10-K 1 d10k.htm FORM 10-K Form 10-K
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 Fiscal Year Ended December 31, 2005   Commission File Number 0-11773

 


LOGO

ALFA CORPORATION

(Exact name of registrant as specified in its charter)

 


 

Delaware   63-0838024

(State or other jurisdiction

incorporation or organization)

 

(I.R.S Employer

Identification No.)

2108 East South Boulevard

P.O. Box 11000, Montgomery, Alabama

  36191-0001
(Address of principal executive offices)   (Zip-Code)

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

 


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

 

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

Common Stock, par value $1.00 per share

  

The NASDAQ Stock Market

(EXCHANGE)

 


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

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

 

Large accelerated filer  ¨

  Accelerated filer  x   Non-accelerated filer  ¨

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

As of June 30, 2005, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $528,638,203 based on the closing sale price as reported on the National Association of Securities Dealers Automated Quotation System National Market System.

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

 

Class

 

Outstanding at February 28, 2006

Common Stock, $1.00 par value per share   80,290,551 shares

DOCUMENTS INCORPORATED BY REFERENCE

1. Portions of the Registrant’s Proxy Statement relating to the Annual Meeting of Stockholders to be held April 25, 2006 are incorporated by reference into Parts II and III of this Form 10-K Report.

 



Table of Contents
Index to Financial Statements

ALFA CORPORATION

FORM 10-K

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005

INDEX

 

          Page
   PART I   
Item 1.   

Business

   1
Item 1A.   

Risk Factors

   9
Item 1B.   

Unresolved Staff Comments

   13
Item 2.   

Properties

   13
Item 3.   

Legal Proceedings

   13
Item 4.   

Submission of Matters to a Vote of Security Holders

   13
   PART II   

Item 5.

  

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

   14

Item 6.

  

Selected Financial Data

   16

Item 7.

  

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

   17

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

   40

Item 8.

  

Financial Statements and Supplementary Data

   43

Item 9.

  

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

   96

Item 9A.

  

Controls and Procedures

   96

Item 9B.

  

Other Information

   96
   PART III   

Item 10.

  

Directors and Executive Officers of the Registrant

   97

Item 11.

  

Executive Compensation

   98

Item 12.

  

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

   98

Item 13.

  

Certain Relationships and Related Transactions

   98

Item 14.

  

Principal Accounting Fees and Services

   98
   PART IV   

Item 15.

   Exhibits, Financial Statement Schedules    99


Table of Contents
Index to Financial Statements

Part I

Item 1. Business.

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

 

    Alfa Insurance Corporation (AIC)

 

    Alfa General Insurance Corporation (AGI)

 

    Alfa Vision Insurance Corporation (AVIC)

 

    Alfa Life Insurance Corporation (Life)

 

    Alfa Financial Corporation (Financial)

 

    The Vision Insurance Group, LLC (Vision)

 

    Alfa Agency Mississippi, Inc. (AAM)

 

    Alfa Agency Georgia, Inc. (AAG)

 

    Alfa Benefits Corporation (ABC)

Alfa Corporation is affiliated with Alfa Mutual Insurance Company, Alfa Mutual Fire Insurance Company, and Alfa Mutual General Insurance Company (collectively, the Mutual Group). The Mutual Group owns 54.9% of Alfa Corporation’s common stock, their largest single investment. Alfa Corporation and its subsidiaries (the Company) together with the Mutual Group comprise the Alfa Group (Alfa). Alfa Virginia Mutual Insurance Company (Virginia Mutual) currently cedes 80% of its direct business to Alfa Mutual Fire Insurance Company (Fire) under an affiliate agreement signed in August 2001.

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

Recent Developments. Effective January 1, 2005, the Pooling Agreement was amended and restated, commuting certain pools from August 1, 1987 through December 31, 2001. In addition, AVIC was added as a participant in the Pooling Agreement with other companies in the Alfa Group and Fire began retroceding the quota share business it receives from Virginia Mutual to the pool. AVIC, a new subsidiary formed by the Company in the third quarter of 2004, writes nonstandard automobile business through Vision and currently operates in Texas, Missouri, Indiana, Ohio, Virginia, Tennessee, Arkansas, Kentucky, and Florida. AVIC cedes 100% of its direct business to the intercompany pool and receives in return 5% of the business included in the Alfa Group intercompany pool. AIC and AGI, both wholly-owned subsidiaries of the Company, reduced their respective pooling participations from 32.5% to 30.0% to allow for the Vision addition.

On January 3, 2005, the Company completed its acquisition of Vision, a full-service managing general agency. Prior to the execution of the purchase agreement, no material relationship existed between the Company and the sellers. The Company purchased Vision for $20 million in cash and stock with an additional purchase consideration of up to $14 million based on future performance.

During the fourth quarter of 2005, the Company completed the sale of Financial’s leasing division, OFC Capital, to OFC Servicing Corporation, a subsidiary of MidCountry Financial Corporation (MidCountry). No gain or loss was recognized and no amounts of revenue and pretax profit or loss have been reported in discontinued operations due to the Company’s significant continuing involvement through its equity-method investment in MidCountry.

 

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Effective January 1, 2006, the Pooling Agreement was amended to reallocate the Alfa Specialty Insurance Corporation (Specialty) coinsurance allocation of catastrophes to Mutual. Specialty is a wholly-owned subsidiary of Mutual.

Nature of Operations. Alfa Corporation’s insurance subsidiaries are direct writers of life insurance in Alabama, Georgia and Mississippi and property casualty insurance in Georgia, Mississippi, Missouri, Indiana, Ohio, Virginia, Tennessee, Arkansas, Kentucky, and Florida. In addition, AVIC assumes business in Texas. The Company’s property casualty business is pooled with that of the Mutual Group, which writes property casualty business in Alabama. Approximately 75.6% of the Company’s property casualty premium income and 66.5% of its total premium income for 2005 was derived from the Company’s participation with the Mutual Group in the Pooling Agreement.

Effective August 1, 1987, the Company entered into a property casualty insurance Pooling Agreement (the “Pooling Agreement”) with Alfa Mutual Insurance Company (Mutual), and other members of the Mutual Group (refer to Note 2—Pooling Agreement in the Notes to Consolidated Financial Statements of this Form 10-K).

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

 

    Property casualty insurance

 

    Life insurance

 

    Noninsurance

 

    Consumer financing

 

    Commercial leasing

 

    Agency operations

 

    Employee benefits administration

 

    Corporate and eliminations

Presented below is summarized financial information for the Company’s four business segments for the years ended December 31, 2005, 2004 and 2003:

 

     Years Ended December 31,  
             2005                     2004                     2003          
     (in thousands)  

Revenues by Segment

      

Property casualty insurance

   $ 606,445     $ 521,371     $ 486,569  

Life insurance

     133,498       132,466       119,491  

Noninsurance operations

     33,266       9,851       15,456  

Corporate

     45,973       27,150       25,680  
                        

Revenues before eliminations

   $ 819,182     $ 690,838     $ 647,196  

Eliminations

     (62,277 )     (29,546 )     (27,379 )
                        

Total revenues

   $ 756,905     $ 661,292     $ 619,817  
                        

Operating Income (Loss)1 by Segment

      

Property casualty insurance operating income

   $ 80,195     $ 68,699     $ 53,112  

Life insurance operating income

     21,736       18,763       19,058  

Noninsurance operating income (loss)

     (38 )     2,138       4,031  

Corporate operating loss

     (6,792 )     (4,737 )     (1,803 )
                        

Total operating income

   $ 95,101     $ 84,863     $ 74,398  

Realized investment gains, net of tax

     3,933       4,582       4,071  
                        

Net income

   $ 99,034     $ 89,445     $ 78,469  
                        

 

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

Property Casualty Insurance:

Alfa’s primary business is personal lines property casualty insurance, which accounts for approximately 78% of total premiums and approximately 69% of total revenues. Automobile and homeowners insurance account for approximately 86% of property casualty premiums. In Alabama, Alfa enjoys approximately a 20% share of the personal automobile and homeowners markets, second only to State Farm.

The Company is a direct writer and distributes its products utilizing a combination of exclusive, independent and independent exclusive sales agents in its core states of operation. The following table shows the Company’s pooled share of direct premium distribution by product for property casualty insurance for 2005:

 

Automobile

   61.5 %

Homeowner

   24.7 %

Farmowner

   4.8 %

Commercial

   4.3 %

Manufactured Home

   2.9 %

Other

   1.8 %
      
   100.0 %
      

A discussion of the Company’s property casualty insurance results of operations is included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K.

Segment disclosures required under Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures about Segments of an Enterprise and Related Information, are included in Note 14—Segment Information in the Notes to Consolidated Financial Statements.

The Company’s strategy in property casualty business has been to operate primarily in its niche, personal lines insurance, and to strive to be the low-cost producer, thereby marketing and underwriting to achieve a preferred, profitable book of business. The Company’s objective is to operate with an underwriting profit. Historically, this objective has been met except for five separate years, each of which was primarily impacted by catastrophic weather. In the wake of Hurricanes Opal and Erin, Alfa initiated intense studies of its catastrophe management strategy. Effective November 1, 1996, Alfa restructured the catastrophe program and amended the intercompany pooling agreement to allocate catastrophe losses among the members of the pool in a fashion that more equitably reflects the realities of catastrophe finance. As a result, the Company’s share of Alfa’s storm-related losses has been substantially reduced, providing greater earnings stability. The lower exposure also means a substantial reduction in reinsurance costs. Alfa’s pooled catastrophe losses for 2005, 2004 and 2003 totaled approximately $293.9 million, $347.5 million and $69 million, respectively. The Company’s share of such losses totaled $11.6 million, $9.2 million and $7.9 million in 2005, 2004 and 2003, respectively.

There are inherent uncertainties in reserving for unpaid losses. Management’s philosophy has been to establish reserves at a high level of confidence. The Company experienced no materially significant large losses or gains in its loss payments during 2003, 2004 or 2005 which led to changes in estimates.

 

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The Company’s pooled business is concentrated geographically in Alabama, Georgia and Mississippi. Accordingly, unusually severe storms or other disasters in these contiguous states might have a more significant effect on the Company’s financial condition and operating results than on a more geographically diversified insurance company. However, the Company’s catastrophe protection program, which began November 1, 1996, reduced the potential adverse impact and earnings volatility caused by such catastrophe exposures.

Life Insurance:

Life directly writes individual life insurance policies consisting primarily of ordinary whole life, term life, interest sensitive whole life and universal life products in Alabama, Georgia and Mississippi and distributes these products utilizing an exclusive and independent exclusive agent sales force. In the highly fragmented life insurance market in Alabama, Alfa ranks among the leaders in market share.

Life offers several different types of whole life and term insurance products. The following table shows the Company’s distribution by product for life insurance premiums and policy charges for 2005:

 

Traditional life insurance premiums

   53.0 %

Universal life policy charges

   27.1 %

Interest sensitive life policy charges

   14.2 %

Universal life policy charges—COLI

   5.0 %

Group life insurance premiums

   0.7 %
      
   100.0 %
      

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

 

     2005    2004    2003
     (in thousands)

Ordinary life

   $ 21,148,519    $ 19,719,825    $ 18,206,689

Credit life

   $ 13,446    $ 12,526    $ 10,554

Group life

   $ 47,269    $ 47,152    $ 45,505

A discussion of the Company’s life insurance results of operations is included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K.

Segment disclosures required under SFAS No. 131 are included in Note 14—Segment Information in the Notes to Consolidated Financial Statements.

While the amount retained on an individual life will vary depending upon age and mortality prospects of the risk, Life generally will not retain more than $500,000 of individual life insurance on a single risk with the exception of company-owned life insurance (COLI) and group policies where the retention is limited to $100,000 per individual. These retention limits are set for the purpose of limiting the liability of Life with respect to any one risk and providing greater diversification of its exposure. When Life reinsures a portion of its risk it must cede the premium income to the reinsurer who reinsures the risk, thereby decreasing the income of Life. Life performs various underwriting procedures and blood testing for AIDS and other diseases before issuance of insurance.

Noninsurance:

The Company operates five subsidiaries which are not considered to be significant by the Securities and Exchange Commission (SEC) Regulations for purposes of separate disclosure: Financial, a lending

 

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Index to Financial Statements

and leasing institution; AAM, AAG, Vision (collectively, Agency operations); and ABC, a provider of benefit services for Alfa.

 

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

 

    AAM and AAG, headquartered in Montgomery, Alabama, provide agents with the opportunity to offer customers a broader portfolio of products by placing insurance risks with third party insurers for a commission. Vision is a full-service managing general agency that currently writes nonstandard automobile insurance policies in nine states. In addition, during 2005, Vision wrote a limited amount of nonstandard homeowner business through non-affiliated carriers as a general agency. Vision is headquartered in Brentwood, Tennessee and provides all underwriting, claims, actuarial and financial services on behalf of its contracted carriers.

 

    ABC serves as a record keeper by handling nonqualified employee benefits.

A discussion of the Company’s noninsurance results of operations is included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K.

Segment disclosures required under SFAS No. 131 are included in Note 14—Segment Information in the Notes to Consolidated Financial Statements.

Investments:

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

The Company’s investment philosophy is long-term and value oriented with focus on total return for both yield and growth potential. During the past ten years, invested assets have grown from approximately $841 million to over $2.0 billion at the end of 2005, a compound annual growth rate of 9.1%. During that same period, net investment income has almost doubled, growing from $50.9 million to over $94.9 million. At year-end, the value of unrealized gains in the Company’s portfolio was $22.1 million, net of tax. The portfolio was invested 70.9% in fixed maturities, 5.4% in equities, 4.2% in short-term investments and 19.5% in other investments which include policy loans, collateral loans, commercial leases, partnerships, notes receivable and equity method investments.

The rating of the Company’s portfolio of fixed maturities using the Standard & Poor’s rating categories is as follows at December 31, 2005 and 2004:

 

     December 31,  
     2005     2004  

AAA to A-

   90.8 %   92.8 %

BBB+ to BBB-

   7.3     6.8  

BB+ and below (below investment grade)

   1.9     0.4  
            
   100.0 %   100.0 %
            

 

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A discussion of the Company’s investments is included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K.

Reserves:

The Company’s property casualty insurance subsidiaries are required to maintain reserves to cover their estimated ultimate liability for losses and loss adjustment expenses with respect to reported and unreported claims incurred. The Company’s life insurance subsidiary is required to maintain reserves for future policy benefits. To the extent that reserves prove to be inadequate or excessive in the future, the Company would have to modify such reserves and incur a charge or credit to earnings in the period such reserves are modified which could have a material effect on the Company’s results of operations and financial condition. Establishing appropriate reserves is an inherently uncertain process and there can be no assurance that ultimate losses will not materially differ from the Company’s established loss reserves. Reserves are estimates involving actuarial and statistical projections at a given time of what the Company expects to be the cost of the ultimate settlement and administration of claims based on facts and circumstances then known, estimates of future trends in claims severity and other variable factors.

Property Casualty Reserves. With respect to reported claims, reserves are established on a case-by-case basis. The reserve amounts on each reported claim are determined by taking into account the circumstances surrounding each claim and policy provision relating to the type of loss. Loss reserves are reviewed on a regular basis and, as new data becomes available, appropriate adjustments are made to reserves.

For incurred but not reported (“IBNR”) losses, a variety of methods have been developed in the insurance industry for determining estimates of loss reserves. One common method of actuarial evaluation, which is used by the Company, is the loss development method. This method uses the pattern by which losses have been reported over time and assumes that each accident year’s experience will develop in the same pattern as the historical loss development.

Reserves are computed by the Company based upon actuarial principles and procedures applicable to the lines of business written by the Company. Management reviews these reserve calculations regularly and as required by state law, the Company annually engages an independent actuary to render an opinion as to the adequacy of reserves established by management, whose opinions are filed with the various jurisdictions in which the Company is licensed. Based upon practice and procedures employed by the Company, without regard to independent actuarial opinions, management believes that the Company’s reserves are adequate.

The liability for estimated unpaid losses and loss adjustment expenses is based on a detailed evaluation of reported losses and of estimates of incurred but not reported losses. Adjustments to the liability based on subsequent developments are included in current operations. The Company is primarily an insurer of private passenger motor vehicles and of single-family homes and has limited exposure for difficult-to-estimate claims such as environmental, product and general liability claims. The Company does not believe that any such claims will have a material impact on the Company’s liquidity, results of operations, cash flows or financial condition.

Life Reserves. The life insurance policy reserves reflected in the Company’s financial statements as future policy benefits are calculated based on accounting principles generally accepted in the United States of America. These reserves, with the addition of premiums to be received and the interest thereon compounded annually at assumed rates, must be sufficient to cover policy and contract obligations as they mature. Generally, the mortality and persistency assumptions used in the calculation of reserves are based on company experience. The assumptions used in the calculation of Life’s reserves are shown in Note 6—Policy Liabilities and Accruals in the Notes to Consolidated Financial Statements of this Form 10-K.

 

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Relationship with Mutual Group:

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

Mutual periodically conducts time usage and related expense allocation studies. Mutual charges the Company for its allocable and directly attributable salaries and other expenses, including office facilities.

The Board of Directors of the Company consisted, at December 31, 2005, of eleven members, six of whom serve on the Executive Committee of the Boards of the Mutual Group and two of whom are Executive Officers of the Company.

At December 31, 2005, Mutual owned 34,296,747 shares, or 42.7%, Fire owned 9,187,970 shares, or 11.4%, and Alfa Mutual General Insurance Company owned 631,166 shares, or 0.8%, of the Company’s outstanding common stock.

Competition:

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

Regulation:

The Mutual Group and the Company’s insurance subsidiaries are subject to the Alabama Insurance Holding Company Systems Regulatory Act and are subject to reporting to the Alabama Insurance Department and to periodic examination of their transactions and regulation under the Act with Mutual being considered the controlling party.

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

The Mutual Group, the Company and its subsidiary, Alfa Financial Corporation, are regulated by, report to and are subject to examination by the Office of Thrift Supervision (“OTS”), pursuant to the Federal Home Owners’ Loan Act (HOLA) and its Control Regulations. The scope of this authority includes the savings association, its holding company and other affiliates, and subsidiaries of the

 

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savings association. In accordance with its responsibilities, OTS has issued regulations and developed examination procedures for savings and loan holding companies.

Restrictions on Dividends to Stockholders: The Company’s insurance subsidiaries are subject to various state statutory and regulatory restrictions, generally applicable to each insurance company in its state of domicile, which limit the amount of dividends or distributions by an insurance company to its stockholders. The restrictions are generally based on certain levels of surplus, investment income and operating income, as determined under statutory accounting practices. Alabama law permits dividends in any year which, together with other dividends or distributions made within the preceding 12 months that do not exceed the greater of (i) 10% of statutory surplus as of the end of the preceding year or (ii) for property casualty companies—the statutory net income for the preceding year, or for life companies—the statutory net gain from operations. Larger dividends are payable only after receipt of regulatory approval. Future dividends from the Company’s subsidiaries may be limited by business and regulatory considerations. However, based upon restrictions presently in effect, the maximum amount available for payment of dividends to the Company by its insurance subsidiaries in 2006 without prior approval of regulatory authorities is approximately $84.4 million based on December 31, 2005 financial condition and results of operations.

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

Personnel:

The Company has no management or operational employees. The Company and its subsidiaries have a Management and Operating Agreement with Mutual whereby it reimburses Mutual for salaries and expenses of employees provided to the Company under the Agreement. Involved are employees in the areas of Life Underwriting, Life Processing, Accounting, Sales, Administration, Legal, Files, Data Processing, Programming, Research, Policy Issuing, Claims, Investments and Management. At December 31, 2005, the Company was represented by 491 agents in Alabama who are employees of Mutual. The Company’s subsidiaries had 132 independent exclusive agents in Georgia and Mississippi and 2,438 independent agents in Georgia, Texas, Missouri, Indiana, Ohio, Virginia, Tennessee, Arkansas, Kentucky, and Florida at December 31, 2005. The Company believes its employee relations are good.

Available Information:

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

 

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

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

Any of the materials the Company files with the SEC may also be read and copied at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. Information on the operation of the SEC’s Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.

Item 1A. Risk Factors.

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

Regulatory Environment

The Company’s insurance subsidiaries are subject to extensive governmental regulation in all of the state and similar jurisdictions in which they operate. These regulations relate to licensing requirements, types of insurance products that may be sold, premium rates, marketing practices, capital and surplus requirements, investment limitations, underwriting limitations, dividend payment limitations, transactions with affiliates, accounting practices, taxation and other matters. While most of the regulation is at the state level, the federal government has increasingly expressed an interest in regulating the insurance industry through the Graham-Leach-Bliley Act, the Patriot Act, financial services regulation, changes in the Internal Revenue Code and other legislation. All of these regulations increase the cost of conducting insurance business through increased compliance expenses. Furthermore, as existing regulations evolve through administrative and court interpretations, and as new regulations are adopted, there can be no way of predicting what impact these changes will have on the Company in the future. Such impact could adversely affect the Company’s profitability and limit its growth.

