ALPS Corporation and Subsidiaries Consolidated Financial Statements (With Independent Auditor s Report Thereon) December 31, 2014 and 2013
Contents Independent Auditor s Report 1 Financial Statements Consolidated balance sheets 2-3 Consolidated statements of operations and comprehensive income 4 Consolidated statements of changes in stockholders equity 5 Consolidated statements of cash flows 6-7 Notes to consolidated financial statements 8-29
Independent Auditor s Report To the Board of Directors ALPS Corporation and Subsidiaries Missoula, Montana Report on the Financial Statements We have audited the accompanying consolidated financial statements of ALPS Corporation and Subsidiaries, which comprise the consolidated balance sheets as of December 31, 2014 and 2013; the related consolidated statements of operations and comprehensive income, changes in stockholders equity, and cash flows for the years then ended; and the related notes to the consolidated financial statements. Management s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditor s Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ALPS Corporation and Subsidiaries as of December 31, 2014 and 2013, and the results of their operations and their cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America. Omaha, Nebraska April 24, 2015 1
Consolidated Balance Sheets December 31, 2014 and 2013 Assets 2014 2013 Investments: Investments in securities available for sale, at fair value: Fixed maturities $ 76,895,689 $ 68,115,055 Equity securities 8,586,337 12,931,878 Total investments 85,482,026 81,046,933 Cash and cash equivalents 9,846,481 8,383,768 Accrued interest receivable 1,053,648 1,001,817 Accounts receivable 742,923 1,292,620 Premiums receivable 3,276,663 4,012,510 Income tax receivable 92,898 - Reinsurance recoverable 40,553,458 38,308,578 Prepaid expenses 223,910 166,415 Deferred acquisition costs 388,375 411,542 Current income taxes recoverable 220,703 - Deferred tax assets 3,864,903 3,868,035 Property and equipment, net 8,121,618 7,963,823 Other invested assets, including discontinued operations available for sale 1,361,888 2,800,396 Deferred surplus note fees 21,308 49,217 Total assets $ 155,250,802 $ 149,305,654 See. 2
Liabilities and Stockholders Equity 2014 2013 Liabilities Loss and loss adjustment expense reserves $ 75,911,727 $ 70,984,594 Unearned premiums 22,333,067 22,383,450 Reinsurance payable 2,524,094 3,209,973 Accounts payable and accrued expenses 4,723,789 4,510,904 Current income tax payable - 406,454 Surplus notes 11,346,358 11,352,677 Long-term debt 7,260,862 7,726,048 Total liabilities 124,099,897 120,574,100 Commitments and Contingencies Stockholders Equity Common stock, $1 par; 5,000,000 shares authorized, issued and outstanding 2,011,363 1,993,130 Additional paid-in-capital 14,579,421 14,334,789 Retained earnings 25,541,523 22,977,491 Treasury stock (13,192,746) (11,238,690) Accumulated other comprehensive income, net of tax 2,211,344 664,834 Total stockholders equity 31,150,905 28,731,554 Total liabilities and stockholders equity $ 155,250,802 $ 149,305,654 3
Consolidated Statements of Operations and Comprehensive Income For the Years Ended December 31, 2014 and 2013 2014 2013 Revenues: Premiums earned $ 42,733,026 $ 41,579,849 Premiums ceded (14,225,789) (13,710,796) Net premiums earned 28,507,237 27,869,053 Investment income, net 4,293,418 3,950,146 Realized gain on sale of investments 42,285 17,577 Other revenue 2,595,235 2,681,809 Total revenues 35,438,175 34,518,585 Expenses: Losses and loss adjustment expense 27,367,334 30,821,278 Reinsurance recoveries (8,422,052) (13,104,938) Net losses and loss adjustment expenses 18,945,282 17,716,340 Underwriting expenses 1,277,909 2,493,874 Other operating expenses 12,208,797 10,088,061 Total expenses 32,431,988 30,298,275 Income before income taxes 3,006,187 4,220,310 Provision for income taxes: Current provision 1,202,719 647,835 Deferred provision (benefit) (829,651) 1,063,287 Total income tax provision 373,068 1,711,122 Net income from continuing operations 2,633,119 2,509,188 Discontinued operations: Income (loss) from operations of First Lawyers Trust Company 47,372 (101,153) Income tax expense (benefit) 17,221 (123,689) Income on discontinued operations 30,151 22,536 Net income 2,663,270 2,531,724 Other comprehensive income (loss) (net of tax): Net unrealized (loss) gain on marketable securities, net of tax 1,504,225 (2,138,510) Reclassification adjustment for net realized gain (loss) included in net income, net of tax 42,285 17,577 Total other comprehensive income (loss) 1,546,510 (2,120,933) Total comprehensive income $ 4,209,780 $ 410,791 See. 4
Consolidated Statements of Changes in Stockholders Equity For the Years Ended December 31 2014 and 2013 Accumulated Additional Other Less: Total Common Stock A Common Stock B Paid-In Retained Comprehensive Treasury Stock, at Cost Stockholders Shares Amount Shares Amount Capital Earnings Income Shares Amount Equity Balance, December 31, 2012 1,988,046 $ 1,988,046 4,835 $ 4,835 $ 14,334,789 $ 20,556,775 $ 2,785,767 576,457 $ (10,265,393) $ 29,404,819 Stock redemption - - - - - (111,008) - 51,453 (973,297) (1,084,305) Stock issuance - - 249 249 - - - - - 249 Unrealized loss, net of tax - - - - - - (2,120,933) - - (2,120,933) Net income - - - - - 2,531,724 - - - 2,531,724 Balance, December 31, 2013 1,988,046 1,988,046 5,084 5,084 14,334,789 22,977,491 664,834 627,910 (11,238,690) 28,731,554 Stock redemption - - - - - (99,238) - 94,844 (1,954,056) (2,053,294) Stock issuance 17,776 17,776 457 457 244,632 - - - - 262,865 Unrealized loss, net of tax - - - - - - 1,546,510 - - 1,546,510 Net income - - - - - 2,663,270 - - - 2,663,270 Balance, December 31, 2014 2,005,822 $ 2,005,822 5,541 $ 5,541 $ 14,579,421 $ 25,541,523 $ 2,211,344 722,754 $ (13,192,746) $ 31,150,905 See. 5
