Net income for the year ended December 31, 2001 reflects a $7.4 million after-tax loss attributable to a write-off of reinsurance recoverables from Reliance Insurance Company. We consider net income (loss) adjusted for write-off of reinsurance recoverables from Reliance Insurance Company to be a non-GAAP financial measure. Because we have not had any other material write-offs of reinsurance recoverables in our history, we believe that the $7.8 million adjusted net income ($0.4 million reported net income plus the $7.4 million after-tax impact of the write-off) is useful to management and investors in understanding our improvement in operating results from 2000 to 2003.
The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes included in this report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this report, particularly under the caption “Risk Factors”.
• commission and service fee income that we earn in connection with the sales and servicing of insurance products underwritten by other insurers and other income; and
• selling, general and administrative, or SGA costs, including salaries, advertising, commissions and other expenses of our employee-agent distribution channel reduced by ceding commissions received under our reinsurance agreements; and
• Net income of $54 million, our highest level in our history and a 25% increase over 2003;
• An annual return on average equity in excess of 25%;
We started 2005 with a new marketing campaign in each of our major Texas markets, and our yellow-page advertising has been incorporated as each major metropolitan area distributes the new version of its publication. We have been primarily writing monthly policies in Texas; but starting in March 2005, we began offering our twelve-month policy as well as our term life product. We are offering financing for these longer term policies.
Reduction in Quota Share Reinsurance. In 2005, we expect to continue to reduce our use of quota share reinsurance. During 2004, we retained 85.0% of gross premiums written as compared to 67.8% in 2003. For 2005, we expect to retain 88% to 90% of our gross premiums written.
Profitability and Return. We expect that our 2005 accident year loss ratio could see some improvement over the approximate 74% accident year loss ratio we experienced in 2004. The potential improvements should increase over the year as our exposure to Miami new business is expected to continue to decline significantly over the next three quarters. We expect that our expense ratio for 2005 will be in the 7% range, which is an increase over what we experienced in 2004, due largely to the timing of the earned premium volume catching up the cost of our expansion in our new states and a continued expected decrease in our overall percentage of premiums being ceded. Overall, we expect to continue to see returns on average equity in excess of 20% in 2005, consistent with our stated long-term objectives.
• increase in the renewal of insurance policies and sales of new policies;
• the timely and successful development and opening of additional neighborhood sales offices in Texas, Missouri and Virginia;
• increase in sales of insurance policies in Texas through the independent agencies that we acquired in January 2005 and our developed neighborhood sales offices;
• the successful transitions from offering monthly policies in Texas to offering six and/or twelve month policies that are supported by our premium finance subsidiary;
• our ability to obtain timely approval of requested rate changes;
• the absence of unfavorable judicial and regulatory developments relative to the automobile insurance industry;
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change, thus having an impact on the amounts reported in the future. We view the estimates and assumptions used in establishing our reserves for losses and loss adjustment expenses and the estimates of future policy cancellations used in determining the amounts recorded as commissions and service fees and ceding commissions as our critical accounting policies.
Effect of Future Cancellations. The insurance policies that we write, through our insurance subsidiaries and on behalf of other insurers for which we receive a commission, are subject to being cancelled by the policyholder prior to the policy expiration date. As a result, we estimate the effect of future cancellations in determining the amount of commission and service fee income and ceding commissions that are recorded in our consolidated financial statements. We use historical cancellation rates that are updated quarterly to estimate future cancellations with the effect of any changes in our estimates being recorded in the period in which the change in the estimate is determined to be necessary. However, actual cancellations may differ materially from the cancellation estimates that we used. As of December 31, 2004, the reserve for return of commission and service fee income and return of ceding commissions was $5.0 million and $1.1 million, respectively.