Geographic Concentration Risk

The Company’s property casualty insurance business is generated in 13 southeastern states and its life insurance business is generated in 3 states. For the year ended December 31, 2005, approximately $514 million of premiums and policy charges representing 81% of such amounts were from policies written in Alabama. Accordingly, unusually severe storms or other disasters in this state might have a more significant effect on the Company than a more geographically diversified company and could have an adverse impact on the Company’s financial condition and operating results.

In addition, the revenues and profitability of the Company are subject to prevailing regulatory, legal, economic, demographic, competitive and other conditions in these states. Changes in any of these conditions could make it less attractive for the Company to do business in these states and could have an adverse effect on the Company’s financial results.

 

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Catastrophic Loss Risk

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

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

Reserves

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

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

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

Excessive Losses and Loss Expenses

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

Investment Risks (Interest and Equity)

The invested assets of the Company’s subsidiaries are centrally managed by the Company. The majority of these invested assets consist of fixed maturity securities. Changes in interest rates directly affect the income from, and the market value of fixed maturity investments and could reduce the value of the Company’s investment portfolio and adversely affect the Company’s, and its subsidiaries’ results of operations and financial condition. A smaller percentage of total investments are in equity securities. A change in general economic conditions, the stock market, or many other external factors could

 

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adversely affect the value of those investments and, in turn, the Company’s, or its subsidiaries’ results and financial condition. Further, the Company manages its fixed maturity investments by taking into account the maturities of such securities and the anticipated liquidity needs of the Company and its subsidiaries. Should the Company suddenly experience greater than anticipated liquidity needs for any reason, it could face a liquidity risk that may adversely affect the Company’s financial condition or results of operations.

Reinsurance

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

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

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

Litigation

The Company and its subsidiaries are named defendants in a number of lawsuits. These lawsuits are described more fully in Note 9—Commitments and Contingencies in the Notes to Consolidated Financial Statements. Litigation, by its nature, is unpredictable and the outcome of these cases is uncertain. The precise nature of the relief that may be sought or granted in any lawsuits is uncertain and may, if these lawsuits are determined adversely to the Company, negatively impact results of operations.

Pricing

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

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

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

 

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Liquidity Risk

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

Dividend Dependence and Liquidity

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

Competition

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

Rating Downgrades

The competitive positions of insurance companies, in general, have come to depend increasingly on independent ratings of their financial strength and claims-paying ability. The rating agencies base their ratings on criteria they establish regarding an insurer’s financial strength, operating performance, strategic position and ability to meet its obligations to policyholders. A significant downgrade in the ratings of any of the Company’s insurance subsidiaries could negatively impact their ability to compete for new business and retain existing business and, as a result, adversely affect the Company’s results of operations and financial condition.

Guaranty Funds and Residual Markets

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

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

 

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

Prior Approval of Rates

Most of the lines of property casualty insurance underwritten by the Company are subject to prior regulatory approval of premium rates in a majority of the states in which it operates. The process of securing regulatory approval can be time consuming and can impair the Company’s ability to effect necessary rate increases in an expeditious manner.

For most types of life business, initial premium rates are not subject to regulatory approval. However, if mortality experience deteriorates on a block of business, the process of securing regulatory approval for a necessary rate increase can be time consuming and impair the Company’s ability to remedy the premium insufficiency in an expeditious manner.

There is a risk that regulators will not approve a requested increase. To the extent that rate increases are not approved on an adequate and timely basis, the Company’s results of operations and financial condition may be adversely impacted.

Item 1B. Unresolved Staff Comments.

None

Item 2. Properties.

Physical Properties of the Company and Its Subsidiaries. The Company leases buildings that are used in the normal course of business. The principal executive office is owned by Mutual and is located at 2108 East South Boulevard, Montgomery, Alabama, in a 342,000 square foot building. The Company leases other offices and facilities in Georgia, Mississippi, and Tennessee. The executive office is a component of all segments. Other offices are components of the insurance segments and noninsurance segment.

Item 3. Legal Proceedings.

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

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

For a more detailed discussion of legal proceedings of the Company, refer to Note 9—Commitments and Contingencies in the Notes to Consolidated Financial Statements of this Form 10-K.

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

No matters were submitted to a vote of stockholders during the fourth quarter of 2005.

 

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Part II

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

MARKET INFORMATION

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

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

 

2005

   High    Low   

Dividends

Per Share

First Quarter

   $ 15.47    $ 13.92    $ 0.0875

Second Quarter

     15.81      12.80      0.1000

Third Quarter

     16.79      14.40      0.1000

Fourth Quarter

     18.00      15.60      0.1000

2004

   High    Low   

Dividends

Per Share

First Quarter

   $ 14.02    $ 13.03    $ 0.0800

Second Quarter

     14.04      12.86      0.0875

Third Quarter

     14.79      12.93      0.0875

Fourth Quarter

     15.60      13.24      0.0875

HOLDERS

As of January 31, 2006, Alfa Corporation has approximately 2,600 stockholders of record.

DIVIDENDS

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

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

SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS

The table “Securities Authorized for Issuance Under Equity Compensation Plans” contained in the Proxy Statement for the annual meeting of stockholders to be held April 25, 2006 is incorporated herein by reference.

 

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PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASES

 

Period

  

Total Number

of Shares

Purchased

  

Average Price

Paid per Share

  

Total Number

of Shares

Purchased as

Part of Publicly

Announced

Plans or

Programs

  

Maximum

Number of

Shares that

May Yet Be

Purchased

Under the Plans

or Programs 1

January 1, 2005 - January 31, 2005

   —      $ —      —      3,952,377

February 1, 2005 - February 28, 2005

   —      $ —      —      3,952,377

March 1, 2005 - March 31, 2005

   —      $ —      —      3,952,377

April 1, 2005 - April 30, 2005

   131,600    $ 13.44    131,600    3,820,777

May 1, 2005 - May 31, 2005

   87,400    $ 13.64    87,400    3,733,377

June 1, 2005 - June 30, 2005

   —      $ —      —      3,733,377

July 1, 2005 - July 31, 2005

   —      $ —      —      3,733,377

August 1, 2005 - August 31, 2005

   —      $ —      —      3,733,377

September 1, 2005 - September 30, 2005

   —      $ —      —      3,733,377

October 1, 2005 - October 31, 2005

   —      $ —      —      3,733,377

November 1, 2005 - November 30, 2005

   —      $ —      —      3,733,377

December 1, 2005 - December 31, 2005

   —      $ —      —      3,733,377
                   

Total

   219,000    $ 13.52    219,000   
                   

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

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

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

 

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Item 6. Selected Financial Data.

 

    Years Ended December 31,  
(dollars in thousands except per share
amounts and number of agents)
  2005     2004     2003     2002     2001  

Premiums—Property Casualty Insurance

  $ 556,439     $ 485,534     $ 454,453     $ 423,593     $ 392,589  

Premiums and policy charges—Life Insurance

    76,633       71,224       66,172       63,005       56,007  

Net investment income

    94,932       89,361       83,096       88,113       84,533  

Realized investment gains

    6,051       7,049       6,264       5,160       6,448  

Other income

    22,850       8,124       9,832       9,225       8,368  
                                       

Total Revenues

    756,905       661,292       619,817       589,096       547,945  

Benefits, Losses and Expenses

    619,043       540,663       513,220       489,751       449,851  
                                       

Income before provision for income taxes

    137,862       120,629       106,597       99,345       98,094  

Provision for income taxes

    38,828       31,184       28,128       27,637       28,132  

Cumulative effect of changes in accounting principles

    —         —         —         —         (456 )
                                       

Net income

  $ 99,034     $ 89,445     $ 78,469     $ 71,708     $ 69,506  
                                       

Balance sheet data at December 31:

         

Invested assets

  $ 2,001,380     $ 1,854,212     $ 1,760,160     $ 1,618,033     $ 1,449,492  

Total assets

  $ 2,381,874     $ 2,222,664     $ 2,031,008     $ 1,862,207     $ 1,670,993  

Future policy benefits, losses and claims, unearned premiums

  $ 1,178,230     $ 1,076,108     $ 988,769     $ 908,178     $ 828,844  

Long-term obligations

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

Total liabilities

  $ 1,625,882     $ 1,531,211     $ 1,392,495     $ 1,296,109     $ 1,161,881  

Stockholders’ equity

  $ 755,992     $ 691,453     $ 638,513     $ 566,098     $ 509,112  

Per share data1:

         

Net income—Basic

  $ 1.24     $ 1.12     $ 0.98     $ 0.91     $ 0.89  

Net income—Diluted

  $ 1.23     $ 1.11     $ 0.98     $ 0.90     $ 0.88  

Cash dividends paid

  $ 0.3875     $ 0.3425     $ 0.315     $ 0.2975     $ 0.2825  

Annual dividend rate

  $ 0.40     $ 0.35     $ 0.32     $ 0.30     $ 0.29  

Stockholders’ equity

  $ 9.42     $ 8.66     $ 7.96     $ 7.14     $ 6.50  

Closing sales price at December 31

  $ 16.10     $ 15.19     $ 12.86     $ 12.01     $ 11.22  

Price/earnings ratio

    13.1 X     13.7 X     13.1 X     13.3 X     12.8 X

Weighted average shares outstanding—Basic

    80,141       79,985       79,809       78,804       78,316  

Weighted average shares outstanding—Diluted

    80,713       80,490       80,390       79,547       78,963  

Other data:

         

Life insurance inforce

  $ 21,209,234     $ 19,779,503     $ 18,262,749     $ 16,736,418     $ 15,167,308  

Number of agents

    3,061       616       615       618       613  

1 Per share amounts have been restated where appropriate to reflect 2-for-1 stock split in June 2002.

 

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

Management’s Discussion and Analysis of Financial Condition and Results of Operations addresses the financial condition of Alfa Corporation and its subsidiaries (the Company) as of December 31, 2005, compared with December 31, 2004 and the results of operations for each of the three years ended December 31, 2005. The following discussion should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements that are included in Item 8 of this Form 10-K.

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

OVERVIEW

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

 

    Alfa Insurance Corporation (AIC)

 

    Alfa General Insurance Corporation (AGI)

 

    Alfa Vision Insurance Corporation (AVIC)

 

    Alfa Life Insurance Corporation (Life)

 

    Alfa Financial Corporation (Financial)

 

    The Vision Insurance Group, LLC (Vision)

 

    Alfa Agency Mississippi, Inc. (AAM)

 

    Alfa Agency Georgia, Inc. (AAG)

 

    Alfa Benefits Corporation (ABC)

Alfa Corporation is affiliated with Alfa Mutual Insurance Company, Alfa Mutual Fire Insurance Company, and Alfa Mutual General Insurance Company (collectively, the Mutual Group). The Mutual Group owns 54.9% of Alfa Corporation’s common stock, their largest single investment. Alfa Corporation and its subsidiaries (the Company) together with the Mutual Group comprise the Alfa Group (Alfa). Alfa Virginia Mutual Insurance Company (Virginia Mutual) currently cedes 80% of its direct business to Alfa Mutual Fire Insurance Company (Fire) under an affiliate agreement signed in August 2001.

The Company’s revenue consists mainly of premiums earned, policy charges, net investment income and fee income. Benefit and settlement expenses consist primarily of claims paid and claims in

 

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process and pending and include an estimate of amounts incurred but not yet reported along with loss adjustment expenses. Other operating expenses consist primarily of compensation expenses, and other overhead business expenses, net of deferred policy acquisition costs.

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

 

    Property casualty insurance

 

    Life insurance

 

    Noninsurance

 

    Consumer financing

 

    Commercial leasing

 

    Agency operations

 

    Employee benefits administration

 

    Corporate and eliminations

Property casualty insurance operations accounted for 80.1% of revenues and 81.1% of net income in 2005. Life insurance operations generated 17.6% of revenues and 25.8% of net income during the same period. Noninsurance net income, combined with corporate expenses for 2005, resulted in a net loss of $6.9 million or 6.9% of net income.

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

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

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP) requires the Company’s management to make significant estimates and assumptions based on information available at the time the financial statements are prepared. In addition, management must ascertain the appropriateness and timing of any changes in these estimates and assumptions. Certain accounting estimates are particularly sensitive because of their significance to the Company’s financial statements and because of the possibility that subsequent events and available information may differ markedly from management’s judgments at the time financial statements are prepared. For the Company, the areas most subject to significant management judgments include reserves for property casualty losses and loss adjustment expenses, reserves for future policy benefits, deferred policy acquisition costs, valuation of investments, and reserves for pending litigation. The application of these critical accounting estimates impacts the values at which

 

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73% of the Company’s assets and 59% of the Company’s liabilities are reported at December 31, 2005 and therefore have a direct effect on net earnings and stockholders’ equity. The Company’s “Summary of Significant Accounting Policies” is presented in Note 1 of the Notes to Consolidated Financial Statements.

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

Reserves For Property Casualty Losses And Loss Adjustment Expenses

The estimated liabilities for losses and loss adjustment expenses include the accumulation of estimates of losses for claims reported prior to the balance sheet dates, estimates of losses for claims incurred but not reported and the development of case reserves to ultimate values, and estimates of expenses for investigating, adjusting and settling all incurred claims. Amounts reported are estimates of the ultimate costs of settlement, net of estimated salvage and subrogation. The estimates are necessarily subject to the outcome of future events, such as changes in medical and repair costs as well as economic, political and social conditions that impact the settlement of claims. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims. Due to the Company’s current mix of exposures, the majority of claims are settled within twelve months of the date of loss.

The amount of loss reserves for reported claims is based primarily upon a case-by-case evaluation of the risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions related to the type of loss. The amounts of loss reserves for unreported claims and loss adjustment expenses are determined using historical information by line of business as adjusted to current conditions. Inflation is implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results. Organized by accident year and evaluation dates, historical data on paid losses, loss adjustment expenses, case reserves, earned premium, catastrophe losses and carried reserves is provided to the Company’s actuaries who apply standard actuarial techniques to estimate a range of reasonable reserves. The carried reserve is then compared to these estimates to determine whether it is reasonable and whether any adjustments need to be recorded. The Company’s appointed actuary conducts his own analysis and renders an opinion as to the adequacy of the reserves. Reserve estimates are closely monitored and are rolled forward quarterly using the most recent information on reported claims. Each quarter, after the rolled forward analysis has been completed, a meeting is held to discuss the actuarial data. Management evaluates reserve level estimates across various segments and adjustments are made as deemed necessary. It is expected that such estimates will be more or less than the amounts ultimately paid when the claims are settled. Changes in these estimates are reflected in current operating results. An increase in the ending reserve for incurred but not reported losses of 1% would have negatively impacted income before income taxes by $453,358 at December 31, 2005. Similarly, increases of 1% in the reserves for unpaid losses and loss adjustment expenses would have reduced pretax earnings by $882,892 and $239,113, respectively.

Due to the Company’s geographically concentrated operations, it is possible that changes in assumptions based on regional data could cause fluctuations in reported results. However, the Company’s exposure to large adjustments in these reserves created by these assumption changes is partially limited by its participation in Alfa’s catastrophe protection program. Historically, the Company’s reserves, in the aggregate, have been adequate when compared to actual results. Given the inherent variability in the estimates, management believes the aggregate reserves are within a reasonable and acceptable range of adequacy.

 

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Reserves For Policyholder Benefits

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

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

In accordance with the provisions of SFAS No. 60 and the AICPA Audit and Accounting Guide, credit insurance reserves are held as unearned premium reserves calculated using the “rule of 78” method. Reserves for supplementary contracts with life contingencies are determined using the 1971 Individual Annuity Mortality Table and an interest rate of 7.5%. Likewise, reserves for accidental death benefits are determined predominately by using the 1959 Accidental Death Benefit Mortality Table and an interest rate of 3%. Reserves for disability benefits, both active and disabled lives, are calculated primarily from the 1952 Disability Study and a rate of 2.5%. A small portion of the Company’s disabled life reserves are calculated based on the 1970 Intercompany Group Disability Study and a rate of 3%.

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

 

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

 

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

 

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

 

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

 

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

Valuation Of Investments

Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in stockholders’ equity as a component of accumulated other comprehensive income (loss) and, accordingly, have no effect on net income. Fair values for fixed maturities are based on quoted market prices. The cost of investment securities sold is determined by using the first-in, first-out methodology. In some instances, the Company may use the specific identification method. The Company monitors its investment portfolio and conducts quarterly reviews of investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. Such evaluations involve judgment and consider the magnitude and reasons for a decline and the prospects for the fair value to recover in the near term. Declines resulting from broad market conditions

 

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or industry related events, and for which the Company has the intent to hold the investment for a period of time believed to be sufficient to allow a market recovery or to maturity, are considered to be temporary. Future adverse investment market conditions, or poor operating results of underlying investments, could result in an impairment charge in the future. Where a decline in fair value of an investment below its cost is deemed to be other than temporary, a charge is reflected in income for the difference between the cost or amortized cost and the estimated net realizable value. As a result, writedowns of approximately $1.0 million and $1.0 million were recorded in 2005 on equity securities and fixed maturities, respectively. During 2004, writedowns of approximately $111,000 were recorded on fixed maturities with no writedowns on equity securities.

Policy Acquisition Costs

Policy acquisition costs, such as commissions, premium taxes and certain other underwriting and marketing expenses that vary with and are directly related to the production of business have been deferred. Traditional life insurance acquisition costs are being amortized over the premium payment period of the related policies using assumptions consistent with those used in computing policy benefit reserves. Acquisition costs for universal life type policies are being amortized over a thirty-year period in relation to the present value of estimated gross profits that are determined based upon surrender charges and investment, mortality and expense margins. Investment income is considered, if necessary, in the determination of the recoverability of deferred policy acquisition costs. Acquisition costs for property casualty insurance are amortized over the period in which the related premiums are earned. Future changes in estimates, such as the relative time certain employees spend in initial policy bookings, may require adjustment to the amounts deferred. Changes in underwriting and policy issuance processes may also give rise to changes in these deferred costs.

Reserves For Litigation

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

 

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RESULTS OF OPERATIONS

The following table sets forth consolidated summarized income statement information for the years ended December 31, 2005, 2004 and 2003:

 

     Years Ended December 31,  
     2005     2004     2003  
     (in thousands, except share and per share data)  

Revenues

      

Property casualty insurance premium

   $ 556,439     $ 485,534     $ 454,453  

Life insurance premiums and policy charges

     76,633       71,224       66,172  
                        

Total premiums and policy charges

   $ 633,072     $ 556,758     $ 520,625  
                        

Net investment income

   $ 94,932     $ 89,361     $ 83,096  
                        

Other income

   $ 22,850     $ 8,124     $ 9,832  
                        

Total revenues

   $ 756,905     $ 661,292     $ 619,817  
                        

Net income

      

Insurance operations

      

Property casualty insurance

   $ 80,195     $ 68,699     $ 53,112  

Life insurance

     21,736       18,763       19,058  
                        

Total insurance operations

   $ 101,931     $ 87,462     $ 72,170  

Noninsurance operations

     (38 )     2,138       4,031  

Realized investment gains, net of tax

     3,933       4,582       4,071  

Corporate

     (6,792 )     (4,737 )     (1,803 )
                        

Net income

   $ 99,034     $ 89,445     $ 78,469  
                        

Net income per share

      

—Basic

   $ 1.24     $ 1.12     $ 0.98  
                        

—Diluted

   $ 1.23     $ 1.11     $ 0.98  
                        

Weighted average shares outstanding

      

—Basic

     80,141,068       79,984,651       79,808,669  
                        

—Diluted

     80,712,923       80,489,502       80,390,001  
                        

Consolidated results of operations have been impacted by the following events in 2005:

 

    Effective January 1, 2005, the property casualty insurance Pooling Agreement (refer to Note 2—Pooling Agreement in the Notes to Consolidated Financial Statements) was modified as follows:

 

    AVIC, which writes nonstandard automobile business in nine states, was added as a participant to the pool.

 

    Fire’s quota share reinsurance agreement with Virginia Mutual was retroceded to the pool.

 

    On January 3, 2005, the Company completed the purchase of Vision, a full-service managing general agency that writes nonstandard automobile insurance policies in nine states, and provides all underwriting, claims, actuarial and financial services on behalf of its contracted carriers, which includes AVIC.

 

    During the fourth quarter, a new property casualty policy administration system was implemented for the automobile line of business.

 

    On December 31, 2005, the Company completed the sale of a substantial portion of its commercial lease portfolio and other assets, net of related liabilities, to OFC Servicing Corporation, a wholly-owned subsidiary of MidCountry Financial Corporation (MidCountry).

