating data is derived from our consolidated financial statements which management believes incorporate all of the adjustments necessary for the fair presentation of the financial condition and results of operations for such periods. All information is presented in accordance with GAAP, but may not be comparable as data stated for periods 2006 and later were impacted by the implementation of SFAS No. 123(R). Actual financial results through December 31, 2008 may not be indicative of future financial performance. Equity compensation expense of approximately $1,200,000 related to our acquisition of API is included in the year ended December 31, 2007 results from operations.
For comparative purposes, we have also included the results of operations for the year ended December 31, 2007 and 2006 on a “pro forma basis” since we did not acquire API until April 1, 2007. This information is provided to highlight the results of operations prior to our acquisition of API and any reference in this Item 7 below to “pro forma” reflects the impact to us had we acquired API as of January 1 of the year indicated.
(2) Expense ratio is defined as the ratio of other underwriting expenses and net change in deferred acquisition costs to net premiums and maintenance fees earned
Further explanation for the year-to-year variances are described below throughout the remainder of Item 7 of this Form 10-K.
Gross premiums and maintenance fees written increased $13,997,000 (28%) from $50,120,000 to $64,117,000 for year ended December 31, 2008 as compared to 2007 as a result of the acquisition of API on April 1, 2007.
On a pro forma basis, gross premiums and maintenance fees written decreased $1,469,000 (2%) from $65,586,000 for the year ended December 31, 2007 to $64,117,000 for the year ended December 31, 2008. While API increased in the number of policyholders to approximately 5,330 at December 31, 2008 from 4,930 at December 31, 2007, gross premiums and maintenance fees written decreased due to rate decreases which averaged 6% for the year ended December 31, 2008 as compared to average rate decreases of 14% for 2007. We continue to experience growth in the number of policyholders; however, premium growth has decreased in 2008 as compared to 2007 as a result of pricing decreases.
On a pro forma basis, net premiums and maintenance fees earned decreased by $8,269,000 (11%) to $64,081,000 from $72,350,000 for the year ended December 31, 2008 as compared to the same period in 2007. Written premiums and maintenance fees were down $1,469,000 year over year primarily due to rate decreases and we recognized $4,086,000 less in favorable development for the prior years’ reinsurance treaties during 2008 as compared to 2007.
Investment income statement data for the year ended December 31, 2008 and pro forma income statement data for the year ended December 31, 2007 are included in the following table:
Realized capital gains and losses income statement data for the years ended December 31, 2008 and 2007 are included in the following table:
36% is comprised of agency-backed mortgage obligations, with underlying collateral consisting of GNMA, FHLMC, or FNMA loans;
38% is comprised of U.S. Treasury, government agency bonds and notes, municipal tax exempt bonds and corporate bonds; and,
The majority of the non-agency CMO’s in our portfolio have underlying mortgages categorized as “Prime” quality loans, and none of our CMO’s have underlying mortgages classified as “Subprime.” Also, all CMO’s have underlying mortgages with fixed rates. However, within our portfolio at December 31, 2008, there were seven CMO securities classified as “Alternative-A” or “Alt-A”. These Alt-A securities are generally considered to have underlying mortgages with underwriting characteristics that are stronger than “Subprime” mortgages but less stringent than “Prime” mortgages. All but one of our Alt-A securities are investment grade, have underlying fixed rate mortgage collateral and as of December 31, 2008 are rated either AA or A. The Alt-A security that is non-investment grade has a book value at December 31, 2008 of $27,000.
Beginning with the three months ended September 30, 2007, we saw a significant and rapid decline in the market value of our Alt-A securities. In evaluating this decline, we considered the deepening national housing crisis and its potential effects on the underlying collateral and concluded that the decreases in value of our Alt-A securities should be considered to be “other than temporary” as defined in SFAS 115, Accounting for Certain Investments in Debt and Equity Securities. Prior to the three months ended December 31, 2008, we had previously determined that all but one of the Alt-A securities was other-than-temporarily impaired. As a result of the continued deterioration in the credit, housing and mortgage market and the erosion in the underlying collateral support for the Alt-A securities, we recorded additional write-downs of $1,220,000 for the three months ended December 31, 2008 primarily due to the remaining AA-rated security that had previously not been deemed other-than-temporarily impaired in prior quarters. The amount of the pretax charge to earnings associated with write-downs of our Alt-A securities for the twelve months ended December 31, 2008 and December 31, 2007 was $5,819,000 and $4,566,000, respectively. The aggregate write-down on Alt-A securities since the quarter ended September 30, 2007 is $10,385,000. While we have the ability to hold all of our Alt-A securities indefinitely, we continue to closely monitor and evaluate these securities and their underlying collateral.
