FORTEGRA FINANCIAL CORP 10-K 2011
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Commission file number 001-35009
Fortegra Financial Corporation
(Exact name of Registrant as specified in its charter)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o 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 Exchange Act. Yes o No x
Note - Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Exchange Act from their obligations under those Sections.
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 o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) 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. o
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 o No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). o
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 the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer o Accelerated filer o Non-accelerated filer x Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
The registrant completed the initial public offering of its common stock on December 17, 2010. Accordingly, there was no public market for the registrant’s common stock as of June 30, 2010, the last business day of the registrant’s most recently completed second fiscal quarter.
The number of outstanding shares of the registrant's Common Stock, $0.01 par value, outstanding as of February 28, 2011 was 20,515,039.
Documents Incorporated by Reference
Certain specifically designated portions of Fortegra Financial Corporation's definitive proxy statement for its 2011 Annual meeting of Stockholders (the "Proxy Statement"), which will be filed on or prior to 120 days following the end of Fortegra Financial Corporation's fiscal year ended December 31, 2010, are incorporated by reference into Part III and IV of this 10-K.
TABLE OF CONTENTS
Unless the context requires otherwise, references in this Annual Report on Form 10-K ("Annual Report") to "Fortegra Financial," "we," "us," "the Company" or similar terms refer to Fortegra Financial Corporation and its subsidiaries.
This Annual Report contains forward-looking statements within the meaning of the Private Securities Litigation Act of 1995. Such statements are subject to risks and uncertainties. All statements other than statements of historical fact included in this Annual Report are forward-looking statements. Forward-looking statements give our current expectations and projections relating to our financial condition, results of operations, plans, objectives, future performance and business. You can identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. These statements may include words such as "anticipate," "estimate," "expect," "project,'' "plan," "intend," "believe," "may," "should," "can have," "likely" and other words and terms of similar meaning in connection with any discussion of the timing or nature of future operating or financial performance or other events.
The forward-looking statements contained in this Annual Report are based on assumptions that we have made in light of our industry experience and our perceptions of historical trends, current conditions, expected future developments and other factors we believe are appropriate under the circumstances. As you read this Annual Report, you should understand that these statements are not guarantees of performance or results. They involve risks, uncertainties (some of which are beyond our control) and assumptions. Although we believe that these forward-looking statements are based on reasonable assumptions, you should be aware that many factors could affect our actual financial results and cause them to differ materially from those anticipated in the forward-looking statements. We believe these factors include, but are not limited to, those described under Item 1A. - "Risk Factors" and Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations." Should one or more of these risks or uncertainties materialize, or should any of these assumptions prove incorrect, our actual results may vary in material respects from those projected in these forward-looking statements.
Any forward-looking statement made by us in this Annual Report speaks only as of the date on which we make it. Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law.
ITEM 1. BUSINESS
We are an insurance services company that provides distribution and administration services to insurance companies, insurance brokers and agents and other financial services companies in the United States. We sell our services and products directly to businesses rather than directly to consumers.
We began nearly 30 years ago as a provider of credit insurance products and, through our transformational efforts, have evolved into a diversified insurance services company. We now leverage our proprietary technology infrastructure, internally developed best practices and access to specialty insurance markets to provide our clients with distribution and administration services and insurance-related products. Our services and products complement consumer credit offerings, provide outsourcing solutions designed to reduce the costs associated with the administration of insurance and other financial products and facilitate the distribution of excess and surplus lines insurance products through insurance companies, brokers and agents. These services and products are designed to increase revenues, improve customer value and loyalty and reduce costs for our clients.
We generally target market segments that are niche and specialty in nature, which we believe are underserved by competitors and have high barriers to entry. We focus on building quality client relationships and emphasizing customer service. This focus, along with our ability to help clients enhance revenue and reduce costs, has enabled us to develop and maintain numerous long-term client relationships. Over 80% of our clients have been with us for more than five years.
Our fee-driven revenue model is focused on delivering a high volume of recurring transactions through our clients and producing attractive profit margins and operating cash flows. Historically, our business has grown both organically and through acquisitions of complementary businesses. During 2010, our total revenues increased $18.2 million to $204.3 million for the year ended December 31, 2010 compared with $186.1 million for the year ended December 31, 2009. Our adjusted earnings before interest expense, taxes, non-controlling interest and depreciation and amortization (Adjusted EBITDA) increased 27.4% from $31.5 million for the year ended December 31, 2009 to $40.1 million for the year ended December 31, 2010. See the section titled "Results of Operations - Segments" included in Item 7 of this Annual Report for more information and a Reconciliation of Adjusted EBITDA. Our net income has grown 40.2% from $11.6 million for the year ended December 31,
2009 to $16.2 million for the year ended December 31, 2010.
Initial Public Offering
On December 17, 2010, we completed our initial public offering (the "IPO"), issuing 6,000,000 shares of common stock at an IPO price of $11.00 per share, of which 4,265,637 shares were sold by us and 1,734,363 shares were sold by selling stockholders and began trading on the New York Stock exchange under the symbol "FRF". We closed the transaction on December 22, 2010 and received $43.6 million in net proceeds from the offering, which reflects underwriting discounts and commissions of $3.3 million. Upon the closing of our IPO, all outstanding shares of our previously issued Class A common stock automatically converted into shares of common stock. At December 31, 2010, we had 20,256,735 shares of common stock outstanding.
We operate in three business segments: (i) Payment Protection, (ii) Business Process Outsourcing ("BPO") and (iii) Wholesale Brokerage. In each segment, we deliver services and products that generate incremental revenues and utilize technology to reduce operating costs. Our businesses benefit from efficiencies by sharing accounting, compliance, legal, technology, human resources and administrative services. In 2010, corporate expenses of $2.1 million consisted principally of costs associated with the acquisition of the car clubs (Continental Car Club and United Motor Club) and the South Bay Acceptance Corporation and re-audit expenses associated with our IPO. The relative contribution of each segment to total pre-tax income is as follows: (1) Payment Protection, 71.0%; (2) BPO, 25.0%; (3) Wholesale Brokerage, 12.5%. This total was offset by costs which are not allocated among the business segments and represented 8.5% of our pre-tax income in 2010.
Payment Protection- Our Payment Protection segment, marketed under our Life of the South, Continental Car Club and United Motor Club brands, delivers credit insurance, debt protection, warranty and service contracts and car club solutions to consumer finance companies, regional banks, community banks, retailers, small loan companies, warranty administrators, automobile dealers, vacation ownership developers and credit unions. Our clients then offer these products to their customers in conjunction with consumer finance transactions. Our Payment Protection segment specializes principally in providing products that protect consumer lenders and their borrowers from death, disability or other events that could otherwise impair their borrowers' ability to repay a debt. We typically maintain long-term business relationships with our clients.
We own and operate insurance company subsidiaries to facilitate, on behalf of our Payment Protection clients, the distribution of credit insurance and payment protection services and products. This allows our clients to sell these services and products to their customers without having to establish their own insurance companies, which saves our clients the cost and time of undertaking and complying with substantial regulatory and licensing requirements. Our clients typically retain the underwriting risk related to such products either through retrospective commission arrangements or fully-collateralized reinsurance companies owned by them, which we administer on their behalf. While the majority of our Payment Protection revenue is fee-based, we assume insurance underwriting risk in select instances to meet clients' needs and to enhance our profitability.
Our Payment Protection business generates service and administrative fees for distributing and administering payment protection products on behalf of our clients. We also earn ceding commissions in our Payment Protection business for credit insurance that we cede to reinsurers through coinsurance arrangements. We elect to cede to reinsurers a significant portion of the credit insurance that we distribute to participate in the underwriting profits of these products and to maximize our return on capital. Our Payment Protection business also generates net investment income from our invested assets portfolio.
BPO- Our BPO segment, marketed under the Consecta brand, provides a broad range of administrative services tailored to insurance and other financial services companies. Our BPO business is our most technology-driven segment. Through our operating platform, which utilizes our proprietary technology, we provide sales and marketing support, electronic underwriting, premium billing and collections, policy administration, claims adjudication and call center management services on behalf of our clients.
Our proprietary administrative technology platform allows our clients to outsource the fixed costs and complexity associated with internal development and ongoing administration of insurance products at a lower cost than if our client performs these functions on its own. In addition, the scalability of our operating platform allows us to add new clients or additional services for clients without incurring significant incremental costs.
Our BPO business generates service and administrative fees and other income under per-unit priced contracts. Service and administrative fees for our BPO business are based on the complexity and volume of business that we manage on behalf of our clients. We do not take any insurance underwriting risk in our BPO business.
Wholesale Brokerage- Our Wholesale Brokerage segment, marketed under our Bliss & Glennon brand, is one of the largest
surplus lines brokers in California according to the Surplus Line Association of California, and ranked in the top 20 wholesale brokers in the United States in 2009 by premium volume according to Business Insurance, an industry publication. We acquired Bliss & Glennon in April 2009. This business segment uses a wholesale model to sell specialty property and casualty ("P&C") and surplus lines insurance through retail insurance brokers and agents and insurance companies. We believe that our emphasis on customer service, rapid responsiveness to submissions and underwriting integrity in this segment has resulted in high customer satisfaction among retail insurance brokers and agents and insurance companies.
Our Wholesale Brokerage business provides retail insurance brokers and agents and insurance companies the ability to obtain various types of commercial insurance coverages outside of their core areas of focus, broader access to insurance markets and the expertise to place complex risks. We also provide underwriting services for ancillary or niche insurance products as a managing general agent ("MGA") for specialized insurance carriers. We believe that insurance carriers value their relationship with us because we provide them with access to new markets without the need for costly distribution infrastructure. Our Wholesale Brokerage business also utilizes our technology platform to provide its clients with administrative services, including policy underwriting, premium and claim administration and actuarial analysis.
Our Wholesale Brokerage business earns wholesale brokerage commissions and fees for the placement of specialty insurance products. We also earn profit commissions in our Wholesale Brokerage business, which are commissions that we receive from carriers based upon the ultimate profitability of the insurance policies that we place with those carriers. We do not take any insurance underwriting risk in our Wholesale Brokerage business.
We operate in the insurance, consumer finance and commercial finance industries in the United States, offering our services and products through the brands and distribution bases of our clients. We believe that we are well positioned to capitalize on following key industry trends:
Growth of Outsourcing in the Insurance Industry. By outsourcing business functions that can be more efficiently and cost effectively provided by specialized service providers, we believe that insurance companies can increase productivity, focus on core competencies and reduce operating costs. According to Celent, an independent research firm, the size of the North American insurance outsourcing market is expected to grow from approximately $2.0 billion in 2008 to over $4.0 billion in 2013, representing a compounded annual growth rate of 14.9%.
Financial Performance of Financial Services Companies and Retailers. Financial services companies and retailers offer complementary services and products, including payment protection and insurance-related services and products, which we believe increase their revenues, enhance customer value and loyalty and improve their profitability. According to the Consumer Credit Industry Association, net written premium for credit-related insurance was $6.2 billion in the United States in 2009.
Growth of the Specialty Property and Casualty Insurance Market. We believe the market for specialty P&C insurance products has grown as a result of increased acceptance of these products by insured parties and the development of new risk management products by insurance carriers. Insurance carriers operating in the surplus lines market generally distribute their products through wholesale insurance brokers, such as Bliss & Glennon. According to A.M. Best, premiums written by surplus lines focused insurance carriers increased from $9.9 billion to $34.4 billion from 1998 to 2008. While this market fluctuates based on the trends generally affecting the insurance industry, we believe that demand for surplus lines insurance will increase if economic conditions in the United States improve.
Our Competitive Strengths
We believe the following to be the key strengths of our business model:
Strong Value Proposition for Our Clients and Their Customers. Our solutions manage the essential aspects of insurance distribution and administration, providing low-cost access to complex, often highly-regulated markets, which we believe enables our clients to generate high-margin, incremental revenues, enter new markets, mitigate risk, improve operating efficiencies and enhance customer loyalty.
Proprietary Technology and Low-Cost Operating Platform. Our proprietary technology delivers low-cost, highly automated services to our clients without significant up-front investments and enables us to automate core business processes and reduce our clients' operating costs.
Scalability. We believe that our scalable and flexible technology infrastructure, together with our highly trained and knowledgeable information technology personnel and consultants, enables us to add new clients and launch new services and products and expand our transaction volume quickly and easily without significant incremental expense.
High Barriers to Entry. We believe that each of our businesses would be time consuming and expensive for new market participants to replicate due to the barriers to entry provided by our long-term relationships with clients and other market participants and substantial experience in the markets that we serve.
Experienced Management Team. We have an experienced management team with extensive operating and industry experience in the markets that we serve. Our management team has successfully developed profitable new services and products and completed the acquisition of seven complementary businesses since January 1, 2008.
While we believe these strengths will enable us to compete effectively, there are various factors that could materially and adversely affect our competitive position. See Item 1A."Risk Factors".
Key Attributes of Our Business Model
We believe the following are the key attributes of our business model:
Recurring Revenue Generation. Our business model, which includes the deployment of our technology with many of our clients, has historically generated substantial recurring revenues, high profit margins and significant operating cash flows.
Long-Term Relationships. By delivering value-added services and products to our clients' customers, and offering fixed-term contracts, we become an important part of our clients' businesses and develop long-term relationships.
Wholesale Distribution. We provide most of our services and products to businesses on a wholesale basis rather than directly to consumers and businesses on a retail basis enabling our clients to enhance their customer relationships and allowing us to take advantage of economies of scale.
Business Diversification. Our businesses and results of operations are highly diversified, which positions us to take better advantage of emerging industry trends and to better manage business and insurance cycles than companies that operate in only one sector of the financial services industry.
Our Growth Strategy
We believe the following are the key contributors to our growth strategy:
Provide High Value Solutions. We continue to enhance our technologies and processes and focus on integrating our operations with those of our clients in order to provide our clients with services and products that will allow them to generate incremental revenues while reducing the costs of providing insurance and other financial products.
Increase Revenue from Our Existing Clients. We will seek to leverage our long-standing relationships with our existing clients by providing them with additional services and products, introducing new services and products for them to market to their customers and establishing volume-based fee arrangements.
Expand Client Base in Existing Markets. We intend to take advantage of business opportunities to develop new client relationships through our direct sales force, from referrals from existing clients and business partners, by responding to requests for proposals and through our participation in industry events.
Enter New Geographic Markets. We will look to expand our market presence in new geographic markets in the United States and internationally by broadening the jurisdictions in which we operate, hiring new employees, opening new offices, seeking additional licenses and regulatory approvals and pursuing acquisition opportunities.
Pursue Strategic Acquisitions. We plan to continue pursuing acquisitions of complementary businesses in each of our segments to expand our service offerings, access new markets and expand our client base.
Our businesses focus on niche segments within broader insurance markets. While we face competition in each of our businesses, we believe that no single competitor competes against us in all of our segments and the markets in which we operate are generally characterized by a limited number of competitors. Competition in our operating segments is based on many factors, including price, industry knowledge, quality of client service, the effectiveness of our sales force, technology platforms and processes, the security and integrity of our information systems, the financial strength ratings of our insurance subsidiaries, office locations, breadth of products and services and brand recognition and reputation. Some competitors may offer a broader array of services and products, may have a greater diversity of distribution resources, may have a better brand recognition, may have lower cost structures or, with respect to insurers, may have higher financial strength or claims paying ratings. Some competitors also have larger client bases than we do. In addition, new competitors could enter our markets in the future. The relative importance of these factors varies by product and market. The competitive landscape for each of the businesses is described below.
In our Payment Protection business, we compete with insurance companies, financial institutions and other insurance service providers. The principal competitors for our Payment Protection business include the payment protection groups of Aon Corporation, Assurant, Inc., Asurion Corporation and smaller regional companies. As a result of state and federal regulatory developments and changes in prior years, certain financial institutions are able to offer debt cancellation plans and are also able to affiliate with other insurance companies in order to offer services similar to those in our Payment Protection business. As financial institutions gain experience with payment protection programs, their reliance on our services and products may diminish.
Our BPO business competes with a variety of companies, including large multinational firms that provide consulting, technology and/or business process services, off-shore business process service providers in low-cost locations like India, and in-house captives of potential clients. Our principal business process outsourcing competitors include Aon Corporation, Computer Sciences Corporation, Direct Response Insurance Administration Services, Inc., Marsh & McLennan Companies, Inc., Perot Systems Corporation (a subsidiary of Dell, Inc.) and Unisys Corporation. The trend toward outsourcing and technological changes may also result in new and different competitors entering our markets. There could also be newer competitors with strong competitive positions as a result of strategic consolidation of smaller competitors or of companies that each provide different services or serve different industries. In addition, a client or potential client may choose not to outsource its business, including by setting up captive outsourcing operations or by performing formerly outsourced services themselves.
Our Wholesale Brokerage business competes with numerous firms for retail insurance clients, including AmWINS Group, Inc., Arthur J. Gallagher & Co., Brown & Brown, Inc. and The Swett & Crawford Group, Inc. Many of our Wholesale Brokerage competitors have relationships with insurance companies or have a significant presence in niche insurance markets that may give them an advantage over us. Because relationships between insurance intermediaries and insurance companies or clients are often local or regional in nature, this potential competitive disadvantage is particularly pronounced outside of California. This could also impact our ability to compete effectively in any new states or regions that we enter. A number of standard market insurance companies are engaged in the sale of products that compete with those products we offer. These carriers sell their products directly through retail agents and brokers, without the involvement of a wholesale broker, which may yield higher commissions to retail agents and brokers and may impact our ability to compete. In addition, the Internet continues to evolve as a source for direct placement of personal lines business.