 

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Total premiums and policy charges increased $76.3 million, or 14% in 2005 and $36.1 million, or 7%, in 2004. For 2005, AVIC contributed $20.8 million and Virginia Mutual contributed $21.8 million, for a combined amount of $42.6 million of the increase. The persistency ratio for life business was 91.2% at December 31, 2005 and 2004. Persistency, a non-GAAP financial measure, represents the ratio of the annualized premium of policies inforce at December 31, 2005 and 2004 as a percentage of the annualized premium paid at December 31, 2005 and 2004, respectively.

Net investment income increased 6% in 2005 due to increased partnership earnings and a slightly lower yield on increased balances of fixed income securities, while net investment income grew 8% in 2004 due to increased earnings from fixed income securities and partnerships. Positive cash flows resulted in an increase in invested assets of 8% and 5% in the twelve months since December 31, 2005 and 2004, respectively.

Other income increased $14.7 million in 2005 after decreasing $1.7 million in 2004. In 2005, AVIC contributed $3.5 million of the increase and Vision contributed $22.9 million, which was offset by intercompany eliminations of $12.0 million.

Operating income for the property casualty subsidiaries increased by approximately $11.5 million, or 17%, in 2005 and $15.6 million, or 29%, in 2004. In 2005, AVIC and Virginia Mutual contributed $2.9 million in operating income. AIC and AGI operating income increased $8.6 million as the non-storm loss ratio, declined from 59.4% in 2004 to 58.2% in 2005. During the first quarter of 2005, $11.6 million in pretax storm losses were incurred which was the limit under the Company’s catastrophe program. Storm losses of $9.2 million were incurred during 2004. The expense ratio was impacted with the introduction of the new policy administration system by $2.4 million, or 0.5% of the expense ratio. The return on average equity for 2005 was 18.6%, compared to 16.7% for 2004. Return on average equity, a non-GAAP financial measure, is defined as net income divided by the simple average of beginning and ending stockholders’ equity.

Life insurance operating income increased $3.0 million or 16% in 2005 as a result of a lower mortality ratio of 96% compared to 104% during 2004, premiums and policy charges growth of 8%, and net investment income growth of 4% due to increased investments in fixed maturities at a slightly lower yield. Mortality, a non-GAAP financial measure, represents the ratio of actual to expected death claims. Therefore, in 2005, the Company experienced more favorable financial results when compared to 2004 due to the lower mortality ratio.

Noninsurance operating income decreased $2.2 million or 102% in 2005 after declining 47% in 2004. Starting in 2005, this segment contains all agency operations, which include Vision, AAG and AAM. Due to unanticipated delays in licensing for AVIC, Vision experienced lower revenues than expected. By the end of the fourth quarter of 2005, all licenses were in place. Also impacting this segment was the reduction in commercial leasing activities as a result of management’s decision to hold this division for sale as of December 31, 2004 and which was subsequently sold on December 31, 2005. Rising interest rates also contributed to reduced margins within Financial’s portfolio. ABC’s operations resulted in an operating loss for 2005 as the result of recognition of a deferred tax asset and subsequent charge to earnings for the change in the deferred tax asset arising from the formation of the entity in 1999.

Corporate expenses increased by $2.1 million in 2005 and $2.9 million in 2004. Current year results were impacted by increased costs on the Company’s short-term borrowings and the elimination of profits generated by transactions between the property casualty segment and Vision, which was acquired in January 2005. In 2004, corporate expenses were negatively influenced by increased professional fees related to the compliance requirements of the Sarbanes-Oxley Act of 2002 and rising interest rates.

 

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Net income improved 10.4% on a per diluted share basis in 2005 compared to 2004 and increased 13.8% on a similar basis in 2004 compared to 2003.

PROPERTY CASUALTY INSURANCE OPERATIONS

The following table sets forth summarized financial information for the Company’s property casualty insurance subsidiaries, AIC, AGI and AVIC, for the years ended December 31, 2005, 2004 and 2003:

 

     Years Ended December 31,  
     2005     2004     2003  
     (in thousands)  

Earned premiums

      

Personal lines

   $ 519,874     $ 473,931     $ 441,668  

Commercial lines

     16,862       16,135       15,325  

Reinsurance ceded

     (3,063 )     (4,706 )     (2,668 )

Reinsurance assumed

     22,766       174       128  
                        

Total earned premiums

   $ 556,439     $ 485,534     $ 454,453  
                        

Net underwriting income

   $ 55,871     $ 50,158     $ 35,224  
                        

Loss ratio

     60.1 %     61.3 %     62.4 %

LAE ratio

     4.3 %     4.2 %     3.9 %

Expense ratio

     25.5 %     24.1 %     25.9 %

GAAP basis combined ratio

     90.0 %     89.7 %     92.2 %

Underwriting margin

     10.0 %     10.3 %     7.8 %

Net investment income

   $ 40,200     $ 34,746     $ 28,503  
                        

Other income and fees

   $ 9,621     $ 5,905     $ 5,899  
                        

Pretax operating income

   $ 105,692     $ 90,809     $ 69,626  
                        

Operating income, net of tax

   $ 80,195     $ 68,699     $ 53,112  
                        

Realized investment gains (losses), net of tax

   $ 121     $ (3,129 )   $ (1,486 )
                        

Net income

   $ 80,316     $ 65,570     $ 51,626  
                        

2005 Compared to 2004

Results of operations for this segment have been impacted by the following events in 2005:

 

    Effective January 1, 2005, the property casualty insurance Pooling Agreement (refer to Note 2—Pooling Agreement in the Notes to Consolidated Financial Statements) was modified as follows:

 

    AVIC, which writes nonstandard automobile business in nine states, was added as a participant to the pool.

 

    Fire’s quota share reinsurance agreement with Virginia Mutual was retroceded to the pool.

 

    On January 3, 2005, the Company completed the purchase of Vision, a full-service managing general agency that writes nonstandard automobile insurance policies in nine states, and provides all underwriting, claims, actuarial and financial services on behalf of its contracted carriers, which includes AVIC.

 

    During the fourth quarter, a new property casualty policy administration system was implemented for the automobile line of business.

 

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AVIC, a direct writer of nonstandard risk automobile business in Missouri, Indiana, Ohio, Virginia, Tennessee, Arkansas, Kentucky and Florida, and assumes business in Texas, contributed $53 million of written premium and $32 million of earned premium to the pool during 2005. Virginia Mutual, a direct writer of personal and commercial automobile business, homeowners, and other personal and commercial business in Virginia and North Carolina, through the quota share agreement, contributed $50.2 million of written premium, of which $16.9 million was related to unearned premium existing at December 31, 2004 with $33.3 written during 2005. In addition, Virginia Mutual contributed $33.5 million of earned premium to the pool during 2005. The Company’s pooled share of AVIC and Virginia Mutual premium is reported as $20.0 million of personal lines earned premiums and $22.6 million of reinsurance assumed earned premiums in the table above.

The loss ratio for the year related to the AVIC business was 61.4% and Virginia Mutual was 49.6%, which represents 4.2% of the overall loss ratio of 60.1%. Also included in the loss ratio are 2.1% of catastrophe losses. Alfa had eight events totaling $293.9 million in gross catastrophe losses during 2005 and five events totaling $347.5 million in 2004 due to the impact of hurricanes, tornadoes and other severe weather. The effect of claims from these events impacted underwriting results by $0.09 and $0.07 per share in 2005 and 2004, respectively, after taxes, based upon the pooling agreement and the catastrophe protection program. For additional information on the pooling agreement, refer to Note 2—Pooling Agreement in the Notes to Consolidated Financial Statements.

The loss adjustment expense (LAE) ratio has been impacted by the addition of AVIC, which has a different expense structure than AIC and AGI. AVIC pays Vision a fee based on earned premiums to provide loss adjustment activities. This fee structure contributed 0.4% to the LAE ratio.

The expense ratio has been impacted by the different expense structure of AVIC. AVIC pays a commission to Vision, which is based on written premium, for underwriting and servicing the business written. In addition, the policy fees collected by AVIC, net of related premium taxes, are paid to Vision. These amounts, net of deferral and amortization, represent 1.5% of the expense ratio. The commission paid to Virginia Mutual under the quota share agreement represents 1.4% of the expense ratio. Also included in the expense ratio for 2005 is the 0.5% effect of the new policy administration system that went into production in the fourth quarter.

The overall higher expense structures of AVIC and Virginia Mutual, along with the impact of technology costs has produced a slightly lower underwriting margin of 10.0% in 2005, compared with 10.3% in 2004. Underwriting margin, a non-GAAP financial measure, represents the percentage of each premium dollar earned which remains after losses, loss adjustment expenses and other operating expenses.

Included in other income and fees in 2005 is the addition of $3.5 million of policy fees collected by AVIC.

Net investment income increased 15.7% for 2005, compared to 21.9% for 2004. The slowdown in growth is the result of slightly lower fixed income securities yields with only a 0.5% increase in fixed income balances, offset by increases in partnership income.

Pretax operating income increased $4.5 million and operating income, net of tax, increased $2.9 million as a result of the addition of AVIC and Virginia Mutual business.

Net income increased 22.5% for 2005, compared to 27.0% in 2004, with AVIC and Virginia Mutual contributing $2.9 million in 2005. Return on equity was 18.6% for 2005 compared to 16.7% in 2004.

 

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At December 31, 2005, the Company’s property casualty subsidiaries’ Adjusted Capital calculated in accordance with National Association of Insurance Commissioners (NAIC) Risk-Based Capital (RBC) guidelines was $407.5 million compared to the Authorized Control Level (Required) RBC of $30.3 million. These statutory measures serve as a benchmark for the regulation of an organization’s solvency by state insurance regulators.

2004 Compared to 2003

Earned premiums increased $31.1 million, or 6.8% in 2004, due to an increase in sales production of new business and the positive impact of homeowner rate increases offset by increases in ceded catastrophe premium of approximately $1.8 million. These factors contributed to the growth in personal lines earned premiums of 7.3% and 7.5% in 2004 and 2003, respectively.

Operating income increased by approximately $15.6 million despite $9.2 million in pretax catastrophic storm losses in 2004. Approximately $7.9 million in similar losses were incurred in 2003. The underwriting margin of 10.3% in 2004 was the result of a 61.3% loss ratio (59.4% excluding storm losses), a 4.2% LAE ratio and a 24.1% expense ratio compared to a loss ratio of 62.4%, a LAE ratio of 3.9% and an expense ratio of 25.9% in 2003.

The non-storm loss ratio decrease was due primarily to a lower loss ratio in the automobile line of business. As the largest line of business within the Company, automobile comprised 60.7% of property casualty written premiums in 2004 and generated another strong loss ratio of 62.2%.

The Alfa Group had approximately $347.5 million in gross catastrophe losses during 2004 due to the impact of hurricanes and other severe weather occurring in the second and third quarters. The effect of claims from these events impacted underwriting results by $0.07 per share, based upon the pooling agreement and catastrophe protection program. Another factor in the improved underwriting margin was a decrease in the expense ratio from 2003 levels primarily attributable to the favorable comparison created by adjustments recorded during 2003 to reserves established to cover the cost of purchasing books of business from independent exclusive agents upon their separation from the Company.

Invested assets grew 16.4% in 2004 while investment income increased by $6.2 million primarily due to an increase in partnership earnings. At December 31, 2004, the Company’s property casualty subsidiaries’ Adjusted Capital calculated in accordance with NAIC RBC guidelines was $369.8 million compared to the Authorized Control Level (Required) RBC of $21.5 million.

 

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LIFE INSURANCE OPERATIONS

The following table sets forth summarized financial information for the Company’s life insurance subsidiary, Life, for the years ended December 31, 2005, 2004 and 2003:

 

     Years Ended December 31,
     2005    2004    2003
     (in thousands)

Premiums and policy charges

        

Universal life policy charges

   $ 20,803    $ 19,863    $ 18,823

Universal life policy charges—COLI

     3,812      3,473      3,245

Interest sensitive life policy charges

     10,884      10,754      10,475

Traditional life insurance premiums

     40,617      36,642      33,087

Group life insurance premiums

     517      492      542
                    

Total premiums and policy charges

   $ 76,633    $ 71,224    $ 66,172
                    

Net investment income

   $ 50,963    $ 49,129    $ 44,735
                    

Benefits and expenses

   $ 87,841    $ 86,864    $ 76,368
                    

Amortization of deferred policy acquisition costs

   $ 9,277    $ 8,024    $ 8,788
                    

Pretax operating income

   $ 30,478    $ 25,465    $ 25,751
                    

Operating income, net of tax

   $ 21,736    $ 18,763    $ 19,058
                    

Realized investment gains, net of tax

   $ 3,837    $ 7,873    $ 5,580
                    

Net income

   $ 25,573    $ 26,636    $ 24,638
                    

2005 Compared to 2004

Life’s premiums and policy charges increased $5.4 million, or 7.6%, for 2005, compared to an increase of $5.1 million, or 7.6% in 2004. Issued annualized new business premium increased by 1.9% to $13.6 million with a total volume of $2.9 billion of insurance being issued.

Total life insurance inforce for 2005 increased $1.4 billion, with term insurance increasing $1.2 billion, or 12.4%. Annualized premiums for inforce business increased 6%, or $7.2 million, for the year, with term insurance increasing 11.6% or $3.4 million. The persistency ratio remained steady at 91.2%.

The mortality ratio declined to 96% of expected in 2005 from 104% of expected in 2004. The result was an increase of only $1.3 million in benefits and claims expense for the year, which is offset by a decline of $918 thousand in legal costs and relatively low growth in operating expenses. Amortization of deferred policy acquisition costs have increased as a result of growth in deferred costs related to new business production increases.

Invested assets increased 7.2%, with an increase of amortized value in fixed income securities of 12.5%, while net investment income increased 3.7%, with income from fixed maturities up $1.1 million, reflecting a slightly lower yield. Writedowns accounted for $1.1 million of the reduction in realized investment gains, net of tax.

Operating income increased 15.9% during 2005 after declining 1.5% in 2004. With a decrease in realized investment gains, net income declined 4.0% in 2005 compared to an increase in net income of 8.1% in 2004, which was the result of an increase in realized investment gains in 2004.

 

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At December 31, 2005, the life subsidiary’s Adjusted Capital calculation in accordance with NAIC RBC guidelines was $189.9 million compared to the Authorized Control Level (Required) RBC amount of $12.9 million.

2004 Compared to 2003

The Company’s life insurance premiums and policy charges increased $5.1 million, or 7.6% in 2004. Universal life policy charges and traditional premiums increased by $1.3 million and $3.6 million, respectively. The increase in traditional premiums was due to continued increases in term product production and a decline in termination rates. In addition, interest sensitive life policy charges grew by $279,000 or 2.7% as a result of re-pricing the product and adding a preferred underwriting class. New business premium increased 1.4% while persistency declined from 92.9% to 91.2%.

Life insurance operating income, net of tax, decreased $295,000 or 1.5% in 2004. Death claims increased $2.6 million, or 10.5% in 2004, while mortality declined from 105% in 2003 to 104% in 2004. Investment income increased 9.8% while invested assets grew by 7.0% due to positive cash flows. General expenses increased by approximately $1.5 million or 16.2% primarily due to an increase in legal costs. Amortization of deferred policy acquisition costs declined by 8.7% as amortization factors were adjusted to properly reflect expected gross profits of universal life products.

At December 31, 2004, the life subsidiary’s Adjusted Capital calculation in accordance with NAIC RBC guidelines was $173.6 million compared to the Authorized Control Level (Required) RBC amount of $11.6 million.

NONINSURANCE OPERATIONS

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

2005 Compared to 2004

Results of operations for this segment have been impacted by the following events in 2005:

 

    On January 3, 2005, the Company completed the purchase of Vision, a full-service managing general agency that currently writes nonstandard automobile insurance policies in nine states. In addition, during 2005, Vision wrote a limited amount of homeowner business through other carriers as a general agency. Vision is headquartered in Brentwood, Tennessee and provides all underwriting, claims, actuarial and financial services on behalf of its contracted carriers, which includes AVIC.

 

    On December 31, 2005, the Company completed the sale of a substantial portion of its commercial lease portfolio and other assets, net of related liabilities, to OFC Servicing Corporation, a wholly-owned subsidiary of MidCountry Financial Corporation (MidCountry).

 

    All agency operations, Vision, AAM and AAG, are included in this segment.

Noninsurance operating income decreased $2.2 million, or 102%, in 2005. Net loss for the year was $64 thousand.

Agency operations for the year produced a net loss of $14 thousand. During 2005, AAM and AAG produced $72 thousand in operating income. Vision generated an operating loss of $86 thousand due to infrastructure costs and lower than anticipated premium volume attributable to delays in licensing.

OFC Capital, the commercial leasing division of Financial, was sold on December 31, 2005. As a result of management’s decision in the fourth quarter of 2004 to sell OFC Capital, a significant portion

 

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of the portfolio was syndicated in 2004, and new lease production was limited in 2005, creating a significant reduction in leasing income for 2005 of 46.9%. In addition, the change in interest rates during the year increased interest expense 12.9%. Results were also negatively impacted by additional bad debt reserves established in the commercial lease portfolio. The net loss for OFC Capital for the year was $2.2 million. No gain or loss was recognized on the sale and all revenue and expenses are included in continuing operations instead of discontinued operations due to the Company’s significant continuing involvement with MidCountry. The Company retained a small portion of the commercial lease portfolio which OFC Servicing Corporation will service. All of the results of operations relating to the retained portfolio activities will continue to be reported in this segment.

Loan operations in Financial continue to grow with a 12.3% increase in the loan portfolio, an increase in the loan portfolio yield to 7.41% from 6.89%, and a delinquency ratio of only 1.44%. Interest rate increases during the year reduced margins slightly. Equity in net earnings (after internal capital charge) of MidCountry increased 113.7% for the year while the carrying value increased 3.6%. These components of Financial produced net income of $3.1 million for the year.

ABC had an operating loss of $931 thousand for 2005 as a result of recognition of a deferred tax asset and subsequent charge to earnings for the change in the deferred tax asset.

2004 Compared to 2003

Noninsurance operations were down 47% due primarily to unfavorable results in the finance subsidiary. Collateral loans grew by 10.4% to $110.8 million at December 31, 2004 while the yield on the portfolio increased 59 basis points in 2004. The commercial lease portfolio decreased by 31.0% to $81.3 million at December 31, 2004 as the commercial leasing division sold portions of its portfolio. Commercial lease operations experienced a decrease in earnings of approximately $2.5 million after reserves were established related to the Chapter 7 bankruptcy filing of NorVergence, a telecommunications provider who previously supplied essential services to approximately 340 of the Company’s leasing customers. In addition, the finance subsidiary’s investment in MidCountry yielded pretax income of approximately $540,000 during 2004 compared to $965,000 in 2003. This decline is attributable to acquisition activity and stock offering expenses incurred in 2004 by MidCountry as well as interest costs associated with the additional investment of $36.1 million by the finance subsidiary. Operating income from the Company’s subsidiary covering certain employee benefits increased by approximately $1.1 million to $1.25 million in 2004. The sales of the Company’s real estate and construction subsidiaries in February 2004 created unfavorable earnings comparisons since these business units incurred losses of approximately $47,000 prior to their dispositions in 2004 compared to earnings of approximately $364,000 during 2003.

CORPORATE

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

2005 Compared to 2004

Corporate expenses, including the impact of eliminations, increased $2.0 million in 2005 due primarily to an increase in borrowing costs and the elimination of profits generated by transactions between the property casualty segment and Vision. Unfavorable increases in short-term interest rates and an increase in the commercial paper borrowings attributable to corporate functions and the purchase of Vision led the Company’s interest expense to rise by approximately $1.9 million from levels experienced in 2004. The weighted average rate increased from 2.3% to 4.3% with corporate debt increasing from $58.1 million at the end of 2004 to $77.6 million on December 31, 2005.

 

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2004 Compared to 2003

Corporate expense increased approximately $2.9 million, or 162.7% in 2004 primarily due to higher auditing and legal expenses compounded by negative comparisons created by a favorable adjustment made to reserves for employee benefit costs of $1.7 million in 2003. In addition, interest expense on short-term borrowings increased by $265,000 as interest rates climbed during 2004. The weighted average rate increased from 1.2% to 2.3% with corporate debt increasing from $52.6 million at the end of 2003 to $58.1 million on December 31, 2004.

