10-K 1 d04256e10vk.txt FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K Annual Report Pursuant to Section 13 or 15 (d) of The Securities Exchange Act of 1934 For the fiscal year ended Commission file number 1-9828 December 31, 2002 GAINSCO, INC. (Exact name of registrant as specified in its charter) TEXAS 75-1617013 (State of Incorporation) (IRS Employer Identification No.) 1445 Ross Ave., Suite 5300 Dallas, Texas 75202 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (214) 647-0415 Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered Common Stock ($.10 par value) OTC Bulletin Board Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained herein, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [ ] No [X] The aggregate market value of the registrant's Common Stock ($.10 par value), the registrant's only class of voting or non-voting common equity stock, held by non-affiliates of the registrant (19,179,131 shares) as of the close of the business on February 28, 2003 was $3,835,826 (based on the closing sale price of $0.20 per share on that date on the OTC Bulletin Board). As of February 28, 2003, there were 21,169,736 shares of the registrant's Common Stock ($.10 par value) outstanding. INCORPORATION BY REFERENCE Portions of the Company's Proxy Statement for its Annual Meeting of Shareholders to be held on May 19, 2003 are incorporated by reference herein in response to Items 10, 11, 12 and 13 of Part III of Form 10-K. 1 PART I ITEM 1. BUSINESS GENERAL DESCRIPTION GAINSCO, INC. ("GNAC") is a holding company that provides administrative and financial services for its wholly owned subsidiaries. The term "Company" as used in this document includes GNAC and its subsidiaries unless the context otherwise requires. GNAC was incorporated in Texas on October 11, 1978. It completed its initial public offering on November 14, 1986. The Company is a property and casualty insurance company concentrating its efforts on the nonstandard personal automobile market in Florida as it concurrently exits its commercial insurance business. The Company's insurance operations for most of 2002 were conducted through four insurance companies: General Agents Insurance Company of America, Inc. ("General Agents"), an Oklahoma corporation; MGA Insurance Company, Inc. ("MGAI"), a Texas corporation; GAINSCO County Mutual Insurance Company ("GCM"), a Texas chartered company; and Midwest Casualty Insurance Company ("MCIC"), a North Dakota insurance corporation acquired January 7, 2000. See "Recent Developments", for information regarding the Company's actions to reduce its involvement in the insurance business, including the Company's decision to cease writing its primary line of business, commercial insurance, and its sale of the management contract controlling GCM. On March 31, 2003, MCIC is to be liquidated and all of its assets, liabilities and equity are to be transferred to General Agents. During 2002 the Company was approved to write insurance in 47 states and the District of Columbia on a non-admitted basis and in 44 states and the District of Columbia on an admitted basis. The Company currently markets its personal lines of insurance through over 550 non-affiliated retail agencies and previously marketed its commercial lines of insurance through 200 non-affiliated general agency offices. Approximately 70% of the Company's gross premiums written during 2002 resulted from risks located in Florida. The Company's lines of insurance are written on certain classes and types of risks which are not generally insured by many of the standard companies, although such companies have been competing in this market more frequently in recent years. The strategy of the Company is to identify various types of risks where it can price its coverages profitably and competitively. For a description of the product lines presently written by the Company, see "Recent Developments" and "Product Lines." The Company sets its policy premiums by applying its own judgment after consideration of the risks involved and the competition. Part of its analysis includes the review of historical premium rate and loss cost information as compiled and reported by independent rating bureaus. RECENT DEVELOPMENTS In March 2003, the Financial Accounting Standards Board announced it expects to issue the proposed limited-scope statement "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity," in the second quarter of 2003. This statement would require redeemable preferred stock to be classified as a liability and any related accretion of discount and accrued dividends to be charged to the results of operations. If this statement is adopted as proposed, the Company would record all series of preferred stock as liabilities and would record the related accretion of discount and accrued dividends as charges to Results of Operations. For 2002 the accretion of discount on redeemable preferred stock was $2,657,000 and the dividends accrued were $670,774. Under this proposed statement these amounts would be recorded as charges to Results of Operations, and we anticipate an increase in the deferred tax valuation allowance equal to the related deferred tax benefit. Discontinuance of Commercial Lines. On February 7, 2002, the Company announced its decision to cease writing its primary line of business, commercial insurance, due to continued adverse claims development and unprofitable results. Approximately 68.5 million of unprofitable commercial lines premiums were subject to this exit decision. The Company notified all of its commercial lines agents of its intent to cancel their agency contracts and notified all states, where required by statute, of its intent to cease writing commercial lines of insurance in their state. The discontinuance of writing commercial lines will likely result in the Company ceasing to be approved to write insurance in a number of states. By December 31, 2002, the Company had non-renewed 86% of its in-force policies. The remaining 14%, amounting to approximately $12 million in premiums, are scheduled to be non-renewed in the first half of 2003 as the applicable policies expire. Concurrently, the Company continued to settle and reduce its inventory of commercial lines claims. At year-end 2002, there were 1,062 claims associated with the runoff book outstanding, compared to 1,720 a year earlier. 2 Due to the long tail nature of these claims, the Company anticipates it will take a substantial number of years to complete an orderly adjustment and settlement process with regard to existing claims and any additional claims it receives in the future from its past business writings. The Company's cost-structure is being reduced with the reduction of premium and claims inventory. Changes in Personal Lines. On August 12, 2002, the Company announced its decision to put itself in a position to exit its remaining active insurance business, personal auto, in as orderly and productive a fashion as possible. In June 2002, the Company entered into a letter of intent to sell its Miami, Florida based operation, the Lalande Group, to an unaffiliated party. In September 2002 negotiations in respect of the possible transaction were terminated. In conjunction with this process, the Company evaluated the related goodwill and recorded an impairment of approximately $2.9 million during the second quarter 2002. The remaining goodwill as of December 31, 2002 is $609,000 and is related to the 1998 acquisition of the Lalande Group. Operationally, the Company implemented rate increases and other measures to enhance the profit potential of this business in 2003 and its future strategic direction, which could include the expansion, contraction or disposition of the business. Redeployment of Capital. The Company anticipates a lengthy period of transition as it lessens its exposure to the insurance industry. During the transition process, the Company may consider the sale of additional subsidiaries associated with that business. The Company intends to redeploy capital no longer required by its insurance business, once it becomes available, to pursue other opportunities in the future that offer a better prospect for profitability. The Company believes that suitable capital redeployment opportunities should be available after the capital no longer required by its insurance business becomes available, but cannot predict the amount of capital that will ultimately be available for redeployment, the timing or the nature of the opportunities that may be available at the time capital becomes available. The opportunities may be outside of the insurance business and could be in the financial services business. Fronting Agreements. The Company had fronting agreements with three non-affiliated insurance companies. The business written under these agreements was ceded 100% to reinsurers rated "A (Excellent)" or better by A.M. Best Company ("Best's"), and 100% of the liabilities were collateralized with pledged investment grade securities or letters of credit or the reinsurer had fully indemnified the Company against business, credit and insurance risk. Two of these fronting agreements were through GCM. See "Recent Developments -- Sale of GAINSCO County Mutual." The remaining fronting agreement was terminated in the second quarter of 2002 and is currently in run-off. Sale of GAINSCO County Mutual. On December 2, 2002, the Company completed the sale and transfer of the management contract controlling GCM to an affiliate of Liberty Mutual Insurance Company ("Liberty"), for a purchase price of up to $10 million, of which $1 million was paid at closing and the balance is payable in contingent payments through September 2009. The $9 million total of future payments would be payable $3 million in September 2003 and $1 million each year thereafter through September 2009. Each payment is contingent on there being no material adverse change in the regulatory treatment of GCM specifically, or county mutuals generally, from legislative or regulatory administrative actions prior to the applicable payment date. Legislation has been introduced in the current session of the Texas Legislature ending June 2, 2003 which, depending upon whether or in what form it is ultimately adopted, could prejudice the rights of the Company to receive some or all of the future payments from Liberty. Following the closing, the surplus of GCM, which was approximately $3,182,000, remained as a part of the combined statutory policyholders' surplus of the Company. Pursuant to a 100% quota share reinsurance agreement (the "General Agents Reinsurance Agreement") entered into at closing among GCM and GAINSCO's subsidiaries, General Agents and MGA Agency, Inc., and certain other arrangements, the Company retained all assets and liabilities associated with GCM's past, present and runoff commercial insurance business. The Company made a number of representations, warranties and covenants in the acquisition agreement and generally indemnifies Liberty for any losses incurred resulting from (i) breaches of representations, warranties or covenants of the Company; (ii) employee benefit plan obligations of GCM relating to pre-closing periods; (iii) tax obligations of GCM relating to pre-closing periods; (iv) all liabilities of GCM, to the extent that they result from conditions or circumstances arising or events occurring before the Closing, subject to certain exceptions; (v) all insurance claims, liabilities and obligations of GCM that are not reinsured pursuant to the General Agents Reinsurance Agreement or certain insurance fronting programs between GCM and Metropolitan Property & Casualty Insurance Company and Omni Insurance Company, respectively; and 3 (vi) any and all insurance claims, liabilities and obligations of General Agents under the General Agents Reinsurance Agreement. GCM did not have any employees or employee benefit plans. The Company made a $500,000 prepayment of outstanding bank debt from the closing proceeds of the transaction. Sale of Office Building; New Office Leases. The Company sold the office building at 500 Commerce Street in Fort Worth, Texas, where the Company's principal executive offices and commercial insurance operations were located, to an unaffiliated third party for $5 million on August 30, 2002. The Company recorded a gain of $455,056 from this transaction. As a result, the Company leased new office space to house its principal executive offices and commercial insurance operations. In August 2002, the Company entered into an office lease for approximately 8,352 square feet of space in Fountain Place, 1445 Ross Avenue, Suite 5300, Dallas, Texas, to house the Company's executive offices. This address is the Company's new registered address. The lease is for a term of four years, although the Company has the right to terminate the lease at its option at the end of 2005 upon payment of a termination fee of approximately $29,000. The annual rental expense is approximately $175,500. The lessor is Crescent Real Estate Funding X, L.P., an affiliate of Crescent Real Estate Equities Company, a Texas real estate investment trust f/k/a Crescent Real Estate Equities, Inc. ("Crescent"). Robert W. Stallings, GAINSCO's Chairman of the Board, became a member of the Board of Trust Managers of Crescent in May 2002, and John C. Goff, a member of GAINSCO's board of directors (the "Board"), is the Chief Executive Officer and Vice Chairman of the Board of Trust Managers of Crescent. Mr. Goff is deemed to be the beneficial owner of 3,630,248 common shares of Crescent, comprising 3.4% of the beneficial ownership of such shares. Mr. Stallings is deemed to be the beneficial owner of 22,000 common shares of Crescent, comprising less than 1% of the beneficial ownership of such shares. The management of the Company believes that the terms of the Company's lease with Crescent are no less favorable to GAINSCO than those offered to other tenants by Crescent or than GAINSCO could obtain for comparable space from unaffiliated parties. In July 2002 the Company also entered an office lease with an unaffiliated third party for 10,577 square feet of space at 5400 Airport Freeway, Suite A, Fort Worth, Texas, to house the Company's commercial insurance operations. The lease is for a term of five years, although the Company may terminate the lease at its option after the expiration of three years. The annual base rental expense is $105,770. Separation Agreement. In December 2002, McRae B. Johnston, the President - Personal Lines Division of the Company, resigned his employment with the Company and each of its subsidiaries other than MGAI, where Mr. Johnston remained employed until March 1, 2003. The Company and Mr. Johnston entered into separation agreements and releases (the "Release Agreements") pursuant to which the Company and Mr. Johnston each mutually released the other from obligations under the stock purchase agreement and employment contract between the Company and Mr. Johnston and generally from any and all other claims that each otherwise may have had against the other. The Company paid Mr. Johnston an aggregate of $400,000 pursuant to the Release Agreements. Mr. Johnston also entered into a one-year Consulting Agreement with MGAI effective after the conclusion of his employment with MGAI on March 1, 2003 pursuant to which MGAI will pay Mr. Johnston an aggregate of $200,000 to be made in four equal payments of $50,000 each in March, June, September and December of 2003. Tri-State Acquisition and Sale. On January 7, 2000, the Company expanded its personal lines business conducted through the Lalande Group through the acquisition of Tri-State, Ltd. ("Tri-State"), an insurance operation specializing in underwriting, servicing and claims handling of nonstandard personal auto insurance in Minnesota, North Dakota and South Dakota. Tri-State owned and operated a managing general agency, a motor vehicle driving records service 4 company and an insurance subsidiary, MCIC that had policyholders' surplus of approximately $3,034,000. The purchase price consideration consisted of $6,000,000 in cash at closing plus additional cash payments of $1,200,000 and $1,600,000 paid in July 2000 and January 2001, respectively. On August 31, 2001, the Company sold all of the stock of Tri-State to Herbert A. Hill for a cash price of $935,000. Mr. Hill is the President and a former owner of Tri-State. The Company retained MCIC, which had policyholders' surplus of approximately $2,965,000 at December 31, 2002 and $3,078,000 at December 31, 2001. MCIC is to be liquidated on March 31, 2003 and all of its assets, liabilities and equity are to be transferred to General Agents. Transactions with Goff Moore Strategic Partners, L.P. 1999 GMSP Transaction. On October 4, 1999, the Company sold to GMSP, for an aggregate purchase price of $31,620,000, (i) 31,620 shares of Series A Preferred Stock, which are convertible into 6,200,000 shares of Common Stock at a conversion price of $5.10 per share (subject to adjustment for certain events), (ii) the Series A Warrant to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise price of $6.375 per share and expiring October 4, 2004 and (iii) the Series B Warrant to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise of $8.50 per share and expiring October 4, 2006. At closing the Company and its insurance company subsidiaries entered into Investment Management Agreements with GMSP, pursuant to which GMSP manages their respective investment portfolios. Completion of these transactions (the "1999 GMSP Transaction") concluded the strategic alternatives review process that the Company initiated in 1998. Proceeds from the 1999 GMSP Transaction were available for acquisitions, investments and other corporate purposes. 2001 GMSP Transaction. On March 23, 2001, the Company consummated a transaction with GMSP (the "2001 GMSP Transaction") pursuant to which, among other things, the Company issued shares of its newly created Series C Preferred Stock to GMSP in exchange for an aggregate purchase price of $3 million in cash. The annual dividend rate on the Series C Preferred Stock is 10% until March 23, 2004 and 20% thereafter. Unpaid dividends are cumulative and compounded. The Series C Preferred Stock is redeemable at the Company's option after March 23, 2006 and at the option of the majority holders after March 23, 2007 at a price of $1,000 per share plus accrued and unpaid dividends. The Series C Preferred Stock is not convertible into Common Stock. The agreement with GMSP in connection with the 2001 GMSP Transaction was conditioned upon the following changes in the securities currently held by GMSP. The exercise prices of the Series A Warrant and the Series B Warrant held by GMSP were amended to $2.25 per share and $2.5875 per share, respectively. Each of these warrants provides for the purchase of 1,550,000 million shares of Common Stock, subject to adjustment. Further, the Company is required to redeem the outstanding shares of its Series A Preferred Stock on January 1, 2006, subject to certain conditions, at a price of $1,000 per share plus accrued and unpaid dividends. Any Series A Preferred Stock unredeemed for any reason after that date would accrue interest, payable quarterly at a rate equal to eight percent per year with any unpaid interest compounded annually. The Series A Preferred Stock is convertible into 6,200,000 shares of Common Stock at a conversion price of $5.10 per share and, should the Company pay dividends on its Common Stock, the Series A Preferred Stock would be entitled to dividends as if converted into Common Stock. The agreement with GMSP provided an opportunity to convert the Company's illiquid investments with a cost of $4.2 million to cash as of November 30, 2002, as follows: the Company could at its option require GMSP to purchase the illiquid investments for $2.1 million, less any future cash received prior to November 30, 2002 from the investments. GMSP could at its option require the Company to sell the illiquid investments to GMSP for $4.2 million, less any future cash received prior to November 30, 2002 from the investments. During the second quarter of 2001, the Company recognized a permanent impairment of these investments and wrote down the carrying value to the amount recoverable from GMSP under the put option. In February 2002, GMSP consented to the early exercise of the Company's option, and the Company exercised its option to require GMSP to purchase the illiquid investments for approximately $2.1 million. Amendment to Investment Management Agreements. In August 2002, the Company entered into an amendment to its Investment Management Agreements with Goff Moore Strategic Partners, L.P. ("GMSP"). See "Transactions with Goff Moore Strategic Partners, L.P. -- 1999 GMSP Transaction". The amendment reduces, effective as of October 1, 2002, the minimum aggregate monthly payment owed by the Company to GMSP from $75,000 to $63,195 (with respect to each calendar month from October 2002 through September 2003), $53,750 (with respect to each calendar month from October 2003 through September 2004), and $45,417 (with respect to each calendar month after September 2004). The amendment also changes the date upon which either party to each of the investment management agreements can terminate such agreements at its sole option from October 4, 2002 to September 30, 2005. Transactions with Robert W. Stallings. On March 23, 2001, the Company consummated a transaction with Mr. Stallings (the "Stallings Transaction") pursuant to which, among other things, the Company issued shares of its newly created Series B Preferred Stock and a warrant to purchase an aggregate of 1,050,000 shares of Common Stock at 5 $2.25 per share and expiring March 23, 2006 in exchange for an aggregate purchase price of $3.0 million in cash. The annual dividend provisions and the redemption provisions of the Series B Preferred Stock are the same as those for the Series C Preferred Stock. The Series B Preferred Stock is convertible into Common Stock at $2.25 per share. Subject to adjustment for certain events, the Series B Preferred Stock is convertible into a maximum of 1,333,333 shares of Common Stock. Mr. Stallings also entered into a Consulting Agreement pursuant to which he provides consulting services (including strategic planning advice, analysis of the subsidiaries' performance in various sectors of their respective business and recommendations for growth strategies and opportunities for new markets and products) to the Company's insurance subsidiaries for a period of five (5) years ending on March 22, 2006 for $300,000 per annum. Mr. Stallings was elected non-executive Vice Chairman of the Board and a director of the Company on March 30, 2001 and on September 6, 2001, he was elected non-executive Chairman of the Board. PRODUCT LINES The Company's principal products previously served certain nonstandard markets within the commercial lines and personal lines. On February 7, 2002, the Company announced its decision to discontinue writing commercial lines insurance business due to continued adverse claims development and unprofitable results. The Company continues to serve the nonstandard personal auto market. The following table sets forth, for each product line, gross premiums written (before ceding any amounts to reinsurers), percentage of gross premiums written for the periods indicated and the number of policies in force at the end of each period.
As of and for the years ended December 31 ------------------------------------------------------------------------------------ 2002 2001 2000 ------------------------ ------------------------ ------------------------ (Dollar amounts in thousands) Gross Premiums Written: Commercial Lines $ 11,992 27% $ 68,499 58% $ 113,354 67% Personal Lines 32,231 73 48,684 42 54,932 33 ---------- -------- ---------- -------- ---------- -------- $ 44,223 100% $ 117,183 100% $ 168,286 100% ========== ======== ========== ======== ========== ======== Policies in Force (End of Period) 26,074 64,797 87,048
Commercial Lines The Company announced on February 7, 2002 its decision to discontinue writing commercial lines insurance business due to continued adverse claims development and unprofitable results. The commercial lines of insurance previously written by the Company include: Commercial Auto The commercial auto coverage underwritten by the Company included risks associated with local haulers of specialized freight, tradespersons' vehicles and trucking companies. Garage The Company's garage product line included garage liability, garage keepers' legal liability and dealers' open lot coverages. The Company targeted its coverage to used car dealers, recreational vehicle dealers, automobile repair shops and wrecker/towing risks. General Liability The Company underwrote general liability insurance for businesses such as car washes, janitorial services, small contractors, apartment buildings, rental dwellings and retail stores. Property The Company underwrote commercial property coverages that included fire, extended coverage and vandalism on commercial establishments packaged with its liability product or on a monoline basis. Specialty Lines The Company underwrote and managed programs in professional liability for lawyers, real estate agents, educators and other general professions, as well as directors and officers liability. Personal Lines The personal lines of insurance currently written by the Company is in the nonstandard personal auto market in Florida only and is primarily written with minimum liability limits. The personal lines of insurance previously written by the Company also included: Umbrella The Company wrote personal umbrella risks which did not have access to the preferred markets. 6 Property The Company wrote nonstandard dwelling fire risks. REINSURANCE The Company may purchase reinsurance in order to reduce its liability on individual risks and to protect against catastrophe claims. A reinsurance transaction takes place when an insurance company transfers, or "cedes," to another insurer a portion or all of its exposure. The reinsurer assumes the exposure in return for a portion or the entire premium. The ceding of insurance does not legally discharge the insurer from its primary liability for the full amount of the policies, and the ceding company is required to pay the claim if the reinsurer fails to meet its obligations under the reinsurance agreement. Commercial Lines Prior to 1999 and again beginning in 2001, the Company wrote commercial casualty policy limits up to $1,000,000. For policies with an effective date occurring from 1995 through 1998 and policies with an effective date occurring during 2001 or 2002, the Company has first excess casualty reinsurance for 100% of casualty claims exceeding $500,000 up to the $1,000,000 limits, resulting in a maximum net claim retention per risk of $500,000 for such policies. During 1999 and 2000, the Company wrote commercial casualty policy limits up to $5,000,000. For policies with an effective date occurring in 1999 or 2000, the Company has first excess casualty reinsurance for 100% of casualty claims exceeding $500,000 up to $1,000,000 and second excess casualty reinsurance for 100% of casualty claims exceeding $1,000,000 up to the $5,000,000 limits, resulting in a maximum net claim retention per risk of $500,000. The Company has facultative reinsurance for policy limits written in excess of the limits reinsured under the excess casualty agreements. Effective December 31, 2000, the Company entered into a quota share reinsurance agreement whereby the Company ceded 100% of its commercial auto liability unearned premiums and 50% of all other commercial business unearned premiums at December 31, 2000 to a non-affiliated reinsurer. For policies with an effective date of January 1, 2001 through December 31, 2001, the Company entered into a quota share reinsurance agreement whereby the Company ceded 20% of its commercial business to a non-affiliated reinsurer. Also effective December 31, 2000, the Company entered into a reserve reinsurance cover agreement with a non-affiliated reinsurer. This agreement reinsures the Company's ultimate net aggregate liability in excess of $32,500,000 up to an aggregate limit of $89,650,000 for net commercial auto liability losses and loss adjustment expense incurred but unpaid as of December 31, 2000. The Company established a reinsurance balance receivable and a liability for funds held under reinsurance agreements for the reserves transferred at December 31, 2000. Also in connection with this agreement, the Company was required to maintain assets in a trust fund with a fair value at least equal to the funds held liability. The trust fund was established during the third quarter of 2001 and at December 31, 2001 the assets in the trust had a fair value of $49,553,698. Because the Company's statutory policyholders' surplus fell below certain levels specified in the agreement, the reinsurer had the option to direct the trustee to transfer the assets of the trust to the reinsurer. On March 29, 2002, the reinsurer exercised this option and the trust assets were transferred to the reinsurer. As a result, investments and funds held under reinsurance agreements were reduced by approximately $44,000,000. The Company recorded a realized gain of approximately $486,000 as a result of the transfer. The reinsurer continues to be responsible for reimbursing the Company for claim payments covered under this agreement. Prior to 2001, the Company has property excess per risk reinsurance that covers property claims exceeding $100,000 up to $5,000,000 net loss each risk. The Company has facultative reinsurance for limits written on individual risks in excess of $5,000,000. Beginning in 2001, the Company has property excess per risk reinsurance that covers property claims exceeding $150,000 up to $1,500,000 net loss each risk. The Company has facultative reinsurance for limits written on individual risks in excess of $1,500,000. For 1998 through 2001, the Company also has excess casualty clash reinsurance for $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of the accident. For 2002, the 7 Company has excess casualty clash reinsurance for 35% of $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of the accident. The Company is operating under excess casualty reinsurance agreements with two reinsurance companies for its commercial lines business, each of which reinsures a given percentage of ceded risks. The Company's excess reinsurance is provided in varying amounts by these reinsurers who are rated "A+ (Superior)" or better by Best's. See "Rating." The following table identifies each such reinsurer and sets forth the percentage of the coverage assumed by each of them:
2002 2001 ---------- ---------- 1st Excess 1st Excess ---------- ---------- GE Reinsurance Corporation 65% 65% GMAC Re/Motors Insurance Corporation 35 15 Liberty Mutual Insurance Company -- 20 ---------- ---------- 100% 100% ========== ==========
For its lawyers professional liability coverages with policy effective dates occurring during 2001 or prior, the Company has quota share reinsurance for 50% of the first $1,000,000 of professional liability claims and excess casualty reinsurance for 100% of professional liability claims exceeding $1,000,000 up to $5,000,000 policy limits resulting in a maximum net claim retention per risk of $500,000. For its real estate agents professional liability coverages with policy effective dates prior to August 1, 2001, the Company has quota share reinsurance for 25% of the first $1,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $750,000. For policies with an effective date occurring on August 1, 2001 through April 15, 2002, the Company has quota share reinsurance for 50% of the first $1,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $500,000. For its educators professional liability coverages with policy effective dates occurring during 2001 or prior, the Company has quota share reinsurance for 60% of the first $1,000,000 of professional liability claims and excess casualty reinsurance for 100% of professional liability claims exceeding $1,000,000 up to $5,000,000 policy limits resulting in a maximum net claim retention per risk of $400,000. For its directors and officers liability coverages with policy effective dates occurring prior to 2001, the Company has quota share reinsurance for 90% of the first $5,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $500,000. For policies with an effective date occurring during 2001, the Company has quota share reinsurance for 85% of the first $5,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $750,000. For its miscellaneous professional liability coverages with policy effective dates occurring during 2001 or prior, the Company has quota share reinsurance for 50% of the first $1,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $500,000. Personal Lines The Company's personal auto business is produced by National Specialty Lines, Inc. ("NSL") and, prior to August 1, 2001, Tri-State or written on a direct basis through MCIC. For business produced by NSL with an effective date of April 1, 2000 through December 31, 2000, the Company has excess of loss reinsurance for 100% of claims in excess of $25,000 up to the $100,000 policy limits and quota share reinsurance for 20% of the first $25,000 of claims resulting in a maximum net claim retention per risk of $20,000. For business produced by NSL with an effective date of January 1, 2001 through December 31, 2001, the Company has excess of loss reinsurance for 100% of claims in excess of $25,000 up to the $100,000 policy limits and quota share reinsurance for 50% of the first $25,000 of claims resulting in a maximum net claim retention per risk of $12,500. Effective December 31, 2001, the Company's 8 personal lines excess of loss and quota share reinsurance treaties expired and were not replaced as satisfactory treaties could not be arranged. Under the terms of these treaties, the reinsurer remains liable for claims with regard to policies in force at the date of expiration. Beginning in 2002 the Company no longer writes nonstandard personal auto limits in excess of $25,000. For business produced by Tri-State or written on a direct basis with MCIC with an effective date prior to August 1, 2001, the Company has excess of loss reinsurance for 100% of claims in excess of $25,000 up to the $100,000 policy limits and quota share reinsurance for 50% of the first $25,000 of claims resulting in a maximum net claim retention per risk of $12,500. For its umbrella coverages for 1999 through 2001, the Company has excess casualty reinsurance for 100% of umbrella claims exceeding $1,000,000 up to $10,000,000 policy limits. For policies with an effective date occurring prior to February 1, 2001, the Company also has quota share reinsurance for 75% of the first $1,000,000 of umbrella claims resulting in a maximum net claim retention per risk of $250,000. For policies with an effective date occurring on February 1, 2001 through December 31, 2001, the Company has quota share reinsurance for 77.5% of the first $1,000,000 of umbrella claims resulting in a maximum net claim retention per risk of $225,000. For its personal auto coverages for 1998 through 2001, the Company has excess casualty clash reinsurance for $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of the accident. In 2002, the Company has excess casualty clash reinsurance for 35% of $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of the accident. Commercial and Personal Lines Certain reinsurance carried by the Company includes "extra-contractual obligations" coverage. This coverage protects the Company against claims arising out of certain legal liability theories not directly based on the terms and conditions of the Company's policies of insurance. Extra-contractual obligation claims are covered 90% under the quota share, excess casualty and excess casualty clash reinsurance treaties up to their respective limits. Prior to 2001, the Company carried catastrophe property reinsurance to protect it against catastrophe occurrences for 95% of the property claims that exceed $500,000 but do not exceed $17,500,000 for a single catastrophe. In 2001, the Company carried catastrophe property reinsurance to protect it against catastrophe occurrences for 95% of the property claims that exceed $1,500,000 but do not exceed $13,000,000 for a single catastrophe as well as second event catastrophe property reinsurance for 100% of $1,000,000 excess of $500,000 on a second catastrophic event. In 2002, the Company carried catastrophe property reinsurance to protect it against catastrophe occurrences for property claims that exceed $500,000 but do not exceed $7,000,000. The Company does not have catastrophe reinsurance for business written in 2003 because of the exit from commercial lines and because the cost for coverage for the remaining personal lines was determined to be excessive in relation to the evaluation of risks to be retained. The Company has signed contracts in force for its reinsurance agreements for all years through 2002. MARKETING AND DISTRIBUTION Certain coverages, such as auto liability, may only be written in some states by companies with the authority to write insurance on an admitted basis in such states. The Company currently is approved to write insurance on a non-admitted basis in 47 states and the District of Columbia and on an admitted basis in 44 states and the District of Columbia. Commercial Lines The Company previously marketed its commercial lines insurance products through approximately 200 non- 9 affiliated general agency offices that were compensated on a commission basis that varied by line of business. These general agents each represented several insurance companies, some of which may have been competitors of the Company. The general agents solicited business from independent local agents or brokers, commonly referred to as retail agents, who are in direct contact with insurance buyers. The Company elected to utilize general agents to market its insurance products in order to avoid the fixed costs of a branch office system. The Company required that its general agents have a specified level of errors and omissions insurance coverage, which indirectly protected the Company against certain negligence on the part of general agents. The Company reviewed its appointed agencies for financial solvency and liquidity levels. The Company had developed underwriting manuals to be used by its general agents. The general agents were authorized to bind the Company to provide insurance if the risks and terms involved in the particular coverage are within the underwriting guidelines set forth in the Company's underwriting manuals. The manuals stipulated minimum rates to be charged for the various classes of coverage offered. Personal Lines The Company markets its nonstandard personal auto insurance through over 550 non-affiliated retail agencies that are compensated on a commission basis. The retail agents may represent several insurance companies, some of which may compete with the Company. The Company utilizes the retail agency market because they are in direct contact with the insurance buyers. The Company requires that its retail agents have a specified level of errors and omissions insurance coverage. The Company has developed underwriting manuals to be used by its retail agents. The retail agents are authorized to bind the Company to provide insurance if the risks and terms involved in the particular coverage are within the underwriting guidelines set forth in the Company's underwriting manuals. UNPAID CLAIMS AND CLAIM ADJUSTMENT EXPENSES The Company maintains reserves for the payment of claims and claim adjustment expenses for both reported and unreported claims. Claims reserves are estimates, at a given point in time, of amounts that the Company expects to pay on incurred claims based on facts and circumstances then known. The amount of claim reserves for reported claims is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding the claim, and the policy provisions relating to the type of claim. The amount of claims reserves for unreported claims and case reserve development is determined on the basis of historical information and anticipated future conditions by lines of insurance and actuarial review. Reserves for claim adjustment expenses are intended to cover the ultimate costs of settling claims, including investigation and defense of lawsuits resulting from such claims. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results. The process of establishing claims reserves is an imprecise science and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. Some judicial decisions and legislative actions, even after coverage is written and reserves are initially set, broaden liability and policy definitions and increase the severity of claim payments. As a result of this and other societal and economic developments, the uncertainties inherent in estimating ultimate claim costs on the basis of past experience have increased significantly, further complicating the already difficult claim reserving process. Ultimate liability may be greater or lower than current reserves. Reserves are monitored by the Company using new information on reported claims and a variety of statistical techniques. The reserves are reviewed annually by an outside actuarial firm. The Company does not discount to present value that portion of its claim reserves expected to be paid in future periods. Beginning in the third quarter of 2002 and for each quarter thereafter, the Company set reserves equal to the selected reserve estimate as established by an outside actuarial firm. Formerly management set reserves based upon its actuarial analysis. 10 The following table sets forth the changes in unpaid claims and claim adjustment expenses, net of reinsurance cessions, as shown in the Company's consolidated financial statements for the periods indicated:
