| AFFIRMATIVE INSURANCE HOLDINGS INC Item 1A Risk Factors We face risks in connection with the material weakness resulting from our Sarbanes-Oxley Section 404 management report and any related remedial measures that we undertake |
| In conjunction with (i) our ongoing reporting obligations as a public company and (ii) the requirements of Section 404 of the Sarbanes-Oxley Act that management report as of December 31, 2005 on the effectiveness of our internal control over financial reporting and identify any material weaknesses in our internal control over financial reporting, we engaged in a process to document, evaluate and test our internal controls and procedures, including corrections to existing controls and additional controls and procedures that we may implement |
| As a result of this evaluation and testing process, our management identified several material weaknesses in our internal control over financial reporting |
| See Item 9A Controls and Procedures for additional disclosure about the material weaknesses |
| In response to the material weaknesses in our internal control over financial reporting, we have implemented and will continue to implement additional controls and procedures, including modifying many of our controls and financial reporting processes, and standardizing our IT policies and procedures |
| These efforts could result in increased cost and could divert management attention away from operating our business |
| As a result of the identified material weaknesses, even though our management believes that our efforts to remediate and re-test our internal control deficiencies have resulted in the improved operation of our internal control over financial reporting, we cannot be certain that the measures we have taken or we are planning to take will sufficiently and satisfactorily remediate the identified material weaknesses in full |
| In future periods, if the process required by Section 404 of the Sarbanes-Oxley Act reveals further material weaknesses or significant deficiencies, the correction of any such material weaknesses or significant deficiencies could require additional remedial measures that could be costly and time-consuming |
| In addition, the discovery of further material weaknesses could also require the restatement of prior period operating results |
| If a material weakness exists as of a future period year-end (including a material weakness identified prior to year-end for which there is an insufficient period of time to evaluate and confirm the effectiveness of the corrections or related new procedures), our management will be unable to report favorably as of such future period year-end as to the effectiveness of our control over financial reporting |
| If we are unable to assert that our internal control over financial reporting is effective in any future period (or if our independent auditors are unable to express an opinion on the effectiveness of our internal controls), or if we continue to experience material weaknesses in our internal control over financial reporting, we could lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price and potentially subject us to litigation |
| If we fail to effectively upgrade our information technology system, we may not be able to accurately report our financial results or prevent fraud |
| As part of our efforts to continue improving our internal control over financial reporting, we plan to upgrade our existing information technology system |
| We may experience difficulties in transitioning to new or upgraded systems, including loss of data and decreases in productivity as personnel become familiar with new systems |
| In addition, our management information systems will require modification and refinement as we grow and as our business needs change, which could prolong difficulties we experience with systems transitions, and we may not always employ the most effective systems for our purposes |
| If we experience difficulties in implementing new or upgraded information systems or experience significant system failures, or if we are unable to successfully modify our management information systems and respond to changes in our business needs, our operating results could be harmed or we may fail to meet our reporting obligations |
| Our largest stockholder controls a significant percentage of our common stock and its interests may conflict with those of our other stockholders |
| New Affirmative beneficially owns approximately 50dtta9prca of our outstanding common stock |
| As a result, New Affirmative exercises significant influence over matters requiring stockholder approval, including the election of directors, changes to our charter documents and significant corporate transactions |
| This concentration of ownership makes it unlikely that any other holder or group of holders of our common stock will be able to affect the way we are managed or the direction of our business |
| The interests of New Affirmative with respect to matters potentially or actually involving or affecting us, such as future acquisitions, financings and other corporate opportunities and attempts to acquire us, may conflict with the interests of our other stockholders |
| New Affirmative’s continued concentrated ownership may have the effect of delaying or preventing a change of 19 _________________________________________________________________ [53]Table of Contents control of us, including transactions in which stockholders might otherwise receive a premium for their shares over then current market prices |
| Future sales of our common stock, or the perception that future sales could occur, may adversely affect our common stock price |
| As of March 31, 2006, we had an aggregate of 59cmam567cmam443 shares of our common stock authorized but unissued and not reserved for specific purposes |