Realized capital gains and losses income statement data for the year ended December 31, 2008 and pro forma income statement data for the year ended December 31, 2007 are included in the following table:
Our Financial Services revenue decreased $14,863,000 (71%) for the year ended December 31, 2008 compared to 2007. APS Financial, our broker/dealer, derives most of its revenue from transactions in the fixed income market, in both investment and non-investment grade securities. As the table above shows, commission revenue at APS Financial was down 10,531,000 (67%) for the year ended December 31, 2008 compared to 2007 due to a continuing trend of very low transaction activity seen throughout the year. Among the factors affecting transaction activity include the well-publicized issues in the mortgage lending and financial markets with the anticipation of the continuation of these factors. This, along with widespread uncertainty as to the length and severity of the current economic recession, has led to the inclination of many of our investors to remain inactive. The same general market conditions affected the revenues derived from our investment banking and the bank debt/trade claims business. Decreases in investment banking revenues totaled $2,331,000 (93%) while bank debt-trade claim revenues were off $2,305,000 (76%) for the year ended December 31 2008 compared to 2007 due again to difficult credit market conditions. While our Financial Services business constitutes a much less significant portion of our consolidated results of operation since the acquisition of API, we are actively exploring avenues to return this segment to profitability. Cost cutting measures have been implemented which included reduction of personnel, compensation reductions and information services. However, a return to profitability for this segment will also depend, to a large extent, on improved market conditions and a corresponding increase in revenues. We cannot predict when this could occur.
Loss and loss adjustment expenses for the year ended December 31, 2008 and pro forma income statement data for the year ended December 31, 2007 are included in the following table:
Other underwriting expenses and net change in deferred acquisition costs for the years ended December 31, 2008 and 2007 are included in the following table:
Prior to the acquisition of API, the historical results of operations of our Insurance Services segment were determined by the management fees we received from API pursuant to a management agreement and the expenses incurred in managing API’s operations. In conjunction with the merger with API on April 1, 2007, our management agreement was terminated as of March 31, 2007, and as such is no longer included in our consolidated results of operations. Thus, as a result of the merger, insurance management services expenses decreased to zero from $3,823,000 for the year ended December 31, 2008 compared to 2007. Insurance services expenses were recorded only through the quarter ended March 31, 2007.
Financial services expenses for the years ended December 31, 2008 and 2007 are included in the following table:
The 3% minority interest in Asset Management, a subsidiary within our Financial Services segment, owned by key individuals within Asset Management, was repurchased by APS Investment Services in the third quarter of 2007 for a nominal amount.
Condensed pro forma income statement data for the year ended December 31, 2007 and condensed pro forma income statement data for the year ended December 31, 2006 are included in the following table:
Premium related income statement data for the years ended December 31, 2007 and 2006 are included in the following table:
On a pro forma basis, gross premiums and maintenance fees written decreased $9,247,000 (12%) to $65,586,000, from $74,833,000 for the year ended December 31, 2007 compared to the same period in 2006. While API increased in the number of policyholders to 4,930 at December 31, 2007 from 4,712 at December 31, 2006, gross premiums and maintenance fees written decreased due to rate decreases which averaged 14% for the year ended December 31, 2007. As a result of increased marketing efforts, we continued to experience growth in the number of policyholders; however, this growth slowed in 2007 as compared to 2006 as a result of pricing and competitive pressures.
