Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

 

x ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For Fiscal Year Ended December 31, 2007

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 0-11773

 

 

ALFA CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   63-0838024

(State or other jurisdiction

incorporation or organization)

 

(I.R.S Employer

Identification No.)

2108 East South Boulevard  
P.O. Box 11000, Montgomery, Alabama   36191-0001
(Address of principal executive offices)   (Zip-Code)

Registrant’s Telephone Number including Area Code (334) 288-3900

 

 

Securities registered pursuant to Section 12 (b) of the Act: None

Securities registered pursuant to Section 12 (g) of the Act:

 

Title of each Class

 

Name of each exchange on which registered

Common Stock, par value $1.00 per share   The NASDAQ Stock Market

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Ye  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

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.    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” and “accelerated filer,” “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨    Accelerated filer  x     Non-accelerated filer  ¨    Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x

As of June 30, 2007, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $567,553,443 based on the closing sale price as reported on the National Association of Securities Dealers Automated Quotation System National Market System.

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class

 

Outstanding at February 29, 2008

Common Stock, $1.00 par value per share   80,904,240 shares

 

 

 


Table of Contents

ALFA CORPORATION

FORM 10-K

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2007

INDEX

 

         Page
  PART I   
Item 1.   Business    3
Item 1A.   Risk Factors    11
Item 1B.   Unresolved Staff Comments    16
Item 2.   Properties    16
Item 3.   Legal Proceedings    17
Item 4.   Submission of Matters to a Vote of Security Holders    18
  PART II   
Item 5.  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   19
Item 6.   Selected Financial Data    22
Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations    23
Item 7A.   Quantitative and Qualitative Disclosures About Market Risk    60
Item 8.   Financial Statements and Supplementary Data    64
Item 9.   Changes in and Disagreements With Accountants on Accounting and Financial Disclosure    122
Item 9A.   Controls and Procedures    122
Item 9B.   Other Information    123
  PART III   
Item 10.   Directors, Executive Officers and Corporate Governance    124
Item 11.   Executive Compensation    126
Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    139
Item 13.   Certain Relationships and Related Transactions, and Director Independence    140
Item 14.   Principal Accounting Fees and Services    141
  PART IV   
Item 15.   Exhibits, Financial Statement Schedules    IV-1

 

2


Table of Contents

Part I

 

Item 1. Business.

Description of the Corporation. Alfa Corporation is a financial services holding company headquartered in Alabama that offers primarily personal lines of property casualty insurance, life insurance and financial services products through its wholly-owned subsidiaries:

 

   

Alfa Insurance Corporation (AIC)

 

   

Alfa General Insurance Corporation (AGI)

 

   

Alfa Vision Insurance Corporation (AVIC)

 

   

Alfa Alliance Insurance Corporation (Alliance)

 

   

Alfa Life Insurance Corporation (Life)

 

   

Alfa Financial Corporation (Financial)

 

   

The Vision Insurance Group, LLC (Vision)

 

   

Alfa Agency Mississippi, Inc. (AAM)

 

   

Alfa Agency Georgia, Inc. (AAG)

 

   

Alfa Benefits Corporation (ABC)

Alfa Corporation is affiliated with Alfa Mutual Insurance Company, Alfa Mutual Fire Insurance Company and Alfa Mutual General Insurance Company (collectively, the Mutual Group). The Mutual Group owns 55.0% of Alfa Corporation’s common stock, their largest single investment. Alfa Specialty Insurance Corporation (Specialty) is a wholly-owned subsidiary of Alfa Mutual Insurance Company (Mutual). Alfa Corporation and its subsidiaries (the Company) together with the Mutual Group and Specialty comprise the Alfa Group (Alfa). Prior to January 1, 2007, Virginia Mutual Insurance Company (Virginia Mutual) ceded 80% of its direct business to Alfa Mutual Fire Insurance Company (Fire) under a Strategic Affiliation Agreement signed in August 2001.

The Company’s common stock is traded on the NASDAQ Stock Market’s National Market under the symbol “ALFA.”

Recent Developments. Effective January 1, 2007, the Company completed the previously approved plan of conversion and acquisition of Virginia Mutual. Under the plan, Virginia Mutual converted from a mutual company to a stock company and simultaneously was recapitalized as Alfa Alliance Insurance Corporation (Alliance), a wholly-owned subsidiary of the Company. In addition, the Pooling Agreement was amended to include Alliance as a participant in the pool and the quota share agreement between Fire and Virginia Mutual was terminated with applicable references removed from the Pooling Agreement (refer to Note 2 – Pooling Agreement in the Notes to Consolidated Financial Statements).

On July 17, 2007, the Company received an offer from the Mutual Group for a transaction that would result in the privatization of the Company. The Mutual Group proposed to acquire all of the outstanding shares of the Company’s common stock that are not currently owned by them. The Company’s Board of Directors appointed a special committee of its four independent directors to review, evaluate and negotiate the proposal. On November 4, 2007, the Company, Mutual and Fire entered into a definitive merger agreement pursuant to which Mutual and Fire will acquire all of the outstanding shares of the Company’s common stock they do not currently own for $22.00 per share. Concurrent with the agreement, Mutual and Fire will acquire General’s (0.8%) ownership at the same price offered to the Company’s stockholders. For additional details, refer to Note 21 – Privatization of the Company and Note 22 – Subsequent Events in the Notes to Consolidated Financial Statements and Item 1A. Risk Factors.

Nature of Operations. During 2007, Alfa Corporation’s insurance subsidiaries were direct writers of life insurance and property casualty insurance in various states. The table below presents the Company’s insurance lines of business by state.

 

3


Table of Contents
     Life    Property Casualty
        Automobile    Homeowner    Commercial    Other

Alabama

              

Arkansas

              

Florida1

              

Georgia

              

Indiana

              

Kentucky

              

Mississippi

              

Missouri

              

North Carolina

              

Ohio

              

Tennessee

              

Texas2

              

Virginia

              

 

1

No direct business is being written in Florida in 2008 as the Company is exiting this market.

2

AVIC assumes auto business in Texas.

The Company’s property casualty business is pooled with that of the Mutual Group, which directly writes property casualty business in Alabama, and Specialty, which directly writes nonstandard auto business in Alabama, Georgia, Mississippi and Virginia. Approximately 61.2% of the Company’s property casualty premium income and 53.6% of its total premium income for 2007 was derived from the Company’s participation in the Pooling Agreement.

The Company reports operating segments based on the Company’s legal entities, which are organized by line of business:

 

   

Property casualty insurance

 

   

Life insurance

 

   

Noninsurance

 

   

Consumer financing

 

   

Commercial leasing

 

   

Agency operations

 

   

Employee benefits administration

 

   

Corporate and eliminations

 

4


Table of Contents

Presented below is summarized financial information for the Company’s four business segments for the years ended December 31, 2007, 2006 and 2005:

 

     Years Ended December 31,  
     2007     2006     2005  
     (in thousands)  

Revenues by Segment

      

Property casualty insurance

   $ 686,301     $ 652,524     $ 606,445  

Life insurance

     147,559       147,639       133,498  

Noninsurance operations

     32,786       41,216       33,266  

Corporate

     33,993       44,234       45,973  
                        

Revenues before eliminations

   $ 900,639     $ 885,613     $ 819,182  

Eliminations

     (64,414 )     (73,475 )     (62,277 )
                        

Total revenues

   $ 836,225     $ 812,138     $ 756,905  
                        

Operating Income (Loss)1 by Segment

      

Property casualty insurance operating income

   $ 85,375     $ 85,034     $ 80,195  

Life insurance operating income

     23,341       23,925       21,736  

Noninsurance operating income (loss)

     (1,332 )     328       (38 )

Corporate operating loss

     (13,159 )     (5,610 )     (6,792 )
                        

Total operating income

   $ 94,225     $ 103,677     $ 95,101  

Realized investment gains (losses), net of tax

     (717 )     2,211       3,933  
                        

Net income

   $ 93,508     $ 105,888     $ 99,034  
                        

 

1

Operating income (loss), a non-GAAP financial measure, is defined as net income (loss) excluding realized investment gains and losses, net of applicable taxes. Management uses operating income as a measure of the Company’s ongoing profitability since it eliminates the effect of securities market volatility from earnings.

Property Casualty Insurance:

The Company’s pooled business consists primarily of personal lines property casualty insurance, which accounts for 96% of property casualty premiums and 72% of total revenues. Automobile and homeowners insurance account for 86% of property casualty premiums. Based on 2006 data, in Alabama, the Mutual Group and Specialty enjoy an approximately 20% share of the personal automobile and homeowners markets, second only to State Farm.

The following table shows the Company’s pooled share of direct premiums by product for 2007:

 

Automobile

   60.6 %

Homeowner

   25.4 %

Farmowner

   4.6 %

Commercial

   4.0 %

Manufactured Home

   2.5 %

Other

   2.9 %
      
   100.0 %
      

A discussion of the Company’s property casualty insurance results of operations is included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Segment disclosures required under Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures about Segments of an Enterprise and Related Information, are included in Note 16 – Segment Information in the Notes to Consolidated Financial Statements.

The Company’s strategy in property casualty business has been to operate primarily as a personal lines insurer that markets and underwrites to achieve a preferred, profitable book of business. The Company’s objective is to

 

5


Table of Contents

operate with an underwriting profit. Historically, this objective has been met except for five separate years, each of which was primarily impacted by catastrophic weather. In the wake of Hurricanes Opal and Erin, Alfa initiated intense studies of its catastrophe management strategy. Effective November 1, 1996, the catastrophe program was restructured and the intercompany pooling agreement was amended to allocate catastrophe losses among the members of the pool in a fashion that more equitably reflects the realities of catastrophe finance. As a result, the Company’s share of storm-related losses has been substantially reduced, providing greater earnings stability. The Company’s pooled share of catastrophe losses totaled $13.9 million, $13.8 million and $11.6 million in 2007, 2006 and 2005, respectively.

There are inherent uncertainties in reserving for unpaid losses. Management establishes reserves using its best estimate determined by using accepted actuarial techniques. The Company experienced no materially significant large losses or gains in its loss payments during 2005, 2006 or 2007 which led to changes in estimates.

Life Insurance:

Life directly writes individual life insurance policies consisting primarily of ordinary whole life, term life, interest-sensitive whole life, universal life products and non-qualified annuities in Alabama, Georgia and Mississippi and distributes these products utilizing an exclusive, independent and independent exclusive agent sales force.

The following table shows the Company’s distribution by product for life insurance premiums and policy charges for 2007:

 

Traditional life insurance premiums

   56.6 %

Universal life policy charges

   25.3 %

Interest-sensitive life policy charges

   12.8 %

Universal life policy charges—COLI

   4.7 %

Group life insurance premiums

   0.6 %
      
   100.0 %
      

As of December 31, for each year indicated, the Company had insurance inforce as follows:

 

     2007    2006    2005
     (in thousands)

Ordinary life

   $ 24,310,054    $ 22,505,208    $ 21,148,519

Credit life

   $ 10,544    $ 10,728    $ 13,446

Group life

   $ 48,425    $ 47,987    $ 47,269

A discussion of the Company’s life insurance results of operations is included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Segment disclosures required under SFAS No. 131 are included in Note 16 – Segment Information in the Notes to Consolidated Financial Statements.

While the amount retained on an individual life will vary depending upon age and mortality prospects of the risk, Life generally will not retain more than $500 thousand of individual life insurance on a single risk with the exception of corporate owned life insurance (COLI) and group policies where the retention is limited to $100 thousand per individual. These retention limits are set for the purpose of limiting the liability of Life with respect to any one risk and providing greater diversification of its exposure. When Life reinsures a portion of its risk it must cede the premium income to the reinsurer who reinsures the risk, thereby decreasing the income of Life. Life performs various underwriting procedures and blood testing for AIDS and other diseases before issuance of insurance.

 

6


Table of Contents

Noninsurance:

The Company operates five subsidiaries which are not considered to be significant under SFAS No. 131 for purposes of separate disclosure: Financial; AAM, AAG, Vision (collectively, Agency operations); and ABC.

 

   

Financial is an institution engaged principally in making consumer loans. Loans are available through all customer service centers. Automobiles and other property collateralize these loans. Financial is also engaged in operating and capital lease activities.

 

   

AAM and AAG, headquartered in Montgomery, Alabama, provide agents with the opportunity to offer customers a broader portfolio of products by placing insurance risks with third party insurers for a commission. Vision is a managing general agency that currently writes nonstandard automobile insurance policies in eight states. Vision, headquartered in Brentwood, Tennessee, provides all underwriting, claims, actuarial and financial services on behalf of its contracted carriers.

 

   

ABC administers certain nonqualified employee and director benefit plans for Mutual.

A discussion of the Company’s noninsurance results of operations is included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Segment disclosures required under SFAS No. 131 are included in Note 16 – Segment Information in the Notes to Consolidated Financial Statements.

Investments:

The Company’s income is directly affected by its investment income and realized gains and losses from its investment portfolio. The capital and reserves of the Company are invested in assets comprising its investment portfolio. In its insurance subsidiaries, insurance regulations prescribe the nature and quality of investments that may be made and included in the insurance subsidiaries’ investment portfolios. Such investments include qualified state, municipal and federal obligations, high quality corporate bonds and stocks, mortgage-backed securities and certain other assets. The Company’s noninsurance segment also holds investments in collateral loans, commercial leases, notes receivable and equity-method investments.

The Company’s investment philosophy is long-term and value oriented with focus on total return for both yield and growth potential. During the past ten years, invested assets have grown from $1.0 billion to over $2.2 billion at the end of 2007, a compound annual growth rate of 8.0%. During that same period, net investment income has almost doubled, growing from $57.5 million to $94.8 million. At year-end, the value of unrealized losses in the Company’s portfolio was $662 thousand, net of tax. The portfolio, including investments in affiliates, was invested 59.1% in fixed maturities, 4.0% in equities, 18.7% in short-term investments and 18.2% in other investments which include policy loans, collateral loans, commercial leases, notes receivable, partnerships, affiliated preferred stock and equity-method investments.

The rating of the Company’s portfolio of fixed maturities using the Standard & Poor’s rating categories is as follows at December 31, 2007 and 2006:

 

     December 31,  
     2007     2006  

AAA to A-

   93.9 %   93.7 %

BBB+ to BBB-

   5.1 %   5.7 %

BB+ and below (below investment grade)

   0.8 %   0.4 %

Not rated

   0.2 %   0.2 %
            
   100.0 %   100.0 %
            

 

7


Table of Contents

At December 31, 2007, all securities in the fixed maturity portfolio, with the exception of a single investment of $3.0 million, were rated by an outside rating service.

A discussion of the Company’s investments is included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Reserves:

The Company’s property casualty insurance subsidiaries are required to maintain reserves to cover their estimated ultimate liability for losses and loss adjustment expenses. These reserves are based on management’s best estimate; however, there can be no assurance that ultimate losses will not materially differ from the Company’s established loss reserves. The Company’s life insurance subsidiary is required to maintain reserves for future policy benefits. To the extent that reserves prove to be inadequate or excessive in the future, the Company would have to modify such reserves and incur a charge or credit to earnings in the period such reserves are modified which could have a material effect on the Company’s results of operations and financial condition.

Property Casualty Reserves. Losses and loss adjustment expenses payable are management’s best estimates at a given point in time of what the Company expects to pay claimants, based on known facts, circumstances, historical trends, emergence patterns and settlement patterns. Reserves for reported losses are established on a case-by-case basis with the amounts determined by claims adjusters based on the Company’s reserving practices, which take into account the type of risk, the circumstances surrounding each claim and policy provisions relating to types of loss. Loss and loss adjustment expense reserves for incurred claims that have not yet been reported (IBNR) are estimated based primarily on historical emergence patterns with consideration given to many variables including statistical information, inflation, legal developments, storm loss estimates, and economic conditions.

The Company’s internal actuarial staff conducts annual reviews of projected loss development information by line of business to assist management in making estimates of reserves for ultimate losses and loss adjustment expenses payable. Several factors are considered in estimating ultimate liabilities including consistency in relative case reserve adequacy, consistency in claims settlement practices, recent legal developments, historical data, actuarial projections, accounting projections, exposure growth, current business conditions, catastrophe developments and late reported claims. In addition, reasonableness is established in the context of claim severity, loss ratio and trend factors, all of which are implicit in the liability estimates.

The annual actuarial reviews are presented to management with a point estimate established within the range of probable outcomes for evaluating the adequacy of reserves and determination of the appropriate reserve value to be included in the financial statements. Management establishes reserves based on its best estimate of ultimate losses. Although management uses many internal and external resources, as well as multiple established methodologies to calculate reserves, there is no method for determining the exact ultimate liability.

Management establishes reserves for loss adjustment expenses that are not attributable to a specific claim. These reserves are referred to as Defense and Cost Containment (DCC) and Adjusting and Other Expenses (AO). DCC and AO reserves are recorded to establish the liability for settling and defending claims that have been incurred, but have not yet been completely settled. For AO, historical ratios of AO to paid losses are developed and then applied to the current outstanding reserves. The method uses a traditional assumption that 50% of the expenses are realized when the claim is open and the other 50% are incurred when the claim is closed. The method also assumes that the underlying claims process and mix of business do not change materially over time.

The Company is primarily an insurer of private passenger motor vehicles and of single-family homes and has limited exposure for difficult-to-estimate claims such as environmental, product and general liability claims. The Company does not believe that any such claims will have a material impact on the Company’s liquidity, results of operations, cash flows or financial condition.

 

8


Table of Contents

Life Reserves. Benefit reserves for traditional life products are determined according to the provisions of SFAS No. 60, Accounting and Reporting by Insurance Enterprises. The methodology used requires that the present value of future benefits to be paid to or on behalf of policyholders less the present value of future net premiums (that portion of the gross premiums required to provide for all future benefits and expenses) be determined. Such determination uses assumptions, including provision for adverse deviation, for expected investment yields, mortality, terminations and maintenance expenses applicable at the time the insurance contracts are issued. These assumptions determine the level and the sufficiency of reserves. The Company annually tests the validity of these assumptions.

Benefit reserves for universal life type products and annuity products are determined according to the provisions of SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. This standard directs that, for policies with an explicit account balance, the benefit reserve is the account balance without reduction for any applicable surrender charge.

Reserves for all other benefits are computed in accordance with presently accepted actuarial standards. Management believes that reserve amounts reflected in the Company’s balance sheet related to life products are adequate.

The assumptions used in the calculation of Life’s reserves are shown in Note 8—Policy Liabilities and Accruals in the Notes to Consolidated Financial Statements.

Relationship with Mutual Group:

The Company’s business and operations are substantially integrated with and dependent upon the management, personnel and facilities of Mutual. Under a Management and Operating Agreement with Mutual, all management personnel are provided by Mutual and the Company reimburses Mutual for field office expenses and operations services rendered by Mutual.

Mutual periodically conducts expense allocation studies. Mutual charges the Company for its allocable and directly attributable expenses, including facilities.

The Board of Directors of the Company consisted, at December 31, 2007, of eleven members, six of whom serve on the Executive Committee of the Boards of the Mutual Group and two of whom are Executive Officers of the Company.

At December 31, 2007, Mutual owned 34,528,589 shares, or 42.8%, Fire owned 9,187,970 shares, or 11.4%, and Alfa Mutual General Insurance Company owned 631,166 shares, or 0.8%, of the Company’s outstanding common stock.

Competition:

Both the life and property casualty insurance businesses are highly competitive. There are numerous insurance companies in the Company’s area of operation and throughout the United States. Many of the companies in direct competition with the Company have been in business for a much longer period of time, have a larger volume of business, offer a more diversified line of insurance coverage, and have greater financial resources than the Company. In its life and property casualty insurance businesses, the Company competes with other insurers in the sale of insurance products to consumers and the recruitment and retention of qualified agents. The Company believes the main competitive factors in its business are price, name recognition and service. The Company believes it competes effectively in these areas in Alabama. In other states, however, the Company’s name is not as well recognized, but such recognition is improving.

 

9


Table of Contents

Regulation:

The Mutual Group and the Company’s insurance subsidiaries are subject to the Alabama Insurance Holding Company Systems Regulatory Act and are subject to reporting to the Alabama Insurance Department and to periodic examination of their transactions and regulation under the Act with Mutual being considered the controlling party. The Company’s insurance subsidiary, Alfa Alliance Insurance Corporation, is a Virginia domiciled property casualty company, and as such, is subject to regulatory oversight and examination by the Virginia State Corporation Commission, Bureau of Insurance.

Additionally, the Company’s insurance subsidiaries are subject to licensing and supervision by the governmental agencies in the jurisdictions in which they do business. The nature and extent of such regulation varies, but generally has its source in state statutes which delegate regulatory, supervisory and administrative powers to State Insurance Commissioners. Such regulation, supervision and administration relate, among other things, to standards of solvency which must be met and maintained, licensing of the companies, periodic examination of the affairs and financial condition of the Company, annual and other reports required to be filed on the financial condition and operation of the Company. Rates of property casualty insurance are subject to regulation and approval of regulatory authorities. Life insurance rates are generally not subject to prior regulatory approval.

The Mutual Group, the Company and Financial are regulated by, report to and are subject to examination by the Office of Thrift Supervision (OTS), pursuant to the Federal Home Owners’ Loan Act (HOLA) and its Control Regulations due to Financial’s investment in MidCountry Financial Corporation (MidCountry). The scope of this authority includes the savings association, its holding company and other affiliates, and subsidiaries of the savings association. In accordance with its responsibilities, the OTS has issued regulations and developed examination procedures for savings and loan holding companies.

Restrictions on Dividends to Stockholders: The Company’s insurance subsidiaries are subject to various state statutory and regulatory restrictions, generally applicable to each insurance company in its state of domicile, which limit the amount of dividends or distributions by an insurance company to its stockholders. The restrictions are generally based on certain levels of surplus, investment income and operating income, as determined under statutory accounting practices. Alabama law permits dividends in any year which, together with other dividends or distributions made within the preceding 12 months that do not exceed the greater of (i) 10% of statutory surplus as of the end of the preceding year or (ii) for property casualty companies—the statutory net income for the preceding year, or for life companies—the statutory net gain from operations. For property casualty insurers, Virginia law permits dividends in any year which, together with other dividends or distributions made within the preceding 12 months that do not exceed the greater of (i) 10% of statutory surplus as of the end of the preceding year or (ii) the statutory net income, excluding capital gains, for the preceding year. Larger dividends are payable only after receipt of regulatory approval. Future dividends from the Company’s subsidiaries may be limited by business and regulatory considerations. However, based upon restrictions presently in effect, the maximum amount available for payment of dividends to the Company by its insurance subsidiaries in 2008 without prior approval of regulatory authorities is $107.0 million based on December 31, 2007 financial condition and results of operations.

Risk-Based Capital Requirements: The National Association of Insurance Commissioners (NAIC) adopted risk-based capital requirements that require insurance companies to calculate and report information under a risk-based formula which attempts to measure statutory capital and surplus needs based on the risks in a company’s mix of products and investment portfolio. The formula is designed to allow state insurance regulators to identify potential weakly capitalized companies. Under the formula, a company determines “risk-based capital” (RBC) by taking into account certain risks related to the insurer’s assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer’s liabilities (including underwriting risks related to the nature and experience of its insurance business). Risk-based capital rules provide for different levels of regulatory attention depending on the ratio of a company’s total adjusted capital to its “authorized control level” of RBC. Based on calculations made by the Company, the risk-based capital levels for each of the Company’s insurance subsidiaries significantly exceed that which would require regulatory attention.

 

10


Table of Contents

Personnel:

The Company has no management or operational employees. The Company and its subsidiaries have a Management and Operating Agreement with Mutual whereby it reimburses Mutual for salaries and expenses of employees provided to the Company under the Agreement. Involved are employees that are directly attributable to the Company’s subsidiaries and those employees allocable for accounting, sales administration, legal, files, data processing, programming, research, policy issuing, claims, investments and management. At December 31, 2007, the Company was represented by 490 agents in Alabama who are employees of Mutual. The Company’s subsidiaries had 139 independent exclusive agents in Georgia and Mississippi and 4,294 independent agents in Arkansas, Florida, Georgia, Indiana, Kentucky, Missouri, North Carolina, Ohio, Tennessee, Texas and Virginia at December 31, 2007. The Company believes its employee relations are good.

Available Information:

The Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the SEC are made available free of charge on its website at www.alfains.com by first selecting “About Alfa” and then selecting “Investor Relations” and finally selecting “SEC Filings.”

Also available on the website is the Company’s Code of Ethics titled “Principles of Business Conduct” which can be accessed under such title.

A free copy of the Company’s Form 10-K, as filed with the SEC, may also be obtained by writing: Al Scott, Senior Vice President, Secretary and General Counsel, Alfa Corporation, P.O. Box 11000, Montgomery, Alabama 36191-0001.

Any of the materials the Company files with the SEC may also be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of the SEC’s Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.

 

Item 1A. Risk Factors.

Risk factors are uncertainties and events over which the Company has limited or no control and which can have a materially adverse effect on the business, the results of operations or the financial condition of the Company and its subsidiaries. The Company and its business segments are subject to a variety of risk factors. The following sections set forth management’s evaluation of the most prevalent material risk factors for the Company and its subsidiaries. There may be risks which management does not presently consider material or which are not presently known to management that may later prove to be material risk factors.

Regulatory Environment

The Company’s insurance subsidiaries are subject to extensive governmental regulation in all of the state jurisdictions in which they operate. These regulations relate to licensing requirements, types of insurance products that may be sold, premium rates, marketing practices, capital and surplus requirements, investment limitations, underwriting limitations, dividend payment limitations, transactions with affiliates, accounting practices, taxation and other matters. While most of the regulation is at the state level, the federal government

 

11


Table of Contents

has increasingly expressed an interest in regulating the insurance industry through the Gramm-Leach-Bliley Act, the Patriot Act, financial services regulation, changes in the Internal Revenue Code and other legislation. All of these regulations increase the cost of conducting insurance business through increased compliance expenses. Furthermore, as existing regulations evolve through administrative and court interpretations, and as new regulations are adopted, there can be no way of predicting what impact these changes will have on the Company in the future. Such impact could adversely affect the Company’s profitability and limit its growth.

Litigation

The Company and its subsidiaries are named defendants in various legal proceedings arising in the normal course of business. These proceedings are described more fully in Note 11 – Commitments and Contingencies in the Notes to Consolidated Financial Statements. Litigation, by its 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 lawsuit is uncertain and may, if determined adversely to the Company, negatively impact results of operations.