As of and for the years ended December 31 ----------------------------------------- 2002 2001 2000 ---------- ---------- ---------- (Amounts in thousands) Unpaid claims and claim adjustment expenses, beginning of period $ 181,059 164,160 132,814 Less: Ceded unpaid claims and claim adjustment expenses, beginning of period 65,571 37,703 37,299 ---------- ---------- ---------- Net unpaid claims and claim adjustment expenses, beginning of period 115,488 126,457 95,515 ---------- ---------- ---------- Net claims and claim adjustment expense incurred related to: Current period 50,518 56,920 124,077 Prior periods 5,896 30,506 19,362 ---------- ---------- ---------- Total net claim and claim adjustment expenses incurred 56,414 87,426 143,439 ---------- ---------- ---------- Net claims and claim adjustment expenses paid related to: Current period 23,203 26,776 58,898 Prior periods 52,230 71,619 54,683 ---------- ---------- ---------- Total net claim and claim adjustment expenses paid 75,433 98,395 113,581 ---------- ---------- ---------- Net reserves acquired through purchase of subsidiary -- -- 1,084 ---------- ---------- ---------- Net unpaid claims and claim adjustment expenses, end of period 96,469 115,488 126,457 Plus: Ceded unpaid claims and claim adjustment expenses, end of period 46,802 65,571 37,703 ---------- ---------- ---------- Unpaid claims and claim adjustment expenses, end of period $ 143,271 181,059 164,160 ========== ========== ==========
The decrease in the unpaid claims and claim adjustment expenses during 2002 is primarily attributable to the exiting of commercial lines and the orderly run-off of the remaining commercial lines claims. For 2002 the development in claims and claim adjustment expenses incurred was primarily the result of unanticipated development of commercial auto claims for the 2001 and 2000 accident years and commercial general liability claims for the 2001, 2000, 1999, 1997 and 1993 accident years. For 2001 the development in claims and claim adjustment expenses incurred was primarily the result of unanticipated development of commercial auto and commercial general liability claims for the 2000, 1999 and 1998 accident years. At December 31, 2002 the Company believes that the unpaid claims and claim adjustment expenses and the reinsurance agreements currently in force are sufficient to support the future emergence of prior year claim and claim adjustment expenses. 11 The following table sets forth, as of December 31, 2002, 2001 and 2000, differences between the amount of net unpaid claims and claim adjustment expenses reported in the Company's statements, prepared in accordance with statutory accounting principles ("SAP"), and filed with the various state insurance departments, and those reported in the consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"):
As of December 31 ---------------------------------------- 2002 2001 2000 ---------- ---------- ---------- (Amounts in thousands) Net unpaid claims and claim adjustment expenses reported on a SAP basis $ 96,469 112,488 126,457 Adjustments: Reserves recorded subsequent to issuance of SAP financial statements -- 3,000 -- Estimated recovery for salvage and subrogation -- -- -- ---------- ---------- ---------- Net unpaid claims and claim adjustment expenses reported on a U.S. GAAP basis and on an adjusted SAP basis $ 96,469 115,488 95,515 ========== ========== ==========
In January 2000 the Company elected to take estimated salvage and subrogation into account when determining ultimate incurred losses and unpaid losses for financial statements prepared in accordance with SAP. The effect on prior periods was reflected in the Company's statutory financial statements as an adjustment to policyholders' surplus. The following table represents the development of U.S. GAAP balance sheet reserves for the years ended December 31, 1992 through 2002. The top line of the table shows the reserves for unpaid claims and claim adjustment expenses for the current and all prior years as recorded at the balance sheet date for each of the indicated years. The reserves represent the estimated amount of claims and claim adjustment expenses for claims arising in the current and all prior years that are unpaid at the balance sheet date, including claims that have been incurred but not yet reported to the Company. The second portion of the following table shows the net cumulative amount paid with respect to the previously recorded liability as of the end of each succeeding year. The third portion of the table shows the reestimated amount of the previously recorded net unpaid claims and claim adjustment expenses based on experience as of the end of each succeeding year, including net cumulative payments made since the end of the respective year. For example, the 1994 liability for net claims and claim adjustment expenses reestimated eight years later (as of December 31, 2002) was $69,425,000 of which $69,180,000 has been paid, leaving a net reserve of $245,000 for claims and claim adjustment expenses in 1994 and prior years remaining unpaid as of December 31, 2002. 12 "Net cumulative deficiency" represents the change in the estimate from the original balance sheet date to the date of the current estimate. For example, the 1994 net unpaid claims and claim adjustment expenses indicates a $8,669,000 net deficiency from December 31, 1994 to December 31, 2002 (eight years later). Conditions and trends that have affected development of liability in the past may or may not necessarily occur in the future. Accordingly, it may or may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
As of and for the years ended December 31 -------------------------------------------------------------------------------------- 1992 1993 1994 1995 1996 1997 1998 -------- -------- -------- -------- -------- -------- -------- (Amounts in thousands) Unpaid claims & claim adjustment expenses: Gross 66,517 72,656 80,729 95,011 105,691 113,227 136,798 Ceded 16,594 16,701 19,972 24,650 26,713 29,524 35,030 -------- -------- -------- -------- -------- -------- -------- Net 49,923 55,955 60,757 70,361 78,978 83,703 101,768 Net cumulative paid as of: One year later 22,470 24,090 24,730 32,584 39,554 48,595 49,951 Two years later 37,032 39,182 41,874 56,605 70,185 82,950 80,158 Three years later 45,884 46,688 55,338 73,349 90,417 103,025 99,446 Four years later 51,082 54,428 62,389 82,667 101,273 114,196 107,654 Five years later 54,092 57,628 66,573 87,432 107,584 118,515 Six years later 55,828 58,191 68,438 90,114 110,301 Seven years later 56,754 59,733 68,673 91,740 Eight years later 56,941 59,744 69,180 Nine years later 56,920 59,897 Ten years later 57,052 Net unpaid claims and claim adjustment expenses reestimated as of: One year later 54,150 59,573 61,157 75,703 87,095 110,421 102,141 Two years later 57,223 59,922 62,296 80,356 104,588 111,981 111,861 Three years later 57,459 59,247 63,871 88,867 105,386 121,024 119,524 Four years later 56,832 58,414 67,442 89,030 111,314 125,418 120,795 Five years later 56,337 59,735 67,607 91,641 114,483 126,161 Six years later 56,721 59,695 68,660 94,177 114,796 Seven years later 56,938 60,008 69,030 94,620 Eight years later 57,354 60,265 69,425 Nine years later 57,445 60,347 Ten years later 57,376 Net cumulative Deficiency (7,453) (4,392) (8,669) (21,280) (35,817) (42,458) (19,027) As of and for the years ended December 31 ----------------------------------------------- 1999 2000 2001 2002 -------- -------- -------- -------- (Amounts in thousands) Unpaid claims & claim adjustment expenses: Gross 132,814 164,160 181,059 143,271 Ceded 37,299 37,703 65,571 46,802 -------- -------- -------- -------- Net 95,515 126,457 115,488 96,469 Net cumulative paid as of: One year later 54,683 71,619 52,230 Two years later 90,403 109,820 Three years later 108,757 Four years later Five years later Six years later Seven years later Eight years later Nine years later Ten years later Net unpaid claims and claim adjustment expenses reestimated as of: One year later 114,876 156,963 121,383 Two years later 130,952 161,922 Three years later 133,738 Four years later Five years later Six years later Seven years later Eight years later Nine years later Ten years later Net cumulative Deficiency (38,224) (35,466) (5,896)
For the year ended December 31, 2002 the net cumulative deficiency reported was $5.896 million. Excluding the effect of quota share reinsurance, the gross cumulative deficiency amount equated to $8.187 million. Of this deficiency amount, $7.720 million was attributable to commercial lines and $467,000 was attributable to personal auto lines. The deficiencies principally resulted from increased projections of ultimate claims severity due to unanticipated factual developments and discoveries, settlement negotiations and jury verdicts during 2002. Changes in claims frequency estimated did not materially impact the net cumulative deficiency in 2002. Of the deficiency reported for commercial lines, $4.741 million was attributable to commercial auto, of which $3.563 million was attributable to adverse claim development in 2002 for claims incurred in accident year 2000. This adverse claim development was primarily due to a 7.1% deterioration in the projected average claim severity for that particular year (the average claims severity increased from $14,989 per claim to $16,059 per claim), and an additional $907,000 deficiency was attributable to adverse claim development in 2002 for claims incurred in accident year 2001, also resulting from an increase in projected average claim severity of 4.7% for that year (the average claims severity was increased from $17,609 per claim to $18,431 per claim). 13 Also in the commercial lines, there was a $3.656 million deficiency in general liability. This was made up of a $6.209 million deficiency in non-professional liability offset by favorable development of $2.553 million in professional liability. The $6.209 million deficiency in non-professional general liability was primarily attributable to adverse claim development in 2002 for the following accident years: $2.574 million for accident year 2001; $1.170 million for accident year 2000; $1.023 million for accident year 1999; $491,000 for accident year 1993; and $269,000 for accident year 1997. During the year 2002, the Company experienced increases in projected average claim severity for non-professional general liability for these respective accident years as follows: 18.5% for 2001 (average claim increased from $20,966 per claim to $24,852); 6.6% for 2000 (average claim increased from $21,000 per claim to $22,485); 13.8% for 1999 (average claim increased from $18,969 per claim to $21,595); 8.6% for 1993 (average claim increased from $6,381 per claim to $6,928); and 5.3% for 1997 (average claim increased from $12,518 per claim to $13,175). The remaining $677,000 of favorable development is related to all other commercial lines. In February 2002, the Company announced its plan to exit its commercial insurance business as a result of this continuing adverse claim experience. The $467,000 deficiency in personal auto was primarily attributable to adverse claim development in 2002 for the following accident years: $145,000 for accident year 1999; $601,000 for accident year 2000; offset by a $279,000 redundancy for accident year 2001. The deficiency in the 1999 and 2000 accident years was primarily related to increases in projected average claim severity for the bodily injury, property damage and personal injury protection coverage lines. The Company completes a full analysis of unpaid claims and claim adjustment expenses on a quarterly basis for each of its coverage lines. Based upon this analysis and the new information that became available during the quarter, reserves are reset each quarter. The deficiencies noted above were recognized throughout the year 2002 consistent with this quarterly analysis. Net unpaid claims and claim adjustment expenses at December 31, 2002 were approximately $96,469,000, which the Company believes is adequate; they are set equal to the selected reserve estimate determined by an outside actuarial firm. See item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. INSURANCE RATIOS CLAIMS, EXPENSE AND COMBINED RATIOS: Claims and expense ratios are traditionally used to interpret the underwriting experience of property and casualty insurance companies. Statutory Accounting Principles (SAP) Basis - Claims and claim adjustment expenses are stated as a percentage of premiums earned because claims may occur over the life of a particular insurance policy. Underwriting expenses on a SAP basis are stated as a percentage of net premiums written rather than premiums earned because most underwriting expenses are incurred when policies are written and are not spread over the policy period. Underwriting profit margin is achieved when the combined ratio is less than 100%. The Company's claims, expense and combined ratios and the property and casualty industry's claims, expense and combined ratios, both on a SAP basis, are shown in the following table:
Years ended December 31 ---------------------------------------------------------------- 2002 2001 2000 1999 1998 -------- -------- -------- -------- -------- COMPANY RATIOS (1) Claims Ratio 99.1% 124.6% 95.6% 67.9% 95.9% Expense Ratio 43.7 38.4 28.6 30.7 37.9 -------- -------- -------- -------- -------- Combined Ratio 142.8% 163.0% 124.2% 98.6% 133.8% ======== ======== ======== ======== ======== INDUSTRY RATIOS (2) Claims Ratio 79.5% 88.4% 81.5% 78.6% 76.2% Expense Ratio 25.4 27.6 27.5 28.0 27.3 -------- -------- -------- -------- -------- Combined Ratio 104.9% 116.0% 109.0% 106.6% 103.5% ======== ======== ======== ======== ========
(1) The Company ratios for 2001 have been adjusted to reflect the $3,000,000 in reserves recorded subsequent to the issuance of the SAP financial statements. (2) The property and casualty industry as a whole, not companies with comparable lines of coverage, was used in the calculation of these ratios. The Insurance Services Office is the source for 2002 (estimated) and 2001. Best's is the source for 2000, 1999 and 1998. The unfavorable variance to the industry for 2002 with regard to the claims ratio is primarily the result of unanticipated development of commercial auto claims for the 2000 accident year and commercial general liability claims for the 2001, 2000 and 1999 accident years. The unfavorable variance to the industry in 2002 for the expense ratio is primarily related to the exiting of commercial lines and the expense reductions lagging the decline in premium writings. 14 The unfavorable variance to the industry for 2001 with regard to the claims ratio is primarily the result of unanticipated development of commercial auto and commercial general liability claims for the 2000, 1999 and 1998 accident years. For 2001 the unfavorable expense ratio in relation to the industry expense ratio is primarily the result of decreases in premiums written due to the commercial quota share reinsurance agreements and the decision to cease writing commercial trucking business. The unfavorable variance to the industry for 2000 with regard to the claims ratio is primarily the result of unanticipated development of commercial auto claims for the 1999, 1997 and 1996 accident years. The favorable variance to the industry for 1999 with regard to the claims ratio is primarily the result of writing shorter duration business than the industry as a whole. The unfavorable variance to the industry with regard to the claims ratio in 1998 is largely related to unanticipated unfavorable claim development recorded in 1998 on the 1997, 1996 and 1995 accident years for the commercial auto liability line. For 1998, the increase in the unfavorable variance to the industry with regard to the expense ratio is largely because of downward adjustments in reinsurance commission income as a result of the unanticipated unfavorable claim development in 1998. For 1999 and prior years, the unfavorable variance to the industry with regard to the expense ratios is a function of the specific lines that the Company writes. The Company ratios in the table above relate only to insurance operations. GNAC as a holding company provides administrative and financial services for its wholly owned subsidiaries. The allocation of GNAC's expenses solely to its insurance companies would have an impact on their results of operations and would also affect the ratios presented. As such, expenses related to GNAC's strategic alternatives review process conducted in 1999 and 1998 are not included in these ratios. Accounting Principles Generally Accepted in the United States of America (U.S. GAAP) Basis - Claims and claim adjustment expenses are stated as a percentage of premiums earned as they are on a SAP basis. However, earned premiums include policy fees earned net of the related commission expense whereas on a SAP basis policy fees earned are recorded gross of the related commission expense. The U.S. GAAP expense ratio is based on premiums earned and includes the change in policy acquisition costs and underwriting expenses. Other differences include the treatment of the allowance for doubtful accounts. The following table presents the Company's claims, expense and combined ratios on a U.S. GAAP basis:
Years ended December 31 ---------------------------------------------------------------- 2002 2001 2000 1999 1998 -------- -------- -------- -------- -------- Claims Ratio 93.6% 127.2% 94.7% 67.4% 93.7% Expense Ratio 32.3 45.4 31.6 32.0 39.0 -------- -------- -------- -------- -------- Combined Ratio 125.9% 172.6% 126.3% 99.4% 132.7% ======== ======== ======== ======== ========
The Company ratios in the table above relate only to insurance operations. The holding company provides administrative and financial services for its wholly owned subsidiaries. The allocation of the holding company's expenses solely to its insurance companies would have an impact on their results of operations and would also affect the ratios presented. 15 PREMIUM TO SURPLUS RATIO: The following table shows, for the periods indicated, the Company's statutory ratios of statutory net premiums written to statutory policyholders' surplus. While there is no statutory requirement which establishes a permissible net premiums written to surplus ratio, guidelines established by the National Association of Insurance Commissioners ("NAIC") provide that this ratio should not be greater than 3 to 1.
As of and for the years ended December 31 ---------------------------------------------------------------------- 2002 2001 2000 1999 1998 ---------- ---------- ---------- ---------- ---------- (Dollar amounts in thousands) Net premiums written $ 41,797 67,313 117,497 130,105 87,040 Policyholders' surplus (1) $ 41,745 49,898 77,532 69,155 71,826 Ratio 1.00 to 1 1.35 to 1 1.52 to 1 1.88 to 1 1.21 to 1
(1) Policyholders' surplus for 2001 has been adjusted to reflect the reserves recorded subsequent to the issuance of the SAP financial statements. INVESTMENT PORTFOLIO HISTORICAL RESULTS AND COMPOSITION The following table sets forth, for the periods indicated, the Company's investment results before income tax effects:
As of and for the years ending December 31 ---------------------------------------------------------------------------- 2002 2001 2000 1999 1998 ---------- ---------- ---------- ---------- ---------- (Dollar amounts in thousands) Average investments (1) $ 143,294 207,765 246,091 228,945 212,215 Investment income $ 4,315 8,091 14,093 9,722 9,803 Return on average investments (2) 3.0% 3.9% 5.7% 4.2% 4.6% Taxable equivalent return on average investments 3.9% 4.3% 6.5% 5.7% 6.2% Net realized gains (losses) $ 2,049 4,275 (1,907) 606 693 Net unrealized gains (losses) (3) $ 3,637 5,425 5,906 (3,456) 2,922
---------- (1) Average investments is the average of beginning and ending investments at amortized cost, computed on an annual basis. (2) Includes taxable and tax-exempt securities. (3) Includes net unrealized gains (losses) for total investments. 16 The following table sets forth the composition of the investment portfolio of the Company.
As of December 31 ------------------------------------------------------------------------------------- 2002 2001 2000 ------------------------- ------------------------- ------------------------- (Amounts in thousands) Amortized Fair Amortized Fair Amortized Fair Cost Value Cost Value Cost Value ---------- ---------- ---------- ---------- ---------- ---------- Type of Investment Fixed Maturities: Bonds available for sale: U.S. Government securities $ 24,217 24,947 16,730 17,167 21,138 21,317 Tax-exempt state and municipal bonds 465 480 8,912 9,139 45,284 45,472 Corporate bonds 34,338 37,231 101,727 106,488 121,564 125,553 Certificates of deposit 645 645 645 645 845 845 Common stock -- -- -- -- 6,027 7,716 Other investments -- -- 2,110 2,112 4,581 4,442 ---------- ---------- ---------- ---------- ---------- ---------- 59,665 63,303 130,124 135,551 199,439 205,345 ---------- ---------- ---------- ---------- ---------- ---------- Short-term investments 51,671 51,671 45,127 45,127 40,840 40,840 ---------- ---------- ---------- ---------- ---------- ---------- Total investments $ 111,336 114,974 175,251 180,678 240,279 246,185 ========== ========== ========== ========== ========== ==========
At December 31, 2002 the Standard & Poor's ratings on the Company's bonds available for sale were in the following categories: 45% AAA, 4% AA, 15% A, 23% BBB, 5% BB and 8% B. No securities were rated below B. The Company does not have any securities for which a fair value cannot be obtained by reference to public markets. The maturity distribution of the Company's investments in fixed maturities is as follows:
As of December 31 ----------------------------------------------------------------------------------------- 2002 2001 2000 -------------------------- -------------------------- ------------------------- (Dollar amounts in thousands) Amortized Amortized Amortized Cost Percent Cost Percent Cost Percent ---------- ---------- ---------- ---------- ---------- ---------- Within 1 year $ 20,392 34.1% $ 15,463 12.1% $ 22,203 11.8% Beyond 1 year but within 5 years 25,783 43.2 68,984 53.9 102,822 54.4 Beyond 5 years but within 10 years 9,943 16.7 42,135 32.9 59,531 31.5 Beyond 10 years but within 20 years 3,547 6.0 1,432 1.1 4,275 2.3 Beyond 20 years -- -- -- -- -- -- ---------- ---------- ---------- ---------- ---------- ---------- $ 59,665 100.0% $ 128,014 100.0% $ 188,831 100.0% ========== ========== ========== ========== ========== ========== Average duration 2.6 yrs 3.3 yrs 2.9 yrs
As of December 31, 2000, the Company did not have any non-performing fixed maturity securities. In 2001 the Company recognized an other than temporary impairment on a non-rated security by recording a charge to earnings of $489,554, net of deferred income taxes of $252,195 (see Note (1c) of Notes to Consolidated Financial Statements). In March 2002, the Company reduced the carrying value of this non-rated security to $0 resulting in a write down of approximately $2,010,000 as a result of a significant increase in the default rate in January and February of 2002 in the underlying collateral, which has disrupted the cash flow stream sufficiently to virtually eliminate future cash flows (see Note 1(c) of Notes to Consolidated Financial Statements). 17 INVESTMENT STRATEGY Commencing with the closing of the 1999 GMSP Transaction on October 4, 1999, the investment portfolios of GNAC and its insurance company subsidiaries are managed by GMSP pursuant to its Investment Management Agreements with the respective companies. The investment policies are subject to the oversight and direction of the Investment Committees of the Boards of Directors of the respective companies. The respective Investment Committees consist entirely of directors not affiliated with GMSP. The investment policies of the insurance subsidiaries, which are also subject to the respective insurance company legal investment laws of the states in which they are organized, are to maximize after-tax yield while maintaining safety of capital together with adequate liquidity for insurance operations. See "Item 7A. Quantitative and Qualitative Disclosures About Market Risk." The insurance company portfolios may also be invested in equity securities within limits prescribed by applicable legal investment laws. RATING Best's has assigned the Company a pooled rating of "B-" (Fair), with a stable outlook. Best's ratings are based on an analysis of the financial condition and operation of an insurance company as they relate to the industry in general. GOVERNMENT REGULATION The Company's insurance companies are subject to varied governmental regulation in the states in which they conduct business. Such regulation is vested in state agencies having broad administrative power dealing with all aspects of the Company's business and is concerned primarily with the protection of policyholders rather than shareholders. The Company's statutory capital exceeds the benchmark capital level under the Risk Based Capital formula for its insurance companies that are subject to Risk Based Capital requirements. The Company is also subject to statutes governing insurance holding company systems in the states of Oklahoma and Texas. These statutes require the Company to file periodic information with the state regulatory authorities, including information concerning its capital structure, ownership, financial condition and general business operation. These statutes also limit certain transactions between the Company and its insurance companies, including the amount of dividends that may be declared and paid by the insurance companies (see Note (7) of Notes to Consolidated Financial Statements). Additionally, the Oklahoma and Texas statutes restrict the ability of any one person to acquire 10% or more of the Company's voting securities without prior regulatory approval. COMPETITION The property and casualty insurance industry is highly competitive. The Company underwrites lines of insurance on risks not generally insured by many of the large standard property and casualty insurers, although such companies have been competing in this market more frequently in recent years. However, few barriers exist to prevent property and casualty insurance companies from entering into the Company's segments of the industry. To the extent this occurs, the Company can be at a competitive disadvantage because many of these companies have substantially greater financial and other resources and can offer a broader variety of specialty risk coverages. EMPLOYEES As of December 31, 2002, the Company employed 136 persons, of whom 12 were officers, 121 were staff and administrative personnel, and 3 were part-time employees. The Company is not a party to any collective bargaining agreement. 18 EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning the executive officers of the Company as of March 28, 2003 is set forth below:
Name Age Position with the Company ---- --- ------------------------- Glenn W. Anderson 50 President, Chief Executive Officer and Director Richard M. Buxton 54 Senior Vice President Daniel J. Coots 51 Senior Vice President, Chief Financial Officer and Chief Accounting Officer Michael S. Johnston 43 President of Personal Lines Division Carolyn E. Ray 50 Senior Vice President Marcia L. Buehler 38 Vice President and Controller Betty J. Graham 57 Vice President Jackiben N. Wisdom 54 Vice President Sam Rosen 67 Secretary and Director
Glenn W. Anderson has served as President, Chief Executive Officer and Director of the Company since April 1998. From 1996 to April 1998, Mr. Anderson served as Executive Vice President of USF&G. From 1993 to 1996, Mr. Anderson held the position of Senior Vice President with USF&G. Mr. Anderson has been engaged in the property and casualty insurance business since 1975. Richard M. Buxton has served as Vice President of the Company since December of 1996. In 1999, Mr. Buxton was promoted to Senior Vice President. Daniel J. Coots has served as Vice President and Chief Financial Officer of the Company since 1987. In 1991 Mr. Coots was promoted to Senior Vice President. Mr. Coots has been engaged in the property and casualty insurance business since 1983. Michael S. Johnston joined the Company in October 1998 when the Company acquired Lalande Group and since that time has served as Vice President of National Specialty Lines, Inc., a subsidiary of the Company. Mr. Johnston was promoted to President in March 2003. Mr. Johnston has been engaged in the property and casualty insurance business since 1993. Carolyn E. Ray has served as Senior Vice President of the Company since 1998. From 1986 to 1998, Ms. Ray served as Vice President of the Company. From 1984 to 1985, Ms. Ray served as Assistant Vice President of the Company. Ms. Ray has been engaged in the property and casualty business since 1976. Marcia L. Buehler has served as Vice President and Controller of the Company since July 2002. Ms. Buehler has been engaged in the property and casualty insurance business since 1989. Betty J. Graham has served as Vice President of the Company since March 2003. From January 1997 to March 2003 Ms. Graham served as Second Vice President. Ms. Graham has been engaged in the property and casualty insurance business since 1978. 19 Jackiben N. Wisdom has served as Vice President of the Company since January 2002. Mr. Wisdom has been engaged in the property and casualty insurance business since 1970. Sam Rosen has served as the Secretary and a Director of the Company since 1983. Mr. Rosen is a partner with the law firm of Shannon, Gracey, Ratliff & Miller, L.L.P. He has been a partner in that firm or its predecessors since 1966. That firm, or its predecessors, has provided significant legal services for the Company since 1979. ITEM 2. PROPERTIES The Company owns a 3.28 acre tract of land in Fort Worth, Texas and all improvements located thereon, including two office buildings with approximately 12,500 square feet of combined space. The Company currently has this property available for sale or lease. ITEM 3. LEGAL PROCEEDINGS In the normal course of its operations, the Company has been named as defendant in various legal actions seeking payments for claims denied by the Company and other monetary damages. In the opinion of the Company's management the ultimate liability, if any, resulting from the disposition of these claims will not have a material adverse effect on the Company's consolidated financial position or results of operations. The Company's management believes that unpaid claims and claim adjustment expenses are adequate to cover liabilities from claims that arise in the normal course of its insurance business. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 20 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS. The Company's Common Stock is listed on the OTC Bulletin Board (Symbol: GNAC). The following table sets forth for the fiscal periods indicated the high and low closing sales prices per share of the Common Stock as reported by the NYSE for the period first quarter 2000 to April 14, 2002 and reported by the OTC Bulletin Board for the period April 15, 2002 through the fourth quarter of 2002. The prices reported reflect actual sales transactions.