| In general, we may issue all of these shares without any action or approval by our stockholders |
| We have reserved 3cmam000cmam000 shares of our common stock for issuance under our equity incentive plan, of which 1cmam588cmam215 shares are issuable upon vesting and exercise of options granted as of March 31, 2006, including options to purchase approximately 213cmam395 shares exercisable as of December 31, 2005 |
| In addition, we may pursue acquisitions of competitors and related businesses and may issue shares of our common stock in connection with these acquisitions |
| Sales or issuances of a substantial number of shares of common stock, or the perception that such sales could occur, could adversely affect prevailing market prices of our common stock, and any sale or issuance of our common stock will dilute the percentage ownership held by our stockholders |
| New Affirmative, our largest stockholder, beneficially owns approximately 50dtta9prca of our common stock |
| New Affirmative has certain demand and piggyback registration rights with respect to the shares of our common stock it beneficially owns |
| Sales of a substantial number of shares of common stock by our largest stockholder, New Affirmative, or the perception that such sales could occur, could also adversely affect prevailing market prices of our common stock |
| Since we are a “controlled company” for purposes of The Nasdaq National Market’s corporate governance requirements, our stockholders will not have, and may never have, the protections that these corporate governance requirements are intended to provide |
| Since we are a “controlled company” for purposes of The Nasdaq National Market’s corporate governance requirements, we are not required to comply with the provisions requiring that a majority of our directors be independent, the compensation of our executives be determined by independent directors or nominees for election to our board of directors be selected by independent directors |
| As a result, our stockholders will not have, and may never have, the protections that these rules are intended to provide |
| The board of directors has determined that Paul J Zucconi, Suzanne T Porter, Thomas C Davis and Nimrod T Frazer are independent under The Nasdaq National Market listing standards |
| Because of our significant concentration in non-standard personal automobile insurance, our profitability may be adversely affected by negative developments and cyclical changes in that industry |
| Substantially all of our gross premiums written and commission and fee income is generated from sales of non-standard personal automobile insurance policies |
| As a result of our concentration in this line of business, negative developments in the business, economic, competitive or regulatory conditions affecting the non-standard personal automobile insurance industry could have a negative effect on our profitability and would have a more pronounced effect on us compared to more diversified companies |
| Examples of such negative developments are increasing trends in automobile repair costs, automobile parts costs, used car prices and medical care expenses, increased regulation, as well as increased litigation of claims and higher levels of fraudulent claims |
| All of these events can result in reduced profitability |
| In addition, the non-standard personal automobile insurance industry historically has been cyclical in nature, characterized by periods of severe price competition and excess underwriting capacity followed by periods of high premium rates and shortages of underwriting capacity |
| We believe that these industry-wide rate reductions, combined with increased costs per claim during the period, contributed to the deterioration of industry loss ratios in the years 1999 through 2001 |
| We believe that in 2002 through 2004, the underwriting results in the non-standard personal automobile insurance business improved as a result of favorable pricing and competitive conditions that allowed for broad increases in rate levels by insurers, including us |
| In late 2004, and continuing through 2005, we are seeing increased price competition and excess underwriting capacity indicating a softening market |
| These fluctuations in the non-standard personal automobile insurance business cycle may negatively impact our profitability |
| Intense competition could adversely affect our profitability |
| The non-standard personal automobile insurance business is highly competitive and, except for regulatory considerations, there are relatively few barriers to entry |
| Our retail agencies and independent agencies that sell our insurance products compete both with these direct writers and with other independent agencies |
| Therefore, our competitors are not only large national insurance companies, but also smaller regional insurance companies and independent agencies |
| Some of our competitors have substantially greater financial and other resources than we have and may offer a broader range of products or competing products at lower prices |
| In addition, given the current favorable pricing conditions, existing competitors may attempt to increase market share by lowering rates and new competitors may enter this market, particularly larger insurance companies that do not presently write non-standard personal automobile insurance |
| In this environment, we may experience a reduction in our underwriting margins or sales of our insurance policies may decrease as individuals purchase lower-priced products from other insurance companies |
| A loss of business to competitors offering similar insurance products at lower prices or having other competitive advantages could negatively affect our revenues and profitability |