Litigation may arise in the future related to alleged breaches of contract, torts, including bad faith and fraud claims and other causes of action against the Company or any of its subsidiaries. These lawsuits could involve claims for unspecified amounts of compensatory damages, mental anguish damages and punitive damages. It should be noted that in Alabama and Mississippi, where the Company has substantial business, the likelihood of a judgment in any given suit, including a large mental anguish and/or punitive damage award by a jury, bearing little or no relation to actual damages, continues to exist, creating the potential for unpredictable material adverse financial results.

Geographic Concentration Risk

The Company’s property casualty insurance business is generated in 12 states, with the majority of the business generated in 3 southeastern states, and its life insurance business is generated in 3 states. Accordingly, unusually severe storms or other disasters in these states might have a more significant effect on the Company than a more geographically diversified company and could have an adverse impact on the Company’s financial condition and operating results.

In addition, the revenues and profitability of the Company are 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 the Company to do business in these states and could have an adverse effect on the Company’s financial results.

Catastrophic Loss Risk

The insurance operations expose the Company to claims arising out of catastrophic events. Catastrophes can be caused by various unpredictable events, including hurricanes, hailstorms, tornadoes, severe winter weather, earthquakes, and other natural or man-made disasters.

Property Casualty: While the Company limits the property exposures it writes in coastal exposure areas, the Company’s critical catastrophic risk is hurricanes because of the proximity of southeastern markets to the Gulf of Mexico and the Atlantic Ocean. The Company also limits its catastrophic loss risk by participating in a catastrophe protection program through an intercompany pooling arrangement (more fully discussed in Note 2 – Pooling Agreement in the Notes to Consolidated Financial Statements). A catastrophic event in excess of the Company’s upper catastrophe pool limit could adversely affect the Company’s business, results of operations and financial condition.

Reserves

Reserves are the amounts that an insurance company records for its anticipated policy liabilities.

 

12


Table of Contents

Property Casualty: Claim reserves are an estimate of liability for unpaid claims and claims defense and adjustment expenses, and cover reported, as well as incurred but not yet reported claims. It is not possible to calculate precisely what these liabilities will amount to in advance and, therefore, the reserves represent a best estimate at any point in time. Such estimates are based upon known historical loss data and trending using actuarial techniques and modeling. Reserve estimates are periodically reviewed in consideration of known developments and, where necessary, adjusted as circumstances may warrant. Nevertheless, the reserving process is inherently uncertain. If for any of these reasons, reserve estimates prove to be inadequate, the Company’s subsidiaries will increase their reported liabilities. Such an occurrence could result in a materially adverse impact on the Company’s results of operations and financial condition.

Life: Reserves for life-contingent contract benefits are computed on the basis of long-term actuarial assumptions of future investment yields, mortality, morbidity, policy terminations and expenses. The Company reviews the adequacy of these reserves on an aggregate basis and, if future experience differs significantly from assumptions, adjustments to reserves may be required, which could have a materially adverse impact on the Company’s results of operations and financial condition.

Excessive Losses and Loss Expenses

A risk factor common to all lines of insurance is excessive losses due to unanticipated claims frequency, severity or a combination of both. Many of the factors affecting the frequency and severity of claims depend upon the type of insurance coverage. Severity and frequency can be affected by unexpectedly adverse outcomes in claims litigation, often as a result of unanticipated jury verdicts, changes in court-made law and adverse court interpretations of insurance policy provisions resulting in increased liability or new judicial theories of liability, together with unexpectedly high costs of defending claims. This could adversely impact the Company’s results of operations and financial condition.

Pricing

Property Casualty: Property casualty premium rates are generally determined on the basis of historical data for claims frequency and severity as well as related production and other expense patterns. In the event ultimate claims and expenses exceed historically projected levels, premium rates are likely to prove insufficient. Premium rate inadequacy may not become evident quickly and may require time to correct.

Life: For currently issued life products, initial premiums are guaranteed for a short period and may be increased thereafter, subject to contractual maximums, if insured mortality experience deteriorates. The Company does not assume mortality improvement when setting the initial premium scale.

Inadequate premiums, much like excessive losses, if material, can adversely affect the Company’s results of operations and financial condition.

Prior Approval of Rates

Property Casualty: Most of the lines of property casualty insurance underwritten by the Company are subject to prior regulatory approval of premium rates in a majority of the states in which it operates. The process of securing regulatory approval can be time consuming and can impair the Company’s ability to make necessary rate increases in an expeditious manner. There is a risk that regulators will not approve a requested increase. To the extent that rate increases are not approved on an adequate and timely basis, the Company’s results of operations and financial condition may be adversely impacted.

Life: Premium rates for life insurance are not subject to regulatory approval.

 

13


Table of Contents

Estimated Profitability of Universal Life Type Products

Deferred policy acquisition costs (DAC) related to universal life type products are amortized in proportion to actual gross profits and estimated gross profits (EGP) over the estimated lives of the contracts. Assumptions underlying EGP, including those relating to surrender charges and mortality, investment, and expense margins, are updated from time to time to reflect actual and expected experience and its potential effect on the valuation of DAC. Updates to these assumptions could result in DAC unlocking, which in turn could adversely affect the Company’s results of operations and financial condition.

Reinsurance

Reinsurance is a contractual arrangement whereby one insurer (the reinsurer) assumes some or all of the risk exposure written by another insurer (the reinsured). The Company uses reinsurance to manage its risks in terms of the amount of coverage it writes, the amount it retains for its own account, and the price at which it is able to market its products. The availability of reinsurance and its price, however, are determined in the reinsurance market by conditions beyond the Company’s control.

Reinsurance does not relieve the reinsured company of its primary liability to its insureds in the event of a loss. It merely reimburses the reinsured company. The ability and willingness of reinsurers to honor their obligations represent credit risks inherent in reinsurance transactions. The Company addresses this risk by limiting its reinsurance to those reinsurers it considers the best credit risks with limited duration contracts.

There can be no assurance that the Company will be able to find the desired or even adequate amounts of reinsurance at favorable rates from acceptable reinsurers in the future. If unable to do so, the Company would be forced to reduce the volume of business it writes or retain increased amounts of liability exposure or both. This could adversely affect the Company’s results of operations and financial condition.

Guaranty Funds and Residual Markets

In nearly all states, licensed insurers are required to participate in guaranty funds through assessments covering a portion of insurance claims against impaired or insolvent insurers. Any increase in the number or size of impaired companies would likely result in an increase in the Company’s share of such assessments.

Residual market or pooling arrangements exist in many states to provide various types of insurance coverage to those that are otherwise unable to find private insurers willing to insure them. All licensed property casualty insurers writing such coverage voluntarily are required to participate in these residual markets or pooling mechanisms.

A material increase in any of these assessments or charges could adversely affect the Company’s results of operations and financial condition.

Competition

Both the property casualty insurance industry and the life insurance industry are highly competitive and are likely to remain so for the foreseeable future. Moreover, existing competitors and the capital markets have brought an influx of capital and newly organized entrants into the industry in recent years, and changes in laws have allowed financial institutions, like banks and savings and loans, to sell insurance products. Increases in competition threaten to reduce demand for the Company’s insurance products, reduce its market share, reduce its growth, reduce its profitability and generally adversely affect its results of operations and financial condition.

 

14


Table of Contents

Investment Risks (Interest and Equity)

The invested assets of the Company’s subsidiaries are centrally managed by the Company. The majority of these invested assets consist of fixed maturity securities. Changes in interest rates directly affect the income from, and the market value of fixed maturity investments and could reduce the value of the Company’s investment portfolio and adversely affect the Company’s and its subsidiaries’ results of operations and financial condition. The Company manages its fixed maturity investments by taking into account the maturities of such securities and the anticipated liquidity needs of the Company and its subsidiaries. Should the Company suddenly experience greater than anticipated liquidity needs for any reason, it could face a liquidity risk that may adversely affect the Company’s financial condition or results of operations. A smaller percentage of total investments are in equity securities.

A change in general economic conditions, the stock market, or many other external factors could adversely affect the value of those investments and, in turn, the Company’s, or its subsidiaries’ results and financial condition.

Liquidity Risk

As indicated above, the Company manages its fixed maturity investments with a view toward matching the maturities of those investments with the anticipated liquidity needs of its subsidiaries for the payment of claims and expenses. If a subsidiary suddenly experienced greater than anticipated liquidity needs for any reason, an injection of funds might be required that may not necessarily be available to the Company at that point in time.

Dividend Dependence and Liquidity

The Parent Company is a financial services holding company with no significant operations. Its principal asset is the stock and interests of its subsidiaries. The Parent Company relies upon dividends from the insurance subsidiaries in order to pay the interest on debt obligations, dividends to its stockholders and corporate expenses. The ability of the insurance subsidiaries to declare and pay dividends is subject to regulations under state laws that limit dividends based on the amount of adjusted unassigned surplus and earnings and require the subsidiaries to maintain minimum amounts of capital, surplus and reserves. Dividends in excess of the ordinary limitations can only be declared and paid with prior regulatory approval, of which there can be no assurance. The inability of the insurance subsidiaries to pay dividends in an amount sufficient to meet debt service and cash dividends to stockholders, as well as other cash requirements of the Company could result in liquidity issues for the Company.

Rating Downgrades

The competitive positions of insurance companies, in general, have come to depend increasingly on independent ratings of their financial strength and claims-paying ability. The rating agencies base their ratings on criteria they establish regarding an insurer’s financial strength, operating performance, strategic position and ability to meet its obligations to policyholders. A significant downgrade in the ratings of any of the Company’s insurance subsidiaries by A. M. Best, Moody’s or Standard and Poor’s could negatively impact their ability to compete for new business and retain existing business and, as a result, adversely affect the Company’s results of operations and financial condition. A significant downgrade in the Company’s commercial paper ratings by Moody’s or Standard and Poor’s could make it more expensive to access capital markets that could adversely affect the Company’s liquidity, results of operations and financial condition.

Business Continuity

As mentioned in Item 1. Business, above, the Company’s business and operations are substantially integrated with and dependent upon the management, personnel and facilities of Mutual. A Business Continuity Plan has been developed by Mutual and a Business Processing Center was completed during 2006 to help mitigate the effects of a catastrophic event in the primary facility. If an event occurs that was unanticipated in the business continuity plan there could be an adverse impact on the Company’s ability to conduct business and on results of operations and financial condition.

 

15


Table of Contents

Majority Owners

The majority owners of the Company’s common stock, the Mutual Group, can control the outcome of stockholder votes requiring a simple majority. In addition, six of the eleven members of the Board of Directors are officers of the Mutual Group and serve on the Boards of the Mutual Group, and two of the Board members are Executive Officers of the Company and the Mutual Group. Through its majority ownership, the Mutual Group has the ability to and may influence actions that may conflict with the interest of other stockholders.

On July 17, 2007, the majority owners, the Mutual Group, made an offer to acquire all of the outstanding shares of the Company’s common stock that are not currently owned by them. The Company’s Board of Directors appointed a Special Committee of its four independent directors to review, evaluate and negotiate the proposal. On November 4, 2007, the Company, Alfa Mutual Insurance Company (Mutual) and Alfa Mutual Fire Insurance Company (Fire) and Alfa Delaware Merger Sub, Inc., a wholly-owned subsidiary of Mutual and Fire, entered into a definitive merger agreement pursuant to which Mutual and Fire will acquire all of the outstanding shares of the Company’s common stock they do not currently own for $22.00 per share. Mutual and Fire have agreed to vote all shares of common stock owned by them in favor of the merger, making the requisite approval assured. However, the transaction remains subject to certain other conditions to consummation. The pendency of this agreement for an extended period of time, as well as the possibility that the proposed transaction might not ultimately be consummated, may result in non-recurring expenses to the Company. Please refer to Item 3. Legal Proceedings and Note 21 – Privatization of the Company and Note 22 – Subsequent Events in the Notes to Consolidated Financial Statements for further information.

Accounting Standards

The Company’s financial statements are prepared based on generally accepted accounting principles issued by the Financial Accounting Standards Board and other standards set by other authoritative organizations. The Company is required to adopt new or revised accounting standards that are issued periodically. Future changes that are adopted could change the accounting treatment applied to the financial statements and could have an adverse impact on the Company’s results of operations and financial condition. A description of potential changes in accounting standards that could currently affect the Company is disclosed in Note 19 – Financial Accounting Developments in the Notes to Consolidated Financial Statements.

 

Item 1B. Unresolved Staff Comments.

None

 

Item 2. Properties.

Physical Properties of the Company and Its Subsidiaries. The principal executive offices are owned by Mutual and are located at 2108 East South Boulevard, Montgomery, Alabama, in a 342 thousand square foot primary facility and a 134 thousand square foot business processing center. The executive offices are a component of all segments.

The Company leases buildings that are used in the normal course of business which includes offices and facilities in Georgia, Mississippi, Tennessee and Virginia. These facilities are used by executive, claims and marketing personnel and are components of the insurance and noninsurance segments. Locations utilized by the Company’s independent exclusive and independent agents are normally leased by those agents as lessees.

 

16


Table of Contents
Item 3. Legal Proceedings.

The Company and its subsidiaries are defendants in legal proceedings arising in the normal course of business. Management believes adequate accruals have been established in these known cases. However, it should be noted that in Mississippi and Alabama, where the Company has substantial business, the likelihood of a judgment in any given suit, including a large mental anguish and/or punitive damage award by a jury, bearing little or no relation to actual damages, continues to exist, creating the potential for unpredictable material adverse financial results.

Subsequent to the end of the second quarter, nine purported class action lawsuits, seven in the Delaware Chancery Court and two in the Circuit Court of Montgomery County, Alabama, have been brought against the Company, the Mutual Group and directors and/or officers on behalf of the public shareholders of the Company, to enjoin the defendants from causing the Company to enter into an agreement to be acquired by the Mutual Group, among other allegations. On August 16, 2007 and on August 29, 2007, orders were entered that consolidated the actions filed in Delaware into In Re Alfa Corporation Shareholders Litigation, in the Court of Chancery of the State of Delaware in and for New Castle County, C.A. No. 3104-VCP. On October 29, 2007, an order was entered that consolidated the actions filed in Alabama into In Re Alfa Corporation Shareholder Litigation, in the Circuit Court of Montgomery County, Alabama, CV-07-900485. The Company believes the actions are without merit.

On November 7, 2007, the counsel to the parties in the above referenced Alabama consolidated action entered into a Memorandum of Understanding to settle such action, subject to approval of the court. Under the terms of the Memorandum of Understanding (Alabama MOU), Mutual and Fire agreed to pay $22.00 per share to acquire the outstanding shares of common stock of the Company that are not currently owned by them. As further consideration, lead counsel to the Alabama consolidated action was provided an opportunity to review and comment on the preliminary proxy statement. The Alabama MOU also provided for confirmatory discovery, which has been completed.

On November 9, 2007, a policyholder of Mutual filed a purported class action and derivative action against Mutual in the Circuit Court of Macon County, Alabama, Preston M. Wright v. Alfa Mutual Insurance Co., No. CV-07-900070. The policyholder contended that Mutual’s and Fire’s acquisition of the outstanding stock of the Company was not in the best interest of the policyholders of Mutual and Fire. Plaintiffs asserted purported claims for the alleged impairment of Mutual’s assets. The plaintiffs sought to enjoin the proposed acquisition, other injunctive relief, and unspecified damages, costs and attorneys’ fees. The Company believed that this action was without merit.

On November 21, 2007, certain policyholders of the Mutual Group filed a purported class action and derivative action against the Company, the Mutual Group and certain of their officers and directors in the Circuit Court of Walker County, Alabama, Mr. and Mrs Prince Hagler et. al. v. Alfa Mutual Insurance Co., et. al., No. CV-07-408. In Hagler, the policyholders contended that the merger was not in the best interest of the policyholders of the Mutual Group and would unjustly enrich the defendants. Plaintiffs asserted purported claims for breach of fiduciary duty and unjust enrichment. The plaintiffs sought to enjoin the proposed acquisition, other injunctive relief, and unspecified damages, costs and attorneys’ fees. The Company believes that this action is without merit.

On or about December 19, 2007, the defendants in the above-described Macon County litigation filed a Motion to Sever and Transfer, requesting that the court sever the class action allegations related to the transaction from unrelated individual insurance fraud allegations contained in the Complaint. The motion requested that, once severed, the class action allegations be transferred to the Circuit Court of Montgomery County, Alabama.

On December 20, 2007, the counsel to the parties in the above referenced Delaware consolidated action entered into a Memorandum of Understanding (Delaware MOU) to settle such action, subject to approval of the court. Under the terms of the Delaware MOU, counsel to the Delaware consolidated action will be provided an opportunity to review and comment on the preliminary proxy statement. The parties to the Delaware litigation subsequently intervened in In Re Alfa Corporation Shareholder Action in the Circuit Court of Montgomery County, Alabama, for the purposes of participating in confirmatory discovery and for participating in the settlement of the action.

 

17


Table of Contents

On December 21, 2007, some of the defendants in the above-described Walker County litigation filed a motion to transfer said litigation to the Circuit Court of Montgomery County, Alabama.

On or about January 4, 2008, the plaintiffs in the above-described Walker County litigation served discovery requests on the defendants, seeking production of documents purportedly related to the transaction.

On or about January 23, 2008, the defendants’ motion to sever and transfer in the Macon County litigation was denied by the trial court. Defendants then filed a petition for writ of mandamus to the Alabama Supreme Court seeking to have the trial court’s denial of defendants’ motion reversed.

On or about February 7, 2008, a preliminary hearing was held in consolidated In Re Alfa Corp. Shareholder Litigation, in the Circuit Court of Montgomery County, Alabama, where the parties filed a Stipulation of Settlement and the court entered a Scheduling Order that, among other things, set a final hearing to determine approval of the class action settlement for April 14, 2007. The court also authorized the form of a Notice of Pendency and Proposed Settlement of Class Action to be sent to all members of the class, as defined in the Notice.

On or about February 8, 2008, plaintiffs in the Macon County litigation voluntarily dismissed the policyholder class action allegation against defendants.

On or about February 12, 2008, the Notice of Pendency and Proposed Settlement of Class Action describing the settlement In Re Alfa Corp. Shareholder Litigation was mailed to members of the class.

On February 23, 2008, counsel for the parties in the above-described Walker County action entered into a Memorandum of Understanding to settle such action, subject to approval of the court. On March 4, 2008, the Walker County court conditionally approved the settlement and set a final approval hearing for May 28, 2008.

Based upon information presently available, management is unaware of any contingent liabilities arising from other threatened litigation that should be reserved or disclosed.

For a more detailed discussion of legal proceedings of the Company, refer to Note 11 – Commitments and Contingencies and Note 21 – Privatization of the Company in the Notes to Consolidated Financial Statements.

 

Item 4. Submission of Matters to a Vote of Security Holders.

No matters were submitted to a vote of stockholders during the fourth quarter of 2007.

 

18


Table of Contents

Part II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

MARKET INFORMATION

The primary market for Alfa Corporation common stock is the National Association of Securities Dealers, Inc. Automated Quotation National Market System (the NASDAQ). The Company’s common stock is quoted under the symbol of “ALFA.” Newspaper listings of NASDAQ stocks list Alfa Corporation as AlfaCp.

The following table sets forth, for each of the fiscal periods indicated, the range of the high and low sale prices per share as reported by the NASDAQ. These prices do not include adjustments for retail markups, markdowns or commissions.

 

2007

   High    Low    Dividends
Per Share

First Quarter

   $ 19.73    $ 17.37    $ 0.1100

Second Quarter

     19.30      15.57      0.1175

Third Quarter

     18.86      14.99      0.1175

Fourth Quarter

     21.91      17.31      0.1175

2006

   High    Low    Dividends
Per Share

First Quarter

   $ 17.62    $ 15.95    $ 0.1000

Second Quarter

     17.37      15.15      0.1100

Third Quarter

     17.88      15.41      0.1100

Fourth Quarter

     19.95      16.66      0.1100

 

19


Table of Contents

PERFORMANCE GRAPH

The following graph compares the performance of Alfa Corporation’s common stock with the performance of the NASDAQ Stock Market Index and the NASDAQ Insurance Stocks Index for a five year period by measuring the changes in common stock prices from December 31, 2002 to December 31, 2007.

LOGO

Assumes $100 invested on December 31, 2002 in Alfa Corporation common stock, the NASDAQ Stock Market (US) Index and NASDAQ Insurance Stocks Index

 

* Total return assumes reinvestment of dividends.
** Fiscal year ending December 31

HOLDERS

As of January 31, 2008, Alfa Corporation has approximately 2,300 stockholders of record.

DIVIDENDS

The Company pays dividends on its common stock upon declaration by the Board of Directors. There are no restrictions on the Company’s present or future ability to pay dividends other than the usual statutory restrictions.

Dividends have been paid annually since 1974 and quarterly since September 1977. There is a present expectation that dividends will continue to be paid in the future. Future dividends depend upon future earnings, the Company’s financial condition and other factors.

 

20


Table of Contents

PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASES

 

Period

   Total Number
of Shares
Purchased
   Average Price
Paid per Share
   Total Number
of Shares
Purchased as
Part of Publicly
Announced
Plans or
Programs
   Maximum
Number of
Shares that
May Yet Be
Purchased
Under the Plans
or Programs 1

October 1, 2007 - October 31, 2007

   —      $ —      —      3,635,877

November 1, 2007 - November 30, 2007

   —        —      —      3,635,877

December 1, 2007 - December 31, 2007

   —        —      —      3,635,877
                   

Total

   —      $ —      —     
                   

 

1

In October 1989, the Company’s Board of Directors approved a stock repurchase program authorizing the repurchase of up to 4,000,000 shares of its outstanding common stock in the open market or in negotiated transactions in such quantities and at such times and prices as management may decide. The Board increased the number of shares authorized for repurchase by 4,000,000 in both March 1999 and September 2001, bringing the total number of shares authorized for repurchase to 12,000,000.

The Company does not contemplate any additional share repurchases under the repurchase program due to the definitive merger agreement. Refer to Note 21 – Privatization of the Company and Note 22 – Subsequent Events in the Notes to Consolidated Financial Statements for additional information.

RECENT SALES OF UNREGISTERED SECURITIES; USE OF PROCEEDS FROM REGISTERED SECURITIES

On January 1, 2005, the Company issued 325,035 non-registered shares of common stock to Mr. John C. Russell, President and one of the owners of Vision. The shares were issued as part of the Company’s acquisition of Vision on January 1, 2005. The shares were issued pursuant to the exemption found in section 4(2) of the Securities Act of 1933 for non-public offerings.

 

21


Table of Contents

Item 6.

Selected Financial Data.

 

     Years Ended December 31,  
(dollars in thousands except per share amounts, ratios and number of
agents)
   2007     2006     2005     2004     2003  

Total Revenues

   $ 836,225     $ 812,138     $ 756,905     $ 661,292     $ 619,817  

Benefits, Claims, Losses and Settlement Expenses

     484,795       462,310       436,865       393,935       368,361  

Operating Expenses

     226,825       210,832       182,178       146,728       144,859  
                                        

Income Before Income Tax Expense

     124,605       138,996       137,862       120,629       106,597  

Income Tax Expense

     31,097       33,108       38,828       31,184       28,128  
                                        

Net Income

   $ 93,508     $ 105,888     $ 99,034     $ 89,445     $ 78,469  
                                        

Balance Sheet Data at December 31:

          

Invested Assets

   $ 2,211,365     $ 2,127,137     $ 2,001,380     $ 1,854,212     $ 1,760,160  

Deferred Acquisition Costs

     235,138       224,517       204,254       183,258       169,633  

Other Assets

     195,250       182,585       177,595       185,849       101,755  
                                        

Total Assets

   $ 2,641,753     $ 2,534,239     $ 2,383,229     $ 2,223,319     $ 2,031,548  
                                        

Future Policy Benefits, Losses and Claims, Unearned Premiums

   $ 1,337,051     $ 1,260,950     $ 1,179,639     $ 1,076,731     $ 989,272  

Other Liabilities

     127,569       141,930       142,920       164,944       132,225  

Short-term Debt

     228,770       234,440       234,678       220,191       201,538  

Long-term Debt

     70,000       70,000       70,000       70,000       70,000  
                                        

Total Liabilities

     1,763,390       1,707,320       1,627,237       1,531,866       1,393,035  

Stockholders' Equity

     878,363       826,919       755,992       691,453       638,513  
                                        

Total Liabilities and Stockholders’ Equity

   $ 2,641,753     $ 2,534,239     $ 2,383,229     $ 2,223,319     $ 2,031,548  
                                        

Per Share Data:

          

Net Income - Basic

   $ 1.16     $ 1.32     $ 1.24     $ 1.12     $ 0.98  

Net Income - Diluted

   $ 1.15     $ 1.30     $ 1.23     $ 1.11     $ 0.98  

Cash Dividends Declared and Paid

   $ 0.4625     $ 0.43     $ 0.3875     $ 0.3425     $ 0.315  

Stockholders' Equity

   $ 10.88     $ 10.28     $ 9.42     $ 8.66     $ 7.96  

Ratio of Earnings to Fixed Charges

          

Excluding Interest Credited to Contractholder Funds

     8.7 x     8.8 x     12.2 x     18.2 x     17.2 x

Including Interest Credited to Contractholder Funds

     3.7 x     3.9 x     4.2 x     4.4 x     4.1 x

Other Data:

          

Life Insurance Inforce

   $ 24,369,023     $ 22,563,923     $ 21,209,234     $ 19,779,503     $ 18,262,749  

Number of Agents

     4,923       4,161       3,061       616       615  

 

22


Table of Contents
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Management’s Discussion and Analysis of Financial Condition and Results of Operations addresses the financial condition of Alfa Corporation and its subsidiaries (the Company) as of December 31, 2007, compared with December 31, 2006 and the results of operations for each of the three years ended December 31, 2007. The following discussion should be read in conjunction with Item 8. Financial Statements and Supplementary Data.

Any statement contained in this report which is not a historical fact, or which might otherwise be considered an opinion or projection concerning the Company or its business, whether expressed or implied, is meant as and should be considered a forward-looking statement as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on assumptions and opinions concerning a variety of known and unknown risks, including but not necessarily limited to changes in market conditions, natural disasters and other catastrophic events, increased competition, changes in availability and cost of reinsurance, changes in governmental regulations, technological changes, political and legal contingencies and general economic conditions, as well as other risks and uncertainties more completely described in the Company’s filings with the Securities and Exchange Commission, including this report on Form 10-K. If any of these assumptions or opinions proves incorrect, any forward-looking statements made on the basis of such assumptions or opinions may also prove materially incorrect in one or more respects and may cause actual future results to differ materially from those contemplated, projected, estimated or budgeted in such forward-looking statements.