On a pro forma basis, premiums ceded expenses decreased $7,115,000 to $2,406,000 from ($4,709,000) for the year ending December 31, 2007 as compared to the same period in 2006. The reinsurance contracts beginning in 2002 through 2007 are variable premium treaties that have various minimum and maximum rates. The actual premium rate will depend upon the ultimate losses ceded to the reinsurer under the related treaty. We, supported periodically by outside consulting actuarial reviews, continually monitor the development of claims subject to reinsurance and adjust premiums ceded for estimated profit sharing provisions based on claims development in the reinsurance layers. The pro forma decrease in premiums ceded of $7,115,000 is primarily the result of lower estimated ceding rates due to lower estimated loss and loss adjustment expenses for prior treaty years 2002 through 2006. This prior year favorable development in the reinsurance layer resulted in us recognizing $10,888,000 primarily as a reduction to ceded premiums for the twelve months ended December 31, 2007. During 2006 we lowered the estimated ceding rates for prior treaty years 2002 through 2005, which caused us to recognize $7,743,000 in positive development as a reduction in ceded premium. Additionally, ceded premiums decreased year over year due to the Company retaining 20% of any claim in excess of $250,000 on individual claims and $350,000 on multiple insured claims for the 2007 reinsurance treaty. We retained 10% of any excess on the 2006 treaty. We retained this additional risk in the reinsurance layer based on decreases in claims since the passage of tort reform legislation in 2003. In addition, ceded premiums were lower for the current period due to lower earned premiums in 2007 as compared to 2006.
Realized capital gain and loss data for the years ended December 31, 2007 and 2006 are included in the following table:
Beginning with the three months ended September 30, 2007, we saw a significant and rapid decline in the market value of our Alt-A securities, particularly those with an A rating. In evaluating this decline, we considered the deepening national housing crisis and its potential effects on the underlying collateral and concluded that the decreases in value of our A rated Alt-A securities should be considered to be “other than temporary.” The amount of the pretax charge to earnings associated with this adjustment for the three months ended December 31, 2007 and September 30, 2007, are $1,426,000 and $3,140,000, respectively. For the year ended December 31, 2007 the total pretax charge to earnings is $4,566,000 lowering our total book value in Alt-A securities to $11,206,000 as of December 31, 2007. In November 2007, we sold one of the AA rated Alt-A securities with a book value of approximately $1,100,000 and recorded a modest loss.
Additionally, for the year ended December 31, 2007 there were $693,000 in impairment charges resulting from our investment in Financial Industries Corporation (“FIC”) as compared to $19,000 for the year ended December 31, 2006, having previously resolved that declines in FIC’s stock price will be considered to be “other than temporary”.
Pro forma realized capital gain and loss data for the years ended December 31, 2007 and 2006 is included in the following table:
On a pro forma basis, realized capital losses were $5,130,000 for the year ended December 31, 2007 compared to a gain of $161,000 for the year ended December 31, 2006. The increase in losses for the current year is primarily due to other than temporary impairment charges of $4,566,000 in the last two quarters of 2007, resulting from fair market value declines in our investment in Alt-A collateralized mortgage-backed securities. In addition, we incurred realized losses on our investment in FIC. Both of these realized investment losses are discussed above under actual results.
As a result of the acquisition of API on April 1, 2007, loss and loss adjustment expenses increased to $13,695,000 from $0 for the year ended December 31, 2007 compared to 2006.
Pro forma other underwriting expenses for the years ended December 31, 2007 and 2006 are included in the following table:
Financial services expenses for the years ended December 31, 2007 and 2006 are included in the following table:
Our Financial Services expenses increased $3,873,000 (26%) for the year ended December 31, 2007 compared to 2006. The primary reason for the 2007 increase is a $3,007,000 (32%) increase in commission expense in 2007 compared to 2006 resulting from the increase of commissions paid on non-investment grade bond and trade claim transactions mentioned above. In addition, incentive compensation costs increased $257,000 (25%) in 2007 as a result of increased profits in 2007 compared to 2006. Legal and professional expenses were higher by $531,000 (150%) for 2007 due to costs incurred for litigation concerning certain transactions and for expenses to further our efforts to become compliant with the Sarbanes-Oxley Act of 2002. Lastly, a claim was settled in 2007 in the amount of $135,000 resulting from a disputed trade claim transaction.