Allowance for Finance Receivable Losses. Losses on finance receivables include an estimate of future credit losses on premium finance accounts. Credit losses on premium finance accounts occur when the unearned premiums received from the insurer upon cancellation of a financed policy are inadequate to pay the balance of the premium finance account. The majority of these shortfalls result in the write-off of unrealized interest and premium finance acquisition fees. We review historical trends of such losses relative to finance receivable balances to develop estimates of future losses. However, actual write-offs may differ materially from the write-off estimates that we used. As of December 31, 2004, the allowance for finance receivable losses was $6.2 million.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Net income increased 25.3% to $54.0 million in 2004, compared to net income of $43.1 million in 2003. The most significant factors contributing to the increase in net income during 2004 included the higher levels of ancillary income and an increase in net premium volume that produced additional underwriting income. Net premiums earned increased by 63% in 2004 as a result of the growth in gross premiums and an increase in the percentage of business retained. This increase was partially offset by a 2.1 point increase in the Company’s loss ratio and a 3.2 point increase in its net expense ratio. Investment income increased more than 60% for the year primarily as a result of the increase in average invested assets as the Company benefited from a full year’s return on the additional capital provided by the initial public offering that occurred in the second half of 2003. There was minimal impact of realized gains and losses on securities and other during 2004; however, in 2003, the Company’s results of operations included pretax realized gains on securities and other of $3.4 million.
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002. Net income increased to $43.1 million in 2003 from $31.0 million in 2002. The increase in net income was primarily attributable to an increase in premium volume that provided additional underwriting income and growth in ancillary income, both of which were partially offset by an increase in operating expenses. Our loss ratio in 2003 was 73.6% compared to a 69.4% loss ratio in 2002. The impact of loss reserve development was insignificant to our 2003 loss ratio; however, our 2002 loss ratio was decreased by approximately 4.4 points due to the combined impact of favorable development on prior year reserves and a gain on the commutation of obligations of one of our reinsurers. Ancillary income increased to $78.5 million in 2003 from $62.9 million in 2002, which was sufficient to offset all but $2.4 million and $3.0 million of operating expenses in 2003 and 2002, respectively. During 2003, we realized net gains on securities and other of $3.4 million as compared to a net realized loss of $0.1 million in 2002.
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002. Ancillary income in 2003 increased 24.8% to $78.5 million from $62.9 million in 2002. This increase was primarily due to increased premium finance income as a result of higher premium volumes, increased sales of ancillary insurance products including business produced by the 42 Florida neighborhood sales offices acquired in November 2003 and increased service fee income related to the administration of our assumed business in Texas. The increase in premium finance income is net of an increase in the provision for finance receivable losses to $7.0 million in 2003 from $5.3 million in 2002. The majority of the increase in premium finance income is attributable to the increase in average gross premium finance receivables outstanding during the year. The allowance for credit losses remained at 2.9% of gross finance receivables in both 2003 and 2002. For the year ended December 31, 2003 and 2002, the ratio of ancillary income to gross premiums earned was 19.9% and 22.1%, respectively, and the ratio of ancillary income to operating expenses was 97.0% and 95.4%, respectively.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Net investment income increased to $10.8 million in 2004 from $6.7 million in 2003 primarily as a result of a 65.0% increase in average invested assets to $298.5 million in 2004 from $180.9 million in 2003. Since our initial public offering in August 2003, we contributed $51.9 million of capital to our insurance companies in the second half of 2003 and made another $11.5 million of capital contributions during 2004. The proceeds from these capital contributions, coupled with the cash flows from our insurance operations and the invested assets acquired in conjunction with the purchase of the new life insurance company in January 2004, resulted in the significant increase in average invested assets. The average investment yield remained relatively consistent at 3.7% in both 2004 and 2003.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Gross gains on debt securities for the year ended December 31, 2004 were $0.4 million, which were partially offset by gross losses of $0.9 million. The sale of certain debt securities during the year were primarily driven by adjustments to the portfolio in conjunction with the changing interest rate environment. Comparatively, in 2003, we realized gross gains on debt securities of $2.6, which were partially offset by gross losses of $0.6 million, as we repositioned our bond portfolio based on our investment guidelines for changes in market conditions and other factors.
In 2003, we also realized gross gains of $2.7 million and gross losses of $0.9 million on closed contracts in our trading portfolio. The trading portfolio primarily consists of futures contracts, swaps, and other derivative instruments. This represents a speculative investment and does not represent a hedge; accordingly, all open contracts are marked to market with the change in market values included in “net realized (losses) gains on securities and other” in our consolidated statement of operations. For the year ended December 31, 2003, “net realized (losses) gains on securities and other” included a net loss of $0.4 million related to open contracts which included gross increases of $0.3 million and gross decreases of $0.7 million.