OVERVIEW

Alfa Corporation is a financial services holding company headquartered in Alabama that offers primarily personal lines of property casualty insurance, life insurance and financial services products through its wholly-owned subsidiaries:

 

   

Alfa Insurance Corporation (AIC)

 

   

Alfa General Insurance Corporation (AGI)

 

   

Alfa Vision Insurance Corporation (AVIC)

 

   

Alfa Alliance Insurance Corporation (Alliance)

 

   

Alfa Life Insurance Corporation (Life)

 

   

Alfa Financial Corporation (Financial)

 

   

The Vision Insurance Group, LLC (Vision)

 

   

Alfa Agency Mississippi, Inc. (AAM)

 

   

Alfa Agency Georgia, Inc. (AAG)

 

   

Alfa Benefits Corporation (ABC)

Alfa Corporation is affiliated with Alfa Mutual Insurance Company, Alfa Mutual Fire Insurance Company, and Alfa Mutual General Insurance Company (collectively, the Mutual Group). The Mutual Group owns 55.0% of Alfa Corporation’s common stock, their largest single investment. Alfa Specialty Insurance Corporation (Specialty) is a wholly-owned subsidiary of Alfa Mutual Insurance Company (Mutual). Alfa Corporation and its subsidiaries (the Company) together with the Mutual Group and Specialty comprise the Alfa Group (Alfa). Prior to January 1, 2007, Virginia Mutual Insurance Company (Virginia Mutual) ceded 80% of its direct business to Alfa Mutual Fire Insurance Company (Fire) under a Strategic Affiliation Agreement signed in August 2001.

Effective January 1, 2007, the Company completed the previously approved plan of conversion and acquisition of Virginia Mutual. Under the plan, Virginia Mutual converted from a mutual company to a stock company and simultaneously was recapitalized as Alfa Alliance Insurance Corporation (Alliance), a wholly-owned subsidiary of the Company. In addition, the Pooling Agreement was amended to include Alliance as a participant in the pool and the quota share agreement between Fire and Virginia Mutual was terminated with applicable references removed from the Pooling Agreement.

On July 17, 2007, the Company received an offer from Alfa Mutual Insurance Company (Mutual), Alfa Mutual Fire Insurance Company (Fire) and Alfa Mutual General Insurance Company (General) (collectively, the Mutual

 

23


Table of Contents

Group), which collectively own a majority of its common stock, for a transaction that would result in the privatization of the Company. The Mutual Group proposed to acquire all of the outstanding shares of the Company’s common stock that are not currently owned by them. The Company’s Board of Directors appointed a special committee of its four independent directors to review, evaluate and negotiate the proposal. On November 4, 2007, the Company, Mutual and Fire entered into a definitive merger agreement pursuant to which Mutual and Fire will acquire all of the outstanding shares of the Company’s common stock they do not currently own for $22.00 per share. Concurrent with the agreement, Mutual and Fire will acquire General’s (0.8%) ownership at the same price offered to the Company’s stockholders. For additional details refer to Note 21 – Privatization of the Company and Note 22 – Subsequent Events in the Notes to Consolidated Financial Statements and Item 1A. Risk Factors.

The Company’s revenue consists mainly of premiums earned, policy charges, net investment income and fee income. Benefit and settlement expenses consist primarily of claims paid and claims in process and pending and include an estimate of amounts incurred but not yet reported along with loss adjustment expenses. Other operating expenses consist primarily of compensation expenses, and other overhead business expenses, net of deferred policy acquisition costs.

The Company reports operating segments based on the Company’s legal entities, which are organized by line of business:

 

   

Property casualty insurance

 

   

Life insurance

 

   

Noninsurance

 

   

Consumer financing

 

   

Commercial leasing

 

   

Agency operations

 

   

Employee benefits administration

 

   

Corporate and eliminations

Property casualty insurance operations accounted for 82.1% of revenues and 91.6% of net income in 2007. Life insurance operations generated 17.6% of revenues and 24.2% of net income during the same period. Noninsurance operations, combined with corporate expenses for 2007, generated 0.3% of revenues and resulted in a net loss of $14.7 million, or 15.8%, of net income.

On January 1, 2007, the Company adopted Statement of Position (SOP) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts. This statement provides guidance on accounting for deferred acquisition costs on an internal replacement. Transactions are accounted for as an internal replacement, as defined by this statement, when a policyholder requests a change not within the terms of the original contract and the change is deemed by the Company to be significant and integrated. For internal replacements of insurance products, the unamortized balance of acquisition costs previously deferred under the original contract is extinguished and charged to income. The new acquisition costs associated with the replacement are deferred and amortized to income.

At the date of adoption, no adjustments were made to retained earnings in the life segment or the property casualty segment. For 2007, there were not any significant impacts in the property casualty segment for internal replacements. In the life segment, internal replacements resulted in the extinguishment of acquisition costs previously deferred and a charge to income through amortization expense of $2.2 million for 2007. During the first quarter of 2007, Life provided an opportunity for policyholders to convert existing policies to the new return of premium product.

On January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Board (FASB) Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109. FIN 48 prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements and provides guidance on derecognition, measurement, classification, interest and

 

24


Table of Contents

penalties, accounting in interim periods, disclosure and transition issues. At the date of adoption no adjustments were made to retained earnings. The total amount of unrecognized tax benefits as of the date of adoption that, if recognized, would affect the effective tax rate was $185 thousand.

Future results of operations will depend in part on the Company’s ability to predict and control benefit and settlement expenses through underwriting criteria, product design and negotiation of favorable vendor contracts. The Company must also seek timely and accurate rate changes from insurance regulators in order to meet strategic business objectives. Selection of insurable risks, proper collateralization of loans and leases and continued staff development also impact the operating results of the Company. The Company’s inability to mitigate any or all risks mentioned above or other factors may adversely affect its profitability.

In evaluating the performance of the Company’s segments, management believes operating income serves as a meaningful tool for assessing the profitability of the Company’s ongoing operations. Operating income, a non-GAAP financial measure, is defined by the Company as net income excluding net realized investment gains and losses, net of applicable taxes. Realized investment gains and losses are somewhat controllable by the Company through the timing of decisions to sell securities. Therefore, realized investment gains and losses are not indicative of future operating performance.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP) requires the Company’s management to make significant estimates and assumptions based on information available at the time the financial statements are prepared. In addition, management must ascertain the appropriateness and timing of any changes in these estimates and assumptions. Certain accounting estimates are particularly sensitive because of their significance to the Company’s financial statements and because of the possibility that subsequent events and available information may differ markedly from management’s judgments at the time financial statements are prepared. For the Company, the areas most subject to significant management judgments include reserves for property casualty losses and loss adjustment expenses, reserves for future policy benefits, deferred policy acquisition costs, valuation of investments, and reserves for pending litigation. The application of these critical accounting estimates impacts the values at which 62% of the Company’s assets and 63% of the Company’s liabilities are reported at December 31, 2007 and, therefore, have a direct effect on net earnings and stockholders’ equity. For additional information, refer to Note 1—Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements.

Management has discussed the Company’s critical accounting policies and estimates, together with any changes therein, with the Audit Committee of the Company’s Board of Directors. The Company’s Audit Committee has also reviewed the disclosures contained herein.

Reserves for Property Casualty Losses and Loss Adjustment Expenses

Losses and loss adjustment expenses payable are management’s best estimates at a given point in time of what the Company expects to pay claimants, based on known facts, circumstances, historical trends, emergence patterns and settlement patterns. Reserves for reported losses are established on a case-by-case basis with the amounts determined by claims adjusters based on the Company’s reserving practices, which take into account the type of risk, the circumstances surrounding each claim and policy provisions relating to types of loss. Loss and loss adjustment expense reserves for incurred claims that have not yet been reported (IBNR) are estimated based primarily on historical emergence patterns with consideration given to many variables including statistical information, inflation, legal developments, storm loss estimates and economic conditions.

The Company’s internal actuarial staff conducts annual reviews of projected loss development information by line of business to assist management in making estimates of reserves for ultimate losses and loss adjustment expenses payable. Several factors are considered in estimating ultimate liabilities including consistency in relative case reserve adequacy, consistency in claims settlement practices, recent legal developments, historical

 

25


Table of Contents

data, actuarial projections, accounting projections, exposure growth, current business conditions, catastrophe developments and late reported claims. In addition, reasonableness is established in the context of claim severity, loss ratio and trend factors, all of which are implicit in the liability estimates. On an interim basis, the Company’s internal actuarial staff reviews the direct emergence for each line of business compared to the expected emergence implied by the most recent annual review. If the emergence is not within acceptable bounds, the opinion on reserve adequacy is revised and reserve amounts are adjusted. Otherwise, IBNR reserves are adjusted as changes in exposure indicate that additional reserves are needed until the next annual review is completed. The following methodologies are used to develop a range of probable outcomes for estimated loss and loss adjustment expense reserves during the annual review, with the Catastrophes methods used during both annual and interim reviews:

 

   

Normal Loss Reserves

 

   

Reported Loss Development

 

   

Paid Loss Development

 

   

Bornhuetter-Ferguson Methods (paid and reported)

 

   

Cape Cod Method (paid and reported)

 

   

Counts and Averages

 

   

Calendar Year Methods

 

   

Judgmental Methods

 

   

Thomas Mack

 

   

Loss Adjustment Expenses Reserves

 

   

Reported Loss Development

 

   

Paid Loss Development

 

   

Bornhuetter-Ferguson Methods (paid and reported)

 

   

Cape Cod Method (paid and reported)

 

   

Ratio Methods

 

   

Calendar Year Methods

 

   

Judgmental Methods

 

   

Accrual Methods

 

   

Catastrophes

 

   

Regression Fit on Incremental Payments

 

   

Regression on Reported Claim Counts

 

   

Leakage Method

 

   

Comparison to Past Catastrophe Development

The annual actuarial reviews are presented to management with a point estimate established within the range of probable outcomes for evaluating the adequacy of reserves and determination of the appropriate reserve value to be included in the financial statements. Management establishes reserves slightly above mid-point to include an estimated provision for uncertainty and to minimize the necessity for changing historical estimates. Although management uses many internal and external resources, as well as multiple established methodologies to calculate reserves, there is no method for determining the exact ultimate liability.

Management establishes reserves for loss adjustment expenses that are not attributable to a specific claim. These reserves are referred to as Defense and Cost Containment (DCC) and Adjusting and Other Expenses (AO). DCC and AO reserves are recorded to establish the liability for settling and defending claims that have been incurred, but have not yet been completely settled. For AO, historical ratios of AO to paid losses are developed, and then applied to the current outstanding reserves. The method uses a traditional assumption that 50% of the expenses are realized when the claim is open, and the other 50% are incurred when the claim is closed. The method also assumes that the underlying claims process and mix of business do not change materially over time.

An important assumption underlying the reserve estimation methods for the property casualty lines is that the loss cost trends implicitly built into the loss and LAE patterns will continue into the future. Some of the factors that could influence assumptions arise from a variety of sources including tort law changes, development of new

 

26


Table of Contents

medical procedures, social inflation, and other inflationary changes in costs beyond assumed levels. Inflation changes have much less impact on short-tail personal lines reserves and more impact on long-tail commercial lines. The Company does not have any significant long-tailed lines of business, so the actuarial assumptions and methodologies are consistent across all lines of business, regardless of the expected payout patterns. This is further evidenced by the fact that approximately 90% of ultimate losses for a given accident year are reported in the first year and by the end of the second year more than 99% are reported.

Reserves for Policyholder Benefits

Benefit reserves for traditional life products are determined according to the provisions of Statement of Financial Accounting Standards (SFAS) No. 60, Accounting and Reporting by Insurance Enterprises. The methodology used requires that the present value of future benefits to be paid to or on behalf of policyholders less the present value of future net premiums (that portion of the gross premiums required to provide for all future benefits and expenses) be determined. Such determination uses assumptions, including provision for adverse deviation, for expected investment yields, mortality, terminations and maintenance expenses applicable at the time the insurance contracts are issued. These assumptions determine the level and the sufficiency of reserves. The Company annually tests the validity of these assumptions.

Benefit reserves for universal life type products and annuity products are determined according to the provisions of SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. This standard directs that, for policies with an explicit account balance, the benefit reserve is the account balance without reduction for any applicable surrender charge.

In accordance with the provisions of SFAS No. 60 and the AICPA Audit and Accounting Guide, credit insurance reserves are held as unearned premium reserves calculated using the “rule of 78” method. Reserves for supplementary contracts with life contingencies are determined using the 1971 Individual Annuity Mortality Table and interest rates that vary depending on date of issue. Likewise, reserves for accidental death benefits are determined predominantly by using the 1959 Accidental Death Benefit Mortality Table and an interest rate of 3%. Reserves for disability benefits, both active and disabled lives, are calculated primarily from the 1952 Disability Study and a rate of 2.5%. A small portion of the Company’s disabled life reserves are calculated based on the 1970 Intercompany Group Disability Study and a rate of 3%.

Reserves for all other benefits are computed in accordance with presently accepted actuarial standards. Management believes that reserve amounts reflected in the Company’s balance sheet related to life products:

 

   

are consistently applied and fairly stated in accordance with sound actuarial principles;

 

   

are based on actuarial assumptions which are in accordance with contract provisions;

 

   

make a good and sufficient provision for all unmatured obligations of the Company guaranteed under the terms of its contracts;

 

   

are computed on the basis of assumptions consistent with those used in computing the corresponding items of the preceding year end; and

 

   

include provision for all actuarial reserves and related items that ought to be established.

Valuation of Investments

Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in stockholders’ equity as a component of accumulated other comprehensive income and, accordingly, have no effect on net income. Fair values for fixed maturities, equity securities and short-term bonds are based on quoted market prices, except for $35.0 million of the structured notes portfolio on which a market quote is not readily available. These structured notes represent 2.7% of fixed maturities available for sale. Those fair values are based on pricing models, and are discussed further in the section titled Investments. The cost of investment securities sold is determined by using the first-in, first-out methodology. In some instances, the Company may use the specific identification method. The Company monitors its investment

 

27


Table of Contents

portfolio and conducts quarterly reviews of investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations involve judgment and consider the magnitude and reasons for a decline and the prospects for the fair value to recover in the near term. Declines resulting from broad market conditions or industry-related events, and for which the Company has the intent to hold the investment for a period of time believed to be sufficient to allow a market recovery or to maturity, are considered to be temporary. Future adverse investment market conditions, or poor operating results of underlying investments, could result in an impairment charge in the future. Where a decline in fair value of an investment below its cost is deemed to be other than temporary, a charge is reflected in income for the difference between the cost or amortized cost and the estimated net realizable value. As a result, writedowns of $15.0 million and $10.3 million were recorded in 2007 on equity securities and fixed maturities, respectively. During 2006, writedowns of $2.9 million and $20 thousand were recorded on equity securities and fixed maturities, respectively.

Policy Acquisition Costs

Policy acquisition costs, such as commissions, premium taxes and certain other underwriting and marketing expenses that vary with and are directly related to the production of business have been deferred.

Life Insurance Products: Traditional life insurance acquisition costs are being amortized over the premium payment period of the related policies using assumptions consistent with those used in computing policy benefit reserves. Acquisition costs for universal life type policies are being amortized over a thirty-year period in relation to the present value of estimated gross profits that are determined based upon surrender charges and investment, mortality and expense margins. Investment income is considered, if necessary, in the determination of the recoverability of deferred policy acquisition costs. If an internal replacement change is considered to be significant and integrated, the unamortized balance of deferred policy acquisition costs related to the original contract is extinguished and charged to income. The policy acquisition costs associated with the replacement policy are deferred and amortized to income.

Property Casualty Products: Acquisition costs for property casualty insurance are amortized over the period in which the related premiums are earned. If an internal replacement change is considered to be significant and integrated, the unamortized balance of deferred policy acquisition costs related to the original contract is extinguished and charged to income. The policy acquisition costs associated with the replacement policy are deferred and amortized to income. Future changes in estimates, such as the relative time certain employees spend in initial policy bookings, may require adjustment to the amounts deferred. Changes in underwriting and policy issuance processes may also give rise to changes in these deferred costs.

Reserves for Litigation

The Company is subject to lawsuits in the normal course of business related to its insurance and noninsurance products. At the time a lawsuit becomes known, management evaluates the merits of the case and determines the need for establishing estimated reserves for potential settlements or judgments as well as reserves for potential costs of defending the Company against the allegations of the complaint. These reserves may be adjusted as the case develops. Periodically, and at least quarterly, management assesses all pending cases as a basis for evaluating reserve levels. At that point, any necessary adjustments are made to applicable reserves as determined by management and are included in current operating results. Reserves may be adjusted based upon outside counsels’ advice regarding the law and facts of the case, any revisions in the law applicable to the case, the results of depositions and/or other forms of discovery, general developments as the case progresses such as a favorable or an adverse trial court ruling, whether a verdict is rendered for or against the Company, whether management believes an appeal will be successful, or other factors that may affect the anticipated outcome of the case. Management believes adequate reserves have been established in known cases. However, due to the uncertainty of future events, there can be no assurance that actual outcomes will not differ from the assessments made by management.

 

28


Table of Contents

RESULTS OF OPERATIONS

The following table sets forth consolidated summarized income statement information for the years ended December 31, 2007, 2006 and 2005:

 

     Years Ended December 31,  
     2007     2006     2005  
     (in thousands, except per share data)  

Revenues

      

Property casualty insurance premium

   $ 625,938     $ 604,242     $ 556,439  

Life insurance premiums and policy charges

     88,900       82,845       76,633  
                        

Total premiums and policy charges

   $ 714,838     $ 687,087     $ 633,072  
                        

Net investment income

   $ 94,805     $ 93,263     $ 94,932  
                        

Other income

   $ 27,685     $ 28,386     $ 22,850  
                        

Total revenues

   $ 836,225     $ 812,138     $ 756,905  
                        

Net income

      

Insurance operations

      

Property casualty insurance

   $ 85,375     $ 85,034     $ 80,195  

Life insurance

     23,341       23,925       21,736  
                        

Total insurance operations

   $ 108,716     $ 108,959     $ 101,931  

Noninsurance operations

     (1,332 )     328       (38 )

Net realized investment gains (losses), net of tax

     (717 )     2,211       3,933  

Corporate

     (13,159 )     (5,610 )     (6,792 )
                        

Net income

   $ 93,508     $ 105,888     $ 99,034  
                        

Net income per share

      

- Basic

   $ 1.16     $ 1.32     $ 1.24  
                        

- Diluted

   $ 1.15     $ 1.30     $ 1.23  
                        

Weighted average shares outstanding

      

- Basic

     80,612       80,346       80,141  
                        

- Diluted

     81,664       81,211       80,713  
                        

Consolidated results of operations have been impacted by the following events in 2006 and 2007:

 

   

On January 1, 2006, the Company adopted SFAS No. 123(R).

 

   

Effective January 1, 2006, a new life policy administration system was implemented with three new product offerings:

 

   

return of premium level term life

 

   

single premium non-qualified annuity

 

   

flexible premium non-qualified annuity

 

   

During the second quarter of 2006, management discovered fraudulent activity occurring within Financial. The misconduct was determined to be limited to the acts of a single person. As a result, the Company provided for a net charge of $3.5 million on a pretax basis and $2.3 million on an after tax basis or a $0.03 impact on diluted earnings per share. Subsequent recoveries of $815 thousand, on a pretax basis, were received during the first quarter of 2007.

 

29


Table of Contents
   

On January 1, 2007, the Company completed the plan of conversion and acquisition of Virginia Mutual. Under the plan, Virginia Mutual converted from a mutual company to a stock company and simultaneously was recapitalized as Alliance, a wholly-owned subsidiary of the Company.

 

   

Effective January 1, 2007, the property casualty insurance Pooling Agreement (refer to Note 2 – Pooling Agreement in the Notes to Consolidated Financial Statements) was modified as follows:

 

   

Alliance, a new subsidiary of the Company, was added as a 2% participant in the pool with AIC’s and AGI’s participation decreasing 1% each. The Company maintained its overall 65% participation.

 

   

The quota share agreement between Fire and Virginia Mutual was terminated and applicable references were removed from the Pooling Agreement.

 

   

On January 1, 2007, the Company adopted SOP 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts.

 

   

During the third quarter of 2007, the Company recorded a loss through its investment in MidCountry Financial Corporation (MidCountry) resulting from the fraudulent misappropriation of principal payments by one of MidCountry’s third-party loan servicers. In addition, the Company was negatively impacted by increased loan loss reserves and charge-offs related to a portfolio of residential construction loans at MidCountry during the third and fourth quarters of 2007.

Revenues

Total premiums and policy charges increased $27.8 million, or 4.0%, in 2007 and $54.0 million, or 8.5%, in 2006.

Property Casualty Insurance Premiums

Property casualty insurance earned and written premiums for 2007 increased $21.7 million, or 3.6%, and $3.6 million, or 0.6%, respectively. In 2006, earned and written premiums increased $47.8 million, or 8.6%, and $33.6 million, or 5.7%, respectively. The following table shows the Company’s growth in earned and written premiums for 2007 and 2006:

 

     Earned Premium Growth     Written Premium Growth  
     2007     2006     2007     2006  

Personal Lines

        

Automobile

   4.3 %   10.4 %   (0.1 )%   8.7 %

Homeowner1

   10.4 %   7.1 %   7.1 %   7.0 %

Farmowner

   4.3 %   6.1 %   1.4 %   6.8 %

Other

   13.7 %   2.9 %   12.5 %   2.4 %
                        

Total Personal Lines

   6.3 %   9.0 %   2.3 %   7.9 %
                        

Commercial Lines

   46.2 %   2.5 %   36.5 %   2.9 %

Reinsurance Ceded

   19.1 %   55.4 %   (311.5 )%   23.1 %

Reinsurance Assumed

   (85.5 )%   9.0 %   (126.7 )%   (26.9 )%
                        

Total

   3.6 %   8.6 %   0.6 %   5.7 %
                        

 

1

Homeowner includes Homeowner and Manufactured Home.

 

30


Table of Contents

2007 Earned and Written Premium Growth: In the table above, premiums generated by Alliance, a new subsidiary of the Company, impact the relative growth rates of both earned and written premiums in personal and commercial lines. Declines in the reinsurance assumed earned and written premiums are primarily due to the termination of the Virginia Mutual quota share agreement.

The 4.3%, or $15.7 million, earned premium growth in the automobile line is mainly attributable to the addition of Alliance. Alliance contributed $10.3 million and AVIC contributed $2.5 million of the earned premiums increase. AIC’s and AGI’s growth for the automobile line was $2.9 million. Written premiums in the automobile line declined $526 thousand, or 0.1%. AVIC declined $9.6 million due to lower production and the Company’s anticipated exit from the Florida market during 2007. AIC’s and AGI’s written premiums increased slightly by $168 thousand with rate increases in the Georgia preferred and standard automobile lines in the first quarter of 2007. Offsetting these rate increases, were rate decreases in the Alabama preferred automobile line during the first quarter of 2006 and in the Alabama standard automobile line during the second quarter of 2007. Alliance contributed written premiums for the automobile line of $8.9 million.

AIC, AGI and Alliance have a broader line of insurance products. AIC’s and AGI’s homeowner line earned premium growth of $10.0 million and written premium growth of $6.0 million was impacted by three rate increases across both preferred and standard lines during 2006 as well as a manufactured home increase in the second quarter of 2007. The farmowner earned and written premium growth of $1.2 million and $399 thousand, respectively, was impacted by a rate increase in the last quarter of 2005. AIC and AGI other personal lines earned premiums increased $421 thousand and commercial lines earned premiums increased slightly at $51 thousand. Alliance contributed earned premiums for the homeowner line of $6.5 million, other personal lines of $1.8 million and commercial lines of $7.9 million and contributed written premiums for the homeowner lines of $5.7 million, other personal lines of $1.7 million and commercial lines of $6.5 million.

Reinsurance ceded earned premiums increased 19.1%, or $909 thousand, mainly due to increases in the Company’s catastrophe reinsurance premiums, increases in the working cover program and the addition of Alliance’s programs. Reinsurance assumed earned premiums decreased 85.5%, or $21.0 million, due to the commutation of the Virginia Mutual quota share reinsurance treaty and a $324 thousand decrease in the assumed premiums from the state of Texas through AVIC. These decreases are offset by a $604 thousand increase in involuntary markets assumed premium. The decreases in reinsurance ceded and assumed written premiums are primarily related to the commutation of the Virginia Mutual quota share reinsurance treaty.

2006 Earned and Written Premium Growth: The growth in the automobile line is attributable to the addition of AVIC to the pool. AVIC writes nonstandard auto business and contributed $29.0 million of the earned premium increase and $23.8 million of the written premium increase. AIC and AGI, which have a broader line of insurance products, contributed $18.5 million of the personal and commercial lines net increase in earned premiums and $19.8 million of the personal and commercial lines net increase in written premiums. AIC’s and AGI’s growth for the automobile line was $5.5 million for earned premiums and $6.4 million for written premiums with a slight rate decrease in the first quarter of 2006. The homeowner line earned premium growth of $10.5 million and written premium growth of $10.7 million was impacted by three rate increases across both preferred and standard lines during 2006 and 2005. The farmowner earned and written premium growth of $1.6 million and $1.8 million, respectively, was impacted by a rate increase in the last quarter of 2005. Other personal lines earned premium growth was $467 thousand and commercial lines earned premium growth was $427 thousand.

Reinsurance ceded earned premiums increased 55.4%, or $1.7 million, due to increases in the Company’s catastrophe reinsurance premiums. Reinsurance assumed earned premiums increased 9.0%, or $2.0 million, due to a $2.6 million increase in the assumed premiums from the state of Texas through AVIC offset by a $556 thousand decrease in the assumed reinsurance premiums from Virginia Mutual’s quota share reinsurance treaty. The 26.9% decrease in reinsurance assumed written premiums is related to Virginia Mutual being added to the pool in 2005 offset by increases in assumed written premiums in Texas.

Pooling Agreement: The property casualty subsidiaries of the Company are participants in the Pooling Agreement with the Mutual Group including Specialty. Under the Pooling Agreement, the Company’s property

 

31


Table of Contents

casualty subsidiaries along with other members of the Mutual Group cede their direct property casualty business, which includes premiums, losses and underwriting expenses to Mutual. Mutual retrocedes to each participant a specified portion of premiums, losses and underwriting expenses based on each participant’s pooling percentage. The Company’s share of the pool was 65% during 2007, 2006 and 2005; therefore, pooling did not impact premium growth. Because premiums are allocated according to the Pooling Agreement, policy count data is not applicable to the Company. Refer to Note 2 – Pooling Agreement in the Notes to Consolidated Financial Statements for additional detail of the Pooling Agreement.