HIGH LOW ---- --- 2000 First Quarter 6 5/16 5 1/2 2000 Second Quarter 6 4 9/16 2000 Third Quarter 4 15/16 3 11/16 2000 Fourth Quarter 4 1/4 2 3/8 2001 First Quarter 4.0625 1.40 2001 Second Quarter 1.90 1.10 2001 Third Quarter 1.55 1.10 2001 Fourth Quarter 1.76 1.30 2002 First Quarter 1.93 0.25 2002 Second Quarter 0.35 0.05 2002 Third Quarter 0.06 0.02 2002 Fourth Quarter 0.14 0.02
Cash dividends of $.0175 per share were paid to shareholders of record on March 31, June 30, September 30 and December 31, 2000. In February 2001, the Company discontinued quarterly dividends on the Common Stock. As of February 28, 2003, there were 249 shareholders of record of the Company's Common Stock. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The selected consolidated financial data presented in the following tables for, and as of the end of each of the years ended December 31, have been derived from the consolidated financial statements of the Company which have been audited by KPMG LLP, independent certified public accountants. The consolidated balance sheets as of December 31, 2002 and 2001, and the consolidated statements of operations, shareholders' equity and comprehensive loss and cash flows for each of the years in the three-year period ended December 31, 2002, and the independent auditors report thereon are included elsewhere in this document. The information presented below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," consolidated financial statements and the notes thereto, and the other financial information included herein. 21
Years ended December 31 -------------------------------------------------------------------------- 2002 2001 2000 1999 1998 ---------- ---------- ---------- ---------- ---------- (Dollar amounts in thousands, except per share data) Income Data: Gross premiums written (1) $ 44,223 117,183 168,286 133,898 91,162 Ceded premiums written 1,629 48,888 49,463 2,761 2,603 ---------- ---------- ---------- ---------- ---------- Net premiums written 42,594 68,295 118,823 131,137 88,559 Decrease (increase) in unearned premiums 17,673 432 32,633 (17,857) 3,644 ---------- ---------- ---------- ---------- ---------- Net premiums earned 60,267 68,727 151,456 113,280 92,203 Net investment income 4,315 8,091 14,093 9,722 9,803 Net realized gains (losses) 2,049 4,275 (1,907) 606 693 Insurance services 4,284 327 1,054 1,849 2,927 ---------- ---------- ---------- ---------- ---------- Total revenues 70,915 81,420 164,696 125,457 105,626 ---------- ---------- ---------- ---------- ---------- Claims and claim adjustment expenses 56,414 87,426 143,439 76,349 86,353 Policy acquisition costs 10,613 14,419 33,326 24,288 23,619 Underwriting and operating expense 10,565 20,210 18,880 16,479 16,934 Goodwill impairment 2,860 18,447 -- -- -- ---------- ---------- ---------- ---------- ---------- Total expenses 80,452 140,502 195,645 117,116 126,906 ---------- ---------- ---------- ---------- ---------- (Loss) income before taxes and cumulative effect of change in accounting principle (9,537) (59,082) (30,949) 8,341 (21,280) Income tax (benefit) expense (776) 16,035 (11,398) 1,214 (9,617) ---------- ---------- ---------- ---------- ---------- (Loss) income before cumulative effect of change in accounting principle (8,761) (75,117) (19,551) 7,127 (11,663) Cumulative effect of change in accounting principle, net of tax -- (490) -- -- -- ---------- ---------- ---------- ---------- ---------- Net (loss) income (2) $ (8,761) (75,607) (19,551) 7,127 (11,663) ========== ========== ========== ========== ========== (Loss) earnings per common share, basic: (Loss) income before cumulative effect of change in accounting principle $ (.57) (3.66) (.97) .34 (.56) Cumulative effect of change in accounting principle -- (.02) -- -- -- ---------- ---------- ---------- ---------- ---------- Net (loss) earnings per common share, basic $ (.57) (3.68) (.97) .34 (.56) ========== ========== ========== ========== ========== (Loss) earnings per common share, diluted: (Loss) income before cumulative effect of change in accounting principle $ (.57) (3.66) (.97) .32 (.56) Cumulative effect of change in accounting principle -- (.02) -- -- -- ---------- ---------- ---------- ---------- ---------- Net (loss) earnings per common share, diluted $ (.57) (3.68) (.97) .32 (.56) ========== ========== ========== ========== ========== U.S. GAAP insurance ratios: Claims ratio 93.6% 127.2% 94.7% 67.4% 93.7% Expense ratio 32.3 45.4 31.6 32.0 39.0 ---------- ---------- ---------- ---------- ---------- Combined ratio 125.9% 172.6% 126.3% 99.4% 132.7% ========== ========== ========== ========== ==========
22
As of December 31 ------------------------------------------------------------------ 2002 2001 2000 1999 1998 ---------- ---------- ---------- ---------- ---------- (Dollar amounts in thousands, except per share data) Balance Sheet Data: Investments $ 114,974 180,678 246,185 245,180 210,989 Premiums receivable $ 3,684 21,242 25,471 25,432 14,885 Reinsurance balances receivable $ 31,623 62,303 54,495 3,254 2,393 Ceded unpaid claims and claim adjustment expense $ 46,802 65,571 37,703 37,299 35,030 Ceded unearned premiums $ 179 21,822 45,995 23,149 22,388 Deferred policy acquisition costs $ 1,674 3,188 2,302 14,928 11,320 Goodwill $ 609 3,469 22,797 18,351 17,058 Total assets $ 214,389 379,218 475,043 395,648 345,590 Unpaid claims and claim adjustment expenses $ 143,271 181,059 164,160 132,814 136,798 Unearned premiums $ 8,580 47,974 72,578 82,220 63,602 Note payable $ 3,700 10,800 16,000 18,000 18,000 Funds held under reinsurance agreements $ -- 47,784 47,850 -- -- Total liabilities $ 171,784 326,671 351,938 257,949 240,106 Redeemable Preferred Stock $ 28,358 25,030 -- -- -- Shareholders' equity $ 14,247 27,516 123,104 137,699 105,484 Shareholders' equity assuming conversion of Preferred Stock(3) $ 38,473 49,085 -- -- -- Shareholders' equity per share, assuming conversion of Preferred Stock(3) $ 1.34 1.71 4.50 5.08 5.05 Shareholders' equity assuming redemption of Preferred Stock(4) $ 3,853 14,465 91,484 106,079 -- Shareholders' equity per share, assuming redemption of Preferred Stock(4) $ .18 .68 4.32 5.07 --
(1) Excludes premiums of $1,727,000 in 2002, $16,627,000 in 2001, $26,973,000 in 2000, $58,137,000 in 1999, and $47,588,000 in 1998 from the Company's fronting arrangements, the commercial automobile plans of Arkansas, California, Louisiana, Mississippi, and Pennsylvania under which the Company was a servicing carrier and the reinsurance arrangement in Florida whereby MGAI premiums are ceded to a non-affiliated reinsurer and assumed by General Agents. (2) Includes after tax net realized gains (losses) from securities transactions of $1,352,000, $2,822,000, $(1,258,000), $400,000, and $457,000 for 2002, 2001, 2000, 1999, and 1998, respectively. (3) Based on shares of Common Stock outstanding of 28,703,069, 28,703,069, 27,369,736, 27,119,833 and 20,896,563 at the end of 2002, 2001, 2000, 1999 and 1998, respectively. Common Stock outstanding at December 31, 2002, 2001, 2000 and 1999 assumes conversion of the Series A Preferred stock that was issued in the 1999 GMSP transaction. Common Stock outstanding at December 31, 2002 and 2001 assumes conversion of the Series B Preferred Stock that was issued in the transactions with Robert W. Stallings in 2001. See Note (7) of Notes to Consolidated Financial Statements. (4) Based on 21,169,736 shares of Common Stock outstanding at the end of 2002, 2001 and 2000 and 20,919,833 shares at the end of 1999. See Note (7) of Consolidated Financial Statements. 23 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CRITICAL ACCOUNTING POLICIES The discussion and analysis of the Company's financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates under different assumptions or conditions. Critical accounting policies are defined as those that are reflective of significant judgements and uncertainties, and potentially result in materially different results under different assumptions and conditions. The Company's critical accounting policies are described below. For a detailed discussion on the application of these and other accounting policies see Note (1) of the Notes to Consolidated Financial Statements. Investments Bonds available for sale and other investments are stated at fair value with changes in fair value recorded as a component of comprehensive income. Short-term investments are stated at cost. The "specific identification" method is used to determine costs of investments sold. Provisions for possible losses are recorded only when the values have experienced impairment considered "other than temporary" by a charge to realized losses resulting in a new cost basis of the investment. The Company's policy is to review investments on a regular basis to evaluate whether or not each investment has experienced an "other than temporary" impairment. Deferred Policy Acquisition Costs and Deferred Ceding Commission Income Policy acquisition costs, principally commissions, premium taxes and certain marketing and underwriting expenses, are deferred and charged to operations over periods in which the related premiums are earned. Ceding commission income, which is realized on a written basis, is deferred and recognized over periods in which the related premiums are earned. Deferred ceding commission income is netted against deferred policy acquisition costs. The change in the resulting deferred asset is charged (credited) to operations. The Company utilizes investment income when assessing recoverability of deferred policy acquisition costs. Estimates of recoverability are based upon assumptions as to loss ratios, investment income and maintenance expenses. Goodwill Goodwill represents the excess of purchase price over fair value of net assets acquired. The Company periodically reviews the recoverability of goodwill based on an assessment of undiscounted cash flows of future operations to ensure it is appropriately valued. The recoverability of goodwill is evaluated on a separate basis for each acquisition. In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 141, "Business Combinations" ("Statement 141") and Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("Statement 142"). Statement 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. Statement 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill, noting that any purchase price allocable to an assembled workforce may not be accounted for separately. Statement 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of Statement 142. Statement 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated 24 residual values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" ("Statement 121"). The Company adopted the provisions of Statement 141 effective July 1, 2001 and Statement 142 effective January 1, 2002. The adoption of Statement 141 had no impact on the consolidated financial statements. The adoption of Statement 142 will result in the Company no longer amortizing the remaining goodwill. The remaining $609,000 of goodwill is associated with the 1998 acquisition of the Lalande Group and reflects a value no less than the estimated fair valuation levels of combined agency and claims handling operations of this type in the personal automobile marketplace. Claims and Claim Adjustment Expenses Claims and claim adjustment expenses, less related reinsurance, are provided for as claims are incurred. The provision for unpaid claims and claim adjustment expenses includes: (1) the accumulation of individual case estimates for claims and claim adjustment expenses reported prior to the close of the accounting period; (2) estimates for unreported claims based on past experience modified for current trends; and (3) estimates of expenses for investigating and adjusting claims based on past experience. Liabilities for unpaid claims and claim adjustment expenses are based on estimates of the ultimate cost of settlement. Changes in claim estimates resulting from the review process and differences between estimates and ultimate payments are reflected in expense for the year in which the revision of these estimates first become known. The process of establishing claim reserves is an imprecise science and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. Some judicial decisions and legislative actions, even after coverage is written and reserves are initially set, broaden liability and policy definitions and increase the severity of claim payments. As a result of this and other societal and economic developments, the uncertainties inherent in estimating ultimate claim costs on the basis of past experience have increased significantly, further complicating the already difficult claim reserving process. Ultimate liability may be greater or lower than current reserves. Reserves are monitored by the Company using new information on reported claims and a variety of statistical techniques. The reserves are reviewed annually by an outside actuarial firm. The Company does not discount to present value that portion of its claim reserves expected to be paid in future periods. Beginning in the third quarter of 2002 and for each quarter thereafter, the Company set reserves equal to the selected reserve estimate as established by an outside actuarial firm. Formerly management set reserves based upon its actuarial analysis. Income Taxes The Company and its subsidiaries file a consolidated Federal income tax return. Deferred income tax items are accounted for under the "asset and liability" method which provides for temporary differences between the reporting of earnings for financial statement purposes and for tax purposes, primarily deferred policy acquisition costs, the discount on unpaid claims and claim adjustment expenses, net operating loss carry forwards and the nondeductible portion of the change in unearned premiums. In assessing the realization of its deferred tax assets, management considers whether it is more likely than not that a portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based upon management's consideration of expected reversal of deferred tax liabilities and projected future taxable income, management believes it is more likely than not that the Company will not realize the benefits of these deferred tax assets in the near future. 25 ACCOUNTING PRONOUNCEMENTS In March 2003, the Financial Accounting Standards Board announced it expects to issue the proposed limited-scope statement "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity", in the second quarter of 2003. This statement would require redeemable preferred stock to be classified as a liability and any related accretion of discount and accrued dividends to be charged to the results of operations. If this statement is adopted as proposed, the Company would record all series of preferred stock as liabilities and would record the related accretion of discount and accrued dividends as charges to Results of Operations. For 2002 the accretion of discount on redeemable preferred stock was $2,657,000 and the dividends accrued were $670,774. Under this proposed statement these amounts would be recorded as charges to Results of Operations, and we anticipate an increase in the deferred tax valuation allowance equal to the related deferred tax benefit. In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities, an interpretation of ARB No. 51." This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities obtained after January 31, 2003. The application of this Interpretation is not expected to have a material effect on the Company's financial statements. In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of FASB Statement No. 123." This Statement amends FASB Statement No. 123, "Accounting for Stock Based Compensation", to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements. Certain of the disclosure modifications are required for fiscal years ending after December 15, 2002 and are included in the notes to these consolidated financial statements. In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34." This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. The Interpretation also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of the Interpretation are applicable to guarantees issued or modified after December 31, 2002 and are not expected to have a material effect of the Company's financial statements. In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("Statement 146"). The provisions of Statement 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of Statement 146 is not expected to have a material effect on the Company's consolidated financial position or result of operations. In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets" ("Statement 144"), establishing financial accounting and reporting for the impairment or disposal of long-lived assets. Statement 144 is effective for fiscal years beginning after December 15, 2001. Pursuant to Statement 144 the discontinuance of commercial lines was not reported as discontinued operations. The Company believes that the adoption of Statement 144 will have no other effect on the Company's financial position or results of operation. Effective January 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("Statement 133"), as amended. Statement 133 establishes accounting and reporting standards for derivative instruments and requires that an entity recognize all derivatives as either assets or liabilities in the financial statements and measure those instruments at fair value with changes in fair value recorded through the income statement. The adoption of Statement 133 had no impact on the consolidated financial statements. 26 BUSINESS OPERATIONS In 2002 the Company recorded a net loss of $8,761,087, or $0.57 per share (basic), primarily due to unfavorable claims experience and goodwill impairment. The Company continues to proceed in an orderly fashion with its exit from commercial lines. The loss of $75,607,047, or $3.68 per share (basic) recorded in 2001 was primarily a result of unfavorable claims experience, goodwill impairment and a valuation allowance for deferred Federal income taxes. On February 7, 2002, the Company announced its plans to discontinue writing commercial lines insurance due to continued adverse claims development and unprofitable results. In 2000 the Company recorded a net loss of $19,551,365, or $.97 per share (basic), primarily as a result of significant unfavorable claims experience in the commercial auto liability line of business. The Company materially increased the ultimate estimated liabilities for the line and entered into a reinsurance agreement, effective December 31, 2000, that provides significant additional protection in the event of further adverse reserve development. Additionally, the Company has reinsured the run-off of this business in 2001. The Company recorded U.S. GAAP combined ratios of 125.9% in 2002, 172.6% in 2001 and 126.3% in 2000. Discontinuance of Commercial Lines and Redeployment of Capital Discontinuance of Commercial Lines. On February 7, 2002, the Company announced its decision to cease writing its primary line of business, commercial insurance, due to continued adverse claims development and unprofitable results. The Company notified all of its commercial lines agents of its intent to cancel their agency contracts and notified all states, where required by statute, of its intent to cease writing commercial lines of insurance in their state. The discontinuance of writing commercial lines will likely result in the Company ceasing to be approved to write insurance in a number of states. By December 31, 2002, the Company had non-renewed 86% of its in-force policies. The remaining 14% are scheduled to be non-renewed in the first half of 2003 as the applicable policies expire. Concurrently, the Company continued to settle and reduce its inventory of commercial lines claims. At year-end 2002, there were 1,062 claims associated with our overall runoff book outstanding, compared to 1,720 a year earlier. As a result, approximately $68.5 million of unprofitable commercial business premium is being eliminated over the course of 2002 and 2003, with continuing reductions in the cost structure of the Company. Due to the long tail nature of these claims, the Company anticipates it will take a substantial number of years to complete an orderly adjustment and settlement process with regard to existing claims and any additional claims it receives in the future from its past business writings. The Company's commercial lines business segment produced approximately $11,992,000 in gross premiums written in 2002. In the course of reducing its employee count, in the first quarter of 2003 the Company outsourced certain of its information technology operations related to the run-off of its commercial lines to an unaffiliated third party provider with which Richard A. Laabs, a former senior executive of the Company, and three other former employees of the Company are affiliated. On August 12, 2002, the Company announced its decision to put itself in a position to exit its remaining active insurance business, personal auto, in as orderly and productive a fashion as possible. In June 2002, the Company entered into a letter of intent to sell its Miami, Florida based operation, the Lalande Group, to an unaffiliated party. In September 2002 negotiations in respect of the possible transaction were terminated. In conjunction with this process, the Company evaluated the related goodwill and recorded an impairment of approximately $2.9 million during the second quarter 2002. The remaining goodwill as of December 31, 2002 is $609,000 and is related to the 1998 acquisition of the Lalande Group. Operationally, the Company implemented rate increases and other measures to enhance the profit potential of this business in 2003 and its future strategic direction, which could include the expansion, contraction or disposition of the business. The Company anticipates a lengthy period of transition as it lessens its exposure to the insurance industry. During the transition process, the Company may consider the sale of additional subsidiaries associated with that business. The Company intends to redeploy capital no longer required by its insurance business, once it becomes available, to pursue other opportunities in the future that offer a better prospect for profitability. The Company believes that suitable capital redeployment opportunities should be available after the capital no longer required by its insurance business becomes available, but cannot predict the amount of capital that will ultimately be available for redeployment, the 27 timing or the nature of the opportunities that may be available at the time capital becomes available. The opportunities may be outside of the insurance business and could be in the financial services business. Sale of GAINSCO County Mutual On December 2, 2002, the Company completed the sale and transfer of the management contract controlling GAINSCO County Mutual Insurance Company ("GCM") to an affiliate of Liberty Mutual Insurance Company ("Liberty"), for a purchase price of up to $10 million, of which $1 million was paid at closing and the balance is payable in contingent payments through September 2009. The $9 million total of future payments would be payable $3 million in September 2003 and $1 million each year thereafter through September 2009. Each payment is contingent on there being no material adverse change in the regulatory treatment of GCM specifically, or county mutuals generally, from legislative or regulatory administrative actions prior to the applicable payment date. Legislation has been introduced in the current session of the Texas Legislature ending June 2, 2003 which, depending upon whether or in what form it is ultimately adopted, could prejudice the rights of the Company to receive some or all of the future payments from Liberty. Following the closing, the surplus of GCM, which was approximately $3,182,000, remained as a part of the combined statutory policyholders' surplus of the Company. Pursuant to a 100% quota share reinsurance agreement (the "General Agents Reinsurance Agreement") entered into at closing among GCM and GAINSCO's subsidiaries, General Agents Insurance Company of America, Inc. ("General Agents") and MGA Agency, Inc., and certain other arrangements, the Company retained all assets and liabilities associated with GCM's past, present and runoff commercial insurance business. The Company made a number of representations, warranties and covenants in the acquisition agreement and generally indemnifies Liberty for any losses incurred resulting from (i) breaches of representations, warranties or covenants of the Company; (ii) employee benefit plan obligations of GCM relating to pre-closing periods; (iii) tax obligations of GCM relating to pre-closing periods; (iv) all liabilities of GCM, to the extent that they result from conditions or circumstances arising or events occurring before the Closing, subject to certain exceptions; (v) all insurance claims, liabilities and obligations of GCM that are not reinsured pursuant to the General Agents Reinsurance Agreement or certain insurance fronting programs between GCM and Metropolitan Property & Casualty Insurance Company and Omni Insurance Company, respectively; and (vi) any and all insurance claims, liabilities and obligations of General Agents under the General Agents Reinsurance Agreement. GCM did not have any employees or employee benefit plans. The Company made a $500,000 prepayment of outstanding bank debt from the closing proceeds of the transaction. Sale of Office Building; New Office Leases The Company sold the office building at 500 Commerce Street in Fort Worth, Texas, where the Company's principal executive offices and commercial insurance operations were located, to an unaffiliated third party for $5 million on August 30, 2002. The Company recorded a gain of $455,056 from this transaction. As a result, the Company leased new office space to house its principal executive offices and commercial insurance operations. In August 2002, the Company entered into an office lease for approximately 8,352 square feet of space in Fountain Place, 1445 Ross Avenue, Suite 5300, Dallas, Texas, to house the Company's executive offices. This address is the Company's new registered address. The lease is for a term of four years, although the Company has the right to terminate the lease at its option at the end of 2005 upon payment of a termination fee of approximately $29,000. The annual rental expense is approximately $175,500. The lessor is Crescent Real Estate Funding X, L.P., an affiliate of Crescent Real Estate Equities Company, a Texas real estate investment trust f/k/a Crescent Real Estate Equities, Inc. ("Crescent"). Robert W. Stallings, GAINSCO's Chairman of the Board, became a member of the Board of Trust Managers of Crescent in May 2002, and John C. Goff, a member of GAINSCO's board of directors (the "Board"), is the Chief Executive Officer and Vice Chairman of the Board of Trust Managers of Crescent. Mr. Goff is deemed to be the beneficial owner of 3,630,248 common shares of Crescent, comprising 3.4% of the beneficial ownership of such shares. Mr. Stallings is deemed to be the beneficial owner of 22,000 common shares of Crescent, comprising less than 1% of the beneficial ownership of such shares. The management of the Company believes that the terms of the Company's lease with Crescent are no less favorable to GAINSCO than those offered to other tenants by Crescent or than GAINSCO could obtain for comparable space from unaffiliated parties. 28 In July 2002 the Company also entered an office lease with an unaffiliated third party for 10,577 square feet of space at 5400 Airport Freeway, Suite A, Fort Worth, Texas, to house the Company's commercial insurance operations. The lease is for a term of five years, although the Company may terminate the lease at its option after the expiration of three years. The annual base rental expense is $105,770. Executive Severance Agreements Because of their importance to the Company, in August 2002 the Company entered into executive severance agreements with two senior executives, Richard M. Buxton and Daniel J. Coots. The agreements generally provide that the Company shall pay the executive, upon termination of the employment of the executive by the Company without cause or by the executive with good reason during the term of the agreement, a lump sum severance amount equal to the base annual salary of the executive as of the date that the executive's employment with the Company ends. The current base annual salaries of Mssrs. Buxton and Coots are $170,000 and $155,000, respectively. The executive severance agreements do not supersede the change in control agreements or any other severance agreements the employees may have with the Company. Richard A. Laabs, a former senior executive of the Company, also entered into an executive severance agreement with the Company in August 2002, but did not receive any severance payments pursuant to such agreement when he resigned his employment with the Company in January 2003. Retention Incentive Agreements The Company entered into retention incentive agreements with sixteen of its employees, three of whom are officers of the Company. Each of the retention incentive agreements generally requires that the Company pay the applicable employee an amount based upon the employee's annual base salary, less amounts owed by the Company to the employee pursuant to any change in control or severance agreements the employee may have with the Company. The Company's obligation to make payments under each retention incentive agreement is conditioned upon the employee remaining in the employ of the Company through a specified date, unless terminated earlier by the Company without cause or by the employee with good reason. The Company could be obligated to make up to an aggregate of approximately $793,000 in payments under the retention incentive agreements. Other than Jackiben N. Wisdom (who was not one of the five most highly compensated employees of the Company at the time he entered into his retention incentive agreement), none of the five most highly compensated employees of the Company are parties to the retention incentive agreements. Separation Agreement In December 2002, McRae B. Johnston, the President - Personal Lines Division of the Company, resigned his employment with the Company and each of its subsidiaries other than MGA Insurance Company, Inc. ("MGAI"), where Mr. Johnston remained employed until March 1, 2003. The Company and Mr. Johnston entered into separation agreements and releases (the "Release Agreements") pursuant to which the Company and Mr. Johnston each mutually released the other from obligations under the stock purchase agreement and employment contract between the Company and Mr. Johnston and generally from any and all other claims that each otherwise may have had against the other. The Company paid Mr. Johnston an aggregate of $400,000 pursuant to the Release Agreements. Mr. Johnston also entered into a one-year Consulting Agreement with MGAI effective after the conclusion of his employment with MGAI on March 1, 2003 pursuant to which MGAI will pay Mr. Johnston an aggregate of $200,000 to be made in four equal payments of $50,000 each in March, June, September and December of 2003. Tri-State Acquisition and Sale On January 7, 2000, the Company expanded its personal lines business conducted through the Lalande Group through the acquisition of Tri-State, Ltd. ("Tri-State"), an insurance operation specializing in underwriting, servicing and claims handling of nonstandard personal auto insurance in Minnesota, North Dakota and South Dakota. Tri-State owned and operated a managing general agency, a motor vehicle driving records service company and an insurance subsidiary, Midwest Casualty Insurance Company ("MCIC") that had policyholders' surplus of approximately $3,034,000. The purchase price consideration consisted of $6,000,000 in cash at closing plus additional cash payments of $1,200,000 and $1,600,000 paid in July 2000 and January 2001, respectively. On August 31, 2001, the Company sold all of the stock of Tri-State to Herbert A. Hill for a cash price of $935,000. Mr. Hill is the President and a former owner of Tri-State. The Company retained MCIC, which had policyholders' surplus of approximately 29 $2,965,000 at December 31, 2002 and $3,078,000 at December 31, 2001. MCIC is to be liquidated on March 31, 2003 and all of its assets, liabilities and equity are to be transferred to General Agents. Transactions with Goff Moore Strategic Partners, L.P. 1999 GMSP Transaction. On October 4, 1999, the Company sold to Goff Moore Strategic Partners, L.P. ("GMSP"), for an aggregate purchase price of $31,620,000, (i) 31,620 shares of Series A Preferred Stock, which are convertible into 6,200,000 shares of Common Stock at a conversion price of $5.10 per share (subject to adjustment for certain events), (ii) the Series A Warrant to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise price of $6.375 per share and expiring October 4, 2004 and (iii) the Series B Warrant to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise of $8.50 per share and expiring October 4, 2006. At closing the Company and its insurance company subsidiaries entered into Investment Management Agreements with GMSP, pursuant to which GMSP manages their respective investment portfolios. Completion of these transactions (the "1999 GMSP Transaction") concluded the strategic alternatives review process that the Company initiated in 1998. Proceeds from the 1999 GMSP Transaction were available for acquisitions, investments and other corporate purposes. 2001 GMSP Transaction. On March 23, 2001, the Company consummated a transaction with GMSP (the "2001 GMSP Transaction") pursuant to which, among other things, the Company issued shares of its newly created Series C Preferred Stock to GMSP in exchange for an aggregate purchase price of $3.0 million in cash. The annual dividend rate on the Series C Preferred Stock is 10% until March 23, 2004 and 20% thereafter. Unpaid dividends are cumulative and compounded. The Series C Preferred Stock is redeemable at the Company's option after March 23, 2006 and at the option of the majority holders after March 23, 2007 at a price of $1,000 per share plus accrued and unpaid dividends. The Series C Preferred Stock is not convertible into Common Stock. The agreement with GMSP in connection with the 2001 GMSP Transaction was conditioned upon the following changes in the securities currently held by GMSP. The exercise prices of the Series A Warrant and the Series B Warrant held by GMSP were amended to $2.25 per share and $2.5875 per share, respectively. Each of these warrants provides for the purchase of 1,550,000 million shares of Common Stock, subject to adjustment. Further, the Company is required to redeem the outstanding shares of its Series A Preferred Stock on January 1, 2006, subject to certain conditions, at a price of $1,000 per share plus accrued and unpaid dividends. Any Series A Preferred Stock unredeemed for any reason after that date would accrue interest, payable quarterly at a rate equal to eight percent per year with any unpaid interest compounded annually. The Series A Preferred Stock is convertible into 6,200,000 shares of Common Stock at a conversion price of $5.10 per share and, should the Company pay dividends on its Common Stock, the Series A Preferred Stock would be entitled to dividends as if converted into Common Stock. The agreement with GMSP provided an opportunity to convert the Company's illiquid investments with a cost of $4.2 million to cash as of November 2002, as follows: the Company could at its option require GMSP to purchase the illiquid investments for $2.1 million, less any future cash received prior to November 2002 from the investments. GMSP could at its option require the Company to sell the illiquid investments to GMSP for $4.2 million, less any future cash received prior to November 2002 from the investments. During the second quarter of 2001, the Company recognized a permanent impairment of these investments and wrote down the carrying value to the amount recoverable from GMSP under the put option. In February 2002, GMSP consented to the early exercise of the Company's option, and the Company exercised its option to require GMSP purchase the illiquid investments for approximately $2.1 million. 30 2002 Amendment to Investment Management Agreements. In August 2002, the Company entered into an amendment to its Investment Management Agreements with GMSP. See "Transactions with Goff Moore Strategic Partners, L.P. - 1999 GMSP Transaction." The amendment reduces, effective as of October 1, 2002, the minimum aggregate monthly payment owed by the Company to GMSP from $75,000 to $63,195 (with respect to each calendar month from October 2002 through September 2003), $53,750 (with respect to each calendar month from October 2003 through September 2004), and $45,417 (with respect to each calendar month after September 2004). The amendment also changes the date upon which either party to each of the investment management agreements can terminate such agreements at its sole option from October 4, 2002 to September 30, 2005. Transactions with Robert W. Stallings On March 23, 2001, the Company consummated a transaction with Mr. Stallings (the "Stallings Transaction") pursuant to which, among other things, the Company issued shares of its newly created Series B Preferred Stock and a warrant to purchase an aggregate of 1,050,000 shares of Common Stock at $2.25 per share and expiring March 23, 2006 in exchange for an aggregate purchase price of $3 million in cash. The annual dividend provisions and the redemption provisions of the Series B Preferred Stock are the same as those for the Series C Preferred Stock. The Series B Preferred Stock is convertible into Common Stock at $2.25 per share. Subject to adjustment for certain events, the Series B Preferred Stock is convertible into a maximum of 1,333,333 shares of Common Stock. Mr. Stallings also entered into a Consulting Agreement pursuant to which he provides consulting services (including strategic planning advice, analysis of the subsidiaries' performance in various sectors of their respective business and recommendations for growth strategies and opportunities for new markets and products) to the Company's insurance subsidiaries for a period of five (5) years ending on March 22, 2006 for $300,000 per annum. Mr. Stallings was elected non-executive Vice Chairman of the Board and a director of the Company, and on September 6, 2001, he was elected non-executive Chairman of the Board. Reinsurance Transaction Effective December 31, 2000, the Company entered into a quota share reinsurance agreement whereby the Company ceded 100% of its commercial auto liability unearned premiums and 50% of all other commercial business unearned premiums at December 31, 2000 to a non-affiliated reinsurer. For policies with an effective date of January 1, 2001 through December 31, 2001, the Company entered into a quota share reinsurance agreement whereby the Company ceded 20% of its commercial business to a non-affiliated reinsurer. Also effective December 31, 2000, the Company entered into a reserve reinsurance cover agreement with a non-affiliated reinsurer. This agreement reinsures the Company's ultimate net aggregate liability in excess of $32,500,000 up to an aggregate limit of $89,650,000 for net commercial auto liability losses and loss adjustment expense incurred but unpaid as of December 31, 2000. The Company established a reinsurance balance receivable and a liability for funds held under reinsurance agreements for the reserves transferred at December 31, 2001. Also in connection with this agreement, the Company was required to maintain assets in a trust fund with a fair value at least equal to the funds held liability. The trust fund was established during the third quarter of 2001 and at December 31, 2001 the assets in the trust had a fair value of $49,553,698. Because the Company's statutory policyholders' surplus fell below certain levels specified in the agreement, the reinsurer had the option to direct the trustee to transfer the assets of the trust to the reinsurer. On March 29, 2002, the reinsurer exercised this option and the trust assets were transferred to the reinsurer. As a result, investments and funds held under reinsurance agreements were reduced by approximately $44,000,000. The Company recorded a realized gain of approximately $486,000 as a result of the transfer. The reinsurer continues to be responsible for reimbursing the Company for claim payments covered under this agreement. RESULTS OF OPERATIONS The discussion below primarily relates to the Company's insurance operations, although the selected consolidated financial data appearing elsewhere is on a consolidated basis. The expense Item "Underwriting and operating expenses" includes the operating expenses of GNAC. Gross premiums written in the 2002 year were 62% below 2001 and the 2001 year was 30% below 2000 year. The Company's decision in the first quarter of 2002 to discontinue writing commercial lines is primarily the reason for the decrease in 2002. The Company's decision in the fourth quarter of 2000 to cease writing certain identified non-profitable commercial trucking business is the primary reason for the decrease in 2001. The following table compares the major product lines between the years for gross premiums written: 31
Years ended December 31 ------------------------------------------------------------------------------- 2002 2001 2000 ----------------------- ----------------------- ----------------------- (Dollar amounts in thousands) Gross Premiums Written: Commercial Lines $ 11,992 27% $ 68,499 58% $ 113,354 67% Personal Lines 32,231 73 48,684 42 54,932 33 ---------- -------- ---------- -------- ---------- -------- $ 44,223 100% $ 117,183 100% $ 168,286 100% ========== ======== ========== ======== ========== ======== Policies in Force (End of Period) 26,074 64,797 87,048