INVESTMENTS

The Company has historically produced positive cash flow from operations which has resulted in increasing amounts of funds available for investment and, consequently, higher investment income. Investment income is also affected by investment yields. Information about cash flows, invested assets and yields are presented below for the years ended December 31, 2005, 2004 and 2003:

 

     Years Ended December 31,  
         2005             2004             2003      

Increase (decrease) in cash flow from operations

   (8.6 )%   31.6 %   7.0 %

Increase in invested assets since January 1, 2005 and 2004

   7.9 %   5.3 %   8.8 %

Investment yield rate

   6.0 %   6.0 %   6.0 %

Increase in net investment income

   6.2 %   7.5 %   (5.7 )%

As a result of the overall positive cash flows from operations, invested assets grew 7.9% since December 31, 2004 while net investment income increased 6.2%. The decrease in cash flow from operations in 2005 was due primarily to the increase in liabilities from higher partnership commitments in 2004 offset by increases in policy liabilities impacted by catastrophes during 2005. Property casualty underwriting income of $55.9 million in 2005, $50.2 million in 2004 and $35.2 million in 2003 positively impacted cash flow from operations. In addition, the COLI plan in the life insurance subsidiary provided approximately $15 million in additional cash flow in 2005, $15 million in 2004 and $16 million in 2003. Net increases in cash resulting from increased borrowings were primarily used to support growth in the loan portfolio of the finance subsidiary and to fund a portion of the acquisition costs of Vision. During 2005, the Company also increased its investment in fixed maturity securities by approximately $89.5 million. The Company’s increase in net investment income resulted primarily from earnings on fixed maturities, equity-method investments and partnerships offset by increased borrowing costs and lower lease revenues.

The overall yield rate, calculated using amortized cost, remained unchanged during 2005 at 6.0%. The Company had net realized investment gains before income taxes of approximately $6.1 million in 2005 compared to realized investment gains of approximately $7.0 million during 2004. These gains are primarily from sales of equity securities. Such realized gains on sales of equity securities are the result of market conditions and therefore can fluctuate from period to period.

 

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The composition of the Company’s investment portfolio is as follows at December 31, 2005 and 2004:

 

     December 31,  
     2005     2004  

Fixed maturities

    

Taxable

    

Mortgage-backed (CMO’s)

   31.3 %   34.0 %

Corporate bonds

   23.5     21.7  
            

Total taxable

   54.8     55.7  

Tax exempts

   16.1     17.3  
            

Total fixed maturities

   70.9     73.0  
            

Equity securities

   5.4     5.4  

Policy loans

   3.1     3.1  

Collateral loans

   6.2     6.0  

Commercial leases

   0.1     0.3  

Other long-term investments

   3.1     3.6  

Other long-term investments in affiliates

   7.0     4.2  

Short-term investments

   4.2     4.4  
            

Total

   100.0 %   100.0 %
            

The majority of the Company’s investment portfolio consists of fixed maturities that are diverse as to both industry and geographic concentration. In 2005, the overall mix of investments shifted with rising interest rates reducing unrealized gains within the fixed maturity portfolio and the Company increasing other long-term investments in affiliates by $55.5 million as a result of the sale of OFC Capital.

The rating of the Company’s portfolio of fixed maturities using the Standard & Poor’s rating categories is as follows at December 31, 2005 and 2004:

 

     December 31,  
     2005     2004  

AAA to A-

   90.8 %   92.8 %

BBB+ to BBB-

   7.3     6.8  

BB+ and below (below investment grade)

   1.9     0.4  
            
   100.0 %   100.0 %
            

At December 31, 2005, all securities in the fixed maturity portfolio were rated by an outside rating service. The Company considers bonds with a quality rating of BB+ and below to be below investment grade or high yield bonds (also called junk bonds).

At December 31, 2005, approximately 44.1% of fixed maturities were mortgage-backed securities. Such securities are comprised of Collateral Mortgage Obligations (CMO’s) and pass through securities. Based on reviews of the Company’s portfolio of mortgage-backed securities, the impact of prepayment risk on the Company’s financial position and results from operation is not believed to be significant. These risks are discussed in more detail in Item 7A of this Form 10-K. At December 31, 2005, the Company’s total portfolio of fixed maturities had gross unrealized gains of $38.3 million and gross unrealized losses of $13.4 million. All securities are priced by nationally recognized pricing services or by broker/dealers securities firms. During 2005, the Company sold approximately $108.4 million in fixed maturities available for sale. These sales resulted in gross realized gains of $426,899 and gross

 

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realized losses of $2,231,672. During 2004, the Company sold approximately $61.4 million in fixed maturities available for sale. These sales resulted in gross realized gains of $391,408 and gross realized losses of $952,108.

The Company monitors its level of investments in high yield fixed maturities and its level of equity investments in companies that issue high yield debt securities. Management believes the level of such investments is not significant to the Company’s financial condition. At December 31, 2005, the Company had unrealized gains in such investments of approximately $134,000 compared to approximately $3.5 million at December 31, 2004. The Company recognized a net gain of $80,256 on the disposal of high yield debt securities in 2005 after recognizing a net loss of $151,375 on similar disposals in 2004.

It is the Company’s policy to write down securities for which declines in value have been deemed to be other than temporary. The amount written down represents the difference between the cost or amortized cost and the fair value at the time of determining the security was impaired. Quarterly reviews are conducted by the Company to ascertain which securities, if any, have become impaired in value. Investments in securities entail general market risk as well as company specific risk. During 2005, the Company wrote down three bond issues totaling $1,046,867 and five equity securities totaling $1,004,197 for which declines in value were deemed to be other than temporary. During 2004, the Company wrote down one bond issue totaling $111,279 for which its decline in value was deemed to be other than temporary. There were no non-performing bonds included in the portfolio at either December 31, 2005 or December 31, 2004.

Of the Company’s approximately $13.4 million in gross unrealized losses on fixed maturities available for sale, $10.2 million or 75.9% are related to mortgage-backed securities, $2.1 million or 15.6% to obligations of United States government corporations and agencies, $583,000 or 4.4% to corporate securities, $461,000 or 3.4% to obligations of states and political subdivisions and $96,000 or 0.7% to United States treasury securities. At December 31, 2005, unrealized losses of approximately $3.2 million existed on equity securities directly owned by the Company. Of this amount, the greatest concentrations of gross unrealized losses were in the healthcare, information technology and consumer discretionary sectors where the Company had losses of approximately $1.1 million, $563,000 and $481,000, respectively. In assessing each security, the Company analyzes the industry and earnings trends of the underlying issuer, the length of time the security has continuously been in a loss position, and the magnitude of the loss in comparison to its cost. Generally, the Company writes down securities that have been continuously in a loss position of at least 20% for six consecutive months. In addition, management reviews the underlying causes for any significant loss position within the debt securities to determine if the item is impaired. Due to the subjectivity of the writedown process, there are risks and uncertainties that could impact the Company’s future earnings and financial position. If recoveries in the price of securities fail to materialize, the Company’s earnings and financial position will be negatively impacted. The Company’s investment philosophy is one that generally looks for long-range growth based on the Company’s willingness and ability to hold investments for extended periods of time.

Six equity securities had experienced a reduction in value of at least 20% in value at the end of 2005. Of these equity securities in loss positions, $413,849 of the losses had been in loss positions for less than three months and $468,715 of the losses had been in loss positions for longer than three months but less than six months. No fixed maturity had experienced a reduction in value of at least 20% at the end of 2005. The Company’s general practice is to re-evaluate any security written down on a periodic basis in order to determine whether additional impairment has occurred.

At December 31, 2005, the Company held below investment grade fixed maturities with a cost of $27,806,121 and a fair value of $27,878,697. While these securities represent 2.0% of both the cost and fair value of the Company’s total fixed maturity portfolio, only three of these investments were in an unrealized loss position. Additionally, at December 31, 2005, the Company owned equity securities

 

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that have issued “junk” bonds with a cost of $7,202,891 and a fair value of $7,264,420. These securities had gross unrealized gains of $562,639 and gross unrealized losses of $501,110 at the end of the year. These unrealized losses comprised less than 0.5% of the total fair value and 13.9% of the total gross unrealized losses from equity securities for the Company at December 31, 2005.

The table below shows a breakdown of the unrealized losses on fixed maturities at December 31, 2005 based on the maturity date of each.

 

    

Gross

Unrealized Loss

Less than 1 year

   $ 637

Between 1 and 3 years

     225,850

Between 3 and 5 years

     726,713

Between 5 and 10 years

     1,655,434

Between 10 and 20 years

     2,266,242

Over 20 years

     8,528,316
      
   $ 13,403,192
      

Of the fixed maturities experiencing declines in value at December 31, 2005, none was in a loss position of over $500,000. Of the equity securities directly owned by the Company with unrealized losses at December 31, 2005, eleven were in a loss position of over $100,000. Of these securities, three securities are part of the healthcare sector, three securities are part of the consumer discretionary sector, two securities are part of the industrials sector, one security is part of the energy sector, one security is part of the materials sector and one security is part of the technology sector. These securities cumulatively represented 14.6% of the fair value of equity securities at December 31, 2005 and a 12.4% decline from cost.

The Company’s investment in collateral loans and commercial leases consists primarily of consumer loans and commercial leases originated by the finance subsidiary. The majority of the commercial lease portfolio was reclassified to Assets Classified as Held for Sale at December 31, 2004 and subsequently sold in the fourth quarter of 2005. Automobiles, equipment and other property collateralize the Company’s loans and leases. At December 31, 2005, the delinquency ratio on the loan portfolio was 1.44%, or $1.8 million. Loans charged off in 2005 totaled $422,288. At December 31, 2005, the Company maintained an allowance for loan losses of $1,406,871 or approximately 1.1% of the outstanding loan balance. In addition, at December 31, the Company maintained an allowance for lease losses of $8,083,758 or approximately 83.2% of the outstanding lease balance. Leases charged off in the same period were $1,415,578. Other significant long-term investments include assets leased under operating leases, partnership investments and other equity-method investments.

The Company periodically invests in affordable housing tax credit partnerships. At December 31, 2005, the Company had legal and binding commitments to fund partnerships of this type in the amount of approximately $23.5 million. The Company’s carrying value of such investments was $43.0 million at December 31, 2005.

During the third quarter of 2002, the Company’s finance subsidiary invested $13.5 million in MidCountry, a financial services holding company. Financial invested an additional $36.1 million in MidCountry during the fourth quarter of 2004 to maintain its approximate original ownership in the entity. Financial accounts for earnings from MidCountry using the equity method of accounting. Pretax operating income was approximately $1.2 million in 2005 compared to approximately $540,000 in 2004.

INCOME TAXES

The effective tax rate was 28.2% in 2005, 25.9% in 2004 and 26.4% in 2003. The increase in the effective tax rate in 2005 from 2004 is due to increases in income before the provision for income

 

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taxes as compared to the relative mix of taxable income versus tax-exempt income. In addition, 1.2% of the increase is related to the recognition of a deferred tax asset and the subsequent charge to income tax expense for the change in this deferred tax asset arising from the formation of Alfa Benefits Corporation in 1999. The slight decrease in effective tax rate in 2004 when compared to 2003 is due primarily to an increase in investments generating affordable housing tax credits.

IMPACT OF INFLATION

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

LIQUIDITY AND CAPITAL RESOURCES

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

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

In evaluating current and potential financial performance of any corporation, investors often wish to view the contractual obligations and commitments of the entity. The Company has a limited number of contractual obligations in the form of long-term debt and leases. These leases have primarily been originated by its insurance subsidiaries and Vision. Operating leases supporting the corporate operations are the responsibility of Mutual. In turn, the Company reimburses Mutual monthly for a portion of these and other expenses based on a management and operating agreement. There are currently no plans to change the structure of this agreement.

The Company’s contractual obligations at December 31, 2005 are summarized below:

 

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

Operating leases

  $ 3,999,378   $ 1,172,572   $ 1,795,471   $ 1,031,335   $ —  

Capital lease obligations

    146,216     124,858     21,358     —       —  

Unconditional purchase obligations

    —       —       —       —       —  

Notes payable to affiliates

    20,887,635     20,887,635     —       —       —  

Long-term debt

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

Other long-term obligations

    —       —       —       —       —  
                             

Total contractual obligations

  $ 95,033,229   $ 22,185,065   $ 1,816,829   $ 1,031,335   $ 70,000,000
                             

 

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The Company maintains a variety of funding agreements in the form of lines of credit with affiliated entities. The chart below depicts, at December 31, 2005, the cash outlay by the Company representing the potential full repayment of lines of credit it has outstanding with others. Also included with the amounts shown as “lines of credit” are the potential amounts the Company would have to supply to other affiliated entities if they made full use of their existing lines of credit during 2006 with the Company’s finance subsidiary. Other commercial commitments of the Company shown below include commercial paper outstanding, scheduled fundings of partnerships, potential performance payouts related to Vision and funding of a policy administration system project of the life subsidiary.

 

    Amount of Commitment Expiration Per Period
   

Total Amounts

Committed

  Less than 1 year   1-3 years   4-5 years   After 5 years

Lines of credit

  $ 43,137,635   $ 22,250,000   $ —     $ 20,887,635   $ —  

Standby letters of credit

    75,000     75,000     —       —       —  

Guarantees

    2,229,248     200,000     —       636,016     1,393,232

Standby repurchase obligations

    —       —       —       —       —  

Other commercial commitments

    266,325,626     245,259,699     14,888,259     3,426,734     2,750,934
                             

Total commercial commitments

  $ 311,767,509   $ 267,784,699   $ 14,888,259   $ 24,950,385   $ 4,144,166
                             

Certain commercial commitments in the table above include items that may, in the future, require recognition within the financial statements of the Company. Events leading to the call of a guarantee, the failure of the policy administration system being developed for use by the life insurance operations to perform properly and achievement of specific metrics by Vision are examples of situations that would impact the financial position and results of the Company.

Net cash provided by operating activities approximated $132 million, $144 million, and $110 million in 2005, 2004 and 2003, respectively. Such net positive cash flows provide the foundation of the Company’s assets/liability management program and are the primary drivers of the Company’s liquidity. As previously discussed, the Company also maintains a diversified portfolio of fixed maturity and equity securities that provide a secondary source of liquidity should net cash flows from operating activities prove inadequate to fund current operating needs. Management believes that such an eventuality is unlikely given the Company’s product mix (primarily short-duration personal lines property casualty products), its ability to adjust premium rates (subject to regulatory oversight) to reflect emerging loss and expense trends and its catastrophe reinsurance program, amongst other factors.

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

Total borrowings increased approximately $14.5 million in 2005 to $304.7 million. The majority of the short-term debt is commercial paper issued by the Company. At December 31, 2005, the Company had approximately $213.8 million in commercial paper at rates ranging from 4.24% to 4.33% with maturities ranging from January 9, 2006 to January 23, 2006. The Company intends to continue to use the commercial paper program as a major source to fund the consumer loan portfolio and other corporate short-term needs. Backup lines of credit are in place up to $300 million. The backup lines

 

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agreements contain usual and customary covenants requiring the Company to meet certain operating levels. The Company has maintained full compliance with all such covenants. The Company has A-1+ and P-1 commercial paper ratings from Standard & Poor’s and Moody’s Investors Service, respectively. The commercial paper is guaranteed by two affiliates, Mutual and Fire. In addition, the Company had $20.9 million in short-term debt outstanding to affiliates at December 31, 2005 with interest payable monthly at rates established using the existing commercial paper rate and renewable for multiples of 30-day periods at the commercial paper rate then applicable.

Included in total borrowings is a variable rate note issued by the Company during the second quarter of 2002 in the amount of $70 million. This note is payable in its entirety on June 1, 2017 with interest payments due monthly. The Company is using the proceeds of this note to partially fund the consumer loan and commercial lease portfolios of its finance subsidiary. The Company has entered into an interest rate swap contract in order to achieve its objective of hedging 100 percent of its variable-rate long-term interest payments over the first five years of the note. Under the interest rate swap, the Company receives variable interest payments and makes fixed interest rate payments, thereby fixing the rate on such debt at 4.945%.

On October 25, 1993, the Company established a Stock Option Plan (“the 1993 Plan”), pursuant to which a maximum aggregate of 4,000,000 shares of common stock have been reserved for grant to key personnel. On April 26, 2001, the 1993 Plan was amended to increase the maximum aggregate number of shares available for grant to 6,400,000 shares. Under the 1993 Plan, options ratably become exercisable annually over three years and may not be exercised after ten years from the date of the award. At December 31, 2005, there had been 2,850,815 options exercised, 2,027,410 options were exercisable and 366,331 had been forfeited or expired. During February 2005, the Company issued 427,000 nonqualified options under this plan. The authority to grant the remaining 442,531 shares under the 1993 Plan was terminated on April 28, 2005 by the stockholder approval of the Alfa Corporation 2005 Amended and Restated Stock Incentive Plan (the “Plan”).

On February 28, 2005, the Company granted 52,000 awards of restricted stock to certain officers, subject to the approval of the Plan by the stockholders at the Company’s annual meeting. On June 1, 2005, the Company granted 24,500 awards of restricted stock to certain officers based on specific target levels of ownership at May 31, 2005 of Company common stock by those officers. During July 2005, the Company issued 2,000 nonqualified options under the Plan.

In October 1989, the Company’s Board of Directors approved a stock repurchase program authorizing the repurchase of up to 4,000,000 shares of its outstanding common stock in the open market or in negotiated transactions in such quantities and at such times and prices as management may decide. The Board increased the number of shares authorized for repurchase by 4,000,000 in both March 1999 and September 2001, bringing the total number of shares authorized for repurchase to 12,000,000. During 2005, the Company repurchased 219,000 shares at a cost of $2,960,751 (refer to Part II, Item 5—Purchases of Equity Securities by the Issuer and Affiliated Purchases). At December 31, 2005, the total repurchased was 8,266,623 shares at a cost of $65,383,384. The Company has reissued 2,850,815 treasury shares as a result of option exercises and sold 1,607,767 shares through funding its dividend reinvestment plan. In January 2005, the Company issued 325,035 non-registered shares to fund a portion of the acquisition of Vision.

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

Due to the sensitivity of the products offered by the life subsidiary to interest rates fluctuations, the Company must assess the risk of surrenders exceeding expectations factored into its pricing program. Internal actuaries are used to determine the need for modifying the Company’s policies on surrender charges and assessing the Company’s competitiveness with regard to rates offered. Cash surrenders paid

 

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to policyholders on a statutory basis totaled $17.1 million in both 2005 and 2004. This level of surrenders is within the Company’s pricing expectations. Historical persistency rates indicate a normal pattern of surrender activity in 2005, 2004 and 2003. The structure of the surrender charges is such that persistency is encouraged. The majority of the policies inforce have surrender charges which grade downward over a 12 to 15 year period. At December 31, 2005, the total amount of cash that would be required to fund all amounts subject to surrender was approximately $649.8 million.

The Company’s business is concentrated geographically in Alabama, Georgia and Mississippi. Accordingly, unusually severe storms or other disasters in these contiguous states might have a more significant effect on the Company’s financial condition and operating results than on a more geographically diversified insurance company. However, the Company’s catastrophe protection program, which began November 1, 1996, reduced the potential adverse impact and earnings volatility caused by such catastrophe exposures.

The Company’s management uses estimates in determining loss reserves for inclusion in its financial statements. Internal actuaries conduct periodic reviews to determine a range of reasonable loss reserves. In addition, the Company’s catastrophe protection program, which began November 1, 1996, was established to address the economics of catastrophe finance. This plan limits the Company’s exposure to catastrophes, which might otherwise deplete the Company’s surplus, through the sharing of catastrophe losses within the Alfa Group (refer to Note 2—Pooling Agreement in the Notes to Consolidated Financial Statements). In addition, the Company supplements this plan with the purchases of reinsurance coverage from external reinsurers.

Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company; therefore, allowances are established if amounts are determined to be uncollectible. The Company evaluates the financial condition of its reinsurers and monitors concentration of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurance to minimize exposure to significant losses from reinsurer insolvencies. At December 31, 2005, the Company does not believe there to be a significant concentration of credit risk related to its reinsurance program.

Lawsuits brought by policyholders or third-party claimants can create volatility in the Company’s earnings. The Company maintains in-house legal staff and, as needed, secures the services of external legal firms to present and protect its position. Certain legal proceedings are in process at December 31, 2005. These proceedings involve alleged breaches of contract, torts, including bad faith and fraud claims, and miscellaneous other causes of action. These lawsuits involve claims for unspecified amounts of compensatory damages, mental anguish damages and punitive damages. Costs for these and similar proceedings, including accruals for outstanding cases, are included in the financial statements of the Company. Management periodically reviews reserves established to cover potential costs of litigation including legal fees and potential damage assessments and adjusts them based on their best estimates. It should be noted that in Mississippi and Alabama, where the Company has substantial business, the likelihood of a judgment in any given suit, including a large mental anguish and/or punitive damage award by a jury, bearing little or no relation to actual damages, continues to exist, creating the potential for unpredictable material adverse financial results.

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

 

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FINANCIAL ACCOUNTING DEVELOPMENTS

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-based Compensation. SFAS 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees and non-employees, including grants of stock options, to be recognized in the income statement based on fair value at grant date. Pro forma disclosure will no longer be an alternative.