We have historically used reinsurance to manage our exposure to loss by ceding a portion of our gross losses and loss adjustment expenses to reinsurers. See “Business - Reinsurance”. We remain obligated for amounts covered by reinsurance, however, in the event that the reinsurers do not meet their obligations under the agreements (due to, for example, disputes with the reinsurer or the reinsurer’s insolvency). Since 2001, in an effort to manage the cost of reinsurance during a period of rising cost and limited availability, we have added provisions to our quota share reinsurance agreements that were structured to reduce the cost of reinsurance to us. In exchange for the reduced cost, our reinsurers were provided with some limit on the amount of potential loss being assumed, while maintaining the transfer of significant insurance risk with the possibility of a significant loss to the reinsurer. We believe our reinsurance arrangements qualify for reinsurance accounting in accordance with SFAS 113 “Accounting for Reinsurance Contracts”.
Reserve Development. We perform an actuarial analysis of our loss reserves each quarter, which encompasses an analysis of developing loss experience from all coverages and states in which we operate. As a result of our fourth quarter actuarial analysis, based upon adversely developing loss trends, we increased our estimate of ultimate incurred losses by approximately $11.2 million, including the related effect of a reduction in ceding commission. Our estimates of incurred losses for accidents that occurred in the first three quarters of 2004 increased by approximately $7.0 million. We considered these adverse trends in determining our estimates for incurred losses attributable to accidents that occurred during the fourth quarter of 2004, which we estimate these trends increased our reserves by approximately $2.0 million. During 2004 we increased our estimate of incurred losses for prior accident years by approximately $6.3 million, approximately $2.2 million of this was recorded during the fourth quarter.
considerably affected by increased fraud activity in the Miami market. For example, we estimate that reported frequency on Florida PIP claims in the Miami market increased over 15.8% from the first quarter to the third quarter of 2004, while during the same period, the reported PIP frequency for the remainder of the Florida markets decreased by 7.3%. In addition to our development in Florida, we increased our prior year estimate of incurred losses in Tennessee by approximately $1.1 million. This increase was principally a result of increases to expected bodily injury frequency trends and increases to the expected average severity of property damage claims.
Florida Results. In 2003, the State of Florida enacted the Florida Motor Vehicle Insurance Affordability Reform Act of 2003 (the “Act”) which entailed various changes that related to PIP coverage in Florida. Purportedly, these changes were “enacted in order to prevent Personal Injury Protection (“PIP”) insurance fraud and abuse and to curb escalating medical, legal and other related costs and thereby restore the health of the PIP insurance market in Florida; preserve the no-fault system; and realize cost savings for consumers.” One of the changes dealt with policies issued on or after October 1, 2003, on which Florida mandated that the maximum PIP coverage deductible be reduced from $2,000 per occurrence to $1,000 and changed the limit of benefit calculation to be $10,000 in excess of the insured’s deductible rather than $10,000 less the insured’s deductible. Prior to the effective date of the law change, we had a rate in place for a $1,000 deductible that was approximately 16% higher than our rate for a $2,000 deductible. We were of the opinion that our rate for this lower deductible, when including the increased coverage limit calculation, was adequate for the additional risk to be assumed by us. We also believe that the effect of the law change as it relates to our 2003 results of operation was not material, as the change only affected policies written on or after October 1, 2003 and the estimated increased premium nearly offset the estimated increase in losses related to the change.