Consolidated Statements of Cash Flows For the Years Ended December 31, 2014 and 2013 2014 2013 Cash Flows From Operating Activities Net income $ 2,663,270 $ 2,531,724 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 580,140 509,576 Bond amortization or accretion 249,104 308,014 Deferred tax provision (benefit) (829,605) 1,246,498 Loss (gain) on sale of investments (42,285) (17,577) Realized loss (gain) on other invested assets (23,169) 87,059 Changes in operating assets and liabilities: Accrued interest receivable (51,831) (51,639) Accounts receivable 632,518 (767,337) Premiums receivable 735,847 384,528 Reinsurance recoverable (2,244,880) (5,192,329) Income tax payable (245,089) 154,231 Current income tax receivable (220,703) - Prepaid expenses (58,177) 61,851 Deferred acquisition costs 23,167 (5,566) Deferred surplus note fees 27,905 27,906 Loss and loss adjustment expense reserve 4,927,134 2,969,963 Unearned premiums (50,384) 1,493,793 Reinsurance payable (685,879) 839,595 Accounts payable and accrued expenses 239,206 752,343 Other (35,699) 3,092 Net cash provided by operating activities 5,590,590 5,335,725 Cash Flows From Investing Activities Purchase of property and equipment (737,935) (269,223) Purchase of fixed maturities (16,659,288) (22,004,431) Purchase of equity securities (5,682,534) (2,887,299) Proceeds from other invested assets 23,169 - Proceeds from sale of fixed maturities 11,296,845 15,400,765 Proceeds from sale of equity securities 8,775,773 2,899,404 Proceeds from payments on mortgage loans 1,079,815 2,496 Net cash used in investing activities (1,904,155) (6,858,288) (Continued) 6
Consolidated Statements of Cash Flows (Continued) For the Years Ended December 31, 2014 and 2013 2014 2013 Cash Flows From Financing Activities Payment of long-term debt (465,188) (385,726) Payment of surplus notes (6,318) (61,581) Surplus payments (99,238) (111,008) Stock redeemed (1,954,056) (973,297) Issuance of stock 262,865 249 Net cash used in financing activities (2,261,935) (1,531,363) Net change in cash and cash equivalents 1,424,500 (3,053,926) Cash and Cash Equivalents Beginning of year 8,472,955 11,526,881 End of year $ 9,897,455 $ 8,472,955 Cash and Cash Equivalents Cash from continuing operations $ 9,846,481 $ 8,383,768 Cash from discontinued operations $ 50,974 $ 89,187 Cash paid for interest $ 793,763 $ 850,975 Cash paid for taxes $ 759,000 $ 186,703 Noncash Financing Activities Increase (decrease) in surplus notes $ - $ 973,297 See. 7
Note 1. Nature of Operations and Summary of Significant Accounting Policies Principles of consolidation: ALPS Corporation (the Company) is a stock corporation and parent holding company organized under Montana law. ALPS Corporation owns 100 percent of the outstanding shares of each of the following entities: (i) ALPS Property & Casualty Insurance Company (ALPS P&C), d.b.a. Attorneys Liability Protection Society, A Risk Retention Group, a Montana domestic stock insurer that underwrites lawyers professional liability insurance on a claims-made basis; (ii) Peak Investment Management, Ltd. (Peak), a Montana corporation that operates as a registered investment management company; (iii) ALPS Risk and Insurance Services, Inc. (ARIS), a Montana corporation that provides startup, management, administrative and support services to captive insurers and other alternative risk transfer entities; (iv) ALPS Insurance Agency (AIA), a Montana corporation that provides insurance underwriting, claims adjusting, insurance producer and other insurance-related services; and (v) First Lawyers Trust Company (FLTC), a South Dakota chartered nondepository trust company providing trust administration services. ALPS P&C is a Montana corporation, admitted in and regulated by the State of Montana as a casualty insurance company. ALPS P&C issues policies of professional liability insurance, employment practices liability insurance, and cyber risk liability insurance to attorneys and law firms. From the date it commenced business on March 1, 1988, until 2013, ALPS P&C was structured and operated exclusively as a risk retention group pursuant to the provisions of the federal Liability Risk Retention Act (LRRA). As of December 31, 2014, ALPS P&C was licensed as an admitted insurer and holds a Certificate of Authority (COA) in the following jurisdictions (in addition to its state of domicile, Montana): Alaska, Arizona, Arkansas, Colorado, Delaware, District of Columbia, Georgia, Hawaii, Idaho, Indiana, Kansas, Maine, Maryland, Michigan, Mississippi, Missouri, Nebraska, Nevada, New Hampshire, New Mexico, North Carolina, North Dakota, Rhode Island, South Carolina, South Dakota, Tennessee, Utah, Vermont, Washington, West Virginia, Wisconsin, Wyoming and the U.S. Virgin Islands. As of December 31, 2014, ALPS P&C remained registered to do business as a risk retention group in Connecticut, Illinois, Iowa, Massachusetts, Minnesota, New York, Pennsylvania, Virginia and the Northern Mariana Islands. At the end of 2014, the Company identified potential buyers interested in purchasing FLTC. The Company hired an independent firm to perform a valuation analysis. The purchase process is ongoing, and thus, the investment has been classified as available-for-sale. The accompanying consolidated financial statements are presented on a comparative basis showing the consolidated balance sheets of ALPS Corporation and its wholly owned subsidiaries as of December 31, 2014 and 2013, and the related consolidated statements of operations and comprehensive income, changes in stockholders equity, and cash flows for the years then ended. All significant intercompany accounts and transactions have been eliminated. On a consolidated basis, ALPS P&C represents the principal business operations of ALPS Corporation and its wholly owned subsidiaries. Cash and cash equivalents: For purposes of the Company s consolidated statements of cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. The Company maintains its cash in bank accounts that at times may exceed federally insured limits. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents 8