COMMERCIAL LINES decreased 82% in 2002 and 40% in 2001. The Company's decision to discontinue writing commercial lines insurance due to continued adverse claims development and unprofitable results in the first quarter of 2002 is the reason for the decrease in 2002. In 2001 commercial auto contributed 30 points to the decrease for the reason mentioned previously and general liability line contributed 6 points to the decrease. PERSONAL LINES decreased 34% in 2002 and 11% in 2001. The decrease in 2002 was primarily related to the Company's decision to discontinue writing nonstandard personal auto outside of Florida and to discontinue writing personal umbrella. Also contributing was the fact that most nonstandard personal auto policies written in 2002 were six month policies, whereas in 2001 a significant amount were twelve month policies, see below. The decrease in 2001 from 2000 was primarily a result of the Florida nonstandard personal auto business. The Company began a transition during 2001 to write a majority of the nonstandard personal auto business on six month policies instead of twelve month policies as had been done in the past. This accounts for a significant portion of the decrease in writings in 2001. This decision gives the Company greater flexibility in managing the business. For 2002 gross premiums written percentages by significant product line are as follows: personal auto (72%), commercial auto (16%) and general liability (10%) with no other product line comprising 5% or more. Net premiums earned decreased 12% primarily as a result of the decision to discontinue writing commercial lines. The decrease was less than the decrease in written premiums primarily due to the absence of commercial and personal quota share reinsurance in 2002. Net premiums earned decreased 55% in 2001 primarily as a result of the commercial quota share reinsurance agreements and exiting certain commercial trucking business. Net investment income decreased 47% and 43% in 2002 and 2001, respectively. The decrease in 2002 was primarily attributed to the decline in investments, short-term investments comprising a significantly greater portion of investments and the decline in interest rates. For 2001, the Company entered into a reserve reinsurance cover agreement with a non-affiliated reinsurer. This agreement required the Company to maintain a funds held liability and to increase this liability at an annual interest rate of 7.5%. This resulted in a charge to investment income of $3,650,417 during 2001. The Company recorded net realized capital gains of $2,048,848 and $4,275,192 in 2002 and 2001, respectively, versus net realized capital losses of $1,906,911 in 2000. During 2002, the Company reduced the carrying value of a non-rated commercial mortgage backed security to $0 resulting in a write down of $2,010,670 (recorded as a realized loss in the statement of operations) as a result of a significant increase in the default rate in the underlying commercial mortgage portfolio, which has disrupted the cash flow stream sufficiently to make future cash flows unpredictable. This write-down was offset by net realized gains of $3,604,462 recorded from the sale of various bond securities and other investments in 2002 and the gain of $455,056 recognized from the sale of the home office building. The losses recorded in 2000 were the result of restructuring the portfolio into higher taxable equivalent yields. Insurance services revenues increased $3,957,583 in 2002 over 2001, primarily as a result of amortization of deferred reinsurance recoveries from claim payments under the reserve reinsurance cover agreement mentioned previously. For 2002, $4,082,469 was recorded which represents the reserve development under the reserve reinsurance cover agreement. In 2001 $1,112,469 was recognized under the reserve reinsurance agreement. Amortization is based upon claims recovered from the reinsurer in relation to the amount of the reinsured layer under the reserve 32 reinsurance cover agreement. Insurance service revenues decreased $727,443 in 2001 from 2000. The decrease was primarily a result of the decrease in service revenues in the Lalande Group. Claims and claim adjustment expenses ("C & CAE") decreased $31,012,337 in 2002 from 2001 and decreased $56,013,096 in 2001 from 2000. The C & CAE ratio was 93.6% in 2002, 127.2% in 2001 and 94.7% in 2000. The decrease in the C & CAE ratio in 2002 is primarily due to smaller increases in estimated ultimate liabilities recorded in 2002 for commercial lines than was recorded in 2001. The C & CAE ratio in 2001 was above the 2000 level primarily because of continued adverse development in commercial lines. The Company began to cease writing new policies in the trucking portion of this line of business in the fourth quarter of 2000. Reinsurance agreements were in place effective December 31, 2000 that are expected to minimize future adverse results from this line of business. Under the reserve reinsurance cover agreement approximately $3,855,000 of C & CAE as of December 31, 2002 will ultimately be amortized as a deferred gain on reinsurance arrangements in future periods. In accordance with U.S. GAAP, the reinsurance recoveries from these reserve increases are recorded as deferred revenue and not immediately recognized as reductions to C & CAE. Recognition of this deferred revenue item occurs through insurance service revenues in the future based upon claims recovered from the reinsurer in relation to the total amount of the reinsured layer under the reserve reinsurance cover agreement. With regard to environmental and product liability claims, the Company has an immaterial amount of exposure. The Company does not provide environmental impairment coverage and excludes pollution and asbestos related coverages in its policies. The Company's premium writings for product liability coverages are immaterial. Inflation impacts the Company by causing higher claim settlements than may have originally been estimated. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results. The ratio of commissions and the change in deferred policy acquisition costs and deferred ceding commission income to net premiums earned is 18% in 2002, 21% in 2001 and 22% in 2000. The progressive decrease in this ratio is primarily due to the shift in the mix of business to nonstandard personal auto which has lower acquisition expenses than commercial lines. Commissions are comprised of commission expenses (which vary with gross premiums written), offset by commission income, (which varies with ceded premium written). Commission expenses are paid to agents to produce the business for the Company. Commission income is received by the Company from reinsurers as compensation to the Company for business the Company cedes to the reinsurers. Commissions decreased in 2002 and in 2001 as a result of the decrease in gross premiums written discussed previously. Change in deferred policy acquisition costs ("DPAC") and deferred ceding commission income ("DCCI") represents the change during the period in the asset "Deferred policy acquisition cost". This asset item is comprised of commission expenses, premium taxes and certain marketing and underwriting expenses which are deferred, offset by commission income received from reinsurers, which is also deferred. This net asset DPAC is amortized into the results of operations through "Change in deferred policy acquisition costs and deferred ceding commission income", as the underlying gross premiums written and ceded premiums written are earned. Change in DPAC and DCCI resulted in a charge in 2002 of $1,513,880, a credit in 2001 of $886,282 and a charge in 2000 of $12,638,482. The charge in 2002 is primarily attributable to the amortization of previous DPAC and DCCI exceeding DPAC and DCCI incurred for 2002 as a result of the decision to discontinue writing commercial lines in 2002. The credit in 2001 is primarily the result of the DPAC and DCCI incurred in 2001 exceeding the amortization of previous DPAC and DCCI. The amortization of previous DPAC and DCCI included a significant amount of DCCI from the 2000 year (see below). The charge in 2000 is primarily the result of a significant amount of DCCI received in 2000 from a quota share reinsurance agreement whereby the Company ceded 100% of its commercial auto liability unearned premiums and 50% of all other commercial business unearned premiums. 33 Interest expense from the note payable decreased in 2002 and 2001 as a result of principal payments on the note and lower interest rates. The Company paid principal amounts of $7,100,000, $5,200,000 and $2,000,000 in 2002, 2001 and 2000, respectively. There is no amortization expense in 2002 due to the adoption of Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" (see Note 1(h) of Notes to Consolidated Financial Statements). Amortization of goodwill decreased in 2001 as a result of the sale of Tri-State and the second quarter 2001 write-off of its goodwill. Underwriting and operating expenses were down 45% in 2002 but were up 12% in 2001. The decrease for 2002 was primarily due to expense reductions implemented as a result of the decision to discontinue writing commercial lines. The increase for 2001 was the result of the Company recording a provision for potentially uncollectible reinsurance balances receivable of $2,653,597. Without this provision underwriting and operating expenses were down 4% primarily as a result of a decrease in personnel costs. Goodwill impairment in 2002 is a result of the Company positioning itself for an exit from the personal auto business in the second quarter of 2002 and the consideration of a sale of the Lalande Group. A re-evaluation of goodwill for the Lalande Group was made during this period and an additional impairment of $2,859,507 was recorded. This re-evaluation was based upon market indications of value contained in a proposal from a potential acquiror and upon the uncertainty of achieving value levels. Goodwill impairment in 2001 was a result of the Company's decision to no longer pursue a long-term geographic expansion strategy in personal automobile beyond that of its core operation in Florida and to sell its Tri-State agency subsidiary. See "BUSINESS OPERATIONS - Tri-State Acquisition and Sale". Tri-State was acquired by the Company in the first quarter of 2000 and failed to achieve profitability during the Company's ownership. Because of the profitability issues surrounding the Lalande Group, (see below), it was decided in the second quarter of 2001 to sell Tri-State to its former owner so the Company could focus all of the personal auto efforts solely on the Lalande Group. As a result the remaining goodwill associated with the Tri-State acquisition was written off in the second quarter of 2001. In December 2001 the Company recorded an impairment of $13,360,603 on the goodwill associated with the 1998 acquisition of the Lalande Group. The Lalande Group was acquired by the Company in the fourth quarter of 1998, it produced a small profit in 1999, but in 2000 it produced a loss. At the end of 2000 the Company was expecting a significant improvement and profitability from the Lalande Group in 2001. During 2001 the Company continued to implement actions throughout the year to return this business to profitability. While results in 2001 showed improvement, they remained unprofitable. In the fourth quarter of 2001 the Company concluded that the value of this operation was significantly below what the Company had paid and accordingly recorded the impairment against goodwill based upon then current estimated market valuation levels of agencies in the personal auto marketplace. The Company recognized a current tax benefit of $2,607,796 during the third quarter of 2002 as a result of a carry back of alternative minimum tax losses. A change in the tax law during 2002 extended the carry back period for losses to offset income in earlier periods. As a result, the Company was entitled to a tax refund which it received in October 2002. The Company recorded deferred tax expense during the first quarter of 2002 due to an increase in the deferred tax asset valuation allowance, as a result of excluding the effects of unrealized gains in the deferred tax asset. The Federal income tax expense for 2001 is a result of the Company recording a valuation allowance of $31,534,712 against its deferred Federal income tax asset offset by the income tax benefit generated by the net loss from operations. Establishing the valuation allowance was necessary because of the uncertainty of future profitability levels. The Company does not lose the right to utilization of its net operating loss carry forwards for Federal income tax purposes in the future. For 2000 the Company generated a current tax benefit, with an effective tax benefit rate of 37%, as a result of a net loss from operations. While the Company produced a loss in 2000, at the end of 2000 the Company projected earnings in 2001 with subsequent increases each year thereafter. During 2001 the Company continued to implement actions to return to profitability, both in commercial lines and the personal lines. However, earnings in 2001 did not materialize and in the first quarter of 2002 the Company announced it was discontinuing the writing of its largest line of business, commercial lines, due to continued adverse claims development and unprofitable results. At that time the prospects for significant profits in personal lines, its only remaining line of business, were unclear. Because the Company had no near-term expectation of profitable results, it was necessary to fully reserve the deferred 34 tax asset due to uncertainty of future profitable results which could utilize this asset. In 2002 the Company continued to record unprofitable results and has no expectation of significant profits at this time. A reconciliation between income taxes computed at the Federal statutory rates and the provision for income taxes is included in Note (6) of Notes to Consolidated Financial Statements. The cumulative effect of change in accounting principle recorded in 2001 was a result of EITF 99-20, which became effective April 1, 2001. This amount represents the write down of an investment that was considered temporarily impaired and was written down in the first quarter of 2001 through accumulated other comprehensive income. EITF 99-20 changed the definition of impairment which resulted in this asset being reclassified as an impairment other than temporary which requires recognition through the statement of operations. LIQUIDITY AND CAPITAL RESOURCES Parent Company GAINSCO, INC. ("GNAC") is a holding company that provides administrative and financial services for its wholly owned subsidiaries. GNAC needs cash for: (1) principal and interest on its bank note payable, (2) administrative expenses, and (3) investments. The primary sources of cash to meet these obligations are statutory permitted payments from its insurance subsidiaries, including (1) dividend payments, (2) surplus debenture interest payments, and (3) tax sharing payments. Statutes in Oklahoma and North Dakota restrict the payment of dividends by the insurance company subsidiaries to the available surplus funds. The maximum amount of cash dividends that each subsidiary may declare without regulatory approval in any 12-month period is the greater of net income for the 12-month period ended the 35 previous December 31 or ten percent (10%) of policyholders' surplus as of the previous December 31. In December 2002 MCIC (the North Dakota subsidiary) declared and paid dividends to GNAC of $300,000. On March 20, 2003, General Agents (the Oklahoma subsidiary) paid dividends to GNAC of $3,878,000, based on its surplus amounts at December 31, 2002. GNAC believes the cash dividends from its insurance subsidiaries should be sufficient to meet its expected obligations for 2003. The Company had Federal income tax net operating loss carry forward tax benefits at December 31, 2002 of $23,017,524 that could be applied against any future tax expense of the Company, subject to certain limitations. Thus, the Company does not currently require funds to satisfy Federal income tax obligations. GNAC entered into an amendment dated as of February 27, 2002 to its bank credit agreement which cured GNAC's covenant breaches and provided for additional principal prepayments. Pursuant to the amendment, GNAC prepaid $6,100,000 of the indebtedness outstanding under the credit agreement. Several covenants in the existing credit agreement were eliminated or modified by the amendment and the interest rate was changed to a base rate (which approximates prime) plus 175 basis points. The major financial covenant of the amended credit agreement requires the statutory surplus of General Agents to be at a minimum of three times the unpaid principal balance after December 31, 2002. General Agents' statutory surplus at December 31, 2002 was approximately $38,780,000. GNAC paid $500,000 of the indebtedness outstanding under the credit agreement in December 2002 as a result of the sale of GCM. The credit agreement requires a note prepayment equal to 50% of any dividends from General Agents. On March 24, 2003, GNAC paid $1,939,000 of the indebtedness outstanding under the credit agreement in conjunction with the receipt of $3,878,000 in dividends from General Agents. The remaining $1,761,000 principal balance under the credit agreement is payable in 2003 which GNAC intends to fund with proceeds from short term investments. The credit agreement, among other things, precludes payment of dividends on common or preferred stock and restricts the kinds of investments that GNAC may make. Subject to bank credit agreement restrictions, GNAC may also obtain cash through the sale of subsidiaries or assets and through the issuance of common or preferred stock. The bank credit agreement generally requires a note prepayment in the event of the sale of GNAC of any subsidiary or assets (except certain ordinary course of business sales), or any issuance of stock (subject to certain exceptions), equal to 50% of the proceeds received. The Company will be in a lengthy period of transition as it lessens its exposure to the insurance industry. During the transition process, the Company may consider the sale of additional subsidiaries associated with that business. See "BUSINESS OPERATIONS - Discontinuance of Commercial Lines and Redeployment of Capital." Subsidiaries, Principally Insurance Operations The primary sources of the insurance subsidiaries' liquidity are funds generated from insurance premiums, net investment income and maturing investments. The short-term investments and cash are intended to provide adequate funds to pay claims without selling fixed maturity investments. At December 31, 2002, the insurance subsidiaries held short-term investments and cash that the insurance subsidiaries believe are adequate liquidity for the payment of claims and other short-term commitments. With regard to long term liquidity, the average duration of the investment portfolio is approximately 1.4 years. The fair value of the fixed maturity portfolio at December 31, 2002 was $3,637,456 above amortized cost, before taxes. With regard to the availability of funds to the holding company, see Note (7) of Notes to Consolidated Financial Statements for restrictions on the payment of dividends by the insurance companies. Various insurance departments of states in which the Company operates require the deposit of funds to protect policyholders within those states. At December 31, 2002 and 2001, the balance on deposit for the benefit of such policyholders totaled $13,731,408 and $15,398,298, respectively. Effective December 31, 2000, the Company entered into a quota share reinsurance agreement whereby the Company ceded 100% of its commercial auto liability unearned premiums and 50% of all other commercial business unearned 36 premiums at December 31, 2000 to a non-affiliated reinsurer. For policies with an effective date of January 1, 2001 through December 31, 2001, the Company entered into a quota share reinsurance agreement whereby the Company ceded 20% of its commercial business to a non-affiliated reinsurer. Also effective December 31, 2000, the Company entered into a reserve reinsurance cover agreement with a non-affiliated reinsurer. This agreement reinsures the Company's ultimate net aggregate liability in excess of $32,500,000 up to an aggregate limit of $89,650,000 for net commercial auto liability losses and loss adjustment expense incurred but unpaid as of December 31, 2000. The Company established a reinsurance balance receivable and a liability for funds held under reinsurance agreements for the reserves transferred at December 31, 2001. Also in connection with this agreement, the Company was required to maintain assets in a trust fund with a fair value at least equal to the funds held liability. The trust fund was established during the third quarter of 2001 and at December 31, 2001 the assets in the trust had a fair value of $49,553,698. Because the Company's statutory policyholders' surplus fell below certain levels specified in the agreement, the reinsurer had the option to direct the trustee to transfer the assets of the trust to the reinsurer. On March 29, 2002, the reinsurer exercised this option and the trust assets were transferred to the reinsurer. The reinsurer continues to be responsible for reimbursing the Company for claim payments covered under this agreement. Net cash used for operating activities was $62,050,686 for 2002 versus $61,384,654 in 2001. The significant usage in 2001 was primarily related to the decrease in premium writings and the ongoing payment of claims and claim adjustment expense. Investments decreased primarily due to a nonaffiliated reinsurer exercising its option, during the first quarter of 2002, to take possession of approximately $44,000,000 in investments, mentioned previously. The remaining decrease is attributable to principal payments on the note payable of $7,100,000 and negative cash flows from operations. At December 31, 2002, 92% of the Company's investments were investment grade with an average duration of approximately 1.4 years, including approximately 45% that were held in short-term investments. On a taxable equivalent basis the return on average investments was 3.9% in 2002, 4.3% in 2001, and 6.5% in 2000. The Company classifies its bond securities as available for sale. In February 2002 GMSP purchased the equity investments and the note receivable, classified as "Other investments", for approximately $2,087,000 which was their carrying value at December 31, 2001. In March 2002, the Company reduced the carrying value of a non-rated security to $0 resulting in a write down of $2,010,670 as a result of a significant increase in the default rate in January and February of 2002 in the underlying collateral, which had disrupted the cash flow stream sufficiently to virtually eliminate future cash flows. The unrealized gain associated with the investment portfolio was $2,400,722 (net of tax effects) at December 31, 2002. The duration of the bonds available for sale approximates the average expected payout of claims. Premiums receivable decreased primarily as a result of the decrease in writings caused primarily by the decision to discontinue writing commercial lines during 2002 and the decision to net deferred payables on policies not yet written against deferred receivables on these same policies. This balance is comprised primarily of premiums due from insureds for nonstandard personal auto. The nonstandard personal auto premiums are written with a down payment of 34% and monthly payment terms of up to four months. The Company has recorded an allowance for doubtful accounts of $275,000 which it considers adequate at the present time. Reinsurance balances receivable decreased primarily as a result of C & CAE claims paid under the reserve reinsurance cover agreement and the quota share reinsurance agreements for both commercial lines and personal lines business written in 2001. This balance is primarily comprised of ceded unpaid claims and claims adjustment expenses under the reserve reinsurance cover agreement and claims and claim adjustment expenses paid by the Company and due from reinsurers under the Company's various reinsurance agreements. The Company recorded an allowance for doubtful accounts of $1,001,461 in 2002 and of $2,653,597 in 2001 as a result of concern regarding the collectibility of amounts due from specific reinsurers. The decrease in the allowance for doubtful accounts was primarily due to the successful recovery of an amount that had been included in the allowance in 2001. Balances written off in previous years have been immaterial. The Company considers the allowance adequate at the present time. Ceded unpaid claims and claim adjustment expenses decreased as a result of the decrease in unpaid claims and claim adjustment expenses and the decrease in cessions under the quota share reinsurance agreements. This balance 37 represents unpaid claims and claim adjustment expenses which have been ceded to reinsurers under the Company's various reinsurance agreements, other than the reserve reinsurance cover agreement. These amounts are not currently due from the reinsurers but are expected to become due in the future when the Company pays the claim and requests reimbursement from the reinsurers. Ceded unearned premiums decreased primarily as a result of the decision to discontinue writing commercial lines in 2002. This balance represents the portion of premiums ceded to reinsurers which are applicable to the unexpired terms of policies in force under the applicable reinsurance agreement. In the event the Company cancels policies, the reinsurer is required to return the premium to the Company. This type of action, on a material scale, is not expected to occur. Deferred policy acquisition costs decreased primarily as a result of the decision to discontinue writing commercial lines. This balance represents commissions, premium taxes and certain marketing and underwriting expenses which are deferred and charged to operations over periods in which the related premiums are earned. Ceding commission income, which is realized on a written basis, is deferred and recognized over periods in which the related premiums are earned. Deferred ceding commission income is netted against deferred policy acquisition costs. The change in the resulting deferred asset is charged (credited) to operations. The Company recorded impairments on its deferred policy acquisition costs at December 31, 2002 of $28,386 and at December 31, 2001 of $2,487,009 related to the property and commercial auto lines of business. Property and equipment decreased primarily as a result of the sale of the former home office building during the third quarter of 2002. A gain of $455,056 was recorded on this sale. The Company adjusted accumulated depreciation to reflect fully depreciated property and equipment that has been disposed. This balance is comprised primarily of computer hardware, computer software, furniture and an office building the Company previously occupied which is under lease until May 2003, and which the Company has listed as available for sale or lease. Current Federal income taxes were received in January 2003. Deferred Federal income taxes have a valuation allowance for its full amount recorded against the asset. This asset is primarily a tax benefit from net operating loss carry forwards which can be used to offset tax expense on future operating earnings or capital gains. See earlier discussion under "RESULTS OF OPERATIONS." A change in ownership of the Company's stock greater than 50% (as specified under Internal Revenue Code Section 382) could severely limit the Company's ability to recover this asset in future periods. The management contract controlling GCM was sold on December 2, 2002 to an unaffiliated third party. See "BUSINESS OPERATIONS - Sale of GAINSCO County Mutual." Other assets increased primarily as a result of funds placed on deposit with a reinsurer in the second quarter of 2002 to collateralize commissions payable balances due the reinsurer. Other assets are comprised primarily of funds held by reinsurers as collateral for the reinsurers and prepaid expenses. Goodwill decreased as a result of the $2,859,507 impairment recorded in the second quarter of 2002 related to the October 1998 Lalande Group acquisition. The remaining goodwill of $609,000 reflects estimated fair valuation of agencies in the personal automobile marketplace. See "RESULTS OF OPERATIONS." Effective in 2002, goodwill will no longer be amortized but will be subject to an impairment test based on its estimated fair value. Therefore, additional impairment losses could be recorded in future periods. Unpaid claims and claim adjustment expenses decreased primarily as a result of the run-off of commercial lines. As of December 31, 2002, the Company had $96.469 million in unpaid claims and claim adjustment expenses. This amount represents management's best estimate, as derived from the actuarial analysis and was set equal to the selected reserve estimate as established by our outside actuary. The reserve estimates considered by our outside actuaries ranged from $83.1 million to $104.1 million. The actuary's range of reserves was developed by applying various methods considered appropriate for each line of coverage written. The actuary selected an estimate for each line of coverage written by accident year based on the results of the various methods applied, along with judgement. Management has reviewed and discussed the results of the actuarial analysis with the actuary and believes the reserve estimate selected by the actuary to be the best estimate of reserves at this time. As of December 31, 2002, in respect of its commercial lines, the Company had $83.664 million in reserves for unpaid claims and claim adjustment expenses. Historically, the Company has experienced significant volatility in its reserve projections for its commercial lines. This volatility has been primarily attributable to its commercial automobile and general liability product lines. See Item 1 "BUSINESS--Unpaid Claims and Claim Adjustment Expenses." On February 7, 2002, the Company announced it had decided to discontinue writing commercial lines insurance due to continued adverse claims development and unprofitable results. Since February 7, 2002, 86% of the Company's commercial policies have been non-renewed and the remainder are scheduled for non-renewal over the course of the first half of 2003. Concurrently, the Company has been settling and reducing its remaining inventory of commercial claims. See "BUSINESS OPERATIONS--Discontinuance of Commercial Lines and Redeployment of Capital." As of December 31, 2002, 1,062 commercial claims remained, compared with 1,720 claims a year earlier. Included in these remaining claims are 82 product liability claims, 32 construction defect type claims, and 1 environmental claim. The Company has no asbestos related claims. The average commercial lines claim at December 31, 2002 was approximately $78,779 per claim. As of December 31, 2002, in respect of its personal lines, the Company had $12.805 million in unpaid claims and claim adjustment expenses. These personal lines claims generally are shorter tailed than the Company's commercial lines claims. At December 31, 2002, the Company had 1,726 personal auto claims. The average personal auto claim at December 31, 2002 was approximately $7,276 per claim. The Company considers the unpaid claims and claim adjustment expenses to be adequate; they are set to equal the selected reserve estimate determined by an outside actuarial firm. Unearned premiums decreased primarily because of the decrease in writings from the decision to discontinue writing commercial lines. This balance represents the portion of premiums written which are applicable to the unexpired terms of policies in force which will earn in future periods. 38 Accounts payable decreased primarily because of the decision to net deferred payables on policies not yet written against deferred receivables on these same policies, as mentioned previously. Reinsurance balance payable decreased primarily due to settlements made in 2002 on prior years quota share reinsurance agreements. Deferred revenues decreased primarily as a result of reinsurance recoveries under the reserve reinsurance cover agreement. This balance is primarily comprised of C & CAE recoveries under this agreement which will be recognized as insurance service revenues in future periods based upon the ratio of actual C & CAE paid to the total of potential C & CAE payable under this reinsurance agreement. Drafts payable decreased primarily as a result of the Company's decision in the third quarter of 2002 to use checks instead of drafts to pay claims. This balance will continue to decrease in the future. Note payable decreased due to principal payments of $7,100,000 made during 2002. In the first quarter of 2002, the Company made a scheduled repayment of $500,000 and an unscheduled prepayment of $6,100,000. The unscheduled prepayment was made in conjunction with an amendment to the credit agreement which cured covenant breaches. The Company made a $500,000 principal payment in December 2002 in conjunction with the sale of GCM. On March 24, 2003 the Company made a $1,939,000 principal payment in conjunction with the receipt of a $3,878,000 dividend from General Agents. The remaining $1,761,000 principal balance under the credit agreement is payable in 2003. (see Note (4) of Notes to Consolidated Financial Statements). Funds held under reinsurance agreements were eliminated due to the reinsurers decision to take possession of investments, which reduced the Company's liability to this reinsurer. See "BUSINESS OPERATIONS - Reinsurance Transaction." Deferred Federal income taxes is comprised of the taxes on the unrealized gains of the bonds available for sale. The unrealized gains have been recorded net of taxes in "Accumulated other comprehensive income." As a result of the 2001 GMSP Transaction and the Stallings Transaction, the Company has three series of redeemable Preferred Stock, which are classified as mezzanine financing. The Series A Preferred Stock was previously classified in shareholders' equity because it was not subject to mandatory redemption. The Company is required to redeem the Series A Preferred Stock on January 1, 2006 at a price of $31,620,000 plus unpaid dividends, if any. As of December 31, 2002, there were no accrued but unpaid dividends in respect of the Series A Preferred Stock. The Series B and Series C Preferred Stock are redeemable at the Company's option in March 2006 and at the option of the majority holders in March 2007 at a price of $3,000,000 each plus accrued dividends. The Series B and the Series C Preferred Stock each include accrued dividends in the amount of $556,059 as of December 31, 2002. With the reclassification of the Series A Preferred Stock during the first quarter of 2001, preferred stock capital was reduced to $0 and additional paid-in capital was reduced by the discount on the convertible redeemable preferred stock. Common stock warrants decreased for the discount in value of the previously issued Series A and Series B Warrants offset by an increase for the issuance of the warrant in the Stallings Transaction. At December 31, 2002, $10,394,002 has yet to be charged to Retained deficit related to the accretion of the discount on the Series A and Series B Preferred Stock. Accumulated other comprehensive income of $2,400,722 was recorded at December 31, 2002 as a result of the unrealized gains on bonds available for sale, net of tax. The increase in Retained deficit of $12,088,861 is attributable to the net loss of $8,761,087, the accretion of discount on the Series A and Series B Preferred Stock of $2,657,000 and the accrual of dividends on the Series B and Series C Preferred Stock of $670,774. The Company is not aware of any current recommendations by regulatory authorities, which if implemented, would have a material effect on the Company's liquidity, capital resources or results of operations. The Company's statutory 39 capital exceeds the benchmark capital level under the Risk Based Capital formula for its insurance companies that are subject to Risk Based Capital requirements. Risk Based Capital is a method for establishing the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. The tragic events of September 11, 2001 did not impact the Company's financial results for 2001 and 2002. OFF-BALANCE SHEET TRANSACTIONS AND RELATED MATTERS There are no off-balance sheet transactions, arrangements, obligations (including contingent obligations), or other relationships of the Company with unconsolidated entities or other persons that have, or may have, a material effect on financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources of the Company. SHAREHOLDERS' EQUITY ASSUMING REDEMPTION OF PREFERRED STOCK At December 31, 2002, total assets less total liabilities of the Company was $42,605,214 and there were outstanding three series of preferred stock with an aggregate liquidation value of $38,752,118 ($37,620,000 stated value plus accrued dividends of $1,132,118). Based on the forgoing, the Shareholders' Equity assuming the redemption of all series of the Preferred Stock at December 31, 2002, would be $3,853,096 ($0.18 per common share). The amount ultimately available to the shareholders would vary with changes in the assets and liabilities of the Company. FORWARD LOOKING STATEMENTS Statements made in this report that are not strictly historical may be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that important factors, representing certain risks and uncertainties, could cause actual results to differ materially from those contained in the forward-looking statements. These factors include, but are not limited to, (a) the Company's ability to effect the successful exit from unprofitable lines and businesses that the Company believes cannot be counted on to produce future profit, (b) heightened competition from existing competitors and new competitor entrants into the Company's markets, (c) the extent to which market conditions firm up, the acceptance of higher prices in the market place and the Company's ability to realize and sustain higher rates, (d) contraction of the markets for the Company's business, (e) acceptability of the Company's A.M. Best rating to its end markets, (f) the Company's ability to meet its obligations under its capital and debt agreements, (g) the ongoing level of claims and claims-related expenses and the adequacy of claim reserves, (h) the effectiveness of investment strategies implemented by the Company's investment manager, (i) continued justification of recoverability of goodwill in the future, (j) the availability of reinsurance and the ability to collect reinsurance recoverables, (k) the Company's ability to invest in new endeavors that are successful, (l) the limitation on the Company's ability to use net operating loss carryforwards as a result of constraints caused by ownership changes within the meaning of Internal Revenue Code Section 382, (m) the ability of the Company to realize contingent acquisition payments in connection with its sale of the management contract controlling GCM, which in turn depends upon whether, or in what form, the Texas Legislature passes legislation that has been introduced in the current session of the Texas Legislature ending June 2, 2003 which could prejudice the rights of the Company to receive any of the future payments from Liberty, and (n) general economic conditions, including fluctuations in interest rates. A forward-looking statement is relevant as of the date the statement is made. The commencement of hostilities involving Iraq could produce economic and other reactions that could adversely affect the Company and its ability to effect changes discussed elsewhere in this report. The Company undertakes no obligation to update any forward-looking statements to reflect events or circumstances arising after the date on which the statements are made. 40 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is the risk of economic losses due to adverse changes in the estimated fair value of a financial instrument as the result of changes in equity prices, interest rates, foreign exchange rates and commodity prices. The Company's consolidated balance sheets include assets whose estimated fair values are subject to market risk. The primary market risk to the Company is interest rate risk associated with investments in fixed maturities. The Company has no foreign exchange, commodity or equity risk. INTEREST RATE RISK The Company's fixed maturity investments are subject to interest rate risk. Increases and decreases in interest rates typically result in decreases and increases in the fair value of these investments. Most of the Company's investable assets are in the portfolios of the insurance company subsidiaries and come from premiums paid by policyholders. These funds are invested predominately in high quality fixed maturities with relatively short durations and short term investments. The fixed maturity portfolio had an average duration of 2.6 years at December 31, 2002. The fixed maturity portfolio is exposed to interest rate fluctuations; as interest rates rise, fair values decline and as interest rates fall, fair values rise. The changes in the fair value of the fixed maturity portfolio are presented as a component of shareholders' equity in accumulated other comprehensive income, net of taxes. The effective duration of the fixed maturity portfolio is managed with consideration given to the estimated duration of the Company's liabilities. The Company has investment policies that limit the maximum duration and maturity of the fixed maturity portfolio. The Company utilizes the modified duration method to estimate the effect of interest rate risk on the fair values of its fixed maturity portfolio. The usefulness of this method is to a degree limited, as it is unable to accurately incorporate the full complexity of market interactions. 41 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, 2002. The selected hypothetical changes do not indicate what could be the potential best or worst case scenarios (dollars in thousands):
Hypothetical Percentage Increase (Decrease) Estimated Fair Value in Shareholders' Estimated Fair Estimated Change in After Hypothetical Hypothetical Percentage Equity Assuming Value at Interest Rates Change in Increase (Decrease) in Redemption of December 31, 2002 (BP=basis points) Interest Rates Shareholders' Equity Preferred Stock ----------------- ------------------- -------------------- ----------------------- --------------- U.S. Government $ 24,947 200 BP Decrease $ 25,596 4.56 16.85 securities 100 BP Decrease $ 25,271 2.27 8.41 100 BP Increase $ 24,623 (2.27) (8.41) 200 BP Increase $ 24,298 (4.56) (16.85) Obligation of $ 480 200 BP Decrease $ 486 .04 .16 municipalities 100 BP Decrease $ 483 .02 .08 100 BP Increase $ 477 (.02) (.08) 200 BP Increase $ 474 (.04) (.16) Corporate bonds and $ 37,876 200 BP Decrease $ 40,452 18.08 66.86 Certificates of 100 BP Decrease $ 39,164 9.04 33.43 Deposit 100 BP Increase $ 36,588 (9.04) (33.43) 200 BP Increase $ 35,300 (18.08) (66.86) Short-term investments $ 51,671 200 BP Decrease $ 51,671 -- -- 100 BP Decrease $ 51,671 -- -- 100 BP Increase $ 51,671 -- -- 200 BP Increase $ 51,671 -- -- Total investments $ 114,974 200 BP Decrease $ 118,204 22.42 83.84 100 BP Decrease $ 116,589 11.21 41.92 100 BP Increase $ 113,359 (11.21) (41.92) 200 BP Increase $ 111,744 (22.42) (83.84)
42 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated Financial Statements are on pages 53 through 95
Page ---- Report of Management 53 Independent Auditors' Report 54 Consolidated Balance Sheets as of December 31, 2002 and 2001 55-56 Consolidated Statements of Operations for the Years Ended December 31, 2002, 2001, and 2000 57-58 Consolidated Statements of Shareholders' Equity and Comprehensive Loss for the Years Ended December 31, 2002, 2001 and 2000 59-60 Consolidated Statements of Cash Flows for the Years Ended December 31, 2002, 2001, and 2000 61-62 Notes to Consolidated Financial Statements December 31, 2002, 2001, and 2000 63-95
The following Consolidated Financial Statements Schedules are on pages 96 through 107
Schedule Page -------- ---- Independent Auditors' Report on Supplementary Information 96 I Summary of Investments 97 II Condensed Financial Information of the Registrant 98-104 III Supplementary Insurance Information 105 IV Reinsurance 106 VI Supplemental Information 107
ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None. 43 PART III The information required by this Part III will be supplied by a Schedule 14A filing or an amendment to this Report. PART IV ITEM 14: CONTROLS AND PROCEDURES Disclosure Controls. The Company maintains a set of disclosure controls and procedures designed to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934 is recorded processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. Within the 90-day period prior to the filing of this annual report, an evaluation was carried out under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. Based on that evaluation, Glenn W. Anderson, the President and Chief Executive Officer of the Company, and Daniel J. Coots, the Senior Vice President, Chief Financial Officer and Chief Accounting Officer of the Company, have concluded that the Company's disclosure controls and procedures are effective. Changes in Internal Controls. Since the date of the evaluation described above, there have not been any significant changes in the Company's internal controls or in other factors that could significantly affect those controls, including any corrective actions with regard to significant deficiencies and material weaknesses. ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORMS 8-K (a) Documents filed as part of the report: 1. The following financial statements filed under Part II, Item 8: Independent Auditors' Report Consolidated Balance Sheets as of December 31, 2002 and 2001 Consolidated Statements of Operations for the Years Ended December 31, 2002, 2001 and 2000 Consolidated Statements of Shareholders' Equity and Comprehensive Loss for the Years Ended December 31, 2002, 2001 and 2000 Consolidated Statements of Cash Flows for the Years Ended December 31, 2002, 2001 and 2000 Notes to Consolidated Financial Statements, December 31, 2002, 2001 and 2000 2. The following Consolidated Financial Statement Schedules are filed under Part II, Item 8:
Schedule Description -------- ----------- I Summary of Investments II Condensed Financial Information of the Registrant III Supplementary Insurance Information IV Reinsurance VI Supplemental Information
44 3. The following Exhibits:
Exhibit No. ----------- *3.1 Restated Articles of Incorporation of Registrant as filed with the Secretary of State of Texas on July 24, 1986 [Exhibit 3.1, filed in Registration Statement No. 33-7846 on Form S-1, effective November 6, 1986]. *3.2 Articles of Amendment to the Articles of Incorporation as filed with the Secretary of State of Texas on June 10, 1988 [Exhibit 3.2, filed in Registration Statement No. 33-25226 on Form S-1, effective November 14, 1988]. *3.3 Articles of Amendment to Articles of Incorporation as filed with the Secretary of State of Texas on August 13, 1993 [Exhibit 3.6, Form 10-K dated March 25, 1994]. *3.4 Statement of Resolution Establishing and Designating Series A Convertible Preferred Stock of Registrant as filed with the Secretary of State of the State of Texas on October 1, 1999 [Exhibit 99.18, Form 8-K dated June 29, 1999]. *3.5 Bylaws of Registrant as amended through September 6, 2001. [Exhibit 3.5, Form 8-K dated August 31, 2001]. *3.6 Statement of Resolution Establishing and Designating Series B Convertible Redeemable Preferred Stock of Registrant as filed with the Secretary of State of the State of Texas on March 22, 2001. [Exhibit 99.19, Form 8-K/A dated March 30, 2001]. *3.7 Statement of Resolution Establishing and Designating Series C Redeemable Preferred Stock of Registrant as filed with the Secretary of State of the State of Texas on March 22, 2001. [Exhibit 99.20, Form 8-K/A dated March 30, 2001]. *4.1 Rights Agreement, dated as of March 3, 1988, between the Registrant and Team Bank/Fort Worth, N.A. [Exhibit 1, Form 8-K dated March 14, 1988]. *4.2 Amendment No. 1 dated as of March 5, 1990 to Rights Agreement dated as of March 3, 1988 between Registrant and Team Bank as Rights Agent [Exhibit 4.2, Form 10-K dated March 27, 1992]. *4.3 Amendment No. 2 dated as of May 25, 1993 to Rights Agreement between Registrant and Society National Bank (successor to Team Bank (formerly Texas American Bank/Fort Worth, N.A.)), as Rights Agent [Exhibit 4.4, Form 10-K dated March 25, 1994]. *4.4 Amendment No. 3 to Rights Agreement and appointment of Continental Stock Transfer & Trust Company as Successor Rights Agent, dated September 30, 1994 [Exhibit 10.29, Form 10-K dated March 30, 1995]. *4.5 Amendment No. 4 dated June 29, 1999 to Rights Agreement between Registrant and Continental Stock Transfer & Trust Company [Exhibit 99.21, Form 8-K dated June 29, 1999]. *4.6 Form of Common Stock Certificate [Exhibit 4.6, Form 10-K dated March 28, 1997]. *4.7 Agreement dated August 26, 1994 appointing Continental Stock Transfer & Trust Company transfer agent and registrar [Exhibit 10.28, Form 10-K dated March 30, 1995].
45 *10.1 1990 Stock Option Plan of the Registrant [Exhibit 10.16, Form 10-K dated March 22, 1991]. *10.2 1995 Stock Option Plan of the Registrant [Exhibit 10.31, Form 10-K dated March 28, 1996]. *10.3 1998 Long Term Incentive Plan of the Registrant [Exhibit 99.8, Form 10-Q dated August 10, 1998]. *10.4 Forms of Change of Control Agreements [Exhibit 10.4, Form 10-K dated March 29, 2002]. *10.5 Employment Agreement dated April 25, 1998 between Glenn W. Anderson and the Registrant [Exhibit 99.5, Form 10-Q/A dated June 16, 1998]. *10.6 Change of Control Agreement for Glenn W. Anderson [Exhibit 99.7, Form 10-Q/A dated June 16, 1998]. *10.7 Replacement Non-Qualified Stock Option Agreement dated July 24, 1998 between Glenn W. Anderson and the Registrant [Exhibit 99.6, Form 10-Q dated August 10, 1998]. *10.8 Management Contract between GAINSCO County Mutual Insurance Company and GAINSCO Service Corp. and related Surplus Debenture, Amendment to Surplus Debenture, Certificate of Authority and accompanying Commissioner's Order granting Certificate Authority, allowing for charter amendments and extension of charter [Exhibits 10.23, 10.24 and 10.25, Form 10-K dated March 29, 1993; Exhibit 10.27, Form 10-K dated March 25, 1994]. *10.9 Revolving Credit Agreement dated November 13, 1998 among Registrant, GAINSCO Service Corp. and Bank One, Texas, N.A., First Amendment thereto dated October 4, 1999 and related Promissory Note, Security Agreement and Pledge Agreement, Amendment No. 2 thereto dated March 23, 2001, Amendment No.3 thereto dated November 13, 2001, and Amendment No. 4 thereto dated February 27, 2002. [Exhibits 10.50 to 10.53, Form 10-K/A dated March 30, 1999; Exhibit 99.22, Form 8-K dated October 4, 1999; Exhibit 99.24, Form 8-K/A dated March 30, 2001, Exhibit 10.23, Form 10-Q dated November 13, 2001, Exhibit 10.9, Form 8-K dated February 27, 2002]. *10.10 Securities Purchase Agreement dated as of June 29, 1999 between Registrant and Goff Moore Strategic Partners, L.P. ("GMSP") and related Series A Common Stock Purchase Warrant and Series B Common Stock Purchase Warrant [Exhibit 2.1, Form 8-K dated June 29, 1999; Exhibits 99.19 and 99.20, Form 8-K dated October 4, 1999]. *10.11 Investment Management Agreements dated October 4, 1999 between GMSP and each of Registrant, General Agents Insurance Company of America, Inc., MGA Insurance Company, Inc. and GAINSCO County Mutual Insurance Company; and Investment Management Agreement dated January 6, 2000 between GMSP and Midwest Casualty Insurance Company. [Exhibit 10.11, Form 10-K dated March 30, 2000].
46 *10.12 Stock Purchase Agreements dated August 17, 1998 with Carlos de la Torre, McRae B. Johnston, Michael S. Johnston and Ralph Mayoral relating to acquisition by Registrant of Lalande Group and related employment agreements with them [Exhibits 99.6 to 99.13, Form 8-K dated August 26, 1998]. *10.13 Asset Purchase Agreement dated March 9, 1999 between the Registrant, Agents Processing Systems, Inc. and Insurance Business Solutions Incorporated [Exhibit 10.49, Form 10-K dated March 30, 1999]. *10.14 Stock Purchase Agreement dated as of November 17, 1999 among Registrant, Tri-State, Ltd., Herbert A. Hill and Alan E. Heidt and related Pledge Agreement dated as of January 7, 2000 executed by the Registrant in favor of Bank One, NA and Unlimited Guaranty dated as of January 7, 2000 executed by Tri-State, Ltd. in favor of Bank One, N.A. [Exhibit 10.14, Form 10-K dated March 30, 2000]. *10.15 Agreement of Limited Partnership of GNA Investments I, L.P. dated as of November 30, 1999 between Registrant and GMSP [Exhibit 10.15, Form 10-K dated March 30, 2000]. *10.16 Professional Service Agreement dated as of October 22, 1999 between Registrant and ClientSoft, Inc. [Exhibit 10.16, Form 10-K dated March 30, 2000]. *10.17 First Amendment to Stock Purchase Agreement dated May 16, 2000 among Registrant, Tri-State, Ltd., Herbert A. Hill and Alan E. Heidt [Exhibit 10.14, Form 10-Q dated August 11, 2000]. *10.18 GAINSCO, INC. 401(k) Plan and related Adoption Agreement [Exhibit 99.1 to Registration Statement on Form S-8, effective April 12, 2000]. *10.19 Securities Purchase Agreement dated as of February 26, 2001 between Registrant and GMSP (including exhibits) and related First Amendment to Securities Purchase Agreement, letter regarding redemption of Registrant's outstanding Series A Convertible Preferred Stock, First Amendment to Series A Common Stock Purchase Warrant, and First Amendment to Series B Common Stock Purchase Warrant [Exhibit 2.1, Form 8-K dated March 2, 2001; Exhibits 2.2, 2.8, 99.21 and 99.22, Form 8-K/A dated March 30, 2001]. *10.20 Securities Purchase Agreement dated as of February 26, 2001 between Registrant and Robert W. Stallings ("Stallings") (including exhibits) and related First Amendment to Securities Purchase Agreement, Assignment and Assumption Agreement between Stallings and ING Pilgrim Capital Corporation, LLC, Amendment to Assignment and Assumption Agreement, letter dated March 23, 2001 from Stallings to Registrant, and Common Stock Purchase Warrant [Exhibit 2.2, Form 8-K dated March 2, 2001; Exhibits 2.4 to 2.7 and 99.23, Form 8-K/A dated March 30, 2001]. *10.21 Consulting Agreement dated as of February 26, 2001 between Registrant and Stallings [Exhibit 99.15, Form 8-K dated March 2, 2001]. *10.22 Agreement dated March 23, 2001 among Registrant, GAINSCO Service Corp., GMSP, Stallings and Bank One, N.A. [Exhibit 99.25, Form 8-K/A dated March 30, 2001].