In addition, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 and regulations enacted thereunder permit banks, securities firms and insurance companies to affiliate. As a result, the financial services industry has experienced and may continue to experience consolidation, which in turn has resulted and could continue to result in increased competition from diversified financial institutions, including competition for acquisition prospects.
Our Payment Protection, BPO and Wholesale Brokerage businesses are subject to extensive regulation and supervision, including at the federal, state, local and foreign level. We cannot predict the impact of future changes to such laws or regulations on our business. Future laws and regulations, or the interpretation thereof, may have a material adverse effect on our results of operations and financial condition.
We are a holding company and have limited direct operations. Our holding company assets consist primarily of the capital stock of our subsidiaries. Accordingly, our future cash flows depend upon the availability of dividends and other payments from our subsidiaries, including statutorily permissible payments from our insurance company subsidiaries, as well as payments under our tax allocation agreement and management agreements with our subsidiaries. The ability of our insurance company subsidiaries to pay such dividends and to make such other payments will be limited by applicable laws and regulations of the states in which our subsidiaries are domiciled, which vary from state to state and by type of insurance provided by the applicable subsidiary. These laws and regulations require, among other things, our insurance subsidiaries to maintain minimum solvency requirements and limit the amount of dividends these subsidiaries can pay to the holding company. Along with solvency regulations, the primary factor in determining the amount of capital available for potential dividends is the level of capital needed to maintain desired financial strength ratings from A.M. Best for our insurance company subsidiaries. Given recent economic events that have affected the insurance industry, both regulators and rating agencies could become more conservative in their methodology and criteria, including increasing capital requirements for our insurance subsidiaries which, in turn, could negatively affect our capital resources. The following table sets forth the dividends paid to us by our insurance company subsidiaries for the years ended December 31, 2010, 2009, and 2008:
Our financial results may be affected by seasonal variations. Revenues in our Payment Protection business may fluctuate seasonally based on consumer spending trends, where consumer spending has historically been higher in April, September and December, corresponding to Easter, back-to-school and the holiday season. Accordingly, our Payment Protection revenues may reflect higher second, third and fourth quarters than in the first quarter.
Revenues in our Wholesale Brokerage business may fluctuate seasonally based on policy renewal dates, which are typically concentrated in July and December, during our third and fourth quarters. In addition, our quarterly revenues may be affected by new placements, cancellations or non renewals of large policies because commission revenues are earned on the effective date as opposed to ratably over the year. Our Wholesale Brokerage quarterly revenues may also be affected by the amount of profit commission that we receive from insurance carriers, because profit commissions are primarily received in the first and second quarters of each year.
Summit Partners Transactions
In June 2007, entities affiliated with Summit Partners, a growth equity investment firm, acquired 91.2% of our capital stock. The acquisition was financed through (i) $20.0 million of subordinated debentures maturing in 2013 issued to affiliates of Summit Partners, (ii) $35.0 million of preferred trust securities maturing in 2037 and (iii) an equity investment of $43.1 million by affiliates of Summit Partners. In connection with the acquisition, all of our $11.5 million of redeemable preferred stock outstanding prior to the acquisition remained outstanding and certain stockholders prior to the acquisition continued to hold such shares after the acquisition. In addition to acquiring our capital stock in the acquisition, the proceeds from the equity and debt financings were used to repay pre-transaction indebtedness of $10.1 million and pay transaction costs of $5.8 million. We refer to the foregoing transactions collectively as the "Summit Partners Transactions."
In April 2009, in connection with our acquisition of Bliss and Glennon, Inc., affiliates of Summit Partners acquired additional shares of our capital stock for $6.0 million. In connection with the IPO, Summit Partners sold 1,548,675 shares of stock. At December 31, 2010, affiliates of Summit Partners beneficially owned 61.4% of our common stock.
Business Acquisitions and Expansion
One of the main drivers of our success has been growth from business acquisitions. From 1994 to 2003, through a series of strategic acquisitions, as well as organic growth, we expanded our Payment Protection client or producer base to include consumer finance companies, retailers, automobile dealers, credit card issuers, credit unions and regional and community banks throughout the United States. During this period, we expanded our product and service offerings to include credit property, debt cancellation and warranty products.
In 2003, we continued the expansion of our administrative capabilities for insurance and payment protection products to customers of financial institutions. We utilized our proprietary technology enhancements to support mass marketing and began providing fulfillment of life and health insurance products. We previously operated our BPO business under the LOTSolutions brand. In 2007, we expanded our BPO segment to provide services to finance companies owned by industrial equipment manufacturers.
In March 2008, we acquired Gulfco Life Insurance Company to expand the presence of our Payment Protection segment in the Louisiana market.
In December 2008, we entered into the asset recovery business through our acquisition of CIRG, a third-party administrator serving commercial lending institutions for pre-collections, recovery, deficiency collections, dealer inventory seizures and management of asset portfolio run-off. Our asset recovery business is part of our BPO segment.
In December 2008, we acquired Darby & Associates, a wholesale provider of payment protection products in North Carolina. This acquisition expanded our Payment Protection segment in North Carolina, which is that segment's third largest state in terms of 2009 revenues and an important foothold with our consumer finance company clients (our largest distribution channel within the Payment Protection segment).
In April 2009, we acquired Bliss & Glennon, an excess and surplus lines wholesale insurance broker, and entered into the wholesale brokerage business, which continued our strategic expansion of specialized and administration services for insurance carriers and other financial services businesses.
With our February 2010 acquisition of South Bay Acceptance Corporation, we expanded into premium finance to support our Wholesale Brokerage segment.
In 2010, we commenced marketing our BPO segment under the Consecta brand.
In May 2010, we acquired Continental Car Club to enable our Payment Protection segment to expand into the roadside assistance market. Continental Car Club provides car club memberships through consumer finance companies.
In September 2010, we acquired United Motor Club, a Kentucky car club company, which also provides car club memberships through consumer finance companies.
As of December 31, 2010, we employed approximately 460 people on a full or part-time basis. None of our employees are represented by unions or trade organizations. We believe that our relations with our employees are satisfactory.
Richard S. Kahlbaugh has been our President and Chief Executive Officer and a director since June 2007 and has been our Chairman since June 2010. Prior to becoming President and Chief Executive Officer, Mr. Kahlbaugh was our Chief Operating Officer from 2003 to 2007. He also serves as the Chief Executive Officer of all of our insurance subsidiaries. Prior to joining us in 2003, Mr. Kahlbaugh served as President and Chief Executive Officer of Volvo's Global Insurance Group. He also served as the first General Counsel of the Walshire Assurance Group, a publicly traded insurance company, and practiced law with McNees, Wallace and Nurick. Mr. Kahlbaugh holds a J.D. from Delaware Law School of Widener University and a B.A. from the University of Delaware. Mr. Kahlbaugh was selected to serve on our board of directors in light of his significant knowledge of our products and markets and his ability to provide valuable insight to our board of directors as to day-to-day business issues we face in his role as our Chief Executive Officer.
Walter P. Mascherin has been our Senior Executive Vice President and Chief Financial Officer since October 2010. Prior to joining us, Mr. Mascherin worked at Volvo Financial Services for 14 years where he served as Senior Vice President of Organization Development and Workouts from 2009 to 2010, Senior Vice President and Chief Credit Officer from 2006 to 2009, Vice President of Corporate Development (US) in 2006 and Vice President and Chief Operating Officer from 2004 to 2005. Mr. Mascherin holds an M.B.A. from Heriot Watt University, Edinburgh, Scotland and a Business Administration Diploma from Ryerson University, Ontario, Canada.
Michael Vrban has been our Executive Vice President since July 2008, Chief Accounting Officer since January 2010 and our Treasurer since July 2007. Mr. Vrban was our Acting Chief Financial Officer from April 2010 to September 2010. Mr. Vrban served as our Chief Financial Officer from July 2007 to December 2009 and as Senior Vice President from July 2007 to July 2008. Prior to joining us, Mr. Vrban served as Senior Vice President and Chief Financial Officer of Commerce West Insurance Company from November 1999 to February 2007 where he was responsible for the management of the finances and operations. Mr. Vrban holds a B.S. from Baldwin-Wallace College.
Daniel A. Reppert has been our Executive Vice President and President of Bliss & Glennon (our Wholesale Distribution business) since May 2009. Mr. Reppert has been an Executive Vice President since January 2008. He served as our Chief Operating Officer from September 2007 to April 2010 and our Chief Actuary from July 2006 to September 2007. Prior to joining us, Mr. Reppert served as Senior Risk Officer of Insurance at Wachovia Corporation from July 2004 to June 2006. He has more than 25 years of experience in insurance and financial services. He is a Fellow of the Casualty Actuarial Society and a Member of the American Academy of Actuaries. Mr. Reppert holds a B.S. from Lebanon Valley College.
W. Dale Bullard has been our Executive Vice President and Chief Marketing Officer since May 2006. Mr. Bullard joined us in 1994 as our Senior Vice President and has over 27 years of experience in the insurance industry. Prior to joining us, Mr. Bullard held various positions at Independent Insurance Group from 1979 to 1994, most recently as a Senior Vice President in 1988. Mr. Bullard holds a B.S. from the University of South Carolina. Mr. Bullard currently serves on the board of directors of the Consumer Credit Insurance Association and previously served as its president.
Alan E. Kaliski has been our Senior Vice President and Chief Risk Officer since May 2010. He also serves as the appointed
actuary for our statutory property and casualty insurance companies. Prior to joining us, Mr. Kaliski spent 32 years with Royal Insurance Group where he held various executive positions, including most recently as its Chief Actuary. Mr. Kaliski holds an M.A. from the University of Georgia and a B.S. from the Virginia Military Institute. In addition, he is a Fellow of the Casualty Actuarial Society and a Member of the American Academy of Actuaries.
Joseph R. McCaw has been our Executive Vice President and President of Life of the South since November 2008. Mr. McCaw joined us in 2003 as our First Vice President of Finance/Retail. Prior to joining us, Mr. McCaw served as President of Financial Institution Group Senior Vice President and Chief Marketing Officer for Protective Life Corporation. Mr. McCaw holds an M.B.A. from Lindenwood University and a B.A. from Westminster College.
Robert S. Fullington has been our Executive Vice President since May 2006 and President of Consecta since 2002. Prior to joining us in 1996 as Vice President and Chief Information Officer, he was a principal in the IBM Management Consulting Group and initially served as an outsourcing manager for IBM. Mr. Fullington holds an M.B.A. and a B.S. from the University of Florida.
Paul S. Romano has been our Executive Vice President and Chief Administrative Officer since October 2010 and was our Senior Vice President, Corporate Development from February 2009 to September 2010. Prior to joining us permanently, Mr. Romano was an independent consultant for us beginning in 2007. Mr. Romano was a business consultant with his own firm after selling Cross Keys Capital, LLC, a construction finance company that he founded with four other partners in 1995. He practiced real estate, banking and finance law with Buchanan Ingersoll, PC in Harrisburg, Pennsylvania and he clerked for the Honorable Richard B. Wickersham of the Superior Court of Pennsylvania. In addition, he is a member of the Pennsylvania Golf Association Executive Committee and is a member of the Pennsylvania Bar Association. Mr. Romano holds a J.D. from Pennsylvania State University Dickinson School of Law and a B.S. from the University of Pennsylvania Wharton School of Business.
John G. Short joined us in September 2007 as our Vice President, General Counsel and Corporate Secretary and became our Senior Vice President in May 2010. Prior to joining us, Mr. Short served as Vice President of State External Affairs at Embarq Corporation from May 2006 to February 2007, and Sprint Corporation from June 1995 to May 2006. Mr. Short holds a J.D. from the College of William and Mary and a B.S. from the University of Richmond.
We own or license a number of trademarks, trade names, copyrights, service marks, trade secrets and other intellectual property rights that relate to our services and products. Although we believe that these intellectual property rights are, in the aggregate, of material importance to our businesses, we believe that none of our businesses are materially dependent upon any particular trademark, trade name, copyright, service mark, license or other intellectual property right. U.S. trademark and service mark registrations are generally for a term of 10 years, renewable every 10 years as long as the trademark or service mark is used in the regular course of trade.
We have entered into confidentiality agreements with our clients. These agreements impose restrictions on these customers' use of our proprietary software and other intellectual property rights.
We are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and its rules and regulations. The Exchange Act requires us to file reports, proxy statements and other information with the Securities and Exchange Commission ("SEC"). We will make available free of charge on our website, at www.fortegra.com, our 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 Exchange Act and the rules promulgated thereunder, as soon as reasonably practicable after electronically filing or furnishing such material to the SEC. These documents are posted on our website at www.fortegra.com. The information that appears on our website is not part of, and is not incorporated into, this Annual Report. Copies of these reports, proxy statements and other information can also be read and copied at the: SEC Public Reference Room, 100 F Street NE, Washington, D.C. 20549
Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. Additionally, the SEC maintains a website that contains reports, proxy statements and other information regarding issuers that file electronically with the SEC. These materials may be obtained electronically by accessing the SEC's website at www.sec.gov.
Upon written request of any stockholder of record on December 31, 2010, Fortegra will provide, without charge, a printed copy of its 2010 Annual Report, including financial statements and schedules, as required to be filed with the SEC. To obtain a copy
of the 2010 Annual Report, Contact: Investor Relations, Fortegra Financial Corporation, 10151 Deerwood Park Boulevard, Building 100, Suite 330, 32,256, or call (866)-961-9529.
ITEM 1A. RISK FACTORS
The following are certain risks that management believes are specific to our business. This should not be viewed as an
all-inclusive list of risks or presenting the risk factors listed in any particular order. You should carefully consider the risks described below, together with the other information contained in this Annual Report and in our other filings with the SEC when evaluating our Company. Should any of the events discussed in the risk factors below occur, our business, results of operations or financial condition could be materially affected. Additional risks unknown at this time, or risks we currently deem immaterial, may also impact our financial condition or results of operations.
Risks Related to our Business and Industries
General economic and financial market conditions may have a material adverse effect on the business, results of operations, cash flows and financial condition of all of our business segments.
General economic and financial market conditions, including the availability and cost of credit, the loss of consumer confidence, reduction in consumer or business spending, inflation, unemployment, energy costs and geopolitical issues, have contributed to increased uncertainty and volatility as well as diminished expectations for the U.S. economy and the financial markets. These conditions could materially and adversely affect each of our businesses. Adverse economic and financial market conditions could result in:
If we are unable to successfully anticipate changing economic or financial market conditions, we may be unable to effectively plan for or respond to such changes, and our business, results of operations and financial condition could be materially and adversely affected.
We face significant competitive pressures in each of our businesses, which could materially and adversely affect our business, results of operations and financial condition.
We face significant competition in each of our businesses. Competition in our businesses is based on many factors, including price, industry knowledge, quality of client service, the effectiveness of our sales force, technology platforms and processes, the security and integrity of our information systems, the financial strength ratings of our insurance subsidiaries, office locations, breadth of services and products and brand recognition and reputation. Some competitors may offer a broader array of services and products, may have a greater diversity of distribution resources, may have better brand recognition, may have lower cost structures or, with respect to insurers, may have higher financial strength or claims paying ratings. Some competitors also have larger client bases than we do. In addition, new competitors could enter our markets in the future. The competitive landscape for each of our businesses is described below.
include Aon Corporation, Assurant, Inc., Asurion Corporation and smaller regional companies. As a result of state and federal regulatory developments and changes in prior years, certain financial institutions are able to offer debt cancellation plans and are also able to affiliate with other insurance companies in order to offer services similar to those in our Payment Protection business. This has resulted in new competitors, some of whom have significant financial resources, entering some of our markets. As financial institutions gain experience with payment protection programs, their reliance on our services and products may diminish.
We expect competition to intensify in each of our businesses. Increased competition may result in lower prices and volumes, higher personnel and sales and marketing costs, increased technology expenditures and lower profitability. We may not be able to supply clients with services that they deem superior and at competitive prices and we may lose business to our competitors. If we are unable to compete effectively in any of our business segments, it would have a material adverse effect on our business, results of operations and financial condition.
Our results of operations may fluctuate significantly, which makes our future results of operations difficult to predict. If our results of operations fall below expectations, the price of our common stock could decline.
Our annual and quarterly results of operations have fluctuated in the past and may fluctuate significantly in the future due to a variety of factors, many of which are beyond our control. In addition, our expenses as a percentage of revenues may be significantly different than our historical rates. As a result, comparing our results of operations on a period-to-period basis may not be meaningful. Factors that may cause our results of operations to fluctuate from period-to-period include:
In addition, our Payment Protection revenues can vary depending on the level of consumer activity and the success of our clients in selling payment protection products. In our Wholesale Brokerage business, our commission income can vary due to the timing of policy renewals, as well as the timing and amount of the receipt of profit commission payments and the net effect of new and lost business production. We do not control the factors that cause these variations. Specifically, customers' demand for insurance products can influence the timing of renewals, new business, lost business (which includes policies that are not
renewed) and cancellations. In addition, we rely on retail insurance brokers and agents and insurance companies for the payment of certain commissions. Because these payments are processed internally by these companies, we may not receive a payment that is otherwise expected from a particular firm in one period until after the end of that period, which can adversely affect our ability to budget for such period.
