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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended September 30, 2006
or
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File Number: 001-12117
First Acceptance Corporation
(Exact name of registrant as specified in its charter)
Delaware | 75-1328153 | |
(State or other jurisdiction | (I.R.S. Employer | |
of incorporation or organization) | Identification No.) | |
3813 Green Hills Village Drive | ||
Nashville, Tennessee | 37215 | |
(Address of principal executive offices) | (Zip Code) |
(615) 844-2800
(Registrant’s telephone number, including area code)
(Registrant’s telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report)
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesþ Noo
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filero Accelerated filerþ Non-accelerated filero
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ
As of November 3, 2006, there were outstanding 47,584,763 shares of the registrant’s common stock, par value $0.01 per share.
FIRST ACCEPTANCE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2006
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2006
INDEX
1 | ||||||||
1 | ||||||||
6 | ||||||||
12 | ||||||||
13 | ||||||||
14 | ||||||||
14 | ||||||||
15 | ||||||||
Ex-31.1 Section 302 Certification | ||||||||
Ex-31.2 Section 302 Certification | ||||||||
Ex-32.1 Section 906 Certification | ||||||||
Ex-32.2 Section 906 Certification |
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PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
September 30, | ||||||||
2006 | ||||||||
(Unaudited) | June 30, 2006 | |||||||
ASSETS | ||||||||
Fixed maturities, available for sale at fair value (amortized cost $141,244 and $131,291, respectively) | $ | 141,052 | $ | 127,828 | ||||
Cash and cash equivalents | 27,266 | 31,534 | ||||||
Premiums and fees receivable | 72,320 | 64,074 | ||||||
Reinsurance recoverables | 1,063 | 1,344 | ||||||
Receivable for securities | — | 999 | ||||||
Deferred tax asset | 47,405 | 48,068 | ||||||
Other assets | 7,979 | 7,796 | ||||||
Property and equipment, net | 3,542 | 3,376 | ||||||
Foreclosed real estate held for sale | 128 | 87 | ||||||
Deferred acquisition costs | 6,057 | 5,330 | ||||||
Goodwill | 137,045 | 137,045 | ||||||
Identifiable intangible assets | 6,721 | 6,825 | ||||||
TOTAL ASSETS | $ | 450,578 | $ | 434,306 | ||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||
Loss and loss adjustment expense reserves | $ | 70,534 | $ | 62,822 | ||||
Unearned premiums | 85,979 | 76,117 | ||||||
Deferred fee income | 2,318 | 2,214 | ||||||
Notes payable and capitalized lease obligations | 22,813 | 24,026 | ||||||
Payable for securities | — | 4,914 | ||||||
Other liabilities | 10,052 | 10,790 | ||||||
Total liabilities | 191,696 | 180,883 | ||||||
Stockholders’ equity: | ||||||||
Preferred stock, $.01 par value, 10,000 shares authorized | — | — | ||||||
Common stock, $.01 par value, 75,000 shares authorized; 47,585 and 47,535 shares issued and outstanding, respectively | 476 | 475 | ||||||
Additional paid-in capital | 459,743 | 459,049 | ||||||
Accumulated other comprehensive loss | (192 | ) | (3,463 | ) | ||||
Accumulated deficit | (201,145 | ) | (202,638 | ) | ||||
Total stockholders’ equity | 258,882 | 253,423 | ||||||
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY | $ | 450,578 | $ | 434,306 | ||||
See notes to consolidated financial statements.
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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(in thousands, except per share data)
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(in thousands, except per share data)
Three Months Ended | ||||||||
September 30, | ||||||||
2006 | 2005 | |||||||
Revenues: | ||||||||
Premiums earned | $ | 67,421 | $ | 42,754 | ||||
Fee income | 9,212 | 6,405 | ||||||
Transaction service fee | 575 | — | ||||||
Investment income | 1,947 | 1,099 | ||||||
Losses on sales of investments | (53 | ) | — | |||||
79,102 | 50,258 | |||||||
Costs and expenses: | ||||||||
Losses and loss adjustment expenses | 52,420 | 28,491 | ||||||
Insurance operating expenses | 22,329 | 15,223 | ||||||
Other operating expenses | 1,108 | 613 | ||||||
Stock-based compensation | 104 | 84 | ||||||
Depreciation | 289 | 178 | ||||||
Amortization of identifiable intangible assets | 104 | 36 | ||||||
Interest expense | 412 | — | ||||||
76,766 | 44,625 | |||||||
Income before income taxes | 2,336 | 5,633 | ||||||
Income tax expense | 843 | 1,920 | ||||||
Net income | $ | 1,493 | $ | 3,713 | ||||
Net income per share, basic and diluted | $ | 0.03 | $ | 0.08 | ||||
Number of shares used to calculate net income per share: | ||||||||
Basic | 47,545 | 47,455 | ||||||
Diluted | 49,663 | 49,465 | ||||||
Reconciliation of net income to comprehensive income: | ||||||||
Net income | $ | 1,493 | $ | 3,713 | ||||
Net unrealized appreciation (depreciation) on investments | 3,271 | (824 | ) | |||||
Comprehensive income | $ | 4,764 | $ | 2,889 | ||||
See notes to consolidated financial statements.