47 *10.23 Letter agreement dated February 27, 2002 between the Registrant and GMSP pursuant to which the Registrant exercised its right to put certain illiquid investments to GMSP for $2,087,354.27 pursuant to Section 6.9 of the Securities Purchase Agreement dated February 26, 2001 between the Registrant and GMSP, as amended [Exhibit 10.24, Form 8-K/A dated February 27, 2002]. *10.24 Agreement of Sale and Purchase dated March 7, 2002 between General Agents Insurance Company of America, Inc. and Turonian Corp. [Exhibit 10.24, Form 10-K dated March 29, 2002]. *10.25 First Amendment to Investment Management Agreements dated August 9, 2002 among Goff Moore Strategic Partners, L.P., the Registrant, General Agents Insurance Company of America, Inc., MGA Insurance Company, Inc., GAINSCO County Mutual Insurance Company and Midwest Casualty Insurance Company [Exhibit 10.25, Form 10-Q dated August 14, 2002]. *10.26 Acquisition Agreement dated August 12, 2002 among the Registrant, GAINSCO Service Corp., GAINSCO County Mutual Insurance Company, Berkeley Management Corporation and Liberty Mutual Insurance Company [Exhibit 10.26, Form 10-Q dated August 14, 2002]. *10.27 Commercial Lease Agreement dated July 31, 2002 between JaGee Real Properties, L.P. and General Agents Insurance Company of America, Inc. [Exhibit 10.27, Form 10-Q dated August 14, 2002]. *10.28 Form of Executive Severance Agreement between GAINSCO Service Corp. and each of Richard M. Buxton, Richard A. Laabs and Daniel J. Coots [Exhibit 10.28, Form 10-Q dated August 14, 2002]. *10.29 Representative Forms of Retention Incentive Agreement [Exhibit 10.30, Form 10-Q dated August 14, 2002]. *10.30 Acquisition Agreement dated August 12, 2002 among the Registrant, GAINSCO Service Corp., Berkeley Management Corporation, Liberty Mutual Insurance Company, and GAINSCO County Mutual Insurance Company and Amendment to Acquisition Agreement dated December 2, 2002 among the Registrant, GAINSCO Service Corp., Berkeley Management Corporation, Liberty Mutual Insurance Company, and GAINSCO County Mutual Insurance Company [Exhibit 10.26, Form 10-Q dated August 14, 2002 and Exhibit 10.32, Form 8-K filed December 5, 2002]. *10.31 Office Lease dated August 19, 2002 between Crescent Real Estate Funding X, L.P. and the Registrant [Exhibit 10.31, Form 10-Q dated November 14, 2002]. *10.32 Separation Agreement and Release dated December 17, 2002 between McRae B. Johnston and MGA Insurance Company, Inc.; Separation Agreement and Release dated December 17, 2002 among McRae B. Johnston, Registrant, National Specialty Lines, Inc., Lalande Financial Group, Inc., DLT Insurance Adjustors, Inc. and Midwest Casualty Insurance Company; Consulting Agreement dated December 17, 2002 between McRae B. Johnston and MGA Insurance Company, Inc.; and Form of Separation Agreement and Release entered into as of March 1, 2003 between McRae B. Johnston and MGA Insurance Company, Inc. [Exhibit 10.33, Form 8-K filed December 17, 2002; Exhibit 10.34, Form 8-K filed December 17, 2002; Exhibit 10.35, Form 8-K filed December 17, 2002; and Exhibit 10.36, Form 8-K filed December 17, 2002].
48 11 Statement regarding Computation of Per Share Earnings (the required information is included in Note 1(m) of Notes to Consolidated Financial Statements included in this Report and no separate statement is, or is required to be, filed as an exhibit). +21 Subsidiaries of Registrant. +23 Consent of KPMG LLP to incorporation by reference. +24 Form of Power of Attorney. +99.1 Certificate of Chief Executive Officer +99.2 Certificate of Chief Financial Officer
---------- * Exhibit has previously been filed with the Commission as an exhibit in the filing designated in brackets and is incorporated herein by this reference. Registrant's file number for reports filed under the Securities Exchange Act of 1934 is 1-9828. + Filed herewith (see Exhibit Index). ---------- (b) Reports on Form 8-K A Report on Form 8-K was filed December 5, 2002 reporting the completion of the sale of the management contract controlling GAINSCO County Mutual Insurance Company. No financial statements were filed with the Report. A Report on Form 8-K was filed December 20, 2002 reporting the resignation of McRae B. Johnston as the President - Personal Lines Division of the Registrant, payments made to Mr. Johnston in connection with mutual releases entered into between Mr. Johnston and the Registrant and a new consulting agreement between Mr. Johnston and the Registrant. No financial statements were filed with the Report. (c) Exhibits required by Item 601 of Regulation S-K. The exhibits listed in Item 14(a) 3 of this Report, and not incorporated by reference to a separate file, are filed herewith. 49 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. GAINSCO, INC. (Registrant) /s/ Glenn W. Anderson ------------------------------------------ By: Glenn W. Anderson, President Date: March 28, 2003 ------------------------------------ Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Name Title Date ---- ----- ---- Robert W. Stallings* Chairman of the Board March 28, 2003 --------------------------- -------------------------- Robert W. Stallings Joel C. Puckett* Vice Chairman of the Board March 28, 2003 --------------------------- -------------------------- Joel C. Puckett /s/ Glenn W. Anderson President, Chief Executive March 28, 2003 --------------------------- Officer and Director -------------------------- Glenn W. Anderson /s/ Daniel J. Coots Senior Vice President March 28, 2003 --------------------------- Chief Financial Officer and -------------------------- Daniel J. Coots Chief Accounting Officer Sam Rosen* Secretary and Director March 28, 2003 --------------------------- -------------------------- Sam Rosen Hugh M. Balloch* Director March 28, 2003 --------------------------- -------------------------- Hugh M. Balloch John C. Goff* Director March 28, 2003 --------------------------- -------------------------- John C. Goff Harden H. Wiedemann* Director March 28, 2003 --------------------------- -------------------------- Harden H. Wiedemann John H. Williams* Director March 28, 2003 --------------------------- -------------------------- John H. Williams
*By: /s/ Daniel J. Coots --------------------------------------- Daniel J. Coots, Attorney in-fact under Power of Attorney 50 CERTIFICATION I, Glenn W. Anderson, certify that: 1. I have reviewed this annual report on Form 10-K of GAINSCO, INC.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 28, 2003 Signature: /s/ Glenn W. Anderson --------------------------- Glenn W. Anderson President & Chief Executive Officer 51 CERTIFICATION I, Daniel J. Coots, certify that: 1. I have reviewed this annual report on Form 10-K of GAINSCO, INC.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 28, 2003 Signature: /s/ Daniel J. Coots -------------------------------- Daniel J. Coots Senior Vice President, Chief Financial Officer and Chief Accounting Officer 52 REPORT OF MANAGEMENT The accompanying consolidated financial statements were prepared by the Company, which is responsible for their integrity and objectivity. The statements have been prepared in conformity with accounting principles generally accepted in the United States of America and include some amounts that are based upon the Company's best estimates and judgment. Financial information presented elsewhere in this report is consistent with the accompanying consolidated financial statements. The accounting systems and controls of the Company are designed to provide reasonable assurance that transactions are executed in accordance with management's criteria, that the financial records are reliable for preparing financial statements and maintaining accountability for assets, and that assets are safeguarded against claims from unauthorized use or disposition. The Company's consolidated financial statements have been audited by KPMG LLP, independent auditors. The auditors have full access to each member of management in conducting their audits. The Audit Committee of the Board of Directors, comprised solely of directors from outside of the Company, meets regularly with management and the independent auditors to review the work and procedures of each. The auditors have free access to the Audit Committee, without management being present, to discuss the results of their work as well as the adequacy of the Company's accounting controls and the quality of the Company's financial reporting. The Board of Directors, upon recommendation of the Audit Committee, appoints the independent auditors, subject to shareholder approval. Date: March 28, 2003 /s/ Glenn W. Anderson ------------------------------------- Glenn W. Anderson President and Chief Executive Officer /s/ Daniel J. Coots ------------------------------------- Daniel J. Coots Senior Vice President Chief Financial Officer, and Chief Accounting Officer 53 INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders GAINSCO, INC.: We have audited the accompanying consolidated balance sheets of GAINSCO, INC. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of operations, shareholders' equity and comprehensive loss and cash flows for each of the years in the three-year period ended December 31, 2002. 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 auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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 GAINSCO, INC. and subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. We have also previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheets of GAINSCO, INC. and subsidiaries as of December 31, 2000, 1999, and 1998, and the related consolidated statements of operations, shareholders' equity and comprehensive loss, and cash flows for the years ended December 31, 1999 and 1998 and we expressed unqualified opinions on those consolidated financial statements. In our opinion, the information set forth in the selected consolidated financial data for each of the years in the five-year period ended December 31, 2002, appearing under Item 6 in the Company's 2002 Form 10-K, is fairly presented, in all material respects, in relation to the consolidated financial statements from which it has been derived. As discussed in 1(h) to the consolidated financial statements, effective January 1, 2002, GAINSCO, INC. and subsidiaries adopted the provisions of Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets." Also, as discussed in note 1(c) to the consolidated financial statements, GAINSCO, INC. and subsidiaries changed its method of accounting for residual interests in securitizations in 2001 as a result of the adoption of EITF 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets." /s/ KPMG LLP ---------------------------- KPMG LLP Dallas, Texas March 24, 2003 54 GAINSCO, INC. AND SUBSIDIARIES Consolidated Balance Sheets December 31, 2002 and 2001
Assets 2002 2001 ------------ ------------ Investments (note 2): Fixed maturities: Bonds available for sale, at fair value (amortized cost: $59,019,871 - 2002, $127,369,239 - 2001) $ 62,657,328 132,794,306 Certificates of deposit, at cost (which approximates fair value) 645,000 645,000 Other investments, at fair value (cost: $0 - 2002, $2,110,467 - 2001) -- 2,111,712 Short-term investments, at cost (which approximates fair value) 51,671,557 45,126,581 ------------ ------------ Total investments 114,973,885 180,677,599 Cash 2,512,454 3,567,717 Accrued investment income 714,760 2,078,582 Premiums receivable (net of allowance for doubtful accounts: $275,000 - 2002 and $200,000 -- 2001) 3,684,195 21,241,819 Reinsurance balances receivable (net of allowance for doubtful accounts: $1,001,461 - 2002, $2,653,597 - 2001) (note 5) 31,622,971 62,303,215 Ceded unpaid claims and claim adjustment expenses (notes 1 and 5) 46,802,114 65,570,973 Ceded unearned premiums (note 5) 178,572 21,822,265 Deferred policy acquisition costs (note 1) 1,674,346 3,188,226 Property and equipment (net of accumulated depreciation and amortization: $5,074,441 - 2002, $9,851,888 - 2001) (note 1) 913,526 6,224,872 Current Federal income taxes (note 1) 1,055,753 1,043,814 Deferred Federal income taxes (net of valuation allowance: $31,972,504 - 2002, $31,534,712 - 2001) (notes 1 and 6) -- -- Management contract -- 1,537,571 Other assets 9,647,641 6,492,486 Goodwill (note 1) 609,000 3,468,507 ------------ ------------ Total assets $214,389,217 379,217,646 ============ ============
(continued) See accompanying notes to consolidated financial statements 55 GAINSCO, INC. AND SUBSIDIARIES Consolidated Balance Sheets December 31, 2002 and 2001
Liabilities and Shareholders' Equity 2002 2001 -------------- -------------- Liabilities: Unpaid claims and claim adjustment expenses $ 143,270,964 181,058,706 Unearned premiums (notes 1 and 5) 8,580,082 47,973,720 Commissions payable 6,110,340 6,498,442 Accounts payable 2,631,066 8,573,166 Reinsurance balances payable (note 5) -- 7,774,187 Deferred revenue 4,451,261 9,066,824 Drafts payable 1,631,846 7,017,595 Note payable (note 4) 3,700,000 10,800,000 Funds held under reinsurance agreements (note 5) -- 47,783,905 Deferred Federal income taxes (note 1) 1,236,736 -- Other liabilities 171,708 124,828 -------------- -------------- Total liabilities 171,784,003 326,671,373 -------------- -------------- Redeemable convertible preferred stock - Series A ($1,000 stated value, 31,620 shares authorized, 31,620 issued at December 31, 2002 and December 31, 2001), liquidation value of $31,620,000 (note 7) 21,343,000 18,722,000 Redeemable convertible preferred stock - Series B ($1,000 stated value, 3,000 shares authorized, 3,000 issued at December 31, 2002 and December 31, 2000), at liquidation value (note 7) 3,449,057 3,077,672 Redeemable preferred stock - Series C ($1,000 stated value, 3,000 shares authorized, 3,000 issued at December 31, 2002 and December 31, 2000), at liquidation value (note 7) 3,566,057 3,230,672 -------------- -------------- 28,358,114 25,030,344 -------------- -------------- Shareholders' Equity (notes 7 and 8): Common stock ($.10 par value, 250,000,000 shares authorized, 22,013,830 issued at December 31, 2002 and December 31, 2001) 2,201,383 2,201,383 Common stock warrants 540,000 540,000 Additional paid-in capital 100,866,124 100,866,124 Accumulated other comprehensive income (notes 2 and 3) 2,400,722 3,580,690 Retained deficit (84,066,604) (71,977,743) Treasury stock, at cost (844,094 shares at December 31, 2002 and December 31, 2001) (note 1) (7,694,525) (7,694,525) -------------- -------------- Total shareholders' equity 14,247,100 27,515,929 -------------- -------------- Commitments and contingencies (notes 5, 8, 9 and 11) Total liabilities and shareholders' equity $ 214,389,217 379,217,646 ============== ==============
See accompanying notes to consolidated financial statements. 56 GAINSCO, INC. AND SUBSIDIARIES Consolidated Statements of Operations Years ended December 31, 2002, 2001 and 2000
2002 2001 2000 ------------ ------------ ------------ Revenues: Net premiums earned (note 5) $ 60,267,023 68,727,021 151,455,505 Net investment income (note 2) 4,314,933 8,090,798 14,092,914 Net realized gains (losses) (note 1) 2,048,848 4,275,192 (1,906,911) Insurance services 4,284,277 326,694 1,054,137 ------------ ------------ ------------ Total revenues 70,915,081 81,419,705 164,695,645 ------------ ------------ ------------ Expenses: Claims and claims adjustment expenses (notes 1 and 5) 56,413,645 87,425,982 143,439,078 Commissions 9,099,541 15,305,110 20,687,486 Change in deferred policy acquisition costs and deferred ceding commission income (note 1) 1,513,880 (886,282) 12,638,482 Interest expense 310,095 842,368 1,409,378 Amortization of goodwill -- 881,965 963,700 Underwriting and operating expenses 10,255,110 18,485,524 16,506,906 Goodwill impairment 2,859,507 18,446,886 -- ------------ ------------ ------------ Total expenses 80,451,778 140,501,553 195,645,030 ------------ ------------ ------------ Loss before Federal income taxes and cumulative effect of change in accounting principle (9,536,697) (59,081,848) (30,949,385) Federal income taxes (note 6): Current benefit (2,619,735) (51,014) (1,110,714) Deferred expense (benefit) 1,844,125 16,086,659 (10,287,306) ------------ ------------ ------------ Total taxes (775,610) 16,035,645 (11,398,020) ------------ ------------ ------------ Loss before cumulative effect of change in accounting principle (8,761,087) (75,117,493) (19,551,365) ------------ ------------ ------------ Cumulative effect of change in accounting principle, net of tax (note 1) -- (489,554) -- ------------ ------------ ------------ Net loss $ (8,761,087) (75,607,047) (19,551,365) ============ ============ ============ Loss per common share, basic (notes 1 and 7): Loss before cumulative effect of change in accounting principle, per common share $ (.57) (3.66) (.97) Cumulative effect of change in accounting principle, net of tax, per common share -- (.02) -- ------------ ------------ ------------ Net loss per common share, basic $ (.57) (3.68) (.97) ============ ============ ============
(continued) 57 GAINSCO, INC. AND SUBSIDIARIES Consolidated Statements of Operations Years ended December 31, 2002, 2001 and 2000
2002 2001 2000 ---------- ---------- ---------- Loss per common share, diluted (notes 1 and 7): Loss before cumulative effect of change in accounting principle, per common share $ (.57) (3.66) (.97) Cumulative effect of change in accounting principle, net of tax, per common share -- (.02) -- ---------- ---------- ---------- Net loss per common share, diluted $ (.57) (3.68) (.97) ========== ========== ==========
See accompanying notes to consolidated financial statements 58 GAINSCO, INC. AND SUBSIDIARIES Consolidated Statements of Shareholders' Equity and Comprehensive Loss Years ended December 31, 2002, 2001 and 2000
2002 2001 2000 ------------ ------------ ------------ Preferred stock: Balance at beginning of year $ -- 3,162,000 3,162,000 Conversion of shares to redeemable preferred stock (31,620 - 2001) -- (3,162,000) -- ------------ ------------ ------------ Balance at end of year -- -- 3,162,000 ------------ ------------ ------------ Common stock: Balance at beginning of year 2,201,383 2,201,383 2,176,393 Exercise of options to purchase shares (249,903 - 2000) -- -- 24,990 ------------ ------------ ------------ Balance at end of year 2,201,383 2,201,383 2,201,383 ------------ ------------ ------------ Common stock warrants: Balance at beginning of year 540,000 2,040,000 2,040,000 Repricing of Series A and Series B warrants -- (1,680,000) -- Issuance of warrants in connection with preferred stock -- 180,000 -- ------------ ------------ ------------ Balance at end of year 540,000 540,000 2,040,000 ------------ ------------ ------------ Additional paid-in capital: Balance at beginning of year 100,866,124 113,540,252 112,674,842 Exercise of options to purchase shares (249,903 - 2000) -- -- 519,246 Conversion of shares to redeemable preferred stock (31,620 - 2001) -- (12,761,278) -- Accretion of discount on preferred shares -- 87,150 346,164 ------------ ------------ ------------ Balance at end of year $100,866,124 100,866,124 113,540,252 ------------ ------------ ------------
(continued) 59 GAINSCO, INC. AND SUBSIDIARIES Consolidated Statements of Shareholders' Equity and Comprehensive Loss Years ended December 31, 2002, 2001 and 2000
2002 2001 2000 ---------------------------- ---------------------------- ---------------------------- Retained (deficit) earnings: Balance at beginning of year $(71,977,743) 5,957,798 27,586,440 Net loss for year (8,761,087) (8,761,087) (75,607,047) (75,607,047) (19,551,365) (19,551,365) Cash dividend - common (note 7) -- -- (1,474,206) Cash dividend - preferred (note 7) -- -- (434,000) Accrued dividends - redeemable preferred stock (note 7) (670,774) (461,344) -- Accretion of discount on preferred shares -- (87,150) (346,164) Accretion of discount on redeemable preferred shares (2,657,000) (1,780,000) -- Tax benefit on non-qualified stock options exercised -- -- 177,093 Balance at end of year (84,066,604) (71,977,743) 5,957,798 ------------ ------------ ------------ Accumulated other comprehensive income (loss): Balance at beginning of year 3,580,690 3,897,371 (2,246,575) Unrealized (losses) gains on securities, net of reclassification adjustment, net of tax (note 3) (1,179,968) (1,179,968) (316,681) (316,681) 6,143,946 6,143,946 ------------ ------------ ------------ ------------ ------------ ------------ Comprehensive loss (9,941,055) (75,923,728) (13,407,419) ============ ============ ============ Balance at end of year 2,400,722 3,580,690 3,897,371 ------------ ------------ ------------ Treasury stock: Balance at beginning and at end of year (7,694,525) (7,694,525) (7,694,525) ------------ ------------ ------------ Total shareholders' equity at end of year $ 14,247,100 27,515,929 123,104,279 ============ ============ ============
See accompanying notes to consolidated financial statements. 60 GAINSCO, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Years ended December 31, 2002, 2001 and 2000
2002 2001 2000 ------------ ------------ ------------ Cash flows from operating activities: Net loss $ (8,761,087) (75,607,047) (19,551,365) Adjustments to reconcile net loss to cash (used for) provided by operating activities: Depreciation and amortization 622,496 1,848,981 2,734,855 Goodwill impairment 2,859,507 18,446,886 -- Impairment of other investments 2,010,670 2,176,231 -- Cumulative effect of change in accounting principle -- 489,554 -- Gain on sale of building (455,056) -- -- Deferred Federal income tax expense (benefit) 1,844,125 16,086,659 (10,287,306) Change in accrued investment income 1,363,822 1,372,346 307,007 Change in premiums receivable 17,557,624 3,518,337 558,442 Change in reinsurance balances receivable 30,680,244 (7,808,248) (50,365,554) Change in ceded unpaid claims and claim adjustment expenses 18,768,859 (27,867,939) 21,819 Change in ceded unearned premiums 21,643,693 24,172,393 (22,846,077) Change in deferred policy acquisition costs and deferred ceding commission income 1,513,880 (886,282) 12,638,482 Change in other assets (2,663,418) 432,256 (734,871) Change in unpaid claims and claim adjustment expenses (37,787,742) 16,899,187 29,836,469 Change in unearned premiums (39,393,638) (24,604,437) (9,786,141) Change in commissions payable (388,102) 4,436,611 355,072 Change in accounts payable (5,942,100) (664,171) 1,158,081 Change in reinsurance balances payable (7,774,187) (19,380,202) 19,254,839 Change in deferred revenue (4,615,563) 7,434,650 404,311 Change in drafts payable (5,385,749) (1,845,254) 4,656,535 Change in funds held under reinsurance agreements (47,783,905) (66,095) 47,850,000 Change in other liabilities 46,880 (120,555) (33,446) Change in current Federal income taxes (11,939) 151,485 (1,521,613) ------------ ------------ ------------ Net cash (used for) provided by operating activities $(62,050,686) (61,384,654) 4,649,539 ------------ ------------ ------------
(continued) 61 GAINSCO, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Years ended December 31, 2002, 2001 and 2000
2002 2001 2000 ------------ ------------ ------------ Cash flows from investing activities: Bonds available for sale: Sold $ 92,507,319 61,152,815 80,469,659 Matured 5,052,000 19,294,852 32,030,354 Purchased (31,084,498) (20,531,623) (98,744,876) Common stock purchased -- -- (6,027,392) Common stock sold -- 6,027,392 -- Other investments purchased -- -- (3,959,136) Other investments sold 2,111,712 382,868 690,016 Certificates of deposit matured 645,000 660,000 740,000 Certificates of deposit purchased (645,000) (460,000) (545,000) Net change in short-term investments (6,544,976) (4,795,577) 5,792,476 Sale of building 4,772,847 -- -- Sale of management contract 1,000,000 -- -- Property and equipment disposed (purchased) 281,019 622,347 (1,341,872) Net assets acquired through purchase of subsidiary (net of cash acquired of $662,422 - 2000) -- -- (8,488,225) Net assets disposed of through sale of subsidiary (net of cash acquired of $847,617 - 2001) -- (198,765) -- ------------ ------------ ------------ Net cash provided by investing activities 68,095,423 62,154,309 616,004 ------------ ------------ ------------ Cash flows from financing activities: Payments on note payable (7,100,000) (5,200,000) (2,000,000) Cash dividends paid -- (478,971) (1,903,832) Redeemable preferred stock and warrants issued (net of transaction fees) -- 5,365,722 -- Proceeds from exercise of common stock options -- -- 544,236 ------------ ------------ ------------ Net cash used for financing activities (7,100,000) (313,249) (3,359,596) ------------ ------------ ------------ Net (decrease) increase in cash (1,055,263) 456,406 1,905,947 Cash at beginning of year 3,567,717 3,111,311 1,205,364 ------------ ------------ ------------ Cash at end of year $ 2,512,454 3,567,717 3,111,311 ============ ============ ============
See accompanying notes to consolidated financial statements. 62 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 (1) SUMMARY OF ACCOUNTING POLICIES (a) Basis of Consolidation The accompanying consolidated financial statements include the accounts of GAINSCO, INC. ("GNAC") and its wholly-owned subsidiaries (collectively, the "Company"), General Agents Insurance Company of America, Inc. ("General Agents"), General Agents Premium Finance Company, Agents Processing Systems, Inc., Risk Retention Administrators, Inc., GAINSCO Service Corp. ("GSC"), Lalande Financial Group, Inc. ("Lalande"), National Specialty Lines, Inc. ("NSL"), DLT Insurance Adjusters, Inc. ("DLT") (Lalande, NSL and DLT collectively, the "Lalande Group") and Midwest Casualty Insurance Company ("MCIC"). On March 31, 2003 MCIC is to be liquidated and all of its assets, liabilities and equity are to be transferred to General Agents. General Agents has one wholly owned subsidiary, MGA Insurance Company, Inc. ("MGAI") which, in turn, owns 100% of MGA Agency, Inc. GSC has one wholly owned subsidiary, MGA Premium Finance Company. All significant intercompany accounts have been eliminated in consolidation. Prior to December 2, 2002, GSC owned the management contract controlling GAINSCO County Mutual Insurance Company ("GCM") and prior to that time its accounts were included in the accompanying consolidated financial statements. The management contract of GCM was sold on December 2, 2002 to an unaffiliated third party. Previously, while GCM was legally owned by its policyholders, it was controlled, through a management contract, by GSC. Inclusion of GCM's accounts in the Company's Consolidated Financial Statements was in accordance with the criteria under EITF 97-2. The term of the management contract was 25 years when the Company acquired it in the fourth quarter of 1992. It was only terminable by GCM for the Company's failure to comply with its obligations under the management contract. The Company had exclusive authority over all decision making related to all operations of GCM, and the operations were under the direction of the same officer group that managed the insurance subsidiaries of the Company. The management contract was unilaterally salable by the Company (subject to normal regulatory approvals), which was done on December 2, 2002. The Company had the right to receive the income of GCM through the management contract as ongoing fees and the proceeds from the sale of its interest in the management contract. Additionally, GCM's insurance business was pooled with all of the other insurance subsidiaries of the Company through an inter-company quota share reinsurance agreement. The accompanying consolidated financial statements are prepared on the basis of accounting principals generally accepted in the United States of America ("U.S. GAAP"). The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. (b) Nature of Operations On February 7, 2002, the Company announced its decision to discontinue writing commercial lines insurance business due to continued adverse claims development and unprofitable results. During 2001 the Company was predominately a property and casualty insurance company 63 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 concentrating its efforts on nonstandard markets within the commercial, personal and specialty insurance lines. Beginning in 2002 the Company became predominantly a property and casualty insurance company concentrating its efforts on nonstandard personal automobile markets. During 2002 the Company was approved to write insurance in 47 states and the District of Columbia on a non-admitted basis and in 44 states and the District of Columbia on an admitted basis. The Company previously marketed its commercial lines of insurance through 200 non-affiliated general agency offices and currently markets its nonstandard personal auto line through over 550 non-affiliated retail agencies. Approximately 70% of the Company's gross premiums written during 2002 resulted from risks located in Florida. On August 12, 2002, the Company announced its decision to put itself in a position to exit its remaining active insurance business, personal auto, in as orderly and productive a fashion as possible. In June 2002, the Company entered into a letter of intent to sell its Miami, Florida based operation, the Lalande Group, to an unaffiliated party. In September 2002 negotiations in respect of the possible transaction were terminated. In conjunction with this process, the Company evaluated the related goodwill and recorded an impairment of approximately $2.9 million during the second quarter 2002. The remaining goodwill as of December 31, 2002 is $609,000 and is related to the 1998 acquisition of the Lalande Group. Operationally, the Company implemented rate increases and other measures to enhance the profit potential of this business in 2003 and its future strategic direction, which could include the expansion, contraction or disposition of the business. The Company anticipates a lengthy period of transition as it lessens its exposure to the insurance industry. During the transition process, the Company may consider the sale of additional subsidiaries associated with that business. The Company intends to redeploy capital no longer required by its insurance business, once it becomes available, to pursue other opportunities in the future that offer a better prospect for profitability. The Company believes that suitable capital redeployment opportunities should be available after the capital no longer required by its insurance business becomes available, but cannot predict the amount of capital that will ultimately be available for redeployment, the timing or the nature of the opportunities that may be available at the time capital becomes available. The opportunities may be outside of the insurance business and could be in the financial services business. On December 2, 2002, the Company completed the sale and transfer of the management contract controlling GCM to an affiliate of Liberty Mutual Insurance Company ("Liberty"), for a purchase price of up to $10 million, of which $1 million was paid at closing and the balance is payable in contingent payments through September 2009. The $9 million total of future payments would be payable $3 million in September 2003 and $1 million each year thereafter through September 2009 and each payment is contingent on there being no materially adverse change in the regulatory treatment of GCM specifically, or county mutuals generally, from legislative or regulatory administrative actions prior to the applicable payment date. Legislation has been introduced in the current session of the Texas Legislature ending June 2, 2003 which, depending whether or in what form it is ultimately adopted, could prejudice the rights of the Company to receive some or all of the future payments from Liberty. Following the closing, the surplus of GCM, which was approximately $3,182,000, remained as a part of the combined statutory policyholders' surplus of the Company. Pursuant to a 100% quota share reinsurance agreement (the "General Agents Reinsurance Agreement") entered into at closing among GCM and GNAC's subsidiaries, General Agents and MGA Agency, Inc., and certain other arrangements, the Company retained all assets and liabilities associated with GCM's past, present and runoff commercial insurance business. The Company made a number of representations, warranties and covenants in the acquisition agreement and generally indemnifies Liberty for any losses incurred resulting from (i) breaches of representations, warranties or covenants of the Company; (ii) employee benefit plan obligations of GCM relating to pre-closing periods; (iii) tax obligations of GCM relating to pre-closing periods; (iv) all liabilities of GCM, to the extent that they result from conditions or circumstances arising or events occurring before the Closing, subject to certain exceptions; (v) all insurance claims, liabilities and obligations of GCM that are not reinsured pursuant to the General Agents Reinsurance Agreement or certain insurance fronting programs between GCM and Metropolitan Property & Casualty Insurance Company and Omni Insurance Company, respectively; and (vi) any and all insurance claims, liabilities and obligations of General Agents under the General Agents Reinsurance Agreement. GCM did not have any employees or employee benefit plans. The Company has recorded a receivable of approximately $500,000 due from Liberty, which represents the Company's cost of the management contract not yet recovered. The Company has a contingent gain related to the sale of the management contract for the amount of the sale in excess 64 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 of cost of approximately $8.5 million. Such gain is to be recognized if and as the related contingencies are satisfied at each due date of future Liberty payments under the sales agreement. The Company made a $500,000 prepayment of outstanding bank debt from the closing proceeds of the transaction. The Company sold the office building at 500 Commerce Street in Fort Worth, Texas, where the Company's principal executive offices and commercial insurance operations were located, to an unaffiliated third party for $5 million on August 30, 2002. The Company recorded a gain of $455,056 from this transaction. As a result, the Company leased new office space to house its principal executive offices and commercial insurance operations. In August 2002, the Company entered into an office lease for approximately 8,352 square feet of space in Fountain Place, 1445 Ross Avenue, Suite 5300, Dallas, Texas, to house the Company's executive offices. This address is the Company's new registered address. The lease is for a term of four years, although the Company has the right to terminate the lease at its option at the end of 2005 upon payment of a termination fee of approximately $29,000. The annual rental expense is approximately $175,500. The lessor is Crescent Real Estate Funding X, L.P., an affiliate of Crescent Real Estate Equities Company, a Texas real estate investment trust f/k/a Crescent Real Estate Equities, Inc. ("Crescent"). Robert W. Stallings, GNAC's Chairman of the Board, became a member of the Board of Trust Managers of Crescent in May 2002 and John C. Goff, a member of GNAC's Board, is the Chief Executive Officer and Vice Chairman of the Board of Trust Managers of Crescent. Mr. Goff is deemed to be the beneficial owner of 3,630,248 common shares of Crescent, comprising 3.4% of the beneficial ownership of such shares. Mr. Stallings is deemed to be the beneficial owner of 22,000 common shares of Crescent, comprising less than 1% of the beneficial ownership of such shares. The management of the Company believes that the terms of the Company's lease with Crescent are no less favorable to GNAC than those offered to other tenants by Crescent or than GNAC could obtain for comparable space from unaffiliated parties. In July 2002 the Company also entered an office lease with an unaffiliated third party for 10,577 square feet of space at 5400 Airport Freeway, Suite A, Fort Worth, Texas, to house the Company's commercial insurance operations. The lease is for a term of five years, although the Company may terminate the lease at its option after the expiration of three years. The annual base rental expense is $105,770. GNAC needs cash for principal and interest payments on its bank note payable and administrative expenses. The primary source of cash to meet these obligations are statutory permitted dividends from its insurance subsidiaries. GNAC believes the cash dividends from its insurance subsidiaries should be sufficient to meet its expected obligations for 2003. (c) Investments Bonds available for sale and other investments are stated at fair value with changes in fair value recorded as a component of comprehensive income. Short-term investments are stated at cost. 65 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 The following schedule summarizes the components of other investments as of December 31, 2001. There were no other investments as of December 31, 2002.
