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EX-21.1 - SUBSIDIARIES OF REGISTRANT - GAINSCO INCdex211.htm
EX-32.2 - CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 OF CHIEF FINANCIAL OFFICER - GAINSCO INCdex322.htm
EX-32.1 - CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 OF CHIEF EXECUTIVE OFFICER - GAINSCO INCdex321.htm
EX-31.1 - SECTION 302 CERTIFICATION OF CHIEF EXECUTIVE OFFICER - GAINSCO INCdex311.htm
EX-31.2 - SECTION 302 CERTIFICATION OF CHIEF FINANCIAL OFFICER - GAINSCO INCdex312.htm
EX-23.1 - CONSENT OF BDO SEIDMAN, LLP - GAINSCO INCdex231.htm
Table of Contents
Index to Financial Statements

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

Annual Report Pursuant to Section 13 or 15 (d) of

The Securities Exchange Act of 1934

For the fiscal year ended December 31, 2009

Commission file number 1-9828

 

 

GAINSCO, INC.

(Exact name of registrant as specified in its charter)

 

 

 

TEXAS   75-1617013
(State of Incorporation)   (IRS Employer Identification No.)

 

3333 Lee Parkway, Suite 1200

Dallas, Texas

  75219
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code (972) 629-4301

 

 

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

 

Title of each class   Name of each exchange on which registered
Common Stock ($.10 par value)   The NYSE Amex

 

 

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark 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 the 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).    Yes  ¨    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405) is not contained herein, and will not be contained herein, to the best of the 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.  ¨

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

 

Large Accelerated Filer   ¨    Accelerated Filer   ¨
Non-Accelerated Filer   ¨    Smaller Reporting Company   x

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

The aggregate market value of the registrant’s Common Stock ($.10 par value), the registrant’s only class of voting or non-voting common equity stock, held by non-affiliates of the registrant (1,293,653 shares) as of the close of the business on June 30, 2009 was $20,375,035 (based on the closing sale price of $15.75 per share on that date on the NYSE Amex).

As of March 22, 2010, there were 4,781,592 shares of the registrant’s Common Stock ($.10 par value) outstanding.

Incorporation by Reference

Portions of the Company’s Proxy Statement for its Annual Meeting of Shareholders expected to be held on May 26, 2010 are incorporated by reference herein in response to Items 10, 11, 12, 13 and 14 of Part III of Form 10-K.

 

 

 


Table of Contents
Index to Financial Statements

TABLE OF CONTENTS

 

          Page
   PART I   

Item 1

   Business    1

Item 1A

   Risk Factors    20

Item 1B

   Unresolved Staff Comments    32

Item 2

   Properties    32

Item 3

   Legal Proceedings    32

Item 4

   Reserved    32
   PART II   

Item 5

   Market for Registrant’s Common Equity, Related Shareholders Matters and Issuer Purchases of Equity Securities    33

Item 6

   Selected Financial Data    34

Item 7

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    35

Item 7A

   Quantitative and Qualitative Disclosures about Market Risk    58

Item 8

   Financial Statements and Supplementary Data    59

Item 9

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosures    59

Item 9A(T)

   Controls and Procedures    60

Item 9B

   Other Information    60
   PART III   

Item 10

   Directors, Executive Officers and Corporate Governance    61

Item 11

   Executive Compensation    61

Item 12

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    61

Item 13

   Certain Relationships and Related Transactions, and Director Independence    61

Item 14

   Principal Accountant Fees and Services    61
   PART IV   

Item 15

   Exhibits and Financial Statement Schedules    62

 

(i)


Table of Contents
Index to Financial Statements

PART I

 

ITEM 1. BUSINESS

OUR BUSINESS

Who We Are

GAINSCO, INC., a Texas corporation, was organized in October 1978, and through our insurance company and managing general agency subsidiaries, we engage in the property and casualty insurance business, focusing on the nonstandard personal auto market. As used in this Report, the term “the Company” refers to GAINSCO, INC. and its subsidiaries, unless the context otherwise requires.

Nonstandard personal auto insurance is usually purchased by drivers who do not meet an insurance company’s “standard” or “preferred” underwriting criteria. These drivers typically seek minimum required insurance coverage as required by state law and generally pay higher premiums than for standard policies. We write minimum and slightly higher coverage limits, nonstandard auto insurance in Arizona, Florida, Georgia, Nevada, New Mexico, South Carolina, Texas and California. We have selected these states based on historical levels of industry profitability, competitive landscapes, and demographic characteristics.

Our insurance operations, which include our ongoing nonstandard personal auto insurance and the runoff of our commercial lines business, are presently conducted through one insurance company: MGA Insurance Company, Inc. (“MGA”). Prior to February 2002, we were engaged in commercial lines underwriting. We exited this business due to continued adverse reserve development and unfavorable financial results, and our commercial lines business has been in run-off since then. We entered the nonstandard personal auto insurance business through the acquisition in 1998 of the Lalande Group, located in Miami, Florida.

We expanded into Texas in 2003, Arizona and Nevada in 2004, California in 2005 and South Carolina in 2006, New Mexico in 2007, and we entered Georgia in 2009. After significant growth in 2005 and 2006, the Company concentrated its efforts in 2007, 2008 and 2009 on improving the profitability of the expanded business through focused pricing, underwriting and claims initiatives which resulted in reduced written premiums in 2007 and a leveling off of written premiums in 2008 and 2009.

For the year ended December 31, 2009, our gross premiums written totaled approximately $179.6 million, down 1% from the year ended December 31, 2008. Our total revenues for the year ended December 31, 2009 were approximately $206.8 million and net income was approximately $4.1 million. Our shareholders’ equity was approximately $63.0 million as of December 31, 2009.

As of the date hereof, our insurance company is rated “B” (fair) by A.M. Best. Our Common Stock is publicly traded on the NYSE Amex under the symbol “GAN.”

 

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Index to Financial Statements

Our Business Model

Insurance Subsidiaries

We execute our strategy through our insurance company subsidiary, as well as two non-risk bearing managing general agency subsidiaries, as follows:

MGA: MGA is the company through which our nonstandard auto business is underwritten in all states. Until 2007, MGA acted as a reinsurer on all business underwritten in Texas through an unaffiliated third party insurance company. Most business in Texas is now written directly by MGA. MGA assumed through reinsurance all of the outstanding claims and liabilities of a former insurance company subsidiary that existed when the former subsidiary was sold in November 2007. The Company markets its nonstandard auto insurance products through approximately 4,800 independent agency locations in Arizona, Florida, Georgia, Nevada, New Mexico, South Carolina and Texas, and one general agency in California that markets through approximately 900 insurance broker locations.

MGA Agency, Inc. (“MGA Agency”): MGA Agency provides marketing and agency relationship management services for MGA and for an unaffiliated insurer that provides fronting paper for MGA in Texas. MGA Agency receives commissions and other administrative fees from MGA and the unaffiliated insurance company based on the amount of gross premiums produced for each respective company. Additionally, MGA Agency receives various fees primarily related to fees charged on insureds’ premiums due that vary according to state insurance laws and regulations.

National Specialty Lines, Inc. (“NSL”): NSL provides marketing and agency relationship management for MGA in Florida. NSL receives various fees primarily related to fees charged on insureds’ premiums due that vary according to state insurance laws and regulations.

Insurance Operations

The following table sets forth our gross premiums written by region for the periods indicated:

 

     Years ended December 31,
     2009    2008
     (Amounts in thousands)

Southeast (Florida, Georgia, South Carolina)

   $ 108,235    110,123

South Central (Texas)

     42,944    41,221

Southwest (Arizona, New Mexico, Nevada)

     26,962    28,381

West (California)

     1,430    2,124
           

Total

   $ 179,571    181,849
           

Geographically, we are focused on marketing our nonstandard personal auto product in selected states in the southern region of the United States. We currently operate in Arizona, Florida, Georgia, New Mexico, South Carolina and Texas; California and Nevada are not significant factors in our ongoing operations. Data published by A.M. Best indicates that approximately $12.4 billion of nonstandard personal auto insurance was written in these states in 2008, representing approximately 48% of the entire U.S. nonstandard personal auto market. We believe that our share of the total nonstandard personal auto market is less than 1% in each of the states in which we operate.

 

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Index to Financial Statements

Our Industry

Personal auto insurance is the largest line of property and casualty insurance in the United States. In 2008, the personal auto insurance market was estimated by A.M. Best to be approximately $161.6 billion in premiums written. Personal auto insurance covers the driver against financial loss for legal liability to others for bodily injury, property damage and medical costs for treating injured parties. Coverage also may provide indemnification for damage to an insured’s vehicle from theft, collision and other perils. Personal auto insurance is comprised of preferred, standard and nonstandard risks. Nonstandard insurance is intended for drivers who typically seek the minimum statutory coverage limits required in the state in which they reside, and their driving record, age, vehicle type or payment history may represent a higher than normal risk. As a result, customers who purchase nonstandard auto insurance generally pay higher premiums for similar coverage than drivers who qualify for standard or preferred policies.

The personal auto insurance industry has historically been cyclical, characterized by periods of price competition and excess capacity followed by periods of high premium rates and shortages of underwriting capacity. When underwriting standards for preferred and standard companies become more restrictive, more insureds seek nonstandard coverage and the size of the nonstandard market increases. While there is no precise industry-recognized demarcation between nonstandard policies and all other personal auto policies, we believe that nonstandard auto risks or specialty auto risks generally constitute approximately 20% to 25% of the overall personal auto insurance market, with the exact percentage fluctuating according to competitive conditions in the market.

Competition

Nonstandard personal auto insurance consumers typically purchase the statutory minimum limits of liability insurance required for registration of their vehicles or slightly higher limits. We believe that we compete effectively in this market on the basis of price, down payment options, payment plans, good relationships with agents and superior quality claims and policy customer service. Because of the insurance purchasing habits of our customers, the rate of policy retention is lower than the retention rate of standard and preferred policies. Our success, therefore, depends in part on maintaining strong relationships with our agents and our ability to replace insureds who do not renew their policies or keep them in force. Approximately 50% of our customers keep their policies in force for the entire term of the policy and of that 50%, approximately 80% purchase a renewal policy from us. Since a majority of our customers purchase policies through one of our several payment plans, the primary reason that a policy lapses or is canceled is due to non-payment of a premium installment.

We compete with large national insurance companies, smaller regional companies and local managing general agents in the sale of nonstandard auto insurance products and services. We market our products primarily through independent agencies that also sell the insurance products of our competitors. Many competitors are national in scope, larger, and better capitalized than we are. Some competitors have aggressive national advertising campaigns and broad distribution networks and market directly to customers through employees rather than independent agents. Smaller regional insurance companies and local agents also compete vigorously at the local level. We believe our regional focus on the nonstandard auto market together with competitive prices, payment terms and an emphasis on superior customer service, allows us to compete with both national competitors and smaller regional companies.

 

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Index to Financial Statements

Our Products

Our principal products previously served certain nonstandard markets within the commercial lines and personal lines. On February 7, 2002, we announced our decision to discontinue writing new commercial lines insurance business due to continued adverse claims development and unprofitable results. Since the first quarter of 2002, nonstandard personal auto has been the only material line of insurance that we write.

Nonstandard Auto Insurance

GAINSCO’s nonstandard personal auto products are primarily aligned with customers seeking to purchase basic coverage and limits of liability required by statutory requirements, or slightly higher. Our products include coverage for third party liability, for bodily injury and physical damage, as well as collision and comprehensive coverage for theft, physical damage and other perils for an insured’s vehicle. Within this context, we offer our product to a wide range of customers who present varying degrees of potential risk to the Company, and we strive to price our product to reflect this range of risk accordingly, in order to earn an underwriting profit. Simultaneously, when actuarially prudent, we attempt to position our product price to be competitive with other companies offering similar products to optimize our likelihood of securing our targeted customers. We offer flexible premium down payment, installment payment, late payment, and policy reinstatement plans that we believe help us secure new customers and retain existing customers, while generating an additional source of income from fees that we charge for those services. We primarily write six month policies in Arizona, Florida, Nevada, and New Mexico and both one month and six month policies in Texas, with one year policies in California and both six month and one year policies in Georgia and South Carolina. The terms of policies we are permitted to offer varies in the states in which we operate.

The following table sets forth our nonstandard personal auto gross premiums written (before ceding any amounts to reinsurers) and percentage of gross premiums written for the periods indicated.

 

     Years ended December 31,  
     2009     2008  
     (Dollar amounts in thousands)  

Gross Premiums Written:

  

Nonstandard Personal Auto

   $ 179,571    100   181,849    100
                        

Policies in Force (End of Period)

     138,313      148,770   
                

Our Target Market

We believe our Company is positioned to succeed in the nonstandard personal automobile market. We are organized into three regions: the Southeast Region, based in Miami, markets to Florida, Georgia, and South Carolina; the Southwest Region, based in Dallas, markets to Arizona, Nevada, New Mexico and Texas; and the West Region, where we write insurance in California through a relationship with an independent managing general agency located in San Diego. Our operations in Nevada and California now have a reduced emphasis compared with the other states in which we operate. From these locations, the Company markets its nonstandard personal auto products through approximately 4,800 independent agency locations in Arizona, Florida, Georgia, Nevada, New Mexico, South Carolina and Texas and one general agency in California that markets through approximately 900 insurance broker locations.

We believe that a significant portion of our customers is Hispanic. To meet the needs of this niche market and effectively compete against other nonstandard auto carriers focused on this market segment, we have undertaken several marketing, distribution and services initiatives to support this segment.

 

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Index to Financial Statements

Our Strategy

The nature of the independent agency system is such that our agents represent a number of insurance companies with whom our Company must compete to secure customers. A key aspect to successfully acquiring end customers from these agents is the ability to provide: (i) competitively priced products with flexible payment options; (ii) high quality and efficient policy and claims services; and, (iii) marketing programs intended to maximize the utility of our brand to independent agents and otherwise help our agents manage and grow their business profitably. We try to optimize our approach to these three key competitive aspects of business while maintaining appropriate risk management, operating, and financial discipline.

Product Focused Strategy

We monitor our claims ratios and, if we are not attaining desired results, we seek to adjust our pricing or curtail writing the products that we believe are negatively affecting our claim ratios. We seek to utilize our data processing systems to identify products and segments where we can achieve acceptable underwriting profits without assuming excessive underwriting risk. Subject to applicable regulatory filing and approval requirements, we modify our rates as often as we believe is necessary to improve our claim ratio and to respond to competitive forces. We also attempt to focus our marketing efforts on segments we believe will result in higher renewal and retention rates. To assist us in pricing our products, we utilize computer programs that run price comparisons between our Company and selected competitors, giving us the ability to identify potential opportunities to improve the positioning of our product prices, while taking into account any potential impact on our claims ratios. We continue updating and refining our pricing methods.

Beginning in the second quarter of 2009, we implemented a new pricing technology in Texas in an effort to use more precise and detailed analyses of accident data, including data maintained by the Company and increased reliance upon information acquired from third parties. We expect to introduce this methodology gradually into the other states in which we operate. Our principal goal in doing so is to seek to attract customers whose risk characteristics will allow us to achieve a lower loss ratio, higher average premiums per policy and higher rates of policy retention and renewal.

Service Focused Strategy

From a service perspective, the Company attempts both to provide our appointed agents the ability to quote, bind and order the issuance of a policy for new customers from within their offices quickly and efficiently and to assure that customers are able to receive prompt, fair resolution of claims when they occur. We employ an easy-to-use proprietary web-based interface system that is able to bridge information contained in the agent’s quoting system to our web-based quoting system. We offer a web-based platform that enables the agent to perform a wide range of policy support functions throughout the course of a policy term. We also utilize an interactive telephonic voice response system that handles thousands of calls a day. This system allows agents and insureds to perform payment and inquiry functions. Our call center handles over 2,500 calls per day, and the majority of our customer service staff speaks both Spanish and English.

Distribution Focused Strategy

We offer agency commission levels that are generally competitive with our primary competitors. Where appropriate, we also offer creative, flexible and responsible incentive-based programs to encourage growth.

We sponsor the GAINSCO #99 auto racing team in the Grand-Am Rolex Sports Car Series and utilize racing themes and logos in many aspects of our marketing program. The image of the car is the primary symbol in our branding efforts, and specific races and other promotional events associated with this sponsorship allow us to build our relationships with productive agents and to participate in community events of interest to our customers.

 

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Insurance Operations

Operations Center

In support of our field-based marketing efforts, we have an Operations Center in our corporate headquarters in Dallas, Texas. The Operations Center is designed to provide essential policy underwriting, issuance, billing, premium collection, customer inquiry, marketing and claims support services for the Company. The Company has upgraded, and continues to upgrade, its information technology infrastructure and operating applications to improve the efficiency, scope, scalability/capacity, and dependability in fulfilling these business functions.

A key component of the Operations Center is its Customer Call unit. The great majority of its staff are bilingual customer service representatives who support the Southeast, South Central and Southwest regions. In 2007, we consolidated our call centers in Dallas in order to reduce the costs of this function while seeking to maintain responsiveness. A key goal of the Customer Call unit is to provide outstanding customer service by attempting to respond to incoming calls within sixty seconds and fulfill the customer’s needs on that same call.

Underwriting

We attempt to underwrite risk by selectively reviewing information pertaining to an applicant, including, as appropriate, state Motor Vehicle Reports (“MVR’s”), Comprehensive Loss Underwriting Exchange (“CLUE”) and A-Plus reports, and Household Driver Reports. State MVR’s provide certain information on the driving history of the applicant. The CLUE and A-Plus reports provide information on claims that may have been submitted by the applicant to previous insurance carriers. The Household Driver Report provides information on whether additional drivers live in the household. Based on information obtained from these sources, the Company may decide to take one of several actions: decline to provide coverage for the customer, adjust the price of the policy, or require additional household drivers to be expressly included or excluded from coverage. The great majority of this underwriting process is done in the system at the point of sale.

Over 99% of our new business is uploaded to us by agents via the Internet, either directly using our website or indirectly through comparative rating software used by agents to compare available policies offered by us and our competitors.

Policy Service

We believe that superior policy service can enhance our competitive position in our markets. Since our product is sold through independent agents who typically represent numerous other nonstandard auto insurance companies, our service levels are constantly being compared to other companies. Independent agents measure service primarily in two areas: speed and ease of use. Because our independent agents can perform many policy functions with us at point of sale and quickly get into contact with a customer service representative by telephone, we believe we have an advantage in selling policies over competitors whose service performance is perceived to be inferior to ours. We continue making technological improvements in the process by which policies, endorsements and information are processed to enhance the customer service experiences of our agents and customers and to increase our productivity.

Because the majority of our customer service representatives speak both Spanish and English, we are generally able to meet the needs of our customers and agents speaking their preferred language.

Claims Administration

We are committed to maintaining a quality claims staff to serve policyholders and claimants effectively and control the cost of claims. Our goals are to have talented staff and leadership focused on operational excellence. Specifically, we are striving to develop a high performing claims operation, which delivers accurate and timely claims resolution and provides a consistently high level of customer service.

 

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We have a corporate claims department led by a senior claims executive, supported by casualty and material damages claims leaders, a training and quality assurance team, and a high exposure injury specialist. This corporate department establishes and monitors claim handling practices, and directs the regional claims officers to enhance claims performance. We maintain a field-based claims department in our Southeast Region and handle all claims for the South Central and Southwest Regions at our headquarters office.

Each regional claims group is led by a senior claims manager and supported by teams of liability adjusters and material damage appraisers. Each claims operation has a set of business practices it uses to attempt to handle claims accurately and promptly, while detecting and combating non-meritorious claims. A claims servicing affiliate of the independent managing general agency in California operates with similar claims policies and procedures.

During 2007 and 2008, oversight of recovery operations (subrogation) and loss reporting was centralized at our corporate headquarters in Dallas. This is intended to lead to better efficiency and consistent handling. In late 2009, we contructed a combined loss report and low complexity claim handling unit at our corporate headquarters in Dallas. This new unit supports all claims regions and is intended to expedite the handling of low complexity physical damage claims.

We have segmented our claims handling across all claims regions based on complexity. The operations structure is designed to support the segmentation strategy by providing dedicated teams to handle low complexity – high frequency claims, higher complexity – low frequency claims, and claims requiring special handling. Additionally, each region is supported by a Special Investigation Unit and a Litigation Specialist. The model is designed to assure that an appropriately skilled adjuster is assigned to the claim and that the correct handling practices are applied. This is intended to ensure that prompt, accurate and fair claims handling is consistently achieved.

During 2009, we continued to upgrade the claims organization. Enhancements to operations included: adding experienced adjusters and managers to our regional claims operations, implementing numerous initiatives to improve claims practices, workflows, and fraud identification, taking steps to better align staff objectives with key performance indicators used by management to measure effectiveness, and focusing additional attention and resources on better serving the needs of our customers.

In 2008, we completed the deployment of a new claims administration system which is intended to improve claims oversight and workflows. The system enhances our ability to intervene at critical points during the claim to ensure that appropriate outcomes are achieved. System functionality is evaluated regularly and tuned when appropriate to support business objectives.

Workloads are maintained at reasonable levels based on adjuster skill sets and claim types being handled. We attempt to hold the average number of claims receipts per adjuster to a reasonable level to allow each adjuster to manage his or her claims inventory more effectively. We believe that this typically improves the quality of file handling and results in earlier resolution of the claim. Subsequently, the customer experience is enhanced, which may ultimately reduce loss costs.

Since announcing our exit from commercial insurance in 2002, we have maintained a separate commercial claims unit focused on adjusting and settling the remaining claims from our previous commercial business.

 

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Product Management

Over the course of time, our claims ratio will be impacted by the pricing and underwriting decisions we make, external claim frequency trends associated with changing driving patterns, the economy, external claim severity trends associated with changing medical, car repair, and other costs, litigation trends, regulatory and legislative changes, and other factors. We use our data base and actuarial tools to regularly monitor our claim ratio by product line to keep it within acceptable limits. We attempt to modify our product rates frequently to make pricing adjustments that we determine are necessary, subject to any applicable regulatory limitations. We offer six month insurance policies in all states except for California where the policy term is one year, Texas, where we offer both one month and six month policies, and Georgia and South Carolina, where we offer both six month and one year policies. The terms of policies we are permitted to offer varies in the states in which we operate. Additionally, the Company has the ability to review policies more thoroughly prior to binding if claim ratios on certain segments of business are not within acceptable limits.

Technology

Technology plays an important role in our operating strategy. We continue our efforts to expand technology resources in order to facilitate the growth of the business in three key areas – infrastructure, business applications and data.

We monitor and seek to improve our infrastructure to provide optimum performance, availability and scalability.

 

   

We have recently replaced the majority of our data backup and recovery infrastructure with a more robust and scalable solution, including de-duplication technology. This has resulted in a higher level of integrity for all critical backup processes, shorter backup windows, and reduced media costs. Through use of mirroring, this initiative also supports our 2-hour requirement for recovery of all Tier 1 applications in the event of a disaster.

 

   

We are continuing to virtualize our server environment. Benefits include quicker deployment of devices to support new applications, load handling, and general growth. Management and performance monitoring have also been enhanced.

 

   

In the first half of 2009, we migrated to a more advanced Wide Area Network. This is intended to provide better redundancy between sites and improved traffic management in conjunction with core switch and router upgrades. We have also implemented wireless redundancy for our Miami site.

 

   

We have implemented better technologies and a robust process for endpoint protection and patch management. All workstations and laptops are managed and receiving updates from the security servers.

 

   

We migrated to enterprise level core switching in the data center and have begun standardizing our network equipment for local area and wide area networks. The new core switching allows us to segment IP networks for security and efficiency, and gives us redundancy for our data center systems.

 

   

Throughout 2009, we continued to build our disaster recovery site with virtual systems for our most critical applications.

 

   

In the last quarter of 2009, we engaged a third party to perform extensive penetration tests to our network. The scope also included security assessments on our public facing web application. In summary of the engagement, our network perimeter and web application are secure and all attempts made by the third party to gain unauthorized access were successful.

 

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We continue to enhance our business applications to seek to provide the functionality being requested by our customers. We support two primary applications – policy administration and claims administration. The policy administration system is the primary application for policy origination and maintenance. We have continued to provide more functionality at the point of sale in the agent’s office.

In the personal nonstandard automobile business, MGA utilizes a claims system developed by Guidewire Software, Inc., an unaffiliated company that provides software systems to the property and casualty insurance industry (“Guidewire”), pursuant to a Software License Agreement entered into in May, 2007 (the “License Agreement”). The license provides for a five year term during which MGA is to pay an annual license fee equal to $318,000. If MGA’s annual written premium, as defined in the license, exceeds $250 million during the initial five-year term or during a renewal term, additional incremental annual fees would be incurred. To date, MGA’s annual written premium, as defined in the license, has not exceeded $250 million. The license entitles MGA to use the claims system and receive software maintenance. At the end of the five year term, MGA will have the option of continuing the license for additional one-year terms, with annual license fees to be negotiated at that time, terminating the license (in which case MGA would be required to develop or acquire an alternative system), or acquiring a perpetual license for an additional fee of approximately $950,000. The License Agreement may be terminated by the licensor immediately for any violation by the Company of the scope of the license rights granted or by either party for a breach or default unless the same is cured after written notice thereof. In addition, the License Agreement will be terminated if at the end of the 5-year initial term or any renewal term it is not renewed.

MGA and Guidewire were also parties to a Consulting Services Agreement (the Consulting Agreement”) for services incident to the design and implementation of the claims software, which were completed in 2008. The Consulting Agreement provided that Guidewire Software, Inc. would provide services needed to adapt its claims software system to the Company’s requirements, including the provision of necessary programming and training of Company personnel in the use and maintenance of the software system. The schedule for adaptation and implementation of the system was subject to the requirement that the Company provide reasonable assistance and performance of its obligations needed to enable Guidewire Software, Inc. to perform its obligations in a timely manner.

The Consulting Agreement was effective until completion of all projects required for implementation of the claims software system in 2008. Either party had the right to terminate the Consulting Agreement if the other party were to be in breach or default of a material term thereof and such breach was not cured after written notice to the breaching party. The Company paid fees and expenses of $625,000 in 2008 pursuant to the Consulting Agreement. Since all the contracted services were completed in 2008, the Company is not obligated to pay any further fees and expenses under the Consulting Agreement in 2009 or subsequent periods.

Reinsurance

We generally purchase reinsurance in order to reduce our liability on individual risks and to protect against catastrophe claims. A reinsurance transaction takes place when an insurance company transfers, or “cedes,” to another insurer a portion or all of its exposure. The reinsurer assumes the exposure in return for a portion or the entire premium. The ceding of insurance does not legally discharge the insurer from its primary liability for the full amount of the policies, and the ceding company is required to pay the claim if the reinsurer fails to meet its obligations under the reinsurance agreement. See note 8 “Reinsurance” in Notes to Consolidated Financial Statements appearing under ITEM 8, “Financial Statements and Supplementary Data” of this Annual Report for detail of effective reinsurance agreements.

 

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In 2008, the Company maintained catastrophe reinsurance on its nonstandard personal auto physical damage business for property claims of $4.0 million in excess of $1.0 million for a single catastrophe, as well as aggregate catastrophe property reinsurance for $3.0 million in excess of $1.0 million in the aggregate. In 2009, the Company maintained catastrophe reinsurance on its nonstandard personal auto physical damage business for property claims of $19.0 million in excess of $1.0 million for a single catastrophe, as well as for aggregate catastrophes. For 2010, the Company maintains catastrophe reinsurance on its nonstandard personal auto physical damage business for property claims of $14.0 million in excess of $1.0 million for a single catastrophe, as well as for aggregate catastrophes. The Company reduced its coverage limits in 2010 due to a decrease in its Florida exposures.

The following table sets forth reinsurance balances receivable and ceded unpaid claims and claim adjustment expenses related to the Company’s exposure to reinsurers as of December 31, 2009. These amounts relate principally to our runoff business:

 

     As of December 31, 2009
     (Amounts in thousands)

Hartford Fire Insurance Company

   $ 798

Munich Reinsurance America

     690

Liberty Mutual Insurance Company

     395

Swiss Reins America Corp.

     394

White Mountains Reins Co of American

     307

Finial Reinsurance Company

     306

Republic Western Insurance Company

     197

All others *

     199
      

Total

   $ 3,286
      

 

* - No individual reinsurer greater than $100,000.

See ITEM 1A. Risk Factors for discussion on the concentration of reinsurers and A.M. Best ratings.

Reserves

As of December 31, 2009, the Company had $72.5 million in net unpaid claim and claim adjustment expenses (unpaid claim and claim adjustment expenses of $75.3 million less ceded unpaid claim and claim adjustment expenses of $2.8 million). This amount represents management’s best estimate of the Company’s claims exposure, as derived from the actuarial analysis.

As of December 31, 2009, in respect of its runoff lines, the Company had $3.1 million in net unpaid claim and claim adjustment expenses. Historically, the Company experienced significant volatility in its reserve projections for its commercial lines. This volatility was primarily attributable to its commercial auto and general liability product lines. The Company has been settling and reducing its remaining inventory of commercial claims.

 

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Index to Financial Statements

Accidents generally result in insurance companies paying amounts to individuals or companies for the risks insured under the insurance policies written by them. Months and sometimes years may elapse between the occurrence of an accident, reporting of the accident to the insurer and payment of the claim. Insurers record a liability for estimates of claims that will be paid for accidents reported to them, which are referred to as “case reserves.” In addition, since accidents are not always reported promptly upon the occurrence and because the assessment of existing known claims may change over time with the development of new facts, circumstances and conditions, insurers estimate liabilities for such items, which are referred to as “IBNR” reserves (Incurred But Not Reported).

We maintain reserves for the payment of claims and claim adjustment expenses for both case and IBNR under policies written by our insurance subsidiaries. These claims reserves are estimates, at a given point in time, of amounts that we expect to pay on incurred claims based on facts and circumstances then known. The amount of case claim reserves is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding the claim, and the policy provisions relating to the type of claim. The amount of IBNR claims reserves is determined on the basis of historical information and anticipated future conditions by lines of insurance and actuarial review. Reserves for claim adjustment expenses are intended to cover the ultimate costs of settling claims, including investigation of claims and defense of lawsuits resulting from such claims. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results.

The process of estimating claims reserves is imprecise and reflects significant judgment. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. The actual emergence of claims and claim adjustment expenses may vary, perhaps materially, from our estimates thereof, because (a) estimates of claims and claim adjustment expense liabilities are subject to large potential errors in estimation as the ultimate disposition of claims incurred prior to the financial statement date, whether reported or not, is subject to the outcome of events that have not yet occurred (e.g., jury decisions, court interpretations, legislative changes after coverage is written and reserves are initially established that broaden liability and policy definitions and increase the severity of claims obligations, subsequent damage to property, changes in the medical condition of claimants, public attitudes and social/economic conditions such as inflation), (b) estimates of claims do not make provision for extraordinary future emergence of new classes of claims or types of claims not sufficiently represented in our historical data base or not yet quantifiable at the time the estimate is made, and (c) estimates of future costs are subject to the inherent limitation on our ability to predict the aggregate course of future events. In addition, we continue to make operational changes in the claims adjustment process, and changing claims trends increase the uncertainties which exist in the estimation process and could lead to inaccurate estimates of claim and claims adjustment expense.

Ultimate liability may be greater or lower than stated reserves at any particular point in time. We monitor reserves using new information on reported claims and a variety of statistical techniques. We do not discount to present value that portion of our claim reserves expected to be paid in future periods.

 

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Index to Financial Statements

The following table sets forth the changes in unpaid claims and claim adjustment expenses, net of reinsurance cessions, as shown in the Company’s consolidated financial statements as of and for the years ended December 31:

 

     2009     2008
     (Amounts in thousands)

Unpaid claims and claim adjustment expenses, beginning of period

   $ 75,482      74,694

Less: Ceded unpaid claims and claim adjustment expenses, beginning of period

     2,405      8,694
            

Net unpaid claims and claim adjustment expenses, beginning of period

     73,077      66,000
            

Net claims and claim adjustment expense incurred related to:

    

Current period

     144,211      126,599

Prior periods

     (6,924   2,963
            

Total net claim and claim adjustment expenses incurred

     137,287      129,562
            

Net claims and claim adjustment expenses paid related to:

    

Current period

     93,191      79,053

Prior periods

     44,628      43,432
            

Total net claim and claim adjustment expenses paid

     137,819      122,485
            

Net unpaid claims and claim adjustment expenses, end of period

     72,545      73,077

Plus: Ceded unpaid claims and claim adjustment expenses, end of period

     2,823      2,405
            

Unpaid claims and claim adjustment expenses, end of period

   $ 75,368      75,482
            

The decrease from 2008 to 2009 in net claims and claim adjustment expenses incurred related to prior periods was primarily the result of the favorable development recorded in 2009 for the nonstandard personal automobile lines primarily in the Southwest region as a result of projected and actual decreases in severity associated with the physical damage lines versus the unfavorable development of $4.4 million recorded for the nonstandard personal automobile lines in 2008. In 2008, the Company’s growth and the associated risks and uncertainties (see ITEM 1A. Risk Factors) made it difficult to estimate ultimate claims liabilities, and the unfavorable development occurred as the Company revised previous estimates to reflect current claims data; see ITEM 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations.” .

The following table represents the development of GAAP balance sheet reserves for the years ended December 31, 1999 through 2009. The top line of the table shows the reserves for unpaid claims and claim adjustment expenses for the current and all prior years as recorded at the balance sheet date for each of the indicated years. The reserves represent the estimated amount of claims and claim adjustment expenses for claims arising in the current and all prior years that are unpaid at the balance sheet date, including claims that have been incurred but not yet reported to the Company.

The second portion of the following table shows the net cumulative amount paid with respect to the previously recorded liability as of the end of each succeeding year. The third portion of the table shows the re-estimated amount of the previously recorded net unpaid claims and claim adjustment expenses based on experience as of the end of each succeeding year, including net cumulative payments made since the end of the respective year. For example, the 2008 liability for net claims and claim adjustment expenses of $73,077,000 re-estimated one year later (as of December 31, 2009) was $66,153,000 of which $44,628,000 has been paid, leaving a net reserve of $21,525,000 for claims and claim adjustment expenses in 2008 and prior years remaining unpaid as of December 31, 2009.

 

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Index to Financial Statements

“Net cumulative (deficiency) redundancy” represents the change in the estimate from the original balance sheet date to the date of the current estimate. For example, the 2008 net unpaid claims and claim adjustment expenses indicate a $6,924,000 net redundancy from December 31, 2008 to December 31, 2009 (one year later) whereas the 2004 net unpaid claims and claim adjustment expenses indicate a $15,352,000 net redundancy from December 31, 2004 to December 31, 2009 (five years later). Conditions and trends that have affected development of liability in the past may or may not necessarily occur in the future. Accordingly, it is generally not appropriate to extrapolate future redundancies or deficiencies based on this table.