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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(in thousands)
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(in thousands)
Three Months Ended | ||||||||
September 30, | ||||||||
2006 | 2005 | |||||||
Cash flows from operating activities: | ||||||||
Net income | $ | 1,493 | $ | 3,713 | ||||
Adjustments to reconcile net income to cash from operating activities: | ||||||||
Depreciation and amortization | 393 | 214 | ||||||
Stock-based compensation | 104 | 84 | ||||||
Amortization of premium on fixed maturities | 56 | 175 | ||||||
Deferred income taxes | 663 | 1,731 | ||||||
Losses on sales of investments | 53 | — | ||||||
Change in: | ||||||||
Premiums and fees receivable | (8,246 | ) | (2,943 | ) | ||||
Reinsurance recoverables | 281 | 1,034 | ||||||
Other assets | (183 | ) | 20 | |||||
Deferred acquisition costs | (727 | ) | (351 | ) | ||||
Loss and loss adjustment expense reserves | 7,712 | 3,005 | ||||||
Unearned premiums | 9,862 | 4,134 | ||||||
Deferred fee income | 104 | (919 | ) | |||||
Other liabilities | (738 | ) | (1,025 | ) | ||||
Net cash provided by operating activities | 10,827 | 8,872 | ||||||
Cash flows from investing activities: | ||||||||
Addition to foreclosed real estate | (41 | ) | — | |||||
Acquisitions of property and equipment | (455 | ) | (392 | ) | ||||
Purchases of fixed maturities, available-for-sale | (18,780 | ) | (13,420 | ) | ||||
Maturities and paydowns of fixed maturities, available for sale | 592 | 582 | ||||||
Sales of fixed maturities, available for sale | 8,126 | — | ||||||
Purchases of investment in mutual fund | — | (219 | ) | |||||
Net (decrease) increase in payable/receivable for securities | (3,915 | ) | 1,007 | |||||
Net cash used in investing activities | (14,473 | ) | (12,442 | ) | ||||
Cash flows from financing activities: | ||||||||
Proceeds from borrowings | 227 | — | ||||||
Net proceeds from sale of common stock | 591 | — | ||||||
Payments on borrowings | (1,440 | ) | — | |||||
Net cash used in financing activities | (622 | ) | — | |||||
Net decrease in cash and cash equivalents | (4,268 | ) | (3,570 | ) | ||||
Cash and cash equivalents at beginning of period | 31,534 | 24,762 | ||||||
Cash and cash equivalents at end of period | $ | 27,266 | $ | 21,192 | ||||
See notes to consolidated financial statements.
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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except per share data)
(Unaudited)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except per share data)
(Unaudited)
1. General
The consolidated financial statements of First Acceptance Corporation (the “Company”) included herein have been prepared without audit pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted. In the opinion of management, the consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair statement of the interim periods. Certain reclassifications have been made to the prior year’s consolidated financial statements to conform with the current year presentation.
The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. These consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements included in its Annual Report on Form 10-K for the fiscal year ended June 30, 2006.
2.Net Income Per Share
The following table sets forth the computation of basic and diluted net income per share:
Three Months Ended | ||||||||
September 30, | ||||||||
2006 | 2005 | |||||||
Net income | $ | 1,493 | $ | 3,713 | ||||
Weighted average common basic shares | 47,545 | 47,455 | ||||||
Effect of dilutive securities — options | 2,118 | 2,010 | ||||||
Weighted average common dilutive shares | 49,663 | 49,465 | ||||||
Basic and diluted net income per share | $ | 0.03 | $ | 0.08 | ||||
3.Stock-Based Compensation
During the three months ended September 30, 2006, the Company issued 500 stock options to employees under its 2002 Long Term Incentive Plan (the “Plan”). The options were issued at $11.81 per share and vest equally in annual installments with 250 shares vesting over five years and 250 shares vesting over four years. Compensation expense related to these options was $3,076, of which $1,538 will be amortized through September 2010 and $1,538 will be amortized through September 2011. None of these options were exercisable at September 30, 2006, and they expire on September 13, 2016. There were no options exercised or forfeited during the three months ended September 30, 2006. Shares remaining available for issuance under the Plan were 3,477 at September 30, 2006.