Our results of operations could be materially and adversely affected if we fail to retain our existing clients, cannot sell additional services and products to our existing clients, do not introduce new or enhanced services and products or are not able to attract and retain new clients.
Our revenue and revenue growth are dependent on our ability to retain clients, to sell them additional services and products, to introduce new services and products and to attract new clients in each of our businesses. Our ability to increase revenues will depend on a variety of factors, including:
In addition, we are subject to risks of losing clients due to consolidation in each of the markets we serve. Our inability to retain existing clients, sell additional services and products, or successfully develop and implement new and enhanced services and products and attract new clients and, accordingly, increase our revenues could have a material adverse effect on our results of operations.
We typically face a long selling cycle to secure new clients in each of our businesses as well as long implementation periods that require significant resource commitments, which result in a long lead time before we receive revenues from new client relationships.
The industries in which we compete generally consist of mature businesses and markets and the companies that participate in these industries have well-established business operations, systems and relationships. Accordingly, each of our businesses typically faces a long selling cycle to secure a new client. Even if we are successful in obtaining a new client engagement, that is generally followed by a long implementation period in which the services are planned in detail and we demonstrate to the client that we can successfully integrate our processes and resources with their operations. We also typically negotiate and enter into a contractual relationship with the new client during this period. There is then a long implementation period in order to commence providing the services.
We typically incur significant business development expenses during the selling cycle. We may not succeed in winning a new client's business, in which case we receive no revenues and may receive no reimbursement for such expenses. Even if we succeed in developing a relationship with a potential client and begin to plan the services in detail, such potential client may choose a competitor or decide to retain the work in-house prior to the time a final contract is signed. If we enter into a contract with a client, we will typically receive no revenues until implementation actually begins. In addition, a significant portion of our revenue is based upon the success of our clients' marketing programs, which may not generate the transaction volume we anticipate. Our clients may also experience delays in obtaining internal approvals or delays associated with technology or system implementations, thereby further lengthening the implementation cycle. If we are not successful in obtaining contractual commitments after the selling cycle, in maintaining contractual commitments after the implementation cycle or in maintaining or reducing the duration of unprofitable initial periods in our contracts, it may have a material adverse effect on our business, results of operations and financial condition. Furthermore, the time and effort required to complete the implementation phases of new contracts makes it difficult to accurately predict the timing of revenues from new clients as well as our costs.
Acquisitions are a significant part of our growth strategy and we may not be successful in identifying suitable acquisition candidates, completing such acquisitions or integrating the acquired businesses, which could have a material adverse effect on our business, results of operations, financial condition or growth.
Historically, acquisitions have played a significant role in our expansion into new businesses and in the growth of some of our businesses. Acquiring complementary businesses is a significant component of our growth strategy. Accordingly, we frequently evaluate possible acquisition transactions for our business. However, we may not be able to identify suitable acquisitions, and such transactions may not be financed and completed on acceptable terms. Furthermore, any future acquisitions may not be successful. In addition, we may be competing with larger competitors with substantially greater resources for acquisition targets. Any deficiencies in the process of integrating companies we may acquire could have a material adverse effect on our results of operations and financial condition. Acquisitions entail a number of risks including, among other things:
Our failure to adequately address these acquisition risks could have a material adverse effect on our business, results of operations, financial condition and growth. Future acquisitions may reduce our cash resources available to fund our operations and capital expenditures and could result in increased amortization expense related to any intangible assets acquired, potentially dilutive issuances of equity securities or the incurrence of debt, which could increase our interest expense.
Our business, results of operations, financial condition or liquidity may be materially and adversely affected by errors and omissions and the outcome of certain actual and potential claims, lawsuits and proceedings.
We are subject to various actual and potential claims, lawsuits and other proceedings relating principally to alleged errors and omissions in connection with our conduct in each of our businesses, including the handling and adjudicating of claims and the placement of insurance. Because such placement of insurance and handling claims can involve substantial amounts of money, clients may assert errors and omissions claims against us alleging potential liability for all or part of the amounts in question. Claimants may seek large damage awards, and these claims may involve potentially significant legal costs. Such claims, lawsuits and other proceedings could, for example, include claims for damages based on allegations that our employees or sub-agents improperly failed to procure coverage, report claims on behalf of clients, provide insurance companies with complete and accurate information relating to the risks being insured or appropriately apply funds that we hold for our clients on a fiduciary basis.
While we would expect most of the errors and omissions claims made against us (subject to our self-insured deductibles) to be covered by our professional indemnity insurance, our results of operations, financial condition and liquidity may be materially and adversely affected if, in the future, our insurance coverage proves to be inadequate or unavailable, or if there is an increase in liabilities for which we self-insure. Our ability to obtain professional indemnity insurance in the amounts and with the deductibles we desire in the future may be materially and adversely impacted by general developments in the market for such insurance or our own claims experience. In addition, claims, lawsuits and other proceedings may harm our reputation or divert management resources away from operating our business.
We may lose clients or business as a result of consolidation within the financial services industry.
There has been considerable consolidation in the financial services industry, driven primarily by the acquisition of small and mid-size organizations by larger entities. We expect this trend to continue. As a result, we may lose business or suffer decreased revenues from retail insurance brokerage firms that are acquired by other firms. Similarly, we may lose business or suffer decreased revenues if one or more of our Payment Protection clients or distributors consolidate or align themselves with other companies. To date, our business has not been materially affected by consolidation. However, we may be affected by industry consolidation that occurs in the future, particularly if any of our significant clients are acquired by organizations that already possess the operations, services and products that we provide.
Our ability to implement and execute our strategic plans may not be successful and, accordingly, we may not be successful in achieving our strategic goals, which may materially and adversely affect our business.
We may not be successful in developing and implementing our strategic plans for our businesses or the operational plans that have been or need to be developed to implement these strategic plans. If the development or implementation of such plans is not successful, we may not produce the revenue, margins, earnings or synergies that we need to be successful. We may also
face delays or difficulties in implementing product, process and system improvements, which could adversely affect the timing or effectiveness of margin improvement efforts in our businesses and our ability to successfully compete in the markets we serve. The execution of our strategic and operating plans will, to some extent, also be dependent on external factors that we cannot control. In addition, these strategic and operational plans need to continue to be assessed and reassessed to meet the challenges and needs of our businesses in order for us to remain competitive. The failure to implement and execute our strategic and operating plans in a timely manner or at all, realize the cost savings or other benefits or improvements associated with such plans, have financial resources to fund the costs associated with such plans or incur costs in excess of anticipated amounts, or sufficiently assess and reassess these plans could have a material and adverse effect on our business or results of operations.
We may not effectively manage our growth, which could materially harm our business.
The growth of our business has placed and may continue to place significant demands on our management, personnel, systems and resources. To manage our growth, we must continue to improve our operational and financial systems and managerial controls and procedures, and we will need to continue to expand, train and manage our personnel. We must also maintain close coordination among our technology, compliance, risk management, accounting, finance, marketing and sales organizations. We may not manage our growth effectively, and if we fail to do so, our business could be materially and adversely harmed.
If we continue to grow, we may be required to increase our investment in facilities, personnel and financial and management systems and controls. Continued growth may also require expansion of our procedures for monitoring and assuring our compliance with applicable regulations and that we recruit, integrate, train and manage a growing employee base. The expansion of our existing businesses, our expansion into new businesses and the resulting growth of our employee base increase our need for internal audit and monitoring processes that are more extensive and broader in scope than those we have historically required. We may not be successful in implementing all of the processes that are necessary. Further, unless our growth results in an increase in our revenues that is proportionate to the increase in our costs associated with this growth, our operating margins and profitability will be materially and adversely affected.
As a holding company, we depend on the ability of our subsidiaries to transfer funds to us to pay dividends and to meet our obligations.
We act as a holding company for our subsidiaries and do not have any significant operations of our own. Dividends from our subsidiaries are our principal sources of cash to meet our obligations and pay dividends, if any, on our common stock. These obligations include our operating expenses and interest and principal payments on our current and any future borrowings. The agreements governing our revolving credit facilities restrict our subsidiaries' ability to pay dividends or otherwise transfer cash to us. Under the agreement with SunTrust Bank and CB&T, our subsidiaries are permitted to make distributions to us if no default or event of default has occurred and is continuing at the time of such distribution. Under our agreement with Wells Fargo, our restricted subsidiary is permitted to make quarterly distributions to us if (i) both prior to and after such payment no default or event of default has occurred or is continuing or would result from such payment and (ii) such subsidiary has provided the lender under such facility its financial statements for the most recently completed quarter and certified to the lender that condition (i) above is satisfied. If the cash we receive from our subsidiaries pursuant to dividends or otherwise is insufficient for us to fund any of these obligations, or if a subsidiary is unable to pay dividends to us, we may be required to raise cash through the incurrence of debt, the issuance of additional equity or the sale of assets.
The payment of dividends and other distributions to us by each of the regulated insurance company subsidiaries in our Payment Protection segment is regulated by insurance laws and regulations of the states in which they operate. In general, dividends in excess of prescribed limits are deemed "extraordinary" and require insurance regulatory approval. Ordinary dividends, for which no regulatory approval is generally required, are limited to amounts determined by a formula, which varies by state. Some states have an additional stipulation that dividends may only be paid out of earned surplus. States also regulate transactions between our insurance company subsidiaries and our other subsidiaries, such as those relating to the shared services, and in some instances, require prior approval of such transactions within the holding company structure. If insurance regulators determine that payment of an ordinary dividend or any other payments by our insurance subsidiaries to us (such as payments for employee or other services) would be adverse to policyholders or creditors, the regulators may block or otherwise restrict such payments that would otherwise be permitted without prior approval. In addition, there could be future regulatory actions restricting the ability of our insurance subsidiaries to pay dividends or share services.
Our success is dependent upon the retention and acquisition of talented people and the skills and abilities of our management team and key personnel.
Our business depends on the efforts, abilities and expertise of our senior executives, particularly our Chairman, President and Chief Executive Officer, Richard S. Kahlbaugh. Mr. Kahlbaugh and our other senior executives are important to our success because they have been instrumental in setting our strategic direction, operating our business, identifying, recruiting and training key personnel and identifying business opportunities. The loss of one or more of these key individuals could impair our
business and development until qualified replacements are found. We may not be able to replace these individuals quickly or with persons of equal experience and capabilities. Although we have employment agreements with certain of these individuals, we cannot prevent them from terminating their employment with us. We do not maintain key man life insurance policies on any of our executive officers except for Mr. Kahlbaugh. If we are unable to attract and retain talented employees, it could have a material adverse effect on our business, operating results and financial condition.
We may need to raise additional capital in the future, but there is no assurance that such capital will be available on a timely basis, on acceptable terms or at all.
We may need to raise additional funds in order to grow our businesses or fund our strategy or acquisitions. Additional financing may not be available in sufficient amounts or on terms acceptable to us and may be dilutive to existing stockholders if raised through additional equity offerings. Additionally, any securities issued to raise such funds may have rights, preferences and privileges senior to those of our existing stockholders. If adequate funds are not available on a timely basis or on acceptable terms, our ability to expand, develop or enhance our services and products, enter new markets, consummate acquisitions or respond to competitive pressures could be materially limited.
Risks Related to Our Payment Protection Business
Our Payment Protection business relies on independent financial institutions, lenders and retailers to distribute its services and products, and the loss of these distribution sources, or the failure of our distribution sources to sell our Payment Protection products could materially and adversely affect our business and results of operations.
We distribute our Payment Protection products through financial institutions, lenders and retailers. Our contracts with these clients are typically not exclusive and many of these clients offer payment protection services and products of our competitors. Our relationships with these clients can be canceled on relatively short notice. In addition, the distributors typically do not have any minimum performance or sales requirements and our Payment Protection revenue is dependent on the level of business conducted by the distributor as well as the effectiveness of their sales efforts for our Payment Protection products, each of which is beyond our control. The impairment of our distribution relationships, the loss of a significant number of our distribution relationships, the failure to establish new distribution relationships, the increase in sales of competitors' services and products by these distributors or the decline in their overall business activity or the effectiveness of their sales of our Payment Protection products could materially reduce our Payment Protection sales and revenues. Also, the growth of our Payment Protection business is dependent in part on our ability to identify, attract and retain new distribution relationships and successfully implement our information systems with those of our new distributors.
Reinsurance may not be available or adequate to protect us against losses, and we are subject to the credit risk of reinsurers.
As part of our overall risk and capacity management strategy, we purchase reinsurance for a substantial portion of the risks underwritten by our Payment Protection business through captive reinsurance companies owned by our Payment Protection clients as well as third party reinsurance companies. Market conditions beyond our control determine the availability and cost of the reinsurance protection we seek to renew or purchase. Our clients may face difficulties forming, capitalizing and operating captive reinsurance companies, which could impact their ability to reinsure future business that we typically cede to them. States also could impose restrictions on these reinsurance arrangements, such as requiring the insurance company subsidiary to retain a minimum amount of underwriting risk, which could affect our profitability and results of operations. Reinsurance for certain types of catastrophes generally could become unavailable or prohibitively expensive for some of our businesses. Such changes could substantially increase our exposure to the risk of significant losses from natural or man-made catastrophes and could hinder our ability to write future business.
Although the reinsurer is liable to the respective insurance subsidiary to the extent of the ceded reinsurance, the insurance company remains liable to the insured as the direct insurer on all risks reinsured. Ceded reinsurance arrangements, therefore, do not eliminate our insurance company obligation to pay claims. While the captive reinsurance companies owned by our clients are generally required to maintain trust accounts with sufficient assets to cover the reinsurance liabilities and we manage these trust accounts on behalf of these reinsurance companies, we are subject to credit risk with respect to our ability to recover amounts due from reinsurers. The inability to collect amounts due from reinsurers could have a material adverse effect on our results of operations and our financial position.
Our reinsurance facilities are generally subject to annual renewal. We may not be able to maintain our current reinsurance facilities and our clients may not be able to continue to operate their captive reinsurance companies. As a result, even where highly desirable or necessary, we may not be able to obtain other reinsurance facilities in adequate amounts and at favorable rates. If we are unable to renew our expiring facilities or to obtain or structure new reinsurance facilities, either our net exposures would increase or, if we are unwilling to bear an increase in net exposures, we may have to reduce the level of our underwriting commitments. Either of these potential developments could have a material adverse effect on our results of operations and financial condition.
Due to the structure of some of our commissions, we are exposed to risks related to the creditworthiness of some of our agents.
We are subject to the credit risk of some of the agents with which we contract within our Payment Protection business. We typically advance agents' commissions as part of our product offerings. These advances are a percentage of the premium charged. If we over-advance such commissions to agents, they may not be able to fulfill their payback obligations, and it could have a material adverse effect on our results of operations and financial condition.
A downgrade in the ratings of our insurer subsidiaries may materially and adversely affect relationships with clients and adversely affect our results of operations.
Claims paying ability and financial strength ratings are each a factor in establishing the competitive position of our insurance company subsidiaries. A ratings downgrade, or the potential for such a downgrade, could, among other things, materially and adversely affect relationships with clients, brokers and other distributors of our services and products, thereby negatively impacting our results of operations, and materially and adversely affect our ability to compete in our markets. Rating agencies can be expected to continue to monitor our financial strength and claims paying ability, and no assurances can be given that future ratings downgrades will not occur, whether due to changes in our performance, changes in rating agencies' industry views or ratings methodologies, or a combination of such factors.
Our actual claims losses may exceed our reserves for claims, which may require us to establish additional reserves that may materially and adversely reduce our business results of operations and financial condition.
We maintain reserves to cover our estimated ultimate exposure for claims with respect to reported claims and incurred but not reported claims as of the end of each accounting period. Reserves, whether calculated under accounting principles generally accepted in the United States or statutory accounting principles, do not represent an exact calculation of exposure. Instead, they represent our best estimates, generally involving actuarial projections, of the ultimate settlement and administration costs for a claim or group of claims, based on our assessment of facts and circumstances known at the time of calculation. The adequacy of reserves will be impacted by future trends in claims severity, frequency, judicial theories of liability and other factors. These variables are affected by external factors such as changes in the economic cycle, unemployment, changes in the social perception of the value of work, emerging medical perceptions regarding physiological or psychological causes of disability, emerging health issues, new methods of treatment or accommodation, inflation, judicial trends, legislative changes, as well as changes in claims handling procedures. Many of these items are not directly quantifiable, particularly on a prospective basis. Reserve estimates are refined as experience develops. Adjustments to reserves, both positive and negative, are reflected in the statement of income of the period in which such estimates are updated. Because establishment of reserves is an inherently uncertain process involving estimates of future losses, there can be no certainty that ultimate losses will not exceed existing claims reserves. In general, future loss development could require reserves to be increased, which could have a material adverse effect on our earnings in the periods in which such increases were made.
Our investment portfolio is subject to several risks that may diminish the value of our invested assets and cash and may materially and adversely affect our business and profitability.