| In addition, our retail stores offer and sell non-standard personal automobile insurance policies both for our insurance companies and for unaffiliated insurance companies |
| As a result, our insurance companies compete with these unaffiliated insurance companies for sales to the customers of our retail stores |
| If the competing insurance products offered by an unaffiliated insurance company are priced lower or have more attractive features than the insurance policies offered by our insurance companies, customers of retail stores may decide not to purchase insurance policies from our insurance companies and may instead purchase policies from the unaffiliated insurance company |
| A loss of business by our insurance companies resulting from our retail stores selling relatively more policies of unaffiliated insurance companies and fewer policies of our insurance companies could negatively affect our revenues and profitability |
| Our success depends on our ability to price accurately the risks we underwrite |
| The results of our operations and the financial condition of our insurance companies depend on our ability to underwrite and set premium rates accurately for a wide variety of risks |
| Rate adequacy is necessary to generate sufficient premiums to pay losses, loss adjustment expenses and 20 _________________________________________________________________ [54]Table of Contents underwriting expenses and to earn a profit |
| In order to price our products accurately, we must collect and properly analyze a substantial amount of data; develop, test and apply appropriate rating formulas; closely monitor and timely recognize changes in trends and project both severity and frequency of losses with reasonable accuracy |
| Our ability to undertake these efforts successfully, and as a result price our products accurately, is subject to a number of risks and uncertainties, some of which are outside our control, including: • the availability of sufficient reliable data and our ability to properly analyze available data; • the uncertainties that inherently characterize estimates and assumptions; • our selection and application of appropriate rating and pricing techniques; and • changes in legal standards, claim settlement practices, medical care expenses and automobile repair costs |
| Consequently, we could underprice risks, which would negatively affect our profit margins, or we could overprice risks, which could reduce our sales volume and competitiveness |
| In either event, the profitability of our insurance companies could be materially and adversely affected |
| If our actual losses and loss adjustment expenses exceed our loss and loss adjustment expense reserves, we will incur additional charges to earnings |
| We maintain reserves to cover our estimated ultimate liability for losses and related loss adjustment expenses for both reported and unreported claims on insurance policies issued by our insurance companies |
| The establishment of appropriate reserves is an inherently uncertain process, involving actuarial and statistical projections of what we expect to be the cost of the ultimate settlement and administration of claims based on historical claims information, estimates of future trends in claims severity and other variable factors such as inflation |
| Due to the inherent uncertainty of estimating reserves, it has been necessary, and will continue to be necessary, to revise estimated future liabilities as reflected in our reserves for claims and related expenses |
| We cannot be sure that our ultimate losses and loss adjustment expenses will not materially exceed our reserves |
| To the extent that our reserves prove to be inadequate in the future, we would be required to increase our reserves for losses and loss adjustment expenses and incur a charge to earnings in the period during which such reserves are increased, which could have a material and adverse impact on our financial condition and results of operations |
| In addition, we have a limited history in establishing reserves, and the historic development of our reserves for losses and loss adjustment expenses may not necessarily reflect future trends in the development of these amounts |
| We may incur significant losses if Vesta Fire, which currently has an AMBest financial strength rating of “C++” (Marginal) or any of our other reinsurers, do not pay our claims in a timely manner |
| Although our reinsurers are liable to us to the extent we transfer risk to the reinsurers, we remain ultimately liable to our policyholders on all risks reinsured |
| Consequently, if any of our reinsurers cannot pay their reinsurance obligations, or dispute these obligations, we remain liable to pay the claims of our policyholders |
| In addition, our reinsurance agreements are subject to specified contractual limits on the amounts and types of losses covered, and we do not have reinsurance coverage to the extent our losses exceed those limits or are not of the type reinsured |
| As of December 31, 2005, we had a total of dlra28dtta1 million of receivables from reinsurers, including dlra18dtta5 million gross recoverable from Vesta Fire |
| Vesta Fire currently has been assigned a financial strength rating of “C++” (Marginal) from AM Best, which is the ninth highest of 15 rating levels |
| According to AM Best, “C++” ratings are assigned to insurers that have a marginal ability to meet their current obligations to policyholders, and are financially vulnerable to adverse changes in underwriting and economic conditions |
| If any of our reinsurers are unable or unwilling to pay amounts they owe us in a timely fashion, we could suffer a significant loss, which would have a material adverse effect on our business and results of operations |
| Because we have reduced our use of quota share reinsurance, we have retained more risk, which could result in losses |