Life Insurance Premiums and Policy Charges

Life insurance premiums and policy charges, net of eliminations, increased $6.1 million, or 7.3%, in 2007 and $6.2 million, or 8.1%, in 2006.

Life insurance premiums, net of eliminations, increased $4.7 million, or 10.3%, in 2007 and $4.9 million, or 11.9%, in 2006. The 2007 increase is primarily the result of an increase in term life premiums of $4.8 million and an increase of 6.4% in term life policies inforce year to date. The 2006 increase is primarily the result of an increase in term life premiums of $4.7 million and an increase of 7.8% in term life policies inforce year to date. The majority of the increase for 2007 and 2006 is attributable to the return of premium level term life product introduced during 2006.

Life insurance policy charges increased $1.3 million, or 3.6%, in 2007 and $1.3 million, or 3.7%, in 2006. The 2007 increase is primarily due to an increase in universal life policy charges resulting from increases in fund balances that the charges are assessed against along with a slight increase of 0.3% in the number of universal life policies inforce. The 2006 increase of $1.3 million is primarily due to an increase in universal life policy charges resulting from increases in fund balances that the charges are assessed against along with a slight increase of 0.3% in the number of universal life policies inforce. The persistency ratio for life business was 90.7% at December 31, 2007 and 2006. Persistency, a non-GAAP financial measure, represents the ratio of the annualized premiums of policies inforce at December 31, 2007 and 2006 as a percentage of the annualized premiums paid at December 31, 2007 and 2006, respectively. There is no comparable GAAP measure for annualized premium. The following table shows the growth in policies inforce and inforce annualized premium, on a statutory accounting basis, for 2007 and 2006:

 

     Policies Inforce Growth     Inforce Annualized
Premium Growth
 
     2007     2006     2007     2006  

Universal Life

   0.3 %   0.3 %   1.6 %   1.7 %

Universal Life—COLI

   66.2 %   4.2 %   (13.0 )%   0.7 %

Interest Sensitive Life

   1.3 %   1.7 %   1.3 %   1.4 %

Traditional Life

   4.3 %   1.7 %   11.0 %   12.9 %

Group Life

   0.1 %   0.6 %   20.0 %   (1.7 )%

Annuities

   40.4 %   100.0 %   54.6 %   100.0 %
                        

Total

   3.3 %   1.4 %   3.6 %   5.2 %
                        

2007 Policies Inforce Growth and Inforce Annualized Premiums Growth: Policies inforce grew for all lines in 2007. The 4.3% increase in traditional life was the result of increases in the new level term product and in the direct mail product. Inforce annualized premium growth was 3.6%, with the largest increase in traditional life at 11.0%, or $5.2 million. Inforce annualized premium growth for annuities increased 54.6%, or $769 thousand, with an inforce growth of 40.4%. Policies inforce growth for the COLI plan was 66.2% in 2007. This increase represents additional coverage for the same group of employees due to the Pension Protection Act of 2006. Paid annualized premiums decreased 13.0% as the demographics of the group covered changed.

2006 Policies Inforce Growth and Inforce Annualized Premium Growth: Policies inforce grew for all lines in 2006. The slight increase in traditional life was the result of increases in new product offerings offset by a decline

 

32


Table of Contents

in the direct mail product. The policies inforce and inforce annualized premium growth for annuities is due to new product offerings in 2006. Inforce annualized premium growth was 5.2%, with the largest increase in traditional life at 12.9%, or $5.4 million.

Net Investment Income

Net investment income increased $1.5 million, or 1.7%, for 2007 due to increases in interest income on fixed maturities, short-term investments and partnership income. Offsetting these increases was a decrease of $8.7 million in equity in net earnings (after internal capital charge) of MidCountry for 2007 as well as a decrease in dividend income on equity securities. In addition, Alliance contributed $2.1 million of the 2007 increase. Net investment income decreased $1.7 million, or 1.8%, during 2006 due to the $3.5 million increase in net loan losses as a result of collateral loans written off, increased interest costs on commercial paper and notes payable, declines in partnership income offset by increases in interest income on fixed maturities, dividend income on equity securities and interest income on collateral loans and short-term investments. Positive cash flows resulted in an increase in total invested assets, including investments in affiliates, of 4.0% and 6.2% in 2007 and 2006, respectively.

Other Income

Other income decreased $701 thousand, or 2.5%, in 2007 mainly due to decreases in Vision’s commission income and AVIC’s policy fee income. Offsetting these decreases is a $1.1 million gain recognized from the purchase of Alliance. The Company considers the amount to not be material to income; therefore, the gain was recorded as other income in the first quarter of 2007. Other income increased $5.5 million, or 24.2%, in 2006 due to increases in fee income from AVIC and commission income from Vision.

Net Income

Property Casualty Insurance

Operating income for the property casualty subsidiaries increased $341 thousand, or 0.4%, in 2007 and $4.8 million, or 6.0%, in 2006. In 2007, earned premiums increased 3.6%, or $21.7 million, with a 2.5%, or $1.8 million, increase derived from the nonstandard automobile market, which includes AVIC and Specialty, a 21.0%, or $4.4 million, increase from Alliance and the remainder of $15.5 million from the Alabama, Georgia and Mississippi preferred and standard markets. In 2006, earned premiums increased 8.6%, or $47.8 million, with a 95.9%, or $34.5 million, increase derived from the nonstandard automobile market and a 2.8%, or $13.9 million, increase derived from the Alabama, Georgia and Mississippi preferred and standard markets. These increases were offset by a decrease of 2.6%, or $556 thousand, in earned premiums derived from Virginia Mutual.

Property casualty losses and related expenses increased 4.3%, or $16.3 million, in 2007 due to a 0.4% increase in the loss ratio offset by a slight 0.1% decrease in the loss adjustment expense (LAE) ratio. In 2006, property casualty losses and related expenses increased 6.1%, or $21.8 million. The loss ratio decreased 2.1% and the LAE ratio increased 0.7%. Operating expenses also increased 4.5%, or $7.6 million, and 18.3%, or $26.0 million, in 2007 and 2006, respectively. The property casualty subsidiaries’ return on average equity for the trailing twelve-month period ended December 31, 2007 was 16.4% compared to 17.2% for 2006. Return on average equity, a non-GAAP financial measure, is defined as net income divided by the simple average of beginning and ending stockholder’s equity.

Life Insurance

Life insurance operating income decreased $584 thousand, or 2.4%, in 2007 as a result of increases in life benefits, amortization of deferred acquisition costs and other operating expenses offset by a 6.7% increase in revenue and a decrease in the mortality ratio. The mortality ratio was 88% of expected for 2007 compared to 104% of expected for 2006. Mortality, a non-GAAP financial measure, represents the ratio of actual to expected death claims. Therefore, the Company experienced more favorable financial results when compared to 2006 due to the lower mortality ratio. The 6.7% revenue increase consisted of premiums and policy charge growth of 7.5% and net investment income growth of 5.5%. Amortization of deferred acquisition costs increased $2.3 million, or 19.5%, during 2007 when compared to 2006. The increase is primarily due to the effect of adopting SOP 05-1 on January 1, 2007, with the majority of the impact associated with a return of premium product conversion program

 

33


Table of Contents

during the first quarter. Under the new guidance, for internal replacements of insurance products deemed by the Company to be significant and integrated, as defined by the statement, the unamortized balance of acquisition costs previously deferred under the original contract is charged to income. The new acquisition costs associated with the replacement are deferred and amortized to income. During 2007, $2.2 million of acquisition costs previously deferred were charged to income.

In 2006, Life insurance operating income increased $2.2 million, or 10.1%, as a result of premiums and policy charges growth of 8.1% and net investment income growth of 10.9% offset by an increase in the mortality ratio to 104% of expected for 2006 compared to 96% of expected for 2005. Therefore, for 2006, the Company experienced less favorable financial results when compared to the same period in 2005 due to the higher mortality ratio.

Noninsurance

Noninsurance operating income decreased $1.7 million to an operating loss of $1.3 million for 2007 compared to an operating profit of $328 thousand for 2006. Agency operations decreased operating income by $1.2 million due to declines in production at Vision; loan operations, including MidCountry, decreased operating income by $2.3 million due to equity-method investment losses; commercial leasing operations increased operating income by $786 thousand; and ABC increased operating income by $974 thousand.

Noninsurance operating income increased $366 thousand to an operating profit of $328 thousand for 2006. Agency operations increased operating income by $2.8 million due to increases in Vision’s operations; loan operations decreased operating income by $2.8 million due to increases in loan losses; commercial leasing operations increased operating income by $263 thousand; and ABC increased operating income by $91 thousand.

Net Realized Investment Gains (Losses)

Net realized investment gains, net of tax, decreased $2.9 million during 2007 to a net realized investment loss, net of tax, of $717 thousand as a result of increased writedowns on fixed maturities and equity securities and losses on tax credit partnerships offset by increased gains on sales of fixed maturities and equity securities. On a pretax basis, writedowns increased from $2.9 million in 2006 to $25.4 million in 2007. The increase in writedowns is due to other than temporary impairments in fixed maturities, including collateralized debt obligations (CDOs), and equity securities. Net realized investment gains, net of tax, declined $1.7 million, or 43.8%, for 2006 as a result of increased losses on tax credit partnerships. On a pretax basis, writedowns increased from $2.1 million in 2005 to $2.9 million in 2006.

Corporate

Corporate expenses increased $7.5 million in 2007 and decreased $1.2 million in 2006. Current year results were impacted by increases in borrowing costs and accounting fees as well as increases in legal and other expenses related to the privatization of the Company (refer to Note 21 – Privatization of the Company in the Notes to Consolidated Financial Statements). Prior year results were impacted by a change in the Company’s tax allocation agreement offset by increased costs on the Company’s short-term borrowings and increases in legal and accounting fees.

Net income declined 12.2% on a per share diluted basis in 2007 compared to 2006 and improved 6.3% on a similar basis in 2006 compared to 2005.

PROPERTY CASUALTY INSURANCE OPERATIONS

The following table sets forth summarized financial information for the Company’s property casualty insurance subsidiaries, AIC, AGI, AVIC and Alliance, for the years ended December 31, 2007, 2006 and 2005:

 

34


Table of Contents
     Years Ended December 31,  
     2007     2006     2005  
     (dollars in thousands)  

Earned premiums

      

Personal lines

   $ 602,788     $ 567,208     $ 519,874  

Commercial lines

     25,274       17,289       16,862  

Reinsurance ceded

     (5,667 )     (4,758 )     (3,063 )

Reinsurance assumed

     3,543       24,503       22,766  
                        

Total earned premiums

   $ 625,938     $ 604,242     $ 556,439  
                        

Net underwriting income

   $ 53,699     $ 55,922     $ 55,871  
                        

Loss ratio

     58.4 %     58.0 %     60.1 %

LAE ratio

     4.9 %     5.0 %     4.3 %

Expense ratio

     28.1 %     27.8 %     25.5 %

GAAP basis combined ratio

     91.4 %     90.8 %     90.0 %

Underwriting margin

     8.6 %     9.2 %     10.0 %

Net investment income

   $ 45,413     $ 39,417     $ 40,200  
                        

Other income and fees

   $ 14,540     $ 13,650     $ 9,621  
                        

Pretax operating income

   $ 113,652     $ 108,989     $ 105,692  
                        

Operating income, net of tax

   $ 85,375     $ 85,034     $ 80,195  
                        

Net realized investment gains (losses), net of tax

   $ 266     $ (3,110 )   $ 121  
                        

Net income

   $ 85,641     $ 81,924     $ 80,316  
                        

 

35


Table of Contents

2007 Compared to 2006

Results of operations for this segment have been impacted by the following events in 2007:

 

   

On January 1, 2007, the Company completed the plan of conversion and acquisition of Virginia Mutual. Under the plan, Virginia Mutual converted from a mutual company to a stock company and simultaneously was recapitalized as Alliance, a wholly-owned subsidiary of the Company.

 

   

Effective January 1, 2007, the property casualty insurance Pooling Agreement (refer to Note 2 – Pooling Agreement in the Notes to Consolidated Financial Statements) was modified as follows:

 

   

Alliance, a new subsidiary of the Company, was added as a 2% participant in the pool with AIC’s and AGI’s participation decreasing 1% each. The Company maintained its overall 65% participation.

 

   

The quota share agreement between Fire and Virginia Mutual was terminated and applicable references were removed from the Pooling Agreement.

 

   

On January 1, 2007, the Company adopted SOP 05-1.

Property casualty insurance earned premiums increased $21.7 million, or 3.6%, during 2007 with AVIC contributing $2.1 million and AIC and AGI contributing $14.8 million of the increase. Alliance earned premiums also increased in 2007 to $25.7 million compared to the Virginia Mutual quota share amount of $20.8 million in 2006.

AVIC earned premiums are reported in the table above as $51.7 million of personal lines, $143 thousand of reinsurance ceded and $2.8 million of reinsurance assumed premiums for 2007 and $49.3 million of personal lines, $80 thousand of reinsurance ceded and $3.1 million of reinsurance assumed premiums for 2006.

Alliance earned premiums are reported as $18.6 million of personal lines, $7.9 million of commercial lines, $1.1 million of reinsurance ceded and $244 thousand of reinsurance assumed premiums in the table above for 2007. The Virginia Mutual quota share earned premiums are reported as $401 thousand of reinsurance ceded and $21.2 million of reinsurance assumed premiums for 2006.

AIC and AGI contributed $14.8 million of earned premiums growth in 2007. The growth from AIC and AGI is related to increases in personal lines. During 2007, AIC’s and AGI’s earned premiums for homeowner and manufactured home increased $10.0 million, or 6.3%, automobile increased $2.9 million, or 0.9%, and farmowner increased $1.2 million, or 4.3%. In addition, there were increases in other personal lines of $421 thousand and a slight increase in commercial lines of $51 thousand with an increase in ceded catastrophe premiums and working cover premiums of $347 thousand. In addition, reinsurance assumed premiums increased $360 thousand.

The overall loss ratio increased 0.4% from 58.0% in 2006 to 58.4% in 2007 with a decline of 0.1% in catastrophe losses. The loss ratio for AIC and AGI increased from 57.3% as of December 31, 2006 to 57.6% as of December 31, 2007. The loss ratio for 2007 related to AVIC business was 73.1% and Alliance was 46.5%, which represents 8.3% of the overall loss ratio of 58.4%. For 2006, the loss ratio for AVIC was 64.6% and Virginia Mutual was 57.9%, which represents 7.6% of the overall loss ratio of 58.0%.

The overall loss ratio includes 2.2% of catastrophe losses in 2007 and 2.3% in 2006. The Company had $13.9 million in gross catastrophe losses during 2007 due to severe weather occurring in the first quarter compared to $13.8 million in similar losses in the first and second quarters of 2006. The effect of claims from these events impacted underwriting results by $0.11 per share, after taxes, in both 2007 and 2006. The Company’s allocated share of catastrophe losses is described in Note 2 – Pooling Agreement in the Notes to Consolidated Financial Statements under the section Catastrophe Protection Program.

The 0.1% decrease in the overall LAE ratio for 2007 is mainly attributable to an AIC and AGI decrease of 0.3% offset by increases in both AVIC’s and Alliance’s LAE ratios. AVIC impacted the LAE ratio by 1.1% in 2007 compared to 1.0% in 2006, and Alliance impacted the current year ratio by 0.2%. Technology costs impacted the LAE ratio by 0.1% in 2007 and 2006.

 

36


Table of Contents

For 2007, the expense ratio was impacted 3.2% by AVIC’s expense structure and 1.5% by Alliance, 0.3% by SFAS No. 123(R) and 0.6% due to technology costs. For 2006, the expense ratio was impacted 3.4% by AVIC, 1.2% by Virginia Mutual, 0.3% with the adoption of SFAS No. 123(R) and 0.7% due to technology costs.

The overall higher expense structures of AVIC and Alliance, the impact of SFAS No. 123(R), technology costs and an increased overall loss ratio produced an underwriting margin of 8.6% in 2007, compared with an underwriting margin of 9.2% in 2006. Underwriting margin, a non-GAAP financial measure, represents the percentage of each premium dollar earned which remains after losses, loss adjustment expenses and other operating expenses.

Net investment income increased $6.0 million, or 15.2%, for 2007, as a result of increases in interest income on fixed maturities, short-term investment income and partnership income. In addition, the Company’s newly capitalized subsidiary, Alliance, contributed $2.1 million of the increase.

Other income and fees increased $890 thousand, or 6.5%, for 2007 mainly due to a gain of $1.1 million recognized in the first quarter of 2007 from the purchase of Alliance. The Company considers the amount to not be material to income; therefore, the gain was recorded as other income in the first quarter of 2007.

For 2007, pretax operating income increased $4.7 million and operating income, net of tax, increased $341 thousand when compared to 2006. The effective tax rate increased from 22.0% in 2006 to 24.9% in 2007. The tax rate for both 2007 and 2006 was impacted by increases in investments in affordable housing tax credits. The tax rate for 2006 was also impacted by a release of reserves for uncertain tax positions.

Net realized investment gains (losses), net of tax, increased $3.4 million during 2007 as a result of increased gains on fixed maturities and equity securities offset by losses on tax credit partnerships and increased writedowns on fixed maturities and equity securities. Pretax net realized investment gains increased $3.1 million and $5.0 million for fixed maturities and equity securities, respectively. On a pretax basis, writedowns increased from $796 thousand in 2006 to $3.2 million in 2007.

Net income increased $3.7 million, or 4.5%, during 2007 compared to an increase in net income of $1.6 million, or 2.0%, in 2006.

At December 31, 2007, the Company’s property casualty subsidiaries’ Adjusted Capital calculated in accordance with National Association of Insurance Commissioners (NAIC) Risk-Based Capital (RBC) guidelines was $508.9 million compared to the Authorized Control Level (Required) RBC of $33.5 million. These statutory measures serve as a benchmark for the regulation of an organization’s solvency by state insurance regulators.

2006 Compared to 2005

Results of operations for this segment have been impacted by the following events in 2006:

 

   

On January 1, 2006, the Company adopted SFAS No. 123(R).

Property casualty insurance earned premiums increased $47.8 million, or 8.6%, during 2006 with AVIC contributing $31.5 million and AIC and AGI contributing $16.9 million of the increase. Virginia Mutual earned premiums decreased slightly to $20.8 million for 2006 compared to $21.4 million for 2005.

AVIC’s increase is a result of all nine states being active during 2006 and overall production increases. AVIC and Virginia Mutual premiums are reported as $49.3 million of personal lines earned premiums, $481 thousand of reinsurance ceded earned premiums and $24.3 million of reinsurance assumed earned premiums in the table above for 2006 and $20.0 million of personal lines, $389 thousand of reinsurance ceded and $22.6 million of reinsurance assumed premiums for 2005.

 

37


Table of Contents

AIC and AGI contributed $16.9 million of earned premiums growth during 2006. The growth from AIC and AGI is related to increases in personal lines. During 2006, earned premiums for homeowner and manufactured home increased $10.5 million, or 7.1%, automobile increased $5.5 million, or 1.8%, farmowner increased $1.6 million, or 6.1%. In addition, there was a slight increase in other lines offset by increases in ceded catastrophe premiums and working cover premiums of $1.6 million.

The loss ratio for 2006 related to AVIC business was 64.6% and Virginia Mutual was 57.9%, which represents 7.6% of the overall loss ratio of 58.0%. For 2005, the loss ratio for AVIC was 60.3% and Virginia Mutual was 49.5%, which represents 4.2% of the overall loss ratio of 60.1%. Also included in the loss ratio are 2.3% of catastrophe losses for 2006 and 2.1% for 2005. The Company had $13.8 million in gross catastrophe losses during 2006 due to severe weather occurring in the first and second quarters compared to $11.6 million in similar losses in the first quarter of 2005. The effect of claims from these events impacted underwriting results by $0.11 and $0.09 per share in 2006 and 2005, respectively, after taxes. The Company’s allocated share of catastrophe losses is described in Note 2 – Pooling Agreement in the Notes to Consolidated Financial Statements under the section Catastrophe Protection Program.

The loss ratio for AIC and AGI declined from 60.6% as of December 31, 2005 to 57.3% as of December 31, 2006. The overall loss ratio declined 2.1% from 60.1% in 2005 to 58.0% in 2006.

AVIC impacted the LAE ratio by 1.0% in 2006 compared to 0.4% in 2005. Technology costs have impacted the LAE ratio by 0.1% in 2006.

For 2006, the expense ratio has been impacted 3.4% by AVIC’s expense structure, 1.2% by Virginia Mutual, 0.3% with the adoption of SFAS No. 123(R) and 0.7% due to technology costs. For 2005, the expense ratio was impacted 1.5% by AVIC, 1.4% by Virginia Mutual and 0.5% due to technology costs.

The overall higher expense structures of AVIC and Virginia Mutual, along with the impact of SFAS No. 123(R) and technology costs offset by a decline of 2.1% in the overall loss ratio produced an underwriting margin of 9.2% in 2006, compared with 10.0% in 2005. Underwriting margin, a non-GAAP financial measure, represents the percentage of each premium dollar earned which remains after losses, loss adjustment expenses and other operating expenses.

Net investment income decreased 1.9% for 2006, as a result of lower partnership income and a decline in interest income on fixed maturities offset by increases in dividend income and short-term investment income.

Other income and fees increased $4.0 million in 2006 due to an increase in fee income from AVIC.

For 2006, pretax operating income increased $3.3 million and operating income, net of tax, increased $4.8 million as a result of a decrease in the effective tax rate from 24.1% to 22.0%. The tax rate for 2005 was impacted by the Company’s tax allocation agreement and an increase in investment in affordable housing tax credits. The tax rate for 2006 was impacted by a change in the Company’s tax allocation agreement, the release of a reserve for uncertain tax positions and an increase in investment in affordable housing tax credits. The uncertain tax position release resulted from the closing of tax years 1999 through 2001, which were under audit by the Internal Revenue Service.

Realized investment losses, net of tax, increased $3.2 million during 2006 as a result of lower net gains on equity securities offset by higher gains on fixed maturities and increased losses on tax credit partnerships. On a pretax basis, writedowns increased from $311 thousand in 2005 to $796 thousand in 2006.

Net income increased 2.0% for 2006, compared to 22.5% in 2005, with AVIC and Virginia Mutual contributing $2.0 million in 2006. Return on equity was 17.2% for 2006 compared to 18.6% in 2005.

 

38


Table of Contents

At December 31, 2006, the Company’s property casualty subsidiaries’ Adjusted Capital calculated in accordance with National Association of Insurance Commissioners (NAIC) Risk-Based Capital (RBC) guidelines was $450.7 million compared to the Authorized Control Level (Required) RBC of $35.7 million. These statutory measures serve as a benchmark for the regulation of an organization’s solvency by state insurance regulators.

LIFE INSURANCE OPERATIONS

The following table sets forth summarized financial information for the Company’s life insurance subsidiary, Life, for the years ended December 31, 2007, 2006 and 2005:

 

     Years Ended December 31,
     2007     2006    2005
     (in thousands)

Premiums and policy charges

       

Traditional life insurance premiums

   $ 50,358     $ 45,526    $ 40,617

Group life insurance premiums

     528       493      517

Universal life policy charges

     22,554       21,695      20,803

Universal life policy charges—COLI

     4,201       4,018      3,812

Interest sensitive life policy charges

     11,403       11,113      10,884

Annuity policy charges

     2       —        —  
                     

Total premiums and policy charges

   $ 89,046     $ 82,845    $ 76,633
                     

Net investment income

   $ 59,644     $ 56,527    $ 50,963
                     

Benefits and expenses

   $ 103,667     $ 93,422    $ 87,841
                     

Amortization of deferred policy acquisition costs

   $ 14,187     $ 11,868    $ 9,277
                     

Pretax operating income

   $ 30,836     $ 34,082    $ 30,478
                     

Operating income, net of tax

   $ 23,341     $ 23,925    $ 21,736
                     

Net realized investment gains (losses), net of tax

   $ (735 )   $ 5,373    $ 3,837
                     

Net income

   $ 22,606     $ 29,298    $ 25,573
                     

2007 Compared to 2006

Results of operations for this segment have been impacted by the following events in 2007:

 

   

On January 1, 2007, the Company adopted SOP 05-1.

Life’s premiums and policy charges increased $6.2 million, or 7.5%, in 2007 compared to $6.2 million, or 8.1%, in 2006.

Life insurance premiums increased $4.9 million, or 10.6%, in 2007 compared to $4.9 million, or 11.9%, in 2006. This growth is attributable to increases in term life premiums of $4.8 million in 2007 and an increase of 6.4% in term life policies inforce year to date. During January 2006, Life began offering a return of premium level term product which contributed the majority of the increase in life insurance premiums during 2007 and 2006.

 

39


Table of Contents

Life insurance policy charges increased $1.3 million, or 3.6%, in 2007 and $1.3 million, or 3.7%, in 2006 primarily due to an increase in universal life policy charges resulting from increases in fund balances that the charges are assessed against along with a slight increase of 0.3% in the number of universal life policies inforce. In addition, interest sensitive policy charges increased with a 1.3% increase in the number of interest sensitive life policies inforce.

On a statutory accounting basis, issued annualized new business premiums decreased by 6.2% to $16.7 million with a total volume of $3.7 billion of insurance being issued in 2007. The new product offerings in 2006 contributed as follows in 2007: return of premium level term – 5,152 policies issued, $3.7 million of issued annualized new business premiums and volume of $928.1 million of insurance issued; annuities – 29 policies issued and $778 thousand of issued annualized new business premium.

Total life insurance inforce as of December 31, 2007 increased $1.8 billion, with term insurance increasing $1.4 billion, or 11.6%, compared to 2006. Annualized premiums for inforce business increased 3.6%, or $4.8 million, with term insurance increasing 12.5%, or $4.8 million. Policies inforce increased 3.3% in 2007 compared to 2006. The persistency ratio for life business was 90.7% at December 31, 2007 and 2006.

The mortality ratio decreased to 88% of expected in 2007 from 104% of expected in 2006. Benefit and claims expense increased 7.0%, or $5.5 million, as a result of reserve increases and benefits interest expense. Operating expenses increased $4.7 million in 2007 with SFAS No. 123(R) expense decreasing $31 thousand to $235 thousand in 2007, legal and consulting expenses increasing $2.9 million due to net legal reserve reductions of $2.2 million in 2006 and increases in expenses related to the new policy administration system of $48 thousand. Also affecting 2007 was a net impairment charge of $691 thousand for an abandonment of software being developed for Life’s new policy administration system.