 

     As of and for the years ended December 31,
     1999     2000     2001     2002    2003    2004    2005    2006     2007    2008    2009
     (Amounts in thousands)

Unpaid claims & claim Adjustment expenses:

                            

Gross

   $ 132,814      164,160      181,059      143,271    120,633    95,545    78,503    77,898      74,694    75,482    75,368

Ceded

     37,299      37,703      65,571      46,802    44,064    37,063    22,672    14,361      8,694    2,405    2,823
                                                            

Net

     95,515      126,457      115,488      96,469    76,569    58,482    55,831    63,537      66,000    73,077    72,545

Net cumulative paid as of:

                            

One year later

     54,683      71,619      52,230      32,035    27,501    21,054    32,541    55,118      43,432    44,628   

Two years later

     90,403      109,820      74,238      53,434    40,274    30,825    41,824    64,962      54,691      

Three years later

     108,757      126,603      91,915      65,375    48,717    35,364    45,358    69,389           

Four years later

     115,966      140,915      101,411      73,189    52,704    37,324    47,922           

Five years later

     121,865      147,708      108,532      76,551    54,512    39,333              

Six years later

     125,402      151,983      111,465      78,340    56,483                 

Seven years later

     126,668      153,530      113,067      80,268                    

Eight years later

     127,766      154,761      114,774                         

Nine years later

     128,593      156,420                           

Ten years later

     128,547                             

Net unpaid claims and claim adjustment expenses reestimated as of:

                            

One year later

     114,876      156,963      121,383      99,020    74,671    52,596    53,802    77,265      68,963    66,153   

Two years later

     130,952      161,922      126,964      98,474    69,761    47,776    55,823    78,329      65,711      

Three years later

     133,738      165,706      128,930      93,690    65,113    46,479    54,961    76,403           

Four years later

     134,626      167,494      125,615      89,165    63,590    45,190    53,805           

Five years later

     136,041      163,758      122,934      86,646    62,253    43,130              

Six years later

     132,726      160,136      120,463      85,299    59,494                 

Seven years later

     130,965      159,105      118,789      83,218                    

Eight years later

     130,530      159,303      117,661                         

Nine years later

     129,512      158,387                           

Ten years later

     129,156                             

Net cumulative (Deficiency) Redundancy

   $ (33,641   (31,930   (2,173   13,251    17,075    15,352    2,026    (12,866   289    6,924   

For the year ended December 31, 2009 the net cumulative redundancy reported was $6.9 million for 2008 and prior years and was attributable primarily to the nonstandard personal auto lines. See further discussion under ITEM 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations.”

The Company completes a full actuarial analysis of unpaid claims and claim adjustment expenses on a quarterly basis for each of its coverage lines. Based upon this actuarial analysis and the new information that becomes available during the quarter, unpaid claims and claim adjustment expenses are re-estimated each quarter.

Of the net unpaid claims and claim adjustment expenses at December 31, 2009 of $72.5 million, 99% is related to the Company’s three primary reserve coverage areas: commercial general liability ($2.7 million); commercial auto liability ($0.2 million); and nonstandard personal auto ($69.4 million). The remaining $0.2 million (1%) relates to professional liability and miscellaneous commercial areas, which are in runoff.

 

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Index to Financial Statements

The following table is a reconciliation of our net unpaid claim and claim adjustment expenses to our gross unpaid claims and claim adjustment expenses for the periods indicated:

 

     As of and for the years ended December 31,
     1999     2000     2001     2002    2003    2004    2005    2006     2007    2008    2009
     (Amounts in thousands)

As Originally estimated:

                            

Net unpaid claims and claim adjustment expenses

   $ 95,515      126,457      115,488      96,469    76,569    58,482    55,831    63,537      66,000    73,077    72,545

Ceded unpaid claims and claim adjustment expenses

     37,299      37,703      65,571      46,802    44,064    37,063    22,672    14,361      8,694    2,405    2,823
                                                            

Unpaid claims and claim adjustment expenses

     132,814      164,160      181,059      143,271    120,633    95,545    78,503    77,898      74,694    75,482    75,368
                                                            

As Re-estimated as of December 31, 2009:

                            

Net unpaid claims and claim adjustment expenses

     129,156      158,387      117,661      83,218    59,494    43,130    53,805    76,403      65,711    66,153   

Ceded unpaid claims and claim adjustment expenses

     47,879      45,894      63,972      43,033    32,964    21,649    10,724    6,278      4,250    4,873   
                                                          

Unpaid claims and claim adjustment expenses

     177,035      204,281      181,633      126,251    92,458    64,779    64,529    82,681      69,961    71,026   
                                                          

Gross Cumulative (Deficiency) Redundancy

   $ (44,221   (40,121   (574   17,020    28,175    30,766    13,974    (4,783   4,733    4,456   

Significant risk factors exist in the estimation of unpaid claims and claim adjustment expense, including the runoff status of the commercial lines, exposure to construction defect claims, exposure to directors’ and officers’ liability and personal umbrella claims on an excess of loss basis and recent changes in the nonstandard personal auto claims operation. The selected estimates make no provision for extraordinary future emergence of new classes of claims or types of claims not sufficiently represented in the Company’s historical base or which are not yet quantifiable, and other risk factors could be identified in the future as having been a significant influence on the Company’s unpaid claims and claim adjustment expenses.

Insurance Ratios

Claims, Expense and Combined Ratios:

Claims and claim adjustment expenses are stated as a percentage of net premiums earned (claims ratio). Claims and expense ratios are traditionally used to interpret the underwriting experience of property and casualty insurance companies. Commissions, change in deferred acquisition costs, underwriting expenses and operating expenses (for the insurance companies only) are stated as a percentage of net premiums earned (expense ratio). Underwriting profit is achieved when the combined ratio is less than 100%.

 

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Index to Financial Statements

The following table presents the insurance company’s claims, expense and combined ratios on an accounting principles generally accepted in the United States of America (“GAAP”) basis:

 

     Years ended
December 31,
 
     2009     2008  

C & CAE Ratio (1)

   74.1   73.3

Expense Ratio (2) (3)

   25.6      25.7   
            

Combined Ratio (2)

   99.7   99.0
            

 

(1) C & CAE is an abbreviation for Claims and claim adjustment expenses, stated as a percentage of net premiums earned.
(2) The Expense and Combined ratios do not reflect expenses of the holding company which include interest expense on the note payable and subordinated debentures.
(3) Commissions, change in deferred acquisition costs, underwriting expenses and operating expenses (insurance subsidiary only) are offset by agency revenues and are stated as a percentage of net premiums earned.

The holding company provides administrative and financial services for its companies and only a portion of these expenses are allocated to the insurance companies. The allocation of the holding company’s expenses solely to its insurance company would have an impact on the insurance company’s results of operations and would also affect the ratios presented.

The increase in the claims ratio for 2009 was primarily due to an increase in accident frequency, particularly in Florida (see ITEM 1A. Risk Factors), offset by additional favorable development in the runoff lines. See ITEM 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of OperationsClaims and claim adjustment expenses.”

Net Premiums Written Leverage Ratios:

The following table shows, for the periods indicated, the Statutory Accounting Practices (“SAP”) net premiums written leverage ratios for the insurance company.

 

     As of the years ended December 31,
     2009    2008

Insurance company

   1.9:1    2.0:1
         

The net premiums written leverage ratio represents the ratio of SAP net retained writings in relation to SAP surplus. This ratio measures a company’s exposure to pricing errors on its current book of business.

 

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Index to Financial Statements

Investment Portfolio Historical Results and Composition

The following table sets forth, for the periods indicated, our investment results before income tax effects:

 

     As of and for the years ended December 31,  
     2009     2008  
     (Dollar amounts in thousands)  

Average investments (1)

   $ 181,600      174,902   
              

Net investment income (2)

   $ 6,677      7,728   
              

Return on average investments (2) (3)

     3.7   4.4
              

Net realized gains (losses)

   $ 2,367      (6,313
              

Net unrealized losses (4)

   $ (317   (7,331
              

 

(1) Average investments is the average of beginning and ending investments at fair value, computed on an annual basis.
(2) Excludes net realized gains (losses) and net unrealized losses.
(3) Includes taxable and tax-exempt securities.
(4) Includes net unrealized gains for total investments, before taxes.

The following table sets forth the composition of our investment portfolio.

 

     As of December 31,
     2009    2008
     (Amounts in thousands)

Type of Investment

   Amortized
Cost
   Fair
Value
   Amortized
Cost
   Fair
Value

Bonds, available for sale:

           

U.S. Treasury

   $ 5,156    5,263    5,179    5,244

U.S. Government agencies

     7,058    6,983    2,998    3,011

Corporate bonds

     82,608    85,403    48,883    47,517

Asset backed bonds

     7,827    8,042    11,909    11,635

Mortgage backed bonds

     36,387    33,629    36,493    31,831

Bonds, trading

     323    323    —      —  

Preferred stocks

     4,947    4,235    8,868    7,781

Common stocks

     466    551    278    277

Certificates of deposit

     185    185    255    255
                     
     144,957    144,614    114,863    107,551

Other long-term investments

     1,068    1,068    1,850    1,850

Short-term investments

     42,289    42,315    65,820    65,801
                     

Total investments

   $ 188,314    187,997    182,533    175,202
                     

At December 31, 2009 the Standard & Poor’s ratings on our bonds available for sale and bonds trading were in the following categories: 33% AAA, 1% AA+, 5% AA, 5% AA-, 2% A+, 18% A, 9% A-, 7% BBB+, 8% BBB, 2% BBB-, 2% BB+, 8% BB and below. See note 1(c) “Background and Summary of Accounting Policies – Investments” in Notes to Consolidated Financial Statements appearing under Item 8 of this Annual Report for further discussion.

 

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The maturity distribution of our investments in fixed maturities is as follows:

 

     As of December 31,  
     2009     2008  
     (Dollar amounts in thousands)  
     Amortized
Cost
   Percent     Amortized
Cost
   Percent  

Within 1 year

   $ 24,865    17.2   20,855    18.2

Beyond 1 year but within 5 years

     58,700    40.7      36,071    31.5   

Beyond 5 years but within 10 years

     7,835    5.4      3,670    3.2   

Beyond 10 years but within 20 years

     2,766    1.9      —      —     

Beyond 20 years

     6,111    4.2      5,587    4.9   

Asset backed securities

     7,827    5.4      11,909    10.4   

Mortgage backed securities

     36,387    25.2      36,493    31.8   
                        

Total fixed maturities

   $ 144,491    100.0   114,585    100.0
                        

Average duration

     2.4 yrs      2.0 yrs   

See further discussion of gross unrealized losses showing the length of time that investments have been continuously in an unrealized loss position as of December 31, 2009 and 2008 in note 2 to the Company’s Consolidated Financial Statements which appears in Item 8 of this Annual Report. See further discussion on asset-backed and mortgage-backed securities in ITEM 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Subsidiaries, Principally Insurance Operations.”

Investment Strategy

The investment policy of the insurance subsidiary, which is subject to applicable investment statutes and regulations, is to maximize after-tax yield while seeking to maintain safety of capital together with adequate liquidity for insurance operations. The insurance company’s portfolio may also be invested in equity securities within limits prescribed by applicable statutes that establish permissible investments. The investment portfolio of the holding company is not subject to such limitations. We manage our investment portfolio internally.

Net Operating Loss Carryforwards

As a result of losses in prior years, as of December 31, 2009 the Company had net operating loss carryforwards for tax purposes aggregating $68.5 million. These net operating loss carryforwards of $7.3 million, $34.0 million, $13.7 million, $0.6 million and $12.9 million, if not utilized, will expire in 2020, 2021, 2022, 2023 and 2027, respectively. As of December 31, 2009, the tax benefit of the net operating loss carryforwards was approximately $23.3 million, which is calculated by applying the Federal statutory income tax rate of 34% against the net operating loss carryforwards of $68.5 million. In 2009, the Company decreased the amount of the valuation allowance by $1.1 million, resulting in an allowance on the gross deferred tax asset of $28.8 million. The Company considered it appropriate to decrease the valuation allowance, see ITEM 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – “Liquidity and Capital Resources – Net Operating Loss Carryforwards.” As of December 31, 2009 and 2008, the net deferred tax assets before valuation allowance were $28.9 million and $32.4 million and the valuation allowance were $28.8 million and $29.9 million, respectively.

 

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Rating

A.M. Best is the principal rating agency of the insurance industry. An insurance company’s ability to effectively compete in the market place is in part dependent upon the rating determination of A.M. Best. A.M. Best provides ratings of insurance companies based on comprehensive quantitative and qualitative evaluations and expresses its rating as an opinion of an insurer’s ability to meet its obligations to policyholders and not upon factors concerning investor protection. In January 2010, A.M. Best affirmed the rating assignment of our insurance subsidiary of “B” (Fair) with a positive outlook. A.M. Best’s assigns a “B” rating to companies that have, in the opinion of A.M. Best, a fair ability to meet their current obligations to policyholders, but are financially vulnerable to adverse changes in underwriting and economic conditions. A “B” rating is the seventh out of the 16 possible ratings.

Government Regulation

Our insurance company is subject to regulation and supervision by the insurance department of each jurisdiction in which it is domiciled or licensed to transact business. The nature and extent of such regulation and supervision varies from jurisdiction to jurisdiction. Generally, an insurance company is subject to a higher degree of regulation and supervision in its state of domicile. State insurance departments have broad administrative power relating to limitations on dividends paid by an insurance company to its parent holding company, licensing insurers and agents, regulating premium charges and policy forms, establishing reserve requirements, prescribing statutory accounting methods and the form and content of statutory financial reports, and regulating the type and amount of investments permitted. Rate regulation varies from “file and use” to prior approval to mandated rates.

Insurance departments are charged with the responsibility of ensuring that insurance companies maintain adequate capital and surplus and comply with a variety of operational standards. Insurance companies are generally required to file detailed annual and other reports with the insurance department of each jurisdiction in which they conduct business. Insurance departments are authorized to make periodic and other examinations of regulated insurers’ financial condition and operations to monitor financial stability of the insurers and to ensure adherence to statutory accounting principles and compliance with state insurance laws and regulations.

Insurance holding company laws enacted in many jurisdictions grant to insurance authorities the power to regulate acquisitions of insurers and certain other transactions and to require periodic disclosure of certain information. These laws impose prior approval requirements for certain transactions between regulated insurers and their affiliates and generally regulate dividend and other distributions, including management fees, loans, and cash advances, between regulated insurers and their affiliates.

Under state insolvency and guaranty laws, regulated insurers can be assessed or required to contribute to state guaranty funds to cover policyholder losses resulting from the insolvency of other insurers. Insurers are also required by many states, as a condition of doing business in the state, to provide coverage to certain risks which are not insurable in the voluntary market. These “assigned risk” plans generally specify the types of insurance and the level of coverage which must be offered to such involuntary risks, as well as the allowable premium. Many states also have involuntary market plans which hire a limited number of servicing carriers to provide insurance to involuntary risks. These plans, through assessments, pass underwriting and administrative expenses on to insurers that write voluntary coverages in those states.

 

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Insurance companies are generally required by insurance regulators to maintain sufficient surplus to support their writings. Although the ratio of writings to surplus that the regulators will allow is a function of a number of factors, including the type of business being written, the adequacy of the insurer’s reserves, the quality of the insurer’s assets and the identity of the regulator, the annual net premiums that an insurer may write are generally limited in relation to the insurer’s total policyholders’ surplus. Thus, the amount of an insurer’s surplus may, in certain cases, limit its ability to grow its business. The National Association of Insurance Commissioners (the “NAIC”) also has developed a risk-based capital (“RBC”) program to enable regulators to carry-out appropriate and timely regulatory actions relating to insurers that show signs of weak or deteriorating financial condition. The RBC program consists of a series of dynamic surplus-related formulas which contain a variety of factors that are applied to financial balances based on a degree of certain risks, such as asset, credit and underwriting risks. The Company’s statutory capital exceeds the benchmark capital level under the RBC formula for its insurance company.

Many states have laws and regulations that limit an insurer’s ability to exit a market. For example, certain states limit an auto insurer’s ability to cancel or non-renew policies. Furthermore, certain states prohibit an insurer from withdrawing one or more lines of business from the state, except pursuant to a plan that is approved by the state insurance department. The state insurance department may disapprove a plan that may lead to market disruption. Laws and regulations that limit cancellation or non-renewal of policies and that subject program withdrawals to prior approval requirements may restrict an insurer’s ability to exit unprofitable markets.

Regulation of insurance frequently changes as real or perceived issues and developments arise. Some changes may be due to economic developments, such as changes in investment laws made to recognize new investment vehicles; other changes result from such general pressures as consumer resistance to price increases and concerns relating to insurer rating and underwriting practices and solvency. In recent years, legislation and voter initiatives have been introduced, and in some areas adopted, which deal with use of non-public consumer information, use of financial responsibility and credit information in underwriting, insurance rate development, rate determination and the ability of insurers to cancel or non-renew insurance policies, reflecting concerns about consumer privacy, coverage, availability, prices and alleged discriminatory pricing. In addition, from time to time, the U.S. Congress and certain federal agencies investigate the current condition of the insurance industry to determine whether federal regulation is necessary.

In some states, the auto insurance industry has been under pressure in past years from regulators, legislators or special interest groups to reduce, freeze, or set rates to or at a level that are not necessarily related to underlying costs, including initiatives to roll back auto and other personal lines rates. This kind of activity has affected adversely, and in the future may affect adversely, the profitability and growth of the auto insurance business in those jurisdictions, and may limit the ability to increase rates to compensate for increases in costs. Adverse legislative and regulatory activity limiting the ability to price auto insurance adequately, or affecting the insurance operations adversely in other ways, may occur in the future. The impact of these regulatory changes on us cannot be predicted.

Employees

As of December 31, 2009, we employed 395 full time employees, of whom 20 were officers and 375 were staff and administrative personnel. We had no part time employees. We are not a party to any collective bargaining agreement.

 

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ITEM 1A. RISK FACTORS

Readers of this Annual Report on Form 10-K should consider the risk factors described in the following paragraphs in conjunction with the other information included herein. See also “Forward-Looking Statements” appearing in ITEM 7, Management’s Discussion And Analysis Of Financial Condition And Results Of Operations.”

Current economic conditions and disruptions in financial markets may materially and adversely affect our business, operations, capital and liquidity and be accompanied by more claims fraud.

The recent severe economic recession and related financial disruptions have adversely affected the capital markets and have been accompanied by market volatility, increased exposure to credit and interest rate risks and uncertainty. Reduced economic activity is likely to affect our customers more severely than other segments of the personal automobile insurance market, and some of our customers may decide to forego automobile insurance or may be unable to afford it. Continuing adverse economic conditions and disrupted financial markets also may adversely affect our investment portfolio and may lead to unpredictable governmental actions affecting financial institutions, other financial firms, and/or rating agencies; see “The performance of our portfolio of fixed-income securities may adversely affect our profitability, capitalization and financial performance.”

The recent recession and related economic problems existing in the states in which we operate (particularly high unemployment, reduced working hours for many employed persons, and residential foreclosures and associated problems) appear to us to have led to higher than normal incidents of claims fraud. The costs we incur in handling such claims may be higher than those for more routine claims, and the investigations may require specialized services and lead to higher litigation costs. Furthermore, such claims tend to take far longer than routine claims to resolve, which significantly increases the number of open claims which we are managing and may adversely affect our ability to estimate our claims and claim adjustment expense.

We face intense competition from other personal automobile insurance providers.

The nonstandard personal automobile insurance business is highly competitive and, except for regulatory considerations, there are relatively few barriers to entry. We compete with large national insurance providers, smaller regional companies and local managing general agents. The largest automobile insurance companies include The Progressive Corporation, The Allstate Corporation, State Farm Mutual Automobile Insurance Company, GEICO, Farmers Insurance Group, and Bristol West Insurance Group, Safeco Corp. and Nationwide Group. Our chief competitors include some of these companies as well as Mercury General Corporation, Infinity Property & Casualty Corporation, Affirmative Insurance Holdings, Inc., United Automobile Insurance Group, Direct General Group, Permanent General Companies, First Acceptance Insurance Companies and Sentry Insurance Group. Some of our competitors spend substantially more on advertising, have more capital, higher ratings and greater resources than we have, may offer a broader range of products, lower prices and down payments than we offer, and may pay higher commissions to agents and offer superior customer service. Some of our competitors that sell insurance policies directly to customers, rather than through agents or brokers as we do, may have certain competitive advantages, including increased name recognition among customers, direct relationships with policyholders and lower cost structures. In addition, it is possible that new competitors will enter the nonstandard automobile insurance market. Our loss of business to competitors could have a material impact on our premiums and profitability. Further, competition could result in lower premium rates and less favorable policy terms and conditions including policy claim limits, which could reduce our underwriting margins. We do not use credit scores in underwriting or pricing, unlike many of our competitors, which may result in additional risks in our business.

The property and casualty insurance industry has historically been characterized by cyclical periods of intense price competition due to excess underwriting capacity, as well as periods of shortages of underwriting capacity that allow for higher premiums and attract additional competitors. The periods of intense price competition may adversely affect our operating results, and the overall cyclicality of the industry may cause fluctuations in our operating results and affect our ability to manage the business profitably.

 

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Our failure to evaluate and pay claims accurately could adversely affect our business, financial condition, results of operations and cash flows.

We must accurately evaluate and pay claims that are made under our policies. Many factors affect our ability to evaluate and pay claims accurately, including but not limited to the training and experience of our claims representatives, our claims organization’s culture and the effectiveness of our management, our ability to develop or select and implement appropriate procedures and systems to support our claims functions and other factors. During periods of economic stress, additional risks exist of fraudulent or overstated claims. Our failure to pay claims timely and accurately could lead to material litigation, undermine our reputation in the marketplace, impair our image, affect our ability to estimate claims and claim adjustment expense accurately and materially adversely affect our financial condition, results of operations and cash flows.

In addition, if we do not train new claims employees effectively or lose a significant number of experienced claims employees, our claims department’s ability to handle an increasing workload and to operate at an acceptable quality level could be adversely affected. Higher than normal levels of claims fraud may make it more difficult for us to handle claims efficiently and mitigate claims costs.

We rely on information technology and telecommunication systems, and the failure of these systems could materially and adversely affect our business.

Our business is highly dependent upon the successful and uninterrupted functioning of our information technology and telecommunications systems and technology services provided by third parties. We rely on these systems to provide quotations for new business, process new and renewal business, provide customer service, adjudicate claims, make claims payments and facilitate billings, collections and cancellations. These systems also enable us to perform actuarial and other modeling functions necessary for underwriting and rate development. The failure of these systems could interrupt our operations or materially impact our ability to evaluate and write new business. Because our information technology and telecommunication systems interface with and depend on third-party systems, we could experience service denials if demand for such service exceeds capacity or such third-party systems fail or experience interruptions. If sustained or repeated, a system failure or service denial could result in a deterioration of our ability to write and process new and renewal business and provide customer service or compromise our ability to pay claims in a timely manner. This outcome could result in a material adverse effect on our business and our results of operations, financial condition and cash flows.

Our profitability and financial condition are affected by the availability of reinsurance.

We utilize catastrophe reinsurance to “transfer” or “cede” a portion of the risks related to our nonstandard personal automobile insurance business through reinsurance arrangements with third parties. We rely heavily on reinsurance to mitigate the risk of catastrophic losses arising from hurricanes, tornados and other natural disasters. The amount, availability and cost of reinsurance are subject to prevailing market conditions that are beyond our control. These conditions may affect our level of business and profitability.

We have used reinsurance to dispose of certain of our discontinued and runoff businesses. Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred, it does not relieve us of our liability to our policyholders. At December 31, 2009, we had approximately $3.3 million in reinsurance receivables and ceded unpaid claims and claim adjustment expenses, comprised primarily of reserves for future claim payments. Approximately 94% of these receivables were concentrated with 13 reinsurers, all of which were companies rated A- or better by A.M. Best and one company with a B++ rating owed approximately 6% of the reinsurance receivables. One company with a NR A.M. Best rating owed less than 1% of the reinsurance receivables. The failure of reinsurers to pay amounts due to us on a timely basis or at all would adversely affect our results of operations.

 

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Reinsurance makes the assuming reinsurer liable to the extent of the risks ceded. We are subject to credit risks with respect to the reinsurers because ceding risks to reinsurers does not relieve our insurance subsidiary’s ultimate liability to its insureds. The insolvency of any reinsurer or the inability of a reinsurer to make payments could have a material adverse effect on our business, our results of operations and our financial condition and cash flows.

Our business is subject to financial and operational risks resulting from our growth.

We limited our business to Florida until the fourth quarter of 2003, when we began writing nonstandard personal automobile insurance policies in Texas. In 2004, we began writing nonstandard personal automobile insurance policies in Arizona and Nevada and in 2005 initiated a California program with an independent managing general agency. We entered the South Carolina market in 2006, the New Mexico market in 2007, and the Georgia market in the second quarter of 2009. Significant growth was realized as a result of these expansion activities, which increased our operating leverage, claims ratio and the overall financial and operating risk profile. We may expand to additional states in the future.

Our strategy necessarily entails increased financial and operational risks and other challenges that include, but are not limited to, the following:

 

   

competitive conditions for our product are significant;

 

   

generally, new business initially produces higher claim ratios than more seasoned in-force business, and this factor is likely to be magnified to the extent that we enter new states and market areas. Furthermore, it amplifies the importance of our ability to assess any new trends accurately and respond effectively;

 

   

pricing decisions in new states and markets, involving different claims environments, distribution sources and customer demographics, must be made without the same level of experience and data that is available in existing markets;

 

   

our growth required additional personnel resources, including management and technical underwriting, claims and servicing personnel, relationships with agents and vendors with whom we had not previously done business, and additional dependence on operating systems and technology; and

 

   

if we grow significantly in future periods or if adverse underwriting results occur, additional capital may be required, and such capital may not be available on favorable or acceptable terms. Our ability to maintain sufficient capital and perform successfully will be important factors in determination of our A.M. Best rating, and a reduction in that rating could have an adverse impact on our results of operations.

Our ability to manage these risks and challenges will determine in large part whether we can operate profitably.

A downgrade in our financial strength ratings may negatively affect our business.

Financial strength ratings are an important factor in establishing the competitive position of insurance companies and may be expected to have an effect on an insurance company’s sales. An insurance company’s ability to effectively compete in the marketplace is in part dependent upon the rating determination of A.M. Best, the principal rating agency of the insurance industry. A.M. Best provides ratings of insurance companies based on comprehensive quantitative and qualitative evaluations and expresses its rating as an opinion of an insurer’s ability to meet its obligations to policyholders. In February, 2010, A.M. Best affirmed the rating assignment of our insurance subsidiary of “B” (Fair) and revised our outlook from “stable” to “positive.” A.M. Best assigns “B” and “B-” ratings to companies that have, in the opinion of A.M. Best, a fair ability to meet their current obligations to policyholders, but are financially vulnerable to adverse changes in underwriting and economic conditions.

 

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If we do not successfully implement our business plan, if the risks we describe materially and adversely affect our results or financial position or if our written premiums exceed levels deemed prudent by A.M. Best, we would face the risk of a downgrade by A.M. Best. A downgrade in our rating may cause our independent agents to limit or stop their marketing of our products and may limit that availability and materially and adversely affect our results of operations, financial condition and the terms of capital to us.

Our success depends on our ability to underwrite risks accurately and to charge adequate rates to policyholders.

Our financial condition, cash flows and results of operations depend on our ability to underwrite and set rates accurately for the risks we underwrite. Rate adequacy is necessary to generate sufficient premium to offset claims, claim adjustment expenses and underwriting expenses and to earn a profit.

Our ability to price accurately is subject to a number of risks and uncertainties, including, without limitation:

 

   

the availability of sufficient reliable data;

 

   

our ability to conduct a complete and accurate analysis of available data;

 

   

our ability to recognize changes in trends in a timely manner and to project both the severity and frequency of losses with reasonable accuracy;

 

   

uncertainties inherent in estimates and assumptions, generally;

 

   

our ability to project changes in certain operating expenses with reasonable certainty;

 

   

the development, selection and application of appropriate rating formulae or other pricing methodologies;

 

   

our ability to innovate with new pricing strategies and marketing initiatives, and the success of those innovations;

 

   

the effects of pricing decisions of competitors on the markets in which we operate;

 

   

our ability to predict policyholder retention accurately;

 

   

unanticipated court decisions, legislation or regulatory action;

 

   

ongoing changes in our claim settlement practices and in the claims environments in which we operate;

 

   

changing driving patterns;

 

   

changes in the medical sector of the economy;

 

   

unanticipated changes in automobile repair costs, automobile parts prices and used car prices or in general inflation rates; and

 

   

timely approval of proposed rates by regulatory agencies.

 

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Such risks may result in our pricing being based on stale, inadequate or inaccurate data or inappropriate analyses, assumptions or methodologies, and may cause us to estimate incorrectly future changes in the frequency or severity of claims. As a result, we could underprice risks, which would negatively affect our margins, or we could overprice risks, which could reduce our volume and competitiveness. In either event, our operating results, financial condition and cash flows could be materially adversely affected.

The rates charged for the Company’s personal nonstandard automobile insurance policies are filed with the insurance regulatory departments in the states in which the Company operates. Beginning in the second quarter of 2009, we implemented a new pricing methodology in Texas in an effort to use more precise and detailed analyses of accident data, including data maintained by the Company and increased reliance upon information acquired from third parties. The Company expects to introduce this new methodology gradually into the other states in which we operate. There are risks associated with any significant change in our methodology for charging rates. The principal added risk arises from the fact that, until this pricing methodology has been used for several years, we must estimate the effects on future trends of changes in our pricing without substantial data from our experience. If we fail to do so accurately, or if other factors discussed above interfere with our ability to analyze the data and our rates properly, then we may suffer significant underwriting losses and/or fail to attract a sufficient level of business to operate profitably.

Failure by insurance agents to follow our policies and requirements or to comply with regulatory requirements may materially affect our business.

As of December 31, 2009, we marketed our products and services through approximately 4,800 independent agency locations in Arizona, Florida, Georgia, Nevada, New Mexico, South Carolina and Texas and one independent general agency in California that markets through approximately 900 insurance broker locations. These agents have the ability to bind us with respect to insurance coverage issued on our behalf. Since the agents are independent, we have only limited ability to exercise control over these agents. In the event that an agent exceeds its authority by binding us on a risk that does not comply with our underwriting guidelines, fails to require and maintain adequate documentation, or fails to comply with regulatory requirements imposed on agents by state insurance departments, we are at risk for that policy until we receive the application and effect a cancellation. This could also result in our paying claims on policies for which we do not receive appropriate premiums. We also may incur losses if agents fail to return unearned commissions on policies that are cancelled. These events may result in a material adverse effect on our results of operations.

We are subject to comprehensive laws and regulations, and our results may be unfavorably impacted by these laws and regulations or by changes in them.

We are subject to comprehensive laws and governmental regulation and supervision. Most insurance laws and regulations are designed to protect the interests of policyholders rather than the shareholders and other investors of insurance companies. These regulations, administered by the department of insurance in each state in which we do business, relate to, among other things:

 

   

establishing mandatory minimum policy limits and coverages,

 

   

approval of policy forms, rates and rating methodologies and underwriting rules,

 

   

standards of solvency, including risk based capital measurements developed by the National Association of Insurance Commissioners, or the NAIC, and used by state insurance regulators to identify inadequately capitalized insurance companies,

 

   

claims practices,

 

   

restrictions on the ability of insurance companies such as our insurance company subsidiary to pay dividends,

 

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licensing of insurers and their agents,

 

   

restrictions on the nature, quality and concentration of investments as well as rules and policies affecting how investments are valued,

 

   

restrictions on transactions between the insurance company subsidiary and its affiliates,

 

   

requiring certain methods of accounting,

 

   

periodic examinations of operations and finances,

 

   

prescribing the form and content of records of financial condition to be filed,

 

   

requiring reserves for unearned premium, claims and other purposes,

 

   

sales plans and practices and commission structures,

 

   

permitted advertising, and

 

   

market conduct.

State insurance departments also conduct periodic examinations of the affairs of insurance companies and require filing of annual and other reports relating to the financial condition of insurance companies, holding company issues and other matters. Insurance regulations and regulators have an impact on a number of factors that could affect our ability to respond to changes in our competitive environment and which could have a material adverse effect on our operations. These factors include regulating our ability to exit a book of business or to exit a state in which we have been producing insurance, our ability to change our rates or products in a timely manner and to receive adequate premiums to achieve acceptable profitability levels, and the amount of statutory dividends from our subsidiaries which the holding company may need to pay expenses and dividends.

Failure to maintain risk-based capital at the required levels or ratios within the NAIC’s usual range could adversely affect our insurance subsidiaries’ ability to secure regulatory approvals as necessary or appropriate and would materially adversely affect their general business, ability to operate and overall financial condition.

Our business depends on compliance with applicable laws and regulations and our ability to maintain valid licenses and approvals for our operations. Regulatory authorities may deny or revoke licenses for various reasons, including violations of regulations. Changes in the level of regulation of the insurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities, could have a material adverse affect on our operations.

Litigation may adversely affect our financial condition, results of operations and cash flows.

As a property and casualty insurance company, we are subject to various claims and litigation seeking damages and penalties, based upon, among other things, payments for claims we have denied, inadvertent mistakes in pricing or other terms of insurance, allegations regarding sales practices, and other claims for monetary damages. In some cases, plaintiffs seek to recover damages far in excess of our policy limits or beyond the coverages afforded by a policy based on assertions of “extra-contractual” liability due to alleged bad faith in the manner in which we have handled particular claims. In some jurisdictions in which we operate, allegations of bad faith are frequently made and can be difficult to defend.

 

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Some litigation against us could take the form of class action complaints. As automobile insurance industry practices and regulatory, judicial and consumer conditions change, unexpected and unintended issues related to claims and coverage may emerge, such as a growing trend of plaintiffs targeting automobile insurers in purported class action litigation relating to claims handling practices and regulatory noncompliance. These issues can have a negative effect on our business by extending coverage beyond our underwriting intent or on the way we are permitted to price products, limiting the factors we may consider when we underwrite risks, requiring us to change our claims handling procedures or our practices for charging fees, or increasing the size of claims or imposing other monetary damages. The damages and penalties in these types of matters can be substantial. The relief requested by the plaintiffs varies but may include requests for compensatory, statutory and punitive damages.