SFAS 123(R) originally required adoption no later than July 1, 2005. In April 2005, the Securities and Exchange Commission (“SEC”) issued a release that amends the compliance dates for SFAS 123(R). Under the SEC’s new rule, the Company will be required to apply SFAS 123(R) as of January 1, 2006.

SFAS 123(R) permits public companies to adopt its requirement using one of two methods:

 

    A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123(R) that remain unvested on the effective date.

 

    A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate, based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures, either (a) all prior periods presented or (b) prior interim periods of the year of adoption.

The Company will adopt SFAS 123(R) using the modified prospective method.

As permitted by SFAS 123, the Company currently accounts for share-based payments to employees using the intrinsic value method described in APB Opinion No. 25 and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123(R)’s fair value method will impact the Company’s results of operations, although it will have no impact on the Company’s overall financial position. The Company will share compensation cost with Mutual based on the Management and Operating Agreement (refer to Note 3—Related Party Transactions in the Notes to Consolidated Financial Statements). The total impact of SFAS 123(R) on 2006 results of operations for Alfa is expected to be $2.5 million, with $1.6 million allocated to the Company, based on historical levels of activity.

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB No. 29, Accounting for Nonmonetary Transactions. This statement requires that exchanges of nonmonetary assets be measured based on fair value and eliminates the exception for exchanges of nonmonetary, similar productive assets, and adds an exemption for nonmonetary exchanges that do not have commercial substance. SFAS No. 153 was effective for nonmonetary asset exchanges in periods beginning after June 15, 2005. This statement has not had a significant impact on the Company’s financial position or results of operations.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement for APB Opinion No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. This statement changes the requirements for the accounting for and reporting of a change in accounting principle. It applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. This statement requires voluntary

 

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changes in accounting principles be recognized retrospectively to financial statements for prior periods, rather than recognition in the net income of the current period. Retrospective application requires restatements of prior period financial statements as if that accounting principle had always been used. This statement carries forward without change the guidance contained in Opinion 20 for reporting the correction of an error in previously issued financial statements and a change in accounting estimate. The provisions of SFAS No. 154 are effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.

In June 2005, the FASB issued a final FASB Staff Position (FSP) EITF 03-1-a (retitled FSP FAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments) which will replace the guidance set forth in paragraphs 10-18 of EITF Issue No. 03-1 and clarifies when an investor should recognize an impairment loss. The provisions of FSP FAS 115-1 are effective for other-than-temporary impairment analysis conducted in periods beginning after September 15, 2005. This staff position has not had a significant impact on the Company’s financial position or results of operations.

In June 2005, the FASB ratified the consensus on EITF Issue No. 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights. This Issue affects accounting by general partners evaluating whether to consolidate limited partnerships. The EITF agreed on a framework for evaluating whether a general partner or a group of general partners controls a limited partnership and therefore should consolidate. The presumption of general-partner control would be overcome only when the limited partners have either “kick-out rights” or “participating rights”. This guidance was effective after June 29, 2005 for all new limited partnerships formed and for existing limited partnership agreements for which the partnership agreements are modified. For general partners in all other limited partnerships, the guidance in this Issue is effective no later than the beginning of the first reporting period in fiscal years beginning after December 31, 2005, and application of either one of two transition methods described in the Issue would be acceptable. During the fourth quarter of 2005, two limited partnerships in which the Company’s life subsidiary has been a general partner with one percent ownership interests were modified to become general partnerships. Consequently, the Company expects EITF Issue No. 04-5 to continue to have no significant impact on the Company’s financial position and results of operations.

In addition, the FASB issued FASB Staff Position (FSP) SOP 78-9-1, Interaction of AICPA Statement of Position 78-9 and EITF Issue No. 04-5 in June 2005. The guidance in this FSP was effective after June 29, 2005 for general partners of all new partnerships formed and for existing partnerships for which the partnership agreements are modified. For general partners in all other partnerships, the guidance in this FSP is effective no later than the beginning of the first reporting period in fiscal years beginning after December 15, 2005, and the application of either transition method as described in the FSP is permitted.

In August 2005, the FASB issued FSP Financial Accounting Standard (FAS) 123(R)-1, Classification and Measurement of Freestanding Financial Instruments Originally Issued in Exchange for Employee Services under FASB Statement No. 123(R). This staff position defers the requirement under SFAS No. 123(R) that a freestanding financial instrument become subject to the recognition and measurement requirements of other applicable generally accepted accounting principles when the rights conveyed by the instrument to the holder are no longer dependent on the holder being an employee of the entity. The Company does not anticipate that this staff position will have a significant impact on its financial position or results of operations at the time SFAS No. 123(R) is adopted.

During the fourth quarter of 2005, the FASB also issued three other staff positions applicable at the time the Company adopts SFAS No. 123(R). They are FSP FAS 123(R)-2, Practical Accommodation to the Application of Grant Date As Defined in FASB Statement No. 123(R); FSP FAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards; and FSP

 

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FAS 123(R)-4, Classification of Options and Similar Instruments Issued As Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event. The Company does not anticipate that these staff positions will have a significant impact on its financial position or results of operations at the time SFAS No. 123(R) is adopted.

In September 2005, the American Institute of Certified Public Accountants issued Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts. This statement provides guidance on accounting for deferred acquisition costs on an internal replacement, defined as a modification in product benefits, rights, coverages, or features that occurs by the exchange of an existing contract for a new contract, or by amendment, endorsement, or rider to an existing contract, or by the election of a benefit, right, coverage, or feature within an existing contract. The guidance in this pronouncement is effective for fiscal years beginning after December 15, 2006. The Company plans to adopt this statement for internal replacements beginning January 1, 2007. Due to its recent issuance, the Company is still assessing the impact this statement will have on its financial position or results of operations.

In November 2005, the FASB issued FSP Nos. FAS 115-1 and 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment. The FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in the FSP amends SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, SFAS No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, and APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. The Company has reviewed the guidance of FSP Nos. FAS 115-1 and 124-1 and has determined that the adoption of the FSP on January 1, 2006 will not have a significant impact on the Company’s financial position or results of operations.

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

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

Interest Rate Risk

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

The Company’s fixed maturity portfolio is invested predominantly in high quality corporate, mortgage-backed, government agency and municipal bonds. The portfolio has an average effective duration of 4.74 years and an average quality rating of AA1. The changes in the fair value of the fixed maturity available for sale portfolio are presented as a component of stockholders’ equity in accumulated other comprehensive income, net of taxes.

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

 

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The estimated fair value of the Company’s investment portfolio at December 31, 2005 was $2.0 billion, 70.8% of which was invested in fixed maturities, 5.3% in equity securities, 6.5% in collateral loans, 0.1% in commercial leases, 4.2% in short-term investments and 13.1% in other long-term investments.

The table below summarizes the Company’s interest rate risk and shows the effect of a hypothetical change in interest rates as of December 31, 2005. The selected hypothetical changes do not indicate what would be the potential best or worst-case scenarios.

 

(dollars in thousands)  

Estimated Fair

Value at

December 31,

2005

 

Estimated Change

in Interest Rate

(bp=basis points)

 

Estimated Fair Value

After Hypothetical

Change in Interest Rate

 

Hypothetical

Percentage Increase

(Decrease) in

Stockholders’ Equity

 

FIXED MATURITY INVESTMENTS

       

U.S. Treasury Securities

  $ 182,687   200 bp decrease   $ 192,124   0.6 %

and obligations of U.S.

    100 bp decrease     188,152   0.4  

government corporations

    100 bp increase     174,106   (0.6 )

and agencies

    200 bp increase     164,713   (1.2 )

Tax-exempt obligations of

  $ 322,431   200 bp decrease   $ 360,266   3.8 %

states, municipalities and

    100 bp decrease     341,266   1.9  

political subdivisions

    100 bp increase     302,367   (2.0 )
    200 bp increase     281,313   (4.1 )

Mortgage-backed securities

  $ 626,295   200 bp decrease   $ 652,171   1.7 %
    100 bp decrease     644,313   1.2  
    100 bp increase     589,693   (2.4 )
    200 bp increase     542,802   (5.4 )

Corporate, taxable municipal

  $ 288,389   200 bp decrease   $ 318,947   2.0 %

and other debt securities

    100 bp decrease     303,020   1.0  
    100 bp increase     274,607   (0.9 )
    200 bp increase     261,509   (1.7 )

TOTAL FIXED MATURITY

  $ 1,419,802   200 bp decrease   $ 1,523,508   6.7 %

INVESTMENTS

    100 bp decrease     1,476,751   3.7  
    100 bp increase     1,340,773   (5.1 )
    200 bp increase     1,250,337   (11.0 )

COLLATERAL LOANS

  $ 130,284   200 bp decrease   $ 135,667   *  
    100 bp decrease     134,032   *  
    100 bp increase     122,670   *  
    200 bp increase     112,915   *  

SHORT-TERM INVESTMENTS

  $ 84,862   200 bp decrease   $ 89,246   *  
    100 bp decrease     87,401   *  
    100 bp increase     80,876   *  
    200 bp increase     76,513   *  

LIABILITIES

       

4.24% to 4.33% Commercial Paper

  $ 213,790   200 bp decrease   $ 224,835   *  
    100 bp decrease     220,186   *  
    100 bp increase     203,749   *  
    200 bp increase     192,756   *  

Short-term Notes Payable

  $ 20,888   200 bp decrease   $ 21,967   *  
    100 bp decrease     21,512   *  
    100 bp increase     19,907   *  
    200 bp increase     18,833   *  

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

 

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Equity Price Risk

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

At December 31, 2005, the Company’s equity portfolio was concentrated in terms of the number of issuers and industries. The Company’s top ten equity holdings represented $28.0 million or 26.2% of the equity portfolio. Investments in the healthcare sector represented 19.4% while the combined financial holdings, energy, materials and consumer discretionary sectors represented 13.6%, 12.6%, 11.4% and 10.5%, respectively, of the equity portfolio. No other sector represented over 10% of the equity portfolio. Such concentration can lead to higher levels of short-term price volatility. Due to its long-term investment focus, the Company is not as concerned with short-term volatility as long as its subsidiaries’ ability to write business is not impaired.

The table below summarizes the Company’s equity price risk and shows the effect of a hypothetical 20% increase and a 20% decrease in market prices as of December 31, 2005. The selected hypothetical changes do not indicate what could be the potential best or worst-case scenarios.

 

Estimated Fair Value

of Equity Securities at

December 31, 2005

  

Hypothetical

Price Change

  

Estimated

Fair Value

After

Hypothetical

Change in

Prices

  

Hypothetical

Percentage

Increase

(Decrease) in

Stockholders’

Equity

 
(dollars in thousands)                 

$107,020

   20% increase    $ 128,424    2.8 %
   20% decrease    $ 85,616    (2.8 )%

 

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Item 8. Financial Statements and Supplementary Data.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page

Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements

   44

Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting

   45

Consolidated Balance Sheets

   46

Consolidated Statements of Income

   47

Consolidated Statements of Stockholders’ Equity

   48

Consolidated Statements of Cash Flows

   49

Notes to Consolidated Financial Statements

   50

 

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Report of Independent Registered Public Accounting Firm

on Consolidated Financial Statements

To the Stockholders and Board of Directors

Alfa Corporation:

We have audited the accompanying consolidated balance sheets of Alfa Corporation and subsidiaries (the Company) as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our 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 the Company as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 7, 2006, expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

KPMG LLP

Birmingham, Alabama

March 7, 2006

 

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Report of Independent Registered Public Accounting Firm

on Internal Control over Financial Reporting

The Stockholders and Board of Directors

Alfa Corporation:

We have audited management’s assessment, included in the accompanying Report on Internal Control Over Financial Reporting, that Alfa Corporation and Subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

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

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Alfa Corporation and Subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2005, and our report dated March 7, 2006, expressed an unqualified opinion on those consolidated financial statements.

KPMG LLP

Birmingham, Alabama

March 7, 2006

 

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ALFA CORPORATION

CONSOLIDATED BALANCE SHEETS

 

     December 31,  
     2005     2004  

Assets

    

Investments:

    

Fixed Maturities Held for Investment, at amortized cost (fair value $93,578 in 2005 and $123,935 in 2004)

   $ 88,330     $ 114,708  

Fixed Maturities Available for Sale, at fair value (amortized cost $1,394,823,078 in 2005 and $1,305,288,027 in 2004)

     1,419,708,095       1,354,507,490  

Equity Securities Available for Sale, at fair value (cost $96,668,040 in 2005 and $83,445,562 in 2004)

     107,020,104       99,701,250  

Policy Loans

     62,101,204       58,476,569  

Collateral Loans

     124,667,449       110,792,974  

Commercial Leases

     2,515,084       4,831,363  

Other Long-Term Investments

     61,961,072       66,855,805  

Other Long-Term Investments in Affiliates

     138,457,224       77,942,989  

Short-Term Investments

     84,861,880       80,988,969  
                

Total Investments

     2,001,380,442       1,854,212,117  

Cash

     37,228,639       20,052,493  

Accrued Investment Income

     16,912,488       16,726,050  

Accounts Receivable

     72,622,465       50,447,800  

Reinsurance Balances Receivable

     6,648,204       5,279,560  

Deferred Policy Acquisition Costs

     204,253,919       183,258,224  

Assets Classified as Held for Sale

     —         77,450,278  

Goodwill

     13,924,306       —    

Other Intangible Assets (net of accumulated amortization of $683,400 in 2005)

     8,424,600       —    

Other Assets

     20,478,836       15,237,024  
                

Total Assets

   $ 2,381,873,899     $ 2,222,663,546  
                

Liabilities and Stockholders’ Equity

    

Policy Liabilities and Accruals—Property Casualty Insurance

   $ 159,639,886     $ 154,107,730  

Policy Liabilities and Accruals—Life Insurance Interest-Sensitive Products

     600,994,074       555,733,736  

Policy Liabilities and Accruals—Life Insurance Other Products

     197,140,294       180,410,535  

Unearned Premiums

     220,456,047       185,856,467  

Dividends to Policyholders

     11,662,085       11,262,132  

Premium Deposit and Retirement Deposit Funds

     5,741,071       6,369,125  

Deferred Income Taxes

     29,118,958       43,070,818  

Liabilities Associated with Assets Classified as Held for Sale

     —         340,876  

Other Liabilities

     74,201,255       73,872,992  

Due to Affiliates

     22,249,975       29,995,986  

Commercial Paper

     213,790,443       204,303,206  

Notes Payable

     70,000,000       70,000,000  

Notes Payable to Affiliates

     20,887,635       15,887,635  
                

Total Liabilities

     1,625,881,723       1,531,211,238  
                

Commitments and Contingencies

    

Stockholders’ Equity :

    

Preferred Stock, $1 par value Shares authorized: 1,000,000 Issued: None

     —         —    

Common Stock, $1 par value Shares authorized: 110,000,000 Issued: 83,783,024 Outstanding: 80,284,018 in 2005 and 79,833,467 in 2004

     83,783,024       83,783,024  

Capital in Excess of Par Value

     21,171,462       10,961,782  

Accumulated Other Comprehensive Income (unrealized gains on securities available for sale, net of tax, of $22,105,684 in 2005 and $39,450,553 in 2004; unrealized (losses) on interest rate swap contract, net of tax, of ($11,265) in 2005 and ($1,406,747) in 2004; unrealized gains/(losses) on other long-term investments, net of tax, of ($394,560) in 2005 and $16,565 in 2004)

     21,699,859       38,060,371  

Retained Earnings

     667,535,056       599,609,509  

Treasury Stock, at cost (shares, 3,499,006 in 2005 and 3,949,557 in 2004)

     (38,197,225 )     (40,962,378 )
                

Total Stockholders’ Equity

     755,992,176       691,452,308  
                

Total Liabilities and Stockholders’ Equity

   $ 2,381,873,899     $ 2,222,663,546  
                

See accompanying Notes to Consolidated Financial Statements.

 

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ALFA CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

 

     Years Ended December 31,
     2005    2004    2003

Revenues

        

Premiums—Property Casualty Insurance

   $ 556,438,727    $ 485,534,231    $ 454,453,266

Premiums—Life Insurance

     41,134,144      37,134,465      33,628,724

Policy Charges—Life Insurance

     35,499,178      34,089,930      32,543,328

Net Investment Income

     94,931,739      89,361,003      83,096,319

Realized Investment Gains

     6,050,873      7,048,654      6,263,619

Other Income

     22,849,897      8,123,307      9,831,374
                    

Total Revenues

     756,904,558      661,291,590      619,816,630
                    

Benefits, Losses and Expenses

        

Benefits, Claims, Losses and Settlement Expenses

     432,856,310      390,061,548      364,599,459

Dividends to Policyholders

     4,009,119      3,873,932      3,761,720

Amortization of Deferred Policy Acquisition Costs

     108,723,470      90,454,509      86,475,442

Other Operating Expenses

     73,453,925      56,272,154      58,383,192
                    

Total Benefits, Losses and Expenses

     619,042,824      540,662,143      513,219,813
                    

Income Before Provision for Income Taxes

     137,861,734      120,629,447      106,596,817

Provision for Income Taxes

     38,827,981      31,184,488      28,127,869
                    

Net Income

   $ 99,033,753    $ 89,444,959    $ 78,468,948
                    

Net Income Per Share

        

—Basic

   $ 1.24    $ 1.12    $ 0.98
                    

—Diluted

   $ 1.23    $ 1.11    $ 0.98
                    

Weighted Average Shares Outstanding

        

—Basic

     80,141,068      79,984,651      79,808,669
                    

—Diluted

     80,712,923      80,489,502      80,390,001
                    

 

See accompanying Notes to Consolidated Financial Statements.

 

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ALFA CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

 

   

Common

Stock

 

Capital in

Excess of

Par Value

   

Accumulated

Other

Comprehensive

Income (Loss)

   

Retained

Earnings

   

Treasury

Stock

    Total  

Balance, December 31, 2002

  $ 83,783,024   $ 5,531,384     $ 32,832,254     $ 484,454,615     $ (40,503,573 )   $ 566,097,704  

Net Income

          78,468,948         78,468,948  

Other Comprehensive Income, net of tax:

           

Change in Net Unrealized Investment Gains, net of reclassification adjustment

        7,561,180           7,561,180  

Change in Unrealized Gain on Interest Rate Swap Contract

        1,058,174           1,058,174  

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

        (100,204 )         (100,204 )
                 

Total Other Comprehensive Income

              8,519,150  
                 

Comprehensive Income

              86,988,098  

Dividends to Stockholders ($.315 per share)

          (25,176,932 )       (25,176,932 )

Issuance of Treasury Shares for Dividend Reinvestment Plan (841,321 shares)

      3,333,612           7,462,200       10,795,812  

Purchase of Treasury Stock (299,183 shares)

            (3,684,667 )     (3,684,667 )

Exercise of Stock Options (396,833 shares)

      (932 )         3,493,355       3,492,423  
                                             

Balance, December 31, 2003

    83,783,024     8,864,064       41,351,404       537,746,631       (33,232,685 )     638,512,438  

Net Income

          89,444,959         89,444,959  

Other Comprehensive Income, net of tax:

           

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

        (6,541,611 )         (6,541,611 )

Change in Unrealized Gain on Interest Rate Swap Contract

        2,949,238           2,949,238  

Change in Unrealized Gain on Other Long-Term Investments

        301,340           301,340  
                 

Total Other Comprehensive (Loss)

              (3,291,033 )
                 

Comprehensive Income

              86,153,926  

Sale of Subsidiaries

      1,682,982             1,682,982  

Dividends to Stockholders ($.3425 per share)

          (27,582,081 )       (27,582,081 )

Issuance of Treasury Shares for Dividend Reinvestment Plan (12,158 shares)

      (103,871 )         103,871       —    

Purchase of Treasury Stock (899,843 shares)

            (12,152,909 )     (12,152,909 )

Exercise of Stock Options (503,836 shares)

      518,607           4,319,345       4,837,952  
                                             

Balance, December 31, 2004

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

Net Income

          99,033,753         99,033,753  

Other Comprehensive Income, net of tax:

           

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

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

Change in Unrealized Gain on Interest Rate Swap Contract

        1,395,482           1,395,482  

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

        (411,125 )         (411,125 )
                 

Total Other Comprehensive (Loss)

              (16,360,512 )
                 

Comprehensive Income

              82,673,241  

Additional Contribution

      4,836,140             4,836,140  

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

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

Dividends to Stockholders ($.3875 per share)

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

Purchase of Treasury Stock (219,000 shares)

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

Restricted Share Awards—Nonvested (77,765 shares)

      282,812             282,812  

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

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

Balance, December 31, 2005

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

See accompanying Notes to Consolidated Financial Statements.