Note 1. Nature of Operations and Summary of Significant Accounting Policies (Continued) Other invested assets: Other invested assets consist of a minority interest in an Arizona limited liability company (LLC), a discontinued and available-for-sale subsidiary, and mortgage receivables. At December 31, 2014 and 2013, mortgage receivables totaled $-0- and $1,079,815, respectively. At December 31, 2014 and 2013, the Company s minority interest in the Arizona LLC and discontinued operations totaled $1,361,888 and $2,800,396, respectively. Investments: The Company s investments have been designated as available-for-sale and are reported at fair value, with the net unrealized appreciation (depreciation) and other-than-temporary impairments determined to be noncredit-related included in comprehensive income, net of deferred income taxes, and accumulated other comprehensive income in stockholders equity. Fair value is based on an exit price, which is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company employs a hierarchal disclosure framework, which prioritizes and ranks the level of market price observability used in measuring financial instruments at fair value. Market price observability is affected by a number of factors, including the type of instrument and the characteristics specific to the instrument. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of market price observability and a lesser degree of judgment used in measuring fair value. Investment in a limited partnership is carried at the fair value of the underlying equity investments, measured as the Company s percentage of ownership of the underlying assets. Investment in common stock is carried at the fair value. Unrealized gains or losses estimated to be temporary in nature and other-than-temporary impairments determined to be noncredit-related, net of deferred taxes, are reported directly in stockholders equity as accumulated other comprehensive income or loss. Declines in the fair value of invested assets are reviewed on a quarterly basis to assess whether any other-than-temporary impairment loss should be recorded. Evidence considered in this assessment includes the reasons for the impairment, the severity and duration of the impairment, changes in value subsequent to period-end, forecasted performance of the investee, and the general market condition in the geographic area or industry the investee operates in. For debt securities with unrealized losses due to market conditions or industry-related events and where no specific evidence of deterioration of the issuers credit exists, if the Company does not intend to sell the debt security and it is more likely than not the Company will not be required to sell the security before a market recovery or maturity, other-thantemporary impairments are not recorded. For equity securities, the Company considers the severity of impairment, duration of impairment, forecasted recovery period, industry outlook, financial condition of the issuer, projected cash flows, issuer credit ratings, and the intent and ability of the Company to hold the investment until the recovery of the cost. For equity securities that are deemed to have an other-thantemporary impairment, the loss is recorded in net income. If the Company intends to sell a debt security or it is more likely than not that the Company would be required to sell a security before the recovery of its amortized cost, the Company records an other-thantemporary impairment and divides the loss between credit and noncredit. The Company recognizes the credit loss portion in net income and the noncredit loss portion in other comprehensive income and accumulated other comprehensive income. The credit loss portion is determined by comparing the net present value of projected future cash flows with the amortized cost basis of the debt security. The net present value is calculated using the Company s best estimate of the projected future cash flows at the effective interest rate implicit in the debt security at the date of acquisition. 9
Note 1. Nature of Operations and Summary of Significant Accounting Policies (Continued) The cost of investments sold is based on the specific identification method. Investment income is recognized as earned. Bond premiums and discounts are amortized by the scientific-yield method and are charged or credited to net investment income. For mortgage-backed securities, the Company anticipates prepayments utilizing published data when applying interest income. In accounting for mortgage-backed securities, the Company uses the prospective method. Recognition of insurance premiums, revenues and costs: All insurance-related revenues, benefits and expenses are reported net of reinsurance. Ceded reinsurance amounts with reinsurers relating to reinsurance recoverables for paid and unpaid loss and loss adjustment expenses are reported on the consolidated balance sheet on a gross basis. The cost of reinsurance ceded is generally amortized over the contract periods of the underlying policies. Premiums are recognized as revenue ratably over the terms of the respective policies. Unearned premiums are calculated on the daily pro rata method. Premiums receivable from policyholders are recorded at cost with no allowance provided, as policies are monitored and canceled before their unearned premium is greater than any corresponding finance balance. The Company provides insureds with an extended reporting endorsement at no additional charge in the event of the insured s death, permanent disability, or retirement. The retirement provision requires the insured to be a policyholder of the Company for at least one full year at mature premium rates and be covered by claims-made insurance policies for three years immediately preceding retirement. Policyholders not eligible to receive the extended reporting endorsement at no additional charge may purchase this endorsement. Insurance liabilities: The liability for incurred but unpaid losses and loss adjustment expense represents estimates of the ultimate cost of losses and the cost to process those losses. The estimated ultimate cost of the losses is intended to provide for outstanding case-basis reserves on known claims, future