4.Segment Information
The Company operates in two business segments with its primary focus being the selling, servicing and underwriting of non-standard personal automobile insurance. The real estate and corporate segment consists of activities related to the disposition of foreclosed real estate held for sale, interest expense associated with all debt and other general corporate overhead expenses. Total assets by segment are those assets used in the operation of each segment.
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The following tables present selected financial data by business segment:
Real Estate | ||||||||||||
and | Consolidated | |||||||||||
Three Months Ended September 30, 2006 | Insurance | Corporate | Total | |||||||||
Revenues: | ||||||||||||
Premiums earned | $ | 67,421 | $ | — | $ | 67,421 | ||||||
Fee income | 9,212 | — | 9,212 | |||||||||
Transaction service fee | 575 | — | 575 | |||||||||
Investment income | 1,859 | 88 | 1,947 | |||||||||
Losses on sales of investments | (53 | ) | — | (53 | ) | |||||||
79,014 | 88 | 79,102 | ||||||||||
Costs and expenses: | ||||||||||||
Losses and loss adjustment expenses | 52,420 | — | 52,420 | |||||||||
Operating expenses | 22,329 | 1,108 | 23,437 | |||||||||
Stock-based compensation | — | 104 | 104 | |||||||||
Depreciation and amortization | 393 | — | 393 | |||||||||
Interest expense | — | 412 | 412 | |||||||||
75,142 | 1,624 | 76,766 | ||||||||||
Income (loss) before income taxes | $ | 3,872 | $ | (1,536 | ) | $ | 2,336 | |||||
Total assets at September 30, 2006 | $ | 400,175 | $ | 50,403 | $ | 450,578 | ||||||
Real Estate | ||||||||||||
and | Consolidated | |||||||||||
Three Months Ended September 30, 2005 | Insurance | Corporate | Total | |||||||||
Revenues: | ||||||||||||
Premiums earned | $ | 42,754 | $ | — | $ | 42,754 | ||||||
Commissions and fees | 6,405 | — | 6,405 | |||||||||
Investment income | 887 | 212 | 1,099 | |||||||||
50,046 | 212 | 50,258 | ||||||||||
Costs and expenses: | ||||||||||||
Losses and loss adjustment expenses | 28,491 | — | 28,491 | |||||||||
Operating expenses | 15,223 | 613 | 15,836 | |||||||||
Stock-based compensation | — | 84 | 84 | |||||||||
Depreciation and amortization | 214 | — | 214 | |||||||||
43,928 | 697 | 44,625 | ||||||||||
Income (loss) before income taxes | $ | 6,118 | $ | (485 | ) | $ | 5,633 | |||||
Total assets at September 30, 2005 | $ | 284,557 | $ | 55,340 | $ | 339,897 | ||||||
5.Stockholders’ Equity
On September 13, 2006, the Company sold 50 shares of common stock to an executive officer for an aggregate purchase price of $591, or $11.81 per share, which was the closing price of the common stock on the New York Stock Exchange on the date of sale.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Management’s Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements which involve risks and uncertainties. The Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a difference include those discussed in Item 1A. “Risk Factors” in the Company’s Annual Report onForm 10-K for the fiscal year ended June 30, 2006. The following discussion should be read in conjunction with the Company’s consolidated financial statements included with this report and our consolidated financial statements and related Management’s Discussion and Analysis of Financial Condition and Results of Operations for the fiscal year ended June 30, 2006 included in our Annual Report onForm 10-K.
General
As of September 30, 2006, we leased and operated 466 retail locations, staffed by employee-agents. Our employee-agents exclusively sell insurance products either underwritten or serviced by us. As of September 30, 2006, we wrote non-standard personal automobile insurance in 12 states and were licensed in 13 additional states. See the discussion in Item 1. “Business - General” in our Annual Report on Form 10-K for the fiscal year ended June 30, 2006 for additional information with respect to our business.