Investment returns are an important part of our overall profitability and significant interest rate fluctuations, or prolonged periods of low interest rates, could impair our profitability. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. We have a significant portion of our investments in cash and highly liquid short-term investments. Accordingly, during prolonged periods of declining or low market interest rates, such as those we have been experiencing since 2008, the interest we receive on such investments decreases and affects our profitability. Fixed maturity and short-term investments represented 97.8% of the fair value of our total investments as December 31, 2010. In addition, certain factors affecting our business, such as volatility of claims experience, could force us to liquidate securities prior to maturity, causing us to incur capital losses. If we do not structure our investment portfolio so that it is appropriately matched with our insurance liabilities, we may be forced to liquidate investments prior to maturity at a significant loss to cover such liabilities.
The fair market value of the fixed maturity securities in our portfolio and the investment income from these securities fluctuate depending on general economic and market conditions. Because all of our fixed maturity securities are classified as available for sale, changes in the market value of these securities are reflected on our balance sheet. The fair market value generally increases or decreases in an inverse relationship with fluctuations in interest rates, while net investment income realized by us from future investments in fixed maturity securities will generally increase or decrease with interest rates. In addition, actual net investment income and/or cash flows from investments that carry prepayment risk may differ from those anticipated at the time of investment as a result of interest rate fluctuations.
We employ asset/liability management strategies to reduce the adverse effects of interest rate volatility and to increase the likelihood that cash flows are available to pay claims as they become due. Our asset/liability management strategies may fail to eliminate or reduce the adverse effects of interest rate volatility, and significant fluctuations in the level of interest rates may
therefore have a material adverse effect on our results of operations and financial condition.
We are subject to credit risk in our investment portfolio, primarily from our investments in corporate bonds and municipal bonds. Defaults by third parties in the payment or performance of their obligations could reduce our investment income and realized investment gains or result in the recognition of investment losses. The value of our investments may be materially and adversely affected by increases in interest rates, downgrades in the corporate bonds included in the portfolio and by other factors that may result in the recognition of other-than-temporary impairments. Each of these events may cause us to reduce the carrying value of our investment portfolio.
Further, the value of any particular fixed maturity security is subject to impairment based on the creditworthiness of a given issuer. As of December 31, 2010 fixed maturity securities represented 64.9% of the fair value of our total invested assets and cash. Our fixed maturity portfolio may include below investment grade securities (rated "BB" or lower by nationally recognized securities rating organizations). At December 31, 2010, we did not have any investments rated BB or lower. These investment generally provide higher expected returns, but present greater risk and can be less liquid than investment grade securities. A significant increase in defaults and impairments on our fixed maturity investment portfolio could have a material adverse effect on our results of operations and financial condition.
Risks Related to Our BPO Business
A significant portion of our BPO revenues are attributable to one client, and any loss of business from, or change in our relationship with this client could materially and adversely affect our business, results of operations and financial condition.
We have derived and are likely to continue to derive a significant portion of our BPO revenues from a limited number of clients. Specifically, in our BPO business, services provided to National Union Fire Insurance Company of Pittsburgh, PA ("NUFIC") accounted for 66.8%, 56.8%, and 52.4% of our BPO revenues for the years ended December 31, 2010, 2009, 2008, respectively. The loss of business from any of our significant clients, particularly NUFIC, could have a material adverse effect on our business, results of operations and financial condition.
The profitability of our BPO business will suffer if we are not able to price our outsourcing services appropriately, maintain asset utilization levels and control our costs.
The profitability of our BPO business is largely a function of the efficiency with which we utilize our assets and the pricing that we are able to obtain for our services. Our utilization rates are affected by a number of factors, including hiring and assimilating new employees, forecasting demand for our services and our need to devote time and resources to training, professional development and other typically non-chargeable activities. The prices we are able to charge for our services are affected by a number of factors, including our clients' perceptions of our ability to add value through our services, competition, the introduction of new services or products by us or our competitors and general economic conditions. Our ability to accurately estimate, attain and sustain revenues over increasingly longer contract periods could negatively impact our margins and cash flows. Therefore, if we are unable to price appropriately or manage our asset utilization levels, there could be a material adverse effect on our business, results of operations and financial condition. The profitability of our BPO business is also a function of our ability to control our costs and improve our efficiency. As we increase the number of our employees and grow our business, we may not be able to manage the significantly larger workforce that may result and our profitability may not improve.
We enter into fixed-term contracts and per-unit priced contracts with our BPO clients, and our failure to correctly price these contracts may negatively affect our profitability.
The pricing of our services is usually included in contracts entered into with our clients, many of which are for terms of between one and three years. In certain cases, we have committed to pricing over this period with only limited sharing of risk regarding inflation. If we fail to estimate accurately future wage inflation rates or our costs, or if we fail to accurately estimate the productivity benefits we can achieve under a contract, it could have a material adverse effect on our business, results of operations and financial condition.
Some of our BPO contracts contain provisions which, if triggered, could result in the payment of penalties or lower future revenues and could materially and adversely affect our business, results of operations and financial condition.
Many of our BPO contracts contain service level and performance provisions, including standards relating to the quality of our services, that would provide our clients with the right to terminate their contract if we do not meet pre-agreed service level requirements and in the case of our contract with NUFIC, require us to pay penalties. Our contract with NUFIC also provides that, during the term of the contract and for 18 months thereafter, we may not develop or service products for NUFIC's competitors that are substantially similar to those we administer on behalf of NUFIC. Failure to meet these requirements could result in the payment of significant penalties by us to our clients which, in turn, could have a material adverse effect on our business, results of operations and financial condition.
Risks Related to our Wholesale Brokerage Business
We may not be able to accurately forecast our commission revenues because our commissions depend on premiums charged by insurance companies, which historically have varied and, as a result, have been difficult to predict.
Our Wholesale Brokerage business derives revenue principally from commissions paid by insurance companies, brokers and agents. Commissions are based upon a percentage of premiums paid by customers for insurance products. The amount of such commissions is therefore highly dependent on premium rates charged by insurance companies. We do not determine insurance premium rates. Premium rates are determined by insurance companies based on a fluctuating market and in many cases are regulated by the states in which they operate. We have generally encountered declining rates for property and casualty insurance since late 2006.
Premium pricing within the commercial property and casualty insurance market in which we operate historically has been cyclical based on the underwriting capacity of the insurance carriers operating in this market and has been impacted by general economic conditions. In a period of decreasing insurance capacity, insurance carriers typically raise premium rates. This type of market frequently is referred to as a "hard" market. In a period of increasing insurance capacity, insurance carriers tend to reduce premium rates. This type of market frequently is referred to as a "soft" market, which the commercial P&C market has been experiencing since 2006. Because our commission rates usually are calculated as a percentage of the gross premium charged for the insurance products that we place, our revenues are affected by the pricing cycle of the market and the amount of risk that is insured. General economic conditions may impact the amount of risk that is insured by companies by affecting the value of the insured properties, the size of company workforces and the willingness of companies to self-insure certain risks to reduce insurance expenses. The frequency and severity of natural disasters and other catastrophic events can affect the timing, duration and extent of industry cycles for many of the product lines we distribute. It is very difficult to predict the severity, timing or duration of these cycles. The cyclical nature of premium pricing in the commercial property and casualty insurance market may make our results of operations volatile and unpredictable. To the extent that an economic downturn and/or "soft" market persist for an extended period of time, our wholesale brokerage commissions and fees, financial condition and results of operations may be materially and adversely affected.
We may experience reductions in the commission revenues we receive from risk-bearing insurance companies as these insurance companies seek to reduce their expenses by reducing commission rates payable to non-affiliated brokers or agents such as us, which may significantly affect the profitability of our Wholesale Brokerage business.
As traditional risk-bearing insurance companies continue to outsource the production of premium revenues to non-affiliated brokers or agents such as us, those insurance companies may seek to reduce further their expenses by reducing the commission rates payable to those insurance agents or brokers. The reduction of these commission rates, along with general volatility and/or declines in premiums, may significantly affect the profitability of our Wholesale Brokerage business. Because we do not determine the timing or extent of premium pricing changes, we may not be able to accurately forecast our commission revenues, including whether they will significantly decline. As a result, we may have to adjust our budgets to account for unexpected changes in revenues, and any decreases in premium rates may have a material adverse effect on our results of operations.
The loss of the services of any of our highly qualified brokers could harm our business and operating results.
Our future performance depends on our ability to recruit and retain highly qualified brokers, including brokers who work in the businesses that we have acquired or may acquire in the future. Competition for productive brokers is intense, and our inability to recruit or retain these brokers could harm our business and operating results. While many of our senior brokers own an equity interest in us and many have entered into employment agreements with us, these brokers may not serve the term of their employment agreements or renew their employment agreements upon expiration. Moreover, any of the brokers who leave our firm may not comply with the provisions of their employment agreements that preclude them from competing with us or soliciting our customers and employees, or these provisions may not be enforceable under applicable law or sufficient to protect us from the loss of any business. In addition, we do not have employment, non-competition or non-solicitation agreements with all of our brokers. We may not be able to retain or replace the business generated by a broker who leaves our firm or replace that broker with an equally qualified broker who is acceptable to our clients.
Because our Wholesale Brokerage business is highly concentrated in California, adverse economic conditions or regulatory changes in that state could materially and adversely affect our financial condition.
A significant portion of our Wholesale Brokerage business is concentrated in California. For the years ended December 31, 2010 and 2009, $17.3 million and $15.9 million, respectively, or 74.3% and 70.5%, respectively, of Bliss & Glennon's wholesale brokerage commissions and fees that are attributable to a specific office were generated by its California offices. We believe the regulatory environment for insurance intermediaries in this state currently is no more restrictive than in other states. The insurance business is a state-regulated industry, and therefore, state legislatures may enact laws, and state insurance regulators may adopt regulations, that adversely affect the profitability of insurance industries in their states. Because our
Wholesale Brokerage business is concentrated in a few states, we face greater exposure to unfavorable changes in regulatory conditions in those states than insurance intermediaries whose operations are more diversified through a greater number of states. In addition, the occurrence of adverse economic conditions, natural or other disasters, or other circumstances specific to or otherwise significantly impacting these states could have a material adverse effect on our financial condition, results of operations and cash flows.
If insurance carriers begin to transact business without relying on wholesale insurance brokers, our business, results of operations, financial condition and cash flows could suffer.
Our Wholesale Brokerage business acts as an intermediary between retail agents and insurance carriers that, in some cases, will not transact business directly with retail insurance brokers and agents. If insurance carriers change the way they conduct business and begin to transact business with retail agents without including us or if retail agents are enabled to transact business directly with insurance carriers as a result of changes in the surplus lines and specialty insurance markets, technological advancements or other factors, our role in the distribution of surplus lines and specialty insurance products could be eliminated or substantially reduced, and our business, results of operations, financial condition and cash flows could suffer.
Our growth strategy may involve opening or acquiring new offices and will involve hiring new brokers and underwriters for our Wholesale Brokerage business, which will require substantial investment by us and may materially and adversely affect our results of operations and cash flows in a particular period.
Our ability to grow our Wholesale Brokerage business organically depends in part on our ability to open or acquire new offices and recruit new brokers and underwriters. We may not be successful in any efforts to open new offices or hire new brokers or underwriters. The costs of opening a new office and hiring the necessary personnel to staff the office can be substantial, and we often are required to commit to multi-year, non-cancelable lease agreements. It has been our experience that our new Wholesale Brokerage offices may not achieve profitability on a stand-alone basis until they have been in operation for at least three years. In addition, we often hire new brokers and underwriters with the expectation that they will not become profitable until 12 months after they are hired. The cost of investing in new offices, brokers and underwriters may have a material adverse effect on our results of operations and cash flows in future periods. Moreover, we may not be able to recover our investments or these offices, brokers and underwriters may not achieve profitability.
Our financial results may be materially and adversely affected by the occurrence of catastrophes.
Portions of our Wholesale Brokerage business involve the placement of insurance policies that cover losses from unpredictable events such as hurricanes, windstorms, hailstorms, earthquakes, fires, industrial explosions, freezes, riots, floods and other man-made or natural disasters, including acts of terrorism. The incidence and severity of these catastrophes in any given period are inherently unpredictable, and climate change could further exacerbate the severity and frequency of weather-related events. We are generally eligible to earn profit commissions, which are commissions we receive from carriers based upon the ultimate profitability of the business that we place with those carriers. The occurrence and severity of catastrophes could impair the amount of profit commissions that we receive in the future which could have a material adverse effect on our results of operations and financial condition.
We are subject to risks related to our profit commission arrangements and other compensation arrangements.
We derive a portion of our Wholesale Brokerage revenues from profit commissions based on the profitability of the insurance business we place with a carrier. Due to the inherent uncertainty of loss in our industry and changes in underwriting criteria due in part to the high loss ratios experienced by some carriers, we cannot predict the receipt of these profit commissions and the amount of such profit commissions may be less than we anticipated. Because profit commissions affect our revenues, any decrease in such amounts could have a material adverse effect on our results of operations and financial condition.
In addition, other companies have been the subject of investigations regarding profit commission arrangements by various governmental authorities within the past several years. Some of these investigations have focused on whether retail insurance brokers have adequately disclosed to their customers the receipt of profit commissions that are paid by insurance carriers to brokers based on the volume of business placed by the broker with the insurance carrier and other factors. We have not been subject to any investigations that are focused on our disclosure of profit commissions. The legislatures of various states may adopt new laws addressing profit commission arrangements, including laws limiting or prohibiting such arrangements, and adding new or different disclosure of such arrangements to insureds. Various state departments of insurance may also adopt new regulations addressing these matters. While we cannot predict the outcome of future governmental actions regarding commission payment practices or the responses by the market and government regulators, any unfavorable resolution of these matters could have a material adverse effect on our results of operations.
Risks Related to Regulatory and Legal Matters
We are subject to extensive governmental laws and regulations, which increase our costs and could restrict the conduct of our business.
Our operating subsidiaries are subject to extensive regulation and supervision in the jurisdictions in which they do business. Such regulation or compliance could reduce our profitability or limit our growth by increasing the costs of compliance, limiting or restricting the products or services we sell, or the methods by which we sell our services and products, or subjecting our businesses to the possibility of regulatory actions or proceedings. In all jurisdictions, the applicable laws and regulations are subject to amendment or interpretation by regulatory authorities. Generally, such authorities have broad discretion to grant, renew or revoke licenses and approvals and to implement new regulations. We may be precluded or temporarily suspended from carrying on some or all of our activities or otherwise fined or penalized in any jurisdiction in which we operate. No assurances can be made that our businesses can continue to be conducted in each jurisdiction as they have been in the past. Such regulation is generally designed to protect the interests of policyholders. To that end, the laws of the various states establish insurance departments with broad powers with respect to matters, such as:
Our non-insurance operations and certain aspects of our insurance operations are subject to various federal and state regulations, including state and federal consumer protection, privacy and other laws. An insurer's ability to write new business is partly a function of its statutory surplus. Maintaining appropriate levels of surplus as measured by Statutory Accounting Principles is considered important by insurance regulatory authorities and the private agencies that rate insurers' claims-paying abilities and financial strength. Failure to maintain certain levels of statutory surplus could result in increased regulatory scrutiny, a downgrade by rating agencies or enforcement action by regulatory authorities.
We may be unable to maintain all required licenses and approvals and, despite our best efforts, our business may not fully comply with the wide variety of applicable laws and regulations or the relevant regulators' interpretation of such laws and regulations. Also, some regulatory authorities have relatively broad discretion to grant, renew or revoke licenses and approvals or to limit or restrain operations in their jurisdiction. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, the insurance regulatory authorities could preclude or temporarily suspend us from operating, limit some or all of our activities or financially penalize us. These types of actions could have a material adverse effect on our results of operations and financial condition.
Failure to protect our clients' confidential information and privacy could result in the loss of reputation and customers, reduction in our profitability and subject us to fines, penalties and litigation.
We retain confidential information in our information systems, and we are subject to a variety of privacy regulations and confidentiality obligations. For example, some of our activities are subject to the privacy regulations of the Gramm-Leach-Bliley Act. We also have contractual obligations to protect confidential information we obtain from our clients. These obligations generally require us, in accordance with applicable laws, to protect such information to the same extent that we protect our own confidential information. We have implemented physical, administrative and logical security systems with the intent of maintaining the physical security of our facilities and systems and protecting our, our clients' and their customers' confidential information and personally-identifiable information against unauthorized access through our information systems or by other electronic transmission or through the misdirection, theft or loss of data. Despite such efforts, we are subject to a breach of our security systems which may result in unauthorized access to our facilities and/or the information we are trying to
protect. Anyone who is able to circumvent our security measures and penetrate our information systems could access, view, misappropriate, alter, or delete any information in the systems, including personally identifiable customer information and proprietary business information. In addition, most states require that customers be notified if a security breach results in the disclosure of personally-identifiable customer information. Any compromise of the security of our information systems that results in inappropriate disclosure of such information could result in, among other things, unfavorable publicity and damage to our reputation, governmental inquiry and oversight, difficulty in marketing our services, loss of clients, significant civil and criminal liability and the incurrence of significant technical, legal and other expenses, any of which may have a material adverse effect on our results of operations and financial condition.
Changes in regulation may reduce our profitability and limit our growth.