Several of our competitors are named as defendants in a number of putative class action and other lawsuits challenging various aspects of their insurance operations. These lawsuits include cases alleging damages as a result of the use of after-market parts; total loss evaluation methodology; the use of credit in underwriting and related requirements under the federal Fair Credit Reporting Act; the methods used for evaluating and paying certain bodily injury, personal injury protection and medical payment claims; methods of imposing finance charges on installment premiums; and policy implementation and renewal procedures, among other matters. Litigation may be filed against us and/or our subsidiaries or disputes may arise in the future concerning these or other business practices. From time to time, we also may be involved in such litigation or other disputes alleging that our business practices violate the patent, trademark or other intellectual property rights of third parties. In addition, lawsuits have been filed, and other lawsuits may be filed in the future, against our competitors and other businesses, and although we are not a party to such litigation, the results of those cases may create additional risks for, and/or impose additional costs and/or limitations on, our business operations.

Lawsuits against us often seek significant monetary damages, and we have been sued in putative class actions similar to some of those referred to above. Moreover, as courts resolve individual or class action litigation in insurance or related fields, a new layer of court-imposed regulation could emerge, resulting in material increases in our costs of doing business. Such litigation is inherently unpredictable. We are unable to predict the effect, if any, that these pending or future lawsuits may have on the business, operations, profitability or financial condition.

An adverse resolution of the litigation pending or threatened against us could have a material adverse effect on our financial condition, results of operations or cash flows and could cause our operating results in reporting periods to fluctuate significantly.

The nonstandard insurance business may become subject to adverse publicity, which may negatively impact our financial condition.

Negative publicity arising from attention of consumer advocacy groups, regulatory authorities, the media or other sources may result in increased regulation and legislative scrutiny of industry practices as well as increased litigation, which could increase our costs of doing business and adversely affect our results of operations.

Our results of operations may be adversely affected by competitive, regulatory or economic conditions that influence the automobile insurance industry in general.

Driving patterns, inflation in the cost of automobile repairs and medical care, and increasing litigation of liability claims are some of the more important factors that affect claim trends, and other nonstandard automobile insurers are generally unable to increase premiums unless permitted by regulators, typically after the costs associated with the coverage have increased. Accordingly, profit margins generally decline in a period of increasing claim costs, and we may be unable to sustain our policies in force. This problem is exacerbated when adverse economic conditions lead to an increased incidence of claims fraud.

 

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Catastrophic losses could have a material, adverse effect on our business.

Catastrophic losses could occur either as a result of insurance claims or because of interruption in our ability to conduct business efficiently.

Property and casualty insurance companies are subject to claims arising from natural and man-made catastrophes that may have a significant impact on their business, results of operations and financial condition. Catastrophic losses can be caused by a wide variety of events, including hurricanes, tropical storms, tornadoes, wind, hail, fires, riots, terrorism and explosions, and their incidence and severity are inherently unpredictable. Changing climate conditions may increase frequency of natural disasters such as hurricanes and other storms or the adverse effects thereof. The extent of claims from a catastrophe is a function of two factors: the total amount of an insurance company’s exposure in the area affected by the event and the severity of the event. Our policyholders are currently concentrated in geographic areas that are periodically subject to adverse weather and other conditions. Accordingly, the occurrence of a catastrophe in the states in which we operate or in which we may operate in the future could have a material adverse effect on our business, results of operations and financial condition.

Separately, a catastrophic interruption of our technology systems or interference with our operations as a result of a pandemic or other catastrophic event could disrupt our operations or prevent us from providing acceptable customer service or managing other aspects of our business effectively.

Our ultimate claims and claim adjustment expense may exceed our claims and claim adjustment expense reserves, which could adversely affect our results of operations, financial condition and cash flows.

Our financial statements include claim and claim adjustment expense reserves for reported and unreported claims which represent our best estimate of what we will ultimately pay on claims and the related costs of adjusting those claims as of the dates of our financial statements. When available, we rely heavily on our historical claim and claim adjustment experience in determining these reserves. We may not have sufficient information and historical data for new markets, and our relatively small size results in our having less data available than many of our competitors. In addition, the historic development of reserves for claim and claim adjustment expense may not accurately reflect future trends. For example, these estimates are subject to:

 

   

large potential errors because the ultimate disposition of claims incurred before the date of our financial statements, whether reported or not, is subject to the outcome of events that have not yet occurred, such as jury decisions, court interpretations, legislative changes, subsequent damage to property, changes in the medical condition of claimants, public attitudes and economic conditions such as inflation;

 

   

new classes of losses or types of losses not sufficiently represented in historical data are not yet identifiable; and

 

   

our inability to predict future events.

Our expansion into new markets and states increases the risk that our reserves do not accurately reflect the ultimate claim and claim adjustment expense that we will incur. There may also be a significant reporting lag between the occurrence of an event and the time it is reported to us. The inherent uncertainties of estimating our reserves are greater for certain types of liabilities, particularly those in which the various considerations affecting the type of claim are subject to change and in which long periods of time may elapse before a definitive determination of liability is made. We continue to make significant operational changes in the claims adjustment process and in our methodology for managing and tracking claims data, and these changes increase the uncertainties which exist in the estimation process and could lead to inaccurate estimates of claim and claim adjustment expense.

Reserve estimates are refined as experience develops and claims are reported and settled. Adjustments to reserves are reflected in the results of the period in which such estimates are changed.

 

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There are significant risks and uncertainties that could result in material adverse deviation of our unpaid claim and claim adjustment expenses. As a result of the factors discussed above, the amount of actual claim and claim adjustment expense that we pay to claimants may be substantially more than the reserves reflected in our financial statements and could therefore cause significant fluctuations in our operating results from one reporting period to another.

Our debt service obligations could impede our operations, flexibility and financial performance.

Our level of debt could affect our financial performance. As of December 31, 2009, we had consolidated indebtedness (other than trade payables and certain other short term debt) of $43.9 million. In addition, borrowings under our credit agreement and the capital securities issued GAINSCO Capital Trust I and GAINSCO Statutory Trust II, which were organized by the Company, bear interest at rates that fluctuate. The capital trust and statutory trust are not consolidated with the Company. Therefore, increases in interest rates on the obligations under our credit agreement and the capital securities would adversely affect our income and cash flow that would be available for the payment of interest and principal on the loans under our credit agreement. Our net interest expense for the year ended December 31, 2009 was $2.1 million.

Our level of debt could have important consequences, including the following:

 

   

we will need to use a portion of the money we earn to pay principal and interest on outstanding amounts due under our capital securities and our credit facility, which will reduce the amount of money available to us for financing our operations and other business activities;

 

   

we may have a much higher level of debt than certain of our competitors, which may put us at a competitive disadvantage;

 

   

we may have difficulty borrowing money in the future; and

 

   

we could be more vulnerable to economic downturns and adverse developments in our business.

We continue to expect to obtain the money to pay our expenses and to pay the principal and interest on our outstanding debt from our operations. Our ability to meet our expenses and debt service obligations thus depends on our future performance, which will be affected by financial, business, economic, demographic and other factors, including competition and the other risk factors discussed herein. Significant increases in interest rates would raise the costs associated with our outstanding debt obligations, which may not be offset by changes in our investment income.

If we do not have enough money to pay our debt service obligations, we may be required to refinance all or part of our existing debt, sell assets, borrow more money or raise equity. In that event, we may not be able to refinance our debt, sell assets, borrow more money or raise equity on terms acceptable to us or at all.

We are subject to restrictive debt covenants, which may restrict our operational flexibility.

Our credit facility contains various operating covenants, including among other things, restrictions on our ability to incur additional indebtedness, pay dividends on and redeem capital stock, make other restricted payments, including investments, sell our assets and enter into consolidations, mergers and transfers of all or substantially all of our assets. These restrictions could limit our ability to take actions that require funds in excess of those available to us.

Our credit facility also requires us to satisfy financial condition tests. Our ability to do so can be affected by events beyond our control, and we cannot assure that we will satisfy those requirements. A breach of any of these covenants, tests or restrictions could result in an event of default under the credit facility. If an event of default exists under the credit facility, the lender could elect to declare all outstanding amounts immediately due and payable. If the lender under our credit facility accelerates the payment of the indebtedness, we cannot assure that our assets would be sufficient to repay in full that indebtedness and our other indebtedness that would become due as a result of such acceleration.

 

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We may need to raise additional capital.

We may need additional capital to maintain adequate levels of capital or liquidity or to support our continuing business, and there can be no assurance that we will be able to do so. If we are unable to obtain required capital on favorable terms, or at all, we may be forced to change our business plan and may be unable to respond to competitive pressures in our business. Even if we are able to raise additional capital through the issuance of equity or debt securities, those securities may have rights, preferences or privileges senior to the rights of existing investors. Additional capital could also be dilutive to our common shareholders and result in significantly higher interest expense and indebtedness or impose restrictive terms on our business, thereby reducing our flexibility or the potential earnings available to common shareholders.

A change in immigration policies could adversely affect our business.

We believe that a significant portion of our current customers is Hispanic, and an important element of our business strategy involves our continued focus on marketing our nonstandard automobile insurance in this market niche. In recent years, there have been a variety of federal, state and local legislative proposals to limit immigration to the United States or make other policy changes that may be adverse to undocumented immigrants. If one or more proposals were to be adopted and had the effect of curtailing such immigration to the United States or to one or more states in which we operate or imposing additional requirements on immigrants requiring insurance, this could result in decline in growth of the Hispanic market, which may have an adverse effect on our abilities to achieve our growth strategies and our ability to expand our business in the markets in which we currently operate and may operate in the future.

The performance of our portfolio of fixed-income securities may adversely affect our profitability, capitalization and financial performance.

We maintain an investment portfolio that currently consists primarily of fixed-income securities. The quality, market value, yield and liquidity of the portfolio have been adversely affected by the ongoing recession and by disruptions in financial markets, and they may be further affected by a number of factors, including the general economic and business environment, changes in the credit quality of the issuer of the fixed-income securities, changes in market conditions or disruptions in particular markets, changes in interest rates, or regulatory changes. These securities are issued by both domestic and foreign entities and are backed either by collateral or the credit of the underlying issuer. Factors such as the continuing economic downturn, a regulatory change pertaining to the issuer’s industry, deterioration in the cash flows or the quality of assets of the issuer, or a change in the issuer’s marketplace may adversely affect our ability to collect principal and interest from the issuer.

We invest in and own securities (including corporate and asset-back securities) issued by bank holding companies and other financial services firms that have been severely affected by and may continue to be so affected by the declining economy and by unpredictable governmental actions taken in response to financial failures or disruptions. Our investment portfolio may be adversely affected by such actions as well as declines or disruptions in the market for such securities.

Both equity and fixed income securities have been affected over the past several years, most severely in 2008, and may be affected in the future, by significant external events. Credit rating downgrades, defaults, and impairments may result in write-downs in the value of the fixed income securities held by the Company. As of December 31, 2009, we held $145.0 million of fixed income securities, $16.5 million of which were rated below BBB based on Standard & Poor’s credit ratings.

The investments our insurance company subsidiary holds are highly regulated by specific legislation that governs the type, amount, and credit quality of allowable investments, and the fixed income securities in which we invest are evaluated by the NAIC’s Security Valuation Office (the “SVO”). Legislative changes, changes in the SVO’s evaluations or revised accounting and financial reporting principles could force us to adjust investment carrying values, with a resulting adverse effect on the level of our statutory capital.

 

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We may use derivative instruments to hedge our interest rate or equity market risks. Although we would take precautions to minimize our exposure, our profitability may be adversely affected if a counterparty to a derivative instrument defaults in its payment or if the market for such instruments is disrupted.

Failure to successfully resolve our remaining commercial lines claims could have an adverse affect on our results of operations.

In 2002, we announced our decision to cease writing commercial insurance due to continued adverse claims development and unprofitable results. As a result, there were no commercial policies remaining in force at December 31, 2009. We continue to settle and reduce our inventory of commercial lines claims. Due to the long tail and litigious nature of these claims, we anticipate that it will take a substantial number of years to complete the adjustment and settlement process with regard to existing claims and the additional claims we expect to receive in the future from our past business writings. Most of the remaining claims are in litigation, and our future results may be impacted negatively if we are unable to resolve the remaining claims and new anticipated claims within our established reserve level.

Our success depends on retaining our current key personnel and attracting additional personnel.

Our success will depend largely on the continuing efforts of our executive officers and senior management, especially those of Robert W. Stallings, our Chairman of the Board and Chief Strategic Officer, Glenn W. Anderson, our President, Chief Executive Officer and Director and James R. Reis, our Vice Chairman. Our business may be adversely affected if the services of these officers or any of our other key personnel become unavailable to us. We have entered into employment agreements with Messrs. Stallings, Anderson and Reis. Even with these employment agreements, there is a risk that these individuals will not continue to serve for any particular period of time.

We may hire additional key employees and officers to support our business, our focus on the nonstandard personal automobile insurance business, our expansion into new geographic markets and the improvement and enhancement of our systems and technologies. Hiring management personnel is very competitive in our industry due to the limited number of people available with the necessary skills, experience and understanding of our business procedures and the necessary leadership ability to guide us through the strategic development initiatives contemplated in the immediate years ahead. In 2005, we adopted a new long-term focused system of performance-based equity compensation for key personnel. Pursuant to such plan, the Compensation Committee, all of whose members are independent, is authorized to offer performance-based incentive grants and potentially issue up to 10% of our outstanding common stock over time based on achievement of performance targets. As of December 31, 2009, there were outstanding 0.2 million restricted stock units which could be earned by the achievement of specified performance criteria. Our operating performance and recently lower stock price may affect the efficacy of the incentives. Our inability to attract, train or retain the number of highly qualified personnel that our business needs may cause our business and prospects to suffer.

We cannot be certain that the net operating loss tax carryforwards will continue to be available to offset our tax liability.

As of December 31, 2009, we had net operating loss tax carryforwards for Federal income tax purposes, which we refer to as “NOLs,” of approximately $68.5 million. In order to utilize the NOLs, we must generate taxable income which can offset such carryforwards. The NOLs will expire if not used. The availability of NOLs to offset taxable income would be substantially reduced if we were to undergo an “ownership change” within the meaning of Section 382(g)(1) of the Internal Revenue Code. We will be treated as having had an “ownership change” if, within the meaning of Section 382 of the Internal Revenue Code and the regulations thereunder, there is more than a 50% change in stock ownership during a three year “testing period” by “5% shareholders.”

 

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The NOLs will expire in various amounts, if not used, between 2020 and 2027. We cannot assure you that we would prevail if the IRS were to challenge the availability of the NOLs. If the IRS were successful in challenging our NOLs, all or some portion of the NOLs would not be available to offset any future consolidated income.

Our stock price may be volatile.

The market price of our common stock has fluctuated significantly in the past and is likely to fluctuate significantly in the future, and the volume of trading in our common stock is very low. In addition, the securities markets have experienced significant price and volume fluctuations and the market prices of the securities of insurance companies, including nonstandard automobile insurance companies, have been especially volatile. Such fluctuations can result from, among other things:

 

   

quarterly variations in operating results;

 

   

changes in market valuations of other similar companies;

 

   

announcements by us or our competitors of new products, contracts, acquisitions, strategic partnerships or joint ventures;

 

   

additions or departures of key personnel;

 

   

significant sales of common stock by insiders or others or the perception that such sales could occur;

 

   

general economic trends and conditions;

 

   

deterioration in the trading market for our common stock; and

 

   

future issuances of stock or debt securities.

In addition, the stock market has periodically experienced extreme volatility that has often been unrelated to the performance of particular companies. These market fluctuations may cause our stock price to fall and could negatively affect an investment in our common stock regardless of our performance.

In the past, companies that have experienced volatility in the market price of their stock, including us, have been the object of securities class action litigation. Securities class action litigation could result in substantial costs and a diversion of management’s attention and resources.

Certain of our executives and directors own a majority of our outstanding capital stock, and therefore exercise voting control over the Company.

Our executive officers and directors, together with our largest shareholder, beneficially own a majority of our outstanding common stock (73.1% as of December 31, 2009). They potentially have the power to control the actions of the Company with respect to items requiring shareholder approval, including the election of directors, the adoption of amendments to our articles of incorporation and bylaws, and the approval of mergers or other significant corporate transactions. Their interests in approving such actions might not be aligned with the interests of other owners of our common stock.

 

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If the Company fails to maintain an effective system of internal controls, the Company may not be able to accurately report financial results.

Effective internal controls are necessary to provide reliable financial reports and to assist in the effective prevention of fraud. Any inability to provide reliable financial reports or prevent fraud could harm our business. We must annually evaluate our internal procedures to satisfy the requirements for Section 404 of the Sarbanes-Oxley Act of 2002, which requires assessment of the effectiveness of our internal controls. If we fail to remedy or maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we could be subject to regulatory scrutiny, civil or criminal penalties or shareholder litigation.

In addition, failure to maintain effective internal controls could result in financial statements that do not accurately reflect our financial condition or results of operations. There can be no assurance that we will be able to maintain a system of internal controls that fully complies with the requirements of the Sarbanes-Oxley Act of 2002.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

 

ITEM 2. PROPERTIES

We lease space in the office building which houses our principal place of business, located at 3333 Lee Parkway, Suite 1200, Dallas, Texas 75219. The property is in good condition and consists of approximately 52,000 square feet. Our Southeast region leases office space in Miami, Florida of approximately 28,100 square feet and our Southwest region leases office space in Phoenix, Arizona of approximately 4,800 square feet both of which are in good condition. We own no real estate properties.

 

ITEM 3. LEGAL PROCEEDINGS

Other Legal Proceedings

In the normal course of its operations, the Company is named as defendant in various legal actions seeking monetary damages, including cases involving allegations that the Company wrongfully denied claims and is liable for damages, in some cases seeking amounts significantly in excess of our policy limits. In the opinion of the Company’s management, based on the information currently available, the ultimate liability, if any, resulting from the disposition of these claims will not have a material adverse effect on the Company’s consolidated financial position or results of operations. However, in view of the uncertainties inherent in such litigation, it is possible that the ultimate cost to the Company might exceed the reserves we have established by amounts that could have a material adverse effect on the Company’s future results of operations, financial condition and cash flows in a particular reporting period.

 

ITEM 4. RESERVED

Not applicable.

 

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PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

On July 25, 2005, the common stock of the Company (“Common Stock”) was listed for trading on the NYSE Amex with the symbol “GAN.” The following table sets forth for the fiscal periods indicated the high and low closing sales prices per share of the Common Stock reported by the NYSE Amex. The prices reported reflect actual sales transactions, share prices for all periods presented have been retroactively adjusted for the one-for-five reverse stock split discussed herein.

 

     High    Low

2008 First Quarter

   $ 20.45    14.10

2008 Second Quarter

     19.50    14.40

2008 Third Quarter

     16.50    13.50

2008 Fourth Quarter

     14.45    5.25

2009 First Quarter

     7.40    4.10

2009 Second Quarter

     18.00    7.25

2009 Third Quarter

     16.75    12.90

2009 Fourth Quarter

     13.98    8.75

2010 First Quarter (through March 22, 2010)

   $ 9.70    7.70

As of March 22, 2010, there were 264 shareholders of record of the Company’s Common Stock, including 70 banks and brokers for whom Depositary Trust Company or its designee is custodian and 194 other holders of record.

Historically the Company has not paid cash dividends. The Company’s ability to pay cash dividends would be subject to the consent of The Frost National Bank, the lender under the Company’s secured lending facility. In addition, the ability to pay dividends would depend on the receipt of dividends from subsidiaries, primarily MGA. MGA’s ability to pay dividends is subject to the approval of the Texas Department of Insurance; see “ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS – Liquidity and Capital Resources – Parent Company” and note 12 to Consolidated Financial Statements set forth in response to Item 8 of this Annual Report.

The information required with respect to securities authorized for issuance under equity compensation plans is incorporated by reference to the table that appears in note 14 to the Consolidated Financial Statements set forth in response to Item 8 of this Annual Report.

 

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During the fiscal years ended December 31, 2009 and 2008, no equity securities of the Company were sold by the Company that were not registered under the Securities Act of 1933, as amended.

During the fiscal year ended December 31, 2009, no repurchases of Common Stock were made by or on behalf of the Company. See note 12 to the Consolidated Financial Statements for information regarding Common Stock.

 

ITEM 6. SELECTED FINANCIAL DATA

Not applicable.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The discussion in this Item includes forward-looking statements and should be read in the context of the risks, uncertainties and other variables referred to below under the caption “Forward-Looking Statements.”

Business Operations

Overview

The Company reported net income of $4.1 million for the year ended December 31, 2009, compared with net loss of $3.4 million for the year ended December 31, 2008. In 2009, the Company recorded total realized investment gains of approximately $2.4 million. In 2008, the Company recorded total realized investment losses of approximately $6.3 million, approximately $5.7 million related to write downs for other-than-temporary impairment losses including $4.0 million from auction preferred securities backed by the preferred stock of the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corp. (“Freddie Mac”). Net premiums earned were $185.2 million and $176.6 million in 2009 and 2008, respectively, and gross premiums written were $179.6 million and $181.8 million in 2009 and 2008, respectively.

As of December 31, 2009, the statutory surplus was $96.1 million, compared to $89.8 million as of December 31, 2008. The reserve for unpaid claims and claim adjustment expenses stood at $75.3 million and $75.5 million at December 31, 2009 and 2008, respectively, of which unpaid claims and claim adjustment expenses attributable to ongoing nonstandard personal automobile lines was $69.4 million and $66.0 million, respectively.

The Company experienced a Claims and claims adjustment expense (“C & CAE”) ratio for nonstandard personal auto in 2009 of 75.3% as compared with 2008 of 74.2%. We believe the increase in the C & CAE ratio for 2009 as compared to 2008 is primarily due to an increase in accident frequency, particularly in Florida. The Company’s ability to maintain or improve upon this C & CAE ratio is subject to the significant risks and uncertainties, including the risks associated with growth in premiums and the fact that new business generally produces higher claims ratios than renewal business. In addition, the Company has encountered an increase in potential claims fraud in Florida and other markets, which has led to an increase in reported frequency, a higher number of open claims and potentially higher claims costs (see ITEM 1A. Risk Factors).

The Company markets its policies through approximately 4,800 independent agency locations in Arizona, Florida, Georgia, Nevada, New Mexico, South Carolina and Texas and one general agency in California that markets through approximately 900 insurance broker locations.

Although premium levels in 2008 and 2009 are generally comparable, the Company experienced a reduction in premiums in the second half of 2009, and we anticipate that this trend will continue in 2010. Important factors leading to this trend were rate increases designed to improve profitability, planned reductions in unprofitable segments of business in Florida, and termination of relationships with certain agents. Gross premiums written were $53.2 million in the first quarter of 2009, $45.0 million in the second quarter, $45.7 million in the third quarter and $35.7 million in the fourth quarter.

A one-for-five reverse stock split of the Company’s Common Stock, which was approved by shareholders in May of 2009, became effective in June of 2009. See “Capital Transactions – 2009 One-for-Five Reverse Split of Common Stock.” All share amounts for all periods presented have been retroactively adjusted for the one-for-five reverse stock split.

 

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The following table presents selected financial information:

 

     Years ended December 31,  
     2009     2008  
     (Dollar amounts in thousands)  

Gross premiums written

   $ 179,571      181,849   
              

Net premiums earned

   $ 185,211      176,606   
              

Net income (loss)

   $ 4,073      (3,401
              

GAAP C & CAE ratio (1)

     74.1   73.3

GAAP Expense ratio (2) (3)

     25.6   25.7
              

GAAP Combined ratio (2)

     99.7   99.0
              

 

(1) C & CAE is an abbreviation for Claims and claim adjustment expenses, stated as a percentage of net premiums earned.
(2) The Expense and Combined ratios do not reflect expenses of the holding company which include interest expense on the note payable and subordinated debentures.
(3) Commissions, change in deferred acquisition costs, underwriting expenses and operating expenses (insurance subsidiaries only) are offset by agency revenues and are stated as a percentage of net premiums earned.

We believe the primary reasons for the decrease in gross premiums written between the comparable periods is the result of planned reductions of unprofitable segments in Florida and cancellation of some large agencies in Arizona. We believe product enhancements, rate adjustments and expanding marketing efforts in the Southeast and Southwest regions during the first six months of 2009 are the main reasons for the increase in net premiums earned in 2009 over 2008. The increase in the C & CAE ratio between the comparable periods was mentioned previously.

The Company believes it is pursuing a strategy that has the potential to build a competitively distinctive and successful franchise in the nonstandard personal auto business over time and is endeavoring to manage its investments and risks to achieve this result. These risks and other challenges are occurring in rapidly changing economic, financial, competitive, regulatory and claims environments. The Company’s operating and financial results vary from period to period as a result of numerous factors inherent in the insurance business, many of which are affected by such changes.

Discontinuance of Commercial Lines

The Company continues to settle and reduce its inventory of open commercial lines claims. As of December 31, 2009, in respect of its runoff lines, the Company had $3.1 million in net unpaid C & CAE compared to $7.1 million as of December 31, 2008. For the periods presented, the Company has recorded favorable development in unpaid C & CAE from the runoff lines with the settlement and reduction in the inventory of commercial lines claims. See “Results of OperationsClaims and claim adjustment expenses.” Due to the long tail and litigious nature of these claims, the Company anticipates it will take a substantial number of years to complete the adjustment and settlement process with regard to existing claims and the additional claims it expects to receive in the future from its past business writings. Most of the remaining claims are in suit and the Company’s future results may or may not be impacted either negatively or positively based on its ability to settle the remaining claims and new anticipated claims within its established reserve levels.

 

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Results of Operations

The discussion below primarily relates to the Company’s insurance operations, although the selected consolidated financial information appearing elsewhere is on a consolidated basis. The expense item “Underwriting and operating expenses” includes the operating expenses of the holding company, GAINSCO, INC. (“GAN”).

Revenue

Gross premiums written in 2009 decreased 1% as compared to 2008. We believe the primary reasons for the decrease between comparable periods to be the result of planned reductions of unprofitable segments in Florida and cancellation of some large agencies in Arizona. The following table presents gross premiums written by region:

 

     For the years ending December 31,  
     2009     2008  
     (Dollar amounts in thousands)  

Region:

          

Southeast (Florida, Georgia, South Carolina)

   $ 108,235    60   110,123    61

Southwest (Arizona, New Mexico, Nevada, Texas)

     69,906    39      69,602    38   

West (California)

     1,430    1      2,124    1   
                        

Total

   $ 179,571    100   181,849    100
                        

Each of the regions, except for Southwest, recorded premium declines in 2009 from 2008. The percent of premium (decrease) increase by region for 2009 from 2008 is as follows: Southeast (2)%, Southwest 1% and West (33)%. In the Southwest region, we believe product enhancements, rate adjustments and expanded marketing efforts accounts for the slight increase in gross premiums written. Total net premiums earned increased 5% in 2009 from 2008 primarily as a result of the product enhancements, rate adjustments and expanding marketing efforts in the Southeast and Southwest regions during the first six months of 2009.

Net investment income decreased $1,051,000 (14)% in 2009 primarily due to the decline in short-term interest rates. At December 31, 2009, Bonds available for sale comprised 74% of Investments versus 59% at December 31, 2008. The return on average investments was 3.7% in 2009 versus 4.4% in 2008.

The Company recorded total realized investment gains of $2,367,000 in 2009, which includes $3,569,000 related to other-than-temporary impairment losses, of which $3,141,000 was transferred to other comprehensive loss, a component of shareholders’ equity. In 2008, the Company recorded total realized investment losses of $6,313,000 which included $5,670,000 related to other-than-temporary impairment losses of which $3,950,000 was from auction preferred securities backed by the preferred stock of Fannie Mae and Freddie Mac. Variability in the timing of net realized capital gains and losses should be expected.

Agency revenues increased $538,000 (4%) in 2009 primarily as a result of the increase in writings in the first six months of 2009 over the first six months of 2008. Agency revenues are primarily fees charged on insureds’ premiums due, as discussed previously.

Other expense was recorded in 2009 as a result of a decrease in ceded unpaid C & CAE under the reserve reinsurance cover agreement on the runoff business. For further discussion on the reserve reinsurance cover agreement, please refer to note 8 – “Summary of Significant Accounting Policies” of the “Notes to the Consolidated Financial Statements” under Part II, Item 8 in this report.

 

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Expenses

Claims and claim adjustment expenses increased $7,725,000 (6%) in 2009 and the C & CAE ratio was 74.1% in 2009 versus 73.3% in 2008. The runoff lines recorded favorable development for prior accident years of approximately $2,057,000 and $1,421,000 during 2009 and 2008, respectively. The C & CAE ratio for nonstandard personal auto was 75.3% and 74.2% for 2009 and 2008, respectively. The increase in the C & CAE ratio was primarily due to an increase in accident frequency, particularly in Florida. The Company has encountered an increase in potential claims fraud in Florida and other markets, which led to an increase in reported frequency, a higher number of open claims and potentially higher claims costs. The increased accident frequency was offset to some extent, by favorable development for claims occurring in prior accident years of approximately $4,867,000 in 2009 versus unfavorable development of $4,385,000 in 2008 for claims occurring in prior accident years. The following table presents the favorable (unfavorable) development in nonstandard personal auto for claims occurring in prior accident years for each region during 2009:

 

   

Southeast Region (Florida, Georgia, South Carolina)—($814,000)

 

   

Southwest Region (Arizona, Nevada, New Mexico, Texas)—$5,678,000

 

   

West Region (California)—$3,000

New business and the entry into new territories and product lines, associated with the Company’s growth beginning in 2005, has generally produced higher claims and greater uncertainty in determining reserves than more seasoned in-force business; see ITEM 1A. Risk Factors. The favorable development for prior accident years for nonstandard personal auto in 2009 is primarily the result of projected and actual decreases in severity associated with the physical damage lines. In 2008, the Company incurred several “extra-contractual” claims totaling $993,000 primarily related to prior accident years which contributed to the unfavorable development in 2008 (see ITEM 1A. Risk Factors – “Litigation may adversely affect our financial condition, results of operations and cash flows”).

Claims for “extra-contractual” liability arise when a claim is originally denied or the claimant asserts that a claim has been handled inappropriately, and the claimant further asserts that such denial or allegedly inappropriate response was improper or in “bad faith.” In such cases, which tend to arise in cases involving serious injury or death, it is not unusual for the amount of the claim to exceed by a substantial amount the policy limits that would otherwise be applicable. When the Company becomes aware of such a potential claim, it typically consults with outside counsel and, if appropriate, seeks to settle the claim on terms as favorable as possible in light of all the relevant circumstances. The amounts required for settlement of such claims, and the potential award if a case cannot be settled on acceptable terms, vary widely depending on the specific facts of the claim, the applicable law and other factors.

With regard to environmental and product liability claims, the Company has an immaterial amount of exposure. The Company did not provide environmental impairment coverage and excluded pollution and asbestos related coverages in its policies. A portion of the Company’s remaining claims is related to construction defects.

Inflation impacts the Company by causing higher claim settlements than may have originally been estimated. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results.

 

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Policy acquisition costs include commissions, premium taxes, marketing expenses and the amortization of any premium deficiency. The expenses are charged to operations over the period in which the related premiums are earned. The increase of $612,000 (2%) in 2009 was primarily due to a decrease in premium deficiency amortization in 2009 from 2008. Commissions are paid to the independent agents based upon premium writings. The marketing expenses are primarily salaries of our territory managers who oversee the efforts of the agents within a geographical area and underwriting reports. Their time is focused on the supervision, relationship management and support of existing agents and recruiting new agents, as well as actively soliciting new business from these agents. Accordingly, these costs vary with and are primarily related to the acquisition of new and renewal insurance policies. The ratio of Policy acquisition costs to Net premiums earned was 16.4% and 16.8% for 2009 and 2008, respectively.

Underwriting and operating expenses increased $1,551,000 (5%) in 2009 from 2008 primarily due to an increase in salaries and salary benefits. Underwriting and operating expenses as a percent of Net premiums earned and Agency revenues were 16.6% for 2009 and 2008, respectively.

The decrease in interest expense of $1,102,000 (35%) is primarily due to the decline in the 3-month London Interbank Offered Rate for U.S. dollar deposits (“LIBOR”) during 2009 and its related impact on the interest expense of the subordinated debentures.

Liquidity and Capital Resources

Reverse Split of Common Stock

A one-for-five reverse split of the Company’s Common Stock was approved by shareholders in May of 2009 and became effective in June of 2009. Each five shares of the Company’s outstanding Common Stock, par value $0.10 per share were converted into one share of Common Stock, par value $0.10 per share, and the number of authorized shares of Common Stock was reduced proportionately.

As a result of the one-for-five reverse split of Common Stock in June 2009, the number of shares of Common Stock outstanding at December 31, 2008 was retroactively adjusted to 4,786,820. Treasury stock held at December 31, 2008 was retroactively adjusted to 252,729. At December 31, 2009 and 2008, Goff Moore Strategic Partners, LP owned approximately 34% of the outstanding Common Stock, Robert W. Stallings owned approximately 23% and James R. Reis owned approximately 12%.

Liquidity and Capital Resources

Parent Company

GAN provides administrative and financial services for its wholly owned subsidiaries. GAN needs cash during 2010 primarily for administrative expenses and interest on the Subordinated debentures and the Note payable. GAN has approximately $4.0 million in cash and marketable securities that can be used for general corporate purposes. Other sources of cash to meet obligations are statutorily permitted dividend payments from its insurance subsidiary, which requires notification of no objection from the Texas Department of Insurance (see note 12 to Consolidated Financial Statements which appears in Item 8 of this Annual Report), and dividends from GAN’s agency subsidiary. For 2009, cash dividends of $1.0 million were paid to GAN by the insurance subsidiary. GAN believes the cash available from its short-term investments and dividends from its subsidiaries should be sufficient to meet its expected obligations for 2010.

 

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Net Operating Loss Carryforwards

Deferred tax assets are evaluated and a valuation allowance is established if it is more likely than not that all or a portion of the deferred tax assets will not be realized. See note 1(j) “Federal Income Taxes” in Notes to Consolidated Financial Statement appearing under Part 1. Financial Information – Item 1. “Financial Statements” of this Annual Report for further discussion.

As a result of losses in prior years, as of December 31, 2009 the Company had net operating loss carryforwards for tax purposes aggregating $68,529,000. These net operating loss carryforwards of $7,358,000, $33,950,000, $13,687,000, $633,000 and $12,901,000, if not utilized, will expire in 2020, 2021, 2022, 2023 and 2027, respectively. As of December 31, 2009, the tax benefit of the net operating loss carryforwards was $23,300,000, which is calculated by applying the Federal statutory income tax rate of 34% against the net operating loss carryforwards of $68,529,000.