The following table shows the changes in the number of our retail locations for the periods presented. Retail location counts are based upon the date that a location commenced writing business. In prior years, we reported this information based upon the date that a location was leased. Information for all prior periods presented has been restated to conform to the current period’s method of presentation.
Three Months Ended | ||||||||
September 30, | ||||||||
2006 | 2005 | |||||||
Retail locations — beginning of period | 460 | 248 | ||||||
Opened | 9 | 63 | ||||||
Closed | (3 | ) | (1 | ) | ||||
Retail locations — end of period | 466 | 310 | ||||||
The following table shows the number of our retail locations by state and the change from the preceding quarter end.
Change in Locations | ||||||||||||||||||||||||
Three Months Ended | ||||||||||||||||||||||||
September 30, | June 30, | September 30, | ||||||||||||||||||||||
2006 | 2005 | 2006 | 2005 | 2006 | 2005 | |||||||||||||||||||
Alabama | 25 | 25 | 25 | 25 | — | — | ||||||||||||||||||
Florida | 40 | 25 | 39 | 20 | 1 | 5 | ||||||||||||||||||
Georgia | 63 | 63 | 63 | 62 | — | 1 | ||||||||||||||||||
Illinois | 85 | 13 | 86 | 5 | (1 | ) | 8 | |||||||||||||||||
Indiana | 26 | 21 | 26 | 21 | — | — | ||||||||||||||||||
Mississippi | 8 | 8 | 8 | 8 | — | — | ||||||||||||||||||
Missouri | 17 | 17 | 18 | 14 | (1 | ) | 3 | |||||||||||||||||
Ohio | 30 | 29 | 30 | 29 | — | — | ||||||||||||||||||
Pennsylvania | 25 | 15 | 25 | 7 | — | 8 | ||||||||||||||||||
South Carolina | 26 | — | 21 | — | 5 | — | ||||||||||||||||||
Tennessee | 21 | 20 | 20 | 20 | 1 | — | ||||||||||||||||||
Texas | 100 | 74 | 99 | 37 | 1 | 37 | ||||||||||||||||||
Total | 466 | 310 | 460 | 248 | 6 | 62 | ||||||||||||||||||
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Critical Accounting Policies
There have been no significant changes to our critical accounting policies and estimates during the three months ended September 30, 2006 compared with those disclosed in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies” included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2006.
Consolidated Results of Operations
Overview
Our primary focus is the selling, servicing and underwriting of non-standard personal automobile insurance. Our real estate and corporate segment consists of activities related to the disposition of foreclosed real estate held for sale, interest expense associated with debt, and other general corporate overhead expenses. The following tables show the results of operations for our insurance operations and real estate and corporate segments for the periods presented:
Three Months Ended | ||||||||
September 30, | ||||||||
2006 | 2005 | |||||||
(in thousands) | ||||||||
Insurance Operations | ||||||||
Revenues: | ||||||||
Premiums earned | $ | 67,421 | $ | 42,754 | ||||
Fee income | 9,212 | 6,405 | ||||||
Transaction service fee | 575 | — | ||||||
Investment income | 1,859 | 887 | ||||||
Losses on sales of investments | (53 | ) | — | |||||
79,014 | 50,046 | |||||||
Costs and expenses: | ||||||||
Losses and loss adjustment expenses | 52,420 | 28,491 | ||||||
Operating expenses | 22,329 | 15,223 | ||||||
Depreciation and amortization | 393 | 214 | ||||||
75,142 | 43,928 | |||||||
Income before income taxes | $ | 3,872 | $ | 6,118 | ||||
Three Months Ended | ||||||||
September 30, | ||||||||
2006 | 2005 | |||||||
(in thousands) | ||||||||
Real Estate and Corporate | ||||||||
Revenues: | ||||||||
Investment income | $ | 88 | $ | 212 | ||||
88 | 212 | |||||||
Costs and expenses: | ||||||||
Operating expenses | 1,108 | 613 | ||||||
Stock-based compensation | 104 | 84 | ||||||
Interest expense | 412 | — | ||||||
1,624 | 697 | |||||||
Loss before income taxes | $ | (1,536 | ) | $ | (485 | ) | ||
Our insurance operations generate revenues from selling, servicing and underwriting non-standard personal automobile insurance policies in 12 states. We conduct our underwriting operations through two insurance company subsidiaries, First Acceptance Insurance Company, Inc. and First Acceptance Insurance Company of Georgia, Inc. Our insurance operations revenues are primarily generated from:
• | premiums earned, including policy and renewal fees, from (i) sales of policies issued by our insurance company subsidiaries, net of the portion of those premiums ceded to reinsurers, and (ii) the sales of policies issued by our managing general agency (“MGA”) subsidiaries that are assumed 100% by our insurance company subsidiaries through quota-share reinsurance; | ||
• | fee income, including installment billing fees on policies written and fees for other ancillary services (principally a motor club product); |
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• | a transaction service fee (for the period from January 12, 2006 through December 31, 2006) for servicing the run-off business previously written by the Chicago agencies whose business we acquired; and | ||
• | investment income earned on the invested assets of the insurance company subsidiaries. |
The following table presents gross premiums earned by state and includes policies written by the insurance company subsidiaries and policies issued by our MGA subsidiaries on behalf of other insurance companies that are assumed 100% by one of the insurance company subsidiaries through quota-share reinsurance. Although we are licensed in Texas, we currently write some business in Texas through the Texas county mutual insurance company system that is assumed 100% by one of the insurance company subsidiaries. Premiums ceded during the three months ended September 30, 2005 reflect only the cost of catastrophic reinsurance. Effective April 14, 2006, we elected to not renew our catastrophic reinsurance.