Legislation or other regulatory reform that increases the regulatory requirements imposed on us or that changes the way we are able to do business may significantly harm our business or results of operations in the future. If we were unable for any reason to comply with these requirements, it could result in substantial costs to us and may have a material adverse effect on our results of operations and financial condition. Legislative or regulatory changes that could significantly harm us and our subsidiaries include, but are not limited to:
In recent years, the state insurance regulatory framework has come under increased federal scrutiny and some state legislatures have considered or enacted laws that may alter or increase state authority to regulate insurance companies and insurance holding companies. Further, the National Association of Insurance Commissioners ("NAIC") and state insurance regulators are re-examining existing laws and regulations, specifically focusing on modifications to holding company regulations, interpretations of existing laws and the development of new laws and regulations. Additionally, there have been attempts by the NAIC and several states to limit the use of discretionary clauses in policy forms. The elimination of discretionary clauses could increase our costs under our Payment Protection products. New interpretations of existing laws and the passage of new legislation may harm our ability to sell new services and products and increase our claims exposure on policies we issued previously. In addition, the NAIC's proposed expansion of the Market Conduct Annual Statement could increase the likelihood of examinations of insurance companies operating in niche markets. Court decisions that impact the insurance industry could result in the release of previously protected confidential and privileged information by departments of insurance, which could increase the risk of litigation.
Traditionally, the U.S. federal government has not directly regulated the business of insurance. However, federal legislation and administrative policies in several areas can significantly and adversely affect insurance companies. These areas include financial services regulation, securities regulation, privacy, tort reform legislation and taxation. In view of recent events involving certain financial institutions and the financial markets, Congress passed and the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act"), which provides for the enhanced federal supervision of financial institutions, including insurance companies in certain circumstances, and financial activities that represent a systemic risk to financial stability or the U.S. economy.
Under the Dodd-Frank Act, the Federal Insurance Office will be established within the U.S. Treasury Department to monitor all aspects of the insurance industry and its authority would likely extend to all lines of insurance that our insurance subsidiaries write. The director of the Federal Insurance Office will serve in an advisory capacity to the Financial Stability Oversight Council and have the ability to recommend that an insurance company or an insurance holding company be subject to heightened prudential standards by the Federal Reserve, if it is determined that financial distress at the company could pose a threat to the financial stability of the U.S. economy. The Dodd-Frank Act also provides for the preemption of state laws when inconsistent with certain international agreements and would streamline the regulation of reinsurance and surplus lines insurance. At this time, we cannot assess whether any other proposed legislation or regulatory changes will be adopted, or what impact, if any, the Dodd-Frank Act or any other legislation or changes could have on our results of operations, financial condition or liquidity.
Further, in a time of financial uncertainty or a prolonged economic downturn, regulators may choose to adopt more restrictive insurance laws and regulations. For example, insurance regulators may choose to restrict the ability of insurance subsidiaries to make payments to their parent companies or reject rate increases due to the economic environment.
With respect to the property and casualty insurance policies our Payment Protection business underwrites, federal legislative proposals regarding National Catastrophe Insurance, if adopted, could reduce the business need for some of the related products we provide. Additionally, as the U.S. Congress continues to respond to the recent housing foreclosure crisis, it could enact legislation placing additional barriers on creditor-placed insurance.
With regard to payment protection products, there are federal and state laws and regulations that govern the disclosures related to lenders' sales of those products. Our ability to administer those products on behalf of financial institutions is dependent upon their continued ability to sell those products. To the extent that federal or state laws or regulations change to restrict or prohibit the sale of these products, our administration services and fees revenues would be adversely affected. The Dodd-Frank Act created a new Bureau of Consumer Financial Protection within the Federal Reserve, which will add new regulatory oversight for these lender products. The full impact of this oversight cannot be determined until the Bureau has been established and implementing regulations are put in place.
In recent years, several large organizations became subjects of intense public scrutiny due to high-profile data security breaches involving sensitive financial and health information. These events focused national attention on identity theft and the duty of organizations to notify impacted consumers in the event of a data security breach. Existing legislation in most states requires customer notification in the event of a data security breach. In addition, some states are adopting laws and regulations requiring minimum information security practices with respect to the collection and storage of personally-identifiable consumer data, and several bills before Congress contain provisions directed to national information security standards and breach notification requirements. Several significant legal, operational and reputational risks exist with regard to a data breach and customer notification. A breach of data security requiring public notification can result in regulatory fines, penalties or sanctions, civil lawsuits, loss of reputation, loss of clients and reduction of our profitability.
Our business is subject to risks related to litigation and regulatory actions.
We may be materially and adversely affected by judgments, settlements, unanticipated costs or other effects of legal and administrative proceedings now pending or that may be instituted in the future, or from investigations by regulatory bodies or administrative agencies. From time to time, we have had inquiries from regulatory bodies and administrative agencies relating to the operation of our business. Such inquiries may result in various audits, reviews and investigations. An adverse outcome of any investigation by, or other inquiries from, such bodies or agencies could have a material adverse effect on us and result in the institution of administrative or civil proceedings, sanctions and the payment of fines and penalties, changes in personnel, and increased review and scrutiny of us by our clients, regulatory authorities, potential litigants, the media and others.
In particular, our insurance-related operations are subject to comprehensive regulation and oversight by insurance departments in jurisdictions in which we do business. These insurance departments have broad administrative powers with respect to all aspects of the insurance business and, in particular, monitor the manner in which an insurance company offers, sells and administers its products. Therefore, we may from time to time be subject to a variety of legal and regulatory actions relating to our current and past business operations, including, but not limited to:
The prevalence and outcomes of any such actions cannot be predicted, and such actions or any litigation may have a material adverse effect on our results of operations and financial condition. In addition, if we were to experience difficulties with our relationship with a regulatory body in a given jurisdiction, it could have a material adverse effect on our ability to do business in that jurisdiction.
In addition, plaintiffs continue to bring new types of legal claims against insurance and related companies. Current and future court decisions and legislative activity may increase our exposure to these types of claims. Multi-party or class action claims may present additional exposure to substantial economic, non-economic and/or punitive damage awards. The success of even one of these claims, if it resulted in a significant damage award or a detrimental judicial ruling could have a material adverse
effect on our results of operations and financial condition. This risk of potential liability may make reasonable settlements of claims more difficult to obtain. We cannot determine with any certainty what new theories of liability or recovery may evolve or what their impact may be on our businesses.
We cannot predict at this time the effect that current litigation, investigations and regulatory activity will have on the industries in which we operate or our business. In light of the regulatory and judicial environments in which we operate, we will likely become subject to further investigations and lawsuits from time to time in the future. Our involvement in any investigations and lawsuits would cause us to incur legal and other costs and, if we were found to have violated any laws, we could be required to pay fines and damages, perhaps in material amounts. In addition, we could be materially and adversely affected by the negative publicity for the insurance and other financial services industries related to any such proceedings and by any new industry-wide regulations or practices that may result from any such proceedings.
Risks Related to Our Indebtedness
Our indebtedness may limit our financial and operating activities and may materially and adversely affect our ability to incur additional debt to fund future needs.
As of December 31, 2010, we had total indebtedness and redeemable preferred stock of $82.8 million. During the year ended December 31, 2010, our annual debt service requirement was $8.5 million. Our debt service obligations vary annually based on our variable rate indebtedness and redeemable preferred stock. Although we believe that our current cash flow will be sufficient to cover our annual interest expense, any increase in our indebtedness or any decline in the amount of cash available increases the possibility that we could not pay, when due, the principal of, interest on or other amounts due with respect to our indebtedness. In addition, our indebtedness and any future indebtedness we may incur could:
Any of the above-listed factors could have a material adverse effect on our business, financial condition, results of operations and cash flows.
Increases in interest rates could increase interest payable under our variable rate indebtedness and a portion of our redeemable preferred stock.
We are subject to interest rate risk in connection with our variable rate indebtedness and a portion of our redeemable preferred stock, which totaled $36.7 million and $2.0 million, respectively, at December 31, 2010. Interest rate changes could increase the amount of our interest payments and thus negatively impact our future earnings and cash flows. If we do not have sufficient earnings, we may be required to refinance all or part of our existing debt, sell assets, borrow more money or sell more securities, none of which we can guarantee we will be able to do.
Despite our indebtedness levels, we and our subsidiaries may still be able to incur more indebtedness, which could further exacerbate the risks described above.
We and our subsidiaries may be able to incur substantial additional indebtedness in the future subject to the limitations contained in the agreements governing our indebtedness. If we or our subsidiaries incur additional debt, the risks that we and they now face as a result of our indebtedness could intensify.
Restrictive covenants in the agreements governing our indebtedness may restrict our ability to pursue our business strategies.
The agreements governing our indebtedness contain a number of restrictive covenants that impose significant operating and financial restrictions on us and may limit our ability to pursue our business strategies or undertake actions that may be in our best interests. The agreements governing our indebtedness include covenants restricting, among other things, our ability to:
Our assets have been pledged to secure some of our existing indebtedness.
Our revolving credit facility with SunTrust Bank is secured by substantially all of our property and assets and property and assets owned by LOTS Intermediate Co. and certain of our subsidiaries that act as guarantors of our existing indebtedness. Such assets include the stock of LOTS Intermediate Co. and the right, title and interest of the borrowers and each guarantor in their respective material real estate property, fixtures, accounts, equipment, investment property, inventory, instruments, general intangibles, money, cash or cash equivalents, software and other assets and, in each case, the proceeds thereof, subject to certain exceptions. The total carrying value of all our assets was $541.5 million as of December 31, 2010. In the event of a default under our indebtedness, the lender could foreclose against the assets securing such obligations. A foreclosure on these assets could have a material adverse effect on our business, financial condition, results of operations and cash flows.
Risks Related to Our Technology and Intellectual Property
Our information systems may fail or their security may be compromised, which could damage our business and materially and adversely affect our results of operations and financial condition.
Our business is highly dependent upon the effective operation of our information systems and our ability to store, retrieve, process and manage significant databases and expand and upgrade our information systems. We rely on these systems throughout our businesses for a variety of functions, including marketing and selling our Payment Protection products, providing our BPO services, managing our operations, processing claims and applications, providing information to clients, performing actuarial analyses and maintaining financial records. The interruption or loss of our information processing capabilities through the loss of stored data, programming errors, the breakdown or malfunctioning of computer equipment or software systems, telecommunications failure or damage caused by weather or natural disasters or any other significant disruptions could harm our business, ability to generate revenues, client relationships, competitive position and reputation. Although we have additional data processing locations in Jacksonville, Florida and Atlanta, Georgia, disaster recovery procedures and insurance to protect against certain contingencies, such measures may not be effective or insurance may not continue to be available at reasonable prices, cover all such losses or be sufficient to compensate us for the loss of business that may result from any failure of our information systems. In addition, our information systems may be vulnerable to physical or electronic intrusions, computer viruses or other attacks which could disable our information systems and our security measures may not prevent such attacks. The failure of our systems as a result of any security breaches, intrusions or attacks could cause significant interruptions to our operations, which could result in a material adverse effect on our business, results of operations and financial condition.
The failure to effectively maintain and modernize our systems to keep up with technological advances could materially and adversely affect our business.
Our businesses are dependent upon our ability to ensure that our information systems keep up with technological advances. Our ability to keep our systems integrated with those of our clients is critical to the success of our businesses. If we do not effectively maintain our systems and update them to address technological advancements, our relationships and ability to do business with our clients may be materially and adversely affected. Our businesses depend significantly on effective information systems, and we have many different information systems for our various businesses. We must commit significant resources to maintain and enhance existing information systems and develop new systems that allow us to keep pace with continuing changes in information processing technology, evolving industry, regulatory and legal standards and changing client preferences. A failure to maintain effective and efficient information systems, or a failure to efficiently and effectively consolidate our information systems and eliminate redundant or obsolete applications, could have a material adverse effect on our results of operations and financial condition or our ability to do business in particular jurisdictions. If we do not effectively maintain adequate systems, we could experience adverse consequences, including:
Our success will depend, in part, on our ability to protect our intellectual property rights and our ability not to infringe upon the intellectual property rights of third parties.
The success of our business will depend, in part, on preserving our trade secrets, maintaining the security of our know-how and
data and operating without infringing upon patents and proprietary rights held by third parties. Failure to protect, monitor and control the use of our intellectual property rights could cause us to lose a competitive advantage and incur significant expenses. We rely on a combination of contractual provisions, confidentiality procedures and copyright, trademark, service mark and trade secret laws to protect the proprietary aspects of our brands, technology and data. These legal measures afford only limited protection, and competitors or others may gain access to our intellectual property and proprietary information.
Our trade secrets, data and know-how could be subject to unauthorized use, misappropriation, or disclosure. Our trademarks could be challenged, forcing us to re-brand our services or products, resulting in loss of brand recognition and requiring us to devote resources to advertising and marketing new brands or licensing. If we are found to have infringed upon the intellectual property rights of third parties, we may be subject to injunctive relief restricting our use of affected elements of intellectual property used in the business, or we may be required to, among other things, pay royalties or enter into licensing agreements in order to obtain the rights to use necessary technologies, which may not be possible on commercially reasonable terms, or redesign our systems, which may not be feasible.
Furthermore, litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets and to determine the validity and scope of our proprietary rights. The intellectual property laws and other statutory and contractual arrangements we currently depend upon may not provide sufficient protection in the future to prevent the infringement, use or misappropriation of our trademarks, data, technology and other services and products. Policing unauthorized use of intellectual property rights can be difficult and expensive, and adequate remedies may not be available. Any future litigation, regardless of outcome, could result in substantial expense and diversion of resources with no assurance of success and could have a material adverse effect on our business, results of operation and financial condition.
Risks Related to Our Common Stock
There may not be an active, liquid trading market for our common stock.
Prior to the Company's Initial Public Offering, there had been no public market for shares of our common stock. We cannot predict the extent to which investor interest in our company will lead to the development of a trading market on the New York Stock Exchange or how liquid that market may become. If an active trading market does not develop, you may have difficulty selling any of our common stock that you purchase.
As a public company, we are subject to additional financial and other reporting and corporate governance requirements that may be difficult for us to satisfy.
We have historically operated our business as a private company. Since the completion of our IPO we have been required to file with the SEC annual and quarterly information and other reports that are specified the Exchange Act. We are required to ensure that we have the ability to prepare financial statements that are fully compliant with all SEC reporting requirements on a timely basis. We are subject to other reporting and corporate governance requirements, including the requirements of the New York Stock Exchange, and certain provisions of the Sarbanes-Oxley Act of 2002, ("SOX") and the regulations promulgated thereunder, which impose significant compliance obligations upon us. As a public company, we are required to:
Our internal control over financial reporting has not been tested and may not meet the standards required by Section 404 of SOX and the failure to achieve and maintain effective internal control over financial reporting in accordance with Section 404 of SOX could materially and adversely affect us.
Prior to our IPO, we were a private company with limited accounting personnel and other resources with which to address our internal controls and procedures over financial reporting. Our internal control over financial reporting may not currently meet the standards required by Section 404, standards that we will be required to meet in the course of preparing our 2011 financial statements. We are currently documenting our internal controls, and evaluating the design effectiveness of our processes and will begin evaluating the operating effectiveness of our controls in accordance with Section 404.
We are in the early stages of addressing our internal control procedures to satisfy the requirements of Section 404, which requires an annual management assessment of the effectiveness of our internal control over financial reporting. We implemented several measures to improve our internal control over financial reporting, including (i) the hiring of a chief financial officer, and a vice president of internal audit and SOX compliance effective October 1, 2010, together with three additional audit professionals; (ii) increasing the headcount of qualified financial reporting personnel, including an SEC reporting manager, effective December 6, 2010; (iii) improving the capabilities of existing financial reporting personnel through training and education in the reporting requirements and deadlines set under U.S. GAAP, SEC rules and regulations and SOX and (iv) transitioning to an Oracle platform for our general ledger, purchasing and accounts payable systems.
If, as a public company, we are not able to implement the requirements of Section 404 in a timely manner or with adequate compliance, our independent registered public accounting firm may not be able to attest to the effectiveness of our internal control over financial reporting. If we are unable to maintain adequate internal control over financial reporting, we may be unable to report our financial information on a timely basis, may suffer adverse regulatory consequences or violations of applicable stock exchange listing rules and may breach the covenants under our credit facilities. There could also be a negative reaction in the financial markets due to a loss of investor confidence in us and the reliability of our financial statements.
If we are unable to comply we would incur additional costs in order to improve our internal control over financial reporting and comply with Section 404, including increased auditing and legal fees and costs associated with hiring additional accounting and administrative staff.
Our principal stockholder has substantial control over us.
Affiliates of Summit Partners collectively and beneficially own approximately 61.4% of our outstanding common stock. As a consequence, Summit Partners or its affiliates continue to be able to exert a significant degree of influence or actual control over our management and affairs and matters requiring stockholder approval, including the election of directors, a merger, consolidation or sale of all or substantially all of our assets, and any other significant transaction. The interests of this stockholder may not always coincide with our interests or the interests of our other stockholders. For instance, this concentration of ownership may have the effect of delaying or preventing a change in control of us otherwise favored by our other stockholders and could depress our stock price.
We expect that our stock price will fluctuate significantly, which could cause the value of your investment to decline, and you may not be able to resell your shares at or above the initial public offering price.
Securities markets worldwide have experienced, and are likely to continue to experience, significant price and volume fluctuations. This market volatility, as well as general economic, market or political conditions, could reduce the market price of our common stock regardless of our operating performance. The trading price of our common stock may be volatile and subject to wide price fluctuations in response to various factors, including:
These and other factors may cause the market price and demand for our common stock to fluctuate substantially, which may limit or prevent investors from readily selling their shares of common stock and may otherwise negatively affect the liquidity of our common stock. In addition, in the past, when the market price of a stock has been volatile, holders of that stock have sometimes instituted securities class action litigation against the company that issued the stock. If any of our stockholders brought a lawsuit against us, we could incur substantial costs defending the lawsuit. Such a lawsuit could also divert the time and attention of our management from our business, which could significantly harm our profitability and reputation.