As of December 31, 2001 ---------------------------- Fair Value Cost ------------ ------------ Equity investments $ 1,058,613 1,058,613 Marketable securities 24,358 23,113 Note receivable 1,028,741 1,028,741 ------------ ------------ Total other investments $ 2,111,712 2,110,467 ============ ============
The equity investments were predominately private equity investments that were not traded in public markets and cost was considered to approximate fair value. Cost was considered to approximate fair value for the equity investments and the note receivable because they were carried at the amount recoverable from Goff Moore Strategic Partners, L.L.P. ("GMSP") under the put option as discussed below. The Company held an embedded derivative financial instrument in common stock warrants attached to the note receivable. As of December 31, 2001, the exercise price of the warrants was not determinable and, therefore, the warrants were not recorded in the financial statements. The agreement with GMSP, disclosed in note (8), provided an opportunity to convert the equity investments and the note receivable with a cost of $4.2 million to cash as of November 2002, as follows: the Company could at its option require GMSP to purchase these investments for $2.1 million, less any future cash received prior to November 2002 from the investments. GMSP could at its option require the Company to sell the equity investments and the note receivable to GMSP for $4.2 million, less any future cash received prior to November 2002 from the investments. During the second quarter of 2001, the Company recognized a permanent impairment of these investments and wrote down the carrying value to the amount recoverable from GMSP under the put. This write down amounted to $2,176,231 and was recorded as a realized capital loss in the Statement of Operations. In February 2002, GMSP consented to the early exercise of the Company's option, and the Company exercised its option to require GMSP purchase the illiquid investments for approximately $2.1 million. The marketable securities were sold in the first quarter of 2002 for a small gain. The "specific identification" method is used to determine costs of investments sold. Provisions for possible losses are recorded only when the values have experienced impairment considered "other than temporary" by a charge to realized losses resulting in a new cost basis of the investment. 66 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 Realized gains and losses on investments for the years ended December 31, 2002, 2001 and 2000 are presented in the following table:
Years ended December 31 -------------------------------------------- 2002 2001 2000 ------------ ------------ ------------ Realized gains: Bonds $ 4,076,680 3,576,530 17,554 Common stock -- 2,730,923 -- Sale of subsidiary -- 281,667 -- Sale of building 455,056 -- -- Other investments -- 20,265 33,602 ------------ ------------ ------------ Total realized gains 4,531,736 6,609,385 51,156 ------------ ------------ ------------ Realized losses: Bonds 470,891 17,456 1,958,067 Impairment of bonds 2,010,670 Other investments 1,327 140,506 -- Impairment of other investments -- 2,176,231 -- ------------ ------------ ------------ Total realized losses 2,482,888 2,334,193 1,958,067 ------------ ------------ ------------ Net realized gains (losses) $ 2,048,848 4,275,192 (1,906,911) ============ ============ ============
During 2002, the Company reduced the carrying value of a non-rated commercial mortgage backed security to $0 resulting in a write down of $2,010,670 as a result of a significant increase in the default rate in January and February of 2002 in the underlying commercial mortgage portfolio, which has disrupted the cash flow stream sufficiently to make future cash flows unpredictable. This write down was offset by net realized gains of $3,604,462 recorded from the sale of various bond securities. In August 2002, the Company entered into an amendment to its Investment Management Agreements with GMSP (See "Transactions with Goff Moore Strategic Partners, L.P. - 1999 GMSP Transaction"). The amendment reduces, effective as of October 1, 2002, the minimum aggregate monthly payment owed by the Company to GMSP from $75,000 to $63,195 (with respect to each calendar month from October 2002 through September 2003), $53,750 (with respect to each calendar month from October 2003 through September 2004) and $45,417 (with respect to each calendar month after September 2004). The amendment also changes the date upon which either party to each of the investment management agreements can terminate the agreement at its sole option from October 4, 2002 to September 30, 2005. The amendment was approved by each of the required applicable state insurance departments. During 2001, approximately $61.2 million in bond securities were sold for a pre-tax gain of $3,576,530 in order to generate realized capital gains and offset the Company's realized capital loss carryforward for Federal income tax purposes. During 2000, approximately $80.5 million in bond securities were sold for a pre-tax loss of $1,906,911 and a large portion of the proceeds were reinvested in bond securities with an average taxable equivalent yield of more than 150 basis points over the bond securities that were sold. Proceeds from the sale of bond securities totaled $92,507,319, $61,152,815, and $80,469,659 in 67 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 2002, 2001 and 2000, respectively. Proceeds from the sale of common stocks totaled $6,027,392 in 2001. There were no sales of common stocks in 2002 or 2000. Proceeds from the sale of other investments totaled $2,111,712, $382,868, and $690,016 in 2002, 2001 and 2000, respectively (d) Financial Instruments For premiums receivable, which include premium finance notes receivable, and all other accounts (except investments) defined as financial instruments in Statement of Financial Accounting Standards No.107, "Disclosures About Fair Values of Financial Instruments," the carrying amount approximates fair value due to the short-term nature of these instruments. The carrying amount of notes payable approximates fair value due to the variable interest rate on the note. These balances are disclosed on the face of the balance sheets. Fair values for investments, disclosed in note 2, were obtained from independent brokers and published valuation guides. (e) Deferred Policy Acquisition Costs and Deferred Ceding Commission Income Policy acquisition costs, principally commissions, premium taxes and certain marketing and underwriting expenses, are deferred and charged to operations over periods in which the related premiums are earned. The marketing expenses are predominately salaries, salary related expenses and travel expenses of the Company's marketing representatives who actively solicit business from the independent general agents. Deferred ceding commission income represents commissions received from reinsurers for premiums ceded to reinsurers, which have not been earned by the Company since the related premiums have not yet been earned. Commission income is paid to the Company by reinsurers as a recovery of the Company's acquisition costs. Statement of Financial Accounting Standards No. 113, paragraphs 18.b and 29, requires this revenue to reduce applicable unamortized acquisition costs in such a manner that unamortized acquisition costs are capitalized and charged to expense in proportion to net revenue recognized. The change in the resulting deferred asset is charged (credited) to operations. The Company utilizes investment income when assessing recoverability of deferred policy acquisition costs. The Company recorded impairments on its deferred policy acquisition costs at December 31, 2002 of $28,386 and at December 31, 2001 of $2,487,009 related to the property and commercial auto lines of business and at December 31, 2000 of $501,930 related to the property and nonstandard personal auto lines of business. 68 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 Information relating to these net deferred amounts, as of and for the years ended December 31, 2002, 2001 and 2000 is summarized as follows:
2002 2001 2000 ------------ ------------ ------------ Asset balance, beginning of period $ 3,188,226 2,301,944 14,927,673 ------------ ------------ ------------ Asset balance acquired through purchase of subsidiary -- -- 12,753 Deferred commissions 8,150,820 22,961,339 34,050,455 Deferred premium taxes, boards & bureaus and fees 1,321,660 2,410,409 2,792,869 Deferred marketing and underwriting expenses -- 2,346,330 2,968,031 Deferred ceding commission income (7,955) (4,274,975) (12,623,698) Amortization (10,950,019) (20,069,812) (39,324,209) Impairment (28,386) (2,487,009) (501,930) ------------ ------------ ------------ Net change (1,513,880) 886,282 (12,625,729) ------------ ------------ ------------ Asset balance, end of period $ 1,674,346 3,188,226 2,301,944 ============ ============ ============
The decrease in deferred commissions in 2002 is primarily attributable to the decrease in premium writings in 2002. The decrease in deferred ceding commission income in 2002 is primarily related to the run-off of the quota share treaties in 2002. The decrease in deferred commissions in 2001 is primarily attributable to the decrease in premium writings in 2001. The decrease in deferred ceding commission income in 2001 is primarily related to the decrease in the quota share cession percentages and the decrease in writings in 2001. (f) Property and Equipment Property and equipment are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful lives of the respective assets (30 years for buildings and primarily 5 years for furniture and software and 3 years for equipment). The following schedule summarizes the components of property and equipment:
As of December 31 ----------------------------- 2002 2001 ------------ ------------ Land $ 127,070 865,383 Buildings 1,007,910 6,391,739 Furniture and equipment 2,186,387 5,219,400 Software 2,666,600 3,600,238 Accumulated depreciation and amortization (5,074,441) (9,851,888) ------------ ------------ $ 913,526 6,224,872 ============ ============
The decrease in land and building is a result of the sale of the former home office building. The decrease in furniture and equipment and in software is a result of disposing of obsolete and fully depreciated items in these categories. The decrease in accumulated depreciation and amortization is a result of the disposals in all categories. 69 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 (g) Software Costs Computer software costs relating to programs for internal use are recorded in property and equipment and are amortized using the straight-line method over five years or the estimated useful life, whichever is shorter. As the Company exits commercial lines, future write-offs of software and equipment will likely occur. (h) Goodwill Goodwill represents the excess of purchase price over fair value of net assets acquired. In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 141, "Business Combinations" ("Statement 141") and Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("Statement 142"). Statement 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. Statement 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill, noting that any purchase price allocable to an assembled workforce may not be accounted for separately. Statement 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of Statement 142. Statement 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." The Company adopted the provisions of Statement 141 effective July 1, 2001 and Statement 142 effective January 1, 2002. The adoption of Statement 141 had no impact on the consolidated financial statements. The adoption of Statement 142 resulted in the Company no longer amortizing the remaining goodwill. As of the date of adoption, the Company had unamortized goodwill in the amount of $3,468,507 that was subject to the transition provisions of Statements 141 and 142. Had Statement 142 been adopted in 2001 and 2000, there would have been no change in net income for the year ended December 31, 2001 and pro forma net loss for the year ended December 31, 2000 would approximate $18.9 million ((.94) per common share). Statement 141 required, upon adoption of Statement 142, that the Company evaluate its existing intangible assets and goodwill that were acquired in a prior purchase business combination, and to make any necessary reclassifications in order to conform with the new criteria in Statement 141 for recognition apart from goodwill. Upon adoption of Statement 142, the Company was required to reassess the useful lives and residual values of all intangible assets acquired in purchase business combinations, and make any necessary amortization period adjustments by the end of the first interim period after adoption. In addition, to the extent an intangible asset is identified as having an indefinite useful life, the Company was required to test the intangible asset for impairment in accordance with the provisions of Statement 142 within the first interim period. The Company did not record any impairments as a result of the adoption of Statement 142. In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets" ("Statement 144"), establishing financial accounting and reporting for the impairment or disposal of long-lived assets. Statement 144 is effective for fiscal years beginning after December 15, 2001. The Company adopted the provisions of Statement 144 effective January 1, 2002. Pursuant to Statement 144 the 70 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 discontinuance of commercial lines has not been reported as discontinued operations. The adoption of Statement 144 had no other effect on the Company's financial position or results of operation. On January 7, 2000, the Company completed the acquisition of Tri-State, an insurance operation specializing primarily in underwriting, servicing and claims handling of nonstandard personal auto insurance in Minnesota, North Dakota and South Dakota. The purchase price was approximately $6,000,000 with an additional payment of $1,148,454 made in July, 2000 and additional payments up to approximately $4,350,000 in cash possible over the next several years based on a conversion goal and specific profitability targets. The Company paid $1,566,081 in January of 2001 for the conversion goal. In 2001, the Company decided to no longer pursue a long-term geographic expansion strategy in personal automobile beyond that of its core operation in Florida, and sold Tri-State to Tri-State's president for $935,000 in cash on August 31, 2001. The remaining goodwill associated with the Tri-State acquisition of $5,086,283 was recorded as goodwill impairment during the second quarter of 2001. The Company recognized a capital loss for tax purposes of $5,066,423 from this sale during the second quarter of 2001. Goodwill impairment in 2001 was a result of the Company's decision to no longer pursue a long-term geographic expansion strategy in personal automobile beyond that of its core operation in Florida and to sell its Tri-State agency subsidiary. Tri-State was acquired by the Company in the first quarter of 2000 and failed to achieve profitability during the Company's ownership. Because of the profitability issues surrounding the Lalande Group, (see below), it was decided in the second quarter of 2001 to sell Tri-State to its former owner so the Company could focus all of the personal auto efforts solely on the Lalande Group. As a result the remaining goodwill associated with the Tri-State acquisition was written off in the second quarter of 2001. In December 2001 the Company recorded an impairment of $13,360,603 on the goodwill associated with the 1998 acquisition of the Lalande Group. The Lalande Group was acquired by the Company in the fourth quarter of 1998, it produced a small profit in 1999, but in 2000 it produced a loss. At the end of 2000 the Company was expecting a significant improvement and profitability from the Lalande Group in 2001. During 2001 the Company continued to implement actions throughout the year to return this business to profitability. While results in 2001 showed improvement, they remained unprofitable. In the fourth quarter of 2001 the Company concluded that the value of this operation was significantly below what the Company had paid and accordingly recorded the impairment against goodwill based upon then current estimated market valuation levels of agencies in the personal auto marketplace. Goodwill impairment in 2002 is a result of the Company positioning itself for an exit from the personal auto business in the second quarter of 2002 and the consideration of a sale of the Lalande Group. A re-evaluation of goodwill for the Lalande Group was made during this period and an additional impairment of $2,859,507 was recorded. This re-evaluation was based upon market indications of value contained in a proposal from a potentially interested acquiring party and upon the uncertainty of achieving likely value levels. The remaining goodwill as of December 31, 2002 is $609,000 and is related to the 1998 acquisition of the Lalande Group and reflects a value no less than the estimated fair valuation of combined agency and claims handling operations of this type in the personal auto marketplace. Effective in 2002, goodwill is no longer amortized but will be subject to an impairment test based on its estimated fair value. Therefore, additional impairment losses could be recorded in future periods. 71 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 (i) Treasury Stock The Company records treasury stock in accordance with the "cost method" described in Accounting Principles Board Opinion ("APB") 6. The Company held 844,094 shares of Common Stock as treasury stock at December 31, 2002 and 2001 with a cost basis of $9.12 per share. (j) Revenue Recognition Premiums are recognized as earned on a pro rata basis over the period the Company is at risk under the related policy. Unearned premiums represent the portion of premiums written which are applicable to the unexpired terms of policies in force. NSL's net commission revenues are recognized as earned on a pro rata basis over the policy period. (k) Claims and Claim Adjustment Expenses Claims and claim adjustment expenses, less related reinsurance, are provided for as claims are incurred. The provision for unpaid claims and claim adjustment expenses includes: (1) the accumulation of individual case estimates for claims and claim adjustment expenses reported prior to the close of the accounting period; (2) estimates for unreported claims based on past experience modified for current trends; and (3) estimates of expenses for investigating and adjusting claims based on past experience. Liabilities for unpaid claims and claim adjustment expenses are based on estimates of the ultimate cost of settlement. Changes in claim estimates resulting from the review process and differences between estimates and ultimate payments are reflected in expense for the year in which the revision of these estimates first become known. The process of establishing claim reserves is an imprecise science and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. Some judicial decisions and legislative actions, even after coverage is written and reserves are initially set, broaden liability and policy definitions and increase the severity of claim payments. As a result of this and other societal and economic developments, the uncertainties inherent in estimating ultimate claim costs on the basis of past experience have increased significantly, further complicating the already difficult claim reserving process. Ultimate liability may be greater or lower than current reserves. Reserves are monitored by the Company using new information on reported claims and a variety of statistical techniques. The reserves are reviewed annually by an outside actuarial firm. The Company does not discount to present value that portion of its claim reserves expected to be paid in future periods. Beginning in third quarter of 2002 and for each quarter thereafter, the Company set reserves equal to the selected reserve estimate as established by an outside actuarial firm. Formerly management set reserves based upon its actuarial analysis. The following table sets forth the changes in unpaid claims and claim adjustment expenses, net of reinsurance cessions, as shown in the Company's consolidated financial statements for the periods indicated: 72 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000
As of and for the years ended December 31 -------------------------------------------- 2002 2001 2000 ------------ ------------ ------------ (Amounts in thousands) Unpaid claims and claim adjustment expenses, beginning of period $ 181,059 164,160 132,814 Less: Ceded unpaid claims and claim adjustment expenses, beginning of period 65,571 37,703 37,299 ------------ ------------ ------------ Net unpaid claims and claim adjustment expenses, beginning of period 115,488 126,457 95,515 ------------ ------------ ------------ Net claims and claim adjustment expense incurred related to: Current period 50,518 56,920 124,077 Prior periods 5,896 30,506 19,362 ------------ ------------ ------------ Total net claim and claim adjustment expenses incurred 56,414 87,426 143,439 ------------ ------------ ------------ Net claims and claim adjustment expenses paid related to: Current period 23,203 26,776 58,898 Prior periods 52,230 71,619 54,683 ------------ ------------ ------------ Total net claim and claim adjustment expenses paid 75,433 98,395 113,581 ------------ ------------ ------------ Net reserves acquired through purchase of subsidiary -- -- 1,084 ------------ ------------ ------------ Net unpaid claims and claim adjustment expenses, end of period 96,469 115,488 126,457 Plus: Ceded unpaid claims and claim adjustment expenses, end of period 46,802 65,571 37,703 ------------ ------------ ------------ Unpaid claims and claim adjustment expenses, end of period $ 143,271 181,059 164,160 ============ ============ ============
For 2002 the development in claims and claim adjustment expense incurred was primarily the result of unanticipated development of commercial auto claims for the 2000 accident year and commercial general liability claims for the 2001, 2000 and 1999 accident years. For 2001 the development in claims and claim adjustment expenses incurred was primarily the result of unanticipated development of commercial auto and commercial general liability claims for the 2000, 1999 and 1998 accident years. At December 31, 2002 the Company believes that the carried reserves and the reinsurance agreements currently in force are sufficient to support the future emergence of prior year claim and claim adjustment expenses. (l) Income Taxes The Company and its subsidiaries file a consolidated Federal income tax return. Deferred income tax items are accounted for under the "asset and liability" method which provides for temporary differences between the reporting of earnings for financial statement purposes and for tax purposes, primarily deferred policy acquisition costs, the discount on unpaid claims and claim adjustment expenses, net operating loss carry forwards and the nondeductible portion of the change in unearned premiums. The Company did not pay income taxes during 2002 and 2001. The Company received Federal income tax refunds totaling $250,000 and $251,644 during 2001 and 2000. The Company paid income taxes of $280,000 during 2000. The Company recognized a current tax benefit of $2,607,796 during 2002 as a result of a carry back of alternative minimum tax losses. A change in the tax law during 2002 extended the carry back period for losses to offset income in earlier periods. As a result, the Company was entitled to a tax refund which it received in October 2002. 73 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 (m) Earnings Per Share The following table sets forth the computation of basic and diluted loss per share:
Years ended December 31 ---------------------------------------------- 2002 2001 2000 ------------ ------------ ------------ Basic loss per share: Numerator: Net loss $ (8,761,087) (75,607,047) (19,551,365) Less: Preferred stock dividends 670,774 461,344 434,000 Less: Accretion of discount on preferred stock 2,657,000 1,867,150 346,164 ------------ ------------ ------------ Net loss available to common shareholders $(12,088,861) (77,935,541) (20,331,529) ------------ ------------ ------------ Denominator: Weighted average shares outstanding 21,169,736 21,169,736 21,027,699 ------------ ------------ ------------ Basic loss per share $ (0.57) (3.68) (.97) ============ ============ ============ Diluted loss per share: Numerator: Net loss $ (8,761,087) (75,607,047) (19,551,365) ------------ ------------ ------------ Denominator: Weighted average shares outstanding 21,169,736 21,169,736 21,027,699 Effect of dilutive securities: Convertible preferred stock -- 1,430,769 6,200,000 ------------ ------------ ------------ Weighted average shares and assumed conversions 21,169,736 22,600,505 27,227,699 ------------ ------------ ------------ Diluted loss per share (1) $ (0.57) (3.68) (.97) ============ ============ ============
(1) The effects of common stock equivalents and convertible preferred stock are antidilutive for the 2002, 2001 and 2000 periods; therefore, diluted loss per share is reported the same as basic loss per share. (n) Stock-Based Compensation In October 1995, the FASB issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("Statement 123"). Statement 123 defines a fair value based method of accounting for an employee stock option or similar equity instrument. Under Statement 123, the Company elects to measure compensation costs using the intrinsic value based method of accounting prescribed by APB 25 "Accounting for Stock Issued to Employees". In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of FASB Statement No. 123." This Statement amends FASB Statement No. 123, "Accounting for Stock Based Compensation", to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements. Certain of the disclosure modifications are required for fiscal years ending after December 15, 2002 and are included in the notes to these consolidated financial statements. The Company applies APB 25 and related Interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its stock option plans. Had compensation cost been determined consistent with Statement 123 for the options granted, the Company's net income and earnings per share would have been the pro forma amounts indicated below: 74 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000
Years ended December 31 ------------------------------------------------------------------------------------------------- 2002 2001 2000 ----------------------------- ----------------------------- ----------------------------- As reported Pro forma As reported Pro forma As reported Pro forma ------------ ------------ ------------ ------------ ------------ ------------ Net loss $ (8,761,087) (9,397,373) (75,607,047) (76,268,498) (19,551,365) (20,098,914) Less: Preferred stock dividends 670,774 670,774 461,344 461,344 434,000 434,000 Less: Accretion of discount on preferred stock 2,657,000 2,657,000 1,867,150 1,867,150 346,164 346,164 ------------ ------------ ------------ ------------ ------------ ------------ Net loss available to common shareholders $(12,088,861) (12,725,147) (77,935,541) (78,596,992) (20,331,529) (20,879,078) ============ ============ ============ ============ ============ ============ Basic loss per common share $ (.57) (.60) (3.68) (3.71) (.97) (.99) Diluted loss per common share $ (.57) (.60) (3.68) (3.71) (.97) (.99)
There were no options granted during 2002 and 2001. The Company granted 531,925 options during 2000. The fair value of the options granted during 2000 were estimated on the dates of grant using the Black-Scholes option-pricing model with the following assumptions: expected volatility of 31.81 to 32.00%, risk free interest rates of 6.31 to 6.66%, expected dividend yields of 1.23 to 1.27 % and an expected life of 7.5 years. (o) Accounting Pronouncements Effective January 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities"("Statement 133"), as amended. Statement 133 establishes accounting and reporting standards for derivative instruments and requires that an entity recognize all derivatives as either assets or liabilities in the financial statements and measure those instruments at fair value with changes in fair value recorded through the income statement. The adoption of Statement 133 had no impact on the consolidated financial statements. In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets" ("Statement 144"), establishing financial accounting and reporting for the impairment or disposal of long-lived assets. Statement 144 is effective for fiscal years beginning after December 15, 2001. Pursuant to Statement 144 the discontinuance of commercial lines will not be reported as discontinued operations. The Company believes that the adoption of Statement 144 will have no other effect on the Company's financial position or results of operation. In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("Statement 146"). The provisions of Statement 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of Statement 146 is not expected to have a material effect on the Company's consolidated financial position or result of operations. In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others, an 75 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34." This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. The Interpretation also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of the Interpretation are applicable to guarantees issued or modified after December 31, 2002 and are not expected to have a material effect of the Company's financial statements. In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities, an interpretation of ARB No. 51." This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities obtained after January 31, 2003. The application of this Interpretation is not expected to have a material effect on the Company's financial statements. (2) INVESTMENTS The following schedule summarizes the components of net investment income:
Years ended December 31 ---------------------------------------------- 2002 2001 2000 ------------ ------------ ------------ Investment income on: Fixed maturities $ 5,423,135 11,022,596 12,137,120 Common stocks 209 378,980 602,300 Other investments -- 1,418 109,307 Short-term investments 605,456 1,288,027 2,266,657 ------------ ------------ ------------ 6,028,800 12,691,021 15,115,384 Investment expenses (1,713,867) (4,600,223) (1,022,470) ------------ ------------ ------------ Net investment income $ 4,314,933 8,090,798 14,092,914 ============ ============ ============
The increase in investment expenses in 2001 was primarily due to the interest charge required under the reserve reinsurance cover agreement the Company entered into effective December 31, 2000. The Company is required to maintain a funds held liability and to increase this liability at an annual interest rate of 7.5%. On March 29, 2002 the reinsurer exercised its option to transfer the trust assets collateralizing the funds held liability to itself and the obligation of the Company to fund the liability at a 7.5% interest rate ceased, therefore investment expenses decreased in 2002. In August 2002, the Company entered into an amendment to its Investment Management Agreements with GMSP. See "Transactions with Goff Moore Strategic Partners, L.P. - 1999 GMSP Transaction". The amendment reduces, effective as of October 1, 2002, the minimum aggregate monthly payment owed by the Company to GMSP from $75,000 to $63,195 (with respect to each calendar month from October 2002 through September 2003), $53,750 (with respect to each calendar month from October 2003 through September 2004), and $45,417 (with respect to each calendar month after September 2004). The amendment also changes the date upon which either party to each of the investment management agreements can terminate such agreements at its sole option from October 4, 2002 to September 30, 2005. 76 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 The following schedule summarizes the amortized cost and estimated fair values of investments in debt securities:
Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value ------------ ------------ ------------ ------------ (Amounts in thousands) Fixed maturities: Bonds available for sale: U.S. Government securities - 2002 $ 24,217 730 -- 24,947 U.S. Government securities - 2001 16,730 470 (33) 17,167 Tax-exempt state & municipal bonds - 2002 465 15 -- 480 Tax-exempt state & municipal bonds - 2001 8,912 227 -- 9,139 Corporate bonds - 2002 34,338 3,105 (212) 37,231 Corporate bonds - 2001 101,727 5,632 (871) 106,488 Certificates of deposit - 2002 645 -- -- 645 Certificates of deposit - 2001 645 -- -- 645 Total Fixed maturities - 2002 59,665 3,850 (212) 63,303 Total Fixed maturities - 2001 $ 128,014 6,329 (904) 133,439
As of December 31, 2002 the Standard and Poor's ratings on the Company's bonds available for sale were in the following categories: 45% AAA, 4% AA, 15% A, 23% BBB, 5% BB and 8% B. No securities were rated below B. The amortized cost and estimated fair value of debt securities at December 31, 2002 and 2001, by maturity, are shown below.
2002 2001 ---------------------------- ---------------------------- Estimated Estimated Amortized Fair Amortized Fair Cost Value Cost Value ------------ ------------ ------------ ------------ (Amounts in thousands) Due in one year or less $ 20,392 20,779 15,463 15,045 Due after one year but within five years 25,783 27,319 68,984 72,670 Due after five years but within ten years 9,943 10,782 42,135 44,156 Due after ten years but within twenty years 3,547 4,423 1,432 1,568 Due beyond twenty years -- -- -- -- ------------ ------------ ------------ ------------ $ 59,665 63,303 128,014 133,439 ============ ============ ============ ============
Investments of $13,731,408 and $15,398,298, at December 31, 2002 and 2001, respectively, were on deposit with various regulatory bodies as required by law. 77 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 (3) ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The following schedule presents the components of other comprehensive (loss) income:
Years ended December 31 ---------------------------------------------- 2002 2001 2000 ------------ ------------ ------------ Unrealized gains (losses) on securities: Unrealized holding gains during period $ 1,815,607 5,689,937 7,455,491 Less: Reclassification adjustment for amounts included in net income for realized gains (losses) 3,604,462 6,169,756 (1,906,911) ------------ ------------ ------------ Other comprehensive (loss) income before Federal income taxes (1,788,855) (479,819) 9,362,402 Federal income tax (benefit) expense (608,887) (163,138) 3,218,456 ------------ ------------ ------------ Other comprehensive (loss) income $ (1,179,968) (316,681) 6,143,946 ============ ============ ============
The 2002 reclassification adjustment for amounts included in net income for realized gains (losses) excludes the realized gain on the sale of the building and the realized loss due to the impairment of bonds because these amounts were not a component of accumulated other comprehensive income as of December 31, 2001. The 2001 reclassification adjustment for amounts included in net income for realized gains (losses) excludes the realized gain on the sale of subsidiary and the realized loss due to the impairment of other investments because these amounts were not a component of accumulated other comprehensive income as of December 31, 2000. (4) NOTE PAYABLE In November 1998, the Company entered into a credit agreement with a commercial bank pursuant to which it borrowed $18,000,000. Interest was due monthly at an interest rate that approximated the 30-day London Interbank Offered Rate ("LIBOR") plus 175 basis points. Principal payments of $500,000 were due each quarter with the balance of $10,500,000 due at maturity of the note on October 1, 2003. In March 2001, the credit agreement was amended, specific breaches of covenants were waived, $2,500,000 in principal was prepaid and certain terms were amended. Interest was due monthly at an interest rate that approximates the 30-day LIBOR plus 250 basis points with an increase of 25 basis points each quarter beginning October 1, 2001 (4.89375% at December 31, 2001). Principal payments of $500,000 were due each quarter and were scheduled to increase to $750,000 beginning April 1, 2002, with the balance of $6,500,000 due at maturity of the note on November 1, 2003. On November 13, 2001, the credit agreement was further amended to change certain covenants and to provide the following revised principal amortization schedule: $200,000 upon effectiveness of the amendment on November 13, 2001; $500,000 on January 2, 2002; and $1,000,000 on the first day of each calendar quarter thereafter. A $50,000 fee was paid to the bank for this amendment. On February 27, 2002 the Company entered into an amendment to the credit agreement which cured covenant breaches and provided for principal prepayments. The Company prepaid $6,100,000 of the indebtedness outstanding under the credit agreement on March 4, 2002. Several covenants in the existing credit agreement were eliminated or modified by the amendment and the interest rate was changed to a base rate (which approximates prime) plus 175 basis points (6.00% at December 31, 2002). The Company paid $500,000 of the indebtedness outstanding under the credit agreement in December 2002 as a result of the sale of GCM. On March 24, 2003 the Company paid $1,939,000 of the indebtedness outstanding under the credit 78 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 agreement, as a result of the dividend received from General Agents of $3,878,000 (see Note 7). The principal amortization schedule was amended such that the remaining $1,761,000 principal balance under the credit agreement is payable in November 2003. The Company recorded interest expense of $310,095, $842,368 and $1,409,378 during 2002, 2001 and 2000, respectively. The Company paid interest of $354,140, $920,227 and $1,286,438 during 2002, 2001 and 2000, respectively. The Company made unscheduled principal prepayments of $2,500,000, $500,000, $200,000 and $500,000 in the first, third and fourth quarters of 2001 and December 2002, respectively, and scheduled principal payments of $500,000 in January, April, July and October of 2001 and in January 2002. (5) REINSURANCE On February 7, 2002, the Company announced its decision to cease writing commercial lines insurance due to continued adverse claims development and unprofitable underwriting results. Commercial lines insurance also includes specialty lines. Ceded Commercial Lines Prior to 1999 and again beginning in 2001, the Company wrote commercial casualty policy limits up to $1,000,000. For policies with an effective date occurring from 1995 through 1998, and policies with an effective date occurring during 2001 or 2002, the Company has first excess casualty reinsurance for 100% of casualty claims exceeding $500,000 up to the $1,000,000 limits, resulting in a maximum net claim retention per risk of $500,000 for such policies. During 1999 and 2000, the Company wrote commercial casualty policy limits up to $5,000,000. For policies with an effective date occurring in 1999 or 2000, the Company has first excess casualty reinsurance for 100% of casualty claims exceeding $500,000 up to $1,000,000 and second excess casualty reinsurance for 100% of casualty claims exceeding $1,000,000 up to the $5,000,000 limits, resulting in a maximum net claim retention per risk of $500,000. The Company has facultative reinsurance for policy limits written in excess of the limits reinsured under the excess casualty reinsurance agreements. Effective December 31, 2000 the Company entered into a quota share reinsurance agreement whereby the Company ceded 100% of its commercial auto liability unearned premiums and 50% of all other commercial business unearned premiums at December 31, 2000 to a non-affiliated reinsurer. For policies with an effective date of January 1, 2001 through December 31, 2001, the Company entered into a quota share reinsurance agreement whereby the Company ceded 20% of its commercial business to a non-affiliated reinsurer. Also effective December 31, 2000, the Company entered into a reserve reinsurance cover agreement with a non-affiliated reinsurer. This agreement reinsures the Company's ultimate net aggregate liability in excess of $32,500,000 up to an aggregate limit of $89,650,000 for net commercial auto liability losses and loss adjustment expense incurred but unpaid as of December 31, 2000. At December 31, 2002 a deferred reinsurance gain of $3,855,062 has been recorded in deferred revenues and $5,194,938 has been recorded in insurance services revenues, which represents the reserve development under the reserve reinsurance cover agreement since its inception at December 31, 2000. The deferred gain item will be recognized in income in future periods based upon the ratio of claims paid in the $57,150,000 layer to the total of the layer. The Company established a reinsurance balance receivable and a liability for funds held 79 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 under reinsurance agreements for the reserves transferred at December 31, 2001 and December 31, 2000. Also in connection with this agreement, the Company was required to maintain assets in a trust fund with a fair value at least equal to the funds held liability. The trust fund was established during the third quarter of 2001 and at December 31, 2001 the assets in the trust had a fair value of $49,553,698. Because the Company's statutory policyholders' surplus fell below certain levels specified in the agreement, the reinsurer had the option to direct the trustee to transfer the assets of the trust to the reinsurer. On March 29, 2002, the reinsurer exercised this option and the trust assets were transferred to the reinsurer. As a result, investments and funds held under reinsurance agreements were reduced by approximately $44,000,000. The Company recorded a realized gain of approximately $486,000 as a result of these transactions. The reinsurer continues to be responsible for reimbursing the Company for claim payments covered under this agreement. For 2000 and 2001, the Company has excess casualty clash reinsurance for $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of each accident. For 2002, the Company has excess casualty clash reinsurance for 35% of $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of each accident. For its lawyers professional liability coverages with policy effective dates occurring during 2001 or prior, the Company has quota share reinsurance for 50% of the first $1,000,000 of professional liability claims and excess casualty reinsurance for 100% of professional liability claims exceeding $1,000,000 up to $5,000,000 policy limits resulting in a maximum net claim retention per risk of $500,000. For its real estate agents professional liability coverages with policy effective dates prior to August 1, 2001, the Company has quota share reinsurance for 25% of the first $1,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $750,000. For policies with an effective date occurring on August 1, 2001 through April 15, 2002, the Company has quota share reinsurance for 50% of the first $1,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $500,000. For its educators professional liability coverages with policy effective dates occurring during 2001 or prior, the Company has quota share reinsurance for 60% of the first $1,000,000 of professional liability claims and excess casualty reinsurance for 100% of professional liability claims exceeding $1,000,000 up to $5,000,000 policy limits resulting in a maximum net claim retention per risk of $400,000. For its directors and officers liability coverages with policy effective dates occurring prior to 2001, the Company has quota share reinsurance for 90% of the first $5,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $500,000. For policies with an effective date occurring during 2001, the Company has quota share reinsurance for 85% of the first $5,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $750,000. For its miscellaneous professional liability coverages with policy effective dates occurring during 2001 or prior, the Company has quota share reinsurance for 50% of the first $1,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $500,000. Personal Lines For its umbrella coverages with policy effective dates occurring in 2000 and 2001, the Company has excess casualty reinsurance for 100% of umbrella claims exceeding $1,000,000 up to $10,000,000 policy limits. For policies with an effective date occurring prior to February 1, 2001, the Company has quota share 80 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 reinsurance for 75% of the first $1,000,000 of umbrella claims resulting in a maximum net claim retention per risk of $250,000. For policies with an effective date occurring February 1, 2001 through December 31, 2001, the Company has quota share reinsurance for 77.5% of the first $1,000,000 of umbrella claims resulting in a maximum net claim retention per risk of $225,000. Prior to 2002, for its personal auto coverages, the Company has excess casualty clash reinsurance for $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of each accident. Beginning in 2002, the Company has excess casualty clash reinsurance for 35% of $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of each accident. The Company's personal auto business is produced by NSL and, prior to August 1, 2001, by Tri-State or written on a direct basis through MCIC. For business produced by NSL with an effective date of April 1, 2000 through December 31, 2000, the Company has excess of loss reinsurance for 100% of claims in excess of $25,000 up to the $100,000 policy limits and quota share reinsurance for 20% of the first $25,000 of claims resulting in a maximum net claim retention per risk of $20,000. For business produced by NSL with an effective date of January 1, 2001 through December 31, 2001, the Company has excess of loss reinsurance for 100% of claims in excess of $25,000 up to the $100,000 policy limits and quota share reinsurance for 50% of the first $25,000 of claims resulting in a maximum net claim retention per risk of $12,500. Effective December 31, 2001, the Company's personal lines excess of loss and quota share reinsurance treaties expired and were not replaced. Under the terms of these treaties, the reinsurer remains liable for claims with regard to policies in force at the date of expiration. Beginning in 2002 the Company no longer writes nonstandard personal auto limits in excess of $25,000 and therefore has no need for excess of loss reinsurance. For business produced by Tri-State or written on a direct basis with MCIC with an effective date prior to August 1, 2001, the Company has excess of loss reinsurance for 100% of claims in excess of $25,000 up to the $100,000 policy limits and quota share reinsurance for 50% of the first $25,000 of claims resulting in a maximum net claim retention per risk of $12,500. For 2001, the Company carried catastrophe property reinsurance to protect it against catastrophe occurrences for 95% of the property claims that exceed $1,500,000 but do not exceed $13,000,000 for a single catastrophe as well as second event catastrophe property reinsurance for 100% of $1,000,000 excess of $500,000 on a second catastrophic event. In 2002, the Company carried catastrophe property reinsurance to protect it against catastrophe occurrences for property claims that exceed $500,000 but do not exceed $7,000,000. The Company does not have catastrophe reinsurance for business written in 2003 because of the exit from commercial lines and because the cost for coverage for the remaining personal lines was determined to be excessive in relation to the evaluation of risks to be retained. Effective August 1, 2001, MGAI and MCIC entered into a fronting arrangement with Tri-State. All business written under this fronting arrangement was ceded to a non-affiliated reinsurer rated "A+ (Superior)" by Best's. The reinsurer has fully indemnified the Company against business, credit and insurance risk. This fronting arrangement was placed in run off during the second quarter of 2002. MGAI utilized a reinsurance arrangement in Florida whereby premiums were ceded to a non-affiliated authorized reinsurer and the reinsurer ceded the premiums to General Agents. This was necessary because General Agents was not an authorized reinsurer in Florida until the fourth quarter of 2000. These reinsurance agreements were commuted in the first quarter of 2003, resulting in MGAI assuming the business from the non-affiliated reinsurer. 81 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 GCM had entered into fronting arrangements with non-affiliated insurance companies. GCM retained no portion, as the business written under these agreements was 100% ceded. Although these cessions were made to authorized reinsurers rated "A- (Excellent)" or better by Best's, the agreements required that collateral (in the form of trust agreements and/or letters of credit) be maintained to assure payment of the unearned premiums and unpaid claims and claim adjustment expenses relating to the risks insured under these fronting arrangements. The balances in such accounts as of December 31, 2001 and 2000 total $11,548,559 and $24,148,000, respectively. These fronting arrangements continued with GCM after its sale in December 2002 and the Company is no longer involved. The amounts deducted in the consolidated financial statements for reinsurance ceded as of and for the years ended December 31, 2002, 2001 and 2000 respectively, are set forth in the following table.