The Company considers available evidence, both objective and subjective, including historical levels of income, expectations and risks associated with estimates of future taxable income in assessing the need for the valuation allowance.

As of December 31, 2009 and 2008, the net deferred tax assets before valuation allowance were $28,967,000 and $32,397,000 and the valuation allowance were $28,830,000 and $29,905,000, respectively. The Company does not record a tax valuation allowance relating to the net unrealized losses on investments, excluding common stocks because it is more likely than not that these losses would reverse or be utilized in future periods. The Company has the ability and it is the Company’s intent to fully recover the principal, which could require the Company to hold these securities until their maturity; therefore, the Company considers the impairment to be temporary.

Subsidiaries, Principally Insurance Operations

The primary sources of the insurance subsidiary’s liquidity are funds generated from insurance premiums, net investment income and maturing investments. The short-term investments and cash are intended to provide adequate funds to pay claims without selling fixed maturity investments. At December 31, 2009, the insurance subsidiary held short-term investments and cash that the insurance subsidiary believes is at adequate liquidity for the payment of claims and other short-term commitments.

With regard to liquidity, the average duration of the investment portfolio is approximately 2.4 years. The fair value of the fixed maturity portfolio at December 31, 2009 was $317,000 below amortized cost, before taxes see note 2 and note 18 of Notes to Consolidated Financial Statements which appear in Item 8 of this Annual Report). Various insurance departments of states in which the Company operates require the deposit of funds to protect policyholders within those states. At December 31, 2009 and 2008, the balance on deposit for the benefit of such policyholders totaled $5,397,000 and $5,447,000, respectively.

Net cash provided by operating activities was $3,638,000 for 2009 versus $15,625,000 for 2008. The decrease in cash as a result of operating activities between the periods was primarily attributable to a higher C & CAE paid ratio in 2009 than in 2008.

Investments and Cash increased in 2009 primarily as a result of the increase in fair value of the investment securities with cash from operations also contributing. At December 31, 2009, 80% of the Company’s investments were rated investment grade. The average duration was approximately 2.4 years, including approximately 23% of the Investments that were held in Short-term investments. The Company classifies its bond securities as available for sale and trading. The net unrealized loss associated with the investment portfolio was $181,000 (net of tax effects) at December 31, 2009 (see note 2 of Notes to Consolidated Financial Statements which appear in Item 8 of this Annual Report).

 

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The Company has performed a detailed review of the securities in the investment portfolio and has recorded approximately $3,569,000 in Net realized losses on certain securities that were considered other than temporarily impaired, of which $3,141,000 of the other-than-temporary impairment was recognized in other comprehensive income (loss), a component of shareholders’ equity. The Company, at this time based upon information currently available and management’s evaluation and intent to hold securities to maturity if necessary to recover the cost, expects to recover the net unrealized loss of $181,000 (net of tax effects) and considers this impairment to be temporary.

Premiums receivable decreased primarily due to the decrease in premium writings for the six months ended December 31, 2009 from the six months ended December 31, 2008. This balance is comprised primarily of premiums due from insureds. Most of the policies are written with a down payment and monthly payment terms of up to four months on six month policies. The Company recorded an allowance for doubtful accounts of $1,084,000 and $1,029,000 as of December 31, 2009 and 2008, respectively, which it considers adequate. The increase in the allowance for doubtful accounts was due primarily to an increase in over thirty day receivables.

Reinsurance balances receivable decreased primarily as a result a decrease in ceded unpaid C & CAE under the reserve reinsurance cover agreement.

Ceded unpaid C & CAE increased primarily as a result of an increase in CAE reserves subject to the excess casualty and quota share reinsurance agreements on the runoff business. This balance represents unpaid C & CAE which have been ceded to reinsurers under the Company’s various reinsurance agreements, other than the reserve reinsurance cover agreement. These amounts are not currently due from the reinsurers but could become due in the future when the Company pays the claim and requests reimbursement from the reinsurers.

Deferred policy acquisition costs are principally commissions, premium taxes and marketing expenses which are deferred. The decrease of $1,412,000 in 2009 from 2008 was primarily due to the decrease in commissions and premium taxes as a result of the decrease in premiums earned for the last six months of 2009 from the last six months of 2008.

Property and equipment decreased primarily as a result of depreciation expense recorded in 2009.

Deferred Federal income taxes include temporary differences and the tax asset from net operating loss carryforwards less a valuation allowance that fully reserves these two items, see “Liquidity and Capital ResourcesNet Operating Loss Carryforwards.” The decrease is primarily due to the decrease in unrealized losses on investments, excluding common stocks.

Unpaid C & CAE decreased slightly in 2009 from 2008. As of December 31, 2009, the Company had $72,545,000 in net unpaid C & CAE (Unpaid C & CAE of $75,368,000 less Ceded unpaid C & CAE of $2,823,000). This amount represents management’s best estimate of the ultimate liabilities. The significant operational changes we continue to make in the nonstandard personal auto claims adjustment process and changing claims trends increase the uncertainties which exist in the estimation process and could lead to inaccurate estimates of claim and claim adjustment expense.

The reserve estimates were made by our in-house actuarial staff. An analysis provided by an independent actuarial consulting firm was used to corroborate the methodologies used by the in-house actuarial staff.

 

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As of December 31, 2009 and 2008, in respect of its runoff lines, the Company had $3,115,000 and $7,118,000, respectively, in net unpaid C & CAE. Historically, the Company has experienced significant volatility in its reserve projections for its commercial lines. This volatility has been primarily attributable to its commercial automobile and general liability product lines. On February 7, 2002, the Company announced it had decided to discontinue writing commercial lines insurance due to continued adverse claims development and unprofitable results. The Company has been settling and reducing its remaining inventory of commercial claims. See “Business Operations“Discontinuance of Commercial Lines.”

Unearned premiums decreased primarily as a result of the decrease in premium writings for the six months ended December 31, 2009 from the six months ended December 31, 2008, mentioned previously.

Accounts payable increased primarily due to increases in return premiums due policyholders and bonuses payable.

Premiums payable, Commissions payable and Reinsurance balances payable all decreased primarily due to a fronting reinsurance arrangement that was reducing throughout 2009.

Cash overdraft increased primarily due to the higher level of claims paid in 2009 than in 2008.

Common stock decreased and Additional paid-in capital increased primarily as a result of a one-for-five reverse split of Common Stock that became effective in June of 2009; see “Capital Transaction” for a detailed discussion

Accumulated deficit decreased due to the net income recorded in 2009.

Accumulated other comprehensive loss decreased as a result of an increase in the unrealized gains on investments, which is a result of improvements in the credit markets.

The Company’s statutory capital exceeds the benchmark capital level under the Risk Based Capital (“RBC”) formula for its insurance company. RBC is a method for establishing the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. As of December 31, 2009, the Company’s RBC authorized control level was $14,077,000 and the total adjusted capital was $96,112,000. This amounts to 6.8 times the minimum amount of RBC level as of December 31, 2009.

 

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Critical Accounting Policies

The discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates under different assumptions or conditions.

Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. The Company’s critical accounting policies are described below. For a detailed discussion on the application of these and other accounting policies, see note 1 of Notes to Consolidated Financial Statements which appears in Item 8 of this Annual Report.

Investments

Investments are generally stated at fair value and are based on prices quoted in the most active market for each security, the fair value of comparable securities, discounted cash flow models or similar methods with changes in fair value recorded as a component of comprehensive income. The “specific identification” method is used to determine costs of investments sold. Provisions for possible credit losses are recorded only when the values have experienced impairment considered “other than temporary” by a charge to realized losses resulting in a new cost basis of the investment, while non-credit losses are recognized in accumulated other comprehensive income (loss). Our securities are issued by domestic entities and are backed either by collateral or the credit of the underlying issuer. Factors such as an economic downturn, disruptions in the credit markets, a regulatory change pertaining to the issuer’s industry, deterioration in the cash flows or the quality of assets of the issuer, or a change in the issuer’s marketplace may adversely affect our ability to collect principal and interest from the issuer. Both equity and fixed income securities have been affected over the past several years, and may be affected in the future, by significant external events. Credit rating downgrades, defaults, and impairments may result in write-downs in the value of the investment securities held by the Company. The Company regularly monitors its portfolio for pricing changes, which might indicate potential other than temporary impairments, and performs reviews of securities with unrealized losses. In such cases, changes in fair value are evaluated to determine the extent to which such changes are attributable to (i) fundamental factors specific to the issuer, such as financial conditions, business prospects or other factors, or (ii) market-related factors, such as interest rates. See Item 7A, “Quantitative and Qualitative Disclosures about Market Risk” for a discussion of variability of estimates.

For fixed maturity securities that are other-than-temporarily impaired, the Company assesses its intent to sell and the likelihood that we will be required to sell the security before recovery of its amortized cost. If a fixed maturity security is considered other-than-temporarily impaired, but the Company does not intend to and is not more than likely to be required to sell the security prior to its recovery to amortized cost, the amount of the impairment is separated into a credit loss component and the amount due to all other factors. The credit loss component of an impairment charge on a fixed maturity security is determined by the excess of the amortized cost over the present value of the expected cash flows. The present value is determined using the best estimate of cash flows discounted at (1) the effective interest rate implicit at the date of acquisition for non-structured securities or (2) the book yield for structured securities. The techniques and assumptions for determining the best estimate of cash flows varies depending on the type of security. The credit loss component of an impairment charge is recognized in net earnings while the non-credit component is recognized in accumulated other comprehensive income (loss).

 

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Fair Value Measurements

The Company’s estimates of fair value for financial assets and financial liabilities are based on the framework established in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 320-10-65, Investments – Debt an Equity Securities – Overall – Transition and Open Effective Date Information (“ASC 320-10-65). The framework is based on the inputs used in valuation, gives the highest priority to quoted prices in active markets and requires that observable inputs be used in the valuations when available. The disclosure of fair value estimates in the ASC 320-10-65 hierarchy is based on whether the significant inputs into the valuation are observable. In determining the level of the hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect the Company’s significant market assumptions. The three levels of the hierarchy are as follows:

 

   

Level 1 – Unadjusted quoted prices for identical assets or liabilities in active markets.

 

   

Level 2 – Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in inactive markets; or valuations based on models where the significant inputs are observable (e.g., interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data.

 

   

Level 3 – Valuations based on models where significant inputs are not observable. The unobservable inputs reflect the Company’s own estimates as to the assumptions that market participants would use.

Valuation of Investments

The Company receives pricing from independent pricing services, and these are compared to prices available from sources accessed through the Bloomberg Professional System. The number of available quotes varies depending on the security, generally we obtain one quote for Level 1 investments, one to three quotes for Level 2 investments and one to two quotes, if available, for Level 3 investments. If there is a material difference in the prices obtained, further evaluation is made. Market prices and valuations from sources such as the Bloomberg system, TRACE and dealer offerings are used as a check on the prices obtained from the independent pricing services. Should a material difference exist, then an internal valuation is made. For purposes of valuing these securities management produces expected cash flows for the security utilizing the standard mortgage security modeling capabilities available on the Bloomberg Professional System. The key inputs are the default rate, severity of default, and voluntary prepayment rate for the underlying mortgage collateral. These are generally based at the start on the actual historical values of these parameters for the prior three months. These cash flows are then discounted by a required yield derived from market based observations of broker inventory offerings, or in some cases Bloomberg Indices of like securities. Management uses this valuation model primarily with mortgage backed securities where the matrix pricing methodology used by the independent pricing service is too broad in its categorizations. This often involves differences in reasonable prepayment assumptions or significant differences in performance among issuers. In some cases, other external observable inputs such as credit default swap levels are used as input in the fair value analysis.

Fixed Maturities

For U. S. Treasury, U. S. government and corporate bonds, the independent pricing services obtain information on actual transactions from a large network of broker-dealers and determine a representative market price based on trading volume levels. For asset backed and mortgage backed instruments, the independent pricing services obtain information on actual transactions from a large network of broker-dealers and sorts the information into various components, such as asset type, rating, maturity, and spread to a benchmark such as the U.S. Treasury yield curve. These components are used to create a pricing matrix for similar instruments.

All broker-dealer quotations obtained are non-binding. For short-term investments classified as Level 1 and Level 2, the Company uses prices provided by independent pricing services. The preferred stocks classified as Level 3 are all auction rate preferred shares, and the Company utilizes an internal model incorporating observable market inputs.

 

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The Company uses the following hierarchy for each instrument in total invested assets:

 

  1. The Company obtains a price from an independent pricing service.

 

  2. If no price is available from an independent pricing service for the instrument, the Company obtains a market price from a broker-dealer or other reliable source, such as Bloomberg.

 

  3. The Company then validates the price obtained by evaluating its reasonableness. The Company’s review process includes quantitative analysis (i.e., credit spreads and interest rate and prepayment fluctuations) and initial and ongoing evaluations of methodologies used by outside parties to calculate fair value and comparing the fair value estimates to its knowledge of the current market. If a price provided by a pricing service is considered to be materially different from the other indications that are obtained, the Company will make a determination of the proper fair value of the instrument based on data inputs available.

 

  4. In order to determine the proper classification for each instrument, the Company obtains from its independent pricing service the pricing procedures and inputs used to price the instrument. The Company analyzes this information, taking into account asset type, rating and liquidity, to determine what inputs are observable and unobservable in order to determine the proper ASC 320-10-65 level. For those valued internally, a determination is made as to whether all relevant inputs are observable or unobservable in order to classify correctly.

Revenue Recognition and Premiums Receivable

Premiums and policy fees are recognized as earned on a pro rata basis over the period the Company is at risk under the related policy. Agency revenues are primarily fees charged on insureds’ premiums due. These fees are earned over the terms of the underlying policies. Unearned premiums represent the portion of premiums written and policy fees which are applicable to the unexpired terms of policies in force. Premiums receivable consist of balances owed for coverages written with the Company. The Company’s allowance for doubtful accounts consists of premiums receivables over thirty days past due.

Deferred Policy Acquisition Costs and Policy Acquisition Costs

Deferred policy acquisition costs are principally commissions, premium taxes and marketing expenses which are deferred. Policy acquisition costs are principally commissions, premium taxes, marketing expenses and the change in deferred policy acquisition costs that are charged to operations over the period in which the related premiums are earned. The Company utilizes investment income when assessing recoverability of Deferred policy acquisition costs. A premium deficiency and a corresponding charge to income is recognized if the sum of the expected claims and claim adjustment expenses, unamortized acquisition costs and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2009, a premium deficiency of $66,000, net of anticipated investment income, that was recognized against Deferred policy acquisition costs for expected underwriting losses on the Southeast business. At December 31, 2008, there was no premium deficiency that was required to be recognized.

 

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Data Processing Software

Costs associated with software developed or purchased for internal use are capitalized based on ASC 350-10-65, Intangibles – Goodwill and Other – Overall – Transition and Open Effective Date Information (“ASC 350-10-65) and other related guidance. Capitalized costs include external direct costs of materials and services consumed in developing or obtaining internal-use software and payroll for employees directly associated with, and who devote time to, the development of the internal-use software. Costs incurred in development and enhancement of software that do not meet the capitalization criteria, such as costs of activities performed during the preliminary and post- implementation stages, are expensed as incurred. Costs incurred in development and enhancements that do not meet the criteria to capitalize are activities performed during the application development stage such as designing, coding, installing and testing. The critical estimate related to this process is the determination of the amount of time devoted by employees to specific stages of internal-use software development projects. We review any impairment of the capitalized costs on a periodic basis.

Goodwill

Goodwill represents the excess of purchase price over fair value of net assets acquired. The goodwill recorded is related to the 1998 acquisition of the Lalande Group. In accordance with ASC 350-10-65, goodwill is not amortized but rather is subject to an annual impairment test, or earlier if certain factors are present, based on its estimated fair value. Therefore, impairment losses could be recorded in future periods. The Company conducts on at least an annual basis a review of its reporting units’ assets and liabilities to determine whether goodwill is impaired. The goodwill impairment test is a two-step test. Under the first step, fair value of the reporting unit is compared with its carrying value (including goodwill). If the fair value of the reporting unit is less than its carrying value, an indication of goodwill impairment exists for the reporting unit and the enterprise must perform step two of the impairment test. Under step two, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of the goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. Fair value of the reporting unit is determined using a variety of methods, including a discounted cash flow analysis. If the fair value of the reporting unit exceeds its carrying value, step two does not need to be performed. GAN performed this test as of December 31, 2009 and 2008. The test results indicated that there was no impairment loss at December 31, 2009 or 2008.

Unpaid Claims and Claim Adjustment Expenses

An insurance company generally makes claims payments as a result of accidents involving the risks insured under the insurance policies it issues. Months and sometimes years may elapse between the occurrence of an accident, reporting of the accident to the insurer and payment of the claim. Insurers record a liability for estimates of claims that will be paid for accidents reported to them, which are referred to as “case reserves”. In addition, since accidents are not always reported promptly upon occurrence and because the assessment of existing known claims may change over time with the development of new facts, circumstances and conditions, insurers estimate liabilities for such items, which are referred to as incurred but not reported (“IBNR”) reserves.

We maintain reserves for the payment of claims and claim adjustment expenses for both case and IBNR under policies written by the insurance company subsidiary. These claims reserves are estimates, at a given point in time, of amounts that we expect to pay on incurred claims based on facts and circumstances then known. The amount of case claims reserves is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding the claim, and the policy provisions relating to the type of claim. The amount of IBNR claims reserves is estimated on the basis of historical information and anticipated future conditions by lines of insurance and actuarial review. Reserves for claim adjustment expenses are intended to cover the ultimate costs of settling claims, including investigation and defense of lawsuits resulting from such claims. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results.

 

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The process of establishing claims reserves is imprecise and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. The actual emergence of claims and claim adjustment expenses may vary, perhaps materially, from the Company’s estimates thereof, because (a) estimates of liabilities are subject to large potential revisions, as the ultimate disposition of claims incurred prior to the financial statement date, whether reported or not, is subject to the outcome of events that have not yet occurred (e.g., jury decisions, court interpretations, legislative changes (even after coverage is written and reserves are initially set) that broaden liability and policy definitions and increase the severity of claims obligations, changes in the medical condition of claimants, public attitudes and social/economic conditions such as inflation), (b) estimates of claims do not make provision for extraordinary future emergence of new classes of claims or types of claims not sufficiently represented in the Company’s historical data base or which are not yet quantifiable, and (c) estimates of future costs are subject to the inherent limitation on the ability to predict the aggregate results of future events.

In addition to the factors described above that are generally applicable to property and casualty insurers, our ability to estimate claims reserves accurately is subject to risks and uncertainties arising out of the recent history and growth of the Company. These factors are discussed in more detail in Item 1A of this Annual Report, “Risk Factors.” The following are particularly significant factors that limit our ability, as compared with a more mature insurer with a larger and more stable book of business, to estimate claims reserves accurately:

 

   

Our growth strategy has entailed increased financial and operational risks and other challenges that are greater than and different from those to which we have previously been subject as the nature of our business has changed and grown. Generally, new business produces higher claim ratios than more seasoned in-force business, and this factor is likely to be magnified to the extent that we enter new states and market areas. Furthermore, it amplifies the importance of our ability to assess any new trends timely and accurately and respond effectively.

 

   

Pricing decisions based on assumed loss ratios in new states and markets, involving different claims environments, distribution sources and customer demographics, must necessarily be made without the same level of experience and data that is available in existing markets.

 

   

Our growth required additional personnel resources, including management and technical underwriting, claims and servicing personnel, relationships with agents and vendors with whom we have not previously done business, and additional dependence on operating systems and technology. As a result, we often do not have as much reliable historical information about costs and trends in claims as would an insurer with more experience in the markets in which we have grown.

 

   

We may not have historical results for new markets, or the historic development of reserves for claim and claim adjustment expense may not accurately reflect future trends. For example, these estimates are subject to:

 

   

new classes or types of losses not sufficiently represented in historical data or not discernible from the data available to us; and

 

   

our inability to predict or recognize future events.

 

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We continue to make significant operational changes in management of our claims administration to accelerate the recognition and resolution of claims. These changes may result in an increase in the amount of aggregate claim settlements and cause our ultimate claim and claim adjustment expense to increase in comparison to prior periods. In addition, changing claims trends increase the uncertainties which exist in the estimation process and could lead to inaccurate estimates of claim and claims adjustment expense.

Ultimate liability may be greater or less than current reserves. The Company monitors reserves using new information on reported claims and a variety of statistical techniques which are discussed below. The Company does not discount to present value that portion of its claims reserves expected to be paid in future periods.

The following table discloses the amount of the gross unpaid claims and claim adjustment expense for each year presented and separately identifies the amount of IBNR for each material line of business.

 

     Gross unpaid claims and claim
adjustment expenses
For the years ending December 31,
     2009    2008
     (Amounts in thousands)

Case:

     

Personal auto

   $ 33,672    28,585

Run-off

     2,691    2,233
           
     36,363    30,818
           

Incurred But Not Reported

     

Personal auto

   $ 35,753    37,366

Run-off

     3,252    7,298
           
     39,005    44,664
           

Total Reserves

   $ 75,368    75,482
           

Key Assumptions

The following discussion provides information regarding the most important assumptions we use in estimating claims reserves in the nonstandard personal automobile insurance business. These assumptions were also important historically in estimating claims reserves in the runoff business but, as discussed below, the decline in the number of remaining runoff claims has made conventional actuarial methods less useful and has resulted in our basing such estimates primarily on case-by-case evaluations of individual claim files.

We rely on several key assumptions regarding the existence of consistency or a discernible trend in the following factors:

 

   

historical information used to prepare a priori expected loss ratios

 

   

the rate at which claims are recorded, settled and/or closed

 

   

historical information regarding claims frequency

 

   

the level of case reserve adequacy

The actuarial staff monitors accident quarter data, seeking to identify whether these assumptions have remained consistent and, if deviations are identified, to adjust reserves to take them into account by making qualitative and quantitative modifications to reflect such deviations. This process necessarily involves the exercise of judgment in assessing the impact of changes from the patterns indicated by the assumptions noted above.

 

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The key assumptions identified above are in turn based on additional underlying assumptions regarding numerous internal and external factors, which often vary for different states, programs and coverage groups, for different accident periods and for different actuarial estimation methodologies. Internal factors include, but are not limited to, the experience level of our claims department personnel, changes in claims department processes, and changes in underwriting standards and rules. External factors include, but are not limited to, claim severity, claim frequency, inflation in costs to repair or replace damaged property, inflation in the cost of medical services, legislative activities, regulatory changes, judicial changes, and litigation trends.

When we reviewed claims data to make estimates for 2008, the following variances were found. Based on the analysis of these variances, we made adjustments described below:

 

Assumption   

Change from Prior Periods and Nature of Adjustment

• Historical information used to prepare a
priori
expected loss ratios; historical
information regarding claims frequency
   During 2008, we continued to diversify further. We also expanded into various other driver classes, namely into the internationally licensed segment. Expanding into different geographical segments meant writing more business in jurisdictions with different judicial systems and negligence laws, including areas that may be more susceptible to insurance fraud. These changes can affect development patterns, so that historical patterns may not be reflective of future patterns. We attempted to take these changes into consideration in our estimate of reserves by the selection of loss development factors, including extending tail factors to older accident periods, and use of actuarial judgment.
• Case Reserve Adequacy    During our review of data for 2008, we continued to notice that the average case reserve per claimant in bodily injury coverages had increased. We attempted to take the increase in case reserves into consideration by selection of loss development factors and use of actuarial judgment.
• All of the key assumptions referred to above    As the trend first observed in 2006 continued, the credibility associated with each accident quarter gradually increased over time. Changes in credibility over time affect development patterns in that past development patterns are less stable than future patterns based on more credible data. However, the fact that the Company has continued to enter new markets results in limits on credibility for the foreseeable future. We attempted to take this into consideration in our estimates by selection of loss development factors, including extending tail factors to older accident periods and use of actuarial judgment.
• Rate of subrogation and salvage recovery    During 2008, we realized that the historical recovery pattern established by our Southeast claims operation was not applicable to recoveries in states other than Florida. We attempted to take this into consideration in our estimates by modifying our subrogation and salvage loss development factors and use of actuarial judgment.

 

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When we reviewed claims data to make estimates for 2009, some of the same variances were found. Based on the analysis of these variances, we made the following adjustments:

 

Assumption   

Change from Prior Periods and Nature of Adjustment

• Historical information used to prepare a
priori
expected loss ratios; historical
information regarding claims frequency
   During 2009, we continued to diversify further. We also expanded into various other driver classes. Expanding into different geographical segments meant writing more business in jurisdictions with different judicial systems and negligence laws, including areas that may be more susceptible to insurance fraud. These changes can affect development patterns, so that historical patterns may not be reflective of future patterns. We attempted to take these changes into consideration in our estimate of reserves by the selection of loss development factors, including extending tail factors to older accident periods, and use of actuarial judgment.
• Case Reserve Adequacy    During our review of data for 2009, we continued to notice that the average case reserve per claimant in bodily injury coverages had increased. We attempted to take the increase in case reserves into consideration by selection of loss development factors and use of actuarial judgment.
• All of the key assumptions referred to above    As the trend first observed in 2006 continued, the credibility associated with each accident quarter gradually increased over time. Changes in credibility over time affect development patterns in that past development patterns are less stable than future patterns based on more credible data. However, the fact that the Company has continued to enter new markets results in limits on credibility for the foreseeable future. We attempted to take this into consideration in our estimates by selection of loss development factors, including extending tail factors to older accident periods and use of actuarial judgment.
• Rate of subrogation and salvage recovery    During 2009, we realized that the historical recovery pattern established by our Southeast claims operation was not applicable to recoveries in states other than Florida. We attempted to take this into consideration in our estimates by modifying our subrogation and salvage loss development factors and use of actuarial judgment.
• Rate of claims settlement in personal bodily
injury protection and bodily injury coverages
   During 2009, we observed significant indications of increased claims fraud and took additional steps to investigate and adjudicate certain claims. One effect of doing so is to lengthen the average period that claims are open, and this change affects the comparability of current claims data as compared with that from prior periods. We attempted to take this change into consideration by the selection of loss development factors and the use of actuarial judgment.

The law of large numbers applies to selecting development patterns; i.e. the confidence of a point estimate is improved by increasing the amount of data used to develop the estimate; however, the data must be reasonably homogeneous, and exhibit little variation over time. Changes associated with the assumptions listed above affect the homogeneity of our data, and the variance associated with the loss development factors derived from the data. This implies that the variance around our point estimate has increased over time, or that the confidence interval around our point estimate has widened over time. This in turn implies there is greater volatility associated with our point estimate and we attempted to take this uncertainty into consideration with our estimates for 2008 and for 2009.

 

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Methodologies

We utilize different processes for the estimation of reserves in the runoff line and in the nonstandard personal automobile business.

For our runoff lines, the remaining number of claims has declined to the point that conventional actuarial methods are of less utility than during the period in which the number of active claims provided more complete statistical data. Accordingly, during 2009 we ceased using conventional actuarial methods in our estimates for runoff claims and relied exclusively on evaluations of individual claim files. This methodology is not used for our personal lines business.

In both personal lines and commercial runoff business, we utilize the same procedures for estimating reserves on a quarterly basis as we do annually. Historically, the independent actuarial consulting firm that we retained had the responsibility for making the reserve estimate used in our financial statements. However, we changed our procedures beginning with the financial statements for the third quarter of 2007 and subsequent quarterly and annual periods. In our revised procedures, the reserve estimates are made for each period by our in-house actuarial staff, and we do not rely upon the review by the independent actuarial firm to estimate the amount of our GAAP reserves. However, an actuarial consulting firm provides analysis to management as requested.

The actuarial procedures we follow are described in detail below. The reserve estimates are developed based on review and analysis of accident quarter data. Once the reserve levels have been estimated, management makes appropriate entries.

These estimates were set forth in a detailed presentation to the Audit Committee of the Board of Directors, together with underlying statistical information on which the estimates are based. The Audit Committee met each quarter with management and engaged in a detailed discussion regarding the reserve selections and underlying statistical data.

Specific Methodologies – Runoff Lines

Within runoff commercial business, the different lines of business each have somewhat different development characteristics, which we take into account in making reserve estimates, as follows:

 

   

Commercial auto – most states in which we wrote policies have two-year statutes of limitation. Because we ceased writing new business in 2002, no new claims are expected to be incurred.

 

   

General liability – generally, new claims are barred by applicable statutes of limitation. However, we continue to receive new claims for alleged construction defects, even though we have included an exclusion for such liability in general liability policies since 1996. We respond to any claims that are asserted.

 

   

Specialty lines – all policies we wrote are on a “claims made” basis, so we do not expect any additional claims.

 

   

Personal umbrella – because coverage is related to the resolution of claims in underlying insurance policies, development tends to occur over a relatively long time period. We do not expect additional claims.

However, as noted above, in recent reporting periods the estimates for all runoff claims have been based primarily on case-by-case evaluations of individual claim files as the number of claims has fallen to the point that conventional actuarial methods have become less useful.

 

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Specific Methodologies—Nonstandard Personal Automobile Insurance

For private passenger auto business, all coverages are considered short-tailed, as we primarily write minimum limits business (primarily six month policies), and approximately two thirds of our ultimate liabilities are realized within 12 months. For this business, we analyze development patterns separately by state for each state in which we write business, and within each state, by each separate line of coverage we offer in that particular state. We further analyze patterns for each accident quarter to ascertain whether development patterns are changing over time. Analyzing our data in this way allows us to group data in homogeneous sets, while maximizing the degree of credibility for each data set where limited data are available. For states and/or coverages where the data are limited, we also consider development patterns from other markets in which we write business that have more credible amounts of data and which have similar policy limits.

We employ various statistical processes to estimate our unpaid claims and CAE. Our actuarial staff performs quarterly analyses on multiple unique, homogenous data subsets to produce estimates of the aggregate unpaid claims and CAE. We analyze the data separately (1) for each of the states in which we write business, (2) for each type of coverage group written, and (3) by accident quarter. We apply the actuarial methodologies outlined below with respect to each of these data subsets to establish separate point estimates for IBNR claims. We then aggregate all of the separate point estimates to develop our best estimate of our overall unpaid claims and CAE.

Development patterns in the personal auto business are somewhat unique by state, since each state has varying policy limits, laws establishing liability, and litigation environments. Development patterns also vary by line of coverage, as liability claims traditionally take longer to settle than physical damage claims.

Finally, development patterns can vary by accident quarter as changes have occurred and are expected to continue within our claims department, including the effects of implementation of a new claims management system. We believe that these changes resulted in an acceleration of exposure recognition and in ultimate claim settlement. Our expansion into different geographical areas within each state has caused our mix of business to change, and the credibility associated with data for each accident quarter has changed over time. As a result, our development patterns exhibit a greater variance than the development patterns for a stable, larger and more mature book of business, and we recognize this volatility in our analysis of the data.

For private passenger auto business, Incurred but Not Reported Reserves include provisions in the aggregate for the following:

 

   

Claims that have occurred, but have not been reported to us.

 

   

Claims that have been reported to us, but have not been recorded on our system, and a case reserve has not been established yet.

 

   

Claims that are closed, but may be re-opened for payment/additional payments at a future date.

 

   

Claims that are known and recorded in our system, but may have development beyond the case reserve established when the claim was first reported.

 

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We compute unpaid claims and claim adjustment expense (excluding claims department expense IBNR) for the above four provisions on a combined basis, by first estimating ultimate claims and claim adjustment expense (CAE) amounts for each accident quarter, and then subtracting from these amounts the cumulative paid and case reserves on known claims for each accident quarter. There are several methods we utilize to estimate ultimate C & CAE amounts:

 

   

Paid Claim Development Method

 

   

Incurred Claim Development Method

 

   

Bornheutter-Ferguson Paid Method

 

   

Bornheutter-Ferguson Incurred Method

In addition, ultimate claim counts are estimated using closed and reported claim count data. Ultimate claims and CAE estimates are divided by ultimate claim count estimates to determine an ultimate claim severity, which provides a reasonability check for our ultimate C & CAE amounts. If severities are in line with expectations, we have an additional degree of confidence in our estimates.

The methods listed above assume that the influences that affect the development patterns for each accident quarter will remain constant over time. Because of this, selection of development patterns that will apply to current open claims and claims incurred but not reported must consider several factors. These include, but are not limited to, the impact of inflation on claim costs and changes in the rate of inflation, the rate and level at which our claims adjusters make payments and settle claims and any changes in this rate or level, changes in the adequacy or method used to establish case reserves, changes in the cost of medical care, changes in judicial decisions, legislation changes, and other factors. Changes in any of these factors imply that development patterns are not remaining constant over time – one key assumption in the methods used to estimate ultimate liability. For example, when the rate at which adjusters make payments and settle claims has accelerated over time, ultimate loss estimates developed using the methods employed above may overstate true projected ultimate liabilities, thus adjustments that take these changes in to consideration are utilized. Various methods are used to adjust for these changes including, but not limited to, adjustments that take into consideration changes in exposure recognition, the rate of claims closure and changes in case reserve adequacy as well as tail factor analysis and actuarial judgment.

Unpaid claims department expenses are estimated using a cost per claim approach. Under this approach historical paid claims department expense data are divided by the historical number of claim activity transactions. It is assumed that the expense associated with settling a liability claim is twice that of settling a physical damage claim, since liability claims are typically more complex. It is also assumed that there are two activities creating expenses associated with pure IBNR claims – the cost to open the claim and the cost to settle and close the claim, while only one activity is associated with claims already open – the cost to settle and close the claim. The cost per activity is multiplied by the total estimated future activities to arrive at an estimate of future claims department expense for all claims that have occurred prior to the evaluation date.

Variability of Claims Reserves

Traditionally, use of multiple methodologies produces a cluster of estimates with modest dispersion in the indicated possible outcomes. However, due to the changes the Company has experienced as outlined above, use of the methodologies cited above produced conflicting results and wider bands of indicated possible outcomes. Such bands do not necessarily constitute a range of outcomes, nor do we calculate a range of outcomes. If there is a significant variation in the results generated by different actuarial methodologies, our actuarial staff further analyzes the data using additional techniques. These processes may include making adjustments to the key assumptions underlying the methodologies, using additional generally accepted actuarial estimation methodologies, and applying actuarial judgment.

 

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Index to Financial Statements

In arriving at each individual point estimate of reserves for IBNR claims and CAE in each separate data subset, our actuarial staff considers the likely predictive value of the various methodologies employed in light of internal and external variables that may impact the reserves. For each data subset in each accident quarter, the point estimate selected is not necessarily one of the points produced by any particular methodology utilized, but may be another point that takes into consideration each of the points produced by the several loss methodologies used and is based on actuarial judgment. For example, the current accident quarter may not have enough paid claims data to rely upon, leading our actuarial staff to conclude that an incurred development methodology provides a better estimate than a paid development methodology. In such a case, more weight would be given to an incurred methodology for that particular accident quarter.