Three Months Ended | ||||||||||||
September 30, | ||||||||||||
2006 | 2005 | Change | ||||||||||
(in thousands) | ||||||||||||
Gross premiums earned: | ||||||||||||
Georgia | $ | 17,190 | $ | 17,316 | $ | (126 | ) | |||||
Florida | 12,229 | 2,589 | 9,640 | |||||||||
Alabama | 7,289 | 6,930 | 359 | |||||||||
Texas | 6,661 | 2,459 | 4,202 | |||||||||
Illinois | 6,637 | 122 | 6,515 | |||||||||
Tennessee | 5,947 | 6,331 | (384 | ) | ||||||||
Ohio | 3,862 | 3,300 | 562 | |||||||||
Indiana | 1,937 | 1,161 | 776 | |||||||||
South Carolina | 1,822 | — | 1,822 | |||||||||
Missouri | 1,430 | 1,234 | 196 | |||||||||
Mississippi | 1,231 | 1,211 | 20 | |||||||||
Pennsylvania | 1,186 | 125 | 1,061 | |||||||||
Total gross premiums earned | 67,421 | 42,778 | 24,643 | |||||||||
Premiums ceded | — | (24 | ) | 24 | ||||||||
Total net premiums earned | $ | 67,421 | $ | 42,754 | $ | 24,667 | ||||||
The following table presents the change in the total number of policies in force for the insurance operations for the periods presented. Policies in force increase as a result of new policies issued and decrease as a result of policies that cancel or expire and are not renewed.
Three Months Ended | ||||||||
September 30, | ||||||||
2006 | 2005 | |||||||
Policies in force — beginning of period | 200,401 | 119,422 | ||||||
Net increase during period | 16,907 | 6,377 | ||||||
Policies in force — end of period | 217,308 | 125,799 | ||||||
Insurance companies present a combined ratio as a measure of their overall underwriting profitability. The components of the combined ratio are as follows:
Loss Ratio —Loss ratio is the ratio (expressed as a percentage) of losses and loss adjustment expenses incurred to premiums earned and is a basic element of underwriting profitability. We calculate this ratio based on all direct and assumed premiums earned, net of ceded reinsurance.
Expense Ratio —Expense ratio is the ratio (expressed as a percentage) of operating expenses to premiums earned. This is a measurement that illustrates relative management efficiency in administering our operations. We calculate this ratio on a net basis as a percentage of net premiums earned. Insurance operating expenses are reduced by fee income from insureds and, for the three months ended September 30, 2006, the transaction service fee we received for servicing the run-off business previously written by the Chicago agencies whose business we acquired in January 2006.
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Combined Ratio —Combined ratio is the sum of the loss ratio and the expense ratio. If the combined ratio is at or above 100%, an insurance company cannot be profitable without sufficient investment income. The following table presents the combined ratios for the insurance operations for the periods presented.
Three Months Ended | ||||||||
September 30, | ||||||||
2006 | 2005 | |||||||
Loss and loss adjustment expense | 77.8 | % | 66.6 | % | ||||
Expense | 18.6 | % | 20.6 | % | ||||
Combined | 96.4 | % | 87.2 | % | ||||
The invested assets of the insurance operations are generally highly liquid and consist substantially of readily marketable, investment grade, municipal and corporate bonds and collateralized mortgage obligations. At September 30, 2006, approximately 6% of our fixed maturities portfolio was tax-exempt. All cash equivalents are taxable. We invest in certain securities issued by political subdivisions in the states of Georgia and Tennessee, as these investments enable our insurance company subsidiaries to obtain premium tax credits. Investment income is comprised primarily of interest earned on these securities, net of related investment expenses. Realized gains and losses on our investment portfolio may occur from time to time as changes are made to our holdings based upon changes in interest rates and changes in the credit quality of securities held.