Based on our estimate of loss reserves as of December 31, 2004, we estimate that losses incurred exceeded the additional premiums earned related to the PIP law change, resulting in a decrease to net income of approximately $3.3 million in 2004. We estimate that $2.2 million of this decrease was related to the Miami market and $1.1 million was related to the remainder of the state. As it relates to the Miami market, we believe that the effects of the PIP law change were impacted by the levels of fraud that are present in this market. In May 2004, we increased our PIP rates in many of our Florida territories, which resulted in additional premiums of approximately $0.8 million for the year. This additional premium would further reduce the 2004 adverse impact of the PIP laws change to approximately $2.5 million.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Operating expenses increased 40.9% to $114.0 million for the year ended December 31, 2004 from $80.9 million in 2003. The largest component of this increase related to ceded reinsurance commissions. The Company receives reinsurance commissions on the premiums ceded to its reinsurers, which represent the reinsurers reimbursement of underwriting expenses associated with the business they assume. These reinsurance commissions, which are included as a component of our net SGA Costs, decreased to $15.4 million in 2004 from $33.7 million in 2003 as we reduced the level of premiums ceded to reinsurers. Gross operating expenses, which exclude the effect of ceded reinsurance commissions, increased $14.9 million or 13.0% during 2004. Approximately $5.4 million of this increase was attributable to our expansion states, primarily Texas, but it also includes some initial start up costs in Missouri and Virginia. In addition, our health insurance costs increased $3.1 million, our corporate insurance costs increased $1.2 million generally as a result of being a public company for a full year, and our expenses for accounting services increased by approximately $0.7 million largely associated with implementing and documenting our compliance with the Sarbanes-Oxley Act. The remaining increases related to general growth and expansion, which were partially offset by the savings we achieved by converting the cost structure of the 42-office Cash Register agency, which we acquired in November 2003, from a variable (commission-based) structure to the largely fixed cost structure provided by our business model in 2004.
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002. Operating expenses increased 22.8% to $80.9 million for the year ended December 31, 2003 from $65.9 million in 2002. Excluding the effect of reinsurance commissions, operating expenses increased $9.7 million. The $9.7 million increase was primarily attributable to $3.6 million related to our expansion into Texas, $1.3 million in commission paid to our employee agents on the sale of ancillary insurance products and term life insurance, and other increases in operating costs primarily associated with increased premium volumes.
Under state insurance laws, dividends, which must be paid from earned surplus, and capital distributions from our insurance companies are subject to restrictions relating to statutory surplus and earnings. Our insurance companies collectively paid dividends of $1.0 million, $1.0 million, and $1.3 million to Direct General Corporation in 2004, 2003 and 2002, respectively. These dividends were generally reinvested in the capital of other insurance subsidiaries. Prior approval from state insurance regulatory authorities is generally required in order for our insurance companies to declare and pay extraordinary dividends to us. The maximum amount of dividend capacity available for payment to Direct General Corporation during the remainder of 2005 by our insurance subsidiaries without seeking regulatory approval is $10.1 million. Dividends from our premium finance subsidiary are limited by the minimum capital requirements in applicable state regulations and by covenants in our bank loan agreements, which require approval of our lenders. There are no restrictions on the payment of dividends from our agency, administrative and other non-insurance subsidiaries, other than typical state corporation law requirements to avoid insolvency. In addition, the NAIC Model Act for RBC 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; a low RBC ratio would prevent an insurance company from paying dividends. At December 31, 2004, each of our insurance subsidiaries maintained an RBC level that is in excess of an amount that would require any corrective actions on our part.
Our operating subsidiaries’ primary sources of funds are premiums received, finance income, commission and service fee income, investment income, borrowings under credit facilities and proceeds from the sale and redemption of investments. Funds are used to pay claims and operating expenses, to pay interest and principal repayments under the terms of our indebtedness for borrowed money, to purchase investments and to pay dividends to Direct General Corporation. We had positive cash flow from operations of approximately $67.0 million in 2004, $67.1 million in 2003, and $52.4 million in 2002. We expect our cash flows to be positive in both the short-term and reasonably foreseeable future.
Capital Raising - Initial Public Offering. In August 2003, we completed our initial public offering of 7,972,276 shares of common stock. We sold 3,750,000 shares and selling shareholders sold 4,222,276 shares resulting in net proceeds to us (after deducting issuance costs) of approximately $71.6 million. In conjunction with the offering of common stock, all outstanding shares of preferred stock were converted into common stock and we received an additional $0.8 million from the exercise of a common stock warrant. We used $51.9 million of the proceeds to increase our investment in our insurance subsidiaries and $0.6 million to increase the capitalization of our non-insurance subsidiaries. In addition, we used $7.7 million of the proceeds to pay off a term loan with two banks. The remaining proceeds have not been permanently deployed to date and generally have been used to reduce the amount outstanding under the premium finance revolving credit facility described below.