| We have historically used quota share reinsurance primarily to increase our underwriting capacity and to reduce our exposure to losses |
| Quota share reinsurance is a form of pro rata reinsurance arrangement in which the reinsurer participates in a specified percentage of the premiums and losses on every risk that comes within the scope of the reinsurance agreement in return for a portion of the corresponding premiums |
| We have reduced, but not eliminated, our use of quota share reinsurance |
| We generally enter into quota share reinsurance agreements that cover business written through our underwriting agencies in specified states or regions |
| Reducing our use of quota share reinsurance will increase our risk and exposure to such losses, which could have a material adverse effect on our business, financial condition and results of operations |
| We are subject to comprehensive regulation that may restrict our ability to earn profits |
| We are subject to comprehensive regulation and supervision by government agencies in Illinois, the state in which our insurance company subsidiaries are domiciled, as well as in the states where our subsidiaries sell insurance products, issue policies and handle claims |
| Certain states impose restrictions or require prior regulatory approval of certain corporate actions, which may adversely affect our ability to operate, innovate, obtain necessary rate adjustments in a timely manner or grow our business profitably |
| These regulations provide safeguards for policyowners and are not intended to protect the interests of stockholders |
| Our ability to comply with these laws and regulations and to obtain necessary regulatory action in a timely manner is and will continue to be critical to our success |
| We operate under licenses issued by various state insurance authorities |
| If a regulatory authority denies or delays granting a new license, our ability to enter that market quickly or offer new insurance products in that market might be substantially impaired |
| • Transactions between insurance companies and their affiliates |
| Transactions between our insurance companies and their affiliates generally must be disclosed to state regulators, and prior approval of the applicable regulator generally is required before any material or extraordinary transaction may be consummated |
| State regulators may refuse to approve or delay approval of such a transaction, which may impact our ability to innovate or operate efficiently |
| 21 _________________________________________________________________ [55]Table of Contents • Restrictions on cancellation, non-renewal or withdrawal |
| Many states have laws and regulations that limit an insurance company’s ability to exit a market |
| For example, certain states limit an automobile insurance company’s ability to cancel or not renew policies |
| Some states prohibit an insurance company from withdrawing from one or more lines of business in the state, except pursuant to a plan approved by the state insurance department |
| In some states, this applies to significant reductions in the amount of insurance written, not just to a complete withdrawal |
| These laws and regulations could limit our ability to exit or reduce our writings in unprofitable markets or discontinue unprofitable products in the future |
| • Other regulations |
| We must also comply with regulations involving, among other things: • the use of non-public consumer information and related privacy issues; • the use of credit history in underwriting and rating; • limitations on the ability to charge policy fees; • limitations on types and amounts of investments; • the payment of dividends; • the acquisition or disposition of an insurance company or of any company controlling an insurance company; • involuntary assignments of high-risk policies, participation in reinsurance facilities and underwriting associations, assessments and other governmental charges; • SEC reporting; • reporting with respect to financial condition; and • periodic financial and market conduct examinations performed by state insurance department examiners |
| Compliance with laws and regulations addressing these and other issues often will result in increased administrative costs |
| In addition, these laws and regulations may limit our ability to underwrite and price risks accurately, prevent us from obtaining timely rate increases necessary to cover increased costs and may restrict our ability to discontinue unprofitable relationships or exit unprofitable markets |
| These results, in turn, may adversely affect our profitability or our ability or desire to grow our business in certain jurisdictions |
| The failure to comply with these laws and regulations may also result in actions by regulators, fines and penalties, and in extreme cases, revocation of our ability to do business in that jurisdiction |
| In addition, we may face individual and class action lawsuits by our insureds and other parties for alleged violations of certain of these laws or regulations |
| Regulation may become more extensive in the future, which may adversely affect our business |
| We cannot assure you that states will not make existing insurance-related laws and regulations more restrictive in the future or enact new restrictive laws |
| In such events, we may seek to reduce our writings in, or to withdraw entirely from, these states |
| In addition, from time to time, the United States Congress and certain federal agencies investigate the current condition of the insurance industry to determine whether federal regulation is necessary |
| We are unable to predict whether and to what extent new laws and regulations that would affect our business will be adopted in the future, the timing of any such adoption and what effects, if any, they may have on our operations, profitability and financial condition |