If a substantial number of shares become available for sale and are sold in a short period of time, the market price of our common stock could decline.
If our stockholders sell substantial amounts of our common stock in the public market, the market price of our common stock could decrease significantly. The perception in the public market that our existing stockholders might sell shares of common stock could also depress the market price of our common stock. At December 31, 2010 we had 20,256,735 shares of common stock outstanding. Our directors, executive officers and affiliates hold 12,903,019 of these shares, some of which are subject to
vesting. After the lock-up agreements, entered into in connection with our IPO, have expired and holding periods subject to Rule 144 have elapsed, these shares will be eligible for sale in the public market. The market price of shares of our common stock may drop significantly when the restrictions on resale by our existing stockholders lapse. A decline in the price of shares of our common stock might impede our ability to raise capital through the issuance of additional shares of our common stock or other equity securities.
If securities or industry analysts do not publish research or reports about our business, publish research or reports containing negative information about our business, adversely change their recommendations regarding our stock or if our results of operations do not meet their expectations, our stock price and trading volume could decline.
The trading market for our common stock is influenced by the research and reports that industry or securities analysts publish about us or our business. If one or more of these analysts cease coverage of our company or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline. Moreover, if one or more of the analysts who cover us downgrade our stock, or if our results of operations do not meet their expectations, our stock price could decline.
Some provisions of Delaware law and our amended and restated certificate of incorporation and bylaws may deter third parties from acquiring us and diminish the value of our common stock.
Our amended and restated certificate of incorporation and bylaws provide for, among other things:
These provisions in our amended and restated certificate of incorporation and bylaws may discourage, delay or prevent a transaction involving a change in control of our company that is in the best interest of our non-controlling stockholders. Even in the absence of a takeover attempt, the existence of these provisions may adversely affect the prevailing market price of our common stock if they are viewed as discouraging future takeover attempts.
Applicable insurance laws may make it difficult to effect a change in control of us.
State insurance regulatory laws contain provisions that require advance approval, by the state insurance commissioner, of any change in control of an insurance company that is domiciled, or, in some cases, having such substantial business that it is deemed to be commercially domiciled, in that state. We own, directly or indirectly, all of the shares of stock of insurance companies domiciled in Delaware, Georgia and Louisiana, and 85% of the shares of stock of an insurance company domiciled in Kentucky. Because any purchaser of shares of our common stock representing 10% or more of the voting power of our capital stock generally will be presumed to have acquired control of these insurance company subsidiaries, the insurance change in control laws of Delaware, Georgia, Louisiana and Kentucky would apply to such a transaction.
In addition, the laws of many states contain provisions requiring pre-notification to state agencies prior to any change in control of a non-domestic insurance company subsidiary that transacts business in that state. While these pre-notification statutes do not authorize the state agency to disapprove the change in control, they do authorize issuance of cease and desist orders with respect to the non-domestic insurer if it is determined that conditions, such as undue market concentration, would result from the change in control.
These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of our company, including through transactions, and in particular unsolicited transactions, that some or all of our shareholders might consider to be desirable.
We do not anticipate paying any cash dividends for the foreseeable future.
We currently intend to retain our future earnings, if any, for the foreseeable future, to repay indebtedness and for general corporate purposes. We do not intend to pay any dividends to holders of our common stock. As a result, capital appreciation in the price of our common stock, if any, will be your only source of gain on an investment in our common stock.
ITEM 1B. UNRESOLVED STAFF COMMENTS
ITEM 2. PROPERTIES
At December 31, 2010, Fortegra Financial leased its principal executive offices located at 100 West Bay Street, Jacksonville, FL 32202, consisting of approximately 50,000 square feet. In October 2010, Fortegra terminated the aforementioned lease and entered into a new 11 year lease for approximately 58,000 square feet of office space at 10151 Deerwood Park Boulevard, Building 100, Jacksonville, FL, 32256. The new lease will commence upon the substantial completion of all necessary leasehold improvements which occurred on March 1, 2011.
In addition, we lease approximately 100,000 square feet of office space in approximately 20 locations throughout the United States. Most of our leases have lease terms of three to five years with provisions for renewals. We believe our properties are adequate for our business as presently conducted. Please refer to the footnotes, "Property and Equipment" and "Leases", in the Notes to the Consolidated Financial Statements included in Item 8 of this Annual Report for additional information.
ITEM 3. LEGAL PROCEEDINGS
We are a party to claims and litigation in the normal course of our operations. We believe that the ultimate outcome of these matters will not have a material adverse effect on our consolidated financial position, results of operations or cash flows. In our Payment Protection business, we are currently a defendant in lawsuits which relate to marketing and/or pricing issues that involve claims for punitive, exemplary or extra-contractual damages in amounts substantially in excess of the covered claim. We consider such litigation customary in our line of business. In our opinion, the ultimate resolution of such litigation, which we are vigorously defending, should not be material to our financial position, results of operations or cash flows. It should be noted that large punitive damage awards, bearing little relation to actual damages sustained by plaintiffs, have been awarded in certain states against other companies in the credit insurance business.
ITEM 4. REMOVED AND RESERVED
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is listed on the New York Stock Exchange under the Symbol "FRF" and began trading on December 17, 2010. At December 31, 2010, there were 20,256,735 shares of our common stock outstanding, held by approximately 32 stockholders of record. The table below sets forth, for the periods indicated, the high and low sales prices for our common stock as reported on the NYSE Composite Tape since our IPO.
Dividend and Issuer Purchases of Equity Securities
For the quarter ended December 31, 2010, the Company did not have any purchases of its stock.
We have not declared or paid cash dividends on our common stock in the past two years. We do not anticipate paying any cash dividends on our capital stock in the foreseeable future. We intend to retain all available funds and any future earnings to reduce debt and fund the development and growth of our business. Any future determination to pay dividends will be at the discretion of our board of directors and will take into account: restrictions in our debt instruments; general economic business conditions; our financial condition and results of operations; the ability of our operating subsidiaries to pay dividends and make distributions to us; and such other factors as our board of directors may deem relevant.
Our 2011 Proxy Statement includes information relating to the compensation plans under which our equity securities are authorized for issuance, under the heading "Equity Compensation Plan," and we incorporate such information herein by reference. Please refer to the footnote, "Stock-Based Compensation", in the Notes to the Consolidated Financial Statements included in Item 8 of this Annual Report for additional information relating to our compensation plans under which our equity securities are authorized for issuance.
Recent Sales of Unregistered Securities
During the year ended December 31, 2010, we made sales of the following unregistered securities:
Use of Proceeds from Registered Securities
On December 22, 2010, we closed our IPO, in which 6,000,000 shares of common stock were sold at a price to the public of $11 per share. We sold 4,265,637 shares of our common stock in the offering and selling stockholders sold 1,734,363 of the shares of common stock in the offering. The aggregate offering price for all shares sold in the offering, including shares sold by us and the selling stockholders, was $66.0 million. The offer and sale of all of the shares in the IPO were registered under the Securities Act of 1933, as amended, pursuant to a registration statement on Form S-1 (File No. 333-169550), which was declared effective by the SEC on December 16, 2010. The offering commenced as of December 16, 2010 and terminated before all but 900,000 shares of our common stock (which were subject to the underwriters' over-allotment option) registered in the registration statement were sold. Piper Jaffray & Co. acted as representatives of the underwriters. We raised approximately $40.7 million in net proceeds after deducting underwriting discounts and commissions and estimated expenses payable by us in connection with the IPO. We used the net proceeds received from the IPO to pay down approximately $8.9 million of our revolving credit facility, $20.6 million to repay, in full, our outstanding subordinated debentures and $14.1 million to pay the conversion amount on our Class A common stock. From the $14.1 million paid for the conversion of our Class A common stock, $14.0 million was paid to affiliates of Summit Partners and $0.1 million was paid to other holders of our Class A common stock, including certain of our executive officers. No other payments were made by us to directors, officers or persons owning ten percent or more of our common stock or to their associates, or to our affiliates, other than payments in the ordinary course of business to officers for salaries and to non-employee directors as compensation for board or board committee service, or as a result of sales of shares of common stock by selling stockholders in the initial public offering. There has been no material change in the planned use of proceeds from our IPO as described in our final prospectus filed with the SEC pursuant to Rule 424(b) on December 17, 2010.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth our consolidated selected financial data for the periods and as of the dates indicated and are derived from our audited consolidated financial statements. On June 20, 2007, affiliates of Summit Partners acquired a majority of our capital stock. All periods prior to June 20, 2007 are referred to as "Predecessor," and all periods including and after such date are referred to as "Successor." The consolidated financial statements for all Successor periods are not comparable to those of the Predecessor periods. The following consolidated financial data should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") in Part II, Item 7 of this Annual Report and the Consolidated Financial Statements and related footnotes included in Part II, Item 8 of this Annual Report. All acquisitions of Fortegra during the five years ended December 31, 2010 are included in results of operations since their respective dates of acquisition.
ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Management's Discussion and Analysis represents an overview of our results of operations and financial condition. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in Part II, Item 8 of this Annual Report.
We are an insurance services company that provides distribution and administration services and insurance-related products to insurance companies, insurance brokers and agents and other financial services companies in the United States. We sell our services and products directly to businesses rather than directly to consumers.
We began nearly 30 years ago as a provider of credit insurance products and, through our transformational efforts, have evolved into a diversified insurance services company. We now leverage our proprietary technology infrastructure, internally developed best practices and access to specialty insurance markets to provide our clients with distribution and administration services and insurance-related products. Our services and products complement consumer credit offerings, provide outsourcing solutions designed to reduce the costs associated with the administration of insurance and other financial products and facilitate the distribution of excess and surplus lines insurance products through insurance companies, brokers and agents. These services and products are designed to increase revenues, improve customer value and loyalty and reduce costs for our clients.
We intend to take advantage of embedded growth opportunities and new market development through geographic expansion, expanding our products and service presence with existing clients and acquiring complementary businesses. To support our growth initiatives, we continue to focus on adding enhanced features to our existing information systems and developing new processes to enhance efficiency, drive economies of scale and provide additional competitive advantages.
We operate in three business segments: Payment Protection, BPO and Wholesale Brokerage.
We were incorporated in 1981 and initially provided credit life and disability insurance for financial institutions, primarily small community banks in Georgia, and their customers under our Life of the South brand. From 1994 to 2003, through a series of strategic acquisitions and organic growth, we expanded our payment protection client or producer base to include consumer finance companies, retailers, automobile dealers, credit card issuers, credit unions and regional and community banks throughout the United States. During this period, we expanded our product and service offerings to include credit property, debt cancellation and warranty products. In 2008, we changed our name from Life of the South Corporation to Fortegra Financial Corporation.
In 2003, we continued the expansion of our administrative capabilities for insurance and payment protection products to customers of financial institutions. We utilized our proprietary technology enhancements to support mass marketing and began
providing fulfillment of life and health insurance products. We previously operated our BPO business under the LOTSolutions brand. In 2007, we expanded our BPO segment to provide services to finance companies owned by industrial equipment manufacturers. We entered into the asset recovery business in December 2008 through our acquisition of CIRG, a third-party administrator serving commercial lending institutions for pre-collections, recovery, deficiency collections, dealer inventory seizures and management of asset portfolio run-off. Our asset recovery business is part of our BPO segment.
In March 2008, we acquired Gulfco Life Insurance Company to expand the presence of our Payment Protection segment in the Louisiana market. In December 2008, we acquired Darby & Associates, a wholesale provider of payment protection products in North Carolina. This acquisition expanded our Payment Protection segment in North Carolina, which is that segment's third largest state in terms of 2009 revenues and an important foothold with our consumer finance company clients (our largest distribution channel within the Payment Protection segment). In April 2009, we acquired Bliss & Glennon, an excess and surplus lines wholesale insurance broker, and entered into the wholesale brokerage business, which continued our strategic expansion of specialized and administration services for insurance carriers and other financial services businesses.
In 2010, we commenced marketing our BPO segment under the Consecta brand. Through our February 2010 acquisition of South Bay Acceptance Corporation, we expanded into premium finance to support our Wholesale Brokerage segment. In May 2010, we acquired Continental Car Club, which provides car club memberships through consumer finance companies, to enable our Payment Protection segment to expand into the roadside assistance market. In September 2010, we acquired United Motor Club, which also provides car club memberships through consumer finance companies.
We historically have used a combination of cash on hand and borrowings under our lines of credit to pay the purchase price of our acquisitions. The following table summarizes our acquisition activity for the years ended December 31, 2010, 2009, and 2008:
(1) Includes the purchase of Gulfco Life Insurance Company in 2008. Gulfco Life Insurance Company was acquired for cash consideration equal to its statutory surplus and the value of the single state license. As of December 31, 2009, Gulfco Life Insurance Company had been merged into one of our other subsidiaries.
Summit Partners Transactions
In June 2007, entities affiliated with Summit Partners, a global growth equity investment firm, acquired 91.2% of our capital stock. The acquisition was financed through (i) $20.0 million of subordinated debentures maturing in 2013 issued to affiliates of Summit Partners, (ii) $35.0 million of preferred trust securities maturing in 2037 and (iii) an equity investment of $43.1 million by affiliates of Summit Partners. In connection with the acquisition, all of our $11.5 million of redeemable preferred stock outstanding prior to the acquisition remained outstanding and certain stockholders prior to the acquisition continued to hold such shares after the acquisition. In addition to acquiring our capital stock in the acquisition, the proceeds from the equity and debt financings were used to repay pre-transaction indebtedness of $10.1 million and pay transaction costs of $5.8 million. We refer to the foregoing transactions collectively as the "Summit Partners Transactions."
In April 2009, in connection with our acquisition of Bliss and Glennon, Inc., affiliates of Summit Partners acquired additional shares of our capital stock for $6.0 million. In connection with the IPO, Summit Partners sold 1,548,675 shares of stock. At December 31, 2010, affiliates of Summit Partners beneficially owned 61.4% of our common stock.
Critical Accounting Policies
The preparation of our consolidated financial statements in accordance with generally accepted accounting principles in the United States of America ("U.S. GAAP") requires management to make estimates that affect the reported amounts of our assets, liabilities, revenues and expenses. Please see the footnote, "Summary of Significant Accounting Policies" in the Notes to the Consolidated Financial Statements, including the use of estimates, included in Item 8 of this Annual Report for additional information.
We periodically evaluate our estimates, which are based on historical experience and on various other assumptions that management believes to be reasonable under the circumstances. Critical accounting policies are those that are most important to the portrayal of our financial condition and results of operations and require management's most difficult, subjective or complex judgments, as a result of the need to make estimates about the effect of matters that are inherently uncertain. If actual performance should differ from historical experience or if the underlying assumptions were to change, our financial condition and results of operations may be materially impacted. In addition, some accounting policies require significant judgment to
apply complex principles of accounting to certain transactions, such as acquisitions, in determining the most appropriate accounting treatment. We believe that the significant accounting estimates and policies described below are material to our financial reporting and are subject to a degree of subjectivity and/or complexity.
We regularly monitor our investment portfolio to ensure investments that may be other-than-temporarily impaired are identified in a timely fashion, properly valued, and charged against earnings in the proper period. The determination that a security has incurred an other-than-temporary decline in value requires the judgment of management. The analysis takes into account relevant factors, both quantitative and qualitative in nature. Among the factors considered are the following: the length of time and the extent to which fair value has been less than cost; issuer-specific considerations, including an issuer's short-term prospects and financial condition, recent news that may have an adverse impact on its results, and an event of missed or late payment or default; the occurrence of a significant economic event that may affect the industry in which an issuer participates; and for loan-backed and structured securities, the undiscounted estimated future cash flows as compared to the current book value. When such impairments occur, the decrease in fair value is reported in net income as a realized investment loss and a new cost basis is established.
With respect to securities where the decline in fair value is determined to be temporary and the security's value is not written down, a subsequent decision may be made to sell that security and realize a loss. If we do not expect for a security's decline in fair value to be fully recovered prior to the expected time of sale, we would record an other-than-temporary impairment in the period in which the decision to sell is made.
There are inherent risks and uncertainties involved in making these judgments. Changes in circumstances and critical assumptions such as a continued weak economy, a more pronounced economic downturn or unforeseen events which affect one or more companies, industry sectors or countries could result in additional impairments in future periods for other-than-temporary declines in value. Please see the footnote, "Investments" in the Notes to the Consolidated Financial Statements included in Item 8 of this Annual Report for additional information and Item 1A - "Risk Factors - Risks Related to Our Payment Protection Business - Our investment portfolio is subject to several risks that may diminish the value of our invested assets and affect our business and profitability" and "Liquidity and Capital Resources - Invested Assets" contained elsewhere in this Annual Report.
Reinsurance receivables include amounts related to paid benefits and estimated amounts related to unpaid policy and contract claims, future policyholder benefits and policyholder contract deposits. The cost of reinsurance is accounted for over the terms of the underlying reinsured policies using assumptions consistent with those used to account for the underlying policies. Amounts recoverable from reinsurers are estimated in a manner consistent with claim and claim adjustment expense reserves or future policy benefits reserves and are reported in our consolidated balance sheets.