Three Months Ended September 30, 2006 Compared With Three Months Ended September 30, 2005
Consolidated Results
Revenues for the three months ended September 30, 2006 increased 57% to $79.1 million from $50.3 million in the same period last year. Net income for the three months ended September 30, 2006 was $1.5 million, compared with $3.7 million for the three months ended September 30, 2005. Basic and diluted net income per share was $0.03 for the three months ended September 30, 2006 compared with $0.08 for the three months ended September 30, 2005.
Insurance Operations
Revenues from insurance operations were $79.0 million for the three months ended September 30, 2006 compared with $50.0 million for the three months ended September 30, 2005. Income before income taxes was $3.9 million for the three months ended September 30, 2006 compared with $6.1 million for the three months ended September 30, 2005.
Premiums Earned
Premiums earned increased by $24.7 million, or 57%, to $67.4 million for the three months ended September 30, 2006, from $42.8 million for the three months ended September 30, 2005. The increase was due primarily to the development of additional retail locations. Approximately 80% of the premium growth was in Florida and Texas, where we opened 81 locations in fiscal year 2006, and Chicago, where we acquired 72 locations in January 2006. The total number of insured policies in force at September 30, 2006 increased 73% over the same date in 2005 from 125,799 to 217,308. At September 30, 2006, we operated 466 retail locations (or “stores”) compared with 310 stores at September 30, 2005.
Fee Income and Transaction Service Fee
Fee income increased 44% to $9.2 million for the three months ended September 30, 2006, from $6.4 million for the three months ended September 30, 2005. The increase was the result of the growth in net premiums earned. However, fee income increased at a rate lower than our increase in premiums earned because we charge lower fees in Florida compared with our other states. Revenues for the three months ended September 30, 2006 included a $0.6 million transaction service fee earned in connection with the Chicago acquisition for servicing the run-off business previously written by the Chicago agencies whose assets we acquired in January 2006.
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Investment Income
Investment income increased primarily as a result of the increase in invested assets as a result of our growth and to a lesser extent as a result of the shift in our portfolio from tax-exempt to taxable investments. The weighted average investment yields for our fixed maturities portfolio were 5.1% and 4.4% at September 30, 2006 and 2005, respectively, with effective durations of 3.63 years and 3.57 years at September 30, 2006 and 2005, respectively. The yields for the comparable Lehman Brothers indices were 4.9% and 4.4% at September 30, 2006 and 2005, respectively.
Loss and Loss Adjustment Expenses
The loss and loss adjustment expense ratio was 77.8% for the three months ended September 30, 2006 compared with 66.6% for the three months ended September 30, 2005. During the three months ended September 30, 2006, loss and loss adjustment expense reserves for prior accident quarters developed adversely by approximately $3.7 million and accounted for 5.5% of the ratio for the current quarter. Of these amounts, $2.5 million, or 3.7%, related to liability coverages and $1.2 million, or 1.8%, related to physical damage coverages. The adverse development related primarily to the estimation of the severity of losses in Florida and Texas, where we had significant growth during 2006 and Georgia where we reduced our physical damage premium rates effective January 23, 2006. We have or will be taking action to modify premium rates in these states. Excluding the adverse development for prior accident quarters, the loss and loss adjustment expense ratio for the current quarter was 72.3% compared with 66.6% for the same quarter last year. This increase in the ratio for the current accident quarter was the result of three factors: anticipated higher loss ratios in Florida and Texas; an increase in the loss adjustment expense ratio (primarily as a result of a planned increase in claims department staffing as a result of recent and future growth); and an increase in the loss ratio in other states.
Operating Expenses
Insurance operating expenses increased 47% to $22.3 million for the three months ended September 30, 2006 from $15.2 million for the three months ended September 30, 2005. This increase is primarily due to the costs associated with new stores (including those acquired in Chicago) and expenses (variable employee-agent compensation and premium taxes) that vary along with the increase in net premiums earned.
The expense ratio decreased from 20.6% for the three months ended September 30, 2005 to 18.6% for the three months ended September 30, 2006. This decrease is primarily as a result of the increase in premiums earned from new stores without a corresponding increase in their fixed operating costs (advertising, rent and base compensation of our employee-agents).