 

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ALFA CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

    Years Ended December 31,  
    2005     2004     2003  

Cash Flows From Operating Activities:

     

Net Income

  $ 99,033,753     $ 89,444,959     $ 78,468,948  

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

     

Policy Acquisition Costs Deferred

    (126,165,508 )     (103,065,322 )     (98,787,583 )

Amortization of Deferred Policy Acquisition Costs

    108,723,470       90,454,509       86,475,442  

Depreciation and Amortization

    3,920,991       2,925,306       2,708,669  

Stock-based Compensation

    415,817       146,888       167,510  

Provision for Deferred Taxes

    (306,215 )     (3,012,541 )     5,342,706  

Interest Credited on Policyholders’ Funds

    28,281,912       27,609,884       26,954,469  

Net Realized Investment Gains

    (6,050,873 )     (7,048,654 )     (6,263,619 )

(Earnings) Losses in Equity Method Investments

    (8,583,398 )     (3,801,774 )     318,223  

Other

    (2,163,332 )     8,832,456       4,229,712  

Changes in Operating Assets and Liabilities:

     

Accrued Investment Income

    (186,438 )     (1,156,955 )     134,909  

Accounts Receivable

    (18,317,051 )     (3,471,131 )     (7,553,528 )

Reinsurance Balances Receivable

    (1,368,644 )     536,122       (2,398,561 )

Other Assets

    (5,173,117 )     3,005,585       (957,014 )

Liability for Policy Reserves

    20,807,581       25,599,547       14,812,239  

Liability for Unearned Premiums

    34,599,580       15,563,692       16,946,943  

Amounts Held for Others

    (228,101 )     394,729       324,427  

Other Liabilities

    13,815,543       2,909,786       (13,411,462 )

Due to/from Affiliates

    (9,255,456 )     (1,625,045 )     2,105,973  
                       

Net Cash Provided by Operating Activities

    131,800,514       144,242,041       109,618,403  
                       

Cash Flows from Investing Activities:

     

Maturities and Redemptions of Fixed Maturities Held for Investment

    26,211       43,072       116,133  

Maturities and Redemptions of Fixed Maturities Available for Sale

    393,899,269       328,912,867       635,219,130  

Maturities and Redemptions of Other Investments

    3,577,276       3,867,840       4,548,307  

Sales of Fixed Maturities Available for Sale

    108,372,196       61,425,800       68,916,066  

Sales of Equity Securities

    137,282,425       167,267,526       126,036,887  

Sales of Commercial Leases

    6,082,177       64,218,420       4,980,629  

Sales of Other Investments

    6,349,904       5,482,372       5,143,110  

Purchases of Fixed Maturities Available for Sale

    (591,177,592 )     (583,668,788 )     (745,426,493 )

Purchases of Equity Securities

    (139,811,006 )     (119,154,022 )     (173,725,650 )

Purchases of Other Investments

    (26,392,547 )     (57,112,951 )     (12,632,523 )

Origination of Consumer Loans Receivable

    (73,540,434 )     (60,409,849 )     (59,061,709 )

Principal Payments on Consumer Loans Receivable

    59,453,752       49,721,101       53,873,695  

Origination of Commercial Leases Receivable

    (21,665,208 )     (83,521,356 )     (76,828,007 )

Principal Payments on Commercial Leases Receivable

    37,085,467       48,965,475       46,324,434  

Net Change in Short-term Investments

    (3,872,911 )     28,472,140       (9,555,341 )

Net Change in Receivable/Payable on Securities

    (1,755,909 )     2,917,338       (7,323,609 )

Net Proceeds from Sales of Subsidiaries

    2,252,520       7,495,925       —    

Purchase of Subsidiary, Net of Cash Acquired

    (12,702,438 )     —         —    
                       

Net Cash Used in Investing Activities

    (116,536,848 )     (135,077,090 )     (139,394,941 )
                       

Cash Flows From Financing Activities:

     

Change in Commercial Paper

    9,487,237       39,859,437       31,020,844  

Change in Notes Payable to Affiliates

    5,000,000       (21,206,141 )     (5,395,011 )

Stockholder Dividends Paid

    (31,108,206 )     (27,582,081 )     (25,176,932 )

Purchases of Treasury Stock

    (2,960,751 )     (12,152,909 )     (3,684,667 )

Proceeds from Exercise of Stock Options

    3,028,748       3,263,270       2,112,838  

Proceeds from Dividend Reinvestment Plan

    —         —         10,795,812  

Deposits of Policyholders’ Funds

    72,109,506       69,738,185       69,379,831  

Withdrawal of Policyholders’ Funds

    (53,644,054 )     (51,924,735 )     (48,145,481 )
                       

Net Cash Provided by (Used in) Financing Activities

    1,912,480       (4,974 )     30,907,234  
                       

Net Change in Cash

    17,176,146       9,159,977       1,130,696  

Cash—Beginning of Period

    20,052,493       10,892,516       9,761,820  
                       

Cash—End of Period

  $ 37,228,639     $ 20,052,493     $ 10,892,516  
                       

See accompanying Notes to Consolidated Financial Statements.

 

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Index to Financial Statements

ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

In the opinion of the Company, the accompanying consolidated financial statements contain all adjustments (consisting primarily of normal recurring accruals, except as explained in Note 2—Pooling Agreement) necessary to present fairly its financial position, results of operations and cash flows. The accompanying financial statements are prepared on the basis of accounting principles generally accepted in the United States of America. Generally accepted accounting principles differ in certain respects from the statutory accounting practices prescribed or permitted by insurance regulatory authorities. Prescribed statutory accounting practices include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (NAIC). Permitted statutory accounting practices encompass all accounting practices that are not prescribed. Such practices differ from state-to-state, may differ from company-to-company within a state, and may change in the future. Currently, the Company’s statutory net income and surplus are the same under the State of Alabama and NAIC accounting practices.

Consolidation

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

 

    Alfa Insurance Corporation (AIC)

 

    Alfa General Insurance Corporation (AGI)

 

    Alfa Vision Insurance Corporation (AVIC)

 

    Alfa Life Insurance Corporation (Life)

 

    Alfa Financial Corporation (Financial)

 

    The Vision Insurance Group, LLC (Vision)

 

    Alfa Agency Mississippi, Inc. (AAM)

 

    Alfa Agency Georgia, Inc. (AAG)

 

    Alfa Benefits Corporation (ABC)

During 2003, one of Financial’s investments, MidCountry Financial Corporation (MidCountry), pursued the opportunity to purchase Bayside Financial Corp. In order for this purchase to take place, approval had to be secured from the Office of Thrift Supervision. Consequently, due to ownership levels, this transaction qualified Financial and the Company as unitary thrift holding companies. As a condition of approval, the Company agreed to sell its residential and commercial construction subsidiary, Alfa Builders, Inc. (Builders) and its real estate sales subsidiary Alfa Realty, Inc. (Realty) to Southern Boulevard Corporation (Southern), a wholly-owned subsidiary of Alfa Mutual Insurance Company (Mutual) for their independently-determined fair values of approximately $5.5 million and $2.6 million, respectively. Southern subsequently became Alfa Properties, Inc. (Alfa Properties) during the first quarter of 2004. No gain or loss was recorded on these transactions. The financial statements and notes to the financial statements contained within this report include the results of these subsidiaries for the first two months of 2004 as well as the year 2003.

Nature of Operations

Alfa Corporation operates predominantly in the insurance industry. At December 31, 2005, its insurance subsidiaries write life insurance in Alabama, Georgia and Mississippi and property casualty

 

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Index to Financial Statements

ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

insurance in Georgia, Mississippi, Missouri, Indiana, Ohio, Virginia, Tennessee, Arkansas, Kentucky, and Florida. In addition, AVIC assumes business in Texas.

Alfa Corporation is affiliated with Mutual, Alfa Mutual Fire Insurance Company (Fire), and Alfa Mutual General Insurance Company (General). These companies are known collectively as the Mutual Group. The Mutual Group owns 54.9% of Alfa Corporation’s common stock, their largest single investment. Alfa Corporation and its subsidiaries (the Company) together with the Mutual Group comprise the Alfa Group (Alfa). Alfa Virginia Mutual Insurance Company (Virginia Mutual) currently cedes 80% of its direct business to Fire under an affiliate agreement signed in August 2001.

As more fully discussed in Note 2—Pooling Agreement, the Company’s property casualty insurance business is pooled with that of the Mutual Group which writes property casualty business in Alabama. The Company’s pooled business is concentrated geographically in Alabama, Georgia and Mississippi. Approximately $514 million of premiums and policy charges representing 81% of such amounts in 2005 were from policies written in Alabama. Accordingly, unusually severe storms or other disasters in this state might have a more significant effect on the Company than on a more geographically diversified insurance company and could have an adverse impact on the Company’s financial condition and operating results. Increasing public interest in the availability and affordability of insurance has prompted legislative, regulatory and judicial activity in several states. This includes efforts to contain insurance prices, restrict underwriting practices and risk classifications, mandate rate reductions and refunds, eliminate or reduce exemptions from antitrust laws and generally expand regulation. Because of Alabama’s low automobile rates as compared to rates in most other states, the Company does not expect the type of punitive legislation and initiatives found in some states to be a factor in its primary market in the immediate future.

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

Use of Estimates in the Preparation of the Financial Statements

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

Revenues, Benefits, Claims and Expenses

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

 

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Index to Financial Statements

ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

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

Stock-Based Employee Compensation

At December 31, 2005, the Company has a stock-based employee compensation plan, which is described more fully in Note 15—Stock-Based Compensation. The Company accounts for this plan under Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, using the recognition and measurement principles of the intrinsic value method. Compensation cost on fixed awards with prorata vesting is recognized using the straight-line method. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

 

     Years Ended December 31,  
     2005     2004     2003  

Net income as reported

   $ 99,033,753     $ 89,444,959     $ 78,468,948  

Add: Total stock-based compensation expense included in reported net income, net of tax effect

     270,281       95,478       108,882  

Less: Total stock-based compensation expense determined under fair value based method for all awards, net of tax effect

     (2,222,017 )     (2,078,716 )     (1,571,820 )
                        

Pro forma net income

   $ 97,082,017     $ 87,461,721     $ 77,006,010  
                        

Earnings per share, as reported

      

—Basic

   $ 1.24     $ 1.12     $ 0.98  

—Diluted

   $ 1.23     $ 1.11     $ 0.98  

Pro forma earnings per share

      

—Basic

   $ 1.21     $ 1.09     $ 0.96  

—Diluted

   $ 1.20     $ 1.09     $ 0.96  

 

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Index to Financial Statements

ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Income Taxes

The Company’s method of accounting for income taxes is the liability method. Under the liability method, deferred tax assets and liabilities are adjusted to reflect changes in statutory tax rates resulting in income adjustments in the period such changes are enacted. Deferred income taxes are recognized for temporary differences between the financial reporting basis and income tax basis of assets and liabilities, based on enacted tax laws and statutory tax rates applicable to the periods in which the temporary difference is expected to reverse. The method of allocation between subsidiaries is subject to a written agreement, approved by the Board of Directors. Current taxes are allocated to each subsidiary within the consolidated group based upon the ratio of the subsidiary’s taxable income to the consolidated taxable income with no credit to subsidiaries with a taxable loss.

Earnings Per Share

Basic EPS is computed by dividing net income by the weighted average number of shares outstanding. Diluted EPS is computed similarly except that the shares outstanding are increased to give effect to all potentially dilutive shares that would have been outstanding if such shares had been issued. The weighted average diluted shares outstanding include, on a post-split basis, potentially dilutive shares which total 571,855 shares in 2005, 504,851 in 2004 and 581,332 shares in 2003. All dilutive shares are the result of stock options outstanding with the exception of 9,149 dilutive shares resulting from restricted stock awards in 2005 (refer to Note 15—Stock-Based Compensation).

Investments

Fixed Maturities: Fixed maturities held for investment include investments that the Company has both the ability and positive intent to hold until maturity; such securities are reported at amortized cost. Securities available for sale include bonds and redeemable preferred stocks that the Company may elect to sell prior to maturity and are reported at their current fair value. The unrealized gains or losses on these securities are reflected as accumulated other comprehensive income within stockholders’ equity, net of taxes. Furthermore, deferred policy acquisition costs for universal and other interest sensitive life insurance products are adjusted to reflect the effect that would have been recognized had the unrealized holding gains and losses been realized. This adjustment to deferred acquisition costs results in a corresponding adjustment to comprehensive income. During 2005, the amount of this adjustment before taxes was $3,553,657. Amortization of premium or discount is calculated using the scientific (constant yield) interest method and is recorded as an adjustment to investment income. The interest method results in a constant effective yield equal to the prevailing rate at the time of purchase or at the time of subsequent adjustments to book value. Fixed maturities containing call provisions (where the issue can be called away from the Company at the issuer’s discretion) are amortized to the call or maturity value/date that produces the lowest asset value (yield to worst). For mortgage-backed securities, the amortization period reflects estimates of the period over which repayment of principal is expected to occur, not the stated maturity period.

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

Declines in fair values of fixed maturities and equity securities deemed to be other than temporary are recognized in the determination of net income. Generally, realized gains and losses on sales of investments are recognized in net income using the first-in, first-out methodology. In some instances, the Company may use the specific identification method if so directed by the investment portfolio

 

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Index to Financial Statements

ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

manager. Realized investment gains and losses are reported on a pretax basis as a component of revenues. Income taxes applicable to net realized investment gains and losses are included in the provision for income tax.

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

Other Long-term Investments: Partnerships, joint ventures and unconsolidated investee companies accounted for using the equity method are a component of other long-term investments and other long-term investments in affiliates. Investments in partnerships, joint ventures and unconsolidated investee companies are stated at the underlying audited equity value based on accounting principles generally accepted in the United States of America. Investments are reviewed annually for impairments and adjusted accordingly. It is the Company’s policy to review investments for applicability of Financial Accounting Standards Board Interpretation (FIN) 46(R), Consolidation of Variable Interest Entities. At December 31, 2005, the Company determined that no investment required consolidation based on FIN 46(R) criteria.

Short-term Investments: Short-term investments with maturities of three months or less are considered to be investments and are not considered to be cash or cash equivalents. The Company’s short-term investments are predominately money market funds. Money market mutual funds seek to maintain a stable net asset value of $1.00 per share. There is no assurance that funds will be able to maintain a stable asset value of $1.00 per share. However, our policy is to invest in money market funds that are rated AAAm and/or Aaa by Standard & Poor’s and/or Moody’s Investor Service, Inc., respectively, or are rated by the NAIC Securities Valuation Office as Class 1. These funds are diversified money market funds investing in Tier 1 commercial paper and bank obligations, U.S. Treasury, U.S. government obligations, certificates of deposits and repurchase agreements.

Cash

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

At December 31, 2005, Vision (refer to Note 17—Business Combinations and Divestitures) had a carrier contract requiring them to fund a collateral trust based on a percentage of written premiums. The primary purpose was to provide collateral for the payment of all obligations and performance of all duties set forth in the contract. The amount in the trust is reviewed on an annual basis and adjusted accordingly. The amount of cash restricted at December 31, 2005 was $957,368.

 

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Index to Financial Statements

ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Accounts Receivable

Accounts receivable are primarily comprised of premium installment plan receivables from policyholders and insurance carrier receivables.

Reinsurance

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

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

Deferred Policy Acquisition Costs and Premium Deficiencies

Life Insurance Products: Commissions and other costs of acquiring insurance that vary with and are primarily related to the production of new and renewal business have been deferred. Traditional life insurance acquisition costs are being amortized over the premium payment period of the related policies using assumptions consistent with those used in computing policy benefit reserves. Acquisition costs for universal life type policies are being amortized over a thirty-year period in relation to the present value of estimated gross profits that are determined based upon surrender charges and investment, mortality and expense margins. The life insurance segment deferred $18,815,613 and recorded amortization expense of $9,277,108 related to acquisition costs leaving a balance of $171,107,909 at December 31, 2005. Included in this balance is a reduction of $1,529,460 which represents an offset to unrealized holding gains that is required as an adjustment to deferred policy acquisition costs under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, when amortization expense is determined under the gross profits method described in SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.

Property Casualty Products: Acquisition costs for property casualty insurance are amortized over the period in which the related premiums are earned. Investment income is considered, if necessary, in the determination of the recoverability of deferred policy acquisition costs. During 2005, the property casualty insurance segment deferred $109,342,742 and recorded amortization expense of $100,652,027 related to acquisition costs, leaving a balance of $33,933,193 in the property casualty segment at December 31, 2005. Due to the elimination of intercompany profits, property casualty deferrals were reduced by $1,992,848 and amortization expense was reduced by $1,205,665 within the corporate and eliminations segment.

A premium deficiency reserve is recognized by recording an additional liability for the deficiency, with a corresponding charge to operations when anticipated losses, loss adjustment expenses, commissions and other acquisition costs, and maintenance costs exceed the recorded unearned premium reserve, and any future installment premiums on existing policies. The Company had no liability related to premium deficiency reserves at December 31, 2005 or December 31, 2004. The Company utilizes anticipated investment income as a factor in the premium deficiency calculation.

 

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Index to Financial Statements

ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Goodwill and Other Intangible Assets

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

Intangible assets include agent relationships, information technology, and restrictive covenants, and are amortized on a straight-line basis over periods ranging from 5 to 20 years. The Company performs an annual review of its intangible assets in the fourth quarter of each year, or more frequently if indicators of potential impairment exist. This review is to determine if facts and circumstances exist which indicate that the useful life is shorter than originally estimated or that the carrying amount of assets may not be recoverable.

Other Assets

Included in other assets, furniture, equipment, capital leases, software and leasehold improvements are stated at cost less accumulated depreciation or amortization. Depreciation is computed principally using the straight-line method over the estimated useful lives of the related assets. Leasehold improvements are amortized on a straight-line basis over the lesser of the lease terms or the estimated useful lives of the improvements.

Derivative Instruments and Hedging Activities

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

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

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

 

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To meet this objective, management entered into an interest rate swap to manage fluctuations in cash flows resulting from interest rate risk. The interest rate swap changes the variable-rate cash flow exposure of the variable-rate long term debt obligation to fixed-rate cash flows by entering into a receive-variable, pay-fixed interest rate swap. Under the interest rate swap, the Company receives variable interest payments and makes fixed interest rate payments, thereby creating long-term debt with a fixed rate of 4.945%. During 2005, interest received ranged from 2.358% to 4.361%.

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

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

Changes in fair value of the interest rate swap designated as a hedging instrument of the variability of cash flows associated with floating-rate, long-term debt obligation are reported in accumulated other comprehensive income, net of taxes. The Company accounts for the hedging instrument using the short-cut method and has not reclassified any of the gains or losses to interest expense in the subsequent periods. The fair value of the interest rate swap contract decreased by $2,146,896 in 2005 prior to a tax benefit of $751,414.

If it is determined that the swap has ceased to be a highly effective hedge, is sold, or is terminated, the Company will discontinue hedge accounting prospectively. The change in fair value of the hedged item attributable to hedged risk, as has been reported in accumulated other comprehensive income, would be amortized to interest expense over the remaining life of the hedged item.

Other Derivative Instruments: Covered call options are contracts that grant the purchaser, for a premium payment, the right, but not the obligation, to purchase a financial instrument at a specified price within a specified period of time. The Company writes (sells) call options on certain common stocks it already owns to enhance returns to the extent of the premium received. The premium received for a written call option is recorded in other liabilities until the option is exercised, expires, or is otherwise terminated. On disposition, gains (losses) are recognized immediately, with gains (losses) on exercise combined with gains (losses) on the covering asset. The liability is marked to market at each statement date with the changes in the market value of the open options recognized as realized gains (losses) and recorded in the statement of income. The Company had $49,700 and $169,450 in options outstanding at December 31, 2005 and 2004, respectively.

Reserve for Litigation

The Company is subject to lawsuits in the normal course of business related to its insurance and noninsurance products. In accordance with SFAS No. 5, Accounting for Contingencies, management evaluates the merits of each case and determines the need for establishing estimated reserves for potential settlements or judgments as well as reserves for potential costs of defending the Company against the allegations of the complaint at the time a lawsuit becomes known. These reserves may be adjusted as the case develops. Periodically, and at least quarterly, management assesses all pending cases as a basis for evaluating reserve levels. At that point, any necessary adjustments are made to

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

applicable reserves as determined by management and are included in current operating results. Reserves may be adjusted based upon outside counsels’ advice regarding the law and facts of the case, any revisions in the law applicable to the case, the results of depositions and/or other forms of discovery, general developments as the case progresses such as a favorable or an adverse trial court ruling, whether a verdict is rendered for or against the Company, whether management believes an appeal will be successful, or other factors that may affect the anticipated outcome of the case. Management believes adequate reserves have been established in known cases. However, due to the uncertainty of future events, there can be no assurance that actual outcomes will not differ from the assessments made by management.