Cash Flows. Our total cash and cash equivalents balance at December 31, 2008 was $22,060,000, an increase of $3,669,000 (20%) in the current year as cash provided by operating activities more than offset net cash used in investing and financing activities. Our cash flows provided from operating activities totaled $25,663,000 for the current year on the strength of net income of $19,163,000 and from net reinsurance reimbursements for prior years’ swing-rated treaties totaling $9,285,000. Our Insurance Services segment generated the bulk of the cash received from operating activities, the result of increased premium and maintenance fee receipts and decreased claims payouts. Our cash flows used in investing activities totaled $13,308,000 in 2008 primarily as a result of purchases of available-for-sale fixed income and equity securities in excess of proceeds from their sale. Cash used in financing activities totaled $8,686,000 for the year ended December 31, 2008 primarily as a result of dividend payments to our common and preferred shareholders, preferred share redemptions and repurchases of our common stock under share repurchase program. For details of the amounts described above, refer to the Condensed Consolidated Statements of Cash Flows of this Form 10-K.
Letters of Credit. We assumed reinsurance liabilities on medical professional liability policies written by another insurance company in the state of Texas. In the course of assuming this business, we have established a letter of credit for the benefit of this insurance company in the amount of $500,000 and pledged assets in the amount of $525,000 to secure the letter of credit as of December 31, 2008. See Note 9 to the Consolidated Financial Statements included herein.
Capital Expenditures. In April 2007 we entered into a contract with a vendor to provide us with and implement an integrated policy and claims administration system. The total capitalized expenditures for the project is anticipated to be approximately $2,000,000. Our capital expenditures for all equipment including hardware and software costs were $810,000 for the year ended December 31, 2008 of which approximately $357,000 were related to this software implementation project and remainder of $453,000 was primarily related to network and hardware upgrades. We expect to incur additional capitalized expenditures of approximately $800,000 for the remainder of this project, which are expected to be funded from cash on hand over the first half of 2009.
At December 31, 2008, API had investments with a fair market value of $1,433,000 on deposit with state insurance departments to satisfy regulatory requirements and these securities are included in fixed maturities, available for sale.
The following is a summary of our contractual obligations as of December 31, 2008:
In permitting clients to purchase on margin, we are subject to the risk of a market decline, which could reduce the value of our collateral below the client’s indebtedness. Agreements with margin account clients permit our clearing organization to liquidate our clients’ securities with or without prior notice in the event of an insufficient amount of margin collateral. Despite those agreements, our clearing organization may be unable to liquidate clients’ securities for various reasons including the fact that the pledged securities may not be actively traded, there is an undue concentration of certain securities pledged or a trading halt is issued with regard to pledged securities. If the value of the collateral were insufficient to repay the margin loan, a loss would occur, which we may be required to fund. As of December 31, 2008, the total of all customer securities pledges on balances held in margin accounts was approximately $249,000 while the total value of the securities within these margin accounts was approximately $1,455,000. We are also exposed to risks should Southwest be unable to fulfill its obligations for securities transactions.
Accrued expenses and other liabilities decreased $921,000 (13%) to $6,266,000 at December 31, 2008 from $7,187,000 at December 31, 2007 primarily as a result of lower accrued incentive compensation in 2008 resulting from lower net income in 2008. In addition, funds held by API increased $610,000 (28%) at December 31, 2008 and represents a timing issue where premiums are received in advance of policy effective dates. Lastly, commissions payable were $231,000 (27%) lower at December 31, 2008 primarily as a result of lower commissions earned in our Financial Services segment. Partially offsetting these decreases was in increase of accrued legal fees of $1,015,000 at December 31, 2008 compared to 2007 and represents costs associated with ongoing litigation.
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (SFAS) 157, Fair Value Measurements. SFAS 157 provides enhanced guidance for using fair value to measure assets and liabilities. Under the standard, fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts its business. SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, SFAS 157 establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy.
In April 2008, the FASB issued FSP No. 142-3, Determination of the Useful Life of Intangible Assets. FSP No. 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangible Assets. FSP No. 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008. Early adoption is prohibited. We are currently evaluating the impact of the pending adoption of FSP No. 142-3 on our consolidated financial statements.