Overall, the combined ratio increased to 96.4% for the three months ended September 30, 2006 from 87.2% for the three months ended September 30, 2005.
Real Estate and Corporate
Loss before income taxes for the three months ended September 30, 2006 was $1.5 million compared with $0.5 million for the three months ended September 30, 2005. There were no gains on sales of foreclosed real estate held for the three month periods ended September 30, 2006 and 2005.
Other operating expenses primarily include other general corporate overhead expenses. During the three months ended September 30, 2006, we incurred costs of $0.3 million (primarily recruiting and relocation expenses) related to the hiring of a new Executive Vice President. In addition, for the three months ended September 30, 2006, we incurred $0.4 million of interest expense in connection with the borrowing related to the Chicago acquisition.
Liquidity and Capital Resources
Our primary sources of funds are premiums, fee income and investment income. Our primary uses of funds are the payment of claims and operating expenses. Operating activities for the three months ended September 30, 2006 provided $10.8 million of cash, compared with $8.9 million provided in the same period in fiscal 2006. Net cash used by investing activities for the three months ended September 30, 2006 was $14.5 million, compared with $12.4 million in the same period in fiscal 2006. Both periods reflect net additions to our investment portfolio
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as a result of the increase in net premiums earned. During the three months ended September 30, 2006, we sold fixed maturity investments of $8.1 million that were reinvested in order to help obtain premium tax credits.
During the three months ended September 30, 2006, we increased the statutory capital and surplus of the insurance company subsidiaries by $2.4 million to support additional premium writings. Of this capital contribution, $1.4 million came from funds our holding company received from the insurance company subsidiaries through an intercompany tax allocation agreement under which the holding company was reimbursed for current tax benefits utilized through the recognition of tax net operating loss carryforwards. At September 30, 2006, we had $8.5 million available in unrestricted cash and investments outside of the insurance company subsidiaries. In October 2006, we used $1.8 million of this amount to pay a scheduled quarterly payment of principal and interest on our notes payable to banks.
We are part of an insurance holding company system with substantially all of our operations conducted by our insurance company subsidiaries. Accordingly, the holding company will only receive cash from operating activities as a result of investment income and the ultimate liquidation of our foreclosed real estate held for sale. Cash could be made available through loans from financial institutions, the sale of common stock, and dividends from our insurance company subsidiaries. In addition, as a result of our tax net operating loss carryforwards, taxable income generated by the insurance company subsidiaries will provide cash to the holding company through an intercompany tax allocation agreement through which the insurance company subsidiaries reimburse the holding company for current tax benefits utilized through recognition of the net operating loss carryforwards.
State insurance laws limit the amount of dividends that may be paid from the insurance company subsidiaries. These limitations relate to statutory capital and surplus and net income. In addition, the National Association of Insurance Commissioners Model Act for risk-based capital (“RBC”) provides formulas to determine the amount of statutory capital and surplus 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. Statutory guidelines suggest that the insurance company subsidiaries should not exceed a ratio of net premiums written to statutory capital and surplus of 3-to-1. We believe that the insurance company subsidiaries have sufficient financial resources available to support their net premium writings in both the short-term and the reasonably foreseeable future.
We believe that existing cash and investment balances, when combined with anticipated cash flows generated from operations and dividends from our insurance company subsidiaries, will be adequate to meet our expected liquidity needs in both the short term and the reasonably foreseeable future. Our growth strategy includes possible acquisitions. Any acquisitions or other unexpected growth opportunities may require external financing, and we may from time to time seek to obtain external financing. We cannot assure you that additional sources of financing will be available to us or that any such financing would not negatively impact our results of operations.
Chicago Acquisition
In order to gain a presence in the market, on January 12, 2006, we acquired certain assets (principally the trade names, customer lists and relationships and the lease rights to 72 retail locations) of two non-standard automobile agencies under common control in Chicago, Illinois for $30.0 million in cash. In addition, in accordance with the terms of the acquisition, we may pay the agencies up to $4 million in additional consideration if certain financial targets through January 31, 2007 are reached.
In connection with the acquisition, we concurrently entered into, and borrowed under, a credit agreement with two banks consisting of a $5 million revolving facility and a $25 million term loan facility, both maturing on June 30, 2010. Both facilities bear interest at LIBOR plus 175 basis points per annum. We entered into an interest rate swap agreement on January 17, 2006 that fixed the interest rate on the term loan facility at 6.63% through June 30, 2010. The term loan facility is due in equal quarterly installments of $1.4 million, plus interest, beginning April 30, 2006 and ending April 30, 2010 with a final payment of $1.4 million due on June 30, 2010. Both facilities are secured by the common stock and certain assets of selected subsidiaries. The credit agreement contains certain financial covenants. At September 30, 2006, the unpaid balance due under the facilities was $22.2 million and we were in compliance with all such covenants.
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Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements, other than leases accounted for as operating leases in accordance with generally accepted accounting principles, or financing activities with special-purpose entities.
Forward-Looking Statements
This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements made in the report, other than statements of historical fact, are forward-looking statements. You can identify these statements from our use of the words “may,” “should,” “could,” “potential,” “continue,” “plan,” “forecast,” “estimate,” “project,” “believe,” “intent,” “anticipate,” “expect,” “target,” “is likely,” “will,” or the negative of these terms, and similar expressions. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may include, among other things:
• | statements and assumptions relating to future growth, income, income per share and other financial performance measures, as well as management’s short-term and long-term performance goals; | ||
• | statements relating to the anticipated effects on results of operations or financial condition from recent and expected developments or events; | ||
• | statements relating to our business and growth strategies; and | ||
• | any other statements or assumptions that are not historical facts. |
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 “Business — Risk Factors” section of the Annual Report on Form 10-K for the year ended June 30, 2006.
You should not place undue reliance on any forward-looking statements contained herein. These statements speak only as of the date of this report. Except as otherwise required by applicable laws, we undertake no obligation to publicly update or revise any forward-looking statements or the risk factors described in this report, whether as a result of new information, future events, changed circumstances or any other reason after the date of this report.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We have an exposure to interest rate risk relating to fixed maturity investments. Changes in market interest rates directly impact the market value of our fixed maturity securities. Some fixed maturity securities have call or prepayment options. This subjects us to reinvestment risk as issuers may call their securities, which could result in us reinvesting the proceeds at lower interest rates. We manage exposure to interest rate risks by adhering to specific guidelines in connection with our investment portfolio. We invest primarily in municipal and corporate bonds and collateralized mortgage obligations that have been rated “A” or better by Standard & Poors. At September 30, 2006, 87.5% of our investment portfolio was invested in securities rated “AA” or better by Standard & Poors, and 98.6% was invested in securities rated “A” or better by Standard & Poors. We have not recognized any other than temporary losses on our investment portfolio. We also utilize the services of a professional fixed income investment manager.
As of September 30, 2006, the impact of an immediate 100 basis point increase in market interest rates on our fixed maturities portfolio would have resulted in an estimated decrease in fair value of 4.3%, or approximately $6.1 million. Conversely, as of the same date, the impact of an immediate 100 basis point decrease in market interest rates on our fixed maturities portfolio would have resulted in an estimated increase in fair value of 4.1%, or approximately $5.8 million.
In connection with the January 12, 2006 Chicago acquisition, we entered into a new $30.0 million credit facility that includes a $25.0 million term loan facility and a $5.0 million revolving facility. Although we have
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fixed the interest rate of the $25.0 million term loan facility through an interest rate swap agreement, we have interest rate risk with respect to the revolving facility, which bears interest at a floating rate of LIBOR plus 175 basis points per annum. At September 30, 2006, there were no outstanding borrowings under the revolving facility.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Company’s chief executive officer and chief financial officer have reviewed and evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended, or Exchange Act) as of September 30, 2006. Based on that evaluation, the Company’s chief executive officer and chief financial officer have concluded that the Company’s disclosure controls and procedures effectively ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission’s rules and forms.
Changes in Internal Control Over Financial Reporting
During the period covered by this report, there has been no change in the Company’s internal control over financial reporting that has materially affected or is reasonably likely to materially affect the Company’s internal control over financial reporting.
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PART II – OTHER INFORMATION
Item 6. Exhibits
The following exhibits are attached to this report:
31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(a). | |
31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(a). | |
32.1 | Chief Executive Officer’s Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
32.2 | Chief Financial Officer’s Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
FIRST ACCEPTANCE CORPORATION | ||||
November 9, 2006 | By: | /s/ Stephen J. Harrison | ||
Stephen J. Harrison | ||||
Chief Executive Officer | ||||
November 9, 2006 | By: | /s/ Edward L. Pierce | ||
Edward L. Pierce | ||||
Chief Financial Officer |
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