Reclassifications

Certain amounts in prior periods have been reclassified to conform to the presentation adopted in the current fiscal year. Such reclassification did not impact earnings.

2. POOLING AGREEMENT

Parties to the Pool

Effective August 1, 1987, the Company’s property casualty insurance subsidiaries entered into a reinsurance Pooling Agreement (the “Pooling Agreement”) with the Mutual Group.

 

    Effective October 1, 1994, participation percentages were amended.

 

    Effective October 1, 1996, Fire withdrew from participation in the Pooling Agreement.

 

    Effective January 1, 2001, Fire and Alfa Specialty Insurance Corporation (Specialty), a subsidiary of Mutual, became participants in the Pooling Agreement.

 

    Effective January 1, 2005, the Pooling Agreement was amended and restated, commuting certain pools from August 1, 1987 through December 31, 2001. In addition, AVIC was added as a participant in the Pooling Agreement with other companies in the Alfa Group and Fire began retroceding the quota share business it receives from Virginia Mutual to the pool.

 

    Effective January 1, 2006, the Pooling Agreement was amended to reallocate Specialty’s coinsurance allocation of catastrophes to Mutual.

The Mutual Group is a direct writer primarily of personal lines property casualty insurance in Alabama. The Company’s subsidiaries similarly are direct writers in: Georgia, Mississippi, Missouri, Indiana, Ohio, Virginia, Tennessee, Arkansas, Kentucky, and Florida; and assume business from Texas. Specialty is a direct writer in Alabama, Georgia, Mississippi, and Virginia. Virginia Mutual is a direct writer in Virginia and North Carolina.

The Mutual Group, Virginia Mutual and the Company write preferred risk automobile and homeowner insurance, manufactured home insurance, fire and allied lines, standard risk automobile and homeowner insurance, and a limited amount of commercial insurance, including auto, church and businessowner insurance. Mutual is also a direct writer of farmowner insurance. Specialty and AVIC are direct writers of nonstandard risk automobile insurance.

Under the Pooling Agreement, each participant cedes premiums, losses, and underwriting expenses on all of their direct property casualty business to Mutual, and Mutual in turn retrocedes to each participant a specified portion of premiums, losses, and underwriting expenses based on each participant’s pooling percentage. The Mutual Group’s direct property casualty business (together with the property casualty business ceded by the Company) is included in the pool.

 

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ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The pooling participants and their percentage participation in the pool since inception are as follows:

 

    

8/1/87 to

9/30/94

   

10/1/94 to

09/30/96

   

10/1/96 to

12/31/00

   

1/1/01 to

12/31/04

   

1/1/05 to

current

 

Mutual2

   32 %   24 %   32 %   18 %   18 %

Fire2

   15 %   8 %   0 %   13 %   13 %

General2

   3 %   3 %   3 %   3 %   3 %

AIC1

   25 %   32.5 %   32.5 %   32.5 %   30 %

AGI1

   25 %   32.5 %   32.5 %   32.5 %   30 %

Specialty3

   —       —       —       1 %   1 %

AVIC1

   —       —       —       —       5 %

1 Subsidiary of the Company
2 Member of Mutual Group
3 Subsidiary of Mutual

Approximately 72.9%, 80.5% and 80.7% of the Company’s property casualty premium income and 66.5%, 70.3% and 70.6% of its total premium income were derived from the Company’s participation in the Pooling Agreement in 2005, 2004 and 2003, respectively.

As a result of the Pooling Agreement, the Company had a receivable of $9,321,639 from and a payable of $714,555 to the Mutual Group at December 31, 2005 and 2004, respectively, for transactions originating in December and settled the following month.

Catastrophe Protection Program

On October 1, 1996, the Pooling Agreement was amended in conjunction with the restructuring of the Alfa Insurance Group’s catastrophe protection program. Effective November 1, 1996, the allocation of catastrophe costs among the members of the pool was changed to better reflect the economics of catastrophe finance. The amendment limited the Company’s participation in any single catastrophic event or series of disasters to its pool share (65%) of a lower catastrophe pool limit unless the loss exceeded an upper catastrophe pool limit. In cases where the upper catastrophe limit is exceeded on a 100% basis, the Company’s share in the loss would be based upon its amount of surplus relative to other members of the group. Lower and upper catastrophe pool limits are adjusted periodically due to increases in insured property risks. The limits and participation levels since inception of the program are summarized below:

 

    

Lower

Catastrophe

Pool Limit

(millions)

  

Upper

Catastrophe

Pool Limit

(millions)

  

Estimated Coinsurance

Allocation of

Catastrophes Exceeding

Upper Catastrophe Pool

Limit

 

November 1, 1996

   $ 10.0    $ 249.0    13 %

July 1, 1999

     11.0      284.0    13 %

January 1, 2001

     11.4      284.0    14 %

January 1, 2002

     11.6      289.0    16 %

January 1, 2003

     12.1      301.5    18 %

January 1, 2004

     14.2      352.0    18 %

January 1, 2005

     17.9      443.7    19 %

January 1, 2006

     21.2      525.5    21 %

 

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ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The Company incurred catastrophe losses of $11.6 million, $9.2 million, and $7.9 million in 2005, 2004, and 2003, respectively. These losses resulted in reductions to the Company’s net income of approximately $0.09, $0.07, and $0.06 per diluted share, after reinsurance and taxes in the respective years.

Management

The Boards of Directors of the Mutual Group and of the Company’s property casualty insurance subsidiaries have established the pool participation percentages and must approve any changes in such participation. The Alabama Insurance Department reviewed the Pooling Agreement and the Department determined that the implementation of the Pooling Agreement did not require the Department’s approval.

A committee consisting of two members of the Boards of Directors of the Mutual Group, two members of the Board of Directors of Specialty, two members of the Board of Directors of the Company and Jerry A. Newby, as chairman of each such Board, has been established to review and approve any changes in the Pooling Agreement. The committee is responsible for matters involving actual or potential conflicts of interest between the Company, Specialty and the Mutual Group and for attempting to ensure that, in operation, the Pooling Agreement is equitable to all parties. Conflicts in geographic markets are currently minimal because the Mutual Group writes property casualty insurance only in Alabama and at present all of such insurance written by the Company is outside of Alabama. The Pooling Agreement is intended to reduce conflicts that could arise in the selection of risks to be insured by the participants by making the results of each participant’s operations dependent on the results of all of the pooled business. Accordingly, the participants should have substantially similar loss ratios for the pooled business excluding catastrophes as long as the Pooling Agreement remains in effect.

Should any member of the affiliated group be unable to meet its obligation on a claim for a policy written by the Company’s property casualty subsidiaries, the obligation to pay the claim would remain with the Company’s subsidiaries. The participation of the Company in the Pooling Agreement may be changed or terminated without the consent or approval of the stockholders, and the Pooling Agreement may be terminated only by mutual agreement of the parties in writing. Any such termination, or a change in the Company’s allocated share of the pooled business, inclusion of riskier business or certain types of reinsurance assumed in the pool, or other changes to the Pooling Agreement, could have a material adverse impact on the Company’s earnings. Participants’ respective abilities to share in the pooled business are subject to regulatory capital requirements.

3. RELATED PARTY TRANSACTIONS

Ownership

Mutual owns 42.7%, Fire owns 11.4% and General owns 0.8% of the Company’s common stock. The Board of Directors of the Company consists of eleven members, six of whom serve as Directors of Mutual, Fire and General and two of whom at December 31, 2005 were executive officers of the Company. One of the Company’s directors and most of the Company’s executive officers, including the Company’s President, also hold the same positions with Mutual, Fire, General and Specialty. The Company paid stockholder dividends to the Mutual Group totaling $17,159,686 in 2005, $15,109,690 in 2004 and $13,741,391 in 2003.

The Mutual Group and the Company’s insurance subsidiaries are considered an insurance company holding system with Mutual being the controlling party under the Alabama Insurance Holding Company Systems Regulatory Act and their activities and transactions are subject to reporting, examination and regulation thereunder.

 

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ALFA CORPORATION

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Management and Operating Agreement

Under a Management and Operating Agreement, Mutual provides substantially all facilities, management and other operational services to the Company and its subsidiaries and to other companies associated with Mutual. Most of the personnel providing management services to the Company are full-time employees of, and are directly compensated by, Mutual. The Company’s business is substantially integrated with that of Mutual, Fire and General. Mutual periodically conducts time usage and other special expense allocation studies. Mutual charges the Company for its allocated and direct salaries, employee benefits and other expenses, including those for the use of office facilities. The amounts paid by the Company to Mutual under the Management and Operating Agreement were approximately $61.8 million in 2005, $50.7 million in 2004 and $46.9 million in 2003. The Company reimburses Mutual for the full amount of all its agents’ commissions paid by Mutual for the sale of the Company’s insurance products.

Debt and Guarantees

The Mutual Group is a partner in a real estate partnership, which in 2000 established a revolving line of credit with Financial of $4.0 million at a rate of interest equal to the prime lending rate less 1.0%. During 2002, this line of credit was increased to $5.0 million. At December 31, 2005 and 2004, the amount loaned to the partnership under the line of credit was $4,000,000 and $4,535,000, respectively. Interest paid by the partnership was $230,589, $154,331 and $140,850 in 2005, 2004, and 2003, respectively.

The Company’s property casualty subsidiaries have agreed to guarantee payment on debt owed by three real estate partnerships affiliated with Fire. These guarantees expire between 2006 and 2035 and, in the unlikely circumstance of a guarantee call, could negatively impact the Company by up to $2.2 million (refer to Note 9—Commitments and Contingencies).

In 1997, Mutual established a revolving line of credit with Financial of $20 million at a rate of interest equal to the one-month London Interbank Offered Rate (LIBOR) plus .75%. No balance was outstanding at either December 31, 2005 or 2004. No interest was paid to Financial related to this line of credit in 2005, 2004 or 2003.

In 1999, Realty secured a line of credit with Financial of $250,000 with interest payable monthly at the Company’s commercial paper rate then applicable plus .35%. No balance was outstanding at either December 31, 2005 or 2004. No interest was paid to Financial related to this line of credit in 2005, 2004 or 2003.

Also, during 1999, Builders established a line of credit with Financial of $5 million with interest payable monthly at the Company’s commercial paper rate then applicable plus 1.00%. The unpaid balance on this line of credit was $4,020,917 and $2,506,774 at December 31, 2005 and 2004, respectively. Interest paid to Financial in 2005 and in 2004 subsequent to the sale of Builders to Southern was $162,461 and $41,334, respectively.

The Company’s commercial paper is guaranteed by Mutual and Fire. The Company paid fees of $50,000 and $25,000 to Mutual and Fire, respectively, for their guarantees in 2005 and 2004.

Insurance Products

On February 1, 1997, Mutual began covering its employees with a Corporate Owned Life Insurance (COLI) plan utilizing Life’s universal life product. Premiums paid to Life totaled approximately

 

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$17.9 million in 2005, $17.9 million in 2004 and $18.7 million in 2003. Policy charges recorded from such premiums totaled approximately $3.8 million in 2005, $3.5 million in 2004 and $3.2 million in 2003. Policy reserves and insurance in force on the COLI plan at December 31, 2005 were approximately $149.0 million and $709.9 million, respectively. Certain of Mutual’s employees and those of the Mutual Group’s sponsoring organization, the Alabama Farmers Federation (Federation), not covered by the COLI plan are covered by group life insurance provided by Life. During 2002, certain retired employees of Virginia Mutual, also began being covered by group life insurance provided by Life. Contingency reserves held for this group as of December 31, 2005 and 2004 were $165,739 and $220,226, respectively. Group life insurance premiums paid to Life totaled $516,752 in 2005, $492,449 in 2004 and $542,167 in 2003. Insurance inforce under this plan at December 31, 2005 was approximately $47.3 million. Reserves for group life insurance represent the excess present value of future guaranteed benefits over future premiums plus any unearned premium. Since this one-year term contract renews on January 1 of each year at the discretion of each party, there is no future excess present value of future guaranteed benefits over future premiums at December 31. Since all of the certificates have a renewal date of January 1, the premium for each certificate is fully earned on the following December 31 and no unearned premium liability is present. This reserving method has been used since the Company’s inception. The only change in resulting reserves in recent years occurred when the plan year was adjusted to coincide with the calendar year.

Periodically, certain of the Company’s subsidiaries have purchased property insurance and general liability insurance protection from Mutual and Fire. The annual premium paid for such policies totaled approximately $19,300 in 2004 and $19,600 in 2003. No premiums were paid to Mutual or Fire for policies of these types in 2005.

Other Related-Party Transactions

During 1999, the Company formed a subsidiary, ABC, in an effort to improve the controls over employee benefits and related payments, to simplify and consolidate the accounting and recordkeeping function, and to improve operating efficiencies. As a result, the accrued benefit liabilities held by the various Alfa property casualty entities and their related assets were transferred to ABC at that time. The amounts of net transfers from ABC to Mutual in 2005 and 2004 for payments of benefits totaled approximately $763,000 and $554,000, respectively.

Financial leases equipment, automobiles, furniture and other property to the Mutual Group and its affiliates. The Mutual Group and its affiliates paid $3,367,415 in 2005, $3,367,326 in 2004 and $3,460,011 in 2003 under these leases. Periodically, the Mutual Group invests in automobile and other installment loans issued and serviced by Financial. However, the Mutual Group held no such investment in these loans at either December 31, 2005 or December 31, 2004. Interest paid by Financial to the Mutual Group on these loans was $199,897 in 2005, $320,900 in 2004 and $434,304 in 2003. The Alabama Farmers Federation (Federation) and Alfa Services, Inc. (Services), a Federation subsidiary, invest in short-term lines of credit with the Company and Financial. The balance outstanding on these lines of credit included in notes payable to affiliates was $20,887,635 and $15,887,635 at December 31, 2005 and 2004, respectively. Interest paid by the Company and Financial to the Federation and its subsidiary was $502,302 in 2005, $166,398 in 2004 and $99,104 in 2003.

In 2004 prior to its being sold, the Company’s real estate construction subsidiary, Builders, purchased 6 residential lots at fair value for $292,207 and 11 residential lots in 2003 at fair value for $542,796 from a partnership in which the Mutual Group is a partner. Builders also purchased one lot

 

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Index to Financial Statements

ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

during the first two months of 2004 at fair value for $20,750 from a partnership in which Alfa Properties is a member. Alfa Properties paid $21,199 in other commissions to Realty in 2003. Builders purchased 4 residential lots in 2003 at fair value for $213,000 from Alfa Properties.

Alfa Properties has a partnership interest in Marshall Creek, Ltd., a real estate development. Financial established capital leases with this entity during 2002 and received payments of $183,900 and $157,646 under these leases in 2005 and 2004, respectively.

Builders contracts with the Mutual Group for the construction of certain commercial facilities. The Mutual Group paid $6,240 in the first two months of 2004 and $299,471 in 2003 to Builders under such contracts. Builders also received $1,429 in rental income from the Mutual Group during 2004.

The Company periodically has investment transactions with the Mutual Group. In 2004, the Company bought one security at fair value of $3,094. In addition, during 2003, the Company sold seven securities to the Mutual Group at fair value for a loss of $1,128,328. No such transactions occurred during 2005. The Company is also a partner in Alfa Investors Partnership with the Mutual Group. The amount contributed to the partnership was $36.3 million and $33.1 million at December 31, 2005 and 2004, respectively. The Company had committed to fund up to $3.2 million additional investment in the partnership at December 31, 2005. The Company received distributions from the partnership of $1.2 million and $3.5 million in 2005 and 2004, respectively. In 2000, the Company became a member in Alfa Ventures II, LLC with the Mutual Group. The amount contributed to the limited liability company was approximately $1.9 million at both December 31, 2005 and 2004, respectively. The Company received distributions from this partnership of $3,002,218 in 2005 and $479,974 in 2004.

The Company’s life subsidiary is a general partner in two investment partnerships with a trust created by Mutual and Fire. The carrying value of the partnerships was $986,658 and $931,384 at December 31, 2005 and 2004, respectively.

On December 31, 2005, the Company completed the sale of Financial’s leasing division, OFC Capital, to OFC Servicing Corporation, a subsidiary of MidCountry. Included in other long-term investments in affiliates is a note receivable of $55.5 million related to this transaction.

 

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Index to Financial Statements

ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

4. INVESTMENTS

Net investment income by source is summarized as follows:

 

     2005     2004     2003  

Fixed maturities:

      

Held for investment

   $ 7,799     $ 10,800     $ 15,929  

Available for sale

     76,742,477       73,679,602       68,422,691  
                        

Total fixed maturities

     76,750,276       73,690,402       68,438,620  

Equity securities

     2,911,867       2,931,221       2,429,561  

Mortgage loans on real estate

     —         88       2,211  

Investment real estate

     —         8,926       376,863  

Policy loans

     4,514,618       4,326,939       4,145,985  

Collateral loans

     8,502,108       7,346,929       7,170,102  

Commercial leases

     6,219,519       11,721,507       9,183,383  

Other long-term investments

     13,194,809       8,267,706       4,547,351  

Short-term investments

     2,571,982       1,268,755       2,637,195  
                        

Total investment income

     114,665,179       109,562,473       98,931,271  

Interest expense

     (11,531,361 )     (6,691,180 )     (5,705,598 )

Investment expenses

     (8,202,079 )     (13,510,290 )     (10,129,354 )
                        

Net investment income

   $ 94,931,739     $ 89,361,003     $ 83,096,319  
                        

Net realized investment gains (losses) are summarized as follows:

 

     2005     2004     2003  

Fixed maturities available for sale

   $ (1,768,154 )   $ (1,077,337 )   $ (2,345 )

Equity securities

     10,693,897       17,440,120       5,337,076  

Other investments

     (2,874,870 )     (9,314,129 )     928,888  
                        

Net realized investment gains, before taxes

     6,050,873       7,048,654       6,263,619  

Less: Tax effect on realized investment gains

     2,117,806       2,467,029       2,192,268  
                        

Net realized investment gains, net of tax

   $ 3,933,067     $ 4,581,625     $ 4,071,351  
                        

Valuation of Investments

Changes in net unrealized investment gains and losses on fixed maturities and equity securities are as follows:

 

     Increase (Decrease)  
     2005     2004     2003  

Fixed maturities:

      

Held for investment

   $ (3,979 )   $ (5,364 )   $ (10,921 )
                        

Available for sale, net of tax

   $ (13,507,513 )   $ (4,765,233 )   $ (3,319,155 )
                        

Equity securities, net of tax

   $ (3,837,356 )   $ (1,776,378 )   $ 10,880,335  
                        

 

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Index to Financial Statements

ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Unrealized investment gains and losses are based on fair values that were determined using nationally recognized pricing services, broker/dealers securities firms and market makers.

The cost and estimated fair value of investments in equity securities are as follows:

 

     December 31, 2005
     Cost   

Gross Unrealized

Gains

  

Gross Unrealized

Losses

   

Estimated Fair

Value

Equity securities

   $ 96,668,040    $ 13,966,406    $ (3,614,342 )   $ 107,020,104
                            
     December 31, 2004
     Cost   

Gross Unrealized

Gains

  

Gross Unrealized

Losses

   

Estimated Fair

Value

Equity securities

   $ 83,445,562    $ 17,888,444    $ (1,632,756 )   $ 99,701,250
                            

Applicable deferred income taxes on net unrealized gains for equity securities aggregated $3,639,602 and $5,705,870 at December 31, 2005 and 2004, respectively.