In an effort to manage our interest rate risk related to our premium finance revolving credit agreement, effective November 1, 2001, we purchased a derivative instrument known as a zero-cost collar from JP Morgan Chase Bank, NA. This derivative instrument requires monthly settlements whereby we pay the difference to the extent the then current 30-day LIBOR rate is below the floor of 5.05% on $25 million and receive the excess of the 30-day LIBOR rate over the cap of 5.05% on $50 million. This derivative instrument was designed to reduce our exposure to changes in LIBOR under our bank loan facilities. Since interest rates are below 5.05% (30-day LIBOR was 2.39% at December 31, 2004), the fair market value of this derivative instrument is unfavorable to us and, accordingly, we recorded a liability of $0.4 million at December 31, 2004. This unrealized loss is reported as a separate component of shareholders’ equity on an after-tax basis. Payments associated with the floor were $0.9 million, $1.0 million, and $0.8 million and for the years ended December 31, 2004, 2003 and 2002, respectively, and were reported in the income statement as interest expense. This derivative instrument is scheduled to terminate on November 1, 2005. See Note 12 to our audited consolidated financial statements included in this report for further discussion on this derivative instrument.
Our investment guidelines also permit us to invest up to 2% of the fair value of our investment portfolio in alternative investments, including commodities. Within those guidelines, we invested $1.0 million in September 2002 in a managed trading account with a commodities trading company. Net realized gains from the trading activities have continually been reinvested and the fair value of this account has increased to $3.1 million as of December 31, 2004. This investment represents less than 1% of our entire investment portfolio. Generally, only 15% of the account balance is invested in commodities and related investments and the remaining portion of the account balance is held in cash, cash equivalents and U.S. Treasury obligations. Because this is a “margin” account, the ultimate losses generated by this investment may greatly exceed the portion of the account balance so invested. However,
Debt Securities. Our investment portfolio consists primarily of debt securities, all of which are classified as available for sale and are carried at fair value with unrealized gains and losses reported in our financial statements as a separate component of shareholders’ equity on an after-tax basis. As of December 31, 2004, the fair value of our investment portfolio of $334.8 million was equal to the amortize cost of the portfolio so there were no net unrealized gains or losses. As of December 31, 2003, the fair value of our investment portfolio of $265.0 million included $1.1 million in pretax net unrealized gains. The decrease in net unrealized gains during 2004 was generally attributable to the declining interest rate environment.
We realized a net pretax loss on the sale of securities of $0.5 million in 2004. Comparatively, we realized pretax net gains of $2.0 million in 2003 when we repositioned our portfolio for changes in market conditions and other factors. Net realized losses on securities available for sale were $0.1 million in 2002. The weighted average book yield of the portfolio was 3.9% for 2004, 3.7% for 2003 and 4.4% for 2002. The effective duration of our investment portfolio was 4.2 years at December 31, 2004, compared to 3.3 years at December 31, 2003.
We monitor our investment results by comparing the total return on our portfolio of debt securities to the total return for a customized benchmark based on a blend of Lehman indices. Total return is comprised of interest income and the change in the fair value of the securities. Because we have a portion of our portfolio invested in the municipal obligations of Tennessee, Louisiana, and Mississippi in an effort to maximize the premium tax credits available to us, we separately evaluate the total return of our taxable and tax-exempt securities by comparing them to customized benchmarks for each investment class. During 2004, our portfolio yield lagged the customized benchmark primarily as a result of holding higher quality securities than the index. The total return on our portfolio of debt securities was 3.7% in 2004, 3.7% in 2003 and 8.5% in 2002.
The following table presents the composition by our internal industry classification of the amortized cost, gross unrealized gains, gross unrealized losses and fair value of debt securities in our investment portfolio as of the dates indicated.
The amortized cost and fair value of debt securities in our investment portfolio as of December 31, 2004, by contractual maturity, is shown below.