Amortization of deferred policy acquisition costs increased $2.3 million, or 19.5%, in 2007 compared to 2006 as a result of growth in deferred costs related to consistent new business production increases in prior periods and the current period effects of the return of premium conversion program after the adoption of SOP 05-1 as previously discussed in the Overview section of the Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Invested assets, including investments in affiliates, increased 3.4% since December 31, 2006, while net investment income increased $3.1 million, or 5.5%. Interest on short-term investments increased $2.5 million, or 142.9%, during 2007. Net realized investment gains (losses), net of tax, decreased $6.1 million, or 113.7%, in 2007 as a result of increased writedowns on fixed maturities and equity securities offset by increased net gains on fixed maturities and equity securities. On a pretax basis, writedowns increased from $2.1 million in 2006 to $22.2 million in 2007. Pretax net gains on fixed maturities and equity securities increased $1.6 million and $8.9 million, respectively, in 2007.

Life’s operating income, net of tax, decreased 2.4%, or $584 thousand, and net income decreased 22.8%, or $6.7 million, in 2007. The decrease in net income results primarily from the decrease in net realized investment gains of $6.1 million. Net income increased 14.6%, or $3.7 million, in 2006, resulting from increases in operating income and net realized investment gains, net of tax, of 10.1% and 40.0%, respectively.

At December 31, 2007, the life subsidiary’s Adjusted Capital calculation in accordance with NAIC RBC guidelines was $222.2 million compared to the Authorized Control Level (Required) RBC amount of $15.1 million.

2006 Compared to 2005

Results of operations for this segment have been impacted by the following events in 2006:

 

   

On January 1, 2006, the Company adopted SFAS No. 123(R).

 

40


Table of Contents
   

Effective January 1, 2006, a new life policy administration system was implemented with three new product offerings:

 

   

return of premium level term life

 

   

single premium non-qualified annuity

 

   

flexible premium non-qualified annuity

Life’s premiums and policy charges increased $6.2 million, or 8.1%, for 2006, compared to an increase of $5.4 million, or 7.6%, in 2005.

Life insurance premiums increased $4.9 million, or 11.9%, in 2006 compared to $4.0 million, or 10.8%, in 2005. This growth is attributable to increases in term life insurance premiums of $4.7 million for 2006. In addition, term life policies inforce on a year to date basis have increased 7.8%. During January 2006, Life began offering a return of premium level term life product which contributed $3.1 million of the $4.9 million increase in life insurance premiums for 2006.

Life insurance policy charges increased $1.3 million during 2006 primarily due to increased fund balances on which policy charges are assessed. In addition, a slight increase of 0.3% in the number of universal life policies inforce contributed to the increase.

On a statutory accounting basis, issued annualized new business premiums increased by 29.0% to $17.8 million with a total volume of $3.4 billion of insurance being issued in 2006. The new product offerings for 2006 contributed as follows: return of premium level term – 6,329 policies issued, $4.6 million of issued annualized new business premiums and volume of $1.1 billion of insurance issued; annuities – 57 policies issued and $1.4 million of issued annualized new business premium.

Total life insurance inforce as of December 31, 2006 increased $1.4 billion, with term insurance increasing $1.3 billion, or 11.7%, compared to 2005. Annualized premiums for inforce business increased 5.2%, or $6.6 million, with term insurance increasing 15.9% or $5.4 million. Policies inforce increased 1.4% for 2006 compared to 2005. The persistency ratio for life business was 90.7% at December 31, 2006, compared to 91.2% at December 31, 2005.

The mortality ratio increased to 104% of expected in 2006 from 96% of expected in 2005. The result was an increase of $5.3 million in benefits and claims expense for 2006. Operating expenses have increased $158 thousand for 2006 with SFAS No. 123(R) adding $266 thousand and the new policy administration system adding $2.4 million offset by decreases in legal costs of $2.5 million primarily due to net legal reserve reductions of $2.2 million. Amortization of deferred policy acquisition costs have increased in 2006 as a result of growth in deferred costs related to consistent new business production increases in prior periods.

Invested assets increased 6.8% since December 31, 2005, while net investment income increased 10.9%. Interest income on fixed maturities increased 9.8% during 2006. Realized investment gains, net of tax, increased $1.5 million, or 40%, for 2006 as a result of increased gains on equity securities and fixed maturities. On a pretax basis, writedowns increased from $1.7 million in 2005 to $2.1 million in 2006.

Operating income, net of tax, increased 10.1% during 2006 and net income increased 14.6%, or $3.7 million. With an increase in realized investment gains in 2006, net income increased 14.6% compared to a decrease in net income of 4.0% in 2005, which was the result of a 51.3% decrease in realized investment gains in 2005.

At December 31, 2006, the life subsidiary’s Adjusted Capital calculation in accordance with NAIC RBC guidelines was $215.3 million compared to the Authorized Control Level (Required) RBC amount of $12.9 million.

 

41


Table of Contents

NONINSURANCE OPERATIONS

The following discussion relates to the Company’s noninsurance subsidiaries, Financial, Vision, AAM, AAG and ABC.

2007 Compared to 2006

Results of operations for this segment have been impacted by the following events in 2007:

 

   

During the third quarter of 2007, the Company recorded a loss through its investment in MidCountry resulting from the fraudulent misappropriation of principal payments by one of MidCountry’s third-party loan servicers. In addition, the Company was negatively impacted by increased loan loss reserves and charge-offs related to a portfolio of residential construction loans at MidCountry during the third and fourth quarters of 2007.

Noninsurance operating income decreased $1.7 million to an operating loss of $1.3 million in 2007 compared to an operating profit of $328 thousand for 2006. Noninsurance produced a net loss of $1.4 million for 2007 compared to net income of $277 thousand in 2006. Included in operating expenses for this segment is $175 thousand of SFAS No. 123(R) expense for 2007 compared to $142 thousand for 2006.

Agency operations for the year produced a decrease in net income of $1.1 million with all of the decrease attributable to a decline in production at Vision. In 2007, Vision generated net income of $1.5 million compared to net income of $2.7 million in 2006. AAM and AAG contributed $99 thousand and $72 thousand in operating income in 2007 and 2006, respectively.

Loan operations in Financial, including MidCountry, produced an operating loss of $2.0 million for 2007 compared to an operating profit of $308 thousand for 2006. During the first quarter of 2007, $815 thousand was received in loan loss recoveries related to the 2006 write-off in Financial’s portfolio. This was offset by a net loss in MidCountry equity earnings of $4.6 million for 2007. During the second quarter of 2006, loans totaling $5.5 million were written off in Financial’s portfolio as a result of fraudulent activity by one agent. These write-offs were offset by $2.0 million of insurance recoveries recorded in the third quarter of 2006. In addition, loan operations declined over the past twelve months with a 5.6% decrease in the loan portfolio due to more competitive interest rates and more conservative underwriting practices based on economic conditions. The loan portfolio yield increased to 8.11% from 7.88% with an average delinquency ratio of 3.12%.

Financial’s equity in net earnings (after internal capital charge) of MidCountry decreased $8.7 million during 2007. The decrease is primarily a result of increases in loan loss reserves and charge-offs related to a portfolio of residential construction loans purchased from a third party and MidCountry’s share of a fraud loss resulting from the failure of a third party servicer to remit loan payments and payoffs from loans they were servicing. Amounts and timing of potential fraud recoveries, if any, by MidCountry cannot be estimated at this time. The carrying value increased 39.1% with an additional investment of $26.6 million during May 2007 for Financial to maintain its approximate original ownership in the entity.

Commercial lease operations in Financial produced a net loss of $1.1 million in 2007 compared to a net loss in 2006 of $1.9 million. Net losses are a result of servicing fee expenses, legal expenses and interest costs.

ABC had operating income of $133 thousand in 2007 compared to an operating loss of $840 thousand for 2006. The increase of $973 thousand is a result of decreased interest expense.

2006 Compared to 2005

Results of operations for this segment have been impacted by the following events in 2006:

 

   

On January 1, 2006, the Company adopted SFAS No. 123(R).

 

   

During the second quarter of 2006, management discovered fraudulent activity occurring within Financial. The misconduct was determined to be limited to the acts of a single person. As a result, the Company provided for a net charge of $3.5 million on a pretax basis and $2.3 million on an after tax basis or a $0.03 impact on diluted earnings per share. Subsequent recoveries of $815 thousand, on a pretax basis, were received during the first quarter of 2007.

 

42


Table of Contents

Noninsurance operating income increased $366 thousand to an operating profit of $328 thousand in 2006 compared to an operating loss of $38 thousand for 2005. Net income for 2006 was $277 thousand compared to a net loss of $64 thousand in 2005. Included in operating expenses for this segment is $142 thousand of SFAS No. 123(R) expense for 2006.

Agency operations for the year produced an increase in net income of $2.8 million. In 2006, Vision generated net income of $2.7 million due to increased production for AVIC compared to an operating loss of $86 thousand in 2005 due to infrastructure costs and lower than anticipated premium volume attributable to delays in licensing. During both 2006 and 2005, AAM and AAG produced $72 thousand in operating income.

Loan operations in Financial produced net income of $308 thousand for the year compared to $3.1 million in 2005. During the second quarter of 2006, loans were written off totaling $5.5 million as a result of fraudulent activity by one agent offset by insurance recoveries of $2 million. Despite the net increases in loan losses, loan operations continued to grow with a 3.1% increase in the loan portfolio, an increase in the loan portfolio yield to 7.88% from 7.41%, and an average delinquency ratio of 1.99%. Interest rate increases during the year reduced margins slightly. Equity in net earnings (after internal capital charge) of MidCountry increased 20.0% for the year while the carrying value increased 7.3%.

Commercial lease operations in Financial produced a net loss of $1.9 million for 2006 as a result of servicing fee expense, legal expenses and reduced lease income compared to a net loss in 2005 of $2.2 million.

ABC had an operating loss of $840 thousand in 2006 compared to an operating loss of $931 thousand in 2005. The operating loss in 2006 is a result of increased benefit expenses offset by an increase in net investment income.

CORPORATE OPERATIONS

The following discussion relates to the Company’s corporate operations and intercompany profit eliminations between the Company and its subsidiaries.

2007 Compared to 2006

Corporate expenses, including the impact of eliminations, increased $7.5 million during 2007 due primarily to increases in borrowing costs and accounting fees as well as increases in legal and other expenses related to the privatization of the Company (refer to Note 21 – Privatization of the Company in the Notes to Consolidated Financial Statements). The Company’s borrowing costs increased $600 thousand in 2007 due to fluctuations in interest rates and the outstanding debt balance throughout the year. The weighted average interest rate at December 31, 2007 was 5.07% with corporate debt decreasing from $97.0 million at December 31, 2006 to $94.9 million at December 31, 2007. Included in the operating results for this segment is $85 thousand of SFAS No. 123(R) expense for 2007 compared to $94 thousand in 2006.

2006 Compared to 2005

Corporate expenses, including the impact of eliminations, decreased $1.2 million in 2006 due primarily to a change in the Company’s tax allocation agreement offset by increases in accounting fees, legal fees and borrowing costs. Unfavorable increases in short-term interest rates and an increase in the commercial paper borrowings attributable to corporate functions led the Company’s interest expense to rise by $1.8 million from levels experienced in 2005. The weighted average rate increased one hundred basis points from 4.3% at December 31, 2005 to 5.3% at December 31, 2006 with corporate debt increasing from $77.6 million at the end of 2005 to $97.0 million on December 31, 2006. Included in the operating results for this segment is $94 thousand of SFAS No. 123(R) expense for 2006.

 

43


Table of Contents

INVESTMENTS

The Company has historically produced positive cash flow from operations which has resulted in increasing amounts of funds available for investment and, consequently, higher investment income. Investment income is also affected by investment yields. Information about cash flows, total invested assets, including investments in affiliates, and yields are presented below for the years ended December 31, 2007, 2006 and 2005:

 

     Years Ended December 31,  
     2007     2006     2005  

Increase (decrease) in cash flow from operations

   (3.3 )%   8.3 %   (5.5 )%

Increase in invested assets since January 1, 2007, 2006 and 2005

   4.0 %   6.2 %   7.9 %

Investment yield rate

   5.4 %   5.7 %   6.0 %

Increase (decrease) in net investment income

   1.7 %   (1.8 )%   6.2 %

As a result of the overall positive cash flows from operations, total invested assets grew 4.0% since December 31, 2006. The decrease in cash flow from operations in 2007 was primarily due to decreases in property casualty production offset by the effects of the termination of the quota share agreement between Virginia Mutual and Fire along with Alliance becoming a participant in the intercompany property casualty insurance pooling agreement. The premium collection from the COLI plan in the life insurance subsidiary provided positive cash flow in the first quarter of both periods. During 2007, the Company decreased its investment in fixed maturity securities by $129.0 million despite Alliance contributing an increase of $22.1 million. The Company also decreased its investment in equity securities by $8.4 million during 2007. Financial invested an additional $26.6 million in its equity-method investment in MidCountry during the second quarter along with a $3.0 million investment in MidCountry preferred stock in the third quarter. Short-term investments increased $245.3 million.

The Company’s 1.7% increase in net investment income for 2007 compares favorably to a decline of 1.8% in net investment income for 2006 due to increases in interest income on fixed maturities, short-term investments and partnership income. Offsetting these increases is a decrease of $8.7 million in equity in net earnings (after internal capital charge) of MidCountry for 2007. Alliance contributed $2.1 million to the increase in net investment income during 2007. The decline in 2006 was the result of the write-off of loans in Financial’s portfolio, increased borrowing costs, reduced income from the equity-method investment in MidCountry and lower partnership earnings. These items were partially offset by increased earnings on fixed maturities, equity securities and short-term investments.

The overall investment yield rate, calculated using amortized cost, declined during 2007 to 5.4%. The Company had net realized investment losses, before income taxes, of $1.1 million in 2007 compared to net realized investment gains of $3.4 million during the same period in 2006. These losses are primarily from writedowns of fixed maturities and equity securities and realized losses on tax credit partnerships offset by gains on sales of equity securities.

 

44


Table of Contents

Investments (Other than Investments in Affiliates)

The composition of the Company’s investment portfolio is as follows at December 31, 2007 and 2006:

 

     December 31,  
     2007     2006  

Fixed maturities

    

Taxable

    

Mortgage-backed securities

   25.4 %   27.4 %

Asset-backed securities

   2.7 %   4.1 %

U.S. Treasury securities

   1.1 %   0.5 %

U.S. government and corporate agencies

   11.5 %   11.0 %

Obligations of states and political subdivisions

   3.3 %   3.6 %

Corporate bonds

   8.1 %   9.4 %
            

Total taxable

   52.1 %   56.0 %

Tax exempts

   10.6 %   16.2 %
            

Total fixed maturities

   62.7 %   72.2 %
            

Equity securities

   4.3 %   5.6 %

Policy loans

   3.3 %   3.2 %

Collateral loans

   5.8 %   6.4 %

Other long-term investments

   4.1 %   4.3 %

Short-term investments

   19.8 %   8.3 %
            

Total

   100.0 %   100.0 %
            

The majority of the Company’s investment portfolio consists of fixed maturities that are diverse as to both industry and geographic concentration. In 2007, the overall mix of investments shifted due to the purchase of Alliance and additional investments in short-term investments from the sales of fixed maturities and equity securities.

The rating of the Company’s portfolio of fixed maturities using the Standard & Poor’s rating categories is as follows at December 31, 2007 and 2006:

 

     December 31,  
     2007     2006  

AAA to A-

   93.9 %   93.7 %

BBB+ to BBB-

   5.1 %   5.7 %

BB+ and below (below investment grade)

   0.8 %   0.4 %

Not rated

   0.2 %   0.2 %
            
   100.0 %   100.0 %
            

At December 31, 2007, all securities in the fixed maturity portfolio, with the exception of a single investment of $3.0 million, were rated by an outside rating service. The Company considers bonds with a quality rating of BB+ and below to be below investment grade or high yield bonds (also called junk bonds).

At December 31, 2007, 40.5% of fixed maturities were mortgage-backed securities. Such securities are comprised of Collateral Mortgage Obligations (CMOs) and pass through securities. Based on reviews of the Company’s portfolio of mortgage-backed securities, the impact of prepayment risk on the Company’s financial position and results from operations is not believed to be significant. These risks are discussed in more detail in Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

At December 31, 2007, the Company’s total portfolio of fixed maturities had gross unrealized gains of $21.4 million and gross unrealized losses of $22.2 million. Primarily all securities are priced by nationally recognized pricing services with $124.3 million, or 9.5%, priced by broker/dealers securities firms. Those that are not are limited to a portion of the structured notes portfolio (primarily the collateralized debt obligations), which are valued using pricing models, and the single investment mentioned above. During 2007, the Company sold

 

45


Table of Contents

$176.3 million in fixed maturities available for sale. These sales resulted in gross realized gains of $8.1 million and gross realized losses of $3.4 million. During 2006, the Company sold $101.7 million in fixed maturities available for sale. These sales resulted in gross realized gains of $1.2 million and gross realized losses of $1.3 million.

The Company has five positions in CDOs purchased as principal protected AAA rated bonds, with a par value of $29.7 million and a fair value of $23.4 million at December 31, 2007. U.S. Treasury securities make up approximately 95% of the book value at December 31, 2007. In estimating fair values, the Company used a valuation approach based on Intex analytic software to predict future cash flow streams. Cash flow models for CDOs also use management’s judgment based on expectations of the assumptions market participants would use in pricing the assets in current market transactions and information received regarding future cumulative default rates, recovery rates, and a discount rate determined as the risk-free treasury rate at the time of purchase plus a risk spread. The risk spread was equal to a BBB bond. Any variation in cash flow assumptions would have an effect on the valuation. However, at December 31, 2007 the total CDO exposure was $1.3 million, or 0.1% of total invested assets. In addition the Company has one structured note on which the fair value was based on evaluations of underlying bond downgrades and internal assumptions about future default rates. The fair value of this security at December 31, 2007 was $11.6 million. Fair values of these six structured securities at December 31, 2006, when the market had potential for trading of these bonds, were based on broker quotes.

It is the Company’s policy to write down securities for which declines in value have been deemed to be other than temporary. The amount written down represents the difference between the cost or amortized cost and the fair value at the time of determining the security was impaired. Quarterly reviews are conducted by the Company to ascertain which securities, if any, have become impaired in value. During quarterly reviews in 2007, the Company evaluated its exposure to subprime mortgage-related risks. The Company does not own direct investments in subprime mortgage loans, or have investments in subsidiary, controlled and affiliated entities with subprime-related risk. Exposure to subprime mortgage-related risk in fixed income securities is limited to investments in CDOs with underlying subprime mortgage exposure. Careful consideration is given in determining the Company’s exposure to subprime mortgage-related risk through analysis of the quality of collateral, rating downgrades, deterioration or loss of credit support, time period in which there has been a decline in value, changes in cash flow, and the Company’s ability and intent to hold the security until full value is recovered. Unrealized losses due to asset valuation changes at December 31, 2007 and 2006 were due to changes in interest rates and not credit quality. Realized losses were taken on those securities in which the Company had determined a decline in credit value of the underlying support had occurred. The Company has investments in four publicly traded equity securities of financial institutions that have been adversely affected by the current credit market. These equity securities were written down to their respective fair values at December 31, 2007. The Company determined that writedowns of $6.5 million and $3.4 million were warranted for other than temporary impairments in the CDO portfolio and the equity portfolio, respectively, related to exposure to the subprime lending market, during the second half of 2007. Based on evaluations of the outstanding portfolio and the Company’s ability to manage its exposure to the subprime market, the Company does not believe its financial condition, results of operations, or liquidity will be materially adversely affected by any further involvement with the subprime market.

Investments in securities entail general market risk as well as company specific risk. During 2007, the Company wrote down fourteen bond issues, including structured securities, totaling $10.3 million and twenty-seven equity securities, including the four subprime exposures, totaling $15.0 million for which declines in value were deemed to be other than temporary. During 2006, the Company wrote down one bond issue totaling $20 thousand and nine equity securities totaling $2.9 million for which declines in value were deemed to be other than temporary. There were no non-performing bonds included in the portfolio at either December 31, 2007 or December 31, 2006.

Of the Company’s $22.2 million in gross unrealized losses on fixed maturities available for sale, $18.9 million, or 85.4%, are related to mortgage-backed securities, $1.4 million, or 6.2%, to asset-backed securities, $1.1 million, or 4.8%, to corporate securities, $553 thousand, or 2.5%, to obligations of states and political subdivisions and $251 thousand, or 1.1%, to obligations of United States government corporations and agencies. At December 31, 2007,

 

46


Table of Contents

unrealized losses of $7.0 million existed on equity securities directly owned by the Company. Of this amount, the greatest concentrations of gross unrealized losses were in the financial, information technology, consumer discretionary, energy and healthcare sectors where the Company had losses of $3.2 million, $1.4 million, $938 thousand, $771 thousand and $624 thousand, respectively. In assessing each security, the Company analyzes the industry and earnings trends of the underlying issuer, the length of time the security has continuously been in a loss position and the magnitude of the loss in comparison to its cost. Generally, the Company writes down securities that, based on its review, appear to be other than temporarily impaired. Due to the subjectivity of the writedown process, there are risks and uncertainties that could impact the Company’s future earnings and financial position. If recoveries in the price of securities fail to materialize, the Company’s earnings and financial position will be negatively impacted. The Company’s investment philosophy is one that generally looks for long-range growth based on the Company’s willingness and ability to hold investments for extended periods of time.

Seven equity securities with unrealized losses of $4.2 million had experienced a reduction of at least 20% in value at the end of 2007. Of these equity securities in loss positions, each had been in a loss position for less than three months. Four fixed maturities with unrealized losses of $3.3 million had experienced a reduction in value of at least 20% at the end of 2007 and had been in a loss position for longer than three months but less than six months. The Company’s general practice is to re-evaluate any security written down on a periodic basis in order to determine whether additional impairment has occurred.

The Company monitors its level of investments in high yield fixed maturities and its level of equity investments in companies that issue high yield debt securities. Management believes the level of such investments is not significant to the Company’s financial condition. At December 31, 2007, the Company held below investment grade fixed maturities with an amortized cost of $10.5 million and a fair value of $10.7 million. These securities had gross unrealized gains of $417 thousand and gross unrealized losses of $132 thousand at the end of the year. These securities represent 0.8% of both the amortized cost and fair value of the Company’s total fixed maturity portfolio. The Company recognized a net loss of $1.8 million on the disposal of high yield debt securities in 2007 after recognizing a net loss of $98 thousand on similar disposals in 2006.

At December 31, 2007, the Company owned equity securities that have issued “junk” bonds with a cost of $19.6 million and a fair value of $18.7 million. These securities had gross unrealized gains of $703 thousand and gross unrealized losses of $1.6 million at the end of the year. These unrealized losses comprised less than 1.7% of the total fair value and 21.0% of the total gross unrealized losses from equity securities for the Company at December 31, 2007.

The table below shows a breakdown of the unrealized losses on fixed maturities at December 31, 2007 based on the maturity date of each.

 

     Gross
Unrealized Loss

Less than 1 year

   $ 10,134

Between 1 and 3 years

     18,193

Between 3 and 5 years

     34,665

Between 5 and 10 years

     1,466,565

Between 10 and 20 years

     2,649,809

Over 20 years

     17,986,540
      
   $ 22,165,906
      

Of the fixed maturities experiencing declines in value at December 31, 2007, eight were in a loss position of over $500 thousand. These securities cumulatively represented 3.1% of the fair value of fixed maturities available for sale at December 31, 2007 and a 15.0% decline from cost. Of the equity securities directly owned by the Company with unrealized losses at December 31, 2007, four were in a loss position of over $500 thousand. Of

 

47


Table of Contents

these securities, one security is part of the financial sector, one security is part of the healthcare sector, one security is part of the consumer discretionary sector and one security is part of the technology sector. These securities cumulatively represented 9.4% of the fair value of equity securities at December 31, 2007 and a 30.6% decline from cost.

The Company’s investment in collateral loans and commercial leases consists primarily of consumer loans and commercial leases originated by the finance subsidiary. The majority of the commercial lease portfolio was sold in the fourth quarter of 2005. Automobiles, equipment and other property collateralize the Company’s loans and leases. At December 31, 2007, the delinquency ratio on the loan portfolio was 3.48%, or $4.2 million. Loans charged off in 2007, 2006 and 2005 totaled $570 thousand, $4.0 million and $496 thousand, respectively. Offsetting these charge-offs in 2007 were $916 thousand of recoveries on loans previously written off. At December 31, 2007, the Company maintained an allowance for loan losses of $1.6 million, or 1.3% of the outstanding loan balance. In addition, at December 31, 2007, the Company maintained an allowance for lease losses of $285 thousand, or 29.3% of the outstanding lease balance. Leases charged off in 2007, 2006 and 2005 were $342 thousand, $328 thousand and $1.4 million, respectively. Other significant long-term investments include assets leased under operating leases.

The Company periodically invests in affordable housing tax credit partnerships. At December 31, 2007, the Company had legal and binding commitments to fund partnerships of this type in the amount of $34.3 million. The Company’s carrying value of such investments was $66.3 million and $64.2 million at December 31, 2007 and 2006, respectively.

The Company’s short-term investments, at December 31, 2007, consisted of $260.0 million of money market funds, $152.4 million of short-term bonds and $558 thousand of certificates of deposit. The short-term bonds had gross unrealized gains of $36 thousand and gross unrealized losses of $1 thousand December 31, 2007. Maturity dates of these short-term bonds, purchased in November and December 2007, ranged from January 16, 2008 to March 13, 2008. At December 31, 2006, money market funds totaled $167.1 million and certificates of deposit were $544 thousand.

Other Long-Term Investments in Affiliates

The composition of the Company’s other long-term investments in affiliates is as follows at December 31, 2007 and 2006:

 

     December 31,  
     2007     2006  

Equity-method investments 1

   82.4 %   67.2 %

Preferred stock

   2.4 %   —   %

Notes receivable

   15.2 %   32.8 %
            

Total

   100.0 %   100.0 %
            

 

1

Includes partnerships, joint ventures and unconsolidated investee companies

During the third quarter of 2002, the Company’s finance subsidiary invested $13.5 million in MidCountry, a financial services holding company. Financial made additional investments of $36.1 million during the fourth quarter of 2004 and $26.6 million during the second quarter of 2007 to maintain its approximate original ownership in the entity. Financial accounts for earnings from MidCountry using the equity method of accounting. Pretax operating loss, net of the cost of capital, was $7.3 million in 2007. Conversely, the Company recognized pretax operating income of $1.4 million in 2006 and $1.2 million in 2005. Other equity-method investments include partnership interests held by the Company’s insurance subsidiaries. For more information on these investments, refer to Note 4 – Investments in the Notes to Consolidated Financial Statements under the section Other Long-term Investments.