As noted above in the discussion of the methodologies we use in setting reserves for our runoff business, the decline in the number of outstanding claims has made traditional actuarial techniques less useful in determining our estimated liabilities, and the estimates for runoff claims have been based primarily on case-by-case evaluations by the claims department of developments in individual claim files. Accordingly, we generally do not depend on assumptions about historical claims development in making these estimates, and it would not be feasible to devise any means of testing the sensitivity of our estimates.

In determining our reserve estimates for nonstandard personal automobile insurance, for each financial reporting date we record our best estimate, which is a point estimate, of our overall unpaid claims and CAE for both current and prior accident years. Because the underlying processes require the use of estimates and professional actuarial judgment, establishing claims reserves is an inherently uncertain process. As our experience develops and we learn new information, our quarterly reserving process may produce revisions to our previously reported claims reserves, which we refer to as “development,” and such changes may be material. We recognize favorable development when we decrease our previous estimate of ultimate C & CAE, which results in an increase in net income in the period recognized. We recognize unfavorable development when we increase our previous estimate of ultimate losses, which results in a decrease in net income in the period recognized. Accordingly, while we record our best estimate, our claims reserves are subject to potential variability.

We believe it is reasonably likely that our loss costs could increase or decrease by 2% from current estimates, as remaining claims are recorded and resolved. Loss costs reflect the incurred loss per unit of exposure and are the product of frequency and severity. A 2% increase or decrease in our loss costs would result in unfavorable or favorable development of $10.6 million (assuming the size of the Company remains constant). This estimate of sensitivity is informational only, is not a projection of future results and does not take into account possible effects of extraordinary litigation events (such as class action claims).

Income Taxes

The Company and its subsidiaries file a consolidated Federal income tax return. Deferred income tax items are accounted for under the “asset and liability” method which provides for temporary differences between the reporting of earnings for financial statement purposes and for tax purposes, primarily deferred policy acquisition costs, the discount on unpaid claims and claim adjustment expenses, net operating loss carry forwards and the nondeductible portion of the change in unearned premiums. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment dates.

 

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As of December 31, 2009 and 2008, the net deferred tax asset before valuation allowance was $28,967,000 and $32,397,000, and the valuation allowance was $28,830,000 and $29,905,000, respectively. The Company does not record a tax valuation allowance relating to the net unrealized losses on investments, excluding stocks, because it is more likely than not that these losses would reverse or be utilized in future periods. The Company has the ability and it is the Company’s intent to fully recover the principal, which could require the Company to hold these securities until their maturity; therefore, the Company considers the impairment to be temporary.

The Company has evaluated tax contingencies in accordance with ASC 740-10-65, Income Taxes – Overall – Transition and Open Effective Date Information. At December 31, 2009 and 2008, the Company does not have any significant uncertain tax positions.

Correction of an Immaterial Error

During the review of the year end close process for 2009, the Company discovered that compensated absences expense had never been recorded. As of December 31, 2008, the cumulative effect of the error is $1,310,000, which arose over many years, and is considered to be immaterial to the individual prior years. However, since the cumulative impact of correcting this error would have been quantitatively material to the results for the quarter ended December 31, 2009, we applied the guidance of ASC 250-10-S99-1 and S99-2. As such, we revised our previously issued 2008 consolidated financial statements as reflected in the December 31, 2008 Consolidated Balance Sheet, the Consolidated Statement of Operations for the year ended December 31, 2008 and the Consolidated Statement of Shareholders’ Equity and Comprehensive Loss for the year ended December 31, 2008 presented in this report. The cumulative effect of establishing the liability was recorded as an adjustment to the January 1, 2008 balance of Accumulated deficit by $1,359,000. For the year ended December 31, 2008, “Underwriting and operating expenses,” “Total expenses,” “Income (loss) before Federal income taxes” and “Net income (loss)” were each reduced by $49,000 resulting in a decrease of $0.01 for basic and diluted loss per common share. “Other liabilities” and “Total liabilities” were increased by $1,310,000. “Accumulated deficit” and “Total shareholders’ equity” were also decreased by $1,310,000 as of December 31, 2008 by revising the 2008 consolidated financial statements. The revision had no impact on the 2008 Net cash provided by operating activities or Net cash used for investing or financing activities in our Consolidated Statements of Cash Flows. In 2010, the Company expects to change its policies with respect to compensated absences in a manner which is likely to reduce the amount of the liability by a significant amount and favorably impact results of operations. For further details, please refer to note 1 – “Summary of Significant Accounting Policies” of the “Notes to the Consolidated Financial Statements” under Part II, Item 8 in this report.

Accounting Pronouncements

In June 20090, the FASB issued guidance now codified as ASC 105, Generally Accepted Accounting Principles (“ASC 105”) as the single source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with U.S. GAAP. ASC 105 explicitly recognizes rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under federal securities laws as authoritative GAAP for SEC registrants. The adoption of ASC 105 did not have a material impact on our financial position, results of operations or cash flows, but does impact our financial reporting process by eliminating all references to pre-codification standards.

 

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Effective April 1, 2009, we adopted ASC 855-10, Subsequent Events – Overall (“ASC 855-10”), which sets forth general standards of accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The adoption of ASC 855-10 did not have a material impact on our condensed consolidated financial condition or results of operations. On February 24, 2010, the FASB issued Accounting Standards Update (“ASU”) 2010-09, Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements (“ASU 2010-09”). The amendments in ASU 2010-09 remove the requirement in ASC 855-10 for a SEC filer to disclose a date through which subsequent events have been evaluated in both issued and revised financial statements.

The Company early adopted the guidance of ASC 820-10-65, Fair Value Measurements and Disclosures – Overall – Transition and Open Effective Date Information (“ASC820-10-65”) in the first quarter of 2009. ASC 820-10-65 provides additional guidance on: 1) estimating fair value when the volume and level of activity for an asset or liability have significantly decreased in relation to the normal market activity for the asset or liability, and 2) identifying transactions that are not orderly. ASC 820-10-65 must be applied prospectively and retrospective application is not permitted. ASC 820-10-65 is effective for interim and annual periods after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009 subject to also early adoption of ASC 320-10-65. Adoption of ASC 855-10 did not have a material impact on our consolidated results of operations or financial condition. See note 3 to the consolidated financial statements included herein for the application of ASC 820-10-65 and further details regarding fair value measurement of the Company’s financial assets as of December 31, 2009.

Effective July 1, 2009, we adopted FASB Accounting Standards Update (“ASU”) No. 2009-05, Fair Value Measurements and Disclosures (Topic 820) (“ASU 2009-05”). ASU 2009-05 provided amendments to ASC 820, Fair Value Measurements and Disclosures, for the fair value measurements of liabilities. ASU 2009-05 provides clarification that in circumstances in which a quoted market price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using certain techniques. ASU 2009-05 also clarifies that when estimating the fair value of a liability, the reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of a liability. ASU 2009-05 also clarifies that both a quoted price in an active market for the identical liability at the measurement date and the quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements. Adoption of ASU 2009-05 did not have a material impact on our consolidated results of operations or financial condition.

The Company early adopted the guidance of ASC 320-10-65, Investments – Debt and Equity Securities – Overall – Transition and Open Effective Date Information (“ASC 320-10-65”) in the first quarter of 2009. ASC 320-10-65 provides new guidance on the recognition and presentation of an other-than-temporary impairment (“OTTI”) for available for sale and held to maturity debt securities (equities are excluded). An impaired security is not recognized as an OTTI impairment if management does not intend to sell the impaired security and it is more likely than not it will not be required to sell the security before the recovery of its amortized costs basis. If management concludes a security is other-than-temporarily impaired, the FSP requires that the difference between the fair value and the amortized cost of the security to be presented as an OTTI charge in the Consolidated Statements of Operations, with an offset for any noncredit-related loss component of the OTTI charge to be recognized in Other comprehensive income (loss). Accordingly, only the credit loss component of the OTTI amount will have an impact on the Company’s results of operations. For all debt securities in unrealized loss positions that do not meet either of the two requirements, ASC 320-10-65 requires the that the Company analyze its ability to recover the amortized cost by comparing the net present value of projected future cash flows with the amortized cost of the security. The net present value is calculated by discounting the Company’s best estimate of projected future cash flows at the effective interest rate implicit in the debt security prior to impairment.

 

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Under ASC 320-10-65, when an OTTI of a debt security has occurred, the amount of the OTTI recognized in earnings depends on whether the Company intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis. If the debt security meets either of these two criteria, the OTTI recognized in earnings is equal to the entire difference between the security’s amortized cost basis and its fair value at the impairment measurement date. For OTTI of debt securities that do not meet either of the two criteria, the net amount recognized in earnings is equal to the difference between the amortized cost of the debt security and its net present value calculated as described above. Any difference between the fair value and the net present value of the debt security at the impairment measurement date is recorded in other comprehensive income (loss). Unrealized gains or losses on securities for which an OTTI has been recognized in earnings is tracked as a separate component of accumulated other comprehensive loss. Prior to the adoption, an OTTI recognized in earnings for debt securities was equal to the total difference between amortized cost and fair value at the time of impairment. ASC 320-10-65 also requires extensive new interim and annual disclosure for both fixed maturities and equities to provide further disaggregating information as well as information about how the credit loss component of the OTTI charge was determined and requiring a roll forward of such amount for each reporting period. See notes 2, 4 and 5 to the consolidated financial statements included herein for the application of ASC 320-10-65 and further details regarding fair value measurement of the Company’s financial assets as of December 31, 2009.

The Company early adopted ASC 825-10-65, Financial Instruments – Overall – Transition and Open Effective Date Information (“ASC 825-10-65”) in the first quarter of 2009. ASC 825-10-65 amends ASC 825-10 to require disclosures about fair value of financial instruments in interim financial statements, as well as in annual financial statements and also amends ASC 270-10 to require those disclosures in all interim financial statements. See note 3 to the consolidated financial statements included herein for these related disclosures.

ASC 325-40-65, Instruments – Overall – Transition and Open Effective Date Information (“ASC 325-40-65) eliminates the requirement that the holder’s best estimate of cash flows be based upon those that a “market participant” would use. ASC 325-40-65 was amended to require recognition of an OTTI when it is “probable” that there has been an adverse change in the holder’s best estimate of cash flows from the cash flows previously projected. This amendment aligns the impairment guidance under ASC 320-10-35. ASC 325-40-65 retains and re-emphasizes the OTTI guidance and disclosures in pre-existing GAAP and SEC requirements. The adoption of ASC 325-40-65 did not have a material impact on the Company’s results of operations or financial position.

All other codified accounting standards and interpretations of those standards issued during the first nine months of 2009 did not relate to accounting policies and procedures pertinent to the Company at this time.

Off-Balance Sheet Transactions and Related Matters

There are no off-balance sheet transactions, arrangements, obligations (including contingent obligations), or other relationships of the Company with unconsolidated entities or other persons that have, or may have, a material effect on financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources of the Company.

 

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Forward-Looking Statements

Some of the statements made in this Report are forward-looking statements. Forward-looking statements relate to future events or our future financial performance and may involve known or unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from future results, performance, or achievements expressed or implied by such forward-looking statements.

These forward-looking statements reflect our current views, but they are based on assumptions and are subject to risks, uncertainties, and other variables which you should consider in making an investment decision, including, in addition to the terms discussed under “PART I. ITEM 1A. Risk Factors” of this document, (a) current and future economic conditions and uncertainties and disruptions in financial markets that may materially and adversely affect our business (including the heightened potential for claims fraud), operations, capital and liquidity, (b) the unpredictability of governmental actions affecting financial institutions and other financial firms and/or rating agencies, (c) operational risks and other challenges associated with growth into new and unfamiliar markets and states, (d) adverse market conditions, including heightened competition, (e) factors considered by A.M. Best in the rating of our insurance subsidiary, and the acceptability of our current rating, or a future rating, to agents and customers, (f) the Company’s ability to adjust and settle its runoff business on terms consistent with our estimates and reserves, (g) the adoption or amendment of legislation and regulations, uncertainties in the outcome of litigation and adverse trends in litigation, (h) inherent uncertainty arising from the use of estimates and assumptions in decisions about pricing and reserves, (i) the effects on claims levels resulting from natural disasters and other adverse weather conditions, (j) the availability of reinsurance and our ability to collect reinsurance recoverables, (k) the availability and cost of capital, which may be required in order to implement the Company’s strategies, and (l) limitations on the our ability to use net operating loss carryforwards.

Forward-looking statements are relevant only as of the dates made, and we undertake no obligation to update any forward-looking statement to reflect new information, events or circumstances after the date on which the statement is made. All written or oral forward-looking statements that are made by or are attributable to us are expressly qualified in their entirety by this cautionary notice. Our actual results may differ significantly from the results we discuss in these forward-looking statements.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

 

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The following Consolidated Financial Statements are on pages 64 through 112:

 

     Page

Management’s Report on Internal Control Over Financial Reporting

   64

Reports of Independent Registered Public Accounting Firm

   68

Consolidated Balance Sheets as of December 31, 2009 and 2008

   69

Consolidated Statements of Operations for the Years Ended December 31, 2009 and 2008

   71

Consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss) for the Years Ended December 31, 2009 and 2008

   72

Consolidated Statements of Cash Flows for the Years Ended December 31, 2009 and 2008

   73

Notes to Consolidated Financial Statements, December 31, 2009 and 2008

   75

The following Consolidated Financial Statements Schedules are on pages 113 through 123:

 

Schedule

      Page

I

   Summary of Investments    113

II

   Condensed Financial Information of the Registrant    114

III

   Supplementary Insurance Information    121

IV

   Reinsurance    122

VI

   Supplemental Information    123

 

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

None.

 

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ITEM 9A(T). CONTROLS AND PROCEDURES

The Company maintains disclosure controls and procedures that are designed to ensure that the information required to be disclosed in its Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures, which, by their nature, can provide only reasonable assurance regarding management’s control objectives.

The Company carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, on the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Exchange Act Rules 13a-15 and 15d-15 as of the end of the period covered by this report. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective as of December 31, 2009, in timely alerting them to information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s Exchange Act reports.

While the Company believes that its existing disclosure controls and procedures have been effective to accomplish their objectives, the Company intends to continue to examine, refine and document its disclosure controls and procedures and to monitor ongoing developments in this area.

Changes in internal control over financial reporting

There have been no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2009 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

 

ITEM 9B. OTHER INFORMATION

None.

 

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PART III

 

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information required by this Item 10 will be supplied by a Schedule 14A filing or an amendment to this Report, to be filed with the SEC no later than April 30, 2010.

 

ITEM 11. EXECUTIVE COMPENSATION

The information required by this Item 11 will be supplied by a Schedule 14A filing or an amendment to this Report, to be filed with the SEC no later than April 30, 2010.

 

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this Item 12 will be supplied by a Schedule 14A filing or an amendment to this Report, to be filed with the SEC no later than April 30, 2010.

 

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information required by this Item 13 will be supplied by a Schedule 14A filing or an amendment to this Report, to be filed with the SEC no later than April 30, 2010.

 

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this Item 14 will be supplied by a Schedule 14A filing or an amendment to this Report, to be filed with the SEC no later than April 30, 2010.

 

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PART IV

 

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a) Documents filed as part of the report:

 

  1. The following financial statements filed under Part II, Item 8:

Reports of Independent Registered Public Accounting Firm

Consolidated Balance Sheets as of December 31, 2009 and 2008

Consolidated Statements of Operations for the Years Ended December 31, 2009 and 2008

Consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss) for the Years Ended December 31, 2009 and 2008

Consolidated Statements of Cash Flows for the Years Ended December 31, 2009 and 2008

Notes to Consolidated Financial Statements, December 31, 2009 and 2008

 

  2. The following Consolidated Financial Statement Schedules are filed under Part II, Item 8:

 

Schedule

  

Description

I    Summary of Investments
II    Condensed Financial Information of the Registrant
III    Supplementary Insurance Information
IV    Reinsurance
VI    Supplemental Information

 

  3. See the Exhibit Index beginning on page 65.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

GAINSCO, INC.

(Registrant)

/s/ Glenn W. Anderson

By:

  Glenn W. Anderson, President

Date:

 

March 31, 2010

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Glenn W. Anderson and Daniel J. Coots, jointly and severally, his attorney-in-fact, each with the full power of substitution, for such person, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might do or could do in person hereby ratifying and confirming all that each of said attorneys-in-fact and agents, or his substitute, may do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

 

Name

 

Title

 

Date

/s/ Robert W. Stallings

  Chairman of the Board   March 31, 2010
Robert W. Stallings    

/s/ Glenn W. Anderson

  President, Chief Executive   March 31, 2010
Glenn W. Anderson   Officer and Director  

/s/ Daniel J. Coots

  Senior Vice President,   March 31, 2010
Daniel J. Coots   Chief Financial Officer and  
  Chief Accounting Officer  

/s/ Joel C. Puckett

  Director   March 31, 2010
Joel C. Puckett    

/s/ Robert J. Boulware

Robert J. Boulware

  Director   March 31, 2010
   

/s/ John C. Goff

  Director   March 31, 2010
John C. Goff    

/s/ Sam Rosen

  Director   March 31, 2010
Sam Rosen    

/s/ Harden H. Wiedemann

  Director   March 31, 2010
Harden H. Wiedemann    

/s/ John H. Williams

  Director   March 31, 2010
John H. Williams    

 

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MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Management of GAINSCO, INC. (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is a process designed under the supervision of the President and Chief Executive Officer and the Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.

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

Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009, based on the framework set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that assessment, management concluded that, as of December 31, 2009, the Company’s internal control over financial reporting is effective based on the criteria established in Internal Control – Integrated Framework.

This annual report does not include an attestation report of the Company’s Independent Registered Public Accounting Firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s Independent Registered Public Accounting Firm pursuant to temporary rules of the United States Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.

 

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Exhibit Index

 

Exhibit No.

    

  3.1

   Restated Articles of Incorporation of Registrant as filed with the Secretary of State of Texas on July 24, 1986 [Exhibit 3.1, filed in Registration Statement No. 33-7846 on Form S-1, effective November 6, 1986].

  3.2

   Articles of Amendment to the Articles of Incorporation as filed with the Secretary of State of Texas on June 10, 1988 [Exhibit 3.2, filed in Registration Statement No. 33-25226 on Form S-1, effective November 14, 1988].

  3.3

   Articles of Amendment to Articles of Incorporation as filed with the Secretary of State of Texas on August 13, 1993 [Exhibit 3.6, Form 10-K dated March 25, 1994].

  3.4

   Articles of Amendment to Articles of Incorporation as filed with the Secretary of State of Texas on November 10, 2005 [Exhibit 3.8, Form 8-K filed November 16, 2005].

  3.5

   Statement of Resolution Establishing and Designating Series A Convertible Preferred Stock of Registrant as filed with the Secretary of State of the State of Texas on October 1, 1999 [Exhibit 99.18, Form 8-K filed October 7, 1999].

  3.6

   Articles of Amendment to the Statement of Resolution Establishing and Designating the Series A Convertible Preferred Stock of Registrant as filed with the Secretary of State of Texas on January 21, 2005 [Exhibit 4.1, Form 8-K filed January 24, 2005].

  3.7

   Articles of Amendment to the Articles of Incorporation effective June 8, 2009 [Exhibit 3.9, Form 8-K filed June 3, 2009].

  3.8

   Amended and Restated Bylaws of Registrant effective January 1, 2010 [Exhibit 3.1, Form 8-K filed November 13, 2009].

  4.1

   Form of Common Stock Certificate [Exhibit 4.6, Form 10-K filed March 28, 1997].

  4.2

   Agreement dated August 26, 1994 appointing Continental Stock Transfer & Trust Company transfer agent and registrar [Exhibit 10.28, Form 10-K dated March 30, 1995].

  4.3

   Series B Common Stock Purchase Warrant dated as of October 4, 1999 between Registrant and Goff Moore Strategic Partners, L.P. (“GMSP”) [Exhibit 99.20, Form 8-K filed October 7, 1999].

  4.4

   First Amendment to Series B Common Stock Purchase Warrant dated as of March 23, 2001 between Registrant and GMSP [Exhibit 99.22, Form 8-K/A filed March 30, 2001].

  4.4

   Second Amendment to Series B Common Stock Purchase Warrant dated as of January 21, 2005 between Registrant and GMSP [Exhibit 10.10, Form 8-K filed January 24, 2005].

  4.5

   Amended and Restated Trust Agreement among GAINSCO, INC. as Depositor, Wilmington Trust Company as Property Trustee, Wilmington Trust Company as Delaware Trustee, and Glenn W. Anderson, Daniel J. Coots and Richard M. Buxton as Administrators, dated as of January 13, 2006 [Exhibit 10.41, Form 8-K filed January 18, 2006].

  4.6

   Junior Subordinated Indenture between GAINSCO, INC. and Wilmington Trust Company, as Trustee, dated as of January 13, 2006 [Exhibit 10.42, Form 8-K filed January 18, 2006].

  4.7

   Guarantee Agreement between GAINSCO, INC. as Guarantor and Wilmington Trust Company as Guarantee Trustee, dated as of January 13, 2006 [Exhibit 10.43, Form 8-K filed January 18, 2006].

  4.8

   Amended and Restated Trust Agreement among GAINSCO, INC. as Depositor, U.S. Bank National Association as Property Trustee, and Glenn W. Anderson and Daniel J. Coots as Administrators, dated as of December 21, 2006 [Exhibit 4.14, Form 10-K filed April 2, 2007].

  4.9

   Junior Subordinated Indenture between GAINSCO, INC. and U.S. Bank National Association, as Trustee, dated as of December 21, 2006 [Exhibit 4.15, Form 10-K filed April 2, 2007].

  4.10

   Guarantee Agreement between GAINSCO, INC. as Guarantor and U.S. Bank National Association as Guarantee Trustee, dated as of December 21, 2006 [Exhibit 4.16, Form 10-K filed April 2, 2007].

10.1*

   1998 Long Term Incentive Plan of the Registrant [Exhibit 99.8, Form 10-Q filed August 11, 1998].

10.2*

   GAINSCO, INC. 401(k) Plan and related Adoption Agreement [Exhibit 10.14, Form 10-Q filed November 14, 2003].

 

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10.3*

   GAINSCO, INC. 2005 Long-Term Incentive Compensation Plan [Exhibit 4.1, registration statement on Form S-8 filed on November 14, 2005].

10.4*

   Form of Restricted Stock Incentive Agreement (incorporated by reference to Exhibit 4.2 to the registration statement on Form S-8 filed on November 14, 2005).

10.5*

   Form of Restricted Stock Unit Incentive Agreement [Exhibit 4.3, registration statement on Form S-8 filed on November 14, 2005].

10.6*

   Form of Restricted Stock Unit Incentive Agreement [Exhibit 10.35, Form 8-K filed September 10, 2008].

10.7*

   Form of 2008 Amendment to Restricted Stock Unit Incentive Agreement [Exhibit 10.36, Form 8-K filed September 10, 2008].

10.8*

   Employment Agreement dated April 25, 1998 between Glenn W. Anderson and the Registrant [Exhibit 99.5, Form 10-Q/A filed June 16, 1998].

10.9*

   Change of Control Agreement for Glenn W. Anderson [Exhibit 99.7, Form 10-Q/A filed June 16, 1998].

10.10*

   Replacement Non-Qualified Stock Option Agreement dated July 24, 1998 between Glenn W. Anderson and the Registrant [Exhibit 99.9, Form 10-Q filed August 11, 1998].

10.11*

   Waiver and First Amendment to Employment Agreement dated as of August 27, 2004 between Registrant and Glenn W. Anderson [Exhibit 10.7, Form 8-K filed August 30, 2004].

10.12*

   Change in Control Agreement dated as of August 27, 2004 between Registrant and Glenn W. Anderson [Exhibit 10.8, Form 8-K filed August 30, 2004].

10.13*

   Restricted Stock Agreement dated as of January 21, 2005 between Registrant and Glenn W. Anderson [Exhibit 10.11, Form 8-K filed January 24, 2005]

10.14*

   Employment Agreement dated as of August 27, 2004 between Registrant and Robert W. Stallings [Exhibit 10.5, Form 8-K filed August 30, 2004].

10.15*

   Employment Agreement dated as of August 27, 2004 between Registrant and James R. Reis [Exhibit 10.6, Form 8-K filed August 30, 2004].

10.16

   Forms of Change of Control Agreements [Exhibit 10.4, Form 10-K filed March 29, 2002].

10.17

   Office Lease dated May 3, 2005 by and between Crescent Real Estate Funding VIII, L.P. and GAINSCO, INC. [Exhibit 10.37, Form 8-K filed May 9, 2005].

10.18

   First Amendment to Office Lease dated July 13, 2005 by and between Crescent Real Estate Funding VIII, L.P. and GAINSCO, INC. [Exhibit 10.38, Form 8-K filed July 19, 2005].

10.19

   Second Amendment to Office Lease dated September 23, 2005 by and between Crescent Real Estate Funding VIII, L.P. and GAINSCO, INC. [Exhibit 10.39, Form 8-K filed September 29, 2005].

10.20

   Third Amendment to Office Lease dated October 27, 2005 by and between Crescent Real Estate Funding VIII, L.P. and GAINSCO, INC. [Exhibit 10.21, Form 10-K, filed March 27, 2009].

10.21

   Fourth Amendment to Office Lease dated January 25, 2006 by and between Crescent Real Estate Funding VIII, L.P. and GAINSCO, INC. [Exhibit 10.22, Form 10-K, filed March 27, 2009].

10.22

   Fifth Amendment to Office Lease dated February 7, 2007 by and between Crescent Real Estate Funding VIII, L.P. and GAINSCO, INC. [Exhibit 10.41, Form 8-K filed February 12, 2007].

10.23

   Acquisition Agreement dated August 12, 2002 among GAINSCO, INC., GAINSCO Service Corp., GAINSCO County Mutual Insurance Company, Berkeley Management Corporation and Liberty Mutual Insurance Company [Exhibit 10.26, Form 10-Q filed August 14, 2002].

10.24

   Acquisition Agreement dated August 12, 2002 among GAINSCO, INC., GAINSCO Service Corp., Berkeley Management Corporation, Liberty Mutual Insurance Company, and GAINSCO County Mutual Insurance Company and Amendment to Acquisition Agreement dated December 2, 2002 among GAINSCO, INC., GAINSCO Service Corp., Berkeley Management Corporation, Liberty Mutual Insurance Company, and GAINSCO County Mutual Insurance Company [Exhibit 10.26, Form 10-Q filed August 14, 2002 and Exhibit 10.32, Form 8-K filed December 5, 2002].

 

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10.25*

   Compensation of non-management directors beginning in 2005 was described in a Form 8-K filed on May 17, 2005, and such description is incorporated herein by reference.

10.26

   Credit Agreement between GAINSCO, INC. and The Frost National Bank dated September 30, 2005 [Exhibit 10.40, Form 8-K filed October 6, 2005].

10.27

   First Amendment to Credit Agreement dated as of January 13, 2006, among the Company, National Specialty Lines, Inc. and The Frost National Bank. [Exhibit 10.28, Form 10-K, filed March 27, 2009].

10.28

   Second Amendment to Credit Agreement dated as of October 31, 2007, among the Company, National Specialty Lines, Inc. and The Frost National Bank [Exhibit 10.30, Form 10-k filed March 28, 2008].

10.29

   Third Amendment to Credit Agreement dated as of November 21, 2008, among the Company, National Specialty Lines, Inc. and The Frost National Bank [Exhibit 10.35, Form 8-K filed November 25, 2008].

10.30

   Sponsorship Agreement executed March 5, 2008, effective January 1, 2008, by and between Stallings Capital Group Consultants, Ltd. and GAINSCO, INC. [Exhibit 10.30, Form 8-K filed March 11, 2008].

10.31

   Sponsorship Agreement executed December 17, 2008, effective January 1, 2009, by and between Stallings Capital Group Consultants, Ltd. and GAINSCO, INC. [Exhibit 10.36, Form 8-K filed December 18, 2008].

10.32

   Sponsorship Agreement effective January 1, 2010, by and between Stallings Capital Group Consultants, Ltd. and GAINSCO, INC. [Exhibit 10.41, Form 8-K filed January 21, 2010].

10.33

   Software License Agreement dated May 3, 2007 by and between Guidewire Software, Inc. and MGA Insurance Company, Inc. [Exhibit 10.27, Form 10-Q filed August 14, 2007].

10.34

   Consulting Services Agreement dated May 2, 2007 by and between Guidewire Software, Inc. and MGA Insurance Company, Inc. [Exhibit 10.28, Form 10-Q filed August 14, 2007].

10.35

   Stock Purchase Agreement by and between GAINSCO, INC., MGA Insurance Company, Inc. and Montpelier Re U.S. Holdings Ltd. dated August 13, 2007 [Exhibit 10.29, Form 8-K filed August 17, 2007].

10.36

   100% Quota Share Reinsurance Agreement dated October 31, 2007 between MGA Insurance Company, Inc. and General Agents Insurance Company of America, Inc. [Exhibit 10.31, Form 10-K filed March 28, 2008].

10.37

   Reinsurance Trust Agreement dated October 31, 2007, by and among MGA Insurance Company, Inc., General Agents Insurance Company of America, Inc. and Bank of Oklahoma, N.A. as Trustee [Exhibit 10.32, Form 10-K filed March 28, 2008].

10.38

   Guaranty Agreement dated October 31, 2007 by GAINSCO, INC. for the benefit of General Agents Insurance Company of America, Inc. [Exhibit 10.33, Form 10-K filed March 28, 2008].

11.1

   Statement regarding Computation of Per Share Earnings (the required information is included in Note [1(k)] of Notes to Consolidated Financial Statements included in this Report and no separate statement is, or is required to be, filed as an exhibit).

21.1

   Subsidiaries of Registrant. †

23.1

   Consent of BDO Seidman, LLP †

31.1

   Section 302 Certification of Chief Executive Officer (certification required pursuant to Rule 13a-14(a) and 15d-14(a)). †

31.2

   Section 302 Certification of Chief Financial Officer (certification required pursuant to Rule 13a-14(a) and 15d-14(a)). †

32.1

   Certification Pursuant to 18 U.S.C. Section 1350 of Chief Executive Officer. (1)

32.2

   Certification Pursuant to 18 U.S.C. Section 1350 of Chief Financial Officer. (1)

 

Filed herewith.
(1) Furnished herewith Exhibits which are not marked “†” in the foregoing table have been previously filed with the Commission as an exhibit to the filing shown following the description of the applicable exhibit.
* Indicates a management contract or compensatory plan or arrangement.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders

GAINSCO, INC.:

We have audited the accompanying consolidated balance sheets of GAINSCO, INC. and subsidiaries (the “Company”) as of December 31, 2009 and 2008, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for each of the two years in the period ended December 31, 2009. In connection with our audits of the financial statements, we also have audited the financial statement schedules II, III, IV and VI. These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedules. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of GAINSCO, INC. and subsidiaries as of December 31, 2009 and 2008, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2009, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

 

/s/ BDO Seidman, LLP        

BDO Seidman, LLP

Dallas, Texas

March 31, 2010

 

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GAINSCO, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

December 31, 2009 and 2008

(Amounts in thousands, except share data)

 

     2009    2008
Assets          

Investments (notes 1, 2 and 3):

     

Bonds, available for sale – at fair value (amortized cost: $139,036 – 2009, $109,879 – 2008)

   $ 139,320    103,800

Bonds, trading – at fair value (cost: $323 – 2009)

     323    —  

Preferred stocks – at fair value (cost: $4,947 – 2009, $4,451 – 2008)

     4,235    3,219

Common stocks – at fair value (cost: $466 – 2009, $278 – 2008)

     551    277

Certificates of deposit – at cost, approximately fair value (amortized cost: $185 – 2009, $255 – 2008)

     185    255

Other long-term investment – at equity method, approximately fair value (cost: $1,068 – 2009, $1,850 – 2008)

     1,068    1,850

Short-term investments – at fair value (amortized cost: $42,289 – 2009, $65,820 – 2008)

     42,315    65,801
           

Total investments

     187,997    175,202

Cash

     1,616    1,373

Accrued investment income (note 1)

     1,570    1,221

Premiums receivable (net of allowance for doubtful accounts: $1,084 – 2009, $1,029 – 2008) (note 1)

     34,162    39,836

Reinsurance balances receivable (net of allowance for doubtful accounts: $130 – 2009, $132 – 2008) (notes 1 and 8)

     463    1,238

Ceded unpaid claims and claim adjustment expenses (notes 8 and 10)

     2,823    2,405

Deferred policy acquisition costs (note 1)

     6,438    7,850

Property and equipment (net of accumulated depreciation and amortization: $8,478 – 2009, $6,915 – 2008) (notes 1 and 9)

     1,764    2,936

Current Federal income taxes (notes 1 and 11)

     16    26

Deferred Federal income taxes (net of valuation allowance: $28,830 – 2009, $29,905 – 2008) (notes 1 and 11)

     137    2,492

Other assets

     4,307    4,295

Goodwill (note 1)

     609    609
           

Total assets

   $ 241,902    239,483
           

(continued)

 

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Index to Financial Statements

GAINSCO, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

December 31, 2009 and 2008

(Amounts in thousands, except share data)

 

      2009     2008  
Liabilities and Shareholders’ Equity     

Liabilities:

    

Unpaid claims and claim adjustment expenses (notes 1 and 10)

   $ 75,368      75,482   

Unearned premiums (note 1)

     41,305      48,482   

Accounts payable

     5,605      4,107   

Commissions payable

     696      1,473   

Premiums payable

     307      784   

Reinsurance balances payable (note 8)

     272      718   

Note payable (note 6)

     900      900   

Subordinated debentures (note 7)

     43,000      43,000   

Other liabilities

     3,097      3,584   

Cash overdraft

     8,303      6,916   
              

Total liabilities

     178,853      185,446   

Commitments and contingencies (notes 6, 7, 8, 14, 16, 17 and 18)

    

Shareholders’ Equity (notes 12 and 14):

    

Common stock ($.10 par value, 12,500,000 shares authorized, 5,039,432 shares issued and 4,782,898 shares outstanding at December 31, 2009, 5,039,549 shares issued and 4,786,820 shares outstanding at December 31, 2008*)

     504      2,519   

Additional paid-in capital

     154,072      151,740   

Accumulated deficit

     (87,166   (91,250

Accumulated other comprehensive loss (notes 2, 3, 4 and 5)

     (192   (4,839

Treasury stock, at cost (256,534 shares at December 31, 2009, 252,729 shares at December 31, 2008*) (notes 1 and 12)

     (4,169   (4,133
              

Total shareholders’ equity

     63,049      54,037   
              

Total liabilities and shareholders’ equity

   $ 241,902      239,483   
              

 

* share amounts retroactively adjusted for a one-for-five reverse stock split

See accompanying notes to consolidated financial statements.