| For example, in 2003, legislation was passed in Texas that has been described as comprehensive insurance reform affecting the homeowners and automobile insurance business |
| With respect to nonstandard personal automobile insurance, the most significant provisions provide for additional rate regulation and limitations on the use of credit scoring and territorial distinctions in underwriting and rating risks |
| In the fiscal year ended December 31, 2005, approximately 28dtta4prca of our total controlled premium was written on policies issued to customers in Texas |
| Currently, all of these policies are written by Old American, a Texas county mutual insurance company |
| We and many of our competitors contract with Texas county mutual insurance companies primarily because these entities historically have not been subject to state rate regulation applicable to other insurance companies |
| Although the new reforms are significant, the primary rate regulation provisions do not apply directly to our business in Texas due to an exemption that applies to certain county mutual insurance companies, including Old American |
| However, because the Texas Commissioner of Insurance has been given broader rulemaking authority under the new law, we cannot determine the ultimate impact this legislation will have on our business until certain rules are developed by the Commissioner |
| Any rule changes that would bring the regulation of county mutual insurance companies more closely in line with the regulation of other property and casualty insurance companies conducting business in Texas would likely increase our regulatory costs and reduce our rate flexibility, which could make our relationship with Old American less profitable and prompt us to change the way we underwrite risk in Texas |
| Our insurance companies are subject to minimum capital and surplus requirements, and our failure to meet these requirements could subject us to regulatory action |
| Our insurance companies are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable state laws, including the laws of their state of domicile, Illinois |
| The risk-based capital standards, based upon the Risk-Based Capital Model Act adopted by the National Association of Insurance Commissioners, or NAIC, require our insurance companies to report their results of risk-based capital calculations to state departments of insurance and the NAIC These risk-based capital standards provide for different levels of regulatory attention depending upon the ratio of an insurance company’s total adjusted capital, as calculated in accordance with NAIC guidelines, to its authorized control level 22 _________________________________________________________________ [56]Table of Contents risk-based capital is the number determined by applying the NAIC’s risk-based capital formula, which measures the minimum amount of capital that an insurance company needs to support its overall business operations |
| Any failure by one of our insurance companies to meet the applicable risk-based capital or minimum statutory capital requirements imposed by the laws of Illinois or other states where we do business could subject it to further examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision or liquidation |
| Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require us to increase our statutory capital levels, which we may be unable to do |
| As of December 31, 2005, Affirmative Insurance Company and Insura had total adjusted capital of dlra129dtta5 and dlra23dtta6 million and exceeded their respective authorized control level risk-based capital by a multiple of 3dtta2 to 1 and 50dtta7 to 1, respectively |
| Insura is a wholly owned subsidiary of Affirmative Insurance Company, therefore Insura’s total adjusted capital is included in Affirmative Insurance Company’s total adjusted capital of dlra129dtta5 million |
| Our failure to pay claims accurately could adversely affect our business, financial results and capital requirements |
| We must accurately evaluate and pay claims that are made under our policies |
| Many factors affect our ability to pay claims accurately, including the training and experience of our claims representatives, the culture of our claims organization and the effectiveness of our management, our ability to develop or select and implement appropriate procedures and systems to support our claims functions and other factors |
| Our failure to pay claims accurately could lead to material litigation, undermine our reputation in the marketplace, impair our image and negatively affect our financial results |
| In addition, if we do not train new claims employees effectively or if we lose a significant number of experienced claims employees, our claims department’s ability to handle an increasing workload as we grow could be adversely affected |
| In addition to potentially requiring that growth be slowed in the affected markets, we could suffer decreased quality of claims work, which in turn could lower our operating margins |
| If we are unable to retain and recruit qualified personnel, our ability to implement our business strategies could be hindered |
| Our success depends in part on our ability to attract and retain qualified personnel |
| Our inability to recruit and retain qualified personnel could prevent us from fully implementing our business strategies and could materially and adversely affect our business, growth and profitability |
| We do not have key person insurance on the lives of any of our executive officers |
| Our Nominating and Corporate Governance Committee is presently conducting search for a permanent Chief Executive Officer and has not yet made a recommendation to the Board of Directors |
