The following tables, presented in a condensed format, reflect the effect of the adjustments resulting from accounting errors on Vesta’s Consolidated Balance Sheets and the Consolidated Statements of Operations as of and for the years ended December 31, 2003, 2002, 2001 and 2000. See “Management’s Discussion and Analysis of Results of Operations and Financial Condition- Restatement of Previously Issued Financial Statements” for a description of the accounting errors and related adjustments, and for analyses of the effect of the adjustments on the principal Consolidated Balance Sheets and Statements of Income accounts affected. See also Note B of Notes to Consolidated Financial Statements.
Reflecting these adjustments in the restated financial statements impacted our Consolidated Statements of Operations and consolidated total comprehensive loss as follows (in thousands):
Correction of Misclassifications-As part of our internal review, the Company identified certain prior period balance sheet items that were improperly classified and therefore are not comparable to the current year balance sheet presentation. These items, which predominately relate to the reclassification of the consolidated income tax receivable of $2.3 million from other liabilities to other assets, were properly classified in the restated December 31, 2003 Consolidated Balance Sheet.
Other Differences-As part of our internal review, the Company identified certain adjustments to reinsurance balances receivable and loss and loss adjustment expenses and unearned premiums as of December 31, 2003. These adjustments increased Consolidated Stockholder’s equity by $258 thousand, $195 thousand and $280 thousand as of December 31, 2003, 2002 and 2001, respectively. No adjustment was necessary as of December 31, 2001.
The following schedule provides details of the adjustments included in the restatement of consolidated stockholders' equity at December 31, 2002 and 2001 (in thousands):
The following table presents the impact of the aforementioned adjustments on our Consolidated Statement of Operations for the period ended December 31, 2002.
After applying step II of the goodwill valuation model as required by SFAS No. 142, Management concluded that the entire $57.7 million of goodwill attributed to the homeowners insurance operations reporting unit was impaired. In addition, the Company impaired $1.5 million of other intangibles. Accordingly, the Company recorded an impairment charge of $59.2 in the third quarter of 2004.
Our investments are recorded at fair value based upon quoted prices, if available. If quoted prices are not available, fair value is primarily determined based upon management’s assessment of the market value of comparable investments. Our determination of fair value also considers various factors including time value and volatility issues, credit quality of the counterparty and existing conditions in the overall financial markets. From time-to-time, the carrying values of our investments may be temporarily impaired because of such factors. We do not adjust the carrying value of any investment unless management determines that its value is other than temporarily impaired. Management evaluates securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic concerns warrant such an evaluation. Factors considered by management in determining whether an impairment of an investment security is other than temporary includes the credit quality of the security, the severity of the decrease between the security’s cost and market value, the length of time of the security’s impairment and the likelihood that the impairment will reverse in the future. In the event that management determines that a reduction in an investment security’s fair value is below its cost basis is other than temporary, the security’s cost basis is reduced to its fair value and a corresponding realized loss is recorded in our consolidated income statement. For the years ended December 31, 2004, 2003 and 2002, we recorded $0.7 million, $3.1 million and $8.0 million, respectively, of realized losses for other than temporary impairments of investment securities.
For the year ended December 31, 2004, we reported a net loss available to common shareholders of $136.7 million or $3.85 per diluted share, compared with a net loss available to shareholders of $119.8 million or $3.43 diluted per share reported for the previous year.
Charges to discontinued operations of $33.5 million related to the commutation of certain assumed and commercial reinsurance treaties, increases to our commercial and assumed reinsurance reserves, and the settlement of the Muhl litigation and other arbitration charges.
Reduction in operating expenses as a result of declines in total employees and other cost reduction initiatives;
(1) As part of the Federal Home Loan Bank program, as more fully described in Note O to our financial statements, we have pledged securities with a market value of approximately $172.2 million to secure our obligation of $163.8 million. In 2005, we sold our life insurance operations and paid off our Federal Home Loan Bank advances associated with our standard property and casualty operations. As such, the Company will have no Federal Home Loan Bank advances outstanding as of December 31, 2005.
Future cash flows were sufficient to fund operations through the date of this filing. Management believes future cash flows will be sufficient to fund operations through 2006 unless the obligations under the Debentures and/or the Capital Securities are accelerated as a result of the Company’s inability to file timely financial statements. See also the Business Strategy and Recent Developments section of Management Discussion and Analysis for further discussion of Management’s plans.
We have completed an integrated audit of Vesta Insurance Group’s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
7. The Company did not maintain effective controls over the accuracy of the reinsurance receivables. Specifically, certain reinsurance receivables were not considered in the analysis of the reserve for uncollectible accounts. This control deficiency resulted in the restatement of the Company’s consolidated financial statements for the years ended December 31, 2003 and 2002, for each of the quarters in the year ended December 31, 2003 and for the first and second quarters of the year ended December 31, 2004 as well as audit adjustments to the third quarter financial statements for the year ended December 31, 2004 to correct ceded reinsurance balances.