 

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GAINSCO, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

Years ended December 31, 2009 and 2008

(Amounts in thousands, except per share data)

 

     2009     2008  

Revenues:

    

Net premiums earned (notes 1 and 8)

   $ 185,211      176,606   

Net investment income (note 2)

     6,677      7,728   

Realized investment gains (losses) (note 2 and 3), net:

    

Other-than-temporary impairment losses

     (3,569   (5,671

Other-than-temporary impairment losses transferred to Other comprehensive loss

     3,141      —     

Other realized investment gains (losses), net

     2,795      (642
              

Total realized investment gains (losses)

     2,367      (6,313
              

Agency revenues (note 1)

     12,999      12,461   

Other (expense) income, net

     (439   52   
              

Total revenues

     206,815      190,534   
              

Expenses:

    

Claims and claim adjustment expenses (notes 1, 8 and 10)

     137,287      129,562   

Policy acquisition costs (note 1)

     30,302      29,690   

Underwriting and operating expenses

     33,000      31,449   

Interest expense, net (notes 6 and 7)

     2,086      3,188   
              

Total expenses

     202,674      193,889   
              
Income (loss) before Federal income taxes      4,141      (3,355

Federal income taxes (notes 1 and 11):

    

Current expense

     68      46   
              

Total income taxes

     68      46   
              

Net income (loss)

   $ 4,073      (3,401
              

Income (loss) per common share (notes 1, 12 and 13):

    

Basic

   $ .85      (.70
              

Diluted

   $ .85      (.70
              

Weighted average common shares outstanding (notes 12 and 13):

    

Basic

     4,785      4,883   
              

Diluted

     4,785      4,883   
              

See accompanying notes to consolidated financial statements.

 

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GAINSCO, INC. AND SUBSIDIARIES

Consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss)

Years ended December 31, 2009 and 2008

(Amounts in thousands)

 

     2009    2008  

Common stock:

         

Balance at beginning of year

   $ 2,519         2,512     

Issuance of restricted common stock

     —           7     

Reverse stock split

     (2,015      —       
                   

Balance at end of year

   $ 504         2,519     
                   

Additional paid-in capital:

         

Balance at beginning of year

   $ 151,740         151,451     

Issuance of restricted common stock

     —           (7  

Reverse stock split

     2,015         —       

Stock-based compensation expense

     217         152     

Accrual of restricted stock units

     100         144     
                   

Balance at end of year

   $ 154,072         151,740     
                   

Accumulated deficit:

         

Balance at beginning of year

   $ (91,250      (86,490  

Correction of an immaterial error (note 1)

     —           (1,359  

Cumulative impact of adoption of ASC 320-10-65, net of tax (note 5)

     11         —       

Net income (loss)

     4,073      $ 4,073    (3,401   (3,401
                   

Balance at end of year

   $ (87,166      (91,250  
                   

Accumulated other comprehensive loss:

         

Balance at beginning of year

   $ (4,839      (489  

Cumulative impact of adoption of ASC 320-10-65, net of tax (note 5)

     (11      —       

Other comprehensive income (loss)

     4,658        4,658    (4,350   (4,350
                           

Comprehensive income (loss)

     $ 8,731      (7,751
                 

Balance at end of year

   $ (192      (4,839  
                   

Treasury stock:

         

Balance at beginning of year

   $ (4,133      (947  

Purchase of treasury stock

     (36      (3,186  
                   

Balance at end of year

   $ (4,169      (4,133  
                   

Total shareholders’ equity end of year

   $ 63,049         54,037     
                   

See accompanying notes to consolidated financial statements.

 

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GAINSCO, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

Years ended December 31, 2009 and 2008

(Amounts in thousands)

 

     2009     2008  

Cash flows from operating activities:

    

Net income (loss)

   $ 4,073      (3,401

Adjustments to reconcile net income (loss) to cash provided by (used for) operating activities:

    

Depreciation and amortization

     2,573      1,831   

Other-than-temporary impairment of investments

     428      5,671   

Non-cash compensation expense

     317      296   

Realized (gains) losses (excluding other-than-temporary impairments)

     (2,701   642   

Realized gains on trading securities

     (94   —     

Realized losses on sale of property and equipment

     —        16   

Change in operating assets and liabilities:

    

Accrued investment income

     (349   224   

Premiums receivable

     5,674      (737

Reinsurance balances receivable

     775      (297

Ceded unpaid claims and claim adjustment expenses

     (418   6,289   

Deferred policy acquisition costs

     1,412      (674

Funds held under reinsurance agreements

     —        3,209   

Other assets

     (82   (406

Unpaid claims and claim adjustment expenses

     (114   788   

Unearned premiums

     (7,177   3,940   

Premiums payable

     (477   (1,850

Commissions payable

     (777   (1,007

Accounts payable

     1,498      894   

Reinsurance balances payable

     (446   (744

Other liabilities

     (487   895   

Current Federal income taxes

     10      46   
              

Net cash provided by operating activities

   $ 3,638      15,625   
              

(continued)

 

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Index to Financial Statements

GAINSCO, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

Years ended December 31, 2009 and 2008

(Dollars in thousands, except per share data)

 

     2009     2008  

Cash flows from investing activities:

    

Bonds available for sale:

    

Sold

   $ 55,827      31,376   

Matured

     13,000      43,490   

Purchased

     (96,147   (53,527

Certificates of deposit:

    

Sold

     255      255   

Matured

     —        1,725   

Purchased

     (185   (255

Bonds trading sold

     277      —     

Bonds trading purchased

     (451   —     

Preferred stocks sold

     162      91   

Preferred stocks purchased

     (764   (12,752

Common stocks sold

     —        68   

Common stocks purchased

     (188   —     

Common stocks trading sold

     195      —     

Common stocks trading purchased

     (289   —     

Other long-term investments proceeds (purchased)

     782      (1,850

Net change in short-term investments

     23,180      (22,090

Proceeds from sale of property and equipment

     —        6   

Property and equipment purchased

     (400   (1,214
              

Net cash used for investing activities

     (4,746   (14,677
              

Cash flows from financing activities:

    

Principal repayment

     —        (1,000

Treasury stock purchased

     (36   (3,186

Net change in cash overdraft

     1,387      2,889   
              

Net cash provided by (used for) financing activities

     1,351      (1,297
              

Net increase (decrease) in cash

     243      (349

Cash at beginning of year

     1,373      1,722   
              

Cash at end of year

   $ 1,616      1,373   
              

Supplemental disclosures of cash flow information:

25,664 shares of common stock were issued during 2008, relating to restricted stock units agreements (note 14).

$2,148 and $3,325 in interest was paid during 2009 and 2008, respectively (notes 6 and 7).

$60 in income tax payments were made during 2009. No income tax payments were made during 2008 (note 11).

See accompanying notes to consolidated financial statements.

 

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Index to Financial Statements

GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

(1) Background and Summary of Accounting Policies

 

  (a) Basis of Consolidation

The accompanying consolidated financial statements include the accounts of GAINSCO, INC. (“GAN”) and its wholly-owned subsidiaries (collectively, the “Company” or “we”), MGA Insurance Company, Inc. (“MGA”), GAINSCO Service Corp. (“GSC”), Lalande Financial Group, Inc. (“Lalande”), National Specialty Lines, Inc. (“NSL”) and DLT Insurance Adjusters, Inc. (“DLT”) (Lalande, NSL and DLT collectively, the “Lalande Group”). MGA has one wholly owned subsidiary, MGA Agency, Inc. All significant intercompany accounts and transactions have been eliminated in consolidation.

See note 12 Shareholders’ Equity regarding a one-for-five reverse stock split that became effective in June of 2009. All share amounts for all periods presented have been retroactively adjusted for the one-for-five reverse stock split.

The consolidated financial statements included herein have been prepared by GAINSCO, INC., on the basis of accounting principles generally accepted in the United States (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

  (b) Nature of Operations

The Company’s nonstandard personal auto products are primarily aligned with customers seeking to purchase basic coverage and limits of liability required by statutory requirements, or slightly higher. Our products include coverage for third party liability, for bodily injury and physical damage, as well as collision and comprehensive coverage for theft, physical damage and other perils for an insured’s vehicle. Within this context, we offer our product to a wide range of customers who present varying degrees of potential risk to the Company, and we strive to price our product to reflect this range of risk accordingly, in order to earn an underwriting profit. Simultaneously, when actuarially prudent, we attempt to position our product price to be competitive with other companies offering similar products to optimize our likelihood of securing our targeted customers. We offer flexible premium down payment, installment payment, late payment, and policy reinstatement plans that we believe help us secure new customers and retain exiting customers, while generating an additional source of income from fees that we charge for those services. We primarily write six-month policies in Arizona, Florida, Nevada and New Mexico and both one month and six month policies in Texas, with one year policies in California and both six month and one year policies in Georgia and South Carolina. The terms of policies we are permitted to offer varies in the states in which we operate.

GAN expects to use cash during the next twelve months primarily for: (1) interest and principal on the Note payable, (2) interest on the Subordinated debentures, (3) administrative expenses, and (4) investments. The primary sources of cash to meet these obligations are assets held by GAN and dividends from its subsidiaries.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

  (c) Investments

Investments are stated at fair value and are based on prices quoted in the most active market for each security, the fair value of comparable securities, discounted cash flow models or similar methods. Premiums and discounts on mortgage-backed and asset-backed securities are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations. The most significant determinants of prepayments are the difference between interest rates on the underlying mortgages, or underlying securities, and the current mortgage loan rates and the structure of the security. Other factors affecting prepayments include the size, type and age of underlying mortgages, the geographic location of the mortgaged properties and the credit worthiness of the borrowers. Variations from anticipated prepayments will affect the life and yield of these securities.

Investment securities are exposed to a number of factors, including general economic and business environment, changes in the credit quality of the issuer of the fixed income securities, changes in market conditions or disruptions in particular markets, changes in interest rates, or regulatory changes. Fair values of securities fluctuate based on the magnitude of changing market conditions. Our securities are issued by domestic entities and are backed either by collateral or the credit of the underlying issuer. Factors such as an economic downturn, disruptions in the credit markets, a regulatory change pertaining to the issuer’s industry, deterioration in the cash flows or the quality of assets of the issuer, or a change in the issuer’s marketplace may adversely affect our ability to collect principal and interest from the issuer. Both equity and fixed income securities have been affected over the past several years, and may be affected in the future, by significant external events. Credit rating downgrades, defaults, and impairments may result in write-downs in the value of the investment securities held by the Company. The Company regularly monitors its portfolio for pricing changes, which might indicate potential impairments, and performs reviews of securities with unrealized losses. In such cases, changes in fair value are evaluated to determine the extent to which such changes are attributable to (i) fundamental factors specific to the issuer, such as financial conditions, business prospects or other factors, or (ii) market-related factors, such as interest rates. When a security in the Company’s investment portfolio has an unrealized loss in fair value that is deemed to be other than temporary, the Company reduces the book value of such security to its current fair value, recognizing the credit related decline as a realized loss in the Consolidated Statements of Operations and a revised GAAP cost basis for the security is established.

For fixed maturity securities that are other-than-temporarily impaired, the Company assesses its intent to sell and the likelihood that we will be required to sell the security before recovery of its amortized cost. If a fixed maturity security is considered other-than-temporarily impaired, but the Company does not intend to and is not more than likely to be required to sell the security prior to its recovery to amortized cost, the amount of the impairment is separated into a credit loss component and the amount due to all other factors. The credit loss component of an impairment charge on a fixed maturity security is determined by the excess of the amortized cost over the present value of the expected cash flows. The present value is determined using the best estimate of cash flows discounted at (1) the effective interest rate implicit at the date of acquisition for non-structured securities or (2) the book yield for structured securities. The techniques and assumptions for determining the best estimate of cash flows varies depending on the type of security. The credit loss component of an impairment charge is recognized in net earnings while the non-credit component is recognized in accumulated other comprehensive income (loss).

 

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Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

Accrued investment income is the interest earned on securities which has been recognized in the results of operations, but the cash has not been received from the various security issuers. This accrual is based on the terms of each of the various securities and uses the ‘effective interest method’ for amortizing the premium and accruing the discount. Realized gains (losses) on securities are computed based upon the “specific identification” method on trade date and include write downs on securities considered to have other than temporary declines in fair value. Dividends on preferred stock are recorded as investment income on the ex-dividend date with a corresponding receivable to be extinguished upon receipt of cash.

 

  (d) Deferred Policy Acquisition Costs and Policy Acquisition Costs

Deferred policy acquisition costs (“DAC”) are principally commissions, premium taxes and marketing expenses which are deferred. Policy acquisition costs are principally commissions, premium taxes, marketing expenses and the change in deferred policy acquisition costs that are charged to operations over the period in which the related premiums are earned. The Company utilizes investment income when assessing recoverability of Deferred policy acquisition costs. A premium deficiency and a corresponding charge to income is recognized if the sum of the expected claims and claim adjustment expenses, unamortized acquisition costs and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2009, there was a premium deficiency of $66,000, net of anticipated investment income, that was recognized against Deferred policy acquisition costs for expected underwriting losses on the Southeast business. At December 31, 2008, there was no premium deficiency that was required to be recognized.

Information relating to these net deferred amounts, as of and for the years ended December 31, 2009 and 2008 is summarized as follows:

 

     2009     2008  
     (Amounts in thousands)  

Asset balance, beginning of period

   $ 7,850      7,176   
              

Deferred commissions

     20,622      22,499   

Deferred premium taxes and marketing expenses

     7,761      7,510   

Premium deficiency

     (66   —     

Amortization

     (29,729   (29,335
              

Net change

     (1,412   674   
              

Asset balance, end of period

   $ 6,438      7,850   
              

 

  (e) Property and Equipment

Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over the estimated useful lives of the respective assets (leasehold improvements are amortized over the terms of the lease and primarily three years for furniture and equipment). Computer software costs relating to programs for internal use are recorded in property and equipment and are amortized using the straight-line method over three years or the estimated useful life, whichever is shorter.

 

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Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

Costs associated with software developed or purchased for internal use are capitalized based on Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 350-40, Intangibles – Goodwill and Other – Internal-use Software, and other related guidance. Capitalized costs include external direct costs of materials and services consumed in developing or obtaining internal-use software and payroll for employees directly associated with, and who devote time to, the development of the internal-use software. Costs incurred in development and enhancement of software that do not meet the capitalization criteria, such as costs of activities performed during the preliminary and post-implementation stages, are expensed as incurred. The critical estimate related to this process is the determination of the amount of time devoted by employees to specific stages of internal-use software development projects. The Company reviews any impairment of the capitalized costs on a periodic basis. The Company amortizes such costs over the estimated useful life of the software, which is three years once the software has been placed in service. The Company capitalized software development costs of approximately $0 and $2,153,000 in 2009 and 2008, respectively. Amortization expense related to capitalized software development costs was approximately $717,000 and $536,000 for the years ended December 31, 2009 and 2008, respectively.

 

  (f) Goodwill

Goodwill carried on GAN’s balance sheet represents the excess of purchase price over fair value of net identifiable assets acquired. The goodwill recorded is related to the 1998 acquisition of the Lalande Group. In accordance with ASC 350-20, Intangibles – Goodwill and Other – Goodwill, goodwill is not amortized but rather is subject to an annual impairment test, or earlier if certain factors are present, based on its estimated fair value. Therefore, impairment losses could be recorded in future periods. The Company conducts on at least an annual basis a review of its reporting units’ assets and liabilities to determine whether goodwill is impaired. The goodwill impairment test is a two-step test. Under the first step, fair value of the reporting unit is compared with its carrying value (including goodwill). If the fair value of the reporting unit is less than its carrying value, an indication of goodwill impairment exists for the reporting unit and the enterprise must perform step two of the impairment test. Under step two, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of the goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. Fair value of the reporting unit is determined using a variety of methods, including a discounted cash flow analysis. If the fair value of the reporting unit exceeds its carrying value, step two does not need to be performed. GAN performed this test as of December 31, 2009 and 2008. The test results indicated that there was no impairment loss at December 31, 2009 or 2008.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

  (g) Claims and Claim Adjustment Expenses

An insurance company generally makes claim payments as a result of accidents involving the risks insured under the insurance policies it issues. Months and sometimes years may elapse between the occurrence of an accident, reporting of the accident to the insurer and payment of the claim. Insurers record a liability for estimates of claims that will be paid for accidents reported to them, which are referred to as “case reserves.” In addition, since accidents are not always reported promptly upon occurrence and because the assessment of existing known claims may change over time with the development of new facts, circumstances and conditions, insurers estimate liabilities for such items, which are referred to as incurred but not reported (“IBNR”) reserves.

We maintain reserves for the payment of claims and claim adjustment expenses for both case and IBNR under policies written by the insurance company subsidiary. These claims reserves are estimates, at a given point in time, of amounts that we expect to pay on incurred claims based on facts and circumstances then known. The amount of case claims reserves is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding the claim, and the policy provisions relating to the type of claim. The amount of IBNR claims reserves is estimated on the basis of historical information and anticipated future conditions by lines of insurance and actuarial review. Reserves for claim adjustment expenses are intended to cover the ultimate costs of settling claims, including investigation and defense of lawsuits resulting from such claims. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results.

The process of establishing claims reserves is imprecise and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. The actual emergence of claims and claim adjustment expenses may vary, perhaps materially, from the Company’s estimates thereof, because (a) estimates of liabilities are subject to large potential revisions, as the ultimate disposition of claims incurred prior to the financial statement date, whether reported or not, is subject to the outcome of events that have not yet occurred (e.g., jury decisions, court interpretations, legislative changes (even after coverage is written and reserves are initially set) that broaden liability and policy definitions and increase the severity of claims obligations, changes in the medical condition of claimants, public attitudes and social/economic conditions such as inflation), (b) estimates of claims do not make provision for extraordinary future emergence of new classes of claims or types of claims not sufficiently represented in the Company’s historical data base or which are not yet quantifiable, and (c) estimates of future costs are subject to the inherent limitation on the ability to predict the aggregate course of future events.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

In determining our reserve estimates for nonstandard personal automobile insurance, for each financial reporting date we record our best estimate, which is a point estimate, of our overall unpaid claims and CAE for both current and prior accident years. Because the underlying processes require the use of estimates and professional actuarial judgment, establishing claims reserves is an inherently uncertain process. As our experience develops and we learn new information, our quarterly reserving process may produce revisions to our previously reported claims reserves, which we refer to as “development,” and such changes may be material. We recognize favorable development when we decrease our previous estimate of ultimate losses, which results in an increase in net income in the period recognized. We recognize unfavorable development when we increase our previous estimate of ultimate losses, which results in a decrease in net income in the period recognized. Accordingly, while we record our best estimate, our claims reserves are subject to potential variability.

 

  (h) Treasury Stock

The Company records treasury stock in accordance with the “cost method” described in ASC 505-30, Equity – Treasury Stock (“ASC 505-30”). The Company held 256,534 and 252,729 shares of Common Stock as treasury stock at December 31, 2009 and 2008, respectively.

 

  (i) Revenue Recognition and Premiums Receivable

Premiums and policy fees are recognized as earned on a pro rata basis over the period the Company is at risk under the related policy. Agency revenues are primarily fees charged on insureds’ premiums due. These fees are earned over the terms of the underlying policies. Unearned premiums represent the portion of premiums written and policy fees which are applicable to the unexpired terms of policies in force. Premiums receivable consist of balances owed for coverages written with the Company. The Company’s allowance for doubtful accounts consists of all premiums receivables over thirty days past due.

 

  (j) Federal Income Taxes

The Company and its subsidiaries file a consolidated Federal income tax return. Deferred income tax items are accounted for under the “asset and liability” method which provides for temporary differences between the reporting of earnings for financial statement purposes and for tax purposes, primarily deferred policy acquisition costs, the discount on unpaid claims and claim adjustment expenses, net operating loss carryforwards and the nondeductible portion of the change in unearned premiums. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment dates.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

The Company currently has a full valuation allowance for the tax benefit from its net operating loss carryforwards. ASC 740-10, Income Taxes – Overall (“ASC 740-10”) requires positive evidence, such as taxable income over the most recent three-year period and other available objective and subjective evidence, for management to conclude that it is “more likely than not” that a portion or all of the deferred tax assets will be realized. While both objective and subjective evidence are considered, it is the Company’s understanding that objective evidence should generally be given more weight in the analysis under ASC 740-10. In making the determination, the Company considered all available evidence, including the fact that the Company incurred a cumulative taxable loss for the three years ended December 31, 2009. The Company does not record a tax valuation allowance relating to the net unrealized losses on investments, excluding equity securities, because it is more likely than not that these losses would reverse or be utilized in future periods. The Company has the ability and it is the Company’s intent to fully recover the principal, which could require the Company to hold these securities until their maturity; therefore, the Company considers the impairment to be temporary – see Note 11.

The Company adopted the provisions of ASC 740-10-65, Income Taxes – Overall – Transition and Open Effective Date Information (“ASC 740-10-65”) on January 1, 2007. As a result, the Company recognized no additional liability or reduction in deferred tax asset for uncertain tax benefits. At December 31, 2009, the Company has not identified any uncertain tax positions in accordance with ASC 740-10-65. The Company is subject to U.S. federal income tax examinations by tax authorities for 2006 and subsequent years.

 

  (k) Fair Value of Financial Instruments

The Company’s financial instruments consist primarily of cash, receivables, payables and debt and equity instruments. The carrying values of these financial instruments approximate their respective fair values as they are either short-term in nature or carry interest rates which approximate market rates.

 

  (l) Earnings Per Share

Earnings per share (“EPS”) for the years ended December 31, 2009 and 2008 is based on a weighted average of the number of common shares outstanding during each year, retroactively adjusted for a one-for-five reverse stock split in June 2009 (see note 12). Basic and diluted EPS is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Common stock equivalents related to stock options are excluded from the diluted EPS calculation if their effect would be anti-dilutive to EPS.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

  (m) Share-Based Compensation

The Company accounts for stock-based employee compensation plans under the provisions of ASC 718-10-65, Stock Compensation – Overall – Transition and Open Effective Date Information (“ASC 718-10-65”) that focuses primarily on accounting for transactions in which an entity exchanges its equity instruments for employee services and carries forward prior guidance for share-based payments for transactions with non-employees. Under the modified prospective transition method, the Company is required to recognize compensation cost, after the effective date, January 1, 2006, for the portion of all previously granted awards that were not vested and the vested portion of all new stock option grants and restricted stock. The compensation cost is based on whether the related service period and performance period achievements are considered probable at the time of measurement using the closing price of GAN’s Common Stock on the grant date, or if the grant has been subsequently modified, on the modification date. The Company recognizes expense relating to stock-based employee compensation on a straight-line basis over the requisite service period which is generally the vesting period. Forfeitures of unvested stock grants are estimated and recognized as reduction of expense. See note 13 of the Condensed Consolidated Financial Statements for more information on share-based compensation.

 

  (n) Recently Issued Accounting Standards

In June 2009, the FASB issued guidance now codified as ASC 105, Generally Accepted Accounting Principles (“ASC 105”) as the single source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with U.S. GAAP. ASC 105 explicitly recognizes rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under federal securities laws as authoritative GAAP for SEC registrants. The adoption of ASC 105 did not have a material impact on our financial position, results of operations or cash flows, but does impact our financial reporting process by eliminating all references to pre-codification standards.

Effective April 1, 2009, we adopted ASC 855-10, Subsequent Events – Overall (“ASC 855-10”), which sets forth general standards of accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The adoption of ASC 855-10 did not have a material impact on our consolidated financial condition or results of operations. On February 24, 2010, the FASB issued Accounting Standards Update (“ASU”) 2010-09, Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements (“ASU 2010-09”). The amendments in ASU 2010-09 remove the requirement in ASC 855-10 for a SEC filer to disclose a date through which subsequent events have been evaluated in both issued and revised financial statements.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

The Company early adopted the guidance of ASC 820-10-65, Fair Value Measurements and Disclosures – Overall – Transition and Open Effective Date Information (“ASC 820-10-65”) in the first quarter of 2009. ASC 820-10-65 provides additional guidance on: 1) estimating fair value when the volume and level of activity for an asset or liability have significantly decreased in relation to the normal market activity for the asset or liability, and 2) identifying transactions that are not orderly. ASC 820-10-65 must be applied prospectively and retrospective application is not permitted. ASC 820-10-65 is effective for interim and annual periods after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009 subject to also early adoption of ASC 320-10-65. See note 3 for the application of ASC 820-10-65 and further details regarding fair value measurement of the Company’s financial assets as of December 31, 2009.

Effective July 1, 2009, we adopted FASB Accounting Standards Update (“ASU”) No. 2009-05, Fair Value Measurements and Disclosures (Topic 820) (“ASU 2009-05”). ASU 2009-05 provided amendments to ASC 820, Fair Value Measurements and Disclosures, for the fair value measurements of liabilities. ASU 2009-05 provides clarification that in circumstances in which a quoted market price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using certain techniques. ASU 2009-05 also clarifies that when estimating the fair value of a liability, the reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of a liability. ASU 2009-05 also clarifies that both a quoted price in an active market for the identical liability at the measurement date and the quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements. Adoption of ASU 2009-05 did not have a material impact on our consolidated results of operations or financial condition.

The Company early adopted the guidance of ASC 320-10-65, Investments – Debt and Equity Securities – Overall – Transition and Open Effective Date Information (“ASC 320-10-65”) in the first quarter of 2009. ASC 320-10-65 provides new guidance on the recognition and presentation of an other-than-temporary impairment (“OTTI”) for available for sale and held to maturity debt securities (equities are excluded). An impaired security is not recognized as an OTTI impairment if management does not intend to sell the impaired security and it is more likely than not it will not be required to sell the security before the recovery of its amortized costs basis. If management concludes a security is other-than-temporarily impaired, the FSP requires that the difference between the fair value and the amortized cost of the security to be presented as an OTTI charge in the Consolidated Statements of Operations, with an offset for any noncredit-related loss component of the OTTI charge to be recognized in Other comprehensive income (loss). Accordingly, only the credit loss component of the OTTI amount will have an impact on the Company’s results of operations. For all debt securities in unrealized loss positions that do not meet either of the two requirements, ASC 320-10-65 requires the that the Company analyze its ability to recover the amortized cost by comparing the net present value of projected future cash flows with the amortized cost of the security. The net present value is calculated by discounting the Company’s best estimate of projected future cash flows at the effective interest rate implicit in the debt security prior to impairment.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

Under ASC 320-10-65, when an OTTI of a debt security has occurred, the amount of the OTTI recognized in earnings depends on whether the Company intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis. If the debt security meets either of these two criteria, the OTTI recognized in earnings is equal to the entire difference between the security’s amortized cost basis and its fair value at the impairment measurement date. For OTTI of debt securities that do not meet either of the two criteria, the net amount recognized in earnings is equal to the difference between the amortized cost of the debt security and its net present value calculated as described above. Any difference between the fair value and the net present value of the debt security at the impairment measurement date is recorded in other comprehensive income (loss). Unrealized gains or losses on securities for which an OTTI has been recognized in earnings is tracked as a separate component of accumulated other comprehensive loss. Prior to the adoption, an OTTI recognized in earnings for debt securities was equal to the total difference between amortized cost and fair value at the time of impairment. ASC 320-10-65 also requires extensive new interim and annual disclosure for both fixed maturities and equities to provide further disaggregating information as well as information about how the credit loss component of the OTTI charge was determined and requiring a roll forward of such amount for each reporting period. See notes 2, 4 and 5 for the application of ASC 320-10-65 and further details regarding fair value measurement of the Company’s financial assets as of December 31, 2009.

The Company early adopted ASC 825-10-65, Financial Instruments – Overall – Transition and Open Effective Date Information (“ASC 825-10-65”) in the first quarter of 2009. ASC 825-10-65 amends ASC 825-10 to require disclosures about fair value of financial instruments in interim financial statements, as well as in annual financial statements and also amends ASC 270-10 to require those disclosures in all interim financial statements. See note 3 to the consolidated financial statements included herein for these related disclosures.

ASC 325-40-65, Instruments – Overall – Transition and Open Effective Date Information (“ASC 325-40-65”) eliminates the requirement that the holder’s best estimate of cash flows be based upon those that a “market participant” would use. ASC 325-40-65 was amended to require recognition of an OTTI when it is “probable” that there has been an adverse change in the holder’s best estimate of cash flows from the cash flows previously projected. This amendment aligns the impairment guidance under ASC 320-10-35. ASC 325-40-65 retains and re-emphasizes the OTTI guidance and disclosures in pre-existing GAAP and SEC requirements. The adoption of ASC 325-40-65 did not have a material impact on the Company’s results of operations or financial position.

All other codified accounting standards and interpretations of those standards issued during 2009 did not relate to accounting policies and procedures pertinent to the Company at this time.

 

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Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

  (o) Correction of an Immaterial Error

During the review of the year end close process for 2009, the Company discovered that compensated absences expense had never been recorded. As of December 31, 2008, the cumulative effect of the error is $1,310,000, which arose over many years, and is considered to be immaterial to the individual prior years. However, since the cumulative impact of correcting this error would have been quantitatively material to the results for the quarter ended December 31, 2009, we applied the guidance of ASC 250-10-S99-1 and S99-2. As such, we revised our previously issued 2008 consolidated financial statements as reflected in the December 31, 2008 Consolidated Balance Sheet, the Consolidated Statement of Operations for the year ended December 31, 2008 and the Consolidated Statement of Shareholders’ Equity and Comprehensive Loss for the year ended December 31, 2008 presented in this report. The cumulative effect of establishing the liability was recorded as an adjustment to the January 1, 2008 balance of Accumulated deficit by $1,359,000. For the year ended December 31, 2008, “Underwriting and operating expenses,” “Total expenses,” “Income (loss) before Federal income taxes” and “Net income (loss)” were each reduced by $49,000 resulting in a decrease of $0.01 for basic and diluted loss per common share. “Other liabilities” and “Total liabilities” were increased by $1,310,000. “Accumulated deficit” and “Total shareholders’ equity” were also decreased by $1,310,000 as of December 31, 2008 by revising the 2008 consolidated financial statements.

The table below highlights certain items revised in prior periods related to the correction of an immaterial error that was incorrectly recorded in prior periods:

 

     Year ended December 31, 2008  
     As originally
filed
             
       Adjustment     As adjusted  
     (Amounts in thousands)  

Statement of Operations

      

Underwriting and operating expenses

   $ 31,498      (49   31,449   

Total expenses

     193,938      (49   193,889   

Loss before Federal income taxes

     (3,404   49      (3,355

Net loss

     (3,450   49      (3,401

Loss per common share – basic

     (0.71   0.01      (0.70

Loss per common share – diluted

     (0.71   0.01      (0.70

Balance Sheet

      

Other liabilities

     2,274      1,310      3,584   

Total liabilities

     184,136      1,310      185,446   

Accumulated deficit

     (89,940   (1,310   (91,250

Total shareholders’ equity

     55,347      (1,310   54,037   

The changes to prior period balances had no impact on the 2008 Total assets, Net cash provided by operating activities or Net cash used for investing or financing activities.

 

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Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

  (p) Reclassifications

Certain amounts in the prior year’s consolidated financial statements have been reclassified to conform to the current period presentation. Previously, $4,562,000 was presented in Preferred stocks at December 31, 2008 and has been reclassified to Bonds available for sale as of December 31, 2009 and $381,000 was presented in Funds held under reinsurance agreements at December 31, 2008 and has been reclassified to Other assets as of December 31, 2009. These reclassifications had no effect on Total assets, Total liabilities, Total shareholders’ equity, Net loss or Net cash used for operating activities as previously reported.

 

(2) Investments

The following schedule summarizes the components of net investment income:

 

     Years ended December 31,  
     2009     2008  
     (Amounts in thousands)  

Fixed maturities

   $ 6,221      5,891   

Preferred stock

     221      659   

Common stock

     31      49   

Other long-term investments

     90      80   

Short-term investments

     395      1,291   
              
     6,958      7,970   

Investment expenses

     (281   (242
              

Net investment income

   $ 6,677      7,728   
              

The following schedules summarize the amortized cost and estimated fair values of investments:

 

     December 31, 2009  
                          Other-than-
temporary
impairments
in AOCL (1)
 
          Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Estimated
Fair
Value
  
     Amortized
Cost
          
               
     (Amounts in thousands)  

Bonds available for sale:

             

U.S. Treasury

   $ 5,156    107    —        5,263    —     

U.S. Government agencies

     7,058    7    (82   6,983    —     

Corporate bonds

     82,608    3,031    (236   85,403    —     

Asset backed

     7,827    233    (18   8,042    —     

Mortgage backed

     36,387    459    (3,217   33,629    (2,266

Bonds, trading

     323    —      —        323    —     

Preferred stocks

     4,947    29    (741   4,235    —     

Common stocks, available for sale

     466    85    —        551    —     

Certificates of deposit

     185    —      —        185    —     

Other long-term investments

     1,068    —      —        1,068    —     

Short-term investments

     42,289    29    (3   42,315    —     
                             

Total investments

   $ 188,314    3,980    (4,297   187,997    (2,266
                             

 

(1) Represents the amount of other-than-temporary impairment losses in “Accumulated other comprehensive loss” or “AOCL” which, from January 1, 2009, were not included in earnings under ASC 320-10-65.