All of the debt securities in our portfolio were rated investment grade by the NAIC and S&P as of December 31, 2004. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated or are rated non-investment grade. The quality distribution of our investment portfolio as of December 31, 2004 was as follows:
Based upon our analysis, we believe that we will recover all contractual principal and interest payments related to those securities that currently reflect unrealized losses and that we have the ability to hold these securities until they mature or recover in value. Should either of these beliefs change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other than temporary impairment could be material to our results of operations in a future period. Management believes it is not likely that future impairment charges will have a significant effect on our liquidity.
Cash and Cash Equivalents. Our balance in cash and cash equivalents was $71.0 million and $87.3 million as of December 31, 2004 and 2003, respectively.
Short-Term Investments. Our short-term investments primarily consist of investments in commercial paper, other interest-bearing time deposits with original maturities from three months to one year and our managed commodities trading account.
We believe that our expectations are based on reasonable assumptions. However, these forward-looking statements involve known and unknown risks, uncertainties and other important factors that could cause our actual results, performance or achievements, or industry results, to differ materially from our expectations of future results, performance or achievements expressed or implied by these forward-looking statements. In addition, our past results of operations do not necessarily indicate our future results. We discuss these and other uncertainties in the “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” sections of this report.
Ernst & Young LLP, the Company’s independent registered public accounting firm has audited the financial statements presented in this Form 10-K and has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting as of December 31, 2004. This attestation report is included on the following page of this Form 10-K.
In our opinion, management’s assessment that Direct General Corporation and Subsidiaries maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Direct General Corporation and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Direct General Corporation and Subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2004, and our report dated March 15, 2005 expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheets of Direct General Corporation and Subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Direct General Corporation and Subsidiaries’ internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 15, 2005 expressed an unqualified opinion thereon.
Direct General Corporation, headquartered in Nashville, Tennessee, is a financial services holding company whose principal operating subsidiaries provide non-standard personal automobile insurance, term life insurance, premium finance and other consumer products and services primarily on a direct basis and primarily in the southeastern United States. Direct General Corporation owns four property/casualty insurance companies, two life/health insurance companies, two premium finance companies, thirteen insurance agencies, two administrative service companies and one company that provides non-insurance consumer products and services.
Reinsurance premiums, losses and loss adjustment expenses are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Ceding commissions are recognized net of a provision for return commissions on anticipated cancellations and the amount necessary to cover future maintenance costs.
Policy acquisition costs include advertising, commissions, premium taxes and certain other underwriting and direct sales costs incurred in connection with writing business. These costs are deferred and are reported net of the related ceding commission received from reinsurers. Such deferred policy acquisition costs are being amortized over the effective period of the related insurance policies. Amortization charged to operations amounted to $33,328,000, $26,271,000 and $21,060,000 in 2004, 2003 and 2002, respectively. The Company considers anticipated investment income in determining the recoverability of these costs and believes they will be fully recovered over the next twelve months.
Goodwill represents the amount by which the cost of acquired net assets exceeds their related fair value. In accordance with Financial Accounting Standards No. 142, the carrying value of goodwill is reviewed annually or whenever events or changes in circumstances indicate that the carrying amount might not be recoverable. If the fair value of the operations to which goodwill relates is less than the carrying amount of those operations, including unamortized goodwill, the carrying amount of goodwill is reduced
accordingly with a charge to expense. Based on its most recent analysis, the Company believes that no impairment of goodwill exists at December 31, 2004.
A valuation allowance for deferred tax assets is provided for all or some portion of the deferred tax asset when it is more likely than not that an amount will not be realized. An increase or decrease in a valuation allowance that results from a change in circumstances that causes a change in judgment about the realizability of the related deferred tax asset is included in income. The Company believes its deferred tax assets are fully realizable at December 31, 2004.
Effective August 11, 2003, the Company effected a stock split pursuant to which each outstanding share of the Company’s common stock became 12 new shares of common stock (see Note 10). The Company has adjusted all share and per share amounts in the financial statements and accompanying notes to reflect the 12 for 1 split.
The Company follows the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for its stock option activity in the financial statements. Using the intrinsic value method under APB No. 25, generally no compensation expenses is recorded for employee options that are granted with an exercise price that equals or exceeds the market price at the date of grant. The disclosure provisions required by Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” is provided in Note 10.
