Bancinsurance Corporation (“Bancinsurance”) is a specialty property insurance holding company incorporated in the State of Ohio in 1970. Bancinsurance Corporation and its subsidiaries (collectively, the “Company”) have three reportable business segments: (1) property/casualty insurance; (2) municipal code publishing; and (3) insurance agency. These segments are described in more detail below.
Other specialty products consist primarily of our waste surety bond program (“WSB”). In the second quarter of 2004, the Company entered into a quota share reinsurance arrangement with a waste surety bond underwriter whereby the Company assumed and ceded 50% of the applicable business. During 2005, the reinsurance arrangement was amended whereby the assumed participation was reduced from 50% to 25%. The majority of these surety bonds satisfy the closure/post-closure financial responsibility imposed on hazardous and solid waste treatment, storage and disposal facilities pursuant to Subtitles C and D of the Federal Resource Conservation and Recovery Act (“RCRA”). Closure/post-closure bonds cover future costs to close and monitor a regulated site such as a landfill. All of the surety bonds are indemnified by the principal and collateral is maintained on the majority of the bonds. The indemnifications and collateralization of this program reduces the risk of loss.
Municipal Code Publishing. Our wholly-owned subsidiary, American Legal Publishing Corporation (“ALPC”), codifies, publishes, supplements and distributes ordinances for over 1,800 municipalities and counties nationwide in addition to state governments. Ordinance codification is the process of collecting, organizing and publishing legislation for state and local governments. ALPC also provides information management services which include electronic publishing, document imaging and internet hosting services.
It should be noted that there is potential for the Company to mitigate its ultimate liability on the program through the arbitrations with the insurance carriers and/or potential settlements with the insurance carriers; however, because of the subjective nature inherent in assessing the outcome of these matters, management can not estimate the probability of an adverse or favorable outcome as of December 31, 2004. In addition, while outside counsel believes we have legal defenses under the agreements, they are unable to assess whether an adverse outcome is probable or remote in the arbitrations as of December 31, 2004. As a result, in accordance with SFAS No. 5, the Company is reserving to its best estimate of the ultimate liability on the program at December 31, 2004 without any adjustment for positive arbitration outcomes or potential settlement amounts.
In consultation with one of our large lender/dealer customers during 2003, we provided the customer with a variety of risk management solutions. This resulted in our customer making a decision to move its coverage to another one of our lender/dealer products that better fit its changing needs. In conjunction with this change in products, we ceded 100% of this customer’s premiums (along with the associated risk) to its PORC beginning in fourth quarter 2003 (the “Reinsurance Transaction”).
During the second quarter of 2004, the Company entered into a 50% quota share reinsurance arrangement whereby the Company cedes and assumes waste surety bond coverage with another insurance carrier. During 2005, this reinsurance arrangement was amended whereby the assumed participation was reduced from 50% to 25%.
The Company is focused on opportunities in specialty insurance to extend our product offerings with appropriate levels of risk that will enhance the Company’s operating performance. Our strategy emphasizes long-term growth through increased market penetration, product line extensions, and providing our customers and agents with superior service and innovative technology.
Net income for 2003 was $3,909,817, or $0.77 per diluted share, compared to $889,613, or $0.16 per diluted share, in 2002. The most significant factors contributing to the increase were a $2,042,638 favorable comparison in net realized gain (loss) on investments compared to 2002 and adoption of SFAS No. 142 “Goodwill and Other Intangible Assets” in the first quarter of 2002, which resulted in a non-cash after-tax impairment charge of $1,481,858, or $0.25 per diluted share. Results for 2003 were also impacted by a decrease in management fees of $635,348 as a result of rising unemployment compensation obligations related to the increased level of unemployment. The impact of lower management fees in 2003 was mitigated by growth in our CPI product which was introduced in fourth quarter of 2002.
The combined ratio, which is the sum of the loss ratio and the expense ratio, is the traditional measure of underwriting experience for insurance companies. The statutory combined ratio is the sum of the ratio of losses to premiums earned plus the ratio of statutory underwriting expenses to premiums written after reducing both premium amounts by dividends to policyholders. Statutory accounting principles differ in certain respects from GAAP. Under statutory accounting principles, policy acquisition costs and other underwriting expenses are recognized immediately, not at the same time premiums are earned. To convert underwriting expenses to a GAAP basis, policy acquisition expenses are deferred and recognized over the period in which the related premiums are earned. Therefore, the GAAP combined ratio is the sum of the ratio of losses to premiums earned plus the ratio of underwriting expenses to premiums earned. The Company’s specialty insurance products are underwritten by Ohio Indemnity, whose results represent the Company’s combined ratio. The following table reflects Ohio Indemnity’s loss, expense and combined ratios on both a statutory and a GAAP basis for the years ended December 31:
ULI net premiums earned decreased 4.5% from $36,077,514 in 2003 to $34,447,702 in 2004. This decline was primarily due to a decrease in net premiums earned associated with the Reinsurance Transaction combined with a decrease in lending volume by two of our large financial institution customers. These decreases were partially offset by an increase in lending volume by several of our other financial institution customers, new customers added in 2004 and a decrease in experience rating adjustments. The experience rating adjustment is primarily influenced by ULI policy experience-to-date and premium growth. A decrease in experience rating adjustments results in a positive impact to net premiums earned whereas an increase in experience rating adjustments results in a decrease to net premiums earned. Experience rating adjustments decreased during 2004 when compared to 2003 primarily due to the Reinsurance Transaction combined with the decrease in lending volume mentioned above. Management anticipates that experience rating adjustments will fluctuate in future periods based upon loss experience and premium growth.
Investment Income. At December 31, 2004, our $82,789,328 investment portfolio was allocated as follows: fixed maturity securities (71.3%); equity securities (12.5%); short-term investments (15.4%); and other invested assets (0.8%). We seek to invest in investment-grade obligations of states and political subdivisions because the majority of the interest income from such investments is tax-exempt and such investments have generally resulted in more favorable net yields. Net investment income increased 35.3% to $2,164,115 in 2004 from $1,599,064 in 2003. This improvement was due to growth in invested assets during the past twelve months combined with a higher after-tax yield. Higher yields resulted from the Company’s reallocation of its portfolio from short-term investments to fixed maturities during the second and third quarters of 2004, which provided a better matching of the Company’s invested assets to its product liability duration and enhanced the Company’s investment return.
During 2004, we recorded a net realized gain on investments of $1,094,174 compared to $822,161 in 2003. This increase was a combination of the timing of the sale of individual securities and other-than-temporary impairment write downs on investments. We generally decide whether to sell securities based upon investment opportunities and tax consequences. We regularly evaluate the quality of our investment portfolio. When we believe that a specific security has suffered an other-than-temporary decline in value, the difference between cost and estimated fair value is charged to income as a realized loss on investments. There were $535,487 in impairment charges included in net realized gain on investments in 2004 compared to $129,729 in 2003. Included in impairment charges for 2004 is a write down of $334,136 related to a private equity investment due to its financial uncertainty. For more information concerning impairment charges, see “Other-Than-Temporary Impairment of Investments” below.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses (“LAE”) represent claims associated with insured loss events and expenses associated with adjusting and recording policy claims, respectively. Total losses and LAE increased 42.8% to $47,237,315 in 2004 from $33,083,172 in 2003 principally due to losses and LAE of $20.2 million on the discontinued bond program. Excluding the discontinued bond program, losses and LAE declined 17.1% to $27,076,212 in 2004 from $32,650,827 in 2003 primarily due to decreases in losses and LAE for our ULI, CPI and UC products which were partially offset by an increase in losses and LAE for our GAP product.
GAP losses and LAE increased 57.2% to $4,146,627 in 2004 from $2,637,004 in 2003 principally due to growth in the business.
ULI losses and LAE declined 16.8% to $21,568,897 in 2004 from $25,934,642 in 2003. This decrease was due to favorable loss development during 2004 when compared to a year ago as a result of fewer loan defaults, bankruptcies and automobile repossessions among our ULI customers.
CPI losses and LAE decreased 60.4% to $700,395 in 2004 from $1,768,674 in 2003. This decrease was principally due to the cancellation of a poor performing book of business in the second quarter 2004.
UC losses and LAE declined 81.5% to $428,191 in 2004 from $2,318,940 in 2003 primarily due to the cancellation of an excess of loss policy at the end of 2003. This decrease was partially offset by an increase in losses and LAE due to reserve strengthening associated with rising unemployment compensation obligations.
For more information concerning losses and LAE, see “Loss and Loss Adjustment Expense Reserves” below.
Commissions and Other Insurance Expenses. Commission expense rose 43.0% to $11,285,050 in 2004 from $7,891,016 in 2003 principally due to commissions associated with the growth in GAP and WSB combined with a decrease in ceding commissions associated with a lender/dealer reinsurance agreement that was cancelled at the end of 2003. Other insurance operating expenses increased 21.0% to $6,030,136 in 2004 from $4,982,456 in 2003 as a result of an increase salaries and benefits combined with an increase in administrative fees associated with the UCassure® product. These increases were partially offset by a decrease in premium taxes which resulted from the cancellation of the lender/dealer reinsurance agreement at the end of 2003.