 

48


Table of Contents

During the third quarter of 2007, Financial invested $3.0 million in MidCountry preferred stock. In 2007, Financial recognized $63 thousand in pretax earnings on this preferred stock.

Also included within other long-term investments in affiliates are notes receivable from several affiliated entities including a note receivable from OFC Servicing Corporation, a wholly-owned subsidiary of MidCountry, resulting from the sale of OFC Capital in 2005. The balances at December 31, 2007 and 2006 were $13.5 million and $33.0 million, respectively.

INCOME TAXES

The effective tax rate was 25.0% in 2007, 23.8% in 2006 and 28.2% in 2005. The increase in 2007 from the 2006 effective rate is due primarily to the release of a reserve for uncertain tax positions in 2006. The decrease in 2006 from the 2005 effective rate is due to a 2005 year-end adjustment for taxes relating to ABC, the release of a reserve for uncertain tax positions mentioned above and an increase in investment by the Company in affordable housing tax credit partnerships in 2006.

IMPACT OF INFLATION

Inflation increases consumers’ needs for both life and property casualty insurance coverage. Inflation increases claims costs incurred by property casualty insurers as property repairs, replacements and medical expenses increase. Such cost increases reduce profit margins to the extent that rate increases are not maintained on an adequate and timely basis. Since inflation has remained relatively low in recent years, financial results have not been significantly impacted by inflation.

LIQUIDITY AND CAPITAL RESOURCES

The Company receives funds from its subsidiaries consisting of dividends, payments for funding federal income taxes and reimbursement of expenses incurred at the corporate level for the subsidiaries. These funds are used for paying dividends to stockholders, corporate interest and expenses, federal income taxes, and for funding additional investments in its subsidiaries’ operations.

The Company’s subsidiaries require cash in order to fund policy acquisition costs, claims, other policy benefits, interest expense, general operating expenses and dividends to the Company. The major sources of the subsidiaries’ liquidity are operations and cash provided by maturing or liquidated investments. A significant portion of the Company’s investment portfolio consists of readily marketable securities that can be sold for cash. Based on a review of the Company’s matching of asset and liability maturities and on the interest sensitivity of the majority of policies inforce, management believes the ultimate exposure to loss from interest rate fluctuations is not significant.

Primary Source of Liquidity

Net cash provided by operating activities was $146.8 million, $151.9 million and $140.2 million in 2007, 2006 and 2005, respectively. Such net positive cash flows provide the foundation of the Company’s assets/liability management program and are the primary drivers of the Company’s liquidity. As previously discussed, the Company also maintains a diversified portfolio of fixed maturity and equity securities that provide a secondary source of liquidity should net cash flows from operating activities prove inadequate to fund current operating needs. Management believes that such an eventuality is unlikely given the Company’s product mix (primarily short-duration personal lines property casualty products), its ability to adjust premium rates (subject to regulatory oversight) to reflect emerging loss and expense trends and its catastrophe reinsurance program, amongst other factors.

 

49


Table of Contents

Contractual Obligations and Commitments

In evaluating current and potential financial performance of any corporation, investors often wish to view the contractual obligations and commitments of the entity. The Company has contractual obligations in the form of debt, benefit obligations to policyholders and leases. Leases have primarily been originated by its insurance subsidiaries and Vision.

The Company’s contractual obligations at December 31, 2007 are summarized below:

 

     Payments Due by Period
     Total    Less than 1 year    1-3 years    4-5 years    After 5 years

Operating leases

   $ 6,435,492    $ 1,754,459    $ 2,298,945    $ 974,573    $ 1,407,515

Partnership funding obligations

     34,283,902      5,793,916      11,424,302      17,065,684      —  

Commercial paper

     198,030,000      198,030,000      —        —        —  

Notes payable to affiliates

     31,402,470      31,402,470      —        —        —  

Long-term debt 1

     70,000,000      —        —        —        70,000,000

Interest on long-term debt 1

     33,052,273      3,516,608      7,014,000      7,023,608      15,498,057

Property casualty loss and loss adjustment expense reserves 2

     200,425,013      152,323,010      44,093,503      4,008,500      —  

Future life insurance obligations 3

     2,149,705,249      81,106,249      231,181,000      160,844,000      1,676,574,000
                                  

Total contractual obligations

   $ 2,723,334,399    $ 473,926,712    $ 296,011,750    $ 189,916,365    $ 1,763,479,572
                                  

 

1

Long-term debt is assumed to be settled at its contractual maturity. Interest on long-term debt is calculated using interest rates in effect at December 31, 2007, for variable rate debt and is shown in the table through the maturity of the underlying debt. Interest on long-term debt is accrued and settled monthly, thus the timing and amount of such payments may vary from the calculated value. For additional information, refer to Note 10 — Debt, in the Notes to Consolidated Financial Statements.

2

The anticipated payout of property casualty loss and loss adjustment expense reserves are based upon historical payout patterns. Both the timing and amount of these payments may vary from the payment indicated. At December 31, 2007, total property casualty reserves in the above table of $200,425,013 are gross of salvage and subrogation recoverables of $12,723,448.

3

Future life insurance obligations consist primarily of estimated future contingent benefit payments on policies inforce at December 31, 2007. These estimated payments are computed using assumptions for future mortality, morbidity and persistency. In contrast to this table, the majority of Life’s obligations is recorded on the balance sheet at the current account values and do not incorporate an expectation of future market growth, interest crediting or future deposits. Therefore, the estimated future life insurance obligations presented in this table significantly exceed the liabilities recorded in the Company’s consolidated balance sheet. Due to the significance of the assumptions used, the actual amount and timing of such payments may differ significantly from the estimated amounts. Management believes that current assets, future premiums and investment income will be sufficient to fund all future life insurance obligations.

Off-Balance Sheet Arrangements

The Company maintains a variety of funding agreements in the form of lines of credit with affiliated entities. The table below depicts, at December 31, 2007, the cash outlay by the Company representing the potential amounts the Company would have to supply to other affiliated entities if they made full use of their existing lines of credit during 2008 with the Company’s finance subsidiary. Other commercial commitments of the Company shown below include partnership commitments, potential performance payouts related to Vision, recourse on commercial leases sold and various fees and expenses, including financial advisory and legal, related to the privatization of the Company (refer to Note 21 – Privatization of the Company and Note 22 – Subsequent Events in the Notes to Consolidated Financial Statements).

 

     Amount of Commitment Expiration Per Period
     Total Amounts
Committed
   Less than 1 year    1-3 years    4-5 years    After 5 years

Lines of credit

   $ 29,596,235    $ 4,450,000    $ 25,146,235    $ —      $ —  

Standby letters of credit

     37,000      37,000      —        —        —  

Guarantees

     4,193,232      200,000      2,600,000      —        1,393,232

Other commercial commitments

     26,103,351      18,526,885      4,825,532      2,750,934      —  
                                  

Total commercial commitments

   $ 59,929,818    $ 23,213,885    $ 32,571,767    $ 2,750,934    $ 1,393,232
                                  

Certain commercial commitments in the table above include items that may, in the future, require recognition within the financial statements of the Company. Events leading to the call of a guarantee, achievement of specific metrics by Vision and the consummation of the privatization transaction are examples of situations that would impact the financial position and results of the Company.

 

50


Table of Contents

Credit Risk

Assessment of credit risk is a critical factor in the Company’s consumer loan and commercial leasing subsidiary. All credit decisions are made by personnel trained to limit loss exposure from unfavorable risks. In attempting to manage risk, the Company regularly reviews delinquent accounts and adjusts reserves for potential loan losses and potential lease losses. To the extent these reserves are inadequate at the time an account is written off, income would be negatively impacted. In addition, the Company monitors interest rates relative to the portfolio duration. Rising interest rates on commercial paper issued, the primary source of funding portfolio growth, could reduce the interest rate spread if the Company failed to adequately adjust interest rates charged to customers.

Debt

Total borrowings decreased $5.7 million in 2007 to $298.8 million. The majority of the short-term debt is commercial paper issued by the Company. At December 31, 2007, the Company had $197.4 million in commercial paper at rates ranging from 4.75% to 5.27% with maturities ranging from January 2, 2008 to January 30, 2008. The Company intends to continue to use the commercial paper program as a major source to fund the consumer loan portfolio and other corporate short-term needs. Backup lines of credit are in place up to $300 million. The backup lines agreements contain usual and customary covenants requiring the Company to meet certain operating levels. The Company has maintained full compliance with all such covenants. The Company has A-1 and P-1 commercial paper ratings from Standard & Poor’s and Moody’s Investors Service, respectively. The commercial paper is guaranteed by two affiliates, Mutual and Fire. In addition, the Company had $31.4 million in short-term debt outstanding to affiliates at December 31, 2007 with interest payable monthly at rates established using the existing commercial paper rate and renewable for multiples of 30-day periods at the commercial paper rate then applicable.

Included in total borrowings is a variable rate note issued by the Company during the second quarter of 2002 in the amount of $70 million. This note is payable in its entirety on June 1, 2017 with interest payments due monthly. The Company is using the proceeds of this note to partially fund the consumer loan and commercial lease portfolios of its finance subsidiary.

Company Stock

On October 25, 1993, the Company established a Stock Incentive Plan (the 1993 Plan). The 1993 Plan was subsequently amended on April 26, 2001. On April 28, 2005, the Company’s stockholders approved the 2005 Amended and Restated Stock Incentive Plan (the 2005 Plan). This Plan amends and restates the 1993 Plan. The 2005 Plan permits the grant of a variety of equity-based incentives based upon the Company’s common stock. These include stock options, which may be either “incentive stock options” as that term is defined in Section 422 of the Internal Revenue Code of 1986, as amended or “nonqualified options”. The 2005 Plan also permits awards of Stock Appreciation Rights, Restricted Shares, Restricted Share Units and Performance Shares. A maximum of 3,800,000 shares of stock may be issued under the 2005 Plan. During 2007, the Company granted 78,134 awards of restricted stock to certain officers and issued 468,000 nonqualified options under the 2005 Plan. At December 31, 2007, 2,648,964 shares were available for grant.

In October 1989, the Company’s Board of Directors approved a stock repurchase program authorizing the repurchase of up to 4,000,000 shares of its outstanding common stock in the open market or in negotiated transactions in such quantities and at such times and prices as management may decide. The Board increased the number of shares authorized for repurchase by 4,000,000 in both March 1999 and September 2001, bringing the total number of shares authorized for repurchase to 12,000,000. There were no repurchases in 2007. Repurchases of 97,500 shares totaling $1,512,869 were made during the second and third quarters of 2006. At December 31, 2007, the total repurchased was 8,364,123 shares at a cost of $66,896,253. The Company has reissued 3,413,805 treasury shares as a result of option exercises, reissued 12,271 treasury shares as a result of restricted stock award releases and sold 1,607,767 shares through funding its dividend reinvestment plan. In January 2005, the Company issued 325,035 non-registered shares to fund a portion of the acquisition of Vision.

 

51


Table of Contents

The Company does not contemplate any additional share repurchases under the repurchase program due to the definitive merger agreement. Refer to Note 21 – Privatization of the Company and Note 22 – Subsequent Events in the Notes to Consolidated Financial Statements for additional information.

Share information presented in this section has been adjusted to reflect the impact of the two-for-one stock split effected in the form of a 100% stock dividend that was paid on June 17, 2002.

Reserves for Policyholder Benefits

Due to the sensitivity of the products offered by the life subsidiary to interest rate fluctuations, the Company must assess the risk of surrenders exceeding expectations factored into its pricing program. Internal actuaries are used to determine the need for modifying the Company’s policies on surrender charges and assessing the Company’s competitiveness with regard to rates offered. Cash surrenders paid to policyholders on a statutory basis totaled $23.1 million and $20.6 million in 2007 and 2006, respectively. This level of surrenders is within the Company’s pricing expectations. Historical persistency rates indicate a normal pattern of surrender activity in 2007, 2006 and 2005. The structure of the surrender charges is such that persistency is encouraged. The majority of the policies inforce have surrender charges which grade downward over a 12 to 15 year period. At December 31, 2007, the total amount of cash that would be required to fund all amounts subject to surrender was $748.5 million.

Reserves for Property Casualty Losses and Loss Adjustment Expenses

Losses and loss adjustment expenses payable are management’s best estimates at a given point in time of what the Company expects to pay claimants, based on known facts, circumstances, historical trends, emergence patterns and settlement patterns. Reserves for reported losses are established on a case-by-case basis with the amounts determined by claims adjusters based on the Company’s reserving practices, which take into account the type of risk, the circumstances surrounding each claim and policy provisions relating to types of loss. Loss and loss adjustment expense reserves for incurred claims that have not yet been reported (IBNR) are estimated based primarily on historical emergence patterns with consideration given to many variables including statistical information, inflation, legal developments, storm loss estimates, and economic conditions.

The Company’s internal actuarial staff conducts annual reviews of projected loss development information by line of business to assist management in making estimates of reserves for ultimate losses and loss adjustment expenses payable. Several factors are considered in estimating ultimate liabilities including consistency in relative case reserve adequacy, consistency in claims settlement practices, recent legal developments, historical data, actuarial projections, accounting projections, exposure growth, current business conditions, catastrophe developments and late reported claims. In addition, reasonableness is established in the context of claim severity, loss ratio and trend factors, all of which are implicit in the liability estimates.

The annual actuarial reviews are presented to management with a point estimate established within the range of probable outcomes for evaluating the adequacy of reserves and determination of the appropriate reserve value to be included in the financial statements. Management establishes reserves using its best estimate determined using accepted actuarial techniques. Although management uses many internal and external resources, as well as multiple established methodologies to calculate reserves, there is no method for determining the exact ultimate liability.

Management establishes reserves for loss adjustment expenses that are not attributable to a specific claim. These reserves are referred to as Defense and Cost Containment (DCC) and Adjusting and Other Expenses (AO). DCC and AO reserves are recorded to establish the liability for settling and defending claims that have been incurred, but have not yet been completely settled. For AO, historical ratios of AO to paid losses are developed, and then applied to the current outstanding reserves. The method uses a traditional assumption that 50% of the expenses are realized when the claim is open, and the other 50% are incurred when the claim is closed. The method also assumes that the underlying claims process and mix of business do not change materially over time.

 

52


Table of Contents

The following table presents the loss and loss adjustment expenses payable by line of business at December 31, 2007 and 2006:

 

     December 31, 2007  
     Case    IBNR    LAE    Total  

Line of Business:

           

Auto 1

   $ 91,116,004    $ 38,009,286    $ 18,850,635    $ 147,975,925  

Homeowner Group 2

     25,328,100      13,643,334      7,271,127      46,242,561  

Other 3

     2,635,531      1,664,726      680,873      4,981,130  

Assumed reinsurance - affiliate 4

     —        —        —        —    

Assumed reinsurance - other 5

     1,039,397      186,000      —        1,225,397  
                             
   $ 120,119,032    $ 53,503,346    $ 26,802,635    $ 200,425,013  
                       

Less: salvage and subrogation recoverable

              (12,723,448 )
                 

Reserve for unpaid losses and loss adjustment expenses

            $ 187,701,565  
                 
     December 31, 2006  
     Case    IBNR    LAE    Total  

Line of Business:

           

Auto 1

   $ 80,997,159    $ 35,146,259    $ 19,383,521    $ 135,526,939  

Homeowner Group 2

     19,495,260      11,732,635      5,599,330      36,827,225  

Other 3

     1,996,790      1,223,200      690,002      3,909,992  

Assumed reinsurance - affiliate 4

     6,797,525      735,268      298,683      7,831,476  

Assumed reinsurance - other 5

     26,725      186,000      —        212,725  
                             
   $ 109,313,459    $ 49,023,362    $ 25,971,536    $ 184,308,357  
                       

Less: salvage and subrogation recoverable

              (11,643,705 )
                 

Reserve for unpaid losses and loss adjustment expenses

            $ 172,664,652  
                 

 

1

Auto represents the Company’s pooled share of preferred, standard, nonstandard and commercial auto as well as assumed nonstandard business in Texas.

2

Homeowner Group represents the Company’s pooled share of the following lines of business: preferred and standard homeowner, manufactured home, farmowner and limited amount of commercial insurance including portfolio, church and businessowner.

3

Other includes the Company’s pooled share of various general liability, fire/allied lines and other lines of business.

4

Assumed reinsurance - affiliate represents the Company’s pooled share of Fire’s quota share reinsurance agreement with Virginia Mutual. The quota share reinsurance agreement was terminated on January 1, 2007.

5

Assumed reinsurance - other represents the Company’s pooled share of business from various underwriting pools and associations.

Refer to Note 2 – Pooling Agreement in the Notes to Consolidated Financial Statements for a detailed discussion of the Company’s Pooling Agreement.

Total losses and loss adjustment expenses payable increased $15.0 million, or 8.7%, from December 31, 2006 to December 31, 2007. The reserve increase is primarily attributable to the addition of Alliance and product level exposure changes. The current year development of the prior years’ ultimate liability does not reflect any changes in the Company’s fundamental claims reserving practices or actuarial assumptions.

The risks and uncertainties inherent in the estimates include, but are not limited to, actual settlement experience being different from historical data and trends, changes in business and economic conditions, court decisions

 

53


Table of Contents

creating unanticipated liabilities, ongoing interpretation of policy provisions by the courts, inconsistent decisions in lawsuits regarding coverage and additional information discovered before settlement of claims. The Company’s results of operations and financial condition could be impacted, perhaps significantly, in the future if the ultimate payments required to settle claims vary from the liability currently recorded.

Activity in the liability for unpaid losses and loss adjustment expenses is summarized below:

 

     2007     2006     2005  

Balance at January 1,

   $ 172,664,652     $ 159,639,886     $ 154,107,730  

less reinsurance recoverables on unpaid losses

     (2,380,370 )     (2,103,540 )     (3,251,046 )
                        

Net balance on January 1,

     170,284,282       157,536,346       150,856,684  
                        

Alliance

      

Balance at January 1,

     23,932,909       —         —    

less reinsurance recoverables on unpaid losses

     (17,174,977 )     —         —    
                        

Net balance on January 1,

     6,757,932       —         —    
                        

Incurred related to:

      

Current year

     400,657,360       388,721,009       353,497,743  

Prior years

     (4,731,739 )     (8,326,507 )     4,598,363  
                        

Total incurred

     395,925,621       380,394,502       358,096,106  
                        

Paid related to:

      

Current year

     289,908,126       278,243,187       252,333,889  

Prior years

     99,406,307       89,403,379       99,082,555  
                        

Total paid

     389,314,433       367,646,566       351,416,444  
                        

Net balance at December 31,

     183,653,402       170,284,282       157,536,346  

plus reinsurance recoverables on unpaid losses

     4,048,163       2,380,370       2,103,540  
                        

Balance at December 31,

   $ 187,701,565     $ 172,664,652     $ 159,639,886  
                        

A tabular presentation of the current year $4.7 million favorable development broken down by accident year is shown below derived from the Company’s 2007 loss development table, as presented in Note 8 – Policy Liabilities and Accruals in the Notes to Consolidated Financial Statements. The development is measured in dollars and as a percentage of the total December 31, 2007 net loss and loss adjustment expenses payable:

 

54


Table of Contents
     Current Year Development
of Ultimate Liability
(Redundancy)/Deficiency
(in thousands)
    % of Total Net Loss and
Loss Adjustment
Expenses Payable
 

1997 and prior

   $ 140     0.08 %

1998

     —       —   %

1999

     112     0.06 %

2000

     (126 )   (0.07 )%

2001

     (38 )   (0.02 )%

2002

     (964 )   (0.52 )%

2003

     (1,043 )   (0.57 )%

2004

     (1,536 )   (0.84 )%

2005

     (3,268 )   (1.78 )%

2006

     1,991     1.08 %
              

Total

   $ (4,732 )   (2.58 )%
              

There was no change in actuarial assumptions or methodology associated with the development of prior accident years. The current 2.58%, or $4.7 million, favorable development and the prior year 4.89%, or $8.3 million, favorable development are the result of normal fluctuations and uncertainty associated with loss reserve development.

The $4.6 million unfavorable development in 2005 is the result of normal fluctuations and uncertainty associated with loss reserve development after adjusting for underestimation of a specific component of IBNR reserves at December 31, 2004.

Reserve ranges provide a quantification of the variability in the reserve projections, which is often referred to as the standard deviation or error term, while the point estimates establish a mean, or expected value for the ultimate reserve. Management’s best estimate of loss and loss adjustment expense reserves considers the actuarial point estimate and expected variation to establish an appropriate position within the range.

Based on a review of historical ultimate development patterns, management has estimated that one standard deviation from mid-point for ultimate development has a 2.0% favorable development opportunity and a 0.2% unfavorable development opportunity. The potential impact of loss reserve variability on net income is quantifiable using a standard deviation and carried reserve amounts listed above. To the extent that ultimate development is favorable compared to expectation, the potential reserve decrease is $3.8 million on a pretax basis. Likewise, if ultimate development is unfavorable compared to expectation, the reserve increase is $375 thousand on a pretax basis.

An important assumption underlying the reserve estimation methods for the property casualty lines is that the loss cost trends implicitly built into the loss and LAE patterns will continue into the future. Some of the factors that could influence assumptions arise from a variety of sources including tort law changes, development of new medical procedures, social inflation, and other inflationary changes in costs beyond assumed levels. Inflation changes have much less impact on short-tail personal lines reserves and more impact on long-tail commercial lines. The Company does not have any significant long-tailed lines of business, so the actuarial assumptions and methodologies are consistent across all lines of business, regardless of the expected payout patterns. This is further evidenced by the fact that approximately 90% of ultimate losses for a given accident year are reported in the first year and by the end of the second year more than 99% are reported.

 

55


Table of Contents

Reinsurance

Property Casualty – Ceded

The property casualty subsidiaries of the Company follow the customary industry practice of reinsuring a portion of their exposures and paying to the reinsurers a portion of the premiums received. Insurance is ceded principally to reduce net liability on individual risks or for individual loss occurrences, including catastrophic losses. Although reinsurance does not legally discharge the individual subsidiary from primary liability for the full amount of limits applicable under their policies, it does make the assuming reinsurer liable to the extent of the reinsurance ceded. The Company evaluates the financial condition of its reinsurers and monitors concentration of credit risk arising from similar geographic regions, activities or economic characteristics of the reinsurance to minimize exposure to significant losses from reinsurance insolvencies. None of the reinsurance receivable amounts have been deemed to be uncollectible at December 31, 2007.

Certain subsidiaries are party to working cover reinsurance treaties for property casualty lines. Under the property per risk excess of loss treaty, AIC, AGI and Alliance are responsible for the first $750 thousand of each covered loss, and the reinsurers are responsible for 100% of the excess over $750 thousand of covered loss with a maximum recovery of $1.75 million. Under a separate treaty, Alliance is responsible for the first $600 thousand of each covered liability loss, and the reinsurers are responsible for 100% of the excess over $600 thousand of covered liability loss with a maximum recovery of $1.4 million. The rates for these reinsurance treaties are negotiated annually. The subsidiaries also make use of facultative reinsurance for unique risk situations.

The Company’s subsidiaries participate in a catastrophe protection program through the Pooling Agreement. Under this program, the Company participates in only its pooled share of a lower catastrophe pool limit unless the losses exceed an upper catastrophe pool limit. In cases where the upper catastrophe limit is exceeded on a 100% basis, the Company’s share in the loss would be based upon its amount of statutory surplus relative to other members of the group as of the most recently filed annual statement. Lower and upper catastrophe pool limits are adjusted periodically due to increases in insured property risks. Refer to Note 2 – Pooling Agreement, Catastrophe Protection Program section in the Notes to Consolidated Financial Statements for further details.

 

56


Table of Contents

The following table details the impact of reinsurance ceded for the years ended December 31, 2007, 2006 and 2005:

 

     Years Ended December 31,  
     2007     2006     2005  

Income Statement:

      

Working Cover - Nonaffiliates:

      

Earned Premium

   $ (3,614,410 )   $ (3,351,944 )   $ (2,676,106 )

Losses Incurred

     (2,521,270 )     (576,350 )     (1,391,345 )

Commission Expense

     (366,960 )     (321,824 )     (309,141 )
                        

Net (Loss)

     (726,180 )     (2,453,770 )     (975,620 )
                        

Other - Nonaffiliates:

      

Earned Premium

     (250,962 )     —         —    

Losses Incurred

     (192,373 )     —         —    

Commission Expense

     (58,609 )     —         —    
                        

Net Profit

     20       —         —    
                        

Catastrophe - Affiliates:

      

Earned Premium

     (1,801,731 )     (1,406,630 )     (386,589 )

Losses Incurred

     —         —         —    

Commission Expense

     —         —         —    
                        

Net (Loss)

     (1,801,731 )     (1,406,630 )     (386,589 )
                        

Total:

      

Earned Premium

     (5,667,103 )     (4,758,574 )     (3,062,695 )

Losses Incurred

     (2,713,643 )     (576,350 )     (1,391,345 )

Commission Expense

     (425,569 )     (321,824 )     (309,141 )
                        

Net (Loss)

   $ (2,527,891 )   $ (3,860,400 )   $ (1,362,209 )
                        
     December 31,        
     2007     2006        

Balance Sheet:

      

Receivables on Unpaid Losses

   $ 4,093,556     $ 2,380,370    

Premiums Receivable

   $ 1,817,495     $ 53,166    

Prepaid Reinsurance Premium

   $ 1,645,095     $ 1,387,964    

Premiums Payable

   $ 1,327,239     $ 1,361,347    

The increase in the working cover earned premiums and the addition of other nonaffiliated programs is due to the addition of Alliance. The fluctuation in working cover losses incurred is due to normal reserving activities as additional information is obtained regarding a claim along with claim settlements made during the year. The increase in catastrophe earned premiums in 2007 and 2006 is the result of renegotiation of the catastrophe program.

Receivables on unpaid losses and premiums receivable increased in 2007 primarily due to the addition of Alliance.