development of those case-basis reserves, and incurred but not reported (IBNR) claims. Such estimates are made without regard to the time value of money. The Company estimates IBNR reserves by applying sound actuarial standards and loss development factors to historical claims experience. Liabilities for unpaid losses and loss adjustment expenses are necessarily based on assumptions and estimates. While management believes the reported reserve amount is adequate, the ultimate liability may be in excess of or less than the reserve amount reported. The methods for making such estimates and recognizing the liability for unpaid losses and loss adjustment expenses are continually reviewed, and any adjustments are reflected in the period determined. Reinsurance: In the normal course of business, the Company seeks to reduce its exposure to the risk of loss that may arise from unfavorable underwriting results by transferring a portion of this risk to other insurance enterprises or insurers. The Company records amounts recoverable from its reinsurers on paid losses plus an estimate of amounts recoverable on unpaid losses. The estimate of amounts recoverable on unpaid losses is a function of the Company s liability for unpaid losses associated with the reinsured policies; therefore, the amount changes in conjunction with any changes to the Company s estimate of unpaid losses. Since the estimate of amounts recoverable from reinsurers on unpaid losses may change at any point in the future because of its relation to the Company s reserves for unpaid losses, a reasonable possibility exists that this estimate may change significantly in the near term from the amounts included in the consolidated financial statements. 10
Note 1. Nature of Operations and Summary of Significant Accounting Policies (Continued) Deferred policy acquisition costs: Certain costs related to the acquisition of insurance contracts have been deferred. Such costs are being amortized as the associated premium revenue is earned. The Company capitalizes only incremental costs directly related to the successful acquisition of new or renewal insurance contracts. Accordingly, acquisition costs consist of commissions and premium taxes of insurance policies that are successfully issued. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned and certain other costs expected to be incurred as the premium is earned. Discontinued operations: The Company reports the results of operations of a business as discontinued operations if the business is classified as held for sale, or being liquidated and disposed. The operations and cash flows of the business have been or will be eliminated from the ongoing operations of the Company as a result of disposal transactions, and the Company will not have any significant continuing involvement in the operations of the business after the disposal transaction. The results of discontinued operations are reported in the discontinued operations in the consolidated statement of operations and comprehensive income for the current and prior periods commencing in the period in which the business is either disposed of or is classified as held for sale, including any gain or loss recognized on closing or adjustment of the carrying amount to fair value less cost to sell. Property and equipment: Property and equipment are recorded at cost less accumulated depreciation. Depreciation is provided using straight-line and accelerated methods based upon the assets useful lives. Costs incurred for normal repairs and maintenance are expensed as incurred. Impairment of long-lived assets: Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets is measured by a comparison of the carrying amount of an asset to future undiscounted cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Income taxes: Deferred income tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the enacted marginal tax rate. Deferred income tax expenses or credits are based on the changes in the asset or liability from period to period. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The Company has not established any liabilities for uncertain tax positions taken or positions expected to be taken on income tax returns. The Company would establish such liabilities when such positions are judged to not meet the more likely than not threshold based on the technical merits of the positions. Estimated interest and penalties related to uncertain tax positions are included as a component of income tax expense. With few exceptions, the Company is no longer subject to examinations by federal tax authorities before 2010, and Montana, Virginia and Ohio state tax authorities before 2007. Receivables: The Company grants credit to customers and agents as part of the normal course of business. Management determines the allowance for doubtful customer accounts based on specific customer balances and industry and economic conditions. Premiums that are financed are charged an interest rate of 8 percent annually. 11
Note 1. Nature of Operations and Summary of Significant Accounting Policies (Continued) Advertising costs: Advertising costs are expensed when incurred, and for 2014 and 2013 were $234,462 and $258,374, respectively. Risks and uncertainties: Certain risks and uncertainties are inherent to the Company s day-to-day operations and to the process of preparing its consolidated financial statements. The more significant of those risks and uncertainties, as well as the Company s methods for mitigating the risks, are presented below and throughout the notes to the consolidated financial statements. The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities. For example, significant estimates and assumptions are utilized in the valuation of investments, amortization of deferred policy acquisition costs, valuation of allowances for deferred income tax assets and doubtful accounts, and calculation of loss and loss adjustment expenses. It is reasonably possible that actual experience could differ from the estimates and assumptions utilized, which could have a material impact on the consolidated financial statements. Reinsurance contracts do not relieve the Company from its obligations to reinsureds. Failure of reinsurers to honor their obligations could result in losses to the Company; consequently, allowances are established for amounts deemed uncollectible. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. Management believes that any liability arising from this contingency would not be material to the Company s financial position. The Company is exposed to risks that issuers of securities owned by the Company will default or that interest rates will change and cause a decrease in the value of its investments. With mortgage-backed securities, the Company is also exposed to prepayment risk, default risks on the underlying mortgages and devaluation of the underlying collateral. As interest rates decline, the velocity at which these securities pay down the principal will increase. Management mitigates these risks by conservatively investing in highgrade securities and by matching maturities of its investments with the anticipated payouts of its liabilities. The Company estimates loss and loss adjustment expenses based on the accumulation of case estimates for direct claims and incidents reported, net of applicable policy deductibles and deduction of amounts for reinsurance ceded on reported claims and incidents. The liability for loss adjustment expenses (LAE) is provided by estimating future expenses to be incurred in settlement of the claims provided for in the reserve for losses, net of reinsurance ceded. Actual results could differ from these estimates. ALPS P&C is highly regulated by the state in which it is domiciled, as well as states in which it does business. Such regulations, among other things, limit the amount of dividends and impose restrictions on the amount and types of investments. The Company may also be required to seek state approval for rates for policies written in each respective state. Certain states may impose restrictions on the amount of rate increases the Company seeks on policies written in that state. The impact of regulatory initiatives in response to the recent financial crisis, including the Dodd-Frank Wall Street Reform and Consumer Protection Act, could subject the Company to substantial additional regulation. 12
Note 1. Nature of Operations and Summary of Significant Accounting Policies (Continued) The National Association of Insurance Commissioners (NAIC) has developed risk-based capital (RBC) standards for property and casualty that relate an insurer s reported statutory capital and surplus to the risks inherent in its overall operations. The RBC formula uses the statutory annual statement to calculate the minimum indicated capital level to protect the Company from the various risks that it faces. The NAIC model law calls for various levels of regulatory action based on the magnitude of an indicated RBC capital deficiency, if any. The Company continues to monitor internal capital levels at ALPS P&C to ensure that they are in excess of the minimum capital requirements for all RBC action levels. Management believes that the capital levels at ALPS P&C are sufficient to support the level of risk inherent in its operations. Concentrations of geographic and credit risk: The Company s total direct gross written premium of $43,214,070 for the year ended December 31, 2014, included $9,777,206 for insureds in Virginia, $4,698,562 for insureds in West Virginia, $3,009,224 for insureds in Montana, $2,923,076 for insureds in South Carolina, $2,715,593 for insureds in Nevada, $2,625,185 for insureds in Alaska, and $2,439,389 for insureds in Idaho. The Company maintains its cash and short-term investments with high-quality financial institutions. Interest-bearing and noninterest-bearing accounts are guaranteed by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. From time to time the Company maintains cash in accounts in excess of FDIC-insured limits. Company has not experienced any losses in such accounts. At December 31, 2014, Company s investment portfolio is composed of security issues in the United States government and agencies, state and municipal governments, corporate securities and mortgagebacked securities, the vast majority of which are investment grade. This portfolio is widely diversified among various issuers and industries and is not dependent on the economic stability of one issuer or industry. The credit quality of the bond portfolio at December 31, 2014 and 2013, at amortized cost, is presented in the following table: 2014 2013 Amount Percentage Amount Percentage Highest quality $ 63,363,776 89% $ 58,299,428 87% High quality 5,600,004 8% 5,342,305 8% Medium quality 1,409,034 2% 1,276,060 2% Low quality 246,996 0% 542,969 1% Lower quality 674,764 1% 573,322 1% In or near default 35,074 0% 40,541 0% All other unclassified 216,947 0% 555,120 1% $ 71,546,595 100% $ 66,629,745 100% Reclassifications: Certain reclassifications have been made to the December 31, 2013, consolidated financial statements to conform to the December 31, 2014, presentation. These reclassifications had no effect on previously reported net income or stockholders equity. 13
Note 2. Property, Plant and Equipment Property, plant and equipment at cost on December 31 are as follows: 2014 2013 Building $ 5,425,551 $ 5,425,551 Building renovations 4,359,280 4,152,466 Land 649,000 649,000 Office furniture and equipment 1,439,342 1,368,973 Vehicles 28,763 28,763 Computer equipment 3,786,875 3,326,124 15,688,811 14,950,877 Less accumulated depreciation (7,567,193) (6,987,054) Property, plant and equipment, net $ 8,121,618 $ 7,963,823 Depreciation expense was $580,140 in 2014 and $509,576 in 2013. Note 3. Investments The amortized cost, adjusted cost and estimated fair values of available-for-sale securities at December 31, 2014 and 2013, are as follows: Gross Gross Amortized Unrealized Unrealized Estimated Cost Gains Losses Fair Value December 31, 2014: Bonds: U.S. government and agencies $ 110,967 $ - $ 684 $ 110,283 State, municipal and other - governments 53,777,549 4,206,967 49,538 57,934,978 Corporate securities 1,901,190 112,203-2,013,393 Commercial mortgage-backed securities 2,412,296 441 5,864 2,406,873 Residential mortgage-backed securities 9,106,190 608,370 9,213 9,705,347 Other asset-backed securities 4,238,403 486,412-4,724,815 Total fixed maturities 71,546,595 5,414,393 65,299 76,895,689 Equity securities 10,347,026 1,220,462 2,981,151 8,586,337 Total $ 81,893,621 $ 6,634,855 $ 3,046,450 $ 85,482,026 14