2002 2001 2000 ------------ ------------ ------------ Premiums earned $ 17,748,690 71,935,247 11,796,216 Premiums earned - Florida business $ (8,687) 598,135 13,928,709 Premiums earned - fronting arrangements $ 7,747,565 17,605,870 27,864,491 Claims and claim adjustment expenses $ 22,977,004 68,950,651 15,824,110 Claims and claim adjustment expenses - Florida business $ 703,768 1,075,935 13,215,687 Claims and claim adjustment expenses - plan servicing $ (642,854) 409,339 1,094,163 Claims and claim adjustment expenses - fronting arrangements $ (2,569,379) 11,645,471 20,315,134
Claims ceded to the commercial automobile plans of Arkansas, California, Louisiana, Mississippi and Pennsylvania are designated as "plan servicing". The amounts included in the Consolidated Balance Sheets for reinsurance ceded under fronting arrangements and reinsurance ceded to the commercial automobile plans of Arkansas, California, Louisiana, Mississippi, and Pennsylvania were as follows:
2002 2001 2000 ------------ ------------ ------------ Unearned premiums - Florida business $ -- -- 617,477 Unearned premiums - fronting arrangements $ 106,145 6,135,014 6,642,887 Unpaid claims and claim adjustment expenses - Florida business $ 556,574 1,222,401 4,253,582 Unpaid claims and claim adjustment expenses - plan servicing $ 184,320 1,578,861 4,700,008 Unpaid claims and claim adjustment expenses - fronting arrangements $ 2,032,541 6,411,608 9,481,175
The Company remains directly liable to its policyholders for all policy obligations and the reinsuring companies are obligated to the Company to the extent of the reinsured portion of the risks. Assumed The Company, from time to time, utilizes reinsurance arrangements with various non-affiliated admitted insurance companies, whereby the Company underwrites the coverage and assumes the policies 100% from the companies. These arrangements require that the Company maintain escrow accounts to assure payment of the unearned premiums and unpaid claims and claim adjustment expenses relating to risks insured through such arrangements and assumed by the Company. As of December 31, 2002, 2001, and 2000, the balance in such escrow accounts totaled $7,817,264, $9,578,961 and $15,059,497, respectively. For 2002, 2001 and 82 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 2000 the premiums earned by assumption were $1,738,792, $3,131,323, and $18,243,710, respectively. The assumed unpaid claims and claim adjustment expenses were $16,512,219, $1,839,889 and $5,142,488, for 2002, 2001 and 2000, respectively. The large increase in 2002 was due to the transfer of unpaid claims and claim adjustment expenses to General Agents in conjunction with the sale of the management contract of GCM in December 2002. (6) FEDERAL INCOME TAXES In the accompanying consolidated statements of operations, the provisions for Federal income tax as a percent of related pretax income differ from the Federal statutory income tax rate. A reconciliation of income tax expense using the Federal statutory rates to actual income tax expense follows:
2002 2001 2000 ------------ ------------ ------------ Income tax benefit at 34% $ (3,242,477) (20,087,828) (10,522,791) Tax-exempt interest income (59,228) (240,604) (988,145) Dividends received deduction (42) (76,959) (144,767) Amortization of goodwill -- 299,868 327,658 Goodwill impairment 972,232 6,271,941 -- Tax loss on sale of Tri-State -- (1,715,943) -- Change in valuation allowance 1,460,052 31,534,712 -- Other, net 93,853 50,458 (69,975) ------------ ------------ ------------ Income tax (benefit) expense $ (775,610) 16,035,645 (11,398,020) ============ ============ ============
Under Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("Statement 109"), the primary objective is to establish deferred tax assets and liabilities for the temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. As a consequence, the portion of the tax expense, which is a result of the change in the deferred tax asset or liability, may not always be consistent with the income reported on the statement of operations. 83 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 The following table represents the tax effect of temporary differences giving rise to the net deferred tax asset established under Statement 109.
As of December 31 ----------------------------- 2002 2001 ------------ ------------ Deferred tax assets: Unpaid claims and claims adjustment expenses $ 4,609,134 5,596,158 Unearned premiums 571,303 1,778,305 Deferred service fee income -- 69,708 Deferred reinsurance gain 1,310,721 2,698,761 Impairments of securities 1,675,741 992,113 Allowance for doubtful accounts 580,070 1,004,752 Alternative minimum tax credit -- 2,619,735 Net operating loss 23,017,524 19,818,063 Capital loss -- 5,772 Basis in management contract 34,228 -- Statutory ceding commission in excess of acquisition costs 705,508 -- Depreciation and amortization 166,356 -- Other 22,468 22,044 ------------ ------------ Total deferred tax assets 32,693,053 34,605,411 ------------ ------------ Deferred tax liabilities: Deferred policy acquisition costs and deferred ceding commission income 569,278 321,268 Unrealized gains on investments 1,236,736 1,844,947 Depreciation and amortization -- 584,334 Accrual of discount on bonds 151,271 320,150 ------------ ------------ Total deferred tax liabilities 1,957,285 3,070,699 ------------ ------------ Net deferred tax assets before valuation allowance 30,735,768 31,534,712 Valuation allowance (31,972,504) (31,534,712) ------------ ------------ Net deferred tax liability $ (1,236,736) -- ============ ============
In assessing the realization of its deferred tax assets, management considers whether it is more likely than not that a portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based upon management's consideration of expected reversal of deferred tax liabilities and projected future taxable income, management believes it is more likely than not that the Company will not realize the benefits of these deferred tax assets in the near future. In 2001 the Company recorded a valuation allowance against its Federal income tax asset. While the Company produced a loss in 2000, at the end of 2000 the Company projected earnings in 2001 with subsequent increases each year thereafter. During 2001 the Company continued to implement actions to return to profitability, both in commercial lines and the personal lines. However, earnings in 2001 did not materialize and in the first quarter of 2002 the Company announced it was discontinuing the writing of its largest line of business, commercial lines, due to continued adverse claims development and unprofitable results. At that time the prospects for significant profits in personal lines, its only remaining line of business, were unclear. Because the Company had no near-term expectation of profitable results, it was necessary to fully reserve the deferred tax asset due to uncertainty of future profitable results which could utilize this asset. In 2002 the Company continued to record unprofitable results and has no expectation of significant profits at this time. 84 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 The Company recognized a current tax benefit of $2,607,796 during the third quarter of 2002 as a result of a carry back of alternative minimum tax losses. A change in the tax law during 2002 extended the carry back period for losses to offset income in earlier periods. As a result, the Company was entitled to a tax refund which it received in October 2002. The Company recorded deferred tax expense during the first quarter of 2002 due to an increase in the deferred tax asset valuation allowance, as a result of excluding the effects of unrealized gains in the deferred tax asset. Gross deferred tax assets and the valuation allowance were reduced in the amount of $1,022,260 due to the sale of GCM. As of December 31, 2002, the Company has net operating loss carry forwards for tax purposes of approximately $692,719, $23,752,756, $33,950,174 and $9,302,951 which, if not utilized, will expire in 2018, 2020, 2021 and 2022, respectively. (7) SHAREHOLDERS' EQUITY GNAC has 250,000,000 shares of authorized $.10 par value common stock (the "Common Stock"). Of the authorized shares 22,013,830 were issued as of December 31, 2002 and 2001, respectively, and 21,169,736 were outstanding as of December 31, 2002 and 2001, respectively. On October 4, 1999 GNAC sold to GMSP, for an aggregate purchase price of $31,620,000 (i) 31,620 shares of Series A Preferred Stock, which are convertible into 6,200,000 shares of Common Stock at a conversion price of $5.10 per share and, should the Company pay dividends on its Common Stock, the Series A Preferred Stock would be entitled to dividends as if converted into Common Stock, (ii) the Series A Warrant to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise price of $6.375 per share with an expiration of October 2004 and (iii) the Series B Warrant to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise of $8.50 per share with an expiration date of October 2006. As a result of the value attributable to the Common Stock purchase warrants issued with the Series A Preferred Stock, the Series A Preferred Stock was issued at a discount which is being amortized over a five year period using the effective interest method. Proceeds were allocated based upon the relative fair values of the Series A Preferred Stock, and the Series A Warrants and the Series B Warrants. The Series A Warrants and the Series B Warrants are anti-dilutive. On March 23, 2001, GNAC consummated the 2001 GMSP Transaction with GMSP pursuant to which, among other things, the Company issued shares of its newly created Series C Preferred Stock to GMSP in exchange for an aggregate purchase price of $3 million in cash. The annual dividend rate on the Series C Preferred Stock is 10% until March 23, 2004 and 20% thereafter. Unpaid dividends are cumulative and compounded. The Series C Preferred Stock is redeemable at GNAC's option after March 23, 2006 and at the option of the majority holders after March 23, 2007 at a price of $1,000 per share ($3,000,000) plus accrued and unpaid dividends. The Series C Preferred Stock is not convertible into Common Stock. The agreement with GMSP was conditioned upon the following changes in the securities currently held by GMSP. The exercise prices of the Series A Warrant and the Series B Warrant held by GMSP were amended to equal $2.25 and $2.5875 per share, respectively. Each of these warrants provides for the purchase of 1,550,000 million shares of Common Stock, subject to adjustment. Further, GNAC is required to redeem the outstanding shares of its Series A Preferred Stock on January 1, 2006, subject to certain conditions at a price of $1,000 per share ($31,620,000) plus unpaid dividends, if any. Any Series A Preferred Stock unredeemed for any reason after that date would accrue interest, payable quarterly at a rate equal to eight percent per year with any unpaid interest compounded annually. 85 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 On March 23, 2001, GNAC consummated the Stallings Transaction pursuant to which, among other things, GNAC issued shares of its newly created Series B Preferred Stock and a Warrant to purchase an aggregate of 1,050,000 shares of Common Stock at $2.25 per share in exchange for an aggregate purchase price of $3 million in cash. The annual dividend provisions and the redemption provisions of the Series B Preferred Stock are the same as those for the Series C Preferred Stock. The Series B Preferred Stock is convertible into Common Stock at $2.25 per share. Subject to adjustment for certain events, the Series B Preferred Stock is convertible into a maximum of 1,333,333 shares of Common Stock. The Warrant expires in March 2006. The transaction dated March 23, 2001 results in all preferred stock being redeemable. The discount on the preferred stock is being amortized over the period until redemption using the effective interest method. At December 31, 2002, there was $10,394,000 in unaccreted discount on the Series A and Series B Preferred Stock and $1,132,118 in accrued dividends on the Series B and Series C Preferred Stock. In 2000, GNAC paid quarterly cash dividends of $.0175 per share on its common stock for every quarter. The Board of Directors discontinued quarterly dividends on the common stock in February 2001. The Company's Common Stock commenced trading on the OTC Bulletin Board on April 15, 2002 under the ticker symbol "GNAC". The OTC Bulletin Board is a regulated quotation service that displays real-time quotes, last sale price and volume information in over-the-counter equity securities. The following table presents the statutory policyholders' surplus and statutory net income (loss) as of and for the years ended December 31, 2002, 2001, and 2000:
As of and for the years ended December 31 --------------------------------------------------------------- 2002 2001 2000 ------------ ----------------------------- ------------ As reported As adjusted Statutory policyholders' surplus: General Agents and MGAI $ 38,780,392 47,749,966 44,852,966 72,383,234 MCIC 2,964,574 3,078,162 3,045,162 3,149,255 GCM -- 2,000,000 2,000,000 2,000,000 ------------ ------------ ------------ ------------ Consolidated statutory policyholders' surplus $ 41,744,966 52,828,128 49,898,128 77,532,489 ============ ============ ============ ============ Statutory net (loss) income: General Agents and MGAI $ (6,376,646) (19,975,679) (22,872,679) (13,173,203) MCIC 166,796 (110,898) (143,898) 144,869 GCM (through 12/2/02) (1,747,973) 1,265,681 1,204,921 (331,520) ------------ ------------ ------------ ------------ Consolidated statutory net loss $ (7,957,823) (18,820,896) (21,811,656) (13,359,854) ============ ============ ============ ============
The 2001 "as adjusted" consolidated statutory policyholders' surplus and consolidated statutory net loss reflects $3,000,000 in C & CAE reserve development that was recorded subsequent to the issuance of the statutory financial statements as filed with the respective state insurance departments. In addition, in the first quarter of 2002, General Agents declared and paid a $7,238,000 cash dividend to GNAC and reduced the carrying value of an investment to $0 resulting in a write-down of approximately $2,010,000. These actions reduce consolidated statutory policyholders' surplus on a pro-forma basis to approximately $40,650,000. The Company's statutory capital exceeds the benchmark capital level under the Risk Based Capital formula for its insurance companies that are subject to Risk Based Capital requirements. The Company adopted the NAIC Accounting Practices and Procedures (Codification of Statutory Accounting) effective January 1, 2001, 86 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 which resulted in a decrease to consolidated statutory policyholders' surplus of $1,123,936. Statutes in Texas and Oklahoma restrict the payment of dividends by the insurance company subsidiaries to the available surplus funds derived from their realized net profits. The maximum amount of cash dividends that each subsidiary ordinarily may declare without regulatory approval in any 12-month period is the greater of net income for the 12-month period ended the previous December 31 or ten percent (10%) of policyholders' surplus as of the previous December 31. On March 20, 2003, General Agents (the Oklahoma subsidiary) paid dividends to GNAC of $3,878,000, based on its surplus amounts at December 31, 2002. In 1988, the Board of Directors declared, pursuant to a Rights Plan, a dividend distribution of one common share purchase right on each outstanding share of $.10 par value Common Stock. The dividend distribution was made on March 18, 1988, payable to shareholders of record on that date. In 1993, the Board of Directors amended the Rights Plan and extended the expiration date of these rights from March 18, 1998 to May 25, 2003. Each right, as amended during 1993, has an exercise price of $70. The rights are not exercisable until the Distribution Date (as defined in the Rights Plan). The Rights Plan provides, among other things, that if any person or group (other than the Company, one of its subsidiaries or an employee benefit plan of the Company or a subsidiary) acquires 20% or more of the Company's Common Stock (except pursuant to an offer for all outstanding Common Stock which the Continuing Directors (as defined in the Rights Plan) have determined to be in the best interests of the Company and its shareholders), if a 20% holder engages in certain self-dealing transactions or if a holder of 15% or more of the Company's Common Stock is declared an Adverse Person (as defined in the Rights Plan) by the Board of Directors, each holder of a right (other than the 20% holder or the Adverse Person, whose rights would become null and void) would have the right to receive, upon exercise of the right, Common Stock having a market value of two times the exercise price of the right. The Company is able to redeem rights under certain conditions set forth in the Rights Plan. If, following a public announcement that a person has acquired 20% or more of the common stock, the Company is acquired in a merger (other than a merger which follows an offer approved by the Continuing Directors as defined in the Rights Plan) or other business combination transaction or if 50% of the assets or earning power of the Company is sold, each right (except rights which have previously become null and void as described above), will entitle its holder to purchase, at the right's then-current exercise price, shares of the acquiring Company's common stock having a market value of two times the exercise price of the right. (8) BUSINESS TRANSACTIONS On October 4, 1999 GNAC sold to GMSP, for an aggregate purchase price of $31,620,000 (i) 31,620 shares of Series A Preferred Stock, which are convertible into 6,200,000 shares of Common Stock at a conversion price of $5.10 per share, (ii) the Series A Warrant to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise price of $6.375 per share and (iii) the Series B Warrant to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise of $8.50 per share (the "1999 GMSP Transaction"). At closing GNAC and its insurance company subsidiaries entered into Investment Management Agreements with GMSP pursuant to which GMSP manages their respective investment portfolios. Completion of the 1999 GMSP Transaction concluded the strategic alternatives review process that the Company initiated in 1998. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Business Operations." On March 23, 2001, the Company consummated a transaction with GMSP pursuant to which, among other things, the Company issued shares of its newly created Series C Preferred Stock to GMSP in exchange for 87 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 an aggregate purchase price of $3 million in cash (the "2001 GMSP Transaction"). In the 2001 GMSP Transaction, the Company and GMSP changed certain terms of certain of the securities issued to GMSP pursuant to the 1999 GMSP Transaction and the Company undertook to redeem the Series A Preferred Stock in 2006, subject to certain conditions. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Business Operations." On March 23, 2001, the Company consummated a transaction with Robert W. Stallings pursuant to which, among other things, the Company issued shares of its newly created Series B Preferred Stock and a warrant to purchase an aggregate of 1,050,000 shares of GNAC Common Stock at $2.25 per share in exchange for an aggregate purchase price of $3 million in cash (the "Stallings Transaction"). See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Business Operations." On December 2, 2002, the Company completed the sale and transfer of the management contract controlling GCM to an affiliate of Liberty, for a purchase price of up to $10 million, of which $1 million was paid at closing and the balance is payable in contingent payments through September 2009 (see Note (1)(b) Nature of Operations). The Company sold the office building at 500 Commerce Street in Fort Worth, Texas, where the Company's principal executive offices and commercial insurance operations were located, to an unaffiliated third party for $5 million on August 30, 2002. The Company recorded a gain of $455,056 from this transaction. As a result, the Company leased new office space to house its principal executive offices and commercial insurance operations (see Note (1)(b) Nature of Operations). (9) BENEFIT PLANS At December 31, 2001, the Company had two plans under which options to purchase shares of GNAC's common stock could be granted: the 1995 Stock Option Plan ("95 Plan") and the 1998 Long-Term Incentive Plan ("98 Plan"). The 1990 Stock Option Plan and all unexercised options thereunder expired during 2000. The 95 Plan was approved by the shareholders on May 10, 1996 and 1,071,000 shares currently are reserved and available for issuance under this plan. Options granted under the 95 Plan have a maximum ten year term and are exercisable at the rate of 20% immediately upon grant and 20% on each of the first four anniversaries of the grant date. The 98 Plan was approved by the shareholders on July 17, 1998, and the aggregate number of shares of common stock that may be issued under the 98 Plan is limited to 1,000,000 and 595,235 shares currently are reserved and available for issuance under this plan. Under the 98 Plan, stock options (including incentive stock options and non-qualified stock options), stock appreciation rights and restricted stock awards may be made. In 2000 options for 531,925 shares were granted to officers, directors and employees of the Company under the 98 Plan at an average exercise price of $5.57 per share. In 1998 options for 579,710 shares were granted to Glenn W. Anderson under an employment agreement at an exercise price of $5.75 per share. The exercise price of each outstanding option equals the market price of the GNAC's common stock on the date of grant. A summary of the status of the Company's outstanding options as of December 31, 2002, 2001 and 2000, and changes during the years ended December 31, 2002, 2001 and 2000 is presented below: 88 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000
2002 2001 2000 ----------------------------- ----------------------------- ----------------------------- Weighted Weighted Weighted Average Average Average Underlying Exercise Underlying Exercise Underlying Exercise Shares Price Shares Price Shares Price ------------ ------------ ------------ ------------ ------------ ------------ Options outstanding, beginning of period: 1,705,335 $ 6.81 1,815,630 $ 6.79 1,565,147 $ 6.49 Options granted -- $ -- -- $ -- 531,925 $ 5.57 Options exercised -- $ -- -- $ -- (249,903) $ 2.18 Options forfeited (190,101) $ 5.79 (110,295) $ 6.69 (31,539) $ 7.35 ------------ ------------ ------------ Options outstanding, end of period 1,515,234 $ 6.93 1,705,335 $ 6.81 1,815,630 $ 6.79 ============ ============ ============ Options exercisable at end of period 1,258,804 1,350,220 1,287,601 Weighted average fair value of options granted during period N/A N/A 2.71
The following table summarizes information for the stock options outstanding at December 31, 2002:
Options Outstanding Options Exercisable ------------------------------------------------ ------------------------------ Number Weighted Average Weighted Number Weighted Range of Outstanding Remaining Average Exercisable Average Exercise Prices at 12/31/02 Contractual Life Exercise Price at 12/31/02 Exercise Price --------------- ----------- ---------------- -------------- ----------- -------------- $ 5 to 7 1,121,395 3.18 years $ 5.72 864,965 $ 5.75 $ 7 to 9 42,000 4.36 years $ 8.31 42,000 $ 8.31 $ 9 to 11 351,839 4.36 years $ 10.63 351,839 $ 10.63 ------------ ------------ $ 5 to 11 1,515,234 3.48 years $ 6.93 1,258,804 $ 7.20 ============ ============
The Company has a 401(k) plan for the benefit of its eligible employees. The Company made quarterly contributions to the plan which totaled $148,634, $232,663 and $265,836 during 2002, 2001 and 2000, respectively. Because of their importance to the Company, in August 2002 the Company entered into executive severance agreements with two senior executives, Richard M. Buxton and Daniel J. Coots. The agreements generally provide that the Company shall pay the executive, upon termination of the employment of the executive by the Company without cause or by the executive with good reason during the term of the agreement, a lump sum severance amount equal to the base annual salary of the executive as of the date that the executive's employment with the Company ends. The current base annual salaries of Mssrs. Buxton and Coots are $170,000 and $155,000, respectively. The executive severance agreements do not supersede the change in control agreements or any other severance agreements the employees may have with the Company. Richard A. Laabs, a former senior executive of the Company, also entered into an executive severance agreement with the Company in August 2002, but did not receive any severance payments pursuant to such agreement when resigned his employment with the Company in January 2003. The Company entered into retention incentive agreements with sixteen employees, three of whom are officers of the Company. 89 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 Each of the retention incentive agreements generally requires that the Company pay the applicable employee an amount based upon the employee's annual base salary, less amounts owed by the Company to the employee pursuant to any change in control or severance agreements the employee may have with the Company. The Company's obligation to make payments under each retention incentive agreement is conditioned upon the employee remaining in the employ of the Company through a specified date, unless terminated earlier by the Company without cause or by the employee with good reason. The Company could be obligated to make up to an aggregate of approximately $793,000 in payments under the retention incentive agreements. Other than Jackiben N. Wisdom (who was not one of the five most highly compensated employees of the Company at the time he entered into his retention agreement), none of the five most highly compensated employees of the Company are parties to the retention incentive agreements. In December 2002, McRae B. Johnston, the President - Personal Lines Division of the Company, resigned his employment with the Company and each of its subsidiaries other than MGAI, where Mr. Johnston remained employed until March 1, 2003. The Company and Mr. Johnston entered into separation agreements and releases (the "Release Agreements") pursuant to which the Company and Mr. Johnston each mutually released the other from obligations under the stock purchase agreement and employment contract between the Company and Mr. Johnston and generally from any and all other claims that each otherwise may have had against the other. The Company paid Mr. Johnston an aggregate of $400,000 pursuant to the Release Agreements. Mr. Johnston also entered into a one-year Consulting Agreement with MGAI effective after the conclusion of his employment with MGAI on March 1, 2003 pursuant to which MGAI will pay Mr. Johnston an aggregate of $200,000 to be made in four equal payments of $50,000 each in March, June, September and December of 2003. (10) SEGMENT REPORTING On February 7, 2002, the Company announced its decision to discontinue writing commercial lines insurance business due to continued adverse claims development and unprofitable results. During 2001 the Company made operating decisions and assessed performance for the commercial lines segment and the personal lines segment. The commercial lines segment wrote primarily commercial auto, general liability and other. The personal lines segment writes primarily nonstandard personal auto coverages. The Company considers many factors including the nature of the insurance product and distribution strategies in determining how to aggregate operating segments. 90 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 The following tables represent a summary of segment data as of and for the years ended December 31, 2002, 2001 and 2000:
2002 ------------------------------------------------------------------ Commercial Personal Lines Lines Other Total ------------ ------------ ------------ ------------ (Dollar amounts in thousands) Gross premiums written $ 11,992 32,231 -- 44,223 ============ ============ ============ ============ Net premiums earned $ 27,929 32,338 -- 60,267 Net investment income 1,738 2,522 55 4,315 Insurance services 3,703 (601) 1,182 4,284 Expenses (41,518) (34,364) (1,400) (77,282) ------------ ------------ ------------ ------------ Operating loss (8,148) (105) (163) (8,416) Net realized gains -- -- 2,049 2,049 Interest expense -- (310) -- (310) Amortization expense -- -- -- -- Goodwill impairment -- (2,860) -- (2,860) ------------ ------------ ------------ ------------ (Loss) income before Federal income taxes $ (8,148) (3,275) 1,886 (9,537) ============ ============ ============ ============ Combined ratio (U.S. GAAP) basis 148.7% 106.3% 0% 125.9% ============ ============ ============ ============ Total assets $ 134,470 72,774 7,145 214,389 ============ ============ ============ ============
The following table provides additional detail of segment revenue components by product line.
2002 ------------------------------------------------------------ Commercial Personal Lines Lines Other Total ------------ ------------ ------------ ------------ (Dollar amounts in thousands) Gross premiums written: Commercial auto $ 6,913 -- -- 6,913 General liability 4,555 -- -- 4,555 Personal auto -- 31,804 -- 31,804 Other 524 427 -- 951 ------------ ------------ ------------ ------------ Total gross premiums written $ 11,992 32,231 -- 44,223 ============ ============ ============ ============ Net premiums earned: Commercial auto $ 16,738 -- -- 16,738 General liability 9,898 -- -- 9,898 Personal auto -- 31,785 -- 31,785 Other 1,293 553 -- 1,846 ------------ ------------ ------------ ------------ Total net premiums earned $ 27,929 32,338 -- 60,267 ============ ============ ============ ============
91 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000
2001 ------------------------------------------------------------------ Commercial Personal Lines Lines Other Total ------------ ------------ ------------ ------------ (Dollar amounts in thousands) Gross premiums written $ 68,499 48,684 -- 117,183 ============ ============ ============ ============ Net premiums earned $ 36,891 31,836 -- 68,727 Net investment income 5,413 2,531 147 8,091 Insurance services -- (1,310) 1,637 327 Expenses (83,928) (34,665) (1,738) (120,331) ------------ ------------ ------------ ------------ Operating (loss) income (41,624) (1,608) 46 (43,186) Net realized gains -- -- 4,275 4,275 Interest expense -- (842) -- (842) Amortization expense -- (882) -- (882) Goodwill impairment -- (18,447) -- (18,447) ------------ ------------ ------------ ------------ (Loss) income before Federal income taxes and cumulative effect of change in accounting principal $ (41,624) (21,779) 4,321 (59,082) ============ ============ ============ ============ Combined ratio (U.S. GAAP) basis 227.5% 108.9% 0% 172.6% ============ ============ ============ ============ Total assets $ 276,275 76,332 26,611 379,218 ============ ============ ============ ============
The following table provides additional detail of segment revenue components by product line.
2001 ------------------------------------------------------------------ Commercial Personal Lines Lines Other Total ------------ ------------ ------------ ------------ (Dollar amounts in thousands) Gross premiums written: Commercial auto $ 40,112 -- -- 40,112 General liability 25,253 -- -- 25,253 Personal auto -- 42,619 -- 42,619 Other 3,134 6,065 -- 9,199 ------------ ------------ ------------ ------------ Total gross premiums written $ 68,499 48,684 -- 117,183 ============ ============ ============ ============ Net premiums earned: Commercial auto $ 18,240 -- -- 18,240 General liability 16,363 -- -- 16,363 Personal auto -- 29,096 -- 29,096 Other 2,288 2,740 -- 5,028 ------------ ------------ ------------ ------------ Total net premiums earned $ 36,891 31,836 -- 68,727 ============ ============ ============ ============
92 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000
2000 ------------------------------------------------------------------ Commercial Personal Lines Lines Other Total ------------ ------------ ------------ ------------ (Dollar amounts in thousands) Gross premiums written $ 113,354 54,932 -- 168,286 ============ ============ ============ ============ Net premiums earned $ 107,922 43,534 -- 151,456 Net investment income 8,671 4,301 1,121 14,093 Insurance services -- 354 700 1,054 Expenses (141,454) (49,847) (1,971) (193,272) ------------ ------------ ------------ ------------ Operating loss (24,861) (1,658) (150) (26,669) Net realized gains -- -- (1,907) (1,907) Interest expense -- (1,409) -- (1,409) Amortization expense -- (964) -- (964) ------------ ------------ ------------ ------------ Loss before Federal income taxes $ (24,861) (4,031) (2,057) (30,949) ============ ============ ============ ============ Combined ratio (U.S. GAAP) basis 131.1% 114.5% 0% 126.3% ============ ============ ============ ============ Total assets $ 308,148 84,599 82,296 475,043 ============ ============ ============ ============
The following table provides additional detail of segment revenue components by product line.