 

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Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

     December 31, 2008
     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Estimated
Fair
Value
            
            
     (Amounts in thousands)

Fixed maturities:

  

Bonds available for sale:

          

U.S. Treasury

   $ 5,179    111    (46   5,244

U.S. Government agencies

     2,998    13    —        3,011

Corporate bonds

     48,883    407    (1,773   47,517

Asset backed

     11,909    18    (292   11,635

Mortgage backed

     36,493    442    (5,104   31,831

Preferred stocks

     8,868    204    (1,291   7,781

Common stocks

     278    —      (1   277

Certificates of deposit

     255    —      —        255

Other long-term investments

     1,850    —      —        1,850

Short-term investments

     65,820    8    (27   65,801
                      

Total investments

   $ 182,533    1,203    (8,534   175,202
                      

The following schedules summarize the gross unrealized losses showing the length of time that investments have been continuously in an unrealized loss position as of December 31, 2009 and 2008:

 

     December 31, 2009
     Less than 12 months    12 months or longer    Total
     Fair Value    Unrealized
Losses
   Fair Value    Unrealized
Losses
   Fair Value    Unrealized
Losses
     (Amounts in thousands)

U.S. Government agencies

   $ 3,976    82    —      —      3,976    82

Corporate bonds

     9,458    95    2,182    141    11,640    236

Asset backed

     —      —      642    18    642    18

Mortgage backed

     5,204    68    9,285    3,149    14,489    3,217

Preferred stocks

     75    421    2,131    320    2,206    741

Short-term investments

     3,559    3    —      —      3,559    3
                               

Total temporarily impaired securities

   $ 22,272    669    14,240    3,628    36,512    4,297
                               

 

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Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

     December 31, 2008
     Less than 12 months    12 months or longer    Total
     Fair Value    Unrealized
Losses
   Fair Value    Unrealized
Losses
   Fair Value    Unrealized
Losses
     (Amounts in thousands)

U.S. Treasury

   $ 1,624    46    —      —      1,624    46

Corporate bonds

     19,159    871    1,877    902    21,036    1,773

Asset backed

     10,127    292    —      —      10,127    292

Mortgage backed

     8,380    922    6,637    4,182    15,017    5,104

Preferred stocks

     4,622    1,016    200    275    4,822    1,291

Common stocks

     116    1    —      —      116    1

Short-term investments

     5,832    27    —      —      5,832    27
                               

Total temporarily impaired securities

   $ 49,860    3,175    8,714    5,359    58,574    8,534
                               

At December 31, 2009, the Company’s fixed maturity portfolio had seventeen (17) securities with gross unrealized losses totaling $3,628,000 that were in the excess of 12 months category. At December 31, 2008, the Company’s fixed maturity portfolio had thirteen securities (13) with gross unrealized losses totaling $5,359,000 that were in excess of 12 months category. At December 31, 2009, one single issuer accounted for gross unrealized loss positions greater than $100,000 totaling $421,000 that was in less than 12 months category. Approximately 72% of the unrealized gross losses were with issuers rated as investment grade by Standard and Poor’s (S&P). The decline in the market value is primarily related to the disruption and lack of liquidity in the markets in which these securities trade, along with credit risk aversion by investors. Other important factors include (i) the slowing of prepayments in mortgage and asset backed securities and (ii) the significant decline in the 3 month London Interbank Offered Rate for U.S. dollar deposits (“LIBOR”) for securities with floating rate coupons since the purchase of these assets. At this time based upon information currently available, the Company has the ability and it is the Company’s intent to fully recover the principal, which could require the Company to hold these securities until their maturity; therefore, the Company considers the impairment to be temporary.

In order to determine whether it is appropriate in an accounting period to recognize OTTI with respect to a portfolio security which has experienced a decline in fair value and as to which the Company has the ability and intent to fully recover principal, the Company considers all available evidence and applies judgment. With corporate debt issues, firm specific performance, industry trends, legislative and regulatory changes, government initiatives, and the macroeconomic environment all play a role in the evaluation process. With respect to asset backed securities (including mortgage backed securities), the Company uses individual cash flow modeling in addition to other available information. In the case of securities as to which the Company has the ability and intent to fully recover principal, if all scheduled principal and interest is expected to be received on a timely basis using the current best estimates of material inputs, such as default frequencies, severities, and prepayment speeds, generally no OTTI would be recognized unless other factors suggest that it would be appropriate to do so. The principal factors that the Company considers in this analysis are the extent to which the fair value of the security has declined, the ratings given to the security by recognized rating agencies, trends in those ratings, and information available to the Company from securities analysts and other commentators, public reports and other credible information.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

At December 31, 2009, the Company had $7,278,000 in nonprime collateralized mortgage obligations (Alt-A securities) with S&P ratings of 21% AAA, 8% AA+ and 71% CCC. At December 31, 2008, the Company had $8,385,000 in Alt-A securities with S&P ratings of 20% AAA, 7% AA+ and 73% B. The carrying value and fair value of these investments were $6,840,000 and $4,894,000, respectively, at December 31, 2009 compared to $8,342,000 and $5,366,000, respectively, at December 31, 2008.

Included in the Company’s fixed income portfolio are hybrid securities with a carrying value of $5,683,000 and fair value of $6,693,000. A hybrid security as used here is one where the issuer of the debt instrument can choose to defer payment of the regularly scheduled interest due for a contractually set maximum period of time, usually five to ten years, without being in technical default on the issue.

One security, with carrying value of $1,466,000 and $1,919,000, and a fair value of $1,008,000 and $995,000, at December 31, 2009 and 2008, respectively, is dependent on the continued claims paying ability of its financial guarantor (MBIA) in order for the Company not to sustain any loss of principal or interest. MBIA is rated BB+ (S&P), we believe that the probable outcome is that principal and interest will be paid in full and, accordingly, the impairment on that security is considered temporary.

The Preferred stocks predominately consist of auction preferred instruments considered to be available for sale and reported at estimated fair value with the net unrealized gains or losses reported after-tax as a component of other comprehensive income. The auction rate securities which the Company owns are each issued by a trust which holds as an asset the preferred stock of a corporation, which are exchange traded. The Company has the option at stated intervals to redeem the auction preferred shares for a pro rata share of the underlying collateral. As of December 31, 2009, we have not chosen this option as the structure of the trust provides a higher coupon on the auction preferred shares than on the underlying collateral shares; and therefore, are of greater economic value. As of December 31, 2009, we do not believe that these underlying shares are other-than-temporarily impaired based on the credit review of the issuers.

During 2009, the general partners of the limited partnership the Company invested in elected to commence dissolution and wind up the partnership’s affairs allowing for liquidation of the partnership’s assets. The Company has classified this investment as Other long-term investment and accounts for it under the equity method.

When a security has an unrealized loss in fair value that is deemed to be other than temporary, the Company reduces the carrying value of the security to its current market value, recognizing the decline as a realized loss in the statement of operations. These determinations primarily reflect the market-related issues associated with the disruption in the mortgage and other credit markets, which created a significant deterioration in both the valuation of the securities as well as our view of future recoverability of the valuation decline.

During the 2009, the Company wrote down $3,569,000 in securities that were determined to have had an other-than-temporary decline in fair value of which $428,000 was determined to have had an other-than-temporary credit related impairment charge and while $3,141,000 of the other-than-temporary impairment was non-credit related and recognized in other comprehensive income (loss), a component of shareholders’ equity.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

During the third quarter of 2008, the Company wrote down $5,027,000 in securities that were determined to have had an other-than-temporary decline in market value, including $3,748,000 of auction preferred securities backed by preferred stock of the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corp. (“Freddie Mac”). On September 7, 2008, the United States Department of the Treasury and the Federal Housing Finance Agency placed Fannie Mae and Freddie Mac in conservatorship. Following this action, the market price of Washington Mutual securities began to decline significantly. On September 11, 2008 the Company decided to reduce its exposure to Washington Mutual and sold part of its bond position for a loss. On September 25, 2008, Washington Mutual Savings was placed into receivership, and the parent company filed bankruptcy the next day. The remainder of the Company’s bond position was sold on September 29, 2008. As a result, approximately $689,000 in realized losses was recorded in the third quarter of 2008 on Washington Mutual bonds. In September 2008, the Company also determined the Washington Mutual preferred stock to be other-than-temporarily impaired and recorded a realized loss of approximately $330,000 on this security. One of our mortgage-backed securities is collateralized by residential mortgage loans that are considered subprime. This security was considered OTTI in the third quarter of 2008 and the carrying value was reduced by $932,000 and this decline was recorded as a realized loss.

During the fourth quarter of 2008, the Company wrote down an additional $643,000 in securities that were determined to have had an other-than-temporary decline in market value and this was recorded as a realized loss, including $202,000 in additional OTTI on Fannie Mae and Freddie Mac auction preferred securities. Two closed end mutual funds comprised of preferred stock and real estate investment trusts investments accounted for $317,000 of the write down. The Company considered these securities to be OTTI because of the magnitude of the decline in both net asset value and market value, the decline in net investment income and weakness in the sectors of the underlying assets.

As of December 31, 2009, the S&P ratings on the Company’s bonds available for sale and bonds trading were in the following categories: 33% AAA, 1% AA+, 5% AA, 5% AA-, 2% A+, 18% A, 9% A-, 7% BBB+, 8% BBB, 2% BBB-, 2% BB+, and 8% BB and below.

Proceeds from the sale of bond securities available for sale totaled $55,827,000 and $31,376,000, including $22,302,000 and $15,809,000 in principal pay downs in 2009 and 2008, respectively. Proceeds from the sale of bond trading securities totaled $277,000 in 2009. Proceeds from the sale of certificate of deposits totaled $255,000 in 2009 and 2008. Proceeds from the sale of preferred stock totaled $162,000 and $91,000 in 2009 and 2008, respectively. Proceeds from the sale of common stock totaled $68,000 in 2008. There were no sales of common stock in 2009. Proceeds from the sale of common stock trading totaled $195,000 in 2009.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

Realized gains and losses on investments for the years ended December 31, 2009 and 2008 are presented in the following table:

 

     Years ended December 31,  
     2009     2008  
     (Amounts in thousands)  

Realized gains:

    

Bonds, available for sale

   $ 2,870      131   

Bonds, trading

     258      —     

Preferred stock

     2      7   
              

Total realized gains

     3,130      138   
              

Realized losses:

    

Bonds, available for sale

     —        (775

Bonds, trading

     (109   —     

Preferred stocks

     (108   —     

Common stocks, available for sale

     —        (5

Common stocks, trading

     (94   —     

Short-term investments

     (24   —     
              

Total realized losses

     (335   (780
              

Other-than-temporary impairment losses

     (428   (5,671
              

Total realized investment gains (losses), net

   $ 2,367      (6,313
              

The amortized cost and estimated fair value of debt securities (including bonds available for sale, preferred stocks and certificates of deposit) at December 31, 2009 and 2008, by maturity, are shown below.

 

     2009    2008
          Estimated         Estimated
     Amortized    Fair    Amortized    Fair
     Cost    Value    Cost    Value
     (Amounts in thousands)

Due in one year or less

   $ 24,865    24,967    20,855    19,659

Due after one year but within five years

     58,700    59,886    36,071    34,993

Due after five years but within ten years

     7,835    8,089    3,670    3,624

Due after ten years but within twenty years

     2,766    2,680    —      —  

Due beyond 20 years

     6,111    6,770    5,587    5,532

Asset backed securities

     7,827    8,042    11,909    11,635

Mortgage backed securities

     36,387    33,629    36,493    31,831
                     
   $ 144,491    144,063    114,585    107,274
                     

Estimated fair value of investments on deposit with various regulatory bodies, as required by law, were approximately $5,397,000 and $5,447,000, at December 31, 2009 and 2008, respectively.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

When a security has an unrealized loss in fair value that is deemed to be other than temporary, the Company reduces the book value of the security to its current market value, recognizing the decline as a realized loss in the statement of operations. These determinations primarily reflect the market-related issues associated with the disruption in the mortgage and other credit markets, which created a significant deterioration in both the valuation of the securities as well as our view of future recoverability of the valuation decline.

As discussed in note 1, a portion of certain OTTI losses on debt securities are recognized in “Other comprehensive income (loss)” (“OCI”). The net amount recognized in earnings (“credit loss impairments”) represents the difference between the amortized cost of the security and the net present value of its projected future cash flows discounted at the effective interest rate implicit in the debt security prior to impairment. Any remaining difference between fair value and amortized cost is recognized in OCI. The following table sets forth the amount of credit loss impairments on debt securities held by the Company as of December 31, 2009, for which a portion of the OTTI loss was recognized in OCI, and the corresponding changes in such amounts.

 

     (Amounts in
     thousands)

Balance, January 1, 2009

   $ —  

Credit losses remaining in accumulated deficit related to adoption of ASC 320-10-65

     5,337

Credit loss impairments previously recognized on securities which matured, paid down, prepaid or were sold during the period

     —  

Credit loss impairments previously recognized on securities impaired to fair value during the period (1)

     —  

Credit loss impairments recognized in the current period on securities not previously impaired

     428

Additional credit loss impairments recognized in the current period on securities previously impaired

     —  

Increases due to the passage of time on previously recorded credit losses

     —  
      

Balance, December 31, 2009

   $ 5,765
      

 

  (1) Represents circumstances where the Company determined in the current period that it intends to sell the security or it is more likely than not that it will be required to sell the security before recovery of the security’s amortized cost.

 

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Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

(3) Fair Value Measurements

The Company’s estimates of fair value for financial assets and financial liabilities are based on the framework established in ASC 320-10-65. The framework is based on the inputs used in valuation, gives the highest priority to quoted prices in active markets and requires that observable inputs be used in the valuations when available. The disclosure of fair value estimates in the ASC 320-10-65 hierarchy is based on whether the significant inputs into the valuation are observable. In determining the level of the hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect the Company’s significant market assumptions. The three levels of the hierarchy are as follows:

 

   

Level 1 – Unadjusted quoted prices for identical assets or liabilities in active markets.

 

   

Level 2 – Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in inactive markets; or valuations based on models where the significant inputs are observable (e.g., interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data.

 

   

Level 3 – Valuations based on models where significant inputs are not observable. The unobservable inputs reflect the Company’s own estimates as to the assumptions that market participants would use.

Valuation of Investments

The Company receives pricing from independent pricing services, and these are compared to prices available from sources accessed through the Bloomberg Professional System. The number of available quotes varies depending on the security, generally we obtain one quote for Level 1 investments, one to three quotes for Level 2 investments and one to two quotes, if available, for Level 3 investments. If there is a material difference in the prices obtained, further evaluation is made. Market prices and valuations from sources such as the Bloomberg system, TRACE and dealer offerings are used as a check on the prices obtained from the independent pricing services. Should a material difference exist, then an internal valuation is made. For purposes of valuing these securities management produces expected cash flows for the security utilizing the standard mortgage security modeling capabilities available on the Bloomberg Professional System. The key inputs are the default rate, severity of default, and voluntary prepayment rate for the underlying mortgage collateral. These are generally based at the start on the actual historical values of these parameters for the prior three months. These cash flows are then discounted by a required yield derived from market based observations of broker inventory offerings, or in some cases Bloomberg Indices of like securities. Management uses this valuation model primarily with mortgage backed securities where the matrix pricing methodology used by the independent pricing service is too broad in its categorizations. This often involves differences in reasonable prepayment assumptions or significant differences in performance among issuers. In some cases, other external observable inputs such as credit default swap levels are used as input in the fair value analysis.

Fixed Maturities

For U. S. Treasury, U. S. government and corporate bonds, the independent pricing services obtain information on actual transactions from a large network of broker-dealers and determine a representative market price based on trading volume levels. For asset backed and mortgage backed instruments, the independent pricing services obtain information on actual transactions from a large network of broker-dealers and sorts the information into various components, such as asset type, rating, maturity, and spread to a benchmark such as the U.S. Treasury yield curve. These components are used to create a pricing matrix for similar instruments.

All broker-dealer quotations obtained are non-binding. For short-term investments classified as Level 1 and Level 2, the Company uses prices provided by independent pricing services. The preferred stocks classified as Level 3 are all auction rate preferred shares, and the Company utilizes an internal model incorporating observable market inputs.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

The Company uses the following hierarchy for each instrument in total invested assets:

 

  1. The Company obtains a price from an independent pricing service.

 

  2. If no price is available from an independent pricing service for the instrument, the Company obtains a market price from a broker-dealer or other reliable source, such as Bloomberg.

 

  3. The Company then validates the price obtained by evaluating its reasonableness. The Company’s review process includes quantitative analysis (i.e., credit spreads and interest rate and prepayment fluctuations) and initial and ongoing evaluations of methodologies used by outside parties to calculate fair value and comparing the fair value estimates to its knowledge of the current market. If a price provided by a pricing service is considered to be materially different from the other indications that are obtained, the Company will make a determination of the proper fair value of the instrument based on data inputs available.

 

  4. In order to determine the proper ASC 320-10-65 classification for each instrument, the Company obtains from its independent pricing service the pricing procedures and inputs used to price the instrument. The Company analyzes this information, taking into account asset type, rating and liquidity, to determine what inputs are observable and unobservable in order to determine the proper ASC 320-10-65 level. For those valued internally, a determination is made as to whether all relevant inputs are observable or unobservable in order to classify correctly.

All of the Company’s Level 1 and Level 2 invested assets held at December 31, 2009 were priced using either independent pricing services or available market prices to determine fair value. The Company classifies such instruments in active markets as Level 1 and those not in active markets as Level 2. The Preferred stocks in Level 3 were auction preferred instruments and were classified in Level 3 because the market in which they trade remains very inactive. The Corporate bonds in Level 3 are private placements which rarely trade and the issuers have no other debt outstanding to provide a valuation benchmark. The residential mortgage-backed securities which are valued in the manner described above are all classified as Level 3. Those for which the individual pricing service value is used are classified as Level 2.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

The quantitative disclosures about the fair value measurements for each major category of assets at December 31, 2009 were as follows (in thousands):

 

           Quoted     Significant        
           Prices in     Other     Significant  
           Active     Observable     Unobservable  
     December 31,     Markets     Inputs     Inputs  
     2009     (Level 1)     (Level 2)     (Level 3)  

Assets:

        

U.S. Treasury

   $ 5,263      5,263      —        —     

U.S. Government agencies

     6,983      —        6,983      —     

Corporate bonds

     85,403      2,916      80,372      2,115   

Asset backed

     8,042      —        8,042      —     

Mortgage backed

     33,629      —        25,564      8,065   
                          

Total available-for-sale securities

     139,320      8,179      120,961      10,180   

Bonds, trading

     323      323      —        —     

Preferred stocks

     4,235      410      —        3,825   

Common stocks, available for sale

     551      551      —        —     

Certificates of deposit

     185      185      —        —     

Short-term investments

     42,315      21,726      20,589      —     
                          

Total assets classified by ASC 320-10-65

   $ 186,929      31,374      141,550      14,005   
                          

Percentage of total

     100   17   76   7
                          

The following table provides a summary of changes in fair value associated with the Level 3 assets for the years ended December 31, 2009 and 2008 (in thousands):

 

     Fair Value  
     Measurements  
     Using Significant  
     Unobservable Inputs  
     (Level 3)  

Beginning balance

   $ 12,797      998   

Total gains or losses (realized/unrealized):

    

Included in earnings (or changes in net assets)

     (428   (3,950

Included in other comprehensive loss

     1,076      (956

Purchases, issuances, and settlements

     —        8,925   

Transfers in and/or out of Level 3

     560      7,780   
              

Ending balance

   $ 14,005      12,797   
              

 

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Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

The preceding table of Level 3 assets begins with the prior period balance and adjusts the balance for the gains or losses (realized and unrealized) that occurred during the current period. Any new purchases that are identified as Level 3 securities are then added and any sales of securities which were previously identified as Level 3 are subtracted. Next, any securities which were previously identified as Level 1 or Level 2 securities and which are currently identified as Level 3 are added. Finally, securities which were previously identified as Level 3 and which are now designated as Level 1 or as Level 2 are subtracted. The ending balance of the Level 3 securities presented above represent our best estimates and may not be substantiated by comparisons to independent markets and, in many cases, could not be realized in immediate settlement of the instruments.

The Company wrote down $428,000 in Alt-A securities (Level 3) for the year ended December 31, 2009 and $3,950,000 in auction preferred securities backed by preferred stock of Fannie Mae and Freddie Mac (Level 3) in 2008 that were determined to have had an other-than-temporary credit related impairment charge.

Certain financial instruments and all non-financial instruments are not required to be disclosed. Therefore, the aggregate fair value amounts presented do not purport to represent our underlying value.

 

(4) Accumulated Other Comprehensive Loss

Comprehensive income (loss) is comprised of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) includes net unrealized investment losses, net of deferred income taxes. The table below provides information about comprehensive income (loss) for the years ended December 31, 2009 and 2008 (amounts in thousands):

 

     2009     2008  

Decrease (increase) in unrealized investment losses during the period

   $ 6,586      (12,261

Less: Other-than-temporary impairment losses recognized in earnings

     (428   (5,671
              

Increase (decrease) in net unrealized investment losses during the period

     7,014      (6,590

Deferred Federal income tax expense (benefit)

     2,356      (2,240
              

Other comprehensive income (loss)

     4,658      (4,350

Net income (loss)

     4,073      (3,401
              

Comprehensive income (loss)

   $ 8,731      (7,751
              

The following table provides accumulated balances related to each component of accumulated other comprehensive loss at December 31, 2009 (amounts in thousands):

 

     Unrealized     Unrealized     Deferred        
     (Loss) Gain on     Loss on     Federal        
     Non-Impaired     Impaired     Income        
     Securities     Securities     Tax     Total  

Accumulated other comprehensive loss, beginning of period

   $ (7,331   —        2,492      (4,839

Cumulative impact of adoption of ASC 320-10-65

     —        (17   6      (11

Other comprehensive gain (loss)

     9,280      (2,266   (2,356   4,658   
                          

Accumulated other comprehensive loss, end of period

   $ 1,949      (2,283   142      (192
                          

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

(5) Cumulative Impact of Adoption of ASC 320-10-65

Pursuant to ASC 320-10-65, the Company reviewed all previously-recorded other-than-temporary impairments of securities and developed an estimate of the portion of such impairments using a methodology consistent with that applied to the current period other-than-temporary bifurcation of credit and non-credit. As a result, the Company determined that $17,000 in previously recorded other-than-temporary impairment had been due to non-credit impairments.

The process used by the Company in estimating the portion of previously recorded other-than-temporary impairments due to credit is consistent with the methodology employed for those securities determined to be other-than-temporarily impaired for the year ended December 31, 2009. Specifically, if the security is unsecured, secured by an asset or includes a guaranty of payment by a third party, the estimate of the portion of impairment due to credit was based upon a comparison of S&P ratings and maturity for the security. This information is used to determine the Company’s best estimate, derived from probability-weighted cash flows.

In the implementation of ASC 320-10-65, the Company recorded an opening balance adjustment that decreased Accumulated deficit in the amount of $11,000 and increased Accumulated other comprehensive loss in the amount of $11,000 related to non-credit impairments taken in prior periods, net of tax.

 

(6) Note Payable

In September 2005, the Company entered into a credit agreement with a commercial bank. Interest, payable monthly, accrued on any outstanding principal balance at a floating rate equal to the 3-month LIBOR plus a margin based on the consolidated net worth of the Company and earnings before interest, taxes, depreciation and amortization for the preceding four calendar quarters. The outstanding principal balance was payable in equal quarterly installments which commenced on October 1, 2007 based on a 60-month amortization schedule, with the balance of the loan payable in full on or before September 30, 2010.

The carrying value on the Note payable was $900,000 at December 31, 2009 and 2008, respectively. On November 21, 2008, the Company amended the credit agreement and paid the principal balance down to $900,000. The amendment changed the interest rate to 2.75% over the three month LIBOR, with a minimum of 4%, deleted provisions requiring the Company to achieve and maintain a specified ratio of earnings to fixed charges, increased the minimum levels of capital required to be maintained by GAN and MGA and provided that, in lieu of monthly principal amortization of the balance of the outstanding credit, all principal will be due at maturity on September 30, 2010. Interest expense of $37,000 and $97,000 was recorded and interest payments of $37,000 and $106,000 were paid in 2009 and 2008, respectively.

 

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Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

(7) Subordinated Debentures

In January 2006, GAN issued $25,000,000 of 30-year subordinated debentures. They require quarterly interest payments at a floating interest rate equal to the 3-month LIBOR plus a margin of 3.85%. They will mature on March 31, 2036 and are redeemable at GAN’s option beginning after March 31, 2011, in whole or in part, at the liquidation amount of $1,000 per debenture. The Company recorded net interest expense of $1,186,000 and $1,856,000 and interest payments of $1,218,000 and $1,909,000 were paid in 2009 and 2008, respectively.

In December 2006, GAN issued $18,000,000 of 30-year subordinated debentures. They require quarterly interest payments at a floating interest rate equal to the 3-month LIBOR plus a margin of 3.75%. They will mature on March 15, 2037 and are redeemable at GAN’s option beginning after March 15, 2012, in whole or in part, at the liquidation amount of $1,000 per debenture. In 2009 and 2008, the Company recorded net interest expense of $863,000 and $1,235,000, respectively. In 2009 and 2008, the Company paid interest on the Subordinated debenture of $893,000 and $1,310,000, respectively.

 

(8) Reinsurance

On February 7, 2002, the Company announced its decision to cease writing commercial, specialty and umbrella lines of insurance due to continued adverse claims development and unprofitable underwriting results, these lines became known as runoff lines.

Assumed

The Company has, in the past, utilized reinsurance arrangements with various non-affiliated admitted insurance companies, whereby the Company underwrote the coverage and assumed the policies 100% from the companies. These arrangements required that the Company maintain escrow accounts to assure payment of the unearned premiums and unpaid claims and claim adjustment expenses relating to risks insured through such arrangements and assumed by the Company.

As of December 31, 2009 and 2008, the balance in such escrow accounts totaled $11,085,000 and $23,295,000, respectively. For 2009 and 2008, the premiums earned by assumption were $6,091,000 and $13,781,000, respectively. As of December 31, 2009 and 2008, the assumed unpaid claims and claim adjustment expenses were $3,650,000 and $8,305,000, respectively.

 

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Index to Financial Statements

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Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

Ceded

Runoff Lines

Prior to 1999 and again beginning in 2001, the Company wrote commercial casualty policy limits up to $1,000,000. For policies with an effective date occurring from 1995 through 1998, and policies with an effective date occurring during 2001 or 2002, the Company has first excess casualty reinsurance for 100% of casualty claims exceeding $500,000 up to the $1,000,000 limits, resulting in a maximum net claim retention per risk of $500,000 for such policies. During 1999 and 2000, the Company wrote commercial casualty policy limits up to $5,000,000. For policies with an effective date occurring in 1999 or 2000, the Company has first excess casualty reinsurance for 100% of casualty claims exceeding $500,000 up to $1,000,000 and second excess casualty reinsurance for 100% of casualty claims exceeding $1,000,000 up to the $5,000,000 limits, resulting in a maximum net claim retention per risk of $500,000.

Effective December 31, 2000, the Company entered into a quota share reinsurance agreement whereby the Company ceded 100% of its commercial auto liability unearned premiums and 50% of all other commercial business unearned premiums at December 31, 2000 to a non-affiliated reinsurer. For policies with an effective date of January 1, 2001 through December 31, 2001, the Company entered into a quota share reinsurance agreement whereby the Company ceded 20% of its commercial business to a non-affiliated reinsurer. Also effective December 31, 2000, the Company entered into a reserve reinsurance cover agreement with a non-affiliated reinsurer. This agreement reinsures the Company’s ultimate net aggregate liability in excess of $32,500,000 up to an aggregate limit of $89,650,000 for net commercial auto liability losses and loss adjustment expense incurred but unpaid as of December 31, 2000.

For 2000 and 2001, the Company has excess casualty clash reinsurance for $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of each accident. For 2002, the Company has excess casualty clash reinsurance for 35% of $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of each accident.

For its lawyers professional liability coverages with policy effective dates occurring during 2001 or prior, the Company has quota share reinsurance for 50% of the first $1,000,000 of professional liability claims and excess casualty reinsurance for 100% of professional liability claims exceeding $1,000,000 up to $5,000,000 policy limits resulting in a maximum net claim retention per risk of $500,000.

For its umbrella coverages with policy effective dates occurring between 1999 and 2001, the Company has excess casualty reinsurance for 100% of umbrella claims exceeding $1,000,000 up to $10,000,000 policy limits. For policies with an effective date occurring prior to February 1, 2001, the Company has quota share reinsurance for 75% of the first $1,000,000 of umbrella claims resulting in a maximum net claim retention per risk of $250,000.

 

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Index to Financial Statements

GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

Nonstandard Personal Auto Lines

For 1998 through 2001, the Company has excess casualty clash reinsurance for $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of each accident. In 2002, the Company has excess casualty clash reinsurance for 35% of $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of each accident.

In 2008, the Company maintained catastrophe reinsurance on its physical damage coverage for property claims of $4,000,000 in excess of $1,000,000 for a single catastrophe, as well as aggregate catastrophe property reinsurance for $3,000,000 in excess of $1,000,000 in the aggregate. In 2009, the Company maintained catastrophe reinsurance on its physical damage coverage for property claims of $19,000,000 in excess of $1,000,000 for a single catastrophe, as well as for aggregate catastrophes. For 2010, the Company maintains catastrophe reinsurance on its physical damage coverage for property claims of $14,000,000 in excess of $1,000,000 for a single catastrophe, as well as for aggregate catastrophes. The Company reduced its coverage limits in 2010 due to a decrease in its Florida exposures.

The amounts deducted in the consolidated statement of operations for reinsurance ceded as of and for the years ended December 31, 2009 and 2008, respectively, are set forth in the following table.

 

     2009     2008  
     (Amounts in thousands)  

Premiums earned – nonstandard personal auto

   $ 1,798      1,275   
              

Premiums earned – runoff

     (261   28   
              

Claims and claim adjustment expenses – runoff

   $ (55   (436
              

The Company remains directly liable to its policyholders for all policy obligations and the reinsuring companies are obligated to the Company to the extent of the reinsured portion of the risks.

 

(9) Property and Equipment

The following schedule summarizes the components of property and equipment:

 

     As of December 31,  
     2009     2008  
     (Amounts in thousands)  

Leasehold improvements

   $ 537      537   

Furniture

     1,207      1,216   

Equipment

     2,214      1,968   

Software

     6,284      6,130   

Accumulated depreciation and amortization

     (8,478   (6,915
              
   $ 1,764      2,936   
              

The Company recorded depreciation expense of $1,572,000 and $1,774,000 in 2009 and 2008, respectively.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

(10) Claims and Claim Adjustment Expenses

The following table sets forth the changes in unpaid claims and claim adjustment expenses, net of reinsurance cessions, as shown in the Company’s consolidated financial statements for the periods indicated:

 

     As of and for the years ended
December 31,
     2009     2008
     (Amounts in thousands)

Unpaid claims and claim adjustment expenses, beginning of period

   $ 75,482      74,694

Less: Ceded unpaid claims and claim adjustment expenses, beginning of period

     2,405      8,694
            

Net unpaid claims and claim adjustment expenses, beginning of period

     73,077      66,000
            

Net claims and claim adjustment expense incurred related to:

    

Current period

     144,211      126,599

Prior periods

     (6,924   2,963
            

Total net claim and claim adjustment expenses incurred

     137,287      129,562
            

Net claims and claim adjustment expenses paid related to:

    

Current period

     93,191      79,053

Prior periods

     44,628      43,432
            

Total net claim and claim adjustment expenses paid

     137,819      122,485
            

Net unpaid claims and claim adjustment expenses, end of period

     72,545      73,077

Plus: Ceded unpaid claims and claim adjustment expenses, end of period

     2,823      2,405
            

Unpaid claims and claim adjustment expenses, end of period

   $ 75,368      75,482
            

The decrease from 2008 to 2009 in net claims and claim adjustment expenses incurred related to prior periods was primarily the result of the favorable development recorded in 2009 for the nonstandard personal automobile lines primarily in the Southwest region as a result of projected and actual decreases in severity associated with the physical damage lines versus the unfavorable development of $4.4 million recorded for the nonstandard personal automobile lines in 2008 primarily the result of projected and actual decreases in severity associated with the material damage lines. In 2008, the Company’s growth and the associated risks and uncertainties made it difficult to estimate ultimate claims liabilities, and the unfavorable development occurred as the Company revised previous estimates to reflect current claims data.

 

(11) Federal Income Taxes

In the accompanying consolidated statements of operations, the provisions for Federal income tax as a percent of related pretax income (loss) differ from the Federal statutory income tax rate. A reconciliation of income tax expense using the Federal statutory rates to actual income tax expense follows:

 

     2009     2008  
     (Amounts in thousands)  

Income tax expense (benefit) at 34%

   $ 1,408      (1,141

Change in valuation allowance

     (1,075   1,206   

Other, net

     (265   (19
              

Income tax expense

   $ 68      46   
              

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

Under ASC 740-10-65, the primary objective is to establish deferred tax assets and liabilities for the temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. As a consequence, the portion of the tax expense, which is a result of the change in the deferred tax asset or liability, may not always be consistent with the income reported on the statements of operations. At December 31, 2009, the Company has not identified any uncertain tax positions in accordance with ASC 740-10-65.

The following table represents the tax effect of temporary differences giving rise to the net deferred tax asset established under ASC 740-10-65.

 

     As of December 31,  
     2009     2008  
     (Amounts in thousands)  

Deferred tax assets:

    

Net operating loss carryforward

   $ 23,300      24,464   

Discount on unearned premium reserve

     2,655      3,134   

Realized capital losses

     2,034      2,126   

Discount on unpaid claims and claim adjustment expenses

     1,519      1,666   

Unearned fees

     771      815   

Compensated absences

     564      —     

Allowance for doubtful accounts

     414      396   

Alternative Minimum Tax carryforward

     324      257   

Net unrealized losses on investments

     108      2,492   

Other

     67      112   
              

Total deferred tax assets

     31,756      35,462   
              

Deferred tax liabilities:

    

Deferred policy acquisition costs

     2,212      2,748   

Accrual of discount on bonds

     347      292   

Depreciation and amortization

     93      25   

Other

     137      —     
              

Total deferred tax liabilities

     2,789      3,065   
              

Net deferred tax asset before valuation allowance

   $ 28,967      32,397   

Valuation allowance

     (28,830   (29,905
              

Net deferred tax asset

   $ 137      2,492   
              

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

As a result of losses in prior years, as of December 31, 2009 the Company has net operating loss carryforwards for tax purposes aggregating $68,529,000. These net operating loss carryforwards of $7,358,000, $33,950,000, $13,687,000, $633,000 and $12,901,000, if not utilized, will expire in 2020, 2021, 2022, 2023 and 2027, respectively. As of December 31, 2009, the tax benefit of the net operating loss carryforwards was $23,300,000, which is calculated by applying the Federal statutory income tax rate of 34% against the net operating loss carryforwards of $68,529,000. The Company does not record a tax valuation allowance relating to the net unrealized losses on investments, excluding common stocks, because it is more likely than not that these losses would reverse or be utilized in future periods. The Company has the ability and it is the Company’s intent to fully recover the principal, which could require the Company to hold these securities until their maturity; therefore, the Company considers the impairment to be temporary.

As of December 31, 2009 and 2008, the net deferred tax asset before valuation allowance were $28,967,000 and $32,397,000, and the valuation allowance were $28,830,000 and $29,905,000, respectively.

The Company recognized a current tax expense of $68,000 and $46,000 during 2009 and 2008 for the alternative minimum tax, respectively. The Company paid Federal income taxes of $60,000 in 2009. No Federal income taxes were paid in 2008.