Note 3. Investments (Continued) Gross Gross Amortized Unrealized Unrealized Estimated Cost Gains Losses Fair Value December 31, 2013: Bonds: U.S. government and agencies $ 111,417 $ - $ 1,424 $ 109,993 State, municipal and other governments 45,363,260 1,443,841 915,096 45,892,005 Corporate securities 2,599,206 149,569 3,388 2,745,387 Commercial mortgage-backed securities 2,722,482 9,944 13,419 2,719,007 Residential mortgage-backed securities 11,579,140 643,102 58,764 12,163,478 Other asset backed securities 4,254,210 248,605 17,630 4,485,185 Total fixed maturities 66,629,715 2,495,061 1,009,721 68,115,055 Equity securities 13,402,508 1,955,092 2,425,722 12,931,878 Total $ 80,032,223 $ 4,450,153 $ 3,435,443 $ 81,046,933 The following table presents the estimated fair value and gross unrealized losses on the Company s investment securities, aggregated by investment category and length of time that individual investment securities have been in a continuous unrealized loss position, at December 31, 2014 and 2013: December 31, 2014 Greater Than or Less Than 12 Months Equal to 12 Months Total Gross Gross Gross Estimated Unrealized Estimated Unrealized Estimated Unrealized Fair Value Losses Fair Value Losses Fair Value Losses Bonds: U.S. government agencies $ - $ - $ 110,284 $ 684 $ 110,284 $ 684 State, municipal and other governments 2,280,326 11,186 1,487,865 38,352 3,768,191 49,538 Corporate securities - - - - - - Commercial mortgagebacked securities 1,930,391 5,864 - - 1,930,391 5,864 Residential mortgagebacked securities 443,265 1,441 578,410 7,772 1,021,675 9,213 Other asset-backed securities - - - - - - 4,653,982 18,491 2,176,559 46,808 6,830,541 65,299 Equity securities 2,512,686 1,437,504 2,271,470 1,543,647 4,784,156 2,981,151 Total $ 7,166,668 $ 1,455,995 $ 4,448,029 $ 1,590,455 $ 11,614,697 $ 3,046,450 15
Note 3. Investments (Continued) December 31, 2013 Greater Than or Less Than 12 Months Equal to 12 Months Total Gross Gross Gross Estimated Unrealized Estimated Unrealized Estimated Unrealized Fair Value Losses Fair Value Losses Fair Value Losses Bonds: U.S. government agencies $ 109,984 $ 1,424 $ - $ - $ 109,984 $ 1,424 State, municipal and other governments 17,122,888 798,505 2,141,697 116,591 19,264,585 915,096 Corporate securities 296,241 3,388 - - 296,241 3,388 Commercial mortgagebacked securities 1,833,193 13,419 - - 1,833,193 13,419 Residential mortgagebacked securities 466,670 9,362 1,795,613 49,402 2,262,283 58,764 Other asset-backed securities 384,615 1,965 423,272 15,665 807,887 17,630 20,213,591 828,063 4,360,582 181,658 24,574,173 1,009,721 Equity securities 2,491,057 587,831 3,760,059 1,837,891 6,251,116 2,425,722 Total $ 22,704,648 $ 1,415,894 $ 8,120,641 $ 2,019,549 $ 30,825,289 $ 3,435,443 The Company evaluates whether unrealized losses on investment securities indicate other-thantemporary impairment. At December 31, 2014 and 2013, 71 and 90 securities were in an unrealized loss position, respectively. The Company considers relevant facts and circumstances in evaluating whether the impairment of a security is other than temporary. Relevant facts and circumstances considered include, but are not limited to: (1) the current fair value of the security as compared to cost; (2) the extent and the length of time the fair value had been below cost; (3) the financial position of the issuer, including the current and future impact of any specific events, material declines in the issuer s revenues, margins, cash positions, liquidity issues, asset quality, debt levels and income results; (4) consideration of information or evidence that supports timely recovery; and (5) other business factors related to the issuer s industry. The unrealized losses in the Company s debt and equity security portfolio at December 31, 2014 and 2013, were not a result of any credit-related problems, rather they were caused by interest rate increases and widening in corporate pricing spreads. Substantially all of the issuers have investment-grade ratings, and therefore, the Company believes each issuer will be able to meet the contractual terms of the obligation. No securities were considered other-than-temporarily impaired during 2014. 16
Note 3. Investments (Continued) The amortized cost and estimated fair value of fixed-maturity securities at December 31, 2014, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Cost Fair Value Due in one year or less $ 719,377 $ 721,652 Due after one year through five years 7,529,639 8,142,251 Due after five years through 10 years 15,192,179 16,603,751 Due after 10 years through 20 years 38,934,493 42,095,431 Due after 20 years 9,170,907 9,332,604 Total $ 71,546,595 $ 76,895,689 ALPS P&C has placed in trust with the State of Montana Insurance Commissioner investments with a fair value of $3,196,930 and $3,072,880 at December 31, 2014 and 2013, respectively, as required by state law. Fair values of deposits with other states as of December 31, 2014, totaled $1,128,456. The Company received proceeds from the sale and maturities of investments totaling $20,072,618 and $18,300,169 in 2014 and 2013, respectively. Gross realized gains and losses on investments, including other-than-temporary impairments, reflected in the results of operations for the years ended December 31, 2014 and 2013, are as follows: Years Ended December 31 2014 2013 Realized: Gross realized gains on sales: Fixed-income securities $ 15,456 $ 32,726 Equity securities 1,255,057 534,426 Total 1,270,513 567,152 Gross realized losses on sales: Fixed-income securities (11,640) (46,730) Equity securities (1,216,588) (502,845) Total (1,228,228) (549,575) Other-than-temporary losses recognized in operations: Fixed-income securities - - Net realized capital gains, net of tax $ 42,285 $ 17,577 17