The amortized cost and estimated fair value of investments in fixed maturity securities are as follows:

 

     December 31, 2005
     Amortized Cost   

Gross Unrealized

Gains

  

Gross Unrealized

Losses

   

Estimated Fair

Value

Held for investment:

          

Mortgage-backed securities

   $ 88,330    $ 5,248    $ —       $ 93,578
                            

Available for Sale:

          

U.S. Treasury securities

   $ 8,453,587    $ 1,533,984    $ (95,774 )   $ 9,891,797

Obligations of U.S. Government corporations and agencies

     173,859,067      1,032,316      (2,096,645 )     172,794,738

Obligations of states and political subdivisions

     380,733,250      17,631,560      (461,293 )     397,903,517

Corporate securities

     196,569,148      14,900,108      (583,434 )     210,885,822

Mortgage-backed securities

     633,188,826      3,178,241      (10,166,046 )     626,201,021

Other debt securities

     2,019,200      12,000      —         2,031,200
                            

Total

   $ 1,394,823,078    $ 38,288,209    $ (13,403,192 )   $ 1,419,708,095
                            

 

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     December 31, 2004
     Amortized Cost   

Gross Unrealized

Gains

  

Gross Unrealized

Losses

   

Estimated Fair

Value

Held for investment:

          

Mortgage-backed securities

   $ 114,708    $ 9,227    $ —       $ 123,935
                            

Available for Sale:

          

U.S. Treasury securities

   $ 12,170,755    $ 1,640,699    $ (85,252 )   $ 13,726,202

Obligations of U.S. Government corporations and agencies

     69,552,353      1,841,239      (317,542 )     71,076,050

Obligations of states and political subdivisions

     372,575,346      22,839,750      (329,295 )     395,085,801

Corporate securities

     217,747,375      23,234,132      (53,302 )     240,928,205

Mortgage-backed securities

     631,069,998      5,687,654      (5,552,470 )     631,205,182

Other debt securities

     2,172,200      313,850      —         2,486,050
                            

Total

   $ 1,305,288,027    $ 55,557,324    $ (6,337,861 )   $ 1,354,507,490
                            

Management analyzes net unrealized losses on investments for impairment. The following table shows the Company’s net unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2005:

 

    Less Than 12 Months   12 Months or More   Total
    Fair Value   Unrealized
Losses
  Fair Value   Unrealized
Losses
  Fair Value   Unrealized
Losses

U.S. Treasury securities

  $ —     $ —     $ 2,711,625   $ 95,774   $ 2,711,625   $ 95,774

Obligations of U.S. Government corporations and agencies

    122,617,873     1,585,228     12,293,110     511,417     134,910,983     2,096,645

Obligations of states and political subdivisions

    25,858,343     125,937     7,705,864     335,356     33,564,207     461,293

Corporate securities

    28,610,474     574,184     1,994,056     9,250     30,604,530     583,434

Mortgage-backed securities

    341,436,969     7,703,819     104,664,491     2,462,227     446,101,460     10,166,046
                                   

Total fixed maturities

    518,523,659     9,989,168     129,369,146     3,414,024     647,892,805     13,403,192

Equity securities

    38,830,001     3,347,259     3,528,551     267,083     42,358,552     3,614,342
                                   

Total temporarily impaired securities

  $ 557,353,660   $ 13,336,427   $ 132,897,697   $ 3,681,107   $ 690,251,357   $ 17,017,534
                                   

Of the 166 fixed maturities in an unrealized loss position at December 31, 2005, the majority are mortgage-backed securities. Of the $10.2 million in unrealized losses on mortgage-backed securities, the majority was issued by governmental agencies. Therefore, return of principal is not currently an issue. Similarly, the interest rate environment has been the primary cause of the other fixed maturity loss positions in the portfolio. While unrealized gains and losses will fluctuate with interest rate changes, receipt of principal is highly probable if these securities are held to maturity. The Company reviews

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

securities for impairment each quarter and considers its intent and ability to hold any debt securities in a loss position until the fair value recovers. Information used in the assessment for impairment includes industry analyst reports, credit ratings, and the volatility of the security’s market price.

There were 53 equity positions with unrealized losses at December 31, 2005. No single position comprised over 12% of the gross unrealized losses at that date.

The Company did not consider any decline in value to be an other than temporary impairment at December 31, 2005.

Fixed Maturities

The amortized cost and estimated fair value of fixed maturities available for sale at December 31, 2005 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

     December 31, 2005
     Amortized Cost    Estimated Fair Value

Available for Sale:

     

Due in one year or less

   $ 32,826,029    $ 33,187,675

Due after one year through five years

     115,719,586      118,990,036

Due after five years through ten years

     248,075,301      256,598,074

Due after ten years

     365,013,336      384,731,289
             
     761,634,252      793,507,074

Mortgage-backed securities

     633,188,826      626,201,021
             

Total

   $ 1,394,823,078    $ 1,419,708,095
             

Proceeds from sales of fixed maturities available for sale were $108,372,196 in 2005, $61,425,800 in 2004 and $68,916,066 in 2003. Gross gains of $426,899 in 2005, $391,408 in 2004 and $1,644,188 in 2003 and gross losses of $2,231,672 in 2005, $952,108 in 2004 and $2,519,043 in 2003 were realized on those sales. In addition, the Company recorded a loss of $1,046,867 in 2005 and $111,279 in 2004 for fixed maturities available for sale whose valuation was deemed to be an other than temporary decline. No fixed maturities available for sale were written down during 2003. At December 31, 2005, the Company’s mortgage-backed securities were comprised of CMO’s and pass through securities. The valuation of such securities is subject to significant fluctuations due to changes in interest rates. The Company has a history of positive cash flow and has the ability to hold such investments to maturity. Management performs periodic assessments of the portfolio to monitor interest rate fluctuations. At December 31, 2005, the Company had $5,501,747 in fixed maturities available for sale on deposit with regulatory agencies in order to meet statutory requirements.

The Company’s fixed maturity portfolio is predominantly comprised of investment grade securities. At December 31, 2005, approximately $26.3 million in fixed maturities (1.9% of the total fixed maturity portfolio) are considered below investment grade. The Company considers bonds with a quality rating of BB+ and below, based on Standard & Poor’s rating scale, to be below investment grade.

Equity Securities

Proceeds from sales of equity securities were $137,282,425 in 2005, $167,267,526 in 2004 and $126,036,887 in 2003. Gross gains of $14,545,779 in 2005, $20,503,986 in 2004 and

 

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ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

$10,785,331 in 2003 and gross losses of $2,847,685 in 2005, $3,063,865 in 2004 and $4,488,106 in 2003 were realized on those sales. The Company also recorded a loss of approximately $1,004,197 in 2005 and $953,349 in 2003 for equity securities whose valuation was deemed to be an other than temporary decline. The Company recorded no such writedowns during 2004.

Policy Loans

The Company’s policy loans are carried at the outstanding balance and earn interest predominately at 8.0% but range from 5.0% to 8.0%. Policy loans have no stated maturity and are often repaid by reductions to benefits and surrenders. Therefore, the carrying amount approximates the fair value of the policy loan portfolio.

Collateral Loans

The Company’s collateral loan portfolio totaled approximately $124.7 million and $110.8 million at December 31, 2005 and 2004, respectively. These portfolios consisted of mortgage and consumer loans in the Company’s primary market area of Alabama, Georgia and Mississippi. Management evaluates the creditworthiness of customers on a case-by-case basis and obtains collateral as deemed necessary based on this evaluation. The Company had charged off loans totaling $422,288, $432,099 and $364,317 in 2005, 2004 and 2003, respectively. At December 31, 2005 and 2004, respectively, the Company maintained an allowance for losses of $1,406,871 and $1,244,280. The Company has estimated the fair value of the collateral loan portfolio to be approximately $130.3 million and $113.9 million at December 31, 2005 and 2004, respectively. The estimated fair value was determined by discounting the estimated future cash flows from the loan portfolio at 5.89% for 2005 and 5.74% for 2004, the current interest rates offered for similar loans, and after allowing for estimated loan losses. The Company had impaired loans of $633,532 and $35,079 subject to individual valuation at December 31, 2005 and 2004, respectively. Loans in nonaccrual status at December 31, 2005 and 2004 were $441,215 and $354,196 respectively. Repossessed assets, net of allowance for losses on disposal, included in other assets were $75,757 and $59,434 at December 31, 2005 and 2004, respectively.

Commercial Leases

The Company’s commercial lease portfolio totaled approximately $2.5 million and $4.8 million at December 31, 2005 and 2004, respectively. The majority of the commercial lease portfolio was reclassified to Assets Classified as Held for Sale at December 31, 2004 and subsequently sold in the fourth quarter of 2005 (refer to Note 17—Business Combinations and Divestitures). During 2005, 2004 and 2003, the Company charged off leases totaling $1,415,578, $8,303,396 and $2,265,023, respectively. At December 31, 2005, the Company had an allowance for losses of $8,083,758 on the lease portfolio. At December 31, 2004, the allowance for losses on the lease portfolio was $9,727,546 including $3,553,763 on assets classified as held for sale. The Company has estimated the fair value of the commercial lease portfolio to be approximately $2.5 million and $5.0 million at December 31, 2005 and 2004, respectively. The estimated fair value of the lease portfolio at December 31, 2005 approximates carrying value after allowing for estimated lease losses. At December 31, 2004, the estimated fair value of the lease portfolio was determined by discounting the estimated future cash flows from the lease portfolio at 8.5%, the current interest rate offered for similar leases, and after allowing for estimated lease losses. Assets leased to affiliated companies are expected to be held until the lease terminates and, therefore, fair value is assumed to equal net cost. The Company had impaired leases of $1,101,050 and $1,173,593 subject to individual valuation at December 31, 2005 and

 

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ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

2004, respectively. Leases that are more than 90 days late are placed in a nonaccrual status and totaled $9,881,175 and $8,571,638 at December 31, 2005 and 2004, respectively. Repossessed assets, net of allowances for losses on disposal, included in other assets were $350,156 and $897,118 at December 31, 2005 and 2004, respectively.

Other Long-term Investments

Partnerships and Equity Method Investments: Investments in partnerships, joint ventures and unconsolidated investee companies are stated at the underlying audited equity value based on accounting principles generally accepted in the United States of America. Income is recognized based on reported earnings by the partnerships, joint ventures and companies. Partnership interests represent 77.5%, or approximately $48.0 million, of other long-term investments at December 31, 2005 and 78.6%, or approximately $52.5 million at December 31, 2004. Similarly, partnership interests represent 15.6%, or approximately $21.6 million, of other long-term investments in affiliates at December 31, 2005 and 24.9%, or approximately $19.4 million at December 31, 2004.

Ownership in partnership interests range from less than 1% to 62.5%. The Company’s investment in MidCountry is also accounted for using the equity method. In addition to earnings reflected within the statements of income, this investment has generated gross accumulated other comprehensive loss of $607,015 before a tax benefit of $212,455 since the investment was made in 2002. The table below summarizes the company’s primary long-term investment interests at December 31, 2005 and related operating results for 2005.

 

   

Segment Holding
Investment

  Ownership   Carrying Value  

Unpaid
Commitment

in Other

Liabilities

  Equity in Net
Earnings
 

Realized

Losses

 

Non-affiliates:

           

Low Income Housing Tax Credit Partnerships

 

  Property Casualty Insurance   Various   $ 36,853,272   $ 23,515,546   $ —     $ (3,391,784 )
  Life Insurance   Various   $ 6,177,375   $ —     $ —     $ (714,790 )

Other Partnerships

  Life Insurance   Various   $ 5,013,643   $ —     $ 342,909   $ —    

Affiliates:

           

Alfa Investors

  Property Casualty Insurance   27%   $ 19,893,941   $ —     $ 4,097,010   $ —    

Alfa Ventures II, LLC

 

  Property Casualty Insurance   20%   $ 703,391   $ —     $ 2,240,193   $ —    

East South Boulevard Investors I, LLP

  Life Insurance   1%   $ 805,500   $ —     $ 45,686   $ —    

East South Boulevard Investors II, LLP

  Life Insurance   1%   $ 181,159   $ —     $ 9,588   $ —    

MidCountry Financial Corporation

  Noninsurance   43%   $ 53,329,870   $ —     $ 1,153,811   $ —    

The Company had net investment income from partnerships and other equity method investments of approximately $7.9 million in 2005 and $4.1 million in 2004 after net investment losses of approximately $2.5 million in 2003. At December 31, 2005 and 2004, partnerships yielding tax credits from investments in low-income housing of approximately $43.0 million and $47.1 million are included in the Company’s other long-term investments. The Company realized losses from its

 

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Index to Financial Statements

ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

investments in low-income housing partnerships of $4.1 million in 2005 and $10.9 million in 2004. In addition, the Company’s investment in MidCountry was approximately $53.3 million, $51.5 million and $14.4 million at December 31, 2005, 2004 and 2003, respectively. Net investment income from MidCountry was $1,153,811, $540,189 and $965,229, respectively in 2005, 2004 and 2003.

Other Investments: Included in the Company’s other long-term investments is its leased asset portfolio (refer to Note 11—Operating Leases) and a position in Waveland NCO Alabama Ventures, LLC, a certified capital company that is an investment premium tax credit program sanctioned by the State of Alabama. This investment is carried at its unpaid principal balance of $2.9 million at December 31, 2005. Principal and interest are received in accordance with a contractual agreement and repayment of principal is protected by strict guidelines imposed by the governing agency. Also included within other long-term investments to affiliates is a note receivable from OFC Servicing Corporation, a wholly-owned subsidiary of MidCountry, for $55,543,362 resulting from the sale of OFC Capital (refer to Note 18—Business Combinations and Divestitures). The leased asset portfolio and the note receivable are carried at the net book value.

Short-term Investments

Short-term investments are reflected at fair value and are comprised almost exclusively of money market funds and are not discounted due to their liquidity and short-term nature. Therefore, the Company considers the fair value of its short-term investments to be equal to cost.

5. FAIR VALUE OF FINANCIAL INSTRUMENTS

SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires disclosures of fair value information of financial instruments. Information about specific valuation techniques and related fair value detail is provided in Note 1—Summary of Significant Accounting Policies, Note 4—Investments and Note 8—Commercial Paper and Notes Payable. The cost and estimated fair value of financial instruments as of December 31 are as follows:

 

    December 31,
    2005   2004
    Cost  

Estimated Fair

Value

  Cost  

Estimated Fair

Value

Assets:

       

Fixed maturities held for investment

  $ 88,330   $ 93,578   $ 114,708   $ 123,935

Fixed maturities available for sale

  $ 1,394,823,078   $ 1,419,708,095   $ 1,305,288,027   $ 1,354,507,490

Equity securities

  $ 96,668,040   $ 107,020,104   $ 83,445,562   $ 99,701,250

Policy Loans

  $ 62,101,204   $ 62,101,204   $ 58,476,569   $ 58,476,569

Collateral loans

  $ 124,667,449   $ 130,283,798   $ 110,792,974   $ 113,917,064

Commercial leases

  $ 2,515,084   $ 2,515,084   $ 4,831,363   $ 5,013,646

Other long-term investments

  $ 62,957,416   $ 61,961,072   $ 75,310,735   $ 66,855,805

Other long-term investments in affiliates

  $ 130,839,787   $ 138,457,224   $ 74,943,872   $ 77,942,989

Short-term investments

  $ 84,861,880   $ 84,861,880   $ 80,988,969   $ 80,988,969

Cash

  $ 37,228,639   $ 37,228,639   $ 20,052,493   $ 20,052,493

Liabilities:

       

Commercial paper

  $ 213,790,443   $ 213,790,443   $ 204,303,206   $ 204,303,206

Notes payable

  $ 90,887,635   $ 90,887,635   $ 85,887,635   $ 85,887,635

Derivative-related liabilities

  $ 103,780   $ 67,031   $ 137,512   $ 2,333,677

 

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ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

6. POLICY LIABILITIES AND ACCRUALS

The composition of the liability for future policy benefits and life and health claim reserves and the more significant assumptions used in its calculation are as follows:

 

        Liability      

Basis of Assumption

    Insurance Inforce   December 31,   Years of Issue  

Interest Rate

 

Mortality and
Morbidity

  Withdrawals
      2005   2004        

Ordinary life

  $ 12,379,235,907   $ 187,849,874   $ 174,193,395   1955 to 1978   5%   1955-60 Basic Select and Ultimate Mortality Tables   Company
experience
        1979 to 1980  

7% graded

to 5%

  Modified 1965-70 Basic Select and Ultimate Mortality Tables   Company
experience
        1981 to 1993  

9% graded

to 7%

  Modified 1965-70 Basic Select and Ultimate Mortality Tables   Company
experience
        1994 to 2005   6%   Modified 1965-70 Basic Select and Ultimate Mortality Tables   Company
experience

Interest sensitive life

    2,492,011,968     246,586,176     235,582,918   1984 to 2005  

4.75%

to 5%*

  Modified 1965-70 Basic Select and Ultimate Mortality Tables   Company
experience

Universal life

    6,277,271,493     341,764,173     307,112,029   1987 to 2005  

4.75%

to 5%*

  Modified 1965-70 Basic Select and Ultimate Mortality Tables   Company
experience

Annuities w/o life contingencies

      12,842,589     12,442,351   1974 to 2005   4.5%*    

Group credit life

    13,445,549     389,197     368,381   1992 to 2005   3.0%   1958 CET  

Group life

    47,269,368     165,739     220,226   2005   4.5%   1960 CSG  
                         
  $ 21,209,234,285   $ 789,597,748   $ 729,919,300        
                 

Accident and health

      248,182     270,889     4.5% to 5%   1972 intercompany reports   200% N&W III

Life and health claim reserves

      8,288,438     5,954,082        
                     
    $ 798,134,368   $ 736,144,271        
                     

* Rates are adjustable annually on policyholders’ anniversary dates.

 

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Index to Financial Statements

ALFA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

For the year ended December 31, 2005, premiums under individual ordinary life insurance participating policies were $5,176,439, or 4% of total premiums collected. The Company accounts for its policyholder dividends based upon dividends apportioned for payment for the next year plus any adjustments for dividends paid differently from those apportioned in the prior year. Total policyholder dividends incurred for 2005 were $4,009,119. The Company paid dividends in the amount of $3,963,044 during 2005 to policyholders and did not allocate any additional income to such policyholders. The Company did not issue any participating policies during 2005. The amount of insurance inforce on participating policies represents 1% of ordinary life insurance inforce or approximately $236 million.

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

 

    2005     2004     2003  
   

Property

Casualty

    Life    

Property

Casualty

    Life    

Property

Casualty

    Life  

Balance at January 1,

  $ 154,107,730     $ 5,954,082     $ 144,723,003     $ 4,567,589     $ 140,019,766     $ 4,372,433  

less reinsurance recoverables on unpaid losses

    (3,251,046 )     (1,677,427 )     (5,133,250 )     (543,978 )     (2,648,790 )     (690,672 )
                                               

Net balance on January 1,

    150,856,684       4,276,655       139,589,753       4,023,611       137,370,976       3,681,761  
                                               

Incurred related to:

           

Current year

    353,497,743       27,921,285       325,446,874       27,089,443       312,309,956       24,427,420  

Prior years

    4,598,363       192,211       (7,280,159 )     28,369       (10,761,807 )     115,329  
                                               

Total incurred

    358,096,106       28,113,496       318,166,715       27,117,812       301,548,149       24,542,749  
                                               

Paid related to:

           

Current year

    252,333,889       25,178,694       232,589,448       24,905,841       229,234,630       22,327,532  

Prior years

    99,082,555       2,179,475       74,310,336       1,958,927       70,094,742       1,873,367  
                                               

Total paid

    351,416,444       27,358,169       306,899,784       26,864,768       299,329,372       24,200,899  
                                               

Net balance at December 31,

    157,536,346       5,031,982       150,856,684       4,276,655       139,589,753       4,023,611  

plus reinsurance recoverables on unpaid losses

    2,103,540       3,256,456       3,251,046       1,677,427       5,133,250       543,978  
                                               

Balance at December 31,

  $ 159,639,886     $ 8,288,438     $ 154,107,730     $ 5,954,082     $ 144,723,003     $ 4,567,589  
                                               

There are inherent uncertainties in reserving for unpaid losses. Management’s philosophy has been to establish reserves at a high level of confidence. The liability for estimated unpaid losses and loss adjustment expenses is based on a detailed evaluation of reported losses and of estimates of incurred but not reported losses. Adjustments to the liability based on subsequent developments are included in current operations. The estimated cost of loss and loss adjustment expenses attributable to insured events of prior years increased by approximately $4.1 million during 2005 as a result of re-estimation of unpaid losses and loss adjustment expenses. Increases or decreases of this nature occur as the result of claim settlements during the current year, and as additional information is received regarding individual claims, causing changes from the original estimates of the cost of these claims. Recent loss development trends are also taken into account in evaluating the overall adequacy of unpaid losses and loss adjustment expenses. The Company is primarily an insurer of private passenger motor vehicles and of single-family homes and has limited exposure for difficult-to-estimate claims such as environmental, product and general liability claims. The Company does not believe that any such claims will have a material impact on the Company’s liquidity, results of operations, cash flows or financial condition. Deducted from the liability for estimated unpaid losses and loss adjustment expenses are the Company’s estimates of salvage and subrogation recoverable of approximately $9.8 million and $10.1 million at December 31, 2005 and 2004, respectively. The table below summarizes the 2005 changes in estimated loss reserves by component and period in thousands of dollars.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

<
    

Reserves at

January 1,

2005

  

Loss

Development

    Paid Loss   

Reserves at

December 31,

2005

     (in thousands)

Prior to 1996

   $ 5,488    $ (133 )   $ 4,955    $ 400

              1996

     886      23       841      68

              1997

     700      (1 )     639      60

              1998

     1,970      (382 )     1,188      400

              1999

     2,076      252       1,996      332

              2000

     3,358      383       2,901      840

              2001

     7,228      (1,563 )     2,185      3,480

              2002

     10,883      (272 )     3,190      7,421

              2003

     25,410      2,624       14,336      13,698

              2004

     92,858      3,667