In the ordinary course of business, we are involved in both the assumption and cession of reinsurance with non-affiliated companies, including reinsurance companies owned by our clients. The following table provides details of the reinsurance receivables balance as of December 31, 2010, and 2009:
We utilize reinsurance for loss protection and capital management. See "Risk Factors - Risks Related to Our Payment Protection Business - Reinsurance may not be available or adequate to protect us against losses, and we are subject to credit risk of reinsurers."
Property and Equipment
Property and equipment are carried at cost, net of accumulated depreciation. Gains and losses on sales and disposals of property and equipment are based on the net book value of the related asset at the disposal date using the specific identification method. Maintenance and repairs, which do not materially extend asset useful life and minor replacements, are charged to earnings when incurred. We recognize depreciation expense using the straight-line method over the estimated useful lives of the respective assets with three years for computers and five years for furniture and fixtures, equipment and software. Leasehold improvements and capitalized leases are depreciated over the remaining life of the lease.
We capitalize internally developed software costs on a project-by-project basis in accordance with Accounting Standards Codification ("ASC") 350-40, Intangibles - Goodwill and Other: Internal-Use Software. All costs to establish the technological feasibility of computer software development is expensed to operations when incurred. Internally developed software development costs are carried at the lower of unamortized cost or net realizable value and are amortized based on the current and estimated useful life of the software. Amortization over the estimated useful life of five years begins when the software is ready for its intended use.
Deferred Acquisition Costs
The costs of acquiring new business and retaining existing business, principally commissions, premium taxes and certain underwriting and marketing costs that vary with and are primarily related to the processing of new business, have been deferred and are amortized as the related premium is earned. The amortization of deferred acquisition costs are recorded in commissions expense or other operating expense in our consolidated statements of income. The amortization of deferred acquisition costs related to commissions is classified as commission expense. The amortization of deferred acquisition costs related to premium taxes and certain underwriting and marketing costs is classified as other operating expenses.
Amortization of deferred acquisition costs for the years ended December 31, 2010, 2009 and 2008, totaled $57.3 million, $57.7 million and $60.6 million, respectively. We consider investment income in determining whether deferred acquisition costs are recoverable at year-end. No write-offs for unrecoverable deferred acquisition costs were recognized during the years ended December 31, 2010, 2009 and 2008.
Goodwill and Other Intangible Assets
Goodwill represents the excess cost of an acquisition over the fair value of the net assets acquired in a business combination.
We review our goodwill annually in the fourth quarter for impairment or more frequently if indicators of impairment exist. We regularly assess whether any indicators of impairment exist. Such indicators include, but are not limited to, a sustained significant decline in our market value or a significant decline in our expected future cash flows due to changes in company-specific factors or the broader business climate. The evaluation of such factors requires considerable judgment by management. Any adverse change in these factors could have a significant impact on the recoverability of goodwill and could have a material impact on our consolidated financial statements. Goodwill and other intangible assets represented $113.7 million, $93.6 million, and $57.7 million of our total assets as of December 31, 2010, 2009 and 2008, respectively.
Goodwill resulting from the Summit Partners Transactions and from acquisitions of other businesses is carried as an asset on the balance sheet and is not amortized, but is evaluated annually to determine whether impairment exists. Management assessed goodwill as of December 31, 2010, and 2009 and determined that no impairment existed as of those dates. During the third quarter of 2008, the amount of goodwill recognized as part of the Summit Partners Transactions was determined to be $31.7 million as part of the remeasurement period. During 2008, we recognized approximately $0.6 million of goodwill related to our acquisition of Darby & Associates, Inc. and approximately $1.3 million related to our acquisition of CIRG. As part of the purchase of Bliss & Glennon in April 2009, we recognized $29.9 million of goodwill and $8.7 million of other intangible assets. As part of the purchase of South Bay Acceptance Corporation in February 2010, we recognized $0.5 million of goodwill. As part of the purchase of Continental Car Club in May 2010, we recorded $11.8 million of goodwill and $1.1 million of other intangible assets. In addition, we recorded $8.5 million of goodwill and $1.4 million of other intangible assets associated with the purchase of United Motor Club in September 2010. We recorded amortization expense of $3.2 million, $2.7 million, and $2.1 million for the year ended December 31, 2010, 2009 and 2008, respectively, related to other intangible assets.
When required, we test goodwill for impairment at the reporting unit level. Following the goodwill guidance, which is included within Accounting Standards Codification ("ASC") Topic 350, Intangibles - Goodwill and Other, we have concluded that our reporting units for goodwill testing are equivalent to our reported business segments, excluding the corporate segment.
The following table illustrates the amount of goodwill assigned to each business segment as of December 31, 2010:
Unpaid claims are reserve estimates that are established in accordance with U.S. GAAP using generally accepted actuarial methods. Credit life, credit disability and accidental death and dismemberment ("AD&D") unpaid claims reserves include claims in the course of settlement and incurred but not reported ("IBNR"). For all other product lines, unpaid claims reserves are entirely IBNR. We use a number of algorithms in establishing our unpaid claims reserves. These algorithms are used to calculate unpaid claims as a function of paid losses, earned premium, target loss ratios, in force amounts, unearned premium reserves; industry recognized morbidity tables or a combination of these factors. The factors used to develop the IBNR vary by product line. However, in general terms, the factor used to develop IBNR for credit life insurance is a function of the amount of life insurance in force. The factor can vary from $0.60 to $1.00 per $1,000 of in force coverage. The factor used to develop IBNR for credit disability is a function of the pro-rata unearned premium reserve and is typically 5% of unearned premium reserve. Finally, IBNR for AD&D policies is a function of in force coverage and is currently $0.11 per $1,000 of in force coverage.
In accordance with applicable statutory insurance company regulations, our unpaid claims reserves are evaluated by appointed actuaries. The appointed actuaries perform this function in compliance with the Standards of Practice and Codes of Conduct of the American Academy of Actuaries. The appointed actuaries perform their actuarial analysis each year and prepare opinions, statements and reports documenting their determinations. The appointed actuaries conduct their actuarial analysis on a basis gross of reinsurance. The same estimates used as a basis in calculating the gross unpaid claims reserves are then used as the basis for calculating the net unpaid claims reserves, which take into account the impact of reinsurance.
Anticipated future loss development patterns form a key assumption underlying these analyses. Our claims are generally reported and settled quickly resulting in a consistent historical loss development pattern. From the anticipated loss development patterns, a variety of actuarial loss projection techniques are employed, such as chain ladder method, the Bornhuetter-Ferguson method and expected loss ratio method.
Our unpaid claims reserves do not represent an exact calculation of exposure, but instead represent our best estimates, generally involving actuarial projections at a given time. The process used in determining our unpaid claims reserves cannot be exact since actual claim costs are dependent upon a number of complex factors such as changes in doctrines of legal liabilities and damage awards. These factors are not directly quantifiable, particularly on a prospective basis. We periodically review and update our methods of making such unpaid claims reserve estimates and establishing the related liabilities based on our actual experience. We have not made any changes to our methodologies for determining unpaid claims reserves in the periods presented. For further information about our reserving methodology, see the footnote, "Unpaid Claims" in the Notes to the Consolidated Financial Statements included in Item 8 of this Annual Report.
The following table provides unpaid claims reserve information by Payment Protection product line: (in thousands)
(1) "In Course of Settlement" represents amounts reserved to pay claims known but are not yet paid.
(2) IBNR reserves represent amounts reserved to pay claims where the insured event has occurred and has not yet been reported. IBNR reserves for credit disability also include the net present value of future claims payment of $1,094, $1,159 and $1,201 as of December 31, 2010, December 31, 2009 and December 31, 2008, respectively.
(3) General liability primarily represents amounts reserved to pay claims on contractual liability policies behind debt cancellation products.
Prior years' incurred claims increased $0.1 million during 2010 due to the unfavorable development in payment patterns for the credit property lines of business. Incurred claims decreased $0.6 million during 2009 due to the favorable development in payment patterns for the credit property lines of business in 2009. The $2.3 million decrease in 2008 primarily resulted from a single bank customer that assumed the exposure on their block of business during that period.
Most of our credit insurance business is written on a retrospective commission basis, which permits management to adjust commissions based on claims experience. Thus, any adjustment to prior years' incurred claims in this line of business is partially offset by a change in retrospective commissions.
While management has used its best judgment in establishing the estimate of required unpaid claims, different assumptions and variables could lead to significantly different unpaid claims estimates. Two key measures of loss activity are loss frequency, which is a measure of the number of claims per unit of insured exposure, and loss severity, which is based on the average size of claims. Factors affecting loss frequency and loss severity include changes in claims reporting patterns, claims settlement patterns, judicial decisions, legislation, economic conditions, morbidity patterns and the attitudes of claimants towards settlements. The adequacy of our unpaid claims reserves will be impacted by future trends that impact these factors.
While our cost of claims has not varied significantly from our reserves in prior periods, if the actual level of loss frequency and severity are higher or lower than expected, our paid claims will be different than management's estimate. We believe that, based on our actuarial analysis, an aggregate change that is greater than ± 10% (or 5% for each of loss frequency and severity) is not probable. The effect of higher and lower levels of loss frequency and severity levels on our ultimate cost for claims occurring in 2010 would be as follows (dollars in thousands):
Adjustments to our unpaid claims reserves, both positive and negative, are reflected in our statement of income for the period in which such estimates are updated. Because the establishment of our unpaid claims reserves is an inherently uncertain process involving estimates of future losses, there can be no certainty that ultimate losses will not exceed existing claims reserves. Future loss development could require our reserves to be increased, which could have a material adverse effect on our earnings in the periods in which such increases are made.
Premiums written are earned over the period that coverage is provided. Unearned premiums represent the portion of premiums that will be earned in the future and are generally calculated using the pro-rata method. A premium deficiency reserve is
recorded if anticipated losses, loss adjustment expenses and maintenance costs exceed the recorded unearned premium reserve and anticipated investment income. As of December 31, 2010, 2009 and 2008, no such reserve was recorded.
The calculation of tax liabilities is complex, and requires the use of estimates and judgments by management since it involves application of complex tax laws. We record our income taxes in accordance with the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recorded based on the difference between the tax basis of assets and liabilities and their carrying amounts for financial reporting purposes, referred to as temporary differences, and are based on the enacted tax laws and statutory tax rates applicable to the periods in which we expect the temporary differences to reverse.
Under ASC Topic 740, a deferred tax asset should be reduced by a valuation allowance if, based on the weight of all available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized. In determining whether our deferred tax asset is realizable, we considered all available evidence, including both positive and negative evidence. The realization of deferred tax assets depends upon the existence of sufficient taxable income of the same character during the carry-back or carry-forward period. We considered all sources of taxable income available to realize the deferred tax asset, including the future reversal of existing temporary differences, future taxable income exclusive of reversing temporary differences and carry forwards, taxable income in carry-back years and tax-planning strategies.
We believe it is more likely than not that our deferred tax assets will be realized in the foreseeable future. Accordingly, a valuation allowance has not been established. The detailed components of our deferred tax assets and liabilities are included in the footnote, "Income Taxes" in the Notes to the Consolidated Financial Statements included in Item 8 of this Annual Report.
We follow the requirements of the contingencies guidance, which is included within ASC Topic 450, Contingencies. This requires management to evaluate each contingent matter separately. A loss is reported if reasonably estimable and probable. We establish reserves for these contingencies at the best estimate, or, if no one estimated number within the range of possible losses is more probable than any other, we report an estimated reserve at the midpoint of the estimated range. Contingencies affecting us include litigation matters which are inherently difficult to evaluate and are subject to significant changes.
Service and Administrative Fees
We earn service and administrative fees for a variety of activities. This includes providing administrative services for other insurance companies, debt cancellation programs, collateral tracking, and asset recovery services.
The Payment Protection administrative service revenue is recognized consistent with the earnings recognition pattern of the underlying insurance policy or debt cancellation contract being administered. For example, if the credit instrument is 36 months in duration, the credit insurance policy or debt cancellation contract is also 36 months. Because we provide administrative services over the life of the policy or debt cancellation contract, we recognize service and administrative fees over the life of the insurance policy or debt cancellation contract. Accordingly, if there is a pre-term cancellation, no funds would be due to our customer. As a result, we have had no changes in earnings patterns, resulting in no prior period adjustments to total revenues or net income.
The BPO service fee revenue is recognized as the services are performed. These services include fulfillment, BPO software development and claims handling for our customers. Collateral tracking fee income is recognized when the service is performed and billed. Asset recovery service revenue is recognized upon the location of a recovered unit. Management reviews the financial results under each significant BPO contract on a monthly basis. Any losses that may occur due to a specific contract would be recognized in the period in which the loss occurs. For the periods presented, we have not incurred a loss with respect to a specific significant BPO contract.
Wholesale Brokerage Commissions and Fees
We earn wholesale brokerage commission and fee income by providing wholesale brokerage services to retail insurance brokers and agents and insurance companies. Wholesale brokerage commission income is primarily recognized when the underlying insurance policies are issued. A portion of the wholesale brokerage commission income is derived from profit agreements with insurance carriers. These commissions are received from carriers based upon the underlying underwriting profitability of the business that we place with those carriers. Profit commission income is generally recognized as revenue on the receipt of cash based on the terms of the respective carrier contracts. In certain instances, profit commission income may be recognized in advance of cash receipt where the profit commission income due to be received has been calculated or has been confirmed by the insurance carrier. We had profit commissions of $1.4 million and $1.3 million for the years ended December 31, 2010 and 2009, respectively. See - "Revenues - Wholesale Brokerage Commissions and Fees" for a discussion
of various factors that impact our wholesale brokerage commissions and fees.
Ceding commissions earned under coinsurance agreements are based on contractual formulas that take into account, in part, underwriting performance and investment returns experienced by the assuming companies. As experience changes, adjustments to the ceding commissions are reflected in the period incurred.
Experience adjustments are based on the claim experience of the related policy. The adjustment is calculated by adding the earned premium and investment income from the assets held in trust for our benefit less earned commissions, incurred claims and the reinsurer's fee for the coverage. Our experience adjustments, exclusive of investment income, were (in thousands):
See - "Revenues - Ceding Commissions" for additional information on our ceding commissions.
Net Earned Premium
Direct and assumed earned premium consists of revenue generated from the direct sale of Payment Protection insurance policies by our distributors or premiums written for Payment Protection insurance policies by another carrier and assumed by us. Whether direct or assumed, the premium is earned over the life of the respective policy. Direct and assumed earned premium are offset by premiums ceded to our reinsurers, including producer owned reinsurance companies ("PORCs"). The amount ceded is proportional to the amount of risk assumed by the reinsurer.
The commission costs include the commissions paid to the distributors for selling the policy. The commission costs also include retrospective commission adjustments. These retrospective commission adjustments are payments made or adjustments to future commission expense based on claims experience. Under these retrospective commission arrangements, the commissions paid are adjusted based on actual losses incurred compared to premium earned after a specified net allowance is retained by us.
Net Investment Income
Net investment income consists of investment income from our invested assets portfolio. We recognize investment income from interest payments, any amortization of premiums and accretion of discounts on securities acquired at other than par value, and dividends on equity securities, less portfolio management expenses. Our investment portfolio is primarily invested in fixed maturity securities. Investment income can be significantly impacted by changes in interest rates. Interest rate volatility can increase or reduce unrealized gains or unrealized losses in our portfolios. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. Fluctuations in interest rates affect our returns on, and the market value of, fixed maturity and short-term investments.
The fair market value of the fixed maturity securities in our portfolio and the investment income from these securities fluctuate depending on general economic and market conditions. The fair market value generally increases or decreases in an inverse relationship with fluctuations in interest rates. We also have investments that carry prepayment risk, such as mortgage-backed and asset-backed securities. Actual net investment income and/or cash flows from investments that carry prepayment risk may differ from estimates at the time of investment as a result of interest rate fluctuations. In periods of declining interest rates, mortgage prepayments generally increase and mortgage-backed securities, commercial mortgage obligations and bonds are more likely to be prepaid or redeemed as borrowers seek to borrow at lower interest rates. Therefore, we may be required to reinvest those funds in lower interest-bearing investments.
We record stock-based compensation in accordance with ASC 718 - Compensation - Stock Compensation, which addresses the accounting for share-based awards, including stock options, with compensation expense measured using fair value and recorded over the requisite service or performance period of the awards.
We currently have outstanding stock options under its Key Employee Stock Option Plan (1995), 2005 Equity Incentive Plan and The 2010 Omnibus Incentive Plan.
The Key Employee Stock Option Plan (1995), which was effective January 26, 1995, permits awards of incentive stock options and non-qualified stock options. We are permitted to issue up to 1,102,500 shares under this plan. Each option granted under
this plan has a maximum contractual term of 10 years. The 1995 plan (but not the outstanding options granted under the plan) terminated on January 25, 2005. As of December 31, 2010, there were 258,300 options outstanding under the 1995 plan.
The 2005 Equity Incentive Plan was established on October 18, 2005 and permits awards of (i) Incentive Stock Options, (ii) Non-qualified Stock Options, (iii) Stock Appreciation Rights, (iv) Restricted Stock and (v) Restricted Stock Units. We are permitted to issue up to 1,312,500 shares under this plan. Each option granted under this plan has a maximum contractual term of 10 years. As of December 31, 2010, there were 1,312,500 options outstanding under the 2005 plan.