Note 3. Investments (Continued) Net investment income consists of the following: Years Ended December 31 2014 2013 Fixed maturities $ 3,726,969 $ 3,484,049 Equity securities 878,689 821,531 Short-term investments 6,770 5,749 Other 101,094 76,146 4,713,522 4,387,475 Investment expenses (420,104) (437,329) Net investment income $ 4,293,418 $ 3,950,146 Note 4. Loss and Loss Adjustment Expense Reserves The following table provides a reconciliation of the beginning and ending reserve balances for losses and loss adjustment expenses (LAE) for 2014 and 2013: Years Ended December 31 2014 2013 Reserve for losses and LAE, beginning of year $ 70,984,594 $ 68,014,631 Add provision for losses and LAE applicable to claims reported in: Current year 25,522,561 23,928,437 Prior years 1,844,773 6,892,841 Total incurred losses during the current year 27,367,334 30,821,278 Payments for losses and LAE reported in: Current year 4,023,561 4,250,320 Prior years 18,416,640 23,600,995 Net claim payments during the year 22,440,201 27,851,315 Reserve for losses and LAE, end of year $ 75,911,727 $ 70,984,594 Reserves for incurred losses and LAE attributable to claims reported to ALPS P&C in prior years on a gross basis increased by $1,844,773 during 2014 and by $6,892,841 during 2013. These changes are generally the result of ongoing analysis of claim files. Original estimates are increased or decreased as additional information becomes known regarding individual claims. 18
Note 5. Reinsurance The Company utilizes reinsurance contracts to reduce its exposure to losses in all aspects of its insurance business. Such reinsurance permits recovery of a portion of losses from reinsurers, although it does not relieve the Company from its primary liability to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial strength of potential reinsurers and continually monitors the financial condition of reinsurers. Amounts recoverable from reinsurers are estimated based upon assumptions consistent with those used in establishing the liabilities related to the underlying reinsured contracts. Management believes the recoverables are appropriately established. The Company generally strives to diversify its credit risks related to reinsurance ceded. At December 31, 2014, the Company did not have any recoverable losses from a reinsurer that exceeded 3 percent of the Company s surplus. There were no disputes with reinsurers at December 31, 2014 or 2013. The Company holds letters of credit in the amount of approximately $13,416,000 and $12,408,000 at December 31, 2014 and 2013, respectively, to secure recoverable balances from unauthorized reinsurers. The Company has no uncollectible reinsurance recoverables that were written off during the year. The Company has unsecured aggregate recoverable for losses, paid and unpaid, loss adjustment expenses and unearned premium with the following individual reinsurers, authorized or unauthorized, exceeding 3 percent of policyholders surplus at December 31: AM Best Rating 2014 2013 Allied World Assurance Co. Ltd. A $ - $ 1,044,000 American Safety Reinsurance Ltd. NR 4,550,000 4,620,000 Aspen Insurance A 3,077,000 2,772,000 AXA RE NR 1,578,000 1,270,000 Everest Reinsurance Co. A+ 2,636,000 2,088,000 Hannover Ruckversicherungs Aktiengesellschaft NR 1,107,000 1,135,000 JRG Reinsurance Co. A- 5,560,000 4,466,000 Lawyer's Reinsurance Co. NR 2,607,000 3,094,000 Lloyd's AFB 2623 NR 1,222,000 - Lloyd's LIB 4472 NR 1,116,000 1,186,000 Navigators Ins Co A 1,408,000 1,459,000 Transatlantic Reinsurance Co. A 4,593,000 3,499,000 $ 29,454,000 $ 26,633,000 19
Note 5. Reinsurance (Continued) A summary of the impact of ceded reinsurance on written, earned and unearned premiums for the years ended December 31, 2014 and 2013, is as follows: 2014 2013 Premiums written: Direct $ 43,214,070 $ 42,190,661 Ceded (14,146,589) (14,112,282) Net premiums written $ 29,067,481 $ 28,078,379 Premiums earned: Direct $ 42,733,026 $ 41,579,849 Ceded (14,225,789) (13,710,796) Net premiums earned $ 28,507,237 $ 27,869,053 Losses and loss adjustment expenses incurred: Direct $ 27,367,334 $ 30,821,278 Ceded (8,422,052) (13,104,938) Net losses and loss adjustment expenses incurred $ 18,945,282 $ 17,716,340 Note 6. Income Taxes The Company prepares a consolidated federal income tax return that includes all direct and indirect subsidiaries. The Company s affiliates included in the consolidated federal income tax return allocate income tax expenses in accordance with a consolidated tax allocation agreement. Generally, this allocation results in profitable companies recognizing income tax incurred as if the individual company filed a separate return and loss companies recognizing a benefit to the extent their losses contribute to reduce consolidated taxes. The effective tax rate on income before income taxes is different from the prevailing federal income tax rate, as follows: Years Ended December 31 2014 2013 Amount computed using statutory rate $ 1,068,746 $ 1,457,613 Increase (reduction) in tax resulting from: Nonallowable meals, entertainment, dues and other 16,438 22,446 Officer's life insurance premiums 17,348 23,457 Tax-exempt interest and dividends (91,967) (108,288) Dividends received deduction (215,280) (201,275) State and foreign income taxes (31,406) 61,096 Change in prior-year estimates (373,590) 332,384 Total provision (benefit) $ 390,289 $ 1,587,433 20