The Company primarily analyzes its results on a state-by-state basis because the insurance rates and finance plan structures are subject to state regulation. All revenue and expense streams are considered when analyzing a particular state’s operating results. Accordingly, management may change any number of factors to achieve the desired results in a state including the premium rates, finance plan structure, amount of advertising, or other factors. The Company’s state operating segments constitute one primary
reporting segment that can be appropriately aggregated because each of the state operating segments has identical operations and products; however, varying state regulations require the operations to be divided geographically.
The amortized cost and fair value of debt securities available-for-sale at December 31, 2004, by contractual maturity, is shown below:
A progression of the allowance for finance receivable losses is as follows:
Depreciation expense was approximately $5,601,000, $4,472,000 and $5,385,000 in 2004, 2003 and 2002, respectively.
During April 1998, the Company entered into a sale and leaseback transaction of its building located in Baton Rouge, Louisiana. The gain of $1,068,000 is being amortized over the term of the lease. At December 31, 2004 and 2003, the unamortized portion of the deferred gain was $349,600 and $456,000, respectively, and is included as a component of other liabilities. The building under capital lease was capitalized using the Company’s average borrowing rate at inception of the lease. Depreciation expense on the capitalized building lease was $636,000 during 2004, 2003 and 2002, and related accumulated depreciation on the building under capital lease was approximately $4,137,000 and $3,500,000 at December 31, 2004 and 2003, respectively.
The Company also leases certain computer equipment under capital lease arrangements. Depreciation expense on capitalized equipment leases during 2004, 2003 and 2002 was $414,000, $149,000 and $828,000 respectively, and related accumulated depreciation as of December 31, 2004 and 2003, was $3,348,000 and $2,934,000, respectively.
The Company’s net loss and LAE reserve development was primarily attributable to revisions to the Company’s estimate of ultimate frequency and severity trends. In 2004, approximately $4,500,000 of the unfavorable development was related to our Florida business and approximately $1,100,000 was related to Tennessee. The Florida development was largely attributable to increases in expected frequency and severity trends related to the personal injury protection and property damage coverages while the Tennessee development was generally evenly split between increases to expected bodily injury frequency trends and increases to the expected average severity of property damage claims. The favorable development in 2002 included lower than expected frequency and severity trends across several states and approximately $1,790,000 related to the commutation of certain reinsurance contracts.
The anticipated effect of inflation is implicitly considered when estimating liabilities for losses and LAE. While anticipated price increases due to inflation are considered in estimating the ultimate claim costs, the increase in average severities of claims is caused by a number of factors that vary with the individual type of policy written. Future average severities are projected based on historical trends adjusted for implemented changes in underwriting standards, policy provisions, and general economic trends. Those anticipated trends are monitored based on actual development and are modified if necessary.
In December 2004, the Company entered into a $30,000,000 revolving credit facility with a consortium of banks. Under the terms of the credit facility the Company may periodically obtain advances until June 30, 2007. Interest is payable quarterly at a rate elected by the Company of either the base commercial rate of First Tennessee Bank, N.A., as “Agent”, or at 2.5% above LIBOR. Principal payments begin 18 months after advances under the credit facility reach $10,000,000 and will be determined based upon a five-year amortization schedule. The credit facility matures on June 30, 2007, with all remaining principal and interest payments being due at that time.
Aggregate principal payment on debt outstanding at December 31, 2004 is $426,000 for 2005 and $135,200,000 for 2007.
The Company is the beneficiary of letters of credit totaling approximately $2,403,000 and trust accounts totaling $5,072,000 in accordance with the terms of its reinsurance agreements. The letters of credit and trust accounts were unused at December 31, 2004.
Premiums associated with personal automobile insurance produced for other insurers and related assumed premiums were as follows:
In August 2003, the Company completed the initial public offering of 7,972,276 shares of common stock (after effect of a 12 for 1 stock split - see Note 1). The Company sold 3,750,000 shares and selling shareholders sold 4,222,276 shares resulting in net proceeds to the Company (after deducting issuance costs) of $71,628,000.
In conjunction with the Company’s initial public offering of common stock, all outstanding shares of preferred stock were converted into, and a common stock warrant was exercised for, shares of common stock.