The Company’s subsidiaries are participants in a Pooling Agreement with the Mutual Group and Specialty in which each participant cedes premiums, losses and underwriting expenses on all of their direct property casualty business to Mutual, and Mutual, in turn, retrocedes to each participant a specified portion of premiums, losses and underwriting expenses based on each participant’s pooling percentage. Refer to Note 2 – Pooling Agreement and Note 13 – Reinsurance in the Notes to Consolidated Financial Statements for further information.

 

57


Table of Contents

Life – Ceded

The Company’s life insurance subsidiary reinsures portions of its risks with other insurers under yearly renewable term agreements and coinsurance agreements. Generally, Life will not retain more than $500 thousand of individual life insurance on a single risk with the exception of COLI and group policies where the retention is limited to $100 thousand per individual. The amount retained on an individual life will vary depending upon age and mortality prospects of the risk. At December 31, 2007, Life had total insurance inforce of $24.4 billion of which $2.6 billion was ceded to other insurers. In addition, reserve credits of $10.6 million have been taken as a result of the ceding of these inforce amounts to other insurers. Although reinsurance does not legally discharge the subsidiary from primary liability for the full amount of a policy claim, it does make the assuming reinsurer liable to the extent of the reinsurance ceded. The Company evaluates the financial condition of its reinsurers and monitors concentration of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurance to minimize exposure to significant losses from reinsurance insolvencies. None of the reinsurance receivable amounts have been deemed to be uncollectible at December 31, 2007.

The following table details the impact of nonaffiliated reinsurance ceded for the years ended December 31, 2007, 2006 and 2005:

 

     Years Ended December 31,  
     2007     2006     2005  

Income Statement:

      

Premiums Paid

   $ (6,750,115 )   $ (6,186,567 )   $ (5,713,469 )

Losses Incurred

     (6,555,094 )     (7,582,269 )     (5,615,471 )
                        

Net Income (Loss)

   $ (195,021 )   $ 1,395,702     $ (97,998 )
                        
     December 31,        
     2007     2006        

Balance Sheet:

      

Receivables on Unpaid Losses

   $ 1,940,016     $ 455,413    

Policy Reserve Credits

   $ 10,649,217     $ 9,069,877    

Premiums Payable

   $ 1,226,150     $ 989,555    

The decrease in losses incurred is the result of a large recovery in the first quarter of 2006 offset by growth in claims reported with reinsurance ceded coverage as well as increases in the dollar amounts of such claims. Receivables on unpaid losses increased in 2007 due to a large claim that occurred in the third quarter.

Effective July 1, 2006, Life entered into a new Accidental Death Catastrophic Reinsurance Agreement. The new agreement covers accidental death exposure in the portfolio by providing attritional and catastrophic protection with Life retaining the first $7.5 million of claims through June 30, 2007. Effective July 1, 2007, Life’s retention increased to the first $8.25 million of claims.

Property Casualty – Assumed

The Company participates in a small number of involuntary pools and underwriting associations on a direct basis and receives a proportional share through the Pooling Agreement. In addition, the Company received a proportional share of Fire’s quota share reinsurance treaty with Virginia Mutual through the Pooling Agreement in 2005 and 2006. Effective January 1, 2007, the quota share agreement between Fire and Virginia Mutual was terminated. AVIC directly participates in a reinsurance program in the state of Texas assuming nonstandard automobile business which is retroceded to the pool.

 

58


Table of Contents

Geographic Concentration

The Company’s property casualty insurance business is generated in 12 states, with the majority of the business generated in 3 southeastern states, and its life insurance business is generated in 3 states. Accordingly, unusually severe storms or other disasters in these states might have a more significant effect on the Company than a more geographically diversified company and could have an adverse impact on the Company’s financial condition and operating results. The Company’s catastrophe protection program, which began November 1, 1996, reduces the potential adverse impact and earnings volatility caused by such catastrophe exposures.

Legal Environment

Lawsuits brought by policyholders or third-party claimants can create volatility in the Company’s earnings. The Company maintains in-house legal staff and, as needed, secures the services of external legal firms to present and protect its position. Certain legal proceedings are in process at December 31, 2007. These proceedings involve alleged breaches of contract, torts, including bad faith and fraud claims, and miscellaneous other causes of action. These lawsuits involve claims for unspecified amounts of compensatory damages, mental anguish damages and punitive damages. Costs for these and similar proceedings, including accruals for outstanding cases, are included in the financial statements of the Company. Management periodically reviews reserves established to cover potential costs of litigation including legal fees and potential damage assessments and adjusts them based on their best estimates. It should be noted that in Mississippi and Alabama, where the Company has substantial business, the likelihood of a judgment in any given suit, including a large mental anguish and/or punitive damage award by a jury, bearing little or no relation to actual damages, continues to exist, creating the potential for unpredictable material adverse financial results.

Increased public interest in the availability and affordability of insurance has prompted legislative, regulatory and judicial activity in several states. This includes efforts to contain insurance prices, restrict underwriting practices and risk classifications, mandate rate reductions and refunds, eliminate or reduce exemptions from antitrust laws and generally expand regulation. Because of Alabama’s low automobile rates as compared to rates in most other states, the Company does not expect the type of punitive legislation and initiatives found in some states to be a factor in its primary market in the immediate future. In 1999, the Alabama legislature passed a tort reform package that has helped to curb some of the excessive litigation experienced in the late 1990s.

FINANCIAL ACCOUNTING DEVELOPMENTS

On January 1, 2007 the Company adopted SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an Amendment of FASB Statements No. 133 and 140. This statement provides clarification and additional guidance regarding derivative accounting, as well as allows the election of fair value measurement at acquisition, at issuance, or when a previously recognized financial instrument is subject to a remeasurement event, on an instrument-by-instrument basis, in cases in which a hybrid financial instrument that contains a derivative would otherwise require bifurcation in accordance with SFAS No. 133. The adoption of this statement did not have an impact on the Company’s financial position or results of operations at January 1, 2007, or for the year ended December 31, 2007.

On January 1, 2007, the Company adopted SFAS No. 156, Accounting for Servicing of Financial Assets, an Amendment of Statement No. 140. This statement requires entities to recognize a servicing asset or liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations. It also requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value and allows a choice of either the amortization or fair value measurement method for subsequent measurement. The adoption of this statement did not have an impact on the Company’s financial position or results of operations.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This statement establishes a common definition for fair value to be applied to U.S. GAAP guidance requiring the use of fair value. It also

 

59


Table of Contents

outlines the framework for measuring fair value and expands disclosure about fair value measurements. In February 2008, the FASB issued FASB Staff Position (FSP) 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13, and FSP 157-2, Effective Date of FASB Statement No. 157. FSP 157-1 amends SFAS No. 157 to remove certain lease transactions from its scope. FSP 157-2 delays the effective date of SFAS No. 157 for all non-financial assets and non-financial liabilities, except for items recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of the first quarter of 2009 for the Company. The measurement and disclosure requirements related to financial assets and financial liabilities are effective for the Company beginning in the first quarter of 2008. The adoption of SFAS No. 157 for financial assets and financial liabilities is not expected to have a significant impact on the Company’s financial position or results of operations. However, the resulting fair values calculated under SFAS No. 157 after adoption may be different from the fair values calculated under previous guidance. The Company is currently evaluating the impact SFAS No. 157 will have on its financial position and results of operations when it is applied to non-financial assets and non-financial liabilities beginning in the first quarter of 2009.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115, which will become effective at the beginning of the fiscal year that begins after November 15, 2007. SFAS No. 159 permits entities to measure eligible financial assets, financial liabilities and firm commitments at fair value, on an instrument-by-instrument basis, that are otherwise not permitted to be accounted for at fair value under other generally accepted accounting principles. The fair value measurement election is irrevocable and subsequent changes in fair value must be recorded in earnings. The Company has elected not to measure eligible items at fair value upon initial adoption on January 1, 2008 and does not believe the adoption of this statement will have a significant impact on its financial position or results of operations.

In June 2007, the FASB ratified the Emerging Issues Task Force (EITF) consensus on EITF Issue No. 06-11, Accounting for Income Tax Benefits on Dividends on Share-Based Payment Awards. This EITF indicates that tax benefits of dividends on unvested restricted stock are to be recognized in equity as an increase in the pool of excess tax benefits. Should the related awards forfeit or no longer become expected to vest, the benefits are to be reclassified from equity to the income statement. The EITF is effective for fiscal years beginning after December 15, 2007. The Company adopted the EITF effective January 1, 2008 and does not currently believe this consensus will have a significant impact on its financial position or results of operations.

In December 2007, the FASB issued SFAS No. 141(R), Business Combinations, and SFAS No. 160, Accounting and Reporting of Noncontrolling Interest in Consolidated Financial Statements, an amendment of ARB No. 51. These statements will significantly change the accounting for and reporting of business combination transactions and noncontrolling (minority) interests in consolidated financial statements. SFAS No. 141(R) retains the fundamental requirements in SFAS No. 141, Business Combinations, while providing additional definitions, such as the definition of the acquirer in a purchase and improvements in the application of how the acquisition method is applied. SFAS No. 160 will change the accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests, and classified as a component of equity. These statements will simultaneously become effective for the Company on January 1, 2009. The Company is currently evaluating the impact these statements may have on its financial position or results of operations upon adoption.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

The Company’s objectives in managing its investment portfolio are to maximize investment income and investment returns while minimizing overall credit risk. Investment strategies are developed based on many factors including underwriting results, overall tax position, regulatory requirements and fluctuations in interest rates. Investment decisions are made by management and approved by the Board of Directors. Market risk represents the potential for loss due to adverse changes in the fair value of securities. The market risk related to the Company’s fixed maturity portfolio is primarily interest rate risk and prepayment risk. The market risk related to the Company’s equity portfolio is equity price risk.

 

60


Table of Contents

Interest Rate Risk

The Company’s fixed maturity investments and borrowings are subject to interest rate risk. Increases and decreases in interest rates typically result in decreases and increases in the fair value of these financial instruments.

The Company’s fixed maturity portfolio is invested predominantly in high quality corporate, mortgage-backed, government agency and municipal bonds. The portfolio has an average effective duration of 4.67 years and an average quality rating of AAA. The changes in the fair value of the fixed maturity available for sale portfolio are presented as a component of stockholders’ equity in accumulated other comprehensive income, net of taxes.

The Company works to manage the impact of interest rate fluctuations on its fixed maturity portfolio. The effective duration of the portfolio is managed to diversify its distribution. This duration distribution, as well as the portfolio’s moderate duration, serves to lessen the impact of large swings in interest rates on the fixed maturity portfolio.

The estimated fair value of the Company’s investment portfolio at December 31, 2007 was $2.2 billion, 58.6% of which was invested in fixed maturities, 4.0% in equity securities, 6.3% in collateral loans, 18.5% in short-term investments and 12.6% in other long-term investments including investments in affiliates.

The table below summarizes the Company’s interest rate risk and shows the effect of a hypothetical change in interest rates as of December 31, 2007. The selected hypothetical changes do not indicate what would be the potential best or worst-case scenarios.

 

61


Table of Contents

(dollars in thousands)

   Estimated
Fair Value at
December 31,
2007
  

Estimated Change

in Interest Rate
(bp=basis points)

   Estimated
Fair Value
After
Hypothetical
Change in
Interest Rate
   Hypothetical
Percentage
Increase
(Decrease) in
Stockholders’
Equity
 

Fixed Maturity Investments

           

U.S. Treasury Securities and obligations of U.S. government corporations and agencies

   $ 263,234    200 bp decrease    $ 268,350    0.3 %
      100 bp decrease      265,629    0.2 %
      100 bp increase      255,297    (0.5 )%
      200 bp increase      242,835    (1.3 )%

Tax-exempt obligations of states, municipalities and political subdivisions

   $ 221,487    200 bp decrease    $ 242,515    2.0 %
      100 bp decrease      231,914    1.0 %
      100 bp increase      210,225    (1.1 )%
      200 bp increase      198,349    (2.2 )%

Mortgage-backed securities

   $ 528,803    200 bp decrease    $ 554,641    1.6 %
      100 bp decrease      549,858    1.3 %
      100 bp increase      486,042    (2.7 )%
      200 bp increase      439,231    (5.6 )%

Asset-backed securities

   $ 57,200    200 bp decrease    $ 59,788    0.2 %
      100 bp decrease      58,471    0.1 %
      100 bp increase      55,971    (0.1 )%
      200 bp increase      54,774    (0.2 )%

Corporate, taxable municipal and other debt securities

   $ 235,675    200 bp decrease    $ 257,102    1.3 %
      100 bp decrease      246,005    0.6 %
      100 bp increase      223,705    (0.8 )%
      200 bp increase      212,700    (1.4 )%

Total Fixed Maturity Investments

   $ 1,306,399    200 bp decrease    $ 1,382,396    4.8 %
      100 bp decrease      1,351,877    2.9 %
      100 bp increase      1,231,240    (4.7 )%
      200 bp increase      1,147,889    (9.9 )%

Collateral Loans

   $ 140,300    200 bp decrease    $ 147,156    *  
      100 bp decrease      145,887    *  
      100 bp increase      128,955    *  
      200 bp increase      116,535    *  

Short-Term Investments

   $ 413,003    200 bp decrease    $ 421,031    0.2 %
      100 bp decrease      416,761    0.1 %
      100 bp increase      400,550    (0.3 )%
      200 bp increase      380,999    (0.7 )%

Liabilities

           

4.75% to 5.27% Commercial Paper

   $ 197,367    200 bp decrease    $ 201,203    *  
      100 bp decrease      199,163    *  
      100 bp increase      191,416    *  
      200 bp increase      182,073    *  

Short-Term Notes Payable

   $ 31,402    200 bp decrease    $ 32,013    *  
      100 bp decrease      31,688    *  
      100 bp increase      30,456    *  
      200 bp increase      28,969    *  

 

* Changes in estimated fair value have no impact on stockholders’ equity.

 

62


Table of Contents

Equity Price Risk

The Company invests in equity securities that have historically, over long periods of time, produced higher returns relative to fixed maturity investments. The Company seeks to invest at reasonable prices in companies with solid business plans and capable management. The Company intends to hold these investments over the long-term. This focus on long-term total investment returns may result in variability in the level of unrealized investment gains and losses from one period to the next. The changes in the estimated fair value of the equity portfolio are presented as a component of stockholders’ equity in accumulated other comprehensive income, net of taxes.

At December 31, 2007, the Company’s equity portfolio was concentrated in terms of the number of issuers and industries. The Company’s top ten equity holdings represented $29.5 million, or 32.7% of the equity portfolio. Investments in the financial holdings sector represented 29.7% while the technology, materials and industrials sectors represented 18.1%, 10.9% and 10.7%, respectively, of the equity portfolio. No other sector represented over 10% of the equity portfolio. Such concentration can lead to higher levels of short-term price volatility. Due to its long-term investment focus, the Company is not as concerned with short-term volatility as long as its subsidiaries’ ability to write business is not impaired.

The table below summarizes the Company’s equity price risk and shows the effect of a hypothetical 20% increase and a 20% decrease in market prices as of December 31, 2007. The selected hypothetical changes do not indicate what could be the potential best or worst-case scenarios.

 

Estimated Fair Value of Equity Securities at December 31, 2007

  

Hypothetical
Price Change

   Estimated
Fair Value
After
Hypothetical
Change in
Prices
   Hypothetical
Percentage
Increase
(Decrease) in
Stockholders’
Equity
(dollars in thousands)               

$90,043

   20% increase    $ 108,051    2.1% 
   20% decrease    $ 72,034    (2.1)%

 

63


Table of Contents
Item 8. Financial Statements and Supplementary Data.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

      Page

Report of Independent Registered Public Accounting Firm

   65

Report of Independent Registered Public Accounting Firm

   66

Consolidated Balance Sheets

   67

Consolidated Statements of Income

   68

Consolidated Statements of Stockholders’ Equity

   69

Consolidated Statements of Cash Flows

   70

Notes to Consolidated Financial Statements

   71

 

64


Table of Contents

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of Alfa Corporation (the “Company”):

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of the Company and its subsidiaries at December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15 (a)(2) presents fairly, in all material respects, the information set forth therein at December 31, 2007 and 2006 and for the two years in the period ended December 31, 2007 when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

As discussed in Note 14 to the consolidated financial statements, the Company changed the manner in which it accounts for share-based compensation effective January 1, 2006. As discussed in Note 1 and Note 6 to the consolidated financial statements, the Company changed the manner in which it accounts for deferred acquisition costs associated with modifications or exchanges of insurance contracts effective January 1, 2007.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

PricewaterhouseCoopers LLP

Birmingham, Alabama

March 11, 2008

 

65


Table of Contents

Report of Independent Registered Public Accounting Firm

To the Stockholders and Board of Directors

Alfa Corporation:

We have audited the accompanying consolidated statement of income, stockholders’ equity and comprehensive income (loss), and cash flows of Alfa Corporation and subsidiaries (the Company) for the year ended December 31, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the Company’s result of their operations and their cash flows for the year ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.

KPMG LLP

Birmingham, Alabama

March 7, 2006

 

66


Table of Contents

ALFA CORPORATION

CONSOLIDATED BALANCE SHEETS

 

     December 31,  
    2007     2006  

Assets

   

Investments:

   

Fixed Maturities Held for Investment, at amortized cost (fair value $32,336 in 2007

and $57,272 in 2006)

  $ 30,217     $ 55,052  

Fixed Maturities Available for Sale, at fair value (amortized cost $1,307,168,345 in

2007 and $1,436,188,473 in 2006)

    1,306,366,704       1,446,693,702  

Equity Securities Available for Sale, at fair value (cost $92,812,252 in 2007 and

$101,177,606 in 2006)

    90,042,579       111,427,207  

Policy Loans

    67,697,107       64,949,875  

Collateral Loans

    121,505,553       128,685,111  

Other Long-Term Investments

    85,966,116       86,823,771  

Short-Term Investments, at fair value (amortized cost $412,967,736 in 2007 and

$167,683,154 in 2006)

    413,003,223       167,683,154  
               

Total Investments

    2,084,611,499       2,006,317,872  

Cash

    35,059,563       37,218,109  

Other Long-Term Investments in Affiliates

    126,753,594       120,819,010  

Accrued Investment Income

    15,800,561       17,026,711  

Accounts Receivable

    98,749,778       84,100,246  

Reinsurance Balances Receivable

    10,004,929       6,015,853  

Deferred Policy Acquisition Costs

    235,137,674       224,516,950  

Goodwill

    9,576,218       9,576,218  

Other Intangible Assets (net of accumulated amortization of $2,050,200 in 2007 and

$1,366,800 in 2006)

    7,057,800       7,741,200  

Other Assets

    19,001,569       20,906,925  
               

Total Assets

  $ 2,641,753,185     $ 2,534,239,094  
               

Liabilities and Stockholders’ Equity

   

Policy Liabilities and Accruals - Property Casualty Insurance

  $ 187,701,565     $ 172,664,652  

Policy Liabilities and Accruals - Life Insurance Interest-Sensitive Products

    687,237,890       646,354,761  

Policy Liabilities and Accruals - Life Insurance Other Products

    221,835,651       205,449,027  

Unearned Premiums

    240,275,755       236,481,371  

Dividends to Policyholders

    12,190,719       11,882,776  

Premium Deposit and Retirement Deposit Funds

    4,534,402       4,921,879  

Deferred Income Taxes

    3,171,775       25,547,554  

Other Liabilities

    80,051,500       75,222,398  

Due to Affiliates

    27,621,447       24,355,859  

Commercial Paper

    197,367,051       206,923,215  

Notes Payable

    70,000,000       70,000,000  

Notes Payable to Affiliates

    31,402,470       27,516,459  
               

Total Liabilities

    1,763,390,225       1,707,319,951  
               

Commitments and Contingencies (Note 11)

   

Stockholders’ Equity :

   

Preferred Stock, $1 par value

   

Shares authorized: 1,000,000

    —         —    

Issued: None

   

Common Stock, $1 par value

   

Shares authorized: 110,000,000

   

Issued: 83,783,024

   

Outstanding: 80,761,779 in 2007 and 80,459,113 in 2006

    83,783,024       83,783,024  

Additional Paid-In Capital

    34,169,542       27,502,452  

Accumulated Other Comprehensive Income (unrealized gains/(losses) on securities

available for sale, net of tax, of ($662,496) in 2007 and $14,019,988 in 2006;

pension liability adjustment, net of tax, of $703,495 in 2007; unrealized gains on

interest rate swap contract, net of tax, of $105,541 in 2006; unrealized gains on

other long-term investments, net of tax, of $306,260 in 2007 and $75,006 in

2006)

    347,259       14,200,535  

Retained Earnings

    794,972,513       738,811,778  

Treasury Stock, at cost (shares, 3,021,245 in 2007 and 3,323,911 in 2006)

    (34,909,378 )     (37,378,646 )
               

Total Stockholders’ Equity

    878,362,960       826,919,143  
               

Total Liabilities and Stockholders’ Equity

  $ 2,641,753,185     $ 2,534,239,094  
               

See accompanying Notes to Consolidated Financial Statements.

 

67


Table of Contents

ALFA CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

 

      Years Ended December 31,
     2007     2006    2005

Revenues

       

Premiums - Property Casualty Insurance

   $ 625,938,511     $ 604,241,557    $ 556,438,727

Premiums - Life Insurance

     50,740,513       46,019,117      41,134,144

Policy Charges - Life Insurance

     38,159,251       36,825,726      35,499,178

Net Investment Income

     94,804,825       93,262,710      94,931,739

Net Realized Investment Gains (Losses)

     (1,103,010 )     3,402,230      6,050,873

Other Income

     27,685,404       28,386,795      22,849,897
                     

Total Revenues

     836,225,494       812,138,135      756,904,558
                     

Benefits, Losses and Expenses

       

Benefits, Claims, Losses and Settlement Expenses

     480,548,807       458,175,979      432,856,310

Dividends to Policyholders

     4,246,480       4,134,455      4,009,119

Amortization of Deferred Policy Acquisition Costs

     134,741,937       130,041,533      108,723,470

Other Operating Expenses

     92,083,066       80,790,556      73,453,925
                     

Total Benefits, Losses and Expenses

     711,620,290       673,142,523      619,042,824
                     

Income Before Income Tax Expense

     124,605,204       138,995,612      137,861,734

Income Tax Expense

     31,096,737       33,107,375      38,827,981
                     

Net Income

   $ 93,508,467     $ 105,888,237    $ 99,033,753
                     

Net Income Per Share

       

- Basic

   $ 1.16     $ 1.32    $ 1.24
                     

- Diluted

   $ 1.15     $ 1.30    $ 1.23
                     

Weighted Average Shares Outstanding

       

- Basic

     80,611,623       80,345,906      80,141,068
                     

- Diluted

     81,663,529       81,211,111      80,712,923
                     

See accompanying Notes to Consolidated Financial Statements.

 

68


Table of Contents

ALFA CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

 

      Common
Stock
   Additional
Paid-In
Capital
    Accumulated
Other
Comprehensive
Income (Loss)
    Retained
Earnings
    Treasury
Stock
    Total  

Balance, December 31, 2004

   $ 83,783,024    $ 10,961,782     $ 38,060,371     $ 599,609,509     $ (40,962,378 )   $ 691,452,308  

Net Income

            99,033,753         99,033,753  

Other Comprehensive Income, net of tax:

             

Change in Net Unrealized Investment Gains (Losses), net of reclassification adjustment

          (17,344,869 )         (17,344,869 )

Change in Unrealized Gain (Loss) on Interest Rate Swap Contract

          1,395,482           1,395,482  

Change in Unrealized Gain (Loss) on Other Long-Term Investments

          (411,125 )         (411,125 )
                   

Total Other Comprehensive (Loss)

                (16,360,512 )
                   

Comprehensive Income

                82,673,241  

Additional Capital Contribution

        4,836,140             4,836,140  

Issuance of Treasury Shares for Acquisition (325,035 shares)

        2,218,848           2,781,152       5,000,000  

Dividends to Stockholders ($.3875 per share)

            (31,108,206 )       (31,108,206 )

Purchase of Treasury Stock (219,000 shares)

              (2,960,751 )     (2,960,751 )

Share-Based Compensation

        282,812             282,812  

Exercise of Stock Options (344,516 shares) and reclassification

        2,871,880           2,944,752       5,816,632  
                                               

Balance, December 31, 2005

     83,783,024      21,171,462       21,699,859       667,535,056       (38,197,225 )     755,992,176  

Net Income

            105,888,237         105,888,237  

Other Comprehensive Income, net of tax:

             

Change in Net Unrealized Investment Gains (Losses), net of reclassification adjustment

          (8,085,696 )         (8,085,696 )

Change in Unrealized Gain (Loss) on Interest Rate Swap Contract

          116,806           116,806  

Change in Unrealized Gain (Loss) on Other Long-Term Investments

          469,566           469,566  
                   

Total Other Comprehensive (Loss)

                (7,499,324 )
                   

Comprehensive Income

                98,388,913  

Dividends to Stockholders ($.43 per share)

            (34,611,515 )       (34,611,515 )

Purchase of Treasury Stock (97,500 shares)

              (1,512,869 )     (1,512,869 )

Share-Based Compensation

        5,366,308             5,366,308  

Release of Restricted Share Awards (12,271 shares)

        (102,913 )         102,913       —    

Exercise of Stock Options (260,324 shares)

        1,067,595           2,228,535       3,296,130  
                                               

Balance, December 31, 2006

     83,783,024      27,502,452       14,200,535       738,811,778       (37,378,646 )     826,919,143  

Net Income

            93,508,467         93,508,467  

Other Comprehensive Income, net of tax:

             

Change in Net Unrealized Investment Gains (Losses), net of reclassification adjustment

          (14,682,484 )         (14,682,484 )

Change in Unrealized Gain (Loss) on Interest Rate Swap Contract

          (105,541 )         (105,541 )

Change in Unrealized Gain (Loss) on Other Long-Term Investments

          231,254           231,254  

Pension Liability Adjustment

          703,495           703,495  
                   

Total Other Comprehensive (Loss)

                (13,853,276 )
                   

Comprehensive Income

                79,655,191  

Dividends to Stockholders ($.4625 per share)

            (37,347,732 )       (37,347,732 )

Share-Based Compensation

        5,128,905             5,128,905  

Exercise of Stock Options (302,666 shares)

        1,538,185           2,469,268       4,007,453  
                                               

Balance, December 31, 2007

   $ 83,783,024    $ 34,169,542     $ 347,259     $ 794,972,513     $ (34,909,378 )   $ 878,362,960  
                                               

See accompanying Notes to Consolidated Financial Statements.