Losses and Loss Adjustment Expenses: The liability for losses and loss adjustment expenses (“LAE”) includes an amount determined for individual cases. It also includes an amount for losses incurred but not reported (“IBNR”) which is based on historical experience. Such liabilities are necessarily based on estimates and, while management believes that the amount is adequate, the ultimate liability may be in excess of or less than the amounts provided. The methods for making such estimates and for establishing the resulting liabilities are continually reviewed, and any adjustments are reflected in earnings currently. Reserves are established on an undiscounted basis and are reduced for estimates of salvage and subrogation.
Reserves are computed using actuarial principles and procedures applicable to the various lines of business and include assumptions for estimated inflation rates. Reserves are carried in our financial statements at an estimate of the ultimate expected loss for each claim without any discount to reflect the time value of money. Reserve calculations are reviewed by management on a regular and ongoing basis and, as required by state law, we engage an independent actuary to render opinions as to the adequacy of statutory reserves we have established. The actuarial opinions are filed with the various jurisdictions in which we are licensed. Based upon the practices and procedures we employ, management believes that our reserves are adequate as of the valuation date.
For traditional life insurance contracts, premiums are recognized as income when due. Benefits and expenses are recognized as a level percentage of earned premiums, accomplished by providing for future policy benefits and by amortizing the DAC.
For the years ended December 31, 2004, 2003 and 2002, potentially dilutive shares of 690 thousand, 759 thousand and 882 thousand of common stock, respectively, were excluded from the calculation of the diluted weighted average shares outstanding since they were anti-dilutive.
Vesta’s actual and pro forma information is as follows (in thousands, except for earnings per share information):
Details of Accounting Adjustments included in the Restatement-The restatement adjustments to previously issued financial statements relate primarily to the categories described below. Following the description of each transaction, accounting entry or entity category is a summary impact of the adjustments relating to that category.
Life Insurance Reinsurance Adjustments-For the year ended December 31, 2003, the Company identified errors in the recording of ceded losses to certain external reinsurers of AFLIC. Specifically, we identified that the Company had erroneously ceded too many losses to these reinsurers. As a result, the Company’s policyholder benefits expense was understated by $213 thousand, net of a tax benefit of $74 thousand, for the year ended December 31, 2003. Reflecting the correction of this error in the restated financial statements impacted our Consolidated Statements of Operations and total comprehensive loss as follows (in thousands):
Income tax (benefit)-The Company determined that errors occurred in 2003 and 2002 relating to the reconciliation of our reported tax expense amounts and the amounts included in our general ledger systems and income tax footnote. These errors resulted in an increase to income tax expense attributable to continuing operations of approximately $0.6 million for the year ended December 31, 2003 and a reduction in income tax expense attributable to continuing operations of $1.5 million for the year ended December 31, 2002.
In addition to the potential deterioration of the Company’s premium volumes resulting from the A.M. Best financial strength rating downgrade, the Company is experiencing increased scrutiny from its various state regulators. Specifically, these state regulators have expressed concerns over the financial condition and operating performance of the Company’s insurance subsidiaries.
At December 31, 2004, the Company’s retained ownership of Affirmative had a recorded value of $88.0 million and market value of $121.6 million, or $16.84 per share. The unrealized gain on the Company’s retained ownership of Affirmative is not reflected in the accompanying Consolidated Balance Sheets or Consolidated Statement of Operations, consistent with the Company’s application of the equity method of accounting to its retained Affirmative ownership. Additionally, the net intercompany balances between Vesta and Affirmative arising from reinsurance contracts was a payable to Affirmative of $14.5 million.
In 2005, we sold our remaining stake in Affirmative in two separately negotiated transactions. First, Vesta Insurance Group, Inc. sold 2.0 million shares of Affirmative common stock to Affirmative for $14.00 per share on June 1, 2005. Vesta received $27.7 million in proceeds, net of closing costs. Vesta will report a gain of approximately $1.6 million in the second quarter of 2005 related to this transaction.
IRIS Ratios. The NAIC has developed the Insurance Regulatory Information System (“IRIS”) to assist state insurance departments in identifying significant changes in the operations of an insurance company, such as changes in product mix, large reinsurance transactions, increases or decreases in premiums received and certain other changes in operations. Such changes may not be attributable to problems with an insurance company, but may indicate changes in certain ratios that are outside predetermined “normal ranges” as defined by the NAIC. When an insurance company has four or more ratios which fall outside normal ranges, state regulators may investigate to determine the reasons for the variance and whether corrective action is warranted.