On December 2, 1994, the Company issued 2,937,744 shares of no par value convertible Series A preferred stock in a private placement offering at a price of $2.04 per share. Each share of Series A preferred stock was converted into one share of common stock in conjunction with the Company’s initial public offering in August 2003. Dividends on Series A shares were payable in cash quarterly at an annual rate of 8% and are included in interest expense in the accompanying financial statements.
On August 11, 2003, the Company granted options to purchase 924,000 shares of the Company’s common stock under the 2003 Plan to certain of its executive officers and employees, the exercise price of which equals the initial public offering price of $21 per share. Each of the options issued in August 2003 have a ten-year term with a five-year vesting schedule.
As of December 31, 2004, the average remaining contractual life of options outstanding under both plans is approximately eight years.
A summary of the status of the Company’s stock option plans as of December 31, 2004, 2003 and 2002, and changes during the years ending on these dates is as follows:
The Company follows the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for its employee stock option activity in the financial statements. The Company generally grants employee stock options at an exercise price equal to the market price at the date of grant. Employee stock options granted at less than the market price at the date of grant and options granted to non-employees are expensed. During 2004, the Company recorded $279,000 of expense related to options granted to both employees and non-employees to purchase 115,000 shares at an exercise price of $31.00 per share that was less than the current market price at the time of grant.
The Company’s statutory-basis financial statements of its insurance subsidiaries are prepared in accordance with accounting practices prescribed or permitted by the Department of Insurance in each state of domicile. Each state of domicile required that insurance companies domiciled in those states prepare their statutory basis financial statements in accordance with the NAIC Accounting Principles and Procedures Manual subject to any deviations prescribed or permitted by the insurance commissioner in each state of domicile.
to the extent it has become favorable to the Company. In accordance with SFAS No. 133, as amended, the Company recorded a liability representing the fair market value of the derivative instrument based on a quoted market price of such instrument as of December 31, 2004 of $446,000, which is included in other liabilities in the accompanying financial statements. During 2004, the Company paid $922,000 under this contract, which was transferred net of taxes of $323,000, from other comprehensive income to interest expense and income tax expense, respectively. As of December 31, 2003, the Company recorded a liability of $1,366,000, which is included in other liabilities in the accompanying financial statements. During 2003, the Company paid $969,000 under this contract, which was transferred net of taxes of $339,000, from other comprehensive income to interest expense and income tax expense, respectively. Additionally, in 2003, the Company recorded an unrealized loss of $374,000, net of deferred taxes of $202,000 that is included in other comprehensive income in the accompanying financial statements. During 2002, the Company paid $824,000 under this contract, which is recorded in interest expense and also recorded an unrealized loss of $1,259,000, net of deferred taxes of $674,000, which are included in other income and other comprehensive income, respectively, in the accompanying financial statements.
The Company leases various office space and equipment. Total rent expense was approximately $7,786,000, $6,248,000 and $5,710,000 in 2004, 2003 and 2002, respectively. Approximate future minimum lease commitments for leases having an initial or remaining term of more than one year are as follows at December 31, 2004:
Short-Term Investments - The carrying values reported in the accompanying balance sheets for these financial instruments approximate their fair values.
On January 30, 2004, the Company acquired an inactive life insurance company for a total purchase price of $7,330,000 of which approximately $1,348,000 was attributable to goodwill. The assets of this life insurance company consist of licenses to conduct life and/or accident and health insurance business in 43 states and the District of Columbia and debt securities.
The Company reviews recent accounting pronouncements issued by the Financial Accounting Standards Board, American Institute of Certified Public Accountants, Emerging Issues Task Force, and Staff Accounting Bulletins issued by the United States Securities and Exchange Commission to determine the potential impact on the Company’s financial statements. Based on its review, the Company has determined that the majority of these recently issued accounting standards either do not apply to the Company or will not have a material impact on its financial statements. However, in December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, which will effect the manner in which the Company accounts for its share-based payment arrangements, including stock options. Accordingly, effective July 1, 2005, the Company will be required to expense the cost resulting from all share-based payment arrangements in its financial statements. The Company is currently in the process of determining the impact this standard will have on its financial statements.