The 2010 Omnibus Incentive Plan was established on December 13, 2010 and permits awards of (i) Incentive Stock Options, (ii) Non-qualified Stock Options, (iii) Stock Appreciation Rights, (iv) Restricted Stock, (v) Other Stock-Based Awards, and (vi) Performance-Based Compensation Awards. We are permitted to issue up to 4,000,000 shares under this plan. Each option granted under this plan has a maximum contractual term of 10 years. As of December 31, 2010, there were 88,268 options and 160,000 restricted shares outstanding under the 2010 plan.
We have 296,724 options outstanding as of December 31, 2010 that were issued outside of the existing plans. Total options granted during 2010 were 88,268. No options were granted in 2009 while in 2008, 41,853 options were granted.
We measure stock-based compensation related to options using the calculated value method. Under that method, we estimate the fair value of each option on the grant date using the Black-Scholes valuation model incorporating the assumptions noted in the following table. We used historical data to estimate expected employee behavior related to stock award exercises and forfeitures. Since there is not sufficient historical market experience for shares of the our stock, we have chosen to estimate its volatility, by using the average volatility of our peers. Expected dividends are based on the assumption that no dividends were expected to be distributed in the near future. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the options. Assumptions related to stock option awards:
A summary of options granted, exercised and canceled under these agreements for the years ended December 31, 2010 and 2009 are as follows:
Additional information regarding options granted, vested and exercised is presented below:
The intrinsic value reported above is calculated as the difference between the market value as of the exercise date and the exercise price of the shares.
Our policy is to issue new shares upon the exercise of stock options. Shares of our stock issued upon the exercise of stock options in 2010, 2009, and 2008, were 44,185, 15,750 and 551,250, respectively.
Stock-based compensation cost is measured at the grant date based on the fair value of the award, and is typically recognized as expense on a straight-line basis over the requisite service period, which is the vesting period. Total stock-based compensation recognized on the consolidated statements of income was as follows:
Total unrecognized compensation cost related to non-vested share based compensation at December 31, 2010 was $0.4 million with a weighted-average recognition period of 1.4 years.
The following table summarizes information concerning our outstanding stock options at December 31, 2010:
Components of Revenues and Expenses
Service and Administrative Fees. We earn service and administrative fees from two of our business segments. Such fees are typically positively correlated with transaction volume and are recognized as revenue as they become both realized and earned. See "- Critical Accounting Policies - Service and Administrative Fees."
Payment Protection. Our Payment Protection products are sold as complementary products to consumer retail and credit transactions and are thus subject to the volatility of volume of consumer purchase and credit activities. We receive service and administrative fees for administering Payment Protection products that are sold by our clients, such as credit insurance, debt protection, car club and warranty solutions. We earn administrative fees for administering debt cancellation plans, facilitating the distribution and administration of warranty or extended service contracts, providing car club membership benefits and providing related services for our clients. For credit insurance products, our clients typically retain the risk associated with credit insurance products that they sell to their customers through economic arrangements with us. Our Payment Protection revenue includes revenue earned from reinsurance arrangements with producer owned reinsurance companies owned by our
clients. Our clients own PORCs that assume the credit insurance premiums and associated risk that they originate in exchange for fees paid to us for ceding the premiums. In addition, our Payment Protection revenue includes administrative fees charged by us under retrospective commission arrangements with producers, where the commissions paid are adjusted based on actual losses incurred compared to premium earned after a specified net allowance retained by us. Under these arrangements, our insurance companies receive the insurance premiums and administer the policies that are distributed by our clients. The producer of the credit insurance policies receives a retrospective commission if the premium generated by that producer in the accounting period exceeds the costs associated with those polices, which includes our administrative fees, incurred claims, reserves and premium taxes. If the net result is negative, we either offset that negative amount against future retrospective commission payments, reduce the producer's up-front commission on a prospective basis to increase the likelihood that it will return to a positive position or request payment of the negative amount from the producer. Revenues in our Payment Protection business may fluctuate seasonally based on consumer spending trends, where consumer spending has historically been higher in April, September and December, corresponding to Easter, back-to-school and the holiday season. Accordingly, our Payment Protection revenues may reflect higher second, third and fourth quarters than in the first quarter.
BPO. Our BPO revenues consist exclusively of service and administrative fees for providing a broad set of administrative services tailored to insurance and other financial services companies including ongoing sales and marketing support, premium billing and collections, policy administration, claims adjudication and call center management services. Our BPO revenues are based on the volume of business that we manage on behalf of our clients. Our BPO segment typically charges fees on a per-unit of service basis as a percentage of our client's insurance premiums.
Wholesale Brokerage Commissions and Fees. Wholesale brokerage commissions and fees consist of commissions paid to us by insurance companies, net of the portion of the commissions we share with retail insurance brokers and agents. The commissions we receive from insurance carriers are typically calculated as a percentage of the premiums paid for the specialized and complex insurance products (commonly known as"surplus lines") we distribute. We typically earn our commissions on the later of the effective date of the policy or the date coverage is bound. We pay our retail insurance agent and broker clients a portion of the gross commissions we receive from insurance carriers for placing insurance. In certain cases, our Wholesale Brokerage segment also charges fees for policy issuance, inspections and other types of transactions.
Wholesale brokerage commissions and fees are generally affected by fluctuations in the amount of premium charged by insurance carriers. The premiums charged fluctuate based on, among other factors, the amount of capital available in the insurance marketplace, the type of risk being insured, the nature of the insured party and the terms of the insurance purchased. If premiums increase or decrease, our revenues are typically affected in a corresponding fashion. In a declining premium rate environment, the resulting decline in our revenue may be offset, in whole or in part, by an increase in commission rates from insurance carriers and by an increased likelihood that insured parties may use the savings generated by the reduction in premium rates to purchase greater coverage. In an increasing pricing environment, the resulting increase in our revenue may be offset, in whole or in part, by a decrease in commission rates by insurance carriers and by an increased likelihood that insured parties may determine to reduce the amount of coverage they purchase. The market for P&C insurance products is cyclical from a capacity and pricing perspective. We refer to a period of reduced capacity and rising premium rates as a "hard" market and a period of increased capacity and declining premium rates as a "soft" market.
Gross commission rates for the products that we distribute in our Wholesale Brokerage segment, whether acting as a wholesale broker or as a Managing General Agent ("MGA"), generally range from 15% to 25% of the annual premium for the policy. Wholesale brokerage commissions and fees net of commissions paid to our retail insurance agent and broker clients are typically approximately 10%.
Demand for surplus lines insurance products also affects our premium volume and net commissions. State regulations generally require a buyer of insurance to have been turned down by three or more traditional carriers before being eligible to purchase the surplus lines distributed by us. As standard insurance carriers eliminate non-core lines of business and implement more conservative risk selection techniques, demand for excess and surplus lines insurance improves. The surplus lines market has increased from approximately 6.7% of total P&C commercial lines insurance premiums in 1998 to approximately 13.8% in 2008, as reported by A.M. Best. Premiums written by surplus lines property and casualty insurers increased from $9.9 billion to $34.4 billion over the same time period.
Our wholesale brokerage commission and fee revenues fluctuate seasonally based on policy renewal dates. Our wholesale brokerage commissions and fees in the first two calendar quarters of any year historically have been higher than in the last two calendar quarters. In addition, our quarterly wholesale brokerage revenues may be affected by new placements and cancellations or non-renewals of large insurance policies as the revenue stream related to this policy is recognized once per year, as opposed to ratably throughout the year.
We also receive profit commissions for certain arrangements with certain insurance carriers on binding authority business. These profit commissions are based on the profitability of the business that we underwrite or broker on the insurance carrier's behalf. Profit commissions typically range from 0.6% to 1.7% of the annual premium and are paid periodically based on the terms of the individual carrier contract.
Ceding Commissions. We elect to cede to reinsurers under coinsurance arrangements a significant portion of the credit insurance that we distribute on behalf of our clients. We continue to provide all policy administration for credit insurance that we cede to reinsurers. Ceding commissions consist of commissions paid to us by our reinsurers to reimburse us for costs related to the acquisition, administration and servicing of policies and premium that we cede to reinsurers. In addition, a portion of the ceding commission is determined based on the underwriting profits of the ceded credit insurance. The credit insurance that we distribute has historically generated attractive underwriting profits. Furthermore, some reinsurers pay to us a portion or all of the investment income earned on reserves that are maintained in trust accounts.
Ceding commissions are generally positively correlated with our credit insurance transaction and premium volumes. The portion of our ceding commissions that is related to the underwriting profits of the ceded credit insurance also fluctuates based on the claims made on such policies. The portion of our ceding commissions that is related to investment income can be impacted by the amount of reserves that are maintained in trust accounts and changes in interest rates. Ceding commissions are earned over the life of the policy. Ceding commissions are generated by the Payment Protection segment only for credit insurance.
Net Earned Premium. Net earned premium consists of revenue generated from the direct sale of Payment Protection insurance policies by our distributors or premiums written for Payment Protection insurance policies by another carrier and assumed by us. Whether direct or assumed, the premium is earned over the term of the respective policy. Premiums earned are offset by earned premiums ceded to our reinsurers, including PORCs. The amount ceded is proportional to the amount of risk assumed by the reinsurer.
The principal factors affecting earned premiums are: (i) the proportion of the risk assumed by the reinsurer as defined in the reinsurance treaty; (ii) increases and decreases in written premium; (iii) increases and decreases in policy cancellation rates; (iv) the average duration of the policies written; and (v) changes in regulation that would modify the earning patterns for the policies underwritten and administered.
We limit the underwriting risk we take in our Payment Protection insurance policies. When we do assume risk in our Payment Protection insurance policies, we utilize both reinsurance (e.g., quota share and excess of loss) and retrospective commission agreements to manage and mitigate our risk.
Net Investment Income. Net investment income consists of investment income from our invested assets portfolio. We recognize investment income from interest payments and dividends less portfolio management expenses. Our investment portfolio is primarily invested in fixed maturity securities. The fair market value of the fixed maturity securities in our portfolio and the investment income from these securities fluctuate depending on general economic and market conditions. The fair market value generally increases or decreases in an inverse relationship with fluctuations in interest rates. Investment income can be significantly impacted by changes in interest rates. Interest rate volatility can increase or reduce unrealized gains or unrealized losses in our portfolios. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. Fluctuations in interest rates affect our returns on, and the market value of, fixed maturity and short-term investments.
We also have investments that carry prepayment risk, such as mortgage-backed and asset-backed securities. Actual net investment income and/or cash flows from investments that carry prepayment risk may differ from estimates at the time of investment as a result of interest rate fluctuations. In periods of declining interest rates, mortgage prepayments generally increase and mortgage-backed securities, commercial mortgage obligations and bonds are more likely to be prepaid or redeemed as borrowers seek to borrow at lower interest rates. Therefore, we may be required to reinvest those funds in lower interest-bearing investments.
We earn realized gains when invested assets are sold for an amount greater than the amortized cost in the case of fixed maturity securities and recognize realized losses when investment securities are written down as a result of an other-than-temporary impairment or sold for an amount less than their carrying cost.
Other Income. Other income primarily consists of miscellaneous fees generated by our Wholesale Brokerage and Payment Protection segments. In 2009, it also included income in our Wholesale Brokerage segment that was derived from the reversal of a cancellation reserve that was no longer deemed to be applicable subsequent to our acquisition of Bliss & Glennon.
Our most significant operating expenses are commissions, personnel costs, including salaries, bonuses and benefits and net losses and loss adjustment expenses. The commissions expense includes the commissions paid to distributors selling credit insurance policies offered by our Payment Protection division. Commission rates, in many instances, are set by state regulators and are also impacted by market conditions. In certain instances, our commissions are subject to retrospective adjustment based on the profitability of the related policies. These retrospective commission adjustments are payments made or adjustments to future commission expense based on claims experience. Under these retrospective commission arrangements, the producer of the credit insurance policies, which is typically our client, receives a retrospective commission if the premium generated by that producer in the accounting period exceeds the costs associated with those policies, which includes our administrative fees, claims, reserves, and premium taxes. If the net result is negative, we either offset that negative amount against future retrospective commission payments, reduce the producer's up-front commission on a prospective basis to increase the likelihood that it will return to a positive position or request payment of the negative amount from the producer.
Net losses and loss adjustment expenses include actual paid claims and the change in unpaid claim reserves, net of reinsurance. Our profitability depends in part on accurately predicting net loss and loss adjustment expenses. Incurred claims are impacted by loss frequency, which is the measure of the number of claims per unit of insured exposure, and loss severity, which is based on the average size of claims. Factors affecting loss frequency and loss severity include changes in claims reporting patterns, claims settlement patterns, judicial decisions, legislation, economic conditions, morbidity patterns and the attitudes of claimants towards settlements.
Actual claims paid are claims payments made to the policyholder or beneficiary during the accounting period. The change in unpaid claim reserve is an increase or reduction to the unpaid claim reserve in the accounting period to maintain the unpaid claim reserve at the levels evaluated by our actuaries.
Unpaid claims are reserve estimates that are established in accordance with GAAP using generally accepted actuarial methods. Credit life, credit disability and AD&D unpaid claims reserves include claims in the course of settlement and IBNR. For all other product lines, unpaid claims reserves are bulk reserves and are entirely IBNR. We use a number of algorithms in establishing our unpaid claims reserves. These algorithms are used to calculate unpaid claims as a function of paid losses, earned premium, target loss ratios, in force amounts, unearned premium reserves, industry recognized morbidity tables or a combination of these factors. The factors used to develop the IBNR reserves vary by product line. However, in general terms, the primary factor used to develop IBNR reserves for credit life insurance is a function of the amount of life insurance in force. This factor can vary from $0.60 to $1.00 per $1,000 of in force coverage. The primary factor used to develop IBNR reserves for credit disability is a function of the pro-rata unearned premium reserve and is typically 5% of unearned premium reserve. Finally, IBNR reserves for AD&D policies is a function of in force coverage and is currently $0.11 per $1,000 of in force coverage.
In accordance with applicable statutory insurance company regulations, our unpaid claims reserves are evaluated by appointed actuaries. The appointed actuaries perform this function in compliance with the Standards of Practice and Codes of Conduct of the American Academy of Actuaries. The appointed actuaries perform their actuarial analyses each year and prepare opinions, statements and reports documenting their determinations.
The appointed actuaries conduct their actuarial analysis on a basis gross of reinsurance. The same estimates used as a basis in calculating the gross unpaid claims reserves are then used as the basis for calculating the net unpaid claims reserves, which take into account the impact of reinsurance. Anticipated future loss development patterns form a key assumption underlying these analyses. Our claims are generally reported and settled quickly, resulting in a consistent historical loss development pattern. From the anticipated loss development patterns, a variety of actuarial loss projection techniques are employed, such as the chain ladder method, the Bornhuetter-Ferguson method and expected loss ratio method.
Our unpaid claims reserves do not represent an exact calculation of exposure, but instead represent our best estimates, generally involving actuarial projections at a given time. The process used in determining our unpaid claims reserves cannot be exact since actual claim costs are dependent upon a number of complex factors such as changes in doctrines of legal liabilities and damage awards. These factors are not directly quantifiable, particularly on a prospective basis. We periodically review and update our methods of making such unpaid claims reserve estimates and establishing the related liabilities based on our actual experience. We have not made any changes to our methodologies for determining unpaid claims reserves in the periods presented.
In addition to our general personnel costs, some of the employees in our Wholesale Brokerage segment are paid a percentage of commissions and fees they generate. Accordingly, compensation for brokers in our Wholesale Brokerage segment is
predominantly variable. Bonuses for the remaining employees are discretionary and are based on an evaluation of their individual performance and the performance of their particular business segment, as well as our entire firm.
Other operating expenses consist primarily of rent, insurance, investigation fees, transaction expenses, professional fees, technology costs, travel and entertainment and advertising, and they are also a significant portion of our expenses. In addition, we have variable costs that are based on the volume of business we process.
A substantial portion of our depreciation and amortization expense consists of amortization of definite-lived intangible assets, such as purchased customer accounts and non-compete agreements, which were acquired as part of our business acquisitions.
We also have interest expense relating to our credit facilities and preferred trust securities. Our interest expense increased as result of our increased indebtedness resulting from the Summit Partners Transactions and recent acquisitions.
Income tax expense is comprised of federal and state taxes based on income in multiple jurisdictions and changes in uncertain tax positions, if any.
Our earnings per share on a fully diluted basis increased 36.2% to $0.94 for the year ended December 31, 2010 from $0.69 for the same period in 2009. Our 2010 performance reflected organic growth and the impact of three business acquisitions completed in 2010. These acquisitions complimented our existing business segments and contributed to $5.2 million our revenue and $1.5 million to our net income in 2010. In December 2010 we also completed our IPO providing us with the funds to eliminate higher interest costs. While the negative economic climate continued in 2010, revenues increased 9.8%. We increased revenues in our Wholesale Brokerage and Payment Protection segments while our BPO segment revenues declined. Total expenses increased 6.8% to $179.4 million with the majority of the increase due to higher levels of personnel costs and net loss and loss adjustments. We managed to increase our net income in 2010.
Results of Operations
The following table set forth our Consolidated Statements of Income for the years ended December 31, 2010, 2009 and 2008: