PART I
Item 1. Business.
Direct General Corporation, headquartered in Nashville, Tennessee, was incorporated in 1993 and is a financial services holding company whose principal operating subsidiaries provide non-standard personal automobile insurance, term life insurance, premium finance and other consumer products and services primarily on a direct basis and primarily in the southeastern United States. Direct General Corporation owns five property/casualty insurance companies, two life/health insurance companies, two premium finance companies, twelve insurance agencies, two administrative service companies and one company that provides non-insurance consumer products and services. We are organized as a holding company system with all of our operations being conducted by our wholly-owned subsidiaries. Throughout this report the pronouns “we”, “us”, “our”, and similar words or phrases are sometimes used when collectively describing or referring to the operations conducted, financial measurements, geographical areas of operations, licensing and other regulatory obligations, etc. of Direct General Corporation and its subsidiaries that make up the Direct General holding company system as a whole. The reader of this report should understand that these generalized descriptions and references relate only to the Company (whether Direct General Corporation and/or one or more of its subsidiaries) within the Direct General holding company system to which the description or reference specifically applies and not literally to every corporate member of the Direct General group.
On December 4, 2006, we entered into a definitive merger agreement with Elara Holdings, Inc., or Elara, an affiliate of Fremont Partners and Texas Pacific Group, and Elara Merger Corporation, pursuant to which Elara agreed to acquire all of our outstanding stock. Upon completion of the merger, Elara will pay $21.25 for each of our outstanding shares of common stock. Recently, Fremont Partners and Texas Pacific Group have changed their names to Calera Capital and TPG Capital, respectively. We sometimes refer to the proposed transaction herein as the “Elara Merger.”
Our Board of Directors approved, and on March 8, 2007, our stockholders voted to approve the Elara Merger. Upon completion of the Elara Merger, we will become a privately held company, and our common stock will no longer be publicly traded. Completion of the Elara Merger is subject to customary conditions to closing. In addition, state insurance, finance and other laws that apply to our various subsidiaries generally require that an acquiring party in a merger transaction obtain approval from the relevant state insurance and finance commissioner or banking or similar department prior to the acquisition. Accordingly, applications have been be filed with the insurance, finance, banking or other required commissioners or departments of the state of domicile (or state of commercial domicile in the case of Florida) of our insurance company, finance company and small loan/payday lending subsidiaries. In addition, filings have been made under the insurance and finance laws of certain other states that require the filing of a pre-acquisition notice and the expiration or termination of a waiting period prior to the consummation of the Elara Merger.
Our Business Model
Our model emphasizes the distribution of our products and services through neighborhood sales offices staffed by employee-agents as opposed to commissioned agents. In contrast to the independent agency distribution model relied upon by many of our insurance competitors, our business model allows us to generate significant revenue from sources other than premiums from our core product, non-standard personal automobile insurance. These additional revenues include premium finance revenues, commissions from the sale of non-core insurance products and other revenues, none of which entails insurance underwriting risk. In the independent agency distribution model, these additional revenues would typically be paid to an unaffiliated premium finance company, independent agent, or other third party.
Our Products and Services
Our core business involves issuing non-standard personal automobile insurance policies. These policies, which generally are issued for the minimum limits of coverage required by state laws, provide coverage to drivers who generally cannot obtain insurance from standard carriers due to a variety of factors, including the lack of flexible payment plans, the failure to maintain continuous coverage, age, prior accidents, driving violations, occupation and type of vehicle.
Through our premium finance subsidiaries, we finance the majority of the insurance policies that we sell. Premium finance involves making a loan to the customer backed by the unearned portion of the insurance premiums being financed, which is the portion of the loan attributable to future periods of coverage. We offer our customers a variety of flexible payment plans that allow for low down payments which we believe is a significant factor our customers consider when purchasing insurance.
We offer a variety of other insurance products designed to benefit and appeal to purchasers of our non-standard personal automobile insurance policies, including term life insurance offered through our wholly-owned life insurance subsidiaries, as well as vehicle protection insurance and hospital indemnity insurance underwritten by unaffiliated insurers for which we receive a commission but do not bear insurance underwriting risk. Since 2004, we have offered private labeled prepaid Visa ® debit cards to our customers. The cards are administered by a third party processor, and we receive issuance and transaction fees. We also offer payday consumer loans in certain of our Florida, Kentucky, Louisiana, Mississippi, Missouri and Tennessee offices. These loans are not offered in every office located in these states because of regulatory or lease restrictions.
Our strategy also contemplates the sale of additional insurance products to our customers. In 2006, we commenced selling motorcycle policies in Tennessee, Arkansas and Illinois, and we plan to roll out motorcycle coverage to the majority of our other states during 2007. We are retaining the underwriting risk for this coverage. We are exploring the possibility of offering additional insurance products, such as renters’, homeowners’ (including mobile homeowners’), and boat and personal watercraft policies. These additional insurance products may either be underwritten by us or by unaffiliated insurers from which we would receive a commission. We will assess the underwriting risk with respect to the products underwritten by us and may cede some portion of the risk to unaffiliated reinsurers.
The following table summarizes the components of our gross revenues for the periods indicated.
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
| ($ in millions) | ||||||||||||
Gross premiums: |
||||||||||||
Gross premiums written — automobile |
$ | 433.2 | $ | 433.1 | $ | 463.5 | ||||||
Gross premiums written — life |
22.7 | 19.9 | 18.4 | |||||||||
Total gross premiums |
455.9 | 453.0 | 481.9 | |||||||||
Ancillary income (1): |
||||||||||||
Finance income |
43.9 | 44.4 | 49.2 | |||||||||
Commission and service fee income |
45.6 | 46.8 | 48.6 | |||||||||
Total ancillary income |
89.5 | 91.2 | 97.8 | |||||||||
Net investment income excluding realized
gains (losses) on securities |
19.0 | 14.7 | 10.8 | |||||||||
Gross revenues (2) |
$ | 564.4 | $ | 558.9 | $ | 590.5 | ||||||
(1) Ancillary income includes income derived from revenue sources that do not entail insurance underwriting risk. (2) Gross revenues, which we consider to be a non-GAAP financial measure, is defined as gross premiums written, including direct premiums written and assumed premiums written, finance income, commission and service fee income, and net investment income (excluding net realized gains (losses) on securities). See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Measurement of Results”.
Our Favorable Cost Structure
We emphasize the use of neighborhood sales offices staffed by employee-agents as opposed to commissioned agents, thereby replacing a variable operating cost structure with a largely fixed operating cost structure. Our sales offices staffed by company employees enable us to capture a significant source of ancillary income that does not entail insurance underwriting risk. Compared to companies operating under the traditional non-
standard automobile insurance business model, where revenues from underwriting operations must cover the operating costs, our ancillary income provides us with a significant source of additional revenues.
Historically, we have relied on distribution relationships with independent agencies, generally as a transitional step in the acquisition of those agencies. In pursuing our strategy of expansion in selected states, since 1991, we have acquired 14 independent insurance agencies with over 250 sales offices in six states.
We seek to attract customers by developing strong brand name recognition in our markets through our television advertising campaigns that emphasize our low down payments, flexible payment plans, convenient neighborhood locations and customer service. Our television advertising campaign is designed to generate telephone inquiries to our neighborhood sales offices or our centralized call center where indications of estimated premiums are given to prospective customers, who are then directed to the nearest neighborhood sales office.
Our neighborhood offices serve as a channel for both product delivery and payment collection. Our widespread and convenient local presence appeals to our customers, most of whom would prefer to conduct business face-to-face rather than by telephone or the Internet. Policy applications are generally completed in the neighborhood sales offices, and most of our customers revisit these offices at least monthly to make their periodic payments.
We have also been pursuing initiatives to broaden our distribution to include sales over the telephone and through the Internet. While we believe that the majority of our business will continue to be conducted through our neighborhood sales offices, we also believe that some customers in the non-standard market prefer the convenience of being able to complete their transactions over the telephone or through the Internet. We commenced selling policies over the phone in the fourth quarter of 2005 and subsequently expanded this alternative distribution to all of our other states during 2006.
We have been testing Internet sales in Florida through an unaffiliated insurance agency over the past few years. In 2006, this agency produced $6.4 million of automobile insurance premiums for us in Florida. We are in the process of expanding our Internet distribution to our other states through both our own website and the website of the unaffiliated agency. We offer online quotes in all markets and customers can purchase their policies through our website in approximately half of our states. Internet sales are now available in Georgia, Illinois, Tennessee, Mississippi, Missouri and Virginia. We expect to make Internet sales available in all of our markets by the end of 2007.
The following table summarizes our operating costs and the percentage of such costs covered by ancillary income for the periods indicated.
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
| ($ in millions) | ||||||||||||
Ancillary income |
$ | 89.5 | $ | 91.2 | $ | 97.8 | ||||||
Operating expenses |
||||||||||||
Selling, general and administrative
costs |
$ | 155.1 | $ | 133.6 | $ | 108.5 | ||||||
Interest expense |
12.0 | 8.3 | 5.5 | |||||||||
Total operating expenses |
$ | 167.1 | $ | 141.9 | $ | 114.0 | ||||||
Ratio of ancillary income to total
operating expenses |
53.6 | % | 64.3 | % | 85.8 | % | ||||||
Our Strengths
We believe that our strengths provide a foundation for profitable growth.
• Our integrated business model enables us to better manage our business and capture a significant amount of premium finance revenues, term life insurance premiums, commissions from the sale of non-core insurance products and other revenues that would typically be paid, in an independent agency
distribution model, to an unaffiliated premium finance company, independent agent or other third party.
• Our broad sales office network, which emphasizes the use of employee-agents, is the cornerstone of our relationship with our customers, who typically would prefer to conduct business face-to-face than by telephone or on the Internet.
• Our premium finance operations, which support the majority of the policies that we sell, provide attractive payment plans for our policyholders and allow us to adjust payment plan structures to meet changes in market demands more quickly than most of our competitors.
• Our favorable cost structure enables us to leverage our largely fixed cost neighborhood sales offices staffed by company employees and reduce our marginal operating cost as we increase revenues.
• Our ancillary revenues, including premium finance revenues, commissions from the sale of non-core insurance products and other revenues, none of which currently entails insurance underwriting risk, defray a significant amount of our operating expenses.
• Our claims settlement philosophy and procedures have been designed with a clear emphasis on controlling costs through the use of our employee-staffed claims operations.
• Our controlled policy underwriting and pricing are supported by an integrated point of sale agency system and back office control system.
• Strong name branding in our markets results from our extensive use of television advertising and the presence of our neighborhood sales offices throughout the states in which we operate.
Our Future Growth
We intend to continue our growth primarily through:
• Increasing Revenues in Existing Markets. We are focused on increasing revenues in our existing markets by:
• generating new customers through our advertising campaigns; and
• increasing the sales of our non-core insurance and non-insurance products and services.
• Expanding Our Product and Service Offerings. We intend to expand the range of non-core insurance and non-insurance products and services we offer.
• Expanding Our Distribution Network. We intend to expand into new states through acquisitions of local agencies and the opening of new sales offices. We also plan to continue to expand alternative distribution channels for our products including further development and enhancement of our Internet distribution to all of our states during 2007.
Our Market
The personal automobile insurance market is comprised of preferred, standard and non-standard insurance segments. The coverages offered by these segments generally include liability (coverage for losses suffered by third parties), physical damage, personal injury protection (no-fault) and uninsured/underinsured motorist coverages. The non-standard automobile insurance coverages, which are generally issued for the minimum limits of coverage required by state laws, provide coverage to drivers who cannot obtain insurance from standard carriers due to a variety of factors, including lack of flexible payment plans, the failure to maintain continuous coverage, age, prior accidents, driving violations, occupation and type of vehicle. In general, customers in the non-standard market have higher average premiums for a comparable amount of coverage than customers who qualify for the standard market.
The higher average premiums compared to the standard market generally result from an increased frequency of losses, which is partially offset by the lower severity of losses resulting from lower limits of coverage. While there is no established industry-recognized demarcation between non-standard and other personal automobile insurance markets, based upon data compiled from A.M. Best, we believe that, as of December 31, 2005, the size of the non-standard automobile market segment in the United States was approximately $37 billion, representing approximately 23% of the total personal automobile insurance market.
In our experience, customers of the non-standard segment generally consider four primary factors when purchasing a personal automobile insurance policy:
• down payment;
• payment frequency and amount;
• total policy premium; and
• customer service.
Our products, premium financing capabilities, neighborhood accessibility, policyholder service, and claims service are designed to meet the needs of our customers, in a manner that recognizes and accommodates our customers’ lifestyles and financial capabilities.
Our Competition
The non-standard automobile insurance business is highly competitive. Since we emphasize sales of insurance policies through neighborhood sales offices staffed by employee-agents, we primarily compete against independent agencies that market insurance on behalf of a number of insurers. We compete with these other insurers based on factors such as price, availability of flexible payment plans, customer service, and claims service. Competition is also based on the availability and quality of products, financial strength, distribution systems and technical expertise.
Based upon data compiled from A.M. Best, we believe that, as of December 31, 2005 (the most recent data available), ten insurance groups accounted for approximately 74% of the approximately $37 billion non-standard market segment. We believe that our primary insurance company competition comes not only from national companies or their subsidiaries, such as the Progressive insurance group, the Allstate insurance group, the Infinity insurance group, the State Farm insurance group, the Berkshire Hathaway insurance group (including GEICO) and the Bristol West insurance group, but also from non-standard insurers and independent agents that operate in a specific region or single state in which we operate. Based upon our direct written premiums for 2005, we believe that, as of December 31, 2005, we would be ranked 15th nationally and ninth in the twelve states in which we operated among non-standard automobile insurers, using the 2005 market data compiled from A.M. Best.
Marketing and Distribution
Television advertising is our most heavily used and, we believe, our most effective advertising medium for reaching our customers. We believe that our local sales office presence, along with our extensive television and yellow page advertising, have allowed us to generate strong brand name recognition in our markets. In addition to our emphasis on television and yellow page advertising, we have begun to explore and implement grass roots marketing efforts that are designed to capitalize on the uniqueness of the designated marketing areas (DMA) in which we operate.
Television Advertising. Our commercials are frequently aired over all of our markets, primarily on network-affiliated stations and a limited number of cable networks. Our advertisements present potential customers with a local phone number, as well as a toll free number for our customer service center in Baton Rouge, Louisiana, and encourage the potential customer to call us for information. Indications of estimated premiums are provided by our employee-agents in our neighborhood sales offices or our representatives located in our customer service center in Baton Rouge. Once the preliminary estimates have been provided over the phone, prospective customers are
directed to the nearest neighborhood sales office where our employee-agents assist in the completion of the policy application, provide an explanation of coverages and policy options, perform an inspection of the insured vehicle and finalize the quote for the coverages selected. Employee-agents then complete the premium finance agreement and collect all amounts that are immediately due under the policy or premium finance agreement. With the implementation of our telephone sales initiative, customers have the option of completing their transaction over the phone by paying their premiums in full or by electing an installment billing option.
Neighborhood Sales Offices. Our neighborhood sales office distribution system is comprised of offices that we have developed, offices that we have obtained through strategic acquisitions of agency operations, and a small number of offices of other independent agents. Our strategy is to place our sales offices in a strip mall on a major thoroughfare in well-populated areas of cities and towns with a population of at least 12,000. We currently lease almost all of our offices subject to operating leases with terms ranging from one month to three years.
We have grown, and we intend to continue to grow, our business by expanding our neighborhood sales office network through the acquisition of independent insurance agencies and the opening of new neighborhood sales offices. The acquisition of independent insurance agencies generally involves the purchase of only the assets of the agency (including customer lists, rights to the agency name and the exclusive right to solicit the customer), and the assumption of certain agreed upon liabilities (generally, office space and equipment leases). We typically hire the employee-agents of the agency and in many cases hire key managers, as well. The acquisition purchase price, which is based on an arm’s-length negotiation, generally varies with the volume of non-standard personal automobile insurance premiums produced by the agency over the twelve months preceding the acquisition.
Since our inception, we have used this expansion model to acquire the assets of 14 independent insurance agencies that included over 250 neighborhood offices in six states. Our most recent agency acquisitions occurred in January 2005, when we paid approximately $5.6 million to acquire the assets of three independent insurance agencies operating through 82 sales offices in Texas.
We believe that our convenient neighborhood sales office concept is an essential component of our business model. Our licensed employee-agents have frequent direct contact with our customers. This direct contact gives us an opportunity to establish a personal relationship with the customer, who in our experience generally prefers face-to-face interaction, and helps us provide quality and efficient service. Our customers use neighborhood sales offices not only to purchase automobile insurance, but also as a convenient location to make their periodic payments and purchase other insurance and non-insurance products and services from us.
Employee-Agents. We believe that our emphasis on the use of employee-agents has made a significant contribution to the overall success of our business model. At our neighborhood sales offices, our employee-agents provide quotes on insurance premiums and payment plan options, sell non-standard personal automobile insurance policies and other insurance and ancillary products, process the relevant forms, inspect the customer’s vehicle and collect and process payments. Additionally, our agents provide other customer support functions, such as contacting customers when they are late on their payments or advising customers when their policies are up for renewal. This level of personal interaction with our customers helps us identify opportunities to provide additional products and services.
New State Expansion. Historically, we have expanded into new states through either the development of neighborhood sales offices or the acquisition of independent agencies. The acquisition of independent agencies generally provides for immediate market recognition and an existing book of business that is able to support the agency expenditures and overhead. In contrast, newly developed neighborhood sales offices in new states where we have not yet established significant name brand recognition, typically operate at a loss during the first several months of operation until such time as we can develop a sufficient customer base to support the cost of the new sales offices.
Alternative Distribution Channels. We believe that a majority of our customer base prefers to conduct business through our neighborhood sales offices. However, we also believe that there is a segment of the non-standard market that has the ability and desire to conduct business over the telephone or through the Internet. Phone sales are available now in all states and sales through the Internet should be available in all of our states in 2007.
Our Products and Services
Non-Standard Personal Automobile Insurance
Non-standard personal automobile insurance policies constitute our core product. These policies, which generally are issued for the minimum limits of coverage required by state laws, provide coverage to drivers who cannot obtain insurance from standard carriers due to a variety of factors, including the lack of flexible payment plans, the failure to maintain continuous coverage, age, prior accidents, driving violations, occupation and type of vehicle. In general, customers in the non-standard market have higher average premiums for a comparable amount of coverage than customers who qualify for the standard market. The higher average premiums compared to the standard market generally result from an increased frequency of losses, which is partially offset by the lower severity of losses resulting from lower limits of coverage.
We believe that the majority of our customers do not qualify for insurance from standard carriers because of financial reasons, including the failure to maintain continuous coverage. Historically, over 75% of the drivers included under our insurance policies had no points associated with moving violations on their driving record at the time they purchased their policy.
The following table provides a summary of gross personal automobile insurance premiums written for the periods indicated.