On September 5, 2002, New Cap Re served us with an Application pursuant to Section 588FF of the Australian Corporations Act seeking an order directing us to pay New Cap Re and its liquidator $1.3 million that Vesta allegedly received as an “unfair preference” and/or arising out of an “uncommercial transaction,” as those terms are defined by the Corporations Act. We filed a Notice of Appearance on October 31, 2002. The liquidator filed a Statement of Claim on August 13, 2003, and the Company filed its defense on December 18, 2003. Document discovery has commenced and is ongoing. Given the status of these proceedings, management believes no reserve is necessary related to the September 5, 2002 complaint. As of December 31, 2003, we had recorded a valuation allowance of approximately $9.9 million related to the $12.5 million of losses ceded to New Cap Re. Based on the updated information from the New Cap liquidator regarding the financial condition of New Cap, we increased the valuation allowance by $1.4 million in the third quarter of 2004 and reflected such charge as a component of operating expenses in our standard property and casualty segment.
Richard V. Forrest vs. Hawaiian Insurance & Guaranty Company, Ltd., (“HIG”) et al. is a lawsuit brought against HIG for breach of implied covenant of good faith and fair dealing. The plaintiff obtained a default judgment in the amount of approximately $35 million against a person formerly insured by HIG, and the issue is whether the defaulting defendant was insured by HIG at the time of the accident that gave rise to the default judgment. On January 31, 2006, the Superior Court of California granted summary judgment in favor of HIG, ruling that the defaulting defendant was not insured by HIG on the date of the accident. Although the plaintiff has appealed this ruling, we believe the likelihood of success of such an appeal is remote. Any exposure (including costs of defense and judgments) HIG may have in this case is ceded to Affirmative Insurance Company (“Affirmative”) under a 100% quota share reinsurance agreement.
The holding company is dependent on dividends from Select Insurance Services, Inc., Florida Select Insurance Agency, Inc. and J. Gordon Gaines to pay the annual interest on its debt obligations and ultimately the principal amounts due. The source of these dividends is from the future operations of Florida Select and Texas Select Lloyds and ultimately from Vesta Fire as a result of the reinsurance agreements between the companies. At current premium levels, we believe that the cash flows available to be dividended in the future will be sufficient to pay the interest and principal on these obligations. However, with the Company’s A.M. Best financial strength rating being downgraded in 2006, no assurances can be given that the Company’s premium levels and resulting cash flows will be sufficient to repay the debt. Failure to repay these inter-company obligations could have a material adverse affect on the statutory capital of our subsidiaries.
We provide a variety of life insurance products through American Founders Financial Corporation (“American Founders”), a holding company for two life insurance companies domiciled in Texas. In 2000, we purchased a 72% interest in American Founders. On February 18, 2003, we purchased the remaining shares held by minority holders and now own 100% of American Founders. At December 31, 2004, American Founders had in force approximately $1.9 billion (face value) of life and annuity products. American Founders markets traditional life products, universal life products, fixed-rate annuities, pension contracts and related products through independent agents located throughout the U.S. As discussed in Note D, the operating subsidiaries of American Founders were sold on September 30, 2005, effectively discontinuing our life insurance operations. In the fourth quarter of 2002, we decided to exit the health insurance business line which was previously included in the life insurance segment. The results for the health insurance line have been reclassified to discontinued operations for all periods presented in this report.
During the year ended December 31, 2002, we extinguished $23.9 million of our Senior Debentures for 1.1 million shares of common stock and approximately $9.4 million plus accrued interest. As a result of the early redemption of this long term debt, we recorded a pre-tax gain of $9.5 million.
Annuity Account Balances-Annuity account balances include single premium and flexible premium deferred and immediate annuity contracts, supplementary contracts not having significant mortality risk, policyholder dividend accumulations, and separate account liabilities. Cash surrender value is used in determining the fair value of single premium and flexible premium deferred annuity contracts. Carrying amounts approximated fair value for immediate annuities, supplementary contracts, policyholder dividend accumulations, and separate account liabilities.
As a result of an unexpected increase in the severity and volume of reported claims associated with both our discontinued commercial and assumed reinsurance lines and an increase in payments on claim reserves, we have
increased our expected losses from discontinued operations in 2004, 2003 and 2002. The increase in our expected losses with respect to our commercial business related to a variety of underlying coverages including general liability. These types of claims may take many years to fully develop and we must continue to monitor trends in their ultimate development. Similarly, we experienced negative development in some of our assumed reinsurance contracts, principally related to certain homeowners coverages. These types of claims should fully develop over a comparatively shorter period of time. During 2002, we incurred an after-tax charge of $9.5 million due to the completion of arbitration with F&G Re related to ceded commercial and assumed reinsurance business.