| We may encounter difficulties in implementing our strategies of expanding in to new markets and acquiring agencies |
| Our growth strategy includes expanding into new geographic markets, introducing additional insurance and non-insurance products and acquiring the business and assets of underwriting and retail agencies |
| Our future growth will face risks, including risks associated with our ability to: • obtain necessary licenses; • properly design and price our products; • identify, hire and train new claims and sales employees; • identify agency acquisition candidates; and • assimilate and integrate the operations, personnel, technologies, products and information systems of the acquired companies |
| We may also encounter difficulties in connection with implementing our growth strategy, including unanticipated expenditures, damaged or lost relationships with customers and independent agencies and contractual, intellectual property or employment issues relating to companies we acquire |
| In addition, our growth strategy may require us to enter into a geographic or business market in which we have little or no prior experience |
| Further, any potential agency acquisitions may require significant capital outlays, and if we issue equity or convertible debt securities to pay for an acquisition, these securities may have rights, preferences or privileges senior to those of our common stockholders or the issuance may be dilutive to our existing stockholders |
| Once agencies are acquired, we could suffer increased costs, disruption of our business and distraction of our management if we are unable to smoothly integrate the agencies into our operations |
| Our expansion will also continue to place significant demands on our management, operations, systems, accounting, internal controls and financial resources |
| Any failure by us to manage our growth and to respond to changes in our business could have a material adverse effect on our business and profitability and could cause the price of our common stock to decline |
| Our financial results may be adversely affected by conditions in the states where our business is concentrated |
| Our business is concentrated in 13 states |
| For the year ended December 31, 2005, approximately 28dtta4prca of our total controlled premium related to policies issued to customers in Texas, 23dtta9prca to customers in Illinois and 13dtta5prca to customers in California |
| Our revenues and profitability are therefore subject to prevailing regulatory, legal, economic, demographic, competitive and other conditions in these states |
| Changes in any of these conditions could make it less attractive for us to do business in these states and could have an adverse effect on our financial results |
| Our underwriting operations are vulnerable to a reduction in the amount of business written by independent agencies |
| For the year ended December 31, 2005, independent agencies were responsible for approximately 58dtta1prca of the total controlled premium produced by our underwriting agencies |
| As a result, our business depends in part on the marketing efforts of independent agencies and on our ability to offer insurance products and services that meet the requirements of these independent agencies and their 23 _________________________________________________________________ [57]Table of Contents customers |
| Independent agencies are not obligated to sell or promote our products, and since many of our competitors rely significantly on the independent agency market, we must compete with other insurance companies and underwriting agencies for independent agencies’ business |
| Some of our competitors offer a larger variety of products, lower prices for insurance coverage or higher commissions, and we therefore may not be able to continue to attract and retain independent agencies to sell our insurance products |
| A material reduction in the amount of business our independent agencies sell would negatively impact our revenues |
| If we are unable to establish and maintain relationships with unaffiliated insurance companies to sell their non-standard personal automobile policies through our under writing agencies and retail stores, our sales volume and profitability may suffer |
| Our underwriting agencies and retail stores sell non-standard personal automobile insurance policies for our insurance companies and also for unaffiliated insurance companies |
| Particularly in soft markets, our commitment to underwriting discipline may result in declining sales of our insurance companies’ policies in favor of lower-priced products from other insurance companies willing to accept less attractive underwriting margins |
| Consequently, part of our strategy in a soft market is to generate increased commission and fee revenue from sales of third-party policies through our underwriting agencies’ relationships with unaffiliated insurance companies and our retail stores’ relationships with unaffiliated underwriting agencies and insurance companies |
| If our underwriting agencies and retail stores are unable to establish and maintain these relationships, they would have a more limited selection of non-standard personal automobile insurance policies to sell |
| In such an event, our underwriting agencies and retail stores might experience a net decline in overall sales volume of non-standard personal automobile insurance policies, which would decrease our profitability |
| Our largely fixed cost structure with respect to our retail stores would work to our disadvantage if our sales volume at our retail stores were to decline significantly |
| We estimate that, for the year ended December 31, 2005, 74prca of the costs related to our retail store operations were largely fixed, including the leasing costs for our retail space and employee compensation expenses for our sales personnel in the retail stores |