2000 ------------------------------------------------------------------ Commercial Personal Lines Lines Other Total ------------ ------------ ------------ ------------ (Dollar amounts in thousands) Gross premiums written: Commercial auto $ 74,748 -- -- 74,748 General liability 32,511 -- -- 32,511 Personal auto -- 47,914 -- 47,914 Other 6,095 7,018 -- 13,113 ------------ ------------ ------------ ------------ Total gross premiums written $ 113,354 54,932 -- 168,286 ============ ============ ============ ============ Net premiums earned: Commercial auto $ 78,341 -- -- 78,341 General liability 23,908 -- -- 23,908 Personal auto -- 41,157 -- 41,157 Other 5,673 2,377 -- 8,050 ------------ ------------ ------------ ------------ Total net premiums earned $ 107,922 43,534 -- 151,456 ============ ============ ============ ============
93 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 (11) CONTINGENCIES In the normal course of its operations, the Company has been named as defendant in various legal actions seeking payments for claims denied by the Company and other monetary damages. The Company's management believes that unpaid claims and claim adjustment expenses are adequate to cover possible liability from lawsuits which arise in the normal course of its insurance business. In the opinion of the Company's management the ultimate liability, if any, resulting from the disposition of all claims will not have a material adverse effect on the Company's consolidated financial position or results of operations. The Company does not have any financial instruments where there is off-balance-sheet-risk of accounting loss due to credit or market risk. There is credit risk in the premiums receivable and reinsurance balances receivable of the Company. At December 31, 2002 the Company had claims receivables that were material with regard to shareholders' equity from Hartford Fire Insurance Company of approximately $2,819,000 and Motors Insurance Corporation of approximately $1,947,000. (12) QUARTERLY FINANCIAL DATA (UNAUDITED) The following table contains selected unaudited consolidated financial data for each quarter (in thousands, except per share data):
2002 Quarter 2001 Quarter ------------------------------------------------ ------------------------------------------------ Fourth Third Second First Fourth Third Second First --------- --------- --------- --------- --------- --------- --------- --------- Gross premiums written $ 6,846 8,942 8,781 19,653 22,873 27,079 29,127 38,104 Total revenues $ 14,684 16,675 19,781 19,776 21,865 19,933 19,346 20,276 Total expenses $ 14,674 19,043 24,581 22,154 61,428 26,292 30,579 22,203 Net gain (loss) $ 23 240 (4,801) (4,223) (62,249) (4,291) (7,879) (1,188) Loss per common share: Basic $ (0.04) (0.03) (.27) (.24) (2.98) (.24) (.41) (.06) Diluted $ (0.04) (0.03) (.27) (.24) (2.98) (.24) (.41) (.06) Common share prices (a) High .14 .06 .35 1.93 1.76 1.55 1.90 4.0625 Low .02 .02 .05 .25 1.30 1.10 1.10 1.40
(a) As reported by the New York Stock Exchange for 2001 through April 14, 2002 and reported by the OTC Bulletin Board for April 15, 2002 to the fourth quarter of 2002. The net loss of $62,249,000 recorded for the fourth quarter of 2001 is primarily a result of unfavorable claims experience, goodwill impairment, a provision for potentially uncollectible receivables and a valuation allowance for deferred Federal income taxes. The Company recorded an increase in estimated ultimate claims liabilities of approximately $20,000,000 in the fourth quarter of 2001. The Company also recorded a provision for potentially uncollectible receivables of approximately $2,654,000. In December 2001 the Company recorded an impairment of approximately $13,361,000 on the goodwill 94 GAINSCO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2002, 2001 and 2000 associated with the 1998 acquisition of the Lalande Group. This action was taken to reflect estimated fair valuation levels of agencies in the personal automobile marketplace. Due to the uncertainty of future profitability levels, the Company recorded a valuation allowance of approximately $31,535,000 against its deferred Federal income tax asset. 95 INDEPENDENT AUDITORS' REPORT ON SUPPLEMENTARY INFORMATION The Board of Directors and Shareholders GAINSCO, INC: Under date of March 24, 2003 we reported on the consolidated balance sheets of GAINSCO, INC. and subsidiaries as of December 31, 2002 and 2001 and the related consolidated statements of operations, shareholders' equity and comprehensive loss and cash flows for each of the years in the three-year period ended December 31, 2002. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Our report refers to a change in accounting for goodwill and other intangible assets in 2002 as a result of the adoption of Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets," and to a change in the method of accounting for residual interests in securitizations in 2001 as a result of the adoption of EITF 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets." /s/ KPMG LLP ------------------------- KPMG LLP Dallas, Texas March 24, 2003 96 SCHEDULE I GAINSCO, INC. AND SUBSIDIARIES Summary of Investments - Other Than Investments in Related Parties (Amounts in thousands)
As of December 31 --------------------------------------------- 2002 2001 --------------------- --------------------- (Amounts in thousands) Amortized Fair Amortized Fair Cost Value Cost Value --------- --------- --------- --------- Type of Investment Fixed Maturities: Bonds available for sale: U.S. Government securities $ 24,217 24,947 16,730 17,167 Tax-exempt municipal bonds 465 480 8,912 9,139 Corporate bonds 34,338 37,231 101,727 106,488 Certificates of deposit 645 645 645 645 Marketable securities -- -- 2,110 2,112 --------- --------- --------- --------- 59,665 63,303 130,124 135,551 --------- --------- --------- --------- Short-term investments 51,671 51,671 45,127 45,127 --------- --------- --------- --------- Total investments $ 111,336 114,974 175,251 180,678 ========= ========= ========= =========
See accompanying independent auditors' report on supplementary information. 97 SCHEDULE II CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT GAINSCO, INC. (PARENT COMPANY) Balance Sheets December 31, 2002 and 2001
2002 2001 -------------- -------------- Assets Investments in subsidiaries $ 42,726,032 56,403,052 Other investments, at cost (which approximates fair value) -- 2,087,354 Short term investments 4,461,558 2,125,213 Cash 4,793 3,119 Net receivables from subsidiaries -- 482,750 Deferred Federal income taxes (net of valuation allowance $4,830,024 in 2002 and $3,840,789 in 2001) -- -- Other assets 50,025 118,290 Goodwill 609,000 3,468,507 -------------- -------------- Total assets $ 47,851,408 64,688,285 ============== ============== Liabilities and Shareholders' Equity Liabilities: Accounts payable $ -- 120,704 Net payables to subsidiaries 218,623 -- Note payable 3,700,000 10,800,000 Other liabilities 90,000 -- Current Federal income taxes 1,237,571 1,221,308 -------------- -------------- Total liabilities 5,246,194 12,142,012 -------------- -------------- Redeemable convertible preferred stock - Series A ($1,000 stated value, 31,620 shares authorized, 31,620 issued at December 31, 2002 and December 31, 2001), liquidation value of $31,620,000 21,343,000 18,722,000 Redeemable convertible preferred stock - Series B ($1,000 stated value, 3,000 shares authorized, 3,000 issued at December 31, 2002 and December 31, 2001), at liquidation value 3,449,057 3,077,672 Redeemable preferred stock - Series C ($1,000 stated value, 3,000 shares authorized, 3,000 issued at December 31, 2002 December 31, 2001), at liquidation value 3,566,057 3,230,672 -------------- -------------- 28,358,114 25,030,344 -------------- -------------- Shareholders' equity: Common stock ($.10 par value, 250,000,000 shares authorized, 22,013,830 issued at December 31, 2002 and December 31, 2001) 2,201,383 2,201,383 Common stock warrants 540,000 540,000 Additional paid-in capital 100,866,124 100,866,124 Accumulated other comprehensive income 2,400,722 3,580,690 Retained deficit (84,066,604) (71,977,743) Treasury stock, at cost (844,094 shares at December 31, 2002 and December 31, 2001) (7,694,525) (7,694,525) -------------- -------------- Total shareholders' equity 14,247,100 27,515,929 -------------- -------------- Total liabilities and shareholders' equity $ 47,851,408 64,688,285 ============== ==============
See accompanying notes to condensed financial statements. See accompanying independent auditors' report on supplementary information. 98 SCHEDULE II CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT GAINSCO, INC. (PARENT COMPANY) Statements of Operations Years ended December 31, 2002, 2001 and 2000
2002 2001 2000 ------------ ------------ ------------ Revenues: Dividend income $ 12,060,048 500,000 1,930,000 Investment income 54,993 146,354 1,121,049 Realized capital (losses) gains -- (1,643,781) 26,676 ------------ ------------ ------------ Total revenues 12,115,041 (997,427) 3,077,725 ------------ ------------ ------------ Expenses: Interest expense 310,095 842,368 1,409,378 Amortization of goodwill -- 881,965 963,700 Operating expense 1,678,188 1,868,240 2,118,502 Goodwill impairment 2,859,507 18,446,886 -- ------------ ------------ ------------ Total expenses 4,847,790 22,039,459 4,491,580 ------------ ------------ ------------ Operating income (loss) before Federal income taxes 7,267,251 (23,036,886) (1,413,855) Federal income taxes: Current expense 348,323 596,386 756,576 Deferred expense (benefit) -- 2,016,628 (1,572,735) ------------ ------------ ------------ 348,323 2,613,014 (816,159) ------------ ------------ ------------ Income (loss) before equity in undistributed income (loss) of subsidiaries 6,918,928 (25,649,900) (597,696) Equity in undistributed loss of subsidiaries (15,680,015) (49,957,147) (18,953,669) ------------ ------------ ------------ Net loss $ (8,761,087) (75,607,047) (19,551,365) ------------ ============ ============ Loss per common share: Basic $ (0.57) (3.68) (.97) ============ ============ ============ Diluted $ (0.57) (3.68) (.97) ============ ============ ============
See accompanying notes to condensed financial statements. See accompanying independent auditors' report on supplementary information. 99 SCHEDULE II CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT GAINSCO, INC. (PARENT COMPANY) Statements of Shareholders' Equity and Comprehensive Loss Years ended December 31, 2002, 2001 and 2000
2002 2001 2000 ------------ ------------ ------------ Preferred stock: Balance at beginning of year $ -- 3,162,000 3,162,000 Conversion of shares to redeemable preferred stock (31,620 - 2001) -- (3,162,000) -- ------------ ------------ ------------ Balance at end of year -- -- 3,162,000 ------------ ------------ ------------ Common stock: Balance at beginning of year 2,201,383 2,201,383 2,176,393 Exercise of options to purchase shares (249,903 - 2000) -- -- 24,990 ------------ ------------ ------------ Balance at end of year 2,201,383 2,201,383 2,201,383 ------------ ------------ ------------ Common stock warrants: Balance at beginning of year 540,000 2,040,000 2,040,000 Repricing of Series A and Series B warrants -- (1,680,000) -- Issuance of warrants in connection with preferred stock -- 180,000 -- ------------ ------------ ------------ Balance at end of year 540,000 540,000 2,040,000 ------------ ------------ ------------ Additional paid-in capital: Balance at beginning of year 100,866,124 113,540,252 112,674,842 Exercise of options to purchase shares (249,903 - 2000) -- -- 519,246 Conversion of shares to redeemable preferred stock (31,620 - 2001) -- (12,761,278) -- Accretion of discount on preferred shares -- 87,150 346,164 ------------ ------------ ------------ Balance at end of year $100,866,124 100,866,124 113,540,252 ------------ ------------ ------------
(continued) 100 SCHEDULE II CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT GAINSCO, INC. (PARENT COMPANY) Statements of Shareholders' Equity and Comprehensive Loss Years ended December 31, 2002, 2001 and 2000
2002 2001 2000 --------------------------- ----------------------------- -------------------------- Retained (deficit) earnings: Balance at beginning of year $(71,977,743) 5,957,798 27,586,440 Net loss for year (8,761,087) (8,761,087) (75,607,047) (75,607,047) (19,551,365) (19,551,365) Cash dividend - common -- -- (1,474,206) Cash dividend - preferred -- -- (434,000) Accrued dividends - redeemable preferred stock (670,774) (461,344) -- Accretion of discount on preferred shares -- (87,150) (346,164) Accretion of discount on redeemable preferred shares (2,657,000) (1,780,000) -- Tax benefit on non-qualified stock options exercised -- -- 177,093 ------------ ------------ ------------ Balance at end of year (84,066,604) (71,977,743) 5,957,798 ------------ ------------ ------------ Accumulated other comprehensive income (loss): Balance at beginning of year 3,580,690 3,897,371 (2,246,575) Unrealized (losses) gains on securities, net of reclassification adjustment, net of tax (1,179,968) (1,179,968) (316,681) (316,681) 6,143,946 6,143,946 ------------ ------------ ------------ ------------ ------------ ------------ Comprehensive loss (9,941,055) (75,923,728) (13,407,419) ============ ============ ============ Balance at end of year 2,400,722 3,580,690 3,897,371 ------------ ------------ ------------ Treasury stock: Balance at beginning and at end of year (7,694,525) (7,694,525) (7,694,525) ------------ ------------ ------------ Total shareholders' equity at end of year $ 14,247,100 27,515,929 123,104,279 ============ ============ ============
See accompanying notes to condensed financial statements. See accompanying independent auditors' report on supplementary information. 101 SCHEDULE II CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT GAINSCO, INC. (PARENT COMPANY) Statements of Cash Flows Years ended December 31, 2002, 2001 and 2000
2002 2001 2000 ------------ ------------ ------------ Cash flows from operating activities: Net loss $ (8,761,087) (75,607,047) (19,551,365) Adjustments to reconcile net loss to cash provided by (used for) operating activities: Depreciation and amortization -- 881,966 963,700 Goodwill impairment 2,859,507 18,446,886 -- Impairment of other investments -- 2,176,231 -- Change in deferred Federal income taxes -- 1,641,139 (1,572,735) Change in accrued investment income -- -- (13,484) Change in net receivables from/payables to subsidiaries 701,373 (6,888,737) 9,852,766 Change in other assets 68,265 338,857 (314,969) Change in other liabilities 90,000 -- -- Change in accounts payable (120,704) (1,953,029) 45,520 Equity in (income) loss of subsidiaries 15,680,015 49,957,147 18,953,669 Change in current Federal income taxes 16,263 464,732 756,576 ------------ ------------ ------------ Net cash provided by (used for) operating activities 10,533,632 (10,541,855) 9,119,678 ------------ ------------ ------------ Cash flows from investing activities: Common stock purchased -- -- (448,097) Common stock sold -- 448,097 -- Other investments purchased -- -- (3,505,932) Other investments sold 2,087,354 -- 247,500 Change in short term investments (2,336,345) 9,714,531 19,195,181 Capital contributions to subsidiaries (3,182,048) -- (12,553,071) Net assets acquired through purchase of subsidiary -- -- (9,150,647) Net assets disposed of through sale of subsidiary (919) 648,852 -- ------------ ------------ ------------ Net cash (used for) provided by investing activities $ (3,431,958) 10,811,480 (6,215,066) ------------ ------------ ------------
(continued) 102 SCHEDULE II CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT GAINSCO, INC. (PARENT COMPANY) Statements of Cash Flows Years ended December 31, 2002, 2001 and 2000
2002 2001 2000 ------------ ------------ ------------ Cash flows from financing activities: Payments on note payable $ (7,100,000) (5,200,000) (2,000,000) Cash dividends paid -- (478,971) (1,903,830) Redeemable preferred stock and warrants issued (net of transaction fees) -- 5,365,722 -- Proceeds from exercise of common stock options -- -- 544,236 ------------ ------------ ------------ Net cash provided used for financing (7,100,000) (313,249) (3,359,594) ------------ ------------ ------------ Net increase (decrease) in cash 1,674 (43,624) (454,982) Cash at beginning of year 3,119 46,743 501,725 ------------ ------------ ------------ Cash at end of year $ 4,793 3,119 46,743 ============ ============ ============
See accompanying notes to condensed financial statements. See accompanying independent auditors' report on supplementary information. 103 SCHEDULE II CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT GAINSCO, INC. (PARENT COMPANY) Notes to Condensed Financial Statements December 31, 2002, 2001 and 2000 (1) GENERAL The accompanying condensed financial statements should be read in conjunction with the notes to the consolidated financial statements for the years ended December 31, 2002, 2001 and 2000 included elsewhere in this Annual Report. (2) RELATED PARTIES The capital contribution made in 2002 was the equity of GCM that was contributed to General Agents in conjunction with General Agents assuming the liabilities of GCM in December 2002. The Company made a cash capital contribution of $2,500,000 to General Agents in June of 2000. Also during 2000, the Company made capital contributions to GAINSCO Service Corp by forgiving intercompany debt in the amount of $2,061,066. Included in the payable to General Agents at December 31, 2000 was an accrued capital contribution of $8,000,000. The cash was paid to General Agents in February 2001. The Company acquired the net assets of Tri-State of $3,732,708 in January 2000 through the purchase of all its outstanding capital stock. The capital stock was sold in August 2001 to Herbert A. Hill, Tri-State's president and former owner. The following table presents the components of the net receivable from and payable to subsidiaries at December 31, 2002 and 2001:
Name of subsidiary 2002 2001 ------------------ ------------ ------------ Agents Processing Systems, Inc. $ 887,775 887,775 GAINSCO Service Corp (1,106,398) (405,525) General Agents Insurance Company of America, Inc. -- 500 ------------ ------------ Net receivable from (payable to) subsidiaries $ (218,623) 482,750 ============ ============
See accompanying independent auditors' report on supplementary information. 104 SCHEDULE III GAINSCO, INC. AND SUBSIDIARIES Supplementary Insurance Information Years ended December, 2002, 2001 and 2000 (Amounts in thousands)
Other Deferred Reserves policy policy for claims claims and Net Net Claims acquisition and claim Unearned benefits premiums Investment and claim Segment costs(1) expenses premiums payable earned Income expenses ------- ------------ ---------- -------- ---------- -------- ---------- --------- Year ended December 31, 2002: Commercial lines $ 179 124,607 967 668 27,929 1,738 28,139 Personal lines 1,495 18,664 7,613 964 32,338 2,522 28,275 Other -- -- -- -- -- 55 -- ------------ ---------- -------- ---------- -------- ---------- --------- Total $ 1,674 143,271 8,580 1,632 60,267 4,315 56,414 ============ ========== ======== ========== ======== ========== ========= Year ended December 31, 2001: Commercial lines $ 2,240 162,255 31,071 5,657 36,891 5,413 58,453 Personal lines 948 18,804 16,903 1,361 31,836 2,531 28,973 Other -- -- -- -- -- 147 -- ------------ ---------- -------- ---------- -------- ---------- --------- Total $ 3,188 181,059 47,974 7,018 68,727 8,091 87,426 ============ ========== ======== ========== ======== ========== ========= Year ended December 31, 2000: Commercial lines $ (375) 150,807 49,286 7,121 107,922 8,671 103,475 Personal lines 2,677 13,353 23,292 1,742 43,534 4,301 39,964 Other -- -- -- -- -- 1,121 -- ------------ ---------- -------- ---------- -------- ---------- --------- Total $ 2,302 164,160 72,578 8,863 151,456 14,093 143,439 ============ ========== ======== ========== ======== ========== =========
Amortization of deferred Other policy operating Net acquisition costs and premiums Segment costs(2) expenses written ------- ------------ --------- -------- Year ended December 31, 2002: Commercial lines 5,102 11,317 10,960 Personal lines 5,848 9,807 31,634 Other -- 1,400 -- ------------ --------- -------- Total 10,950 22,524 42,594 ============ ========= ======== Year ended December 31, 2001: Commercial lines 10,678 28,090 45,001 Personal lines 9,392 24,134 23,294 Other -- 1,738 -- ------------ --------- -------- Total 20,070 53,962 68,295 ============ ========= ======== Year ended December 31, 2000: Commercial lines 28,883 26,543 75,516 Personal lines 10,441 11,053 43,307 Other -- 1,971 -- ------------ --------- -------- Total 39,324 39,567 118,823 ============ ========= ========
(1) Net of deferred ceding commission income. (2) Net of the amortization of deferred ceding commission income. See accompanying independent auditors' report on supplementary information. 105 SCHEDULE IV GAINSCO, INC. AND SUBSIDIARIES Reinsurance Years ended December 31, 2002, 2001 and 2000 (Amounts in thousands, except percentages)
Percentage Ceded to Assumed of amount Direct other from other Net Assumed amount Companies Companies amount to net ------------ ------------ ------------ ------------ ------------ Year ended December 31, 2002: Premiums earned: Property and casualty $ 76,268 -- -- 76,268 Reinsurance -- (17,740) 1,739 (16,001) ------------ ------------ ------------ ------------ Total $ 76,268 (17,740) 1,739 60,267 2.9% ============ ============ ============ ============ ============ Year ended December 31, 2001: Premiums earned: Property and casualty $ 138,130 -- -- 138,130 Reinsurance -- (72,534) 3,131 (69,403) ------------ ------------ ------------ ------------ Total $ 138,130 (72,534) 3,131 68,727 4.6% ============ ============ ============ ============ ============ Year ended December 31, 2000 Premiums earned: Property and casualty $ 158,937 -- -- 158,937 Reinsurance -- (25,725) 18,244 (7,481) ------------ ------------ ------------ ------------ Total $ 158,937 (25,725) 18,244 151,456 12.0% ============ ============ ============ ============ ============
See accompanying independent auditors' report on supplementary information. 106 SCHEDULE VI GAINSCO, INC. AND SUBSIDIARIES Supplemental Information Years ended December 31, 2002, 2001 and 2000 (Amounts in thousands)
Column A Column B Column C Column D Column E Column F Column H ----------- ----------- ---------- -------- -------- ---------- ---------- Reserves for unpaid Discount Deferred claims if any, Affiliation policy and claim deducted Net with acquisition adjustment in Unearned Net earned Investment Segment registrant costs(1) expenses Column C premiums premiums Income ------- ----------- ----------- ---------- -------- -------- ---------- ---------- Year ended December 31, 2002: Commercial lines $ -- 179 124,607 -- 967 27,929 1,737 Personal lines -- 1,495 18,664 -- 7,613 32,338 2,522 Other -- -- -- -- -- -- 55 ----------- ----------- ---------- -------- -------- ---------- ---------- Total $ -- 1,674 143,271 -- 8,580 60,267 4,314 =========== =========== ========== ======== ======== ========== ========== Year ended December 31, 2001: Commercial lines $ -- 2,240 162,255 -- 31,071 36,891 5,413 Personal lines -- 948 18,804 -- 16,903 31,836 2,531 Other -- -- -- -- -- -- 147 ----------- ----------- ---------- -------- -------- ---------- ---------- Total $ -- 3,188 181,059 -- 47,974 68,727 8,091 =========== =========== ========== ======== ======== ========== ========== Year ended December 31, 2000: Commercial lines $ -- (375) 150,807 -- 49,286 107,922 8,671 Personal lines -- 2,677 13,353 -- 23,292 43,534 4,301 Other -- -- -- -- -- -- 1,121 ----------- ----------- ---------- -------- -------- ---------- ---------- Total $ -- 2,302 164,160 -- 72,578 151,456 14,093 =========== =========== ========== ======== ======== ========== ==========
Column I Column J Column K Column L ----------------- ------------ ---------- ---------- Claims and claim adjustment expenses incurred related to Amortization Paid ----------------- of deferred claims and policy claim Net Current Prior acquisition adjustment premiums Segment year year costs(2) expenses written ------- ------- ------- ------------ ---------- ---------- Year ended December 31, 2002: Commercial lines 22,270 5,868 5,102 49,533 10,960 Personal lines 28,248 28 5,848 25,900 31,634 Other -- -- -- -- -- ------- ------- ------------ ---------- ---------- Total 50,518 5,896 10,950 75,433 42,594 ======= ======= ============ ========== ========== Year ended December 31, 2001: Commercial lines 28,695 29,758 10,678 78,828 45,001 Personal lines 28,225 748 9,392 19,567 23,294 Other -- -- -- -- -- ------- ------- ------------ ---------- ---------- Total 56,920 30,506 20,070 98,395 68,295 ======= ======= ============ ========== ========== Year ended December 31, 2000: Commercial lines 86,339 17,136 28,883 78,342 75,516 Personal lines 37,738 2,226 10,441 35,239 43,307 Other -- -- -- -- -- ------- ------- ------------ ---------- ---------- Total 124,077 19,362 39,324 113,581 118,823 ======= ======= ============ ========== ==========
(1) Net of deferred ceding commission income. (2) Net of the amortization of deferred ceding commission income. See accompanying independent auditors' report on supplementary information. 107 EXHIBIT INDEX
Exhibit No. ----------- *3.1 Restated Articles of Incorporation of Registrant as filed with the Secretary of State of Texas on July 24, 1986 [Exhibit 3.1, filed in Registration Statement No. 33-7846 on Form S-1, effective November 6, 1986]. *3.2 Articles of Amendment to the Articles of Incorporation as filed with the Secretary of State of Texas on June 10, 1988 [Exhibit 3.2, filed in Registration Statement No. 33-25226 on Form S-1, effective November 14, 1988]. *3.3 Articles of Amendment to Articles of Incorporation as filed with the Secretary of State of Texas on August 13, 1993 [Exhibit 3.6, Form 10-K dated March 25, 1994]. *3.4 Statement of Resolution Establishing and Designating Series A Convertible Preferred Stock of Registrant as filed with the Secretary of State of the State of Texas on October 1, 1999 [Exhibit 99.18, Form 8-K dated June 29, 1999]. *3.5 Bylaws of Registrant as amended through September 6, 2001. [Exhibit 3.5, Form 8-K dated August 31, 2001]. *3.6 Statement of Resolution Establishing and Designating Series B Convertible Redeemable Preferred Stock of Registrant as filed with the Secretary of State of the State of Texas on March 22, 2001. [Exhibit 99.19, Form 8-K/A dated March 30, 2001]. *3.7 Statement of Resolution Establishing and Designating Series C Redeemable Preferred Stock of Registrant as filed with the Secretary of State of the State of Texas on March 22, 2001. [Exhibit 99.20, Form 8-K/A dated March 30, 2001]. *4.1 Rights Agreement, dated as of March 3, 1988, between the Registrant and Team Bank/Fort Worth, N.A. [Exhibit 1, Form 8-K dated March 14, 1988]. *4.2 Amendment No. 1 dated as of March 5, 1990 to Rights Agreement dated as of March 3, 1988 between Registrant and Team Bank as Rights Agent [Exhibit 4.2, Form 10-K dated March 27, 1992]. *4.3 Amendment No. 2 dated as of May 25, 1993 to Rights Agreement between Registrant and Society National Bank (successor to Team Bank (formerly Texas American Bank/Fort Worth, N.A.)), as Rights Agent [Exhibit 4.4, Form 10-K dated March 25, 1994]. *4.4 Amendment No. 3 to Rights Agreement and appointment of Continental Stock Transfer & Trust Company as Successor Rights Agent, dated September 30, 1994 [Exhibit 10.29, Form 10-K dated March 30, 1995]. *4.5 Amendment No. 4 dated June 29, 1999 to Rights Agreement between Registrant and Continental Stock Transfer & Trust Company [Exhibit 99.21, Form 8-K dated June 29, 1999]. *4.6 Form of Common Stock Certificate [Exhibit 4.6, Form 10-K dated March 28, 1997]. *4.7 Agreement dated August 26, 1994 appointing Continental Stock Transfer & Trust Company transfer agent and registrar [Exhibit 10.28, Form 10-K dated March 30, 1995].
*10.1 1990 Stock Option Plan of the Registrant [Exhibit 10.16, Form 10-K dated March 22, 1991]. *10.2 1995 Stock Option Plan of the Registrant [Exhibit 10.31, Form 10-K dated March 28, 1996]. *10.3 1998 Long Term Incentive Plan of the Registrant [Exhibit 99.8, Form 10-Q dated August 10, 1998]. *10.4 Forms of Change of Control Agreements [Exhibit 10.4, Form 10-K dated March 29, 2002]. *10.5 Employment Agreement dated April 25, 1998 between Glenn W. Anderson and the Registrant [Exhibit 99.5, Form 10-Q/A dated June 16, 1998]. *10.6 Change of Control Agreement for Glenn W. Anderson [Exhibit 99.7, Form 10-Q/A dated June 16, 1998]. *10.7 Replacement Non-Qualified Stock Option Agreement dated July 24, 1998 between Glenn W. Anderson and the Registrant [Exhibit 99.6, Form 10-Q dated August 10, 1998]. *10.8 Management Contract between GAINSCO County Mutual Insurance Company and GAINSCO Service Corp. and related Surplus Debenture, Amendment to Surplus Debenture, Certificate of Authority and accompanying Commissioner's Order granting Certificate Authority, allowing for charter amendments and extension of charter [Exhibits 10.23, 10.24 and 10.25, Form 10-K dated March 29, 1993; Exhibit 10.27, Form 10-K dated March 25, 1994]. *10.9 Revolving Credit Agreement dated November 13, 1998 among Registrant, GAINSCO Service Corp. and Bank One, Texas, N.A., First Amendment thereto dated October 4, 1999 and related Promissory Note, Security Agreement and Pledge Agreement, Amendment No. 2 thereto dated March 23, 2001, Amendment No.3 thereto dated November 13, 2001, and Amendment No. 4 thereto dated February 27, 2002. [Exhibits 10.50 to 10.53, Form 10-K/A dated March 30, 1999; Exhibit 99.22, Form 8-K dated October 4, 1999; Exhibit 99.24, Form 8-K/A dated March 30, 2001, Exhibit 10.23, Form 10-Q dated November 13, 2001, Exhibit 10.9, Form 8-K dated February 27, 2002]. *10.10 Securities Purchase Agreement dated as of June 29, 1999 between Registrant and Goff Moore Strategic Partners, L.P. ("GMSP") and related Series A Common Stock Purchase Warrant and Series B Common Stock Purchase Warrant [Exhibit 2.1, Form 8-K dated June 29, 1999; Exhibits 99.19 and 99.20, Form 8-K dated October 4, 1999]. *10.11 Investment Management Agreements dated October 4, 1999 between GMSP and each of Registrant, General Agents Insurance Company of America, Inc., MGA Insurance Company, Inc. and GAINSCO County Mutual Insurance Company; and Investment Management Agreement dated January 6, 2000 between GMSP and Midwest Casualty Insurance Company. [Exhibit 10.11, Form 10-K dated March 30, 2000].
*10.12 Stock Purchase Agreements dated August 17, 1998 with Carlos de la Torre, McRae B. Johnston, Michael S. Johnston and Ralph Mayoral relating to acquisition by Registrant of Lalande Group and related employment agreements with them [Exhibits 99.6 to 99.13, Form 8-K dated August 26, 1998]. *10.13 Asset Purchase Agreement dated March 9, 1999 between the Registrant, Agents Processing Systems, Inc. and Insurance Business Solutions Incorporated [Exhibit 10.49, Form 10-K dated March 30, 1999]. *10.14 Stock Purchase Agreement dated as of November 17, 1999 among Registrant, Tri-State, Ltd., Herbert A. Hill and Alan E. Heidt and related Pledge Agreement dated as of January 7, 2000 executed by the Registrant in favor of Bank One, NA and Unlimited Guaranty dated as of January 7, 2000 executed by Tri-State, Ltd. in favor of Bank One, N.A. [Exhibit 10.14, Form 10-K dated March 30, 2000]. *10.15 Agreement of Limited Partnership of GNA Investments I, L.P. dated as of November 30, 1999 between Registrant and GMSP, L.P. [Exhibit 10.15, Form 10-K dated March 30, 2000]. *10.16 Professional Service Agreement dated as of October 22, 1999 between Registrant and ClientSoft, Inc. [Exhibit 10.16, Form 10-K dated March 30, 2000]. *10.17 First Amendment to Stock Purchase Agreement dated May 16, 2000 among Registrant, Tri-State, Ltd., Herbert A. Hill and Alan E. Heidt [Exhibit 10.14, Form 10-Q dated August 11, 2000]. *10.18 GAINSCO, INC. 401(k) Plan and related Adoption Agreement [Exhibit 99.1 to Registration Statement on Form S-8, effective April 12, 2000]. *10.19 Securities Purchase Agreement dated as of February 26, 2001 between Registrant and GMSP (including exhibits) and related First Amendment to Securities Purchase Agreement, letter regarding redemption of Registrant's outstanding Series A Convertible Preferred Stock, First Amendment to Series A Common Stock Purchase Warrant, and First Amendment to Series B Common Stock Purchase Warrant. [Exhibit 2.1, Form 8-K dated March 2, 2001; Exhibits 2.2, 2.8, 99.21 and 99.22, Form 8-K/A dated March 30, 2001]. *10.20 Securities Purchase Agreement dated as of February 26, 2001 between Registrant and Robert W. Stallings ("Stallings") (including exhibits) and related First Amendment to Securities Purchase Agreement, Assignment and Assumption Agreement between Stallings and ING Pilgrim Capital Corporation, LLC, Amendment to Assignment and Assumption Agreement, letter dated March 23, 2001 from Stallings to Registrant, and Common Stock Purchase Warrant. [Exhibit 2.2, Form 8-K dated March 2, 2001; Exhibits 2.4 to 2.7 and 99.23, Form 8-K/A dated March 30, 2001]. *10.21 Consulting Agreement dated as of February 26, 2001 between Registrant and Stallings. [Exhibit 99.15, Form 8-K dated March 2, 2001]. *10.22 Agreement dated March 23, 2001 among Registrant, GAINSCO Service Corp., GMSP, Stallings and Bank One, N.A. [Exhibit 99.25, Form 8-K/A dated March 30, 2001].
*10.23 Letter agreement dated February 27, 2002 between the Registrant and GMSP pursuant to which the Registrant exercised its right to put certain illiquid investments to GMSP for $2,087,354.27 pursuant to Section 6.9 of the Securities Purchase Agreement dated February 26, 2001 between the Registrant and GMSP, as amended. [Exhibit 10.24, Form 8-K/A dated February 27, 2002]. *10.24 Agreement of Sale and Purchase dated March 7, 2002 between General Agents Insurance Company of America, Inc. and Turonian Corp. [Exhibit 10.24, Form 10-K dated March 29, 2002]. *10.25 First Amendment to Investment Management Agreements dated August 9, 2002 among Goff Moore Strategic Partners, L.P., the Registrant, General Agents Insurance Company of America, Inc., MGA Insurance Company, Inc., GAINSCO County Mutual Insurance Company and Midwest Casualty Insurance Company [Exhibit 10.25, Form 10-Q dated August 14, 2002]. *10.26 Acquisition Agreement dated August 12, 2002 among the Registrant, GAINSCO Service Corp., GAINSCO County Mutual Insurance Company, Berkeley Management Corporation and Liberty Mutual Insurance Company [Exhibit 10.26, Form 10-Q dated August 14, 2002]. *10.27 Commercial Lease Agreement dated July 31, 2002 between JaGee Real Properties, L.P. and General Agents Insurance Company of America, Inc. [Exhibit 10.27, Form 10-Q dated August 14, 2002]. *10.28 Form of Executive Severance Agreement between GAINSCO Service Corp. and each of Richard M. Buxton, Richard A. Laabs and Daniel J. Coots. [Exhibit 10.28, Form 10-Q dated August 14, 2002]. *10.29 Representative Forms of Retention Incentive Agreement [Exhibit 10.30, Form 10-Q dated August 14, 2002]. *10.30 Acquisition Agreement dated August 12, 2002 among the Registrant, GAINSCO Service Corp., Berkeley Management Corporation, Liberty Mutual Insurance Company, and GAINSCO County Mutual Insurance Company and Amendment to Acquisition Agreement dated December 2, 2002 among the Registrant, GAINSCO Service Corp., Berkeley Management Corporation, Liberty Mutual Insurance Company, and GAINSCO County Mutual Insurance Company [Exhibit 10.26, Form 10-Q dated August 14, 2002 and Exhibit 10.32, Form 8-K filed December 5, 2002]. *10.31 Office Lease dated August 19, 2002 between Crescent Real Estate Funding X, L.P. and the Registrant. [Exhibit 10.31, Form 10-Q dated November 14, 2002]. *10.32 Separation Agreement and Release dated December 17, 2002 between McRae B. Johnston and MGA Insurance Company, Inc.; Separation Agreement and Release dated December 17, 2002 among McRae B. Johnston, Registrant, National Specialty Lines, Inc., Lalande Financial Group, Inc., DLT Insurance Adjustors, Inc. and Midwest Casualty Insurance Company; Consulting Agreement dated December 17, 2002 between McRae B. Johnston and MGA Insurance Company, Inc.; and Form of Separation Agreement and Release entered into as of March 1, 2003 between McRae B. Johnston and MGA Insurance Company, Inc. [Exhibit 10.33, Form 8-K filed December 17, 2002; Exhibit 10.34, Form 8-K filed December 17, 2002; Exhibit 10.35, Form 8-K filed December 17, 2002; and Exhibit 10.36, Form 8-K filed December 17, 2002].
11 Statement regarding Computation of Per Share Earnings (the required information is included in Note 1(m) of Notes to Consolidated Financial Statements included in this Report and no separate statement is, or is required to be, filed as an exhibit). +21 Subsidiaries of Registrant. +23 Consent of KPMG LLP to incorporation by reference. +24 Form of Power of Attorney. +99.1 Certificate of Chief Executive Officer +99.2 Certificate of Chief Financial Officer
---------- * Exhibit has previously been filed with the Commission as an exhibit in the filing designated in brackets and is incorporated herein by this reference. Registrant's file number for reports filed under the Securities Exchange Act of 1934 is 1-9828. + Filed herewith (see Exhibit Index).