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
| ($ in millions) | ||||||||||||
Gross premiums written – Automobile |
$ | 433.2 | $ | 433.1 | $ | 463.5 | ||||||
In 2006, we began issuing motorcycle coverage in Tennessee, Arkansas and Illinois. Because this product is very similar to automobile insurance and we have in-house expertise related to this coverage, we have decided to retain the underwriting risk for this product. We plan to make this product available in the majority of our states in 2007.
Individual Term Life Insurance
We offer our customers individual term life insurance policies with face amounts of $10,000, $15,000, $20,000 or $25,000. These are basic, one-year term policies that are guaranteed to be renewable for two additional one-year periods. Underwriting for this product generally consists of applicants answering certain health related questions. This product, which is sold in our neighborhood sales offices by our licensed employee-agents in each of the states in which we operate, is underwritten by our life insurance subsidiaries. Our employee-agents presently receive a small commission on the sale of this term life product.
The following table provides a summary of gross term life insurance premiums written for the periods indicated.
| Year Ended December 31, | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
| ($ in millions) | ||||||||||||
Gross premiums written – Life |
$ | 22.7 | $ | 19.9 | $ | 18.4 | ||||||
Premium Finance
In 2006, our premium finance subsidiaries financed the premiums on over 95% of the insurance policies that we sold, excluding the monthly policies produced in the State of Texas, which are not financed. Premium
finance involves making a loan to the customer that is backed by the unearned portion of the insurance premiums being financed. We offer our customers a variety of payment plans that allow for low down payments.
We believe that the amount of down payment and the availability of flexible payment plans are two of the primary factors that our customers consider when purchasing non-standard personal automobile insurance. Down payments and payment plans typically are offered by insurers and agents in the form of either installment billing or premium financing arrangements. Insurers typically use installment billing arrangements to bill for the premium of a single policy. Independent agents, who may offer policies from multiple insurers, use premium financing to finance multiple policies through one premium finance agreement. Under our business model, we generally choose to use premium financing versus installment billing because we believe it offers several advantages, including:
• the ability to finance multiple policies through a single premium finance agreement,
• returns comparable to or exceeding those of installment billing,
• a greater flexibility of payment plan structure and down payment,
• the ability to generate revenues in our non-insurance subsidiaries, and
• a more defined regulatory framework for financing premiums.
In a typical premium finance arrangement, the premium finance company lends the amount of the premium (minus the insured’s down payment) to the insured and pays it to the insurance company on behalf of the insured. The insured makes periodic payments to the premium finance company over the term of the finance agreement. Our payment plans and down payments are developed giving consideration to expected default rates and their timing and the amount of the unearned portion of the insurance premiums being financed, which provides security for the loan.
If an insurance policy is cancelled before its term expires, the policyholder has a right to receive a return of the unearned premium. Under a premium finance agreement, however, the policyholder assigns this right to the premium finance company to secure his or her obligations under the loan. If the policyholder defaults on a payment and, after being notified of the default, fails to cure the default within the prescribed time period, the premium finance company has the right to order the insurance company to cancel the policy and pay to the premium finance company the amount of any unearned premium on the policy. If the amount of unearned premium exceeds the balance due on the loan plus any interest and applicable fees owed by the policyholder to the premium finance company, then the premium finance company returns the excess amount to the policyholder in accordance with applicable law.
The regulatory framework under which our premium finance procedures are established is generally set forth in the premium finance statutes of the states in which we operate. Among other restrictions, the interest rate we may charge our customers for financing their premiums is limited by these state statutes. In Arkansas, which has not enacted premium finance legislation or established premium finance regulations, we are generally subject to the usury laws of that state that are applicable to consumer loans. See “Regulatory Environment — Premium Finance Regulation” for additional information about state usury and other regulatory restrictions applicable to our premium finance operations.
We strive to mitigate the risk to us of potential losses from the insured’s default under the premium finance agreement by designing payment plans that give consideration to the principal amount of the loan that is outstand