| If we are unable to maintain our sales volume of non-standard personal automobile policies at our retail stores, we may be forced to close some of our retail store locations or lay off store personnel to manage our fixed expenses |
| These actions in turn could harm our profitability and likely would detract from our future growth potential |
| If our insurance companies, which currently have AM Best financial strength ratings of “B+”, fail to maintain commercially acceptable financial strength ratings, our ability to implement our business strategies successfully could be significantly and negatively affected |
| Financial strength ratings are important in establishing the competitive position of insurance companies and could have an effect on an insurance company’s sales |
| AM Best, generally considered to be a leading authority on insurance company ratings and information, has currently assigned our insurance companies ratings of “B+” (Very Good) |
| The “B+” rating is the sixth highest of 15 rating categories that AM Best assigns to insurance companies, ranging from “A++” (Superior) to “F” (In Liquidation) |
| According to AM Best, “B+” ratings are assigned to insurers that have a good ability to meet their current obligations to policyholders |
| AM Best’s ratings reflect its opinion of an insurance company’s financial strength, operating performance and ability to meet its obligations to policyholders and are not evaluations directed to potential or current investors in our common stock or recommendations to buy, sell or hold our common stock |
| Our insurance companies’ ratings are subject to change at any time and may be revised downward or revoked at the sole discretion of AM Best |
| Because lenders and reinsurers will use our AM Best ratings as a factor in deciding whether to transact business with us, the current ratings of our insurance companies or their failure to maintain the current ratings may dissuade a financial institution or reinsurance company from conducting any business with us or may increase our interest or reinsurance costs |
| We face litigation, which if decided adversely to us, could adversely impact our financial results |
| We are named as a defendant in a number of lawsuits |
| These lawsuits are described more fully elsewhere in this report |
| Litigation, by its very nature, is unpredictable and the outcome of these cases is uncertain |
| The precise nature of the relief that may be sought or granted in any lawsuits is uncertain and may, if these lawsuits are determined adversely to us, negatively impact our earnings |
| In addition, potential litigation involving new claim, coverage and business practice issues could adversely affect our business by changing the way we price our products, extending coverage beyond our underwriting intent or increasing the size of claims |
| Recent examples of some emerging issues include a growing trend of plaintiffs targeting automobile insurers in purported class action litigation relating to claims handling practices such as total loss evaluation methodology and the alleged diminution in value to insureds’ vehicles involved in accidents and the relatively new trend of plaintiffs targeting insurers, including automobile insurers, in purported class action litigation which seeks to recharacterize installment fees and other allowed chargers related to insurers’ installment billing programs as interest that violates state usury laws or other interest rate restrictions |
| The effects of these and other unforeseen emerging claims, coverage and business practice issues could negatively impact our profitability or our methods of doing business |
| Adverse securities market conditions can have a significant and negative impact on our investment portfolio |
| Our results of operations depend in part on the performance of our invested assets |
| As of December 31, 2005, dlra210dtta8 million of our investment portfolio was invested in fixed income securities |
| Certain risks are inherent in connection with fixed maturity securities including loss upon default and price volatility in reaction to changes in interest rates and general market factors |
| In general, the fair value of a portfolio of fixed income securities increases or decreases inversely with changes in the market interest rates, while net investment income realized from future investments in fixed income securities increases or decreases along with interest rates |
| In addition, some of our fixed income securities have call or prepayment options |
| This could subject us to reinvestment risk should interest rates fall and issuers call their securities |
| We attempt to mitigate this risk by investing in securities with varied maturity dates, so that only a portion of the portfolio will mature at any point in time |
| Furthermore, actual net investment income and/or cash flows 24 _________________________________________________________________ [58]Table of Contents from investments that carry prepayment risk, such as mortgage-backed and other asset-backed securities, may differ from those anticipated at the time of investment as a result of interest rate fluctuations |
| An investment has prepayment risk when there is a risk that the timing of cash flows that result from the repayment of principal might occur earlier than anticipated because of declining interest rates or later than anticipated because of rising interest rates |
| If market interest rates were to change 1dtta0prca (for example, the difference between 5dtta0prca and 6dtta0prca), the fair value of our fixed income securities would change approximately dlra8dtta0 million |
| The change in fair value was determined using duration modeling assuming no prepayments |