 

(12) Shareholders’ Equity

A one-for-five reverse split of the Company’s Common Stock was approved by shareholders in May of 2009 and became effective in June of 2009. Each five shares of the Company’s outstanding Common Stock, par value $0.10 per share were converted into one share of Common Stock, par value $0.10 per share, and the number of authorized shares of Common Stock was reduced proportionately. At December 31, 2009, the Company has authorized 12,500,000 shares of Common Stock, of which 5,039,432 shares were issued and 4,782,898 shares were outstanding. At December 31, 2009, the Company held 256,534 shares as treasury stock.

As a result of the one-for-five reverse split of Common Stock in June 2009, the numbers of shares of Common Stock authorized, issued and outstanding at December 31, 2008 were retroactively adjusted to 12,500,000, 5,039,549 and 4,786,820, respectively. Treasury stock held at December 31, 2008 was retroactively adjusted to 252,729. At December 31, 2009 and 2008, Goff Moore Strategic Partners, LP (“GMSP”) owned approximately 34% of the outstanding Common Stock, Robert W. Stallings owned approximately 23% and James R. Reis owned approximately 12%.

The expiration date of GMSP’s Series B Warrant to purchase 77,500 shares of Common Stock for $41.52 per share (adjusted for the reverse stock split described above) is January 1, 2011.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

The following table reflects changes in the number of shares of common stock outstanding as of and for the years ended December 31, retroactively adjusted for the reverse stock split, as discussed above:

 

     2009     2008  

Shares outstanding

    

Balance at beginning of period

   4,786,820      5,001,870   

Stock issued

   —        15,332   

One-for-five reverse stock split

   (116   —     

Treasury stock acquired

   (3,806   (230,382
            

Balance at end of period

   4,782,898      4,786,820   
            

In November 2007, the Board of Directors of the Company authorized the repurchase of up to $5 million worth of the Company’s Common Stock. Repurchase may be made from time to time in both the open market and through negotiated transactions. The value of shares that may yet be purchased under the plan is $1,859,354.

The following table presents the statutory policyholders’ surplus for MGA as of December 31, 2009 and 2008, and the statutory net income for MGA for the year ended December 31, 2009 and 2008:

 

     2009    2008
     (Amounts in thousands)

Statutory policyholders’ surplus

   $ 96,112    89,811
           

Statutory net income

   $ 7,092    787
           

Statutes in Texas restrict the payment of dividends by MGA to earned surplus (surplus derived from net income less dividends paid and other statutory based adjustments), among other provisions. At December 31, 2009, earned surplus was $7,809,000. Dividends cannot be paid without regulatory notification of no objection from the Texas Department of Insurance.

The Company’s statutory capital exceeds the benchmark capital level under the Risk Based Capital (“RBC”) formula for its insurance companies. RBC is a method for establishing the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. As of December 31, 2009, the Company’s RBC authorized control level was $14,077,000 and the total adjusted capital was $96,112,000. This amounts to 6.8 times the minimum amount of RBC level as of December 31, 2009.

 

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Index to Financial Statements

GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

(13) Earnings Per Share

The following table sets forth the computation of basic and diluted loss per share (amounts in thousands, except for per share data):

 

     Years ended December 31,  
     2009    2008  

Numerator:

     

Net income (loss)

   $ 4,073.    (3,401

Numerator for basic earnings (loss) per share – income (loss) available to common shareholders

     4,073    (3,401
             

Numerator for diluted earnings (loss) per share – income (loss) available to common shareholders after assumed conversions

   $ 4,073    (3,401
             

Denominator:

     

Denominator for basic earnings (loss) per share – weighted average common shares outstanding

     4,785    4,883   
             

Denominator for diluted earnings (loss) per share – adjusted weighted average common shares outstanding & assumed conversions

     4,785    4,883   
             

Basic earnings (loss) per share

   $ .85    (.70
             

Diluted earnings (loss) per share (1)

   $ .85    (.70
             

 

  (1) Weighted average common shares for all periods presented have been retroactively adjusted for the reverse stock split in June 2009. Options can be exercised to purchase an aggregate of 15,801 shares of Common Stock, adjusted for the reverse stock split in June 2009. Warrants can be exercised to purchase an aggregate of 77,500 shares of Common Stock, adjusted for the reverse stock split in June 2009. Options and warrants are convertible or exercisable at prices in excess of the quoted market price of the Common Stock on December 31, 2009. Since options and warrants are convertible or exercisable at prices in excess of the quoted market price of the Common Stock on December 31, 2009, there are no incremental/dilutive shares assigned to these outstanding instruments.

 

(14) Benefit Plans

2005 Long-Term Incentive Compensation Plan (“2005 Plan”)

The 2005 Plan provides for a maximum of 404,000 shares of Common Stock to be available. There are two types of awards, restricted stock units (“RSU”) and restricted stock. The RSU awards are intended for key employees of the Company and are based on the completion of the related service period and the attainment of specific performance criteria. The fair value of the RSU and restricted stock awards is measured using the closing price of GAN’s Common Stock on the grant date, or if the grant has been subsequently modified, on the modification date, and is recognized as compensation expense over the vesting period of the awards in the Underwriting and operating expense line item, consistent with other compensation to these employees. The Company recognizes compensation expense for awards based on whether the related service period and performance period achievements are considered probable at the time of measurement and in accordance with the guidance in ASC 718-10-65. The 2005 Plan will terminate on December 31, 2010, unless it is terminated earlier by the Board, but awards outstanding on that date would continue in effect.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

Restricted Stock Units

The following table outlines the Company’s RSU activity for the years ended December 31, 2009 and 2008 (dollar amounts in thousands):

 

     2009     2008  
          Unrecognized          Unrecognized  
     RSU’s    Grant Date     RSU’s    Grant Date  
     Outstanding    Fair Value     Outstanding    Fair Value  

Beginning of Period

   243,600    $ 3,409      176,962    $ 6,631   

New awards

   —        66,638      983   

Change in assumptions, including forfeitures

   —        —        (4,061

Payments

   —        —        —        —     

Vested shares

   —        —        —        —     

Actual forfeitures

   20,000      (295   —        —     

Expense recognized

   —        (100   —        (144
                          

End of Period

   223,600    $ 3,014      243,600    $ 3,409   
                          

Under the 2005 Plan, 66,638 RSUs shown as granted during the third quarter of 2008 by the Compensation Committee could be awarded for results of the performance period ending December 31, 2010. The closing price of GAN’s Common Stock on the date of grant was $14.75 per share. The number of RSUs to be awarded will be estimated on a regular basis based on forecasts of expected future results for the performance period. During the fourth quarter of 2009, 20,000 of the RSU’s granted in 2005 had been terminated under provisions of the Plan and had become RSU’s available to be granted. As of December 31, 2009, the estimate of RSUs to be awarded under these grants is zero, as the performance period future results are not considered probable at this time. The actual number of RSUs to be awarded for the performance period may be less than the 66,638.

During the third quarter of 2008, the Company offered amendments to existing grantees that modified the terms of their previous agreements, defining a new performance period which would end on December 31, 2010 and with revised performance levels for the performance period. All the grantees accepted the amendments. The modifications resulted in a decrease in the unrecognized grant date fair value of such awards under the 2005 Plan of $4,061,000, as the fair value on the date of modification was significantly less than the previous fair value used.

For awards that have been modified, compensation expense is recognized if the award ultimately vests under the modified vesting conditions or would have vested under the original vesting conditions. As of December 31, 2009, no RSUs have vested. Vested RSUs remain outstanding until the completion of the full service period of the RSU awards, remain subject to the certification by the Compensation Committee, and, under certain circumstances, would be subject to forfeiture.

 

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Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

The following table summarizes RSUs outstanding and the unrecognized grant date fair value of such RSUs at December 31, 2009, for each award period (dollar amounts in thousands):

 

          Unrecognized
     RSU’s    Grant Date

Award Date and Cycle (performance period ends December 31, 2010 for all)

   Outstanding    Fair Value

RSU awards granted in 2005

   157,475    $ 2,043

RSU awards granted in 2006

   5,000      69

RSU awards granted in 2008

   61,125      902
           

Total at December 31, 2009

   223,600    $ 3,014
           

Restricted Stock

In November 2008, 10,200 shares of restricted stock were granted by the Board of Directors to non-employee directors, which are recognized as compensation expense over the vesting period of the restricted stock in the Underwriting and operating expense line item, consistent with other compensation to employees at a fair value of $9.95 per share based on the closing price of our Common Stock on the date of grant. These shares vest on the later of March 1, 2011, or the date on which the audit of the financial statements for 2010 is completed. In July 2007, 2,500 shares of restricted stock were granted to an officer of the Company by the Compensation Committee of the Board of Directors, at a fair value of $25.00 per share. Per the terms of the agreement, the shares were forfeited in the fourth quarter of 2009 as the officer was no longer employed by the Company. The related compensation cost for the restricted stock was recorded in the Underwriting and operating expenses line item, consistent with other compensation to this individual.

The following table outlines the Company’s restricted stock activity for the years ended December 31, 2009 and 2008 (dollar amounts in thousands):

 

     2009     2008  
     Restricted     Unrecognized     Restricted    Unrecognized  
     Stock     Grant Date     Stock    Grant Date  
     Outstanding     Fair Value     Outstanding    Fair Value  

Beginning of Period

   12,700      $ 134      2,500    $ 53   

New awards

   —          —        10,200      101   

Change in assumptions, including forfeitures

   —          —        —        —     

Payments

   —          —        —        —     

Vested shares

   —          —        —        —     

Actual forfeitures

   (2,500     (15   —        —     

Expense recognized

   —          (68   —        (20
                           

End of Period

   10,200      $ 51      12,700    $ 134   
                           

 

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Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

1998 Long-Term Incentive Plan (“98 Plan”)

At December 31, 2009, the Company had one plan under which options to purchase shares of GAN’s common stock could be granted. The 98 Plan will terminate in 2010, the aggregate number of shares of Common Stock that may be issued under the 98 Plan is limited to 50,000, and options to purchase 15,801 shares were outstanding under this Plan at December 31, 2009. There were no options granted during any of the periods presented.

A summary of the status of the Company’s outstanding options as of December 31, 2009 and 2008, and changes during the years ended December 31, 2009 and 2008 is presented below:

 

     2009    2008
           Weighted          Weighted
           Average          Average
     Underlying     Exercise    Underlying     Exercise
     Shares     Price    Shares     Price

Options outstanding, beginning of period

   15,830      $ 112.15    16,295      $ 112.05

Options forfeited

   (29   $ 110.00    (465   $ 110.00
                 

Options outstanding, end of period

   15,801      $ 112.14    15,830      $ 112.15
                 

Options exercisable at end of period

   15,801         15,830     
                 

Weighted average fair value of options granted during period

   N/A         N/A     

The following table summarizes information for the stock options and long-term incentive plan restricted stock and restricted stock units outstanding at December 31, 2009:

 

     (a)    (b)    (c)    (d)

Plan Category

   Number of
securities to be
issued upon

exercise of
outstanding options,

warrants and rights
   Weighted-average
exercise price

of outstanding
options,
warrants and
rights
   Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding those

reflected in column (a))
   Weighted-average
remaining
contractual life

of securities
to be issued
(from column (a))

Equity compensation plans approved by security holders

   183,239    $ 28.79    211,137    1 yrs

Equity compensation plans not approved by security holders

   —      $ —      —     
                   

Total

   183,239    $ 28.79    211,137    1 yrs
                   

The Company has a 401(k) plan for the benefit of its eligible employees. The Company made contributions to the plan that totaled $327,000 and $325,000 during 2009 and 2008, respectively.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

The Company entered into executive severance agreements with two executive officers, Richard M. Buxton and Daniel J. Coots. The agreements generally provide that the Company shall pay the executive, upon termination of the employment of the executive by the Company without cause or by the executive with good reason during the term of the agreement, a lump sum severance amount equal to the base annual salary of the executive as of the date that the executive’s employment with the Company ends. The executive severance agreements do not supersede change in control agreements or any other severance agreements the employees may have with the Company.

As an integral part of the recapitalization consummated in January 2005, the Company entered into new employment agreements with Messrs. Stallings and Reis and an amended employment and related agreements with Mr. Anderson, which were approved by shareholders on January 18, 2005.

The terms of the employment agreements with Messrs. Stallings and Reis are each three years, and each term is automatically extended by an additional year on the same terms and conditions on each anniversary of the effective date (so that, as of each anniversary of the effective date, the term of the employment agreement remains three years), unless either party gives notice of an intention not to extend the term. As of December 31, 2009, the terms and conditions of the employment agreements have been extended.

The term of Mr. Anderson’s employment is four years and is automatically extended by an additional year on the same terms and conditions on each anniversary of the effective date (so that, as of each anniversary of the effective date, the term of the employment agreement remains four years), unless either party gives notice of an intention not to extend the term. As of December 31, 2009, the terms and conditions of the employment agreement have been extended.

In connection with Mr. Anderson’s employment agreement, the Company granted in January of 2005 10,000 shares of Common Stock, which are fully vested, entered into a restricted stock agreement pursuant to which Mr. Anderson was issued an additional 20,000 shares of restricted Common Stock that vest and cease to be subject to forfeiture conditions as to 4,000 shares on each anniversary of the date of grant, and agreed to a revised change in control agreement to replace an agreement entered into when Mr. Anderson joined the Company in 1998.

 

(15) Segment Reporting

On February 7, 2002, the Company announced its decision to discontinue writing commercial lines insurance business due to continued adverse claims development and unprofitable results.

The Company makes operating decisions and assesses performance for the nonstandard personal auto lines segment and the runoff lines segment. The runoff lines segment was primarily commercial auto and general liability. The Company considers many factors in determining how to aggregate operating segments.

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

The following tables represent a summary of segment data as of and for the years ended December 31, 2009 and 2008:

 

     2009  
     Nonstandard                    
     Personal Auto     Runoff              
     Lines     Lines     Other     Total  
     (Amounts in thousands)  

Gross premiums written

   $ 179,571      —        —        179,571   
                          

Net premiums earned

   $ 184,950      261      —        185,211   

Net investment income

     2,726      171      3,780      6,677   

Realized investment gains (losses), net:

        

Other-than-temporary impairment losses

     —        —        (3,569   (3,569

Other-than-temporary impairment losses transferred to Other comprehensive loss

     —        —        3,141      3,141   

Other realized investment gains, net

     —        —        2,795      2,795   
                          

Total realized investment gains, net

     —        —        2,367      2,367   
                          

Agency revenues

     12,999      —        —        12,999   

Other expense, net

     (48   (391   —        (439

Expenses, excluding interest expense

     (193,960   1,908      (8,536   (200,588

Interest expense, net

     —        —        (2,086   (2,086
                          

Income (loss) before Federal income taxes

   $ 6,667      1,949      (4,475   4,141   
                          
     2008  
     Nonstandard                    
     Personal Auto     Runoff              
     Lines     Lines     Other     Total  
     (Amounts in thousands)  

Gross premiums written

   $ 181,849      —        —        181,849   
                          

Net premiums earned

   $ 176,634      (28   —        176,606   

Net investment income

     2,834      368      4,526      7,728   

Realized investment losses, net:

        

Other-than-temporary impairment losses

     —        —        (5,670   (5,670

Other-than-temporary impairment losses transferred to Other comprehensive loss

     —        —        —        —     

Other realized investment losses, net

     —        —        (643   (643
                          

Total realized investment losses, net

     —        —        (6,313   (6,313
                          

Agency revenues

     12,461      —        —        12,461   

Other (expense) income, net

     (26   71      7      52   

Expenses, excluding interest expense

     (183,149   564      (8,116   (190,701

Interest expense, net

     —        —        (3,188   (3,188
                          

Income (loss) before Federal income taxes

   $ 8,754      975      (13,084   (3,355
                          

 

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GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

(16) Commitments and Contingencies

Legal Proceedings

In the normal course of its operations, the Company is named as defendant in various legal actions seeking monetary damages, including cases involving allegations that the Company wrongfully denied claims and is liable for damages, in some cases seeking amounts significantly in excess of our policy limits. In the opinion of the Company’s management, based on the information currently available, the ultimate liability, if any, resulting from the disposition of these claims will not have a material adverse effect on the Company’s consolidated financial position or results of operations. However, in view of the uncertainties inherent in such litigation, it is possible that the ultimate cost to the Company might exceed the reserves we have established by amounts that could have a material adverse effect on the Company’s future results of operations, financial condition and cash flows in a particular reporting period.

Off-balance-sheet-risk

The Company does not have any financial instruments where there is off-balance-sheet-risk of accounting loss due to credit or market risk. There is credit risk in the premiums receivable and reinsurance balances receivable of the Company. At December 31, 2009 and 2008, the Company did not have any claims receivables by individual non-affiliated reinsurers that were material with regard to shareholders’ equity.

 

(17) Leases

The Company entered into a ten-year lease agreement for the home office in May of 2005. Under the terms of this lease, the Company has the option of terminating the lease agreement at the end of the fifth year of the term subject to payment of a penalty. The Company amended the lease in February 2007 to included additional office space of approximately 52,500 square feet. The following table summarizes the Company’s lease obligations as of December 31, 2009.

 

     Payments due by period
     Total    Less than
1 year
   2-3
years
   4-5
years
   More than
5 years
     (Amounts in thousands)

Total operating leases

   $ 8,236    2,719    2,758    2,071    688
                          

Rental expense is recognized over the term of the lease on a straight line basis. Rental expense for the Company was $1,910,000 and $1,780,000 for the years ended December 31, 2009 and 2008, respectively.

 

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Index to Financial Statements

GAINSCO, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

December 31, 2009 and 2008

 

(18) Related Parties

In December 2009, the Company entered into a Sponsorship Agreement with Stallings Capital Group Consultants, Ltd. dba Blackhawk Motorsports (“Stallings Racing”), continuing the Company’s role as the primary sponsor of a Daytona Prototype Series racing team through December 31, 2010. The Sponsorship Agreement provides that, in consideration of the payment by the Company of a sponsorship fee of $750,000, the Company will receive various benefits customary for sponsors of Daytona Prototype Series racing teams, including rights relating to signage on team equipment and access for customers and agents to certain race facilities. The sponsorship fee of $750,000 will be paid and expensed commencing January 1, 2010 and throughout the remainder of 2010. The related sponsorship fee will be recorded in the Underwriting and operating expenses line item, consistent with prior sponsorship payments. During 2009 and 2008, the Company paid and expensed $1.75 million, as the primary sponsor for Stallings Racing.

Stallings Racing is owned and controlled by Robert W. Stallings, the Executive Chairman of the Company. The Company’s Board of Directors authorized the agreement at a meeting in March 2008. In authorizing the agreement, the Board of Directors considered Mr. Stallings’ role and concluded that, under the circumstances, the Sponsorship Agreement is fair to, and in the best interests of, the Company. The Sponsorship Agreement contains provisions protecting the Company’s interests, including a termination provision that permits the Company to unilaterally terminate the agreement at any time and thereby cease making installment payments of the sponsorship fee.

 

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Index to Financial Statements

Schedule I

GAINSCO, INC. AND SUBSIDIARIES

Summary of Investments

 

     As of December 31,
     2009    2008
     (Amounts in thousands)
     Amortized    Fair    Amortized    Fair
     Cost    Value    Cost    Value

Type of investment

           

Fixed Maturities:

           

Bonds, available for sale:

           

U.S. Treasury

   $ 5,156    5,263    5,179    5,244

U.S. Government agencies

     7,058    6,983    2,998    3,011

Corporate bonds

     82,608    85,403    48,883    47,517

Asset backed bonds

     7,827    8,042    11,909    11,635

Mortgage backed bonds

     36,387    33,629    36,493    31,831

Bonds, trading

     323    323    —      —  

Preferred stocks

     4,947    4,235    8,868    7,781

Common stocks, available for sale

     466    551    278    277

Certificates of deposit

     185    185    255    255
                     
     144,957    144,614    114,863    107,551

Other long term investment

     1,068    1,068    1,850    1,850

Short-term investments

     42,289    42,315    65,820    65,801
                     

Total investments

   $ 188,314    187,997    182,533    175,202
                     

 

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Schedule II

CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT

GAINSCO, INC.

(PARENT COMPANY)

Balance Sheets

December 31, 2009 and 2008

(Amounts in thousands, except per share data)

 

     2009     2008  
Assets     

Investments in subsidiaries

   $ 100,428      91,432   

Bonds available for sale, at fair value (amortized cost: $503 – 2009, $682 – 2008)

     541      488   

Bonds trading, at fair value (amortized cost: $323 – 2009)

     323     

Preferred stocks, at fair value (amortized cost: $1,476 – 2009, $1,475 – 2008)

     1,237      633   

Common stocks, at fair value (amortized cost: $278 – 2009, $278 – 2008)

     359      277   

Short term investments, at fair value (amortized cost: $1,434 – 2009, $1,752 – 2008)

     1,434      1,752   

Cash

     61      223   

Accrued investment income

     12      12   

Receivables from subsidiaries

     42      78   

Deferred Federal income taxes (net of valuation allowance $5,053 – 2009, $5,250 – 2008)

     68      353   

Other assets

     1,950      2,136   

Goodwill

     609      609   
              

Total assets

   $ 107,064      97,993   
              
Liabilities and Shareholders’ Equity     

Liabilities:

    

Payable to subsidiaries

     61      —     

Note payable

     900      900   

Subordinated debentures

     43,000      43,000   

Other liabilities

     54      56   
              

Total liabilities

     44,015      43,956   
              

Shareholders’ equity:

    

Common stock ($.10 par value, 12,500,000 shares authorized, 5,039,432 shares issued and 4,782,898 shares outstanding at December 31, 2009, 5,039,549 shares issued and 4,786,820 shares outstanding at December 31, 2008*)

     504      2,519   

Additional paid-in capital

     154,072      151,740   

Accumulated deficit

     (87,166   (91,250

Accumulated other comprehensive loss

     (192   (4,839

Treasury stock, at cost (256,534 shares at December 31, 2009, 252,729 shares at December 31, 2008*)

     (4,169   (4,133
              

Total shareholders’ equity

     63,049      54,037   
              

Total liabilities and shareholders’ equity

   $ 107,064      97,993   
              

 

* share amounts retroactively adjusted for a one-for-five reverse stock split

See accompanying notes to financial statements.

The condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of GAINSCO, INC. and subsidiaries in this Annual Report.

 

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Schedule II

CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT

GAINSCO, INC.

(PARENT COMPANY)

Statements of Operations

Years ended December 31, 2009 and 2008

(Amounts in thousands, expect per share data)

 

     2009     2008  

Revenues:

    

Dividend income from subsidiaries

   $ 4,135      7,100   

Net investment income

     248      406   

Realized losses, net (note 2)

     (63   (493
              

Total revenues

     4,320      7,013   
              

Expenses:

    

Operating expense

     3,069      3,477   

Interest expense, net

     2,149      3,284   
              

Total expenses

     5,218      6,761   
              

Operating (loss) income

     (898   252   

(Loss) income before equity in undistributed income (loss)

     (898   252   

Equity in undistributed income (loss) of subsidiaries

     4,971      (3,653
              

Net income (loss)

   $ 4,073      (3,401
              

Income (loss) per share:

    

Basic

   $ .85      (.70
              

Diluted

   $ .85      (.70
              

Weighted average common shares outstanding:

    

Basic

     4,785      4,883   
              

Diluted

     4,785      4,883   
              

See accompanying notes to financial statements.

The condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of GAINSCO, INC. and subsidiaries in this Annual Report.

 

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Schedule II

CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT

GAINSCO, INC.

(PARENT COMPANY)

Statements of Shareholders’ Equity and Comprehensive Loss

Years ended December 31, 2009 and 2008

(Amounts in thousands)

 

     2009    2008  

Common stock:

         

Balance at beginning of year

   $ 2,519         2,512     

Issuance of restricted common stock

     —           7     

Reverse stock split

     (2,015      —       
                   

Balance at end of year

   $ 504         2,519     
                   

Additional paid-in capital:

         

Balance at beginning of year

   $ 151,740         151,451     

Issuance of restricted common stock

     —           (7  

Reverse stock split

     2,015         —       

Stock-based compensation expense

     217         152     

Accrual of restricted stock units

     100         144     
                   

Balance at end of year

   $ 154,072         151,740     
                   

Accumulated deficit:

         

Balance at beginning of year

   $ (91,250      (86,490  

Correction of an immaterial error

     —           (1,359  

Cumulative impact of adoption of ASC 320-10-65, net of tax

     11         —       

Net income (loss)

     4,073      $ 4,073    (3,401   (3,401
                   

Balance at end of year

   $ (87,166      (91,250  
                   

Accumulated other comprehensive loss:

         

Balance at beginning of year

   $ (4,839      (489  

Cumulative impact of adoption of ASC 320-10-65, net of tax

     (11      —       

Other comprehensive income (loss)

     4,658        4,658    (4,350   (4,350
                           

Comprehensive income (loss)

     $ 8,731      (7,751
                 

Balance at end of year

   $ (192      (4,839  
                   

Treasury stock:

         

Balance at beginning of year

   $ (4,133      (947  

Purchase of treasury stock

     (36      (3,186  
                   

Balance at end of year

   $ (4,169      (4,133  
                   

Total shareholders’ equity end of year

   $ 63,049         54,037     
                   

See accompanying notes to financial statements.

The condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of GAINSCO, INC. and subsidiaries in this Annual Report.

 

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Schedule II

CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT

GAINSCO, INC.

(PARENT COMPANY)

Statements of Cash Flows

Years ended December 31, 2009 and 2008

(Amounts in thousands, except per share data)

 

     2009     2008  

Cash flows from operating activities:

    

Net income (loss)

   $ 4,073      (3,401

Adjustments to reconcile net income (loss) to cash (used for) provided by operating activities:

    

Equity in undistributed (income) loss of subsidiaries

     (4,971   3,653   

Depreciation/amortization

     61      54   

Other-than-temporary impairment of investments

     —        459   

Non-cash compensation expense

     317      296   

Realized losses (excluding other-than-temporary impairments)

     157      34   

Realized gains on trading securities

     (94   —     

Change in operating assets and liabilities:

    

Accrued investment income

     —        41   

Net receivables from/payable to subsidiaries

     97      (190

Other assets

     116      (18

Other liabilities

     (2   (61
              

Net cash (used for) provided by operating activities

   $ (246   867   
              

(continued)

 

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Schedule II

CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT

GAINSCO, INC.

(PARENT COMPANY)

Statements of Cash Flows

Years ended December 31, 2009 and 2008

(Amounts in thousands, except per share data)

 

     2009     2008  
     (Amounts in thousands)  

Cash flows from investing activities:

    

Bonds available for sale sold

   $ 250      2,633   

Bonds available for sale purchased

     (50   (222

Bonds trading sold

     277      —     

Bonds trading purchased

     (451   —     

Preferred stocks sold

     162      —     

Preferred stocks purchased

     (268   (998

Common stocks sold

     —        68   

Common stocks trading sold

     195      —     

Common stock trading purchased

     (289   —     

Net change in short term investments

     294      2,039   
              

Net cash provided by investing activities

     120      3,520   
              

Cash flows from financing activities:

    

Principal payment on note payable

     —        (1,000

Purchase of treasury stock

     (36   (3,186
              

Net cash used for financing activities

     (36   (4,186
              

Net increase (decrease) in cash

     (162   201   

Cash at beginning of year

     223      22   
              

Cash at end of year

   $ 61      223   
              

Supplemental disclosures of cash flow information:

25,664 shares of common stock were issued during 2008, relating to restricted stock unit agreements (note 14).

$2,148 and $3,325 in interest was paid during 2009 and 2008, respectively (notes 6 and 7).

$60 in income tax payments were made during 2009. No income tax payments were made during 2008 (note 11).

See accompanying notes to financial statements.

The condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of GAINSCO, INC. and subsidiaries in this Annual Report.

 

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Index to Financial Statements

Schedule II

CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT

GAINSCO, INC.

(PARENT COMPANY)

Notes to Condensed Financial Statements

December 31, 2009 and 2008

 

(1) General

The accompanying condensed financial statements should be read in conjunction with the notes to the consolidated financial statements for the years ended December 31, 2009 and 2008 included elsewhere in this Annual Report.

 

(2) Investments

Proceeds from the sale of bonds available for sale securities totaled $250,000 in 2009 and $2,633,000 in 2008. Proceeds from the sale of bonds trading securities totaled $277,000 in 2009. Proceeds from the sale of preferred stocks totaled $162,000 in 2009. There were no sales of preferred stock in 2008. Proceeds from the sale of common stock totaled $68,000 in 2008. There were no sales of common stock in 2009. Proceeds from the sale of common stock trading totaled $195,000 in 2009.

Realized gains and losses on investments for the years ended December 31, 2009 and 2008 are presented in the following table:

 

     Years ended December 31,  
     2009     2008  
     (Amounts in thousands)  

Realized gains:

    

Bonds, available for sale

   $ 12      58   

Bonds, trading

     258      —     

Preferred stocks

     2      —     
              

Total realized gains

     272      58   
              

Realized losses:

    

Bonds, available for sale

     —        (87

Bonds, trading

     (109   —     

Preferred stocks

     (108   —     

Common stocks, available for sale

     —        (5

Common stocks, trading

     (94   —     

Short-term investments

     (24   —     
              

Total realized losses

     (335   (92
              

Other-than-temporary impairment losses

     —        (459
              

Net realized losses

   $ (63   (493
              

 

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Schedule II

CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT

GAINSCO, INC.

(PARENT COMPANY)

Notes to Condensed Financial Statements

December 31, 2008 and 2007

During the third quarter of 2008, the Company wrote down $17,000 in securities that were determined to have had an other-than-temporary impairment (OTTI). During the fourth quarter of 2008, the Company wrote down $442,000 in securities that were determined to have had an other-than-temporary decline in market value and this was recorded as a realized loss, including $317,000 on two closed end mutual funds comprised primarily of preferred stock. The Company considered these securities to be OTTI because of the magnitude of the decline in both net asset value and market value, the decline in the net investment income and weakness in the sectors of the underlying assets.

 

(3) Related Parties

During 2009 and 2008, there were no contributions to the capital of the insurance company.

The following table presents the components of the net receivable from and payable to subsidiaries at December 31, 2009 and 2008:

 

     2009     2008
     (Amounts in thousands)
Name of subsidiary     

MGA Insurance Company, Inc.

   $ (61   6

GAINSCO Service Corp

     42      72
            

Net (payable to) receivable from subsidiaries

   $ (19   78
            

 

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Schedule III

GAINSCO, INC. AND SUBSIDIARIES

Supplementary Insurance Information

Years ended December, 2009 and 2008

(Amounts in thousands)

 

                                          Amortization            
     Deferred    Reserves                               of deferred    Other       
     policy    for claims              Net     Net    Claim     policy    operating    Net  
     acquisition    and claim    Unearned    Drafts    premiums     investment    and claim     acquisition    costs and    premiums  

Segment

   costs (1)    expenses    premiums    payable    earned     income    expenses     costs (2)    expenses (3)    written  

Year ended December 31, 2009:

                           

Nonstandard personal auto

   $ 6,438    69,425    41,305    43    184,950      2,726    139,344      29,729    24,888    177,773   

Runoff lines

     —      5,943    —      —      261      171    (2,057   —      149    261   
                           

Other

     —      —      —      —      —        3,780    —        —      10,622    —     
                                                       

Total

   $ 6,438    75,368    41,305    43    185,211      6,677    137,287      29,729    35,659    178,034   
                                                       

Year ended December 31, 2008:

                           

Nonstandard personal auto

   $ 7,850    65,951    48,482    77    176,634      2,834    130,983      29,335    22,831    180,574   

Runoff lines

     —      9,531    —      —      (28   368    (1,421   —      857    (28
                             

Other

     —      —      —      —      —        4,526    —        —      11,353    —     
                                                       

Total

   $ 7,850    75,482    48,482    77    176,606      7,728    129,562      29,335    35,041    180,546   
                                                       

 

(1) Net of deferred ceding commission income.
(2) Net of the amortization of deferred ceding commission income.
(3) Includes Corporate underwriting and operating expenses and interest expense, net, also includes insurance company underwriting and operating expenses.

 

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Index to Financial Statements

Schedule IV

GAINSCO, INC. AND SUBSIDIARIES

Reinsurance

Years ended December 31, 2009 and 2008

(Amounts in thousands, except percentages)

 

                          Percentage  
          Ceded to     Assumed         of amount  
     Direct    other     from other    Net    assumed  
     amount    companies     companies    amount    to net  

Year ended December 31, 2009:

             

Premiums earned:

             

Property and casualty

   $ 180,657    —        —      180,657   

Reinsurance

     —      (1,537   6,091    4,554   
                         

Total

   $ 180,657    (1,537   6,091    185,211    3.3
                             

Year ended December 31, 2008:

             

Premiums earned:

             

Property and casualty

   $ 164,128    —        —      164,128   

Reinsurance

     —      (1,303   13,781    12,478   
                         

Total

   $ 164,128    (1,303   13,781    176,606    7.8
                             

 

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Index to Financial Statements

Schedule VI

GAINSCO, INC. AND SUBSIDIARIES

Supplemental Information

Years ended December 31, 2009 and 2008

(Amounts in thousands)

 

                                    Claims and claim
adjustment
expenses incurred
related to
                 
               Reserves                                   
               for unpaid                      Amortization    Paid       
          Deferred    claims                      of deferred    claims and       
     Affiliation    policy    and claim         Net     Net      policy    claim    Net  
     with    acquisition    adjustment    Unearned    earned     investment    Current    Prior     acquisition    adjustment    premiums  

Segment

   registrant    costs (1)    expenses    premiums    premiums     income    year    year     costs (2)    expenses    written  

Year ended December 31, 2009

                              

Nonstandard personal auto

   $ —      6,438    69,425    41,305    184,950      2,726    144,211    (4,867   29,729    135,872    177,773   

Runoff lines

     —      —      5,943    —      261      171    —      (2,057   —      1,946    261   

Other

     —      —      —      —      —        3,780    —      —        —      —      —     
                                                            

Total

   $ —      6,438    75,368    41,305    185,211      6,677    144,211    (6,924   29,729    137,818    178,034   
                                                            

Year ended December 31, 2008

                              

Nonstandard personal auto

   $ —      7,850    65,951    48,482    176,634      2,834    126,598    4,385      29,335    120,731    180,574   

Runoff lines

     —      —      9,531    —      (28   368    —      (1,421   —      1,754    (28

Other

     —      —      —      —      —        4,526    —      —        —      —      —     
                                                            

Total

   $ —      7,850    75,482    48,482    176,606      7,728    126,598    2,964      29,335    122,485    180,546   
                                                            

 

(1) Net of deferred ceding commission income.
(2) Net of the amortization of deferred ceding commission income.

 

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