Note 6. Income Taxes (Continued) Comprehensive income tax expense (benefit) included in the consolidated financial statements for the years ended December 31, 2014 and 2013, is as follows: 2014 2013 Current: U.S. federal provision $ 1,251,300 $ 279,839 States and foreign (31,406) 61,096 1,219,894 340,935 Deferred: U.S. federal provision (benefit) (829,605) 1,246,498 Total tax provision (benefit) $ 390,289 $ 1,587,433 Deferred income taxes have been established based upon the temporary differences between the financial statement and income tax bases of assets and liabilities. The tax effect of temporary differences that give rise to significant portions of the Company s net deferred income tax asset is as follows: December 31 2014 2013 Ordinary: Unearned/advanced premium adjustment $ 1,093,908 $ 1,056,753 Unpaid losses and LAE 1,086,400 1,107,050 SARS payable 271,532 275,684 LTIP payable 366,995 217,875 NOL carryforward - - Deferred acquisition costs (135,931) (144,040) Deferred surplus loan fees (7,459) (17,226) Change in allowance for bad debts - - Book to tax depreciation (85,208) (132,116) Stock options basis 271,480 157,843 Other 2 887 2,861,719 2,522,710 Capital: Unrealized gains (1,190,724) (357,987) OTTI impairments 21,000 21,000 (1,169,724) (336,987) AMT credit 2,172,908 1,682,312 Total deferred tax asset $ 3,864,903 $ 3,868,035 Based upon anticipated future taxable income, the Company s net realized gains, and consideration of all other available evidence, management believes that it is more likely than not that the Company s net deferred income tax asset will be realized. 21
Note 7. Fair Value of Financial Instruments The distribution of the Company s investments, which are measured at fair value on a recurring basis, in the valuation hierarchy, is as follows: December 31, 2014 Assets Level 1 Level 2 Level 3 Total Fixed maturities available for sale: U.S. government and agencies $ - $ 110,283 $ - $ 110,283 State, municipal and other governments - 57,934,978-57,934,978 Corporate securities - 2,013,393-2,013,393 Commercial mortgage-backed securities - 2,406,873-2,406,873 Residential mortgage-backed securities - 9,705,347-9,705,347 Other asset-backed securities - 4,724,815-4,724,815-76,895,689-76,895,689 Equity securities available for sale 7,566,532-1,019,805 8,586,337 Total $ 7,566,532 $ 76,895,689 $ 1,019,805 $ 85,482,026 December 31, 2013 Assets Level 1 Level 2 Level 3 Total Fixed maturities available for sale: U.S. government and agencies $ - $ 109,994 $ - $ 109,994 State, municipal and other governments - 45,892,005-45,892,005 Corporate securities - 2,745,387-2,745,387 Commercial mortgage-backed securities - 2,719,007-2,719,007 Residential mortgage-backed securities - 12,163,478-12,163,478 Other asset-backed securities - 4,485,184-4,485,184-68,115,055-68,115,055 Equity securities available for sale 11,960,087 971,791-12,931,878 Total $ 11,960,087 $ 69,086,846 $ - $ 81,046,933 Reconciliations of assets and liabilities measured and carried at fair value on a recurring basis with the use of significant unobservable inputs (Level 3) for the year ended December 31, 2014, is as follows: Investments In Fixed Securities Investments In Equity Securities Balance at December 31, 2013 $ - $ - Gains (losses) included in: Earnings - - Other comprehensive income - 513,667 Acquisitions, dispositions and settlements - - Transfers into (out of) Level 3-506,138 Balance at December 31, 2014 $ - $ 1,019,805 22
Note 7. Fair Value of Financial Instruments (Continued) Fair values of fixed-income and equity securities are based on quoted market prices, where available. The Company obtains one price for each security, primarily from a third-party pricing service (pricing service), which generally uses quoted or other observable inputs for the determination of fair value. The pricing service normally derives the security prices through recently reported trades for identical or similar securities, making adjustments through the reporting date based upon available observable market information. For securities not actively traded, the pricing service may use quoted market prices of comparable instruments or incorporate inputs that are currently observable in the markets for similar securities. Inputs that are often used in the valuation methodologies include, but are not limited to, benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing. In addition, the pricing service uses model processes, such as the Option Adjusted Spread model, to assess interest rate impact and develop prepayment scenarios. As the Company is responsible for the determination of fair value, it performs monthly analysis on the prices received from third parties for its internally managed portfolios to determine whether the prices are reasonable estimates of fair value. The analysis includes a comparison of prices received from third parties to prices obtained from other sources. There were no adjustments to quoted market prices obtained from third-party pricing services during 2014 and 2013 that were material to the consolidated financial statements. In instances in which the inputs used to measure fair value fall into different levels of the fair value hierarchy, the fair value measurement has been determined based on the lowest level input that is significant to the fair value. Following is a description of the valuation methodologies used by the Company to value assets measured at fair value. Major Category State and/or U.S. government obligations and common and/or preferred stock Mutual funds Partnership Fixed-income securities, including corporate, commercial and residential mortgage-backed securities Valued at Closing price reported in the active market in which the individual security is traded. If in an inactive market, based on quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. Securities that trade infrequently and therefore have little or no price transparency are valued using the investment manager s best estimates. Net asset value (NAV) of shares, which are provided by the administrator of the fund. Based on the most recent audited financial results. Closing price reported in the active market in which the bond is traded, or based on yields currently available on comparable securities of issuers with similar credit ratings or discounted cash flows approach that maximizes observable inputs, such as current yields of similar instruments, but includes adjustments for certain risks that may not be observable, such as credit and liquidity risks. 23