 

69


Table of Contents

ALFA CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

      Years Ended December 31,  
     2007     2006     2005  

Cash Flows From Operating Activities:

      

Net Income

   $ 93,508,467     $ 105,888,237     $ 99,033,753  

Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:

      

Policy Acquisition Costs Deferred

     (143,660,436 )     (148,261,850 )     (126,165,508 )

Amortization of Deferred Policy Acquisition Costs

     134,741,937       130,041,533       108,723,470  

Depreciation and Amortization

     9,279,874       7,428,717       5,089,466  

Stock-Based Compensation

     3,242,107       3,469,135       415,817  

Excess Tax Benefits from Stock-Based Compensation

     (790,929 )     (558,512 )     —    

Deferred Income Tax

     (9,288,407 )     466,694       (306,215 )

Interest Credited on Policyholders’ Funds

     30,487,655       28,807,284       28,281,912  

Net Realized Investment (Gains) Losses

     1,103,010       (3,402,230 )     (6,050,873 )

(Earnings) Losses in Equity-Method Investments, Net of Cash Distributions Received

     3,606,578       (2,436,192 )     (4,941,468 )

Other, Net

     (4,322,784 )     2,569,586       (1,553,119 )

Changes in Operating Assets and Liabilities:

      

Accrued Investment Income

     1,345,130       (168,303 )     (100,420 )

Accounts Receivable

     3,629,458       (11,042,915 )     (18,999,520 )

Reinsurance Balances Receivable

     16,552,347       632,351       (1,368,644 )

Other Assets

     15,943,250       1,018,237       (2,256,881 )

Policy Reserves

     9,614,250       24,347,606       20,807,581  

Unearned Premiums

     (17,649,608 )     14,616,501       35,385,333  

Amounts Held for Others

     (79,534 )     (598,501 )     (228,101 )

Other Liabilities

     197,559       (4,933,102 )     13,729,555  

Due to/from Affiliates

     (619,601 )     4,003,086       (9,255,486 )
                        

Net Cash Provided by Operating Activities

     146,840,323       151,887,362       140,240,652  
                        

Cash Flows From Investing Activities:

      

Maturities and Redemptions of Fixed Maturities Held for Investment

     20,334       33,052       26,211  

Maturities and Redemptions of Fixed Maturities Available for Sale

     220,193,316       287,911,669       393,899,269  

Maturities and Redemptions of Other Investments

     25,228,032       28,372,246       4,291,897  

Sales of Fixed Maturities Available for Sale

     176,309,784       101,700,623       108,372,196  

Sales of Equity Securities

     200,028,094       170,557,091       137,282,425  

Sales of Commercial Leases

     —         —         6,082,177  

Sales of Other Investments and Other Assets

     1,948,804       2,575,915       1,389,451  

Return of Capital Distributions from Equity-Method Investments

     —         76,813       602,286  

Purchases of Fixed Maturities Available for Sale

     (262,913,768 )     (427,986,542 )     (591,177,592 )

Purchases of Equity Securities

     (185,045,013 )     (166,811,284 )     (139,811,006 )

Purchases of Other Investments and Other Assets

     (54,181,672 )     (36,702,995 )     (31,261,395 )

Origination of Consumer Loans Receivable

     (49,088,391 )     (71,712,711 )     (73,540,434 )

Principal Payments on Consumer Loans Receivable

     56,257,165       63,650,546       59,170,054  

Origination of Commercial Leases Receivable

     —         —         (21,665,208 )

Principal Payments on Commercial Leases Receivable

     1,724,247       741,119       37,441,421  

Net Change in Short-term Investments

     (238,903,970 )     (83,353,073 )     (9,515,299 )

Net Change in Receivable/Payable on Securities

     (9,492,978 )     (1,606,222 )     3,886,479  

Net Proceeds from Sales of Subsidiaries

     —         —         2,252,520  

Purchase of Subsidiary, Net of Cash Acquired

     —         —         (12,702,438 )
                        

Net Cash Used in Investing Activities

     (117,916,016 )     (132,553,753 )     (124,976,986 )
                        

Cash Flows From Financing Activities:

      

Change in Commercial Paper

     (9,556,164 )     (6,867,228 )     9,487,237  

Change in Notes Payable

     (1,524,878 )     —         —    

Change in Notes Payable to Affiliates

     3,886,011       6,628,824       5,000,000  

Stockholder Dividends Paid

     (37,347,732 )     (34,611,515 )     (31,108,206 )

Purchases of Treasury Stock

     —         (1,512,869 )     (2,960,751 )

Proceeds from Exercise of Stock Options

     3,297,905       2,775,392       3,028,748  

Excess Tax Benefits from Stock-Based Compensation

     790,929       558,512       —    

Deposits of Policyholders’ Funds

     72,741,513       74,018,163       72,109,506  

Withdrawal of Policyholders’ Funds

     (63,370,437 )     (60,333,418 )     (53,644,054 )
                        

Net Cash Provided by (Used in) Financing Activities

     (31,082,853 )     (19,344,139 )     1,912,480  
                        

Net Change in Cash

     (2,158,546 )     (10,530 )     17,176,146  

Cash - Beginning of Period

     37,218,109       37,228,639       20,052,493  
                        

Cash - End of Period

   $ 35,059,563     $ 37,218,109     $ 37,228,639  
                        

See accompanying Notes to Consolidated Financial Statements.

 

70


Table of Contents

ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

In the opinion of the management of Alfa Corporation and its subsidiaries (the Company), the accompanying consolidated financial statements contain all adjustments (consisting primarily of normal recurring accruals) necessary to present fairly its financial position, results of operations and cash flows. The accompanying consolidated financial statements have been prepared on the basis of accounting principles generally accepted in the United States of America (GAAP).

Statutory Practices: Generally accepted accounting principles differ in certain respects from the statutory accounting practices prescribed or permitted by insurance regulatory authorities. Prescribed statutory accounting practices include state laws, regulations and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (NAIC). Permitted statutory accounting practices encompass all accounting practices that are not prescribed. Such practices differ from state-to-state, may differ from company-to-company within a state and may change in the future. Currently, the Company’s statutory net income and surplus is the same under NAIC accounting practices and the State of Alabama for Alfa Life Insurance Corporation, Alfa Insurance Corporation, Alfa General Insurance Corporation and Alfa Vision Insurance Corporation and the Commonwealth of Virginia for Alfa Alliance Insurance Corporation.

Consolidation

The consolidated financial statements include, after intercompany eliminations, Alfa Corporation and its wholly-owned subsidiaries:

 

   

Alfa Insurance Corporation (AIC)

 

   

Alfa General Insurance Corporation (AGI)

 

   

Alfa Vision Insurance Corporation (AVIC)

 

   

Alfa Alliance Insurance Corporation (Alliance)

 

   

Alfa Life Insurance Corporation (Life)

 

   

Alfa Financial Corporation (Financial)

 

   

The Vision Insurance Group, LLC (Vision)

 

   

Alfa Agency Mississippi, Inc. (AAM)

 

   

Alfa Agency Georgia, Inc. (AAG)

 

   

Alfa Benefits Corporation (ABC)

Affiliates

Alfa Corporation is affiliated with Alfa Mutual Insurance Company, Alfa Mutual Fire Insurance Company and Alfa Mutual General Insurance Company (collectively, the Mutual Group). The Mutual Group owns 55.0% of Alfa Corporation’s common stock, their largest single investment. Alfa Specialty Insurance Corporation (Specialty) is a wholly-owned subsidiary of Alfa Mutual Insurance Company (Mutual). The Company together with the Mutual Group and Specialty comprise the Alfa Group (Alfa). Prior to January 1, 2007, Virginia Mutual Insurance Company (Virginia Mutual) ceded 80% of its direct business to Alfa Mutual Fire Insurance Company (Fire) under a Strategic Affiliation Agreement signed in August 2001. On January 1, 2007, Virginia Mutual demutualized and Alfa Alliance Insurance Corporation (Alliance), a new subsidiary of the Company, was formed.

Nature of Operations

Alfa Corporation operates predominantly in the insurance industry. During 2007, its insurance subsidiaries wrote life insurance in Alabama, Georgia and Mississippi and property casualty insurance in Arkansas, Florida, Georgia, Indiana, Kentucky, Mississippi, Missouri, North Carolina, Ohio, Tennessee and Virginia. In addition, AVIC assumed business in Texas.

As more fully discussed in Note 2 – Pooling Agreement, the Company’s property casualty insurance business is pooled with that of the Mutual Group, which writes property casualty business in Alabama, and

 

71


Table of Contents

Specialty, which writes nonstandard auto business in Alabama, Georgia, Mississippi and Virginia. The Company’s pooled business is concentrated geographically in Alabama, Georgia and Mississippi with $543 million of premiums and policy charges, or 76%, generated during 2007 from policies written in Alabama. Accordingly, unusually severe storms or other disasters in this state might have a more significant effect on the Company than on a more geographically diversified insurance company and could have an adverse impact on the Company’s financial condition and operating results. Increasing public interest in the availability and affordability of insurance has prompted legislative, regulatory and judicial activity in several states. This includes efforts to contain insurance prices, restrict underwriting practices and risk classifications, mandate rate reductions and refunds, eliminate or reduce exemptions from antitrust laws and generally expand regulation. Because of Alabama’s low automobile rates as compared to rates in most other states, the Company does not expect the type of punitive legislation and initiatives found in some states to be a factor in its primary market in the immediate future.

The Company’s noninsurance subsidiaries are engaged in consumer financing, commercial leasing, agency operations and benefits administration.

Use of Estimates in the Preparation of the Financial Statements

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates and assumptions are particularly important in determining reserves for future policyholder benefits, reserves for losses and loss adjustment expenses payable, evaluation of other-than-temporary impairments on investments, capitalization and amortization of deferred policy acquisition costs and reserves relating to litigation. Actual results could differ from those estimates.

Revenues, Benefits, Claims and Expenses

Traditional Life Insurance Products: Traditional life insurance products include those products with fixed and guaranteed premiums and benefits and consist principally of whole life insurance policies, term life insurance policies and certain annuities with life contingencies. Premiums are recognized as revenue over the premium-paying period of the policy when due. The liability for future policy benefits is computed using a net level method including assumptions as to investment yields, mortality, withdrawals and other assumptions based on the Company’s experience, modified as necessary, to reflect anticipated trends and to include provisions for possible unfavorable deviations. Policy benefit claims are charged to expense in the period that the claims are incurred.

Universal Life Products: Universal life type products include universal life insurance, other interest-sensitive life insurance policies and annuity products. Universal life revenues, which are considered operating cash flows, consist of policy charges for the cost of insurance, policy administration and surrender charges that have been assessed against policy account balances during the period. The timing of revenue recognition is determined by the nature of the charge. Cost of insurance and policy administrative charges are assessed on a monthly basis and recognized as revenue when remittances are processed. Percent of premium charges are assessed at the time of payment by the policyholder and recognized as revenue when processed. Surrender charges are recognized as revenue upon surrender of a contract by the policyholder in accordance with contractual terms. Benefit reserves for universal life represent policy account balances before applicable surrender charges. Policy benefits and claims that are charged to expense include interest credited to policy account balances on a monthly basis and death claims reported in the period in excess of related policy account balances.

Property Casualty Products: Premiums written are earned ratably over the periods of the related insurance and reinsurance contracts or policies. Unearned premium reserves are established to cover the remainder of the unexpired contract period. Premiums reported are net of ceded premiums. The liability for estimated unpaid property casualty losses and loss adjustment expenses is based upon an evaluation of reported losses and on estimates of incurred but not reported losses. Adjustments to the liability based upon subsequent developments are included in current operations.

 

72


Table of Contents

Share-Based Employee Compensation

The Company recognizes expense for its share-based compensation based on the fair value of the awards that are granted. The fair value of stock options is estimated at the date of grant using the Black-Scholes-Merton option valuation model. Option valuation methods require the input of assumptions, including the expected stock price volatility, expected option term, risk-free interest rate and expected dividend yield. The fair value of nonvested restricted shares is measured at the date of grant using the closing price of the Company’s common stock on the date of grant.

Compensation cost is recognized ratably over the vesting period of the related share-based compensation award to non-retirement eligible employees. Compensation cost is recognized immediately for grants to retirement eligible employees or over the period from the grant date to the date retirement eligibility is achieved.

Taxes

The Company’s method of accounting for income taxes is the liability method in accordance with Statement of Financial Accounting Standard (SFAS) No. 109, Accounting for Income Taxes. Under the liability method, deferred tax assets and liabilities are adjusted to reflect changes in statutory tax rates resulting in income adjustments in the period such changes are enacted. Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and liabilities, based on enacted tax laws and statutory tax rates applicable to the periods in which the temporary difference is expected to reverse. The Company files a consolidated tax return. The method of allocation between subsidiaries is subject to a written agreement, approved by the Board of Directors. The tax liability of the Company is allocated to each subsidiary on the basis of the percentage of total tax of the subsidiary, if computed on a separate return, compared to the total amount of taxes computed for the Company.

On January 1, 2007, the Company adopted the provisions of FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109. FIN 48 prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements and provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition issues.

At the date of adoption, the Company had an unrecognized tax benefit of $2.8 million. No adjustments were made to retained earnings at the date of adoption.

The Company’s policy is to recognize interest and penalties related to uncertain tax positions in income tax expense. At the date of adoption, the amount of interest and penalties included in the consolidated balance sheet was $285 thousand.

The Company files its tax returns as prescribed by the tax laws of the jurisdictions in which it operates. Tax years 2004 through 2006 are still subject to examination by the Internal Revenue Service. There are no federal income tax examinations currently in process. Tax years 2004 through 2006 are still subject to examination by the various state jurisdictions.

The Company does not anticipate any significant changes to its total unrecognized tax benefits within the next 12 months.

On January 1, 2007, the Company adopted Emerging Issues Task Force (EITF) Issue No. 06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation). This consensus requires disclosure of the accounting policy employed by the Company for any tax assessed by a governmental authority that is directly related to a revenue-producing transaction between a seller and a customer. EITF 06-3 requires that taxes be presented in the income statement either on a gross basis (included in revenues and costs) or a net basis (excluded from revenues), and that this accounting policy decision be disclosed. The Company has not changed its accounting policy for reporting taxes collected from customers. Two subsidiaries of the Company collect taxes that are remitted to governmental authorities. AVIC, in the property casualty segment, collects taxes from policyholders and reports the premiums collected on a net basis. Financial, in the noninsurance segment, collects taxes on lease payments from customers and reports the lease revenue on a gross basis. The amount of tax collected is not significant to the amount of revenue reported.

 

73


Table of Contents

Investments

Fixed Maturities: Fixed maturities held for investment include investments that the Company has both the ability and positive intent to hold until maturity; such securities are reported at amortized cost. Securities available for sale include bonds and redeemable preferred stocks that the Company may elect to sell prior to maturity and are reported at their current fair value. The unrealized gains or losses on these securities are reflected in accumulated other comprehensive income within stockholders’ equity, net of taxes. Furthermore, deferred policy acquisition costs for universal and other interest-sensitive life insurance products are adjusted to reflect the effect that would have been recognized had the unrealized holding gains and losses been realized. This adjustment to deferred acquisition costs results in a corresponding adjustment to comprehensive income. The amount of this adjustment before taxes was $1.7 million and $2.0 million in 2007 and 2006, respectively. Amortization of premium or discount is calculated using the scientific (constant yield) interest method and is recorded as an adjustment to investment income. The interest method results in a constant effective yield equal to the prevailing rate at the time of purchase or at the time of subsequent adjustments to book value. Fixed maturities containing call provisions (where the issue can be called away from the Company at the issuer’s discretion) are amortized to the call or maturity value/date that produces the lowest asset value (yield to worst). For mortgage-backed and asset-backed securities, the amortization period reflects estimates of the period over which repayment of principal is expected to occur, not the stated maturity period.

Equity Securities: Equity securities (common and non-redeemable preferred stocks) are carried at fair value. The unrealized gains or losses on these securities are reflected as accumulated other comprehensive income within stockholders’ equity, net of taxes.

Declines in fair values of fixed maturities and equity securities deemed to be other than temporary are recognized in the determination of net income. Generally, realized gains and losses on sales of investments are recognized in net income using the first-in, first-out methodology. In some instances, the Company may use the specific identification method if so directed by the investment portfolio manager. Realized investment gains and losses are reported on a pretax basis as a component of revenues. Income taxes applicable to net realized investment gains and losses are included in the provision for income tax.

Collateral Loans and Commercial Leases: Collateral loans and lease financings, included in other long-term investments, are reported in the balance sheet at outstanding principal balance adjusted for charge-offs and the allowance for losses in accordance with Statement of Position (SOP) 01-6, Accounting by Certain Entities That Lend to or Finance the Activities of Others. The allowance for losses on collateral loans and commercial leases represents the Company’s best estimate of probable losses inherent in the portfolios based on relevant observable data that include, but are not limited to, historical experience, collateral type, account balance and delinquency. Credit losses are deducted from the allowance and charged off in the period in which the loans or leases are deemed uncollectible. Recoveries previously charged off are recorded when received. The Company considers an account to be delinquent if it is thirty or more days late in its scheduled payments. If the account is over 90 days late, the Company considers repossession of the collateral. If collateral is repossessed, the loan or lease is written down against the allowance for losses and the asset is transferred to other assets and carried at the lower of cost or estimated fair value less the cost to dispose. Loans are placed on a nonaccrual status when a bankruptcy is reported or the collateralized assets are repossessed. The Company uses the effective interest method to recognize income on loans and leases. Deferred fees are amortized over the term of the commercial lease.

Other Long-term Investments: Partnerships, joint ventures and unconsolidated investee companies are a component of other long-term investments and other long-term investments in affiliates. With the exception of two partnerships carried at cost, investments in partnerships, joint ventures and unconsolidated investee companies are stated at the underlying audited equity value based on accounting principles generally accepted in the United States of America. Investments are reviewed annually for impairments and adjusted accordingly. It is the Company’s policy to review investments for applicability of Financial Accounting Standards Board Interpretation (FIN) 46(R), Consolidation of Variable Interest Entities. At December 31, 2007, the Company determined that no investment required consolidation based on FIN 46(R) criteria.

Short-term Investments: Short-term investments with maturities of three months or less are considered to be investments and are not considered to be cash or cash equivalents. The Company’s short-term investments include money market funds, bonds and certificates of deposit. Money market mutual funds seek to maintain a stable net asset value of $1.00 per share. There is no assurance that funds will be able to maintain a stable asset value of $1.00 per share. However, the Company’s policy is to invest in money market funds that are rated AAAm and/or Aaa by Standard & Poor’s and/or Moody’s Investor Service,

 

74


Table of Contents

Inc., respectively, or are rated by the NAIC Securities Valuation Office as Class 1. These funds are diversified money market funds investing in Tier 1 commercial paper and bank obligations, U.S. Treasury, U.S. government obligations, certificates of deposits and repurchase agreements. Bonds consist of notes and treasury bills. These securities are carried at fair value with the unrealized gains or losses reflected in accumulated other comprehensive income within stockholders’ equity, net of taxes. Amortization of discount is calculated using the scientific interest method and is recorded as an adjustment to investment income. Certificates of deposit are carried at cost which approximates fair value.

Cash

Cash consists of demand deposits at banks. Fair value equals the carrying value of such assets.

At December 31, 2007, Vision had a carrier contract requiring them to fund a collateral trust based on a percentage of written premiums. The primary purpose was to provide collateral for the payment of all obligations and performance of all duties set forth in the contract. The amount in the trust is reviewed on an annual basis and adjusted accordingly. The amount of cash restricted at December 31, 2007 and 2006 was $1.0 million and $982 thousand, respectively.

Accounts Receivable

Accounts receivable are primarily comprised of premium installment plan receivables from policyholders, insurance policy-related receivables and amounts due from brokers for security trades not yet settled. The allowance for doubtful accounts at December 31, 2007 and 2006 was $561 thousand and $1.5 million, respectively.

Reinsurance

Amounts recoverable from property casualty reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Amounts paid for reinsurance contracts are expensed over the contract period during which insured events are covered by the reinsurance contracts.

The cost of reinsurance related to long-duration contracts is accounted for over the life of the underlying reinsured policies using assumptions consistent with those used to account for the underlying policies.

Deferred Policy Acquisition Costs and Premium Deficiencies

Commissions and other costs of acquiring insurance that vary with and are primarily related to the production of new and renewal business have been deferred.

Life Insurance Products: Traditional life insurance acquisition costs are being amortized over the premium payment period of the related policies using assumptions consistent with those used in computing policy benefit reserves. Acquisition costs for universal life type policies are being amortized over a thirty-year period in relation to the present value of estimated gross profits that are determined based upon surrender charges and investment, mortality and expense margins. Investment income is considered, if necessary, in the determination of the recoverability of deferred policy acquisition costs. Unrealized holding gains are recorded as an adjustment to deferred policy acquisition costs under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, when amortization expense is determined under the gross profits method described in SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.

Internal replacements, as defined by Statement of Position (SOP) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts, are reviewed by the Company to determine whether changes made are considered to be significant and integrated. If changes are significant and integrated, the unamortized balance of deferred policy acquisition costs related to the original contract is extinguished and charged to income. Acquisition costs associated with the replacement policy are deferred and amortized to income. At the date of adoption of SOP 05-1, no adjustments were made to retained earnings in the life segment.

Property Casualty Products: Acquisition costs for property casualty insurance are amortized over the period in which the related premiums are earned. Internal replacements, as defined by SOP 05-1,

 

75


Table of Contents

Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts, are reviewed by the Company to determine whether changes made are considered to be significant and integrated. If changes are significant and integrated, the unamortized balance of deferred policy acquisition costs related to the original contract is extinguished and charged to income. Acquisition costs associated with the replacement policy are deferred and amortized to income. At the date of adoption of SOP 05-1, no adjustments were made to retained earnings in the property casualty segment.

A premium deficiency reserve is recognized by recording an additional liability for the deficiency, with a corresponding charge to operations when anticipated losses, loss adjustment expenses, commissions, other acquisition costs and maintenance costs exceed the recorded unearned premium reserve, and any future installment premiums on existing policies. The Company had no liability related to premium deficiency reserves at December 31, 2007 or 2006. The Company utilizes anticipated investment income as a factor in the premium deficiency calculation.

Goodwill and Other Intangible Assets

Goodwill is recorded when the purchase price paid for an acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired. The Company performs an annual review in the fourth quarter of each year, or more frequently if indicators of potential impairment exist, to determine if the carrying value of the recorded goodwill is impaired. If the fair value of the subsidiary were less than its carrying value at the valuation date, an impairment loss would be recorded to the extent that the implied value of the goodwill is less than the recorded amount of goodwill. Fair value is estimated based on various valuation metrics.

Intangible assets include agent relationships, information technology and restrictive covenants, and are amortized on a straight-line basis over periods ranging from 5 to 20 years. The Company evaluates the remaining useful life of the intangible assets each reporting period to determine whether events and circumstances warrant a revision to the remaining period of amortization. If the estimate of the remaining useful life is changed, the remaining carrying amount of the intangible asset would be amortized prospectively over the revised remaining useful life.

Other Assets

Included in other assets, furniture, equipment, capital leases, software and leasehold improvements are stated at cost less accumulated depreciation or amortization. Depreciation is computed principally using the straight-line method over the estimated useful lives of the related assets. Software amortization for significant business software projects is computed using the 200% double declining basis (half year convention) over five years. Costs to develop internal use software in accordance with SOP 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, is capitalized and depreciated on a straight-line basis over the estimated useful life of the software, not to exceed five years. Leasehold improvements are amortized on a straight-line basis over the lesser of the lease terms or the estimated useful lives of the improvements, not to exceed seven years. Accumulated depreciation and amortization at December 31, 2007 and 2006 was $8.4 million and $7.1 million, respectively. Depreciation and amortization expense for 2007, 2006 and 2005 was $5.0 million, $3.4 million and $1.6 million, respectively.

Derivative Instruments and Hedging Activities

The Company accounts for derivative instruments in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities – An Amendment of FASB Statement No. 133, SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, and SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an Amendment of FASB Statements No. 133 and 140. The statements require that the Company recognize all derivatives as either assets or liabilities in the consolidated balance sheet at fair value. Changes in the fair value of derivatives are recorded currently in earnings unless special hedge accounting criteria are met. For derivatives designated as fair value hedges, the changes in the fair value of both the derivative instrument and the hedged item are recorded in earnings. For derivatives designated as cash flow hedges, the effective portions of changes in fair value of the derivative are reported in other comprehensive income. Any ineffective portions of hedges would be recognized in earnings.

 

76


Table of Contents

Cash Flow Hedges: The Company uses variable-rate debt to partially fund its consumer loan and commercial lease portfolios. In particular, it issued variable-rate long-term debt and commercial paper. These debt obligations exposed the Company to variability in interest payments due to changes in interest rates. If interest rates increase, interest expense increases. Conversely, if interest rates decrease, interest expense also decreases.

As part of its funding efforts, the Company issued a $70 million long-term obligation maturing on June 1, 2017 in the second quarter of 2002 that is included in total borrowings. Management believed it was prudent to limit the variability of a portion of its interest payments. It was the Company’s objective to hedge 100 percent of its variable-rate long-term interest payments over the first five years of the life of the debt obligation.

To meet this objective, management entered into an interest rate swap to manage fluctuations in cash flows resulting from interest rate risk. The interest rate swap changed the variable-rate cash flow exposure of the variable-rate long-term debt obligation to fixed-rate cash flows by entering into a receive-variable, pay-fixed interest rate swap. Under the interest rate swap, the Company received variable interest payments and made fixed interest rate payments, thereby creating long-term debt with a fixed rate of 4.945%. During 2007, interest received ranged from 5.32% to 5.32113%. The interest rate swap expired April 30, 2007.

The Company assesses interest rate cash flow risk by continually identifying and monitoring changes in interest rate exposures that may adversely impact expected future cash flows and by evaluating hedging opportunities.

The Company maintains risk management control systems to monitor interest rate cash flow risk attributable to both the Company’s outstanding or forecasted debt obligations as well as the Company’s offsetting hedge position. The risk management control systems involve the use of analytical techniques, including cash flow sensitivity analysis, to estimate the expected impact of changes in interest rates on the Company’s future cash flows.

Changes in fair value of the interest rate swap designated as a hedging instrument of the variability of cash flows associated with floating-rate, long-term debt obligation were reported in accumulated other comprehensive income, net of taxes. The Company accounted for the hedging instrument using the short-cut method and has not reclassified an