| We rely on our information technology and telecommunications systems, and the failure of these systems could disrupt our operations |
| Our business is highly dependent upon the successful and uninterrupted functioning of our current information technology and telecommunications systems as well as our future integrated policy and claims system |
| We rely on these systems to process new and renewal business, provide customer service, make claims payments and facilitate collections and cancellations, as well as to perform actuarial and other analytical functions necessary for pricing and product development |
| As a result, the failure of these systems could interrupt our operations and adversely affect our financial results |
| See Item 9A Controls and Procedures for additional disclosure about a material weakness in our internal control over financial reporting at December 31, 2005 related to our information technology systems and our remediation process |
| Severe weather conditions and other catastrophes may result in an increase in the number and amount of claims filed against us |
| Our business is exposed to the risk of severe weather conditions and other catastrophic events, such as rainstorms, snowstorms, hail and ice storms, hurricanes, tornadoes, earthquakes, fires and other events such as explosions, terrorist attacks and riots |
| The incidence and severity of catastrophes and severe weather conditions are inherently unpredictable |
| Such conditions generally result in higher incidence of automobile accidents and an increase in the number of claims filed, as well as the amount of compensation sought by claimants |
| As a holding company, we are dependent on the results of operations of our operating subsidiaries to meet our obligations and pay future dividends |
| We are organized as a holding company, a legal entity separate and distinct from our operating subsidiaries |
| As a holding company without significant operations of our own, we are dependent upon dividends and other payments from our operating subsidiaries, which include our agency subsidiaries and our insurance company subsidiaries |
| We cannot pay dividends to our stockholders and meet our other obligations unless we receive dividends and other payments from our operating subsidiaries, including our insurance company subsidiaries |
| State insurance laws limit the ability of our insurance company subsidiaries to pay dividends and require our insurance company subsidiaries to maintain specified minimum levels of statutory capital and surplus |
| In addition, for competitive reasons, our insurance companies need to maintain financial strength ratings which require us to maintain certain levels of capital and surplus in those subsidiaries |
| The need to maintain these capital and surplus levels may affect the ability of our insurance company subsidiaries to pay dividends to us |
| Without regulatory approval, the aggregate maximum amount of dividends that can be paid in 2006 to us by our insurance company subsidiaries is approximately dlra7dtta2 million |
| The aggregate maximum amount of dividends permitted by law to be paid by an insurance company does not necessarily indicate an insurance company’s actual ability to pay dividends |
| The actual ability to pay dividends may be further constrained by business and regulatory considerations, such as the impact of dividends on surplus, which could affect an insurance company’s ratings, competitive position, amount of premiums that can be written, and ability to pay future dividends |
| State insurance regulators have broad discretion to limit the payment of dividends by insurance companies and our rights to participate in any distribution of assets of our insurance company subsidiaries are subject to prior claims of policyholders and creditors, except to the extent that our rights, if any, as a creditor are recognized |
| As a result, a prolonged, significant decline in the profits of our insurance company subsidiaries or regulatory action limiting dividends could subject us to shortages of cash because our insurance company subsidiaries would not be able to pay us dividends |
| We have a limited operating history as a stand-alone entity and may experience difficulty in operating as an independent public company |
| We have limited operating history as an independent company |
| Prior to our initial public offering, we operated our business as a subsidiary of Vesta and we relied on Vesta for assistance with certain financial, administrative, managerial and other matters |
| Following our initial public offering, we have our own credit, banking and reinsurance relationships and will perform our own financial, reporting, regulatory compliance and investor relation functions |
| In order to operate successfully as an independent public company, we must continue to establish the internal systems and capabilities, and hire or train the personnel, necessary to maintain these relationships and perform these functions effectively |
| We may not be successful in developing these systems and capabilities or in hiring new employees or training existing employees to carry out these new responsibilities |
| Even if successful, the development of such systems, capabilities and personnel may require a substantial amount of time and resources and divert our management’s attention away from our business |
| In addition, we are responsible for complying with the various regulatory requirements applicable to public companies |
| We will incur increased costs as a result of being a public company, particularly in light of recently enacted and proposed changes in laws, regulations and listing requirements |
| Our business and financial condition may be adversely affected if we are unable to effectively manage these increased costs and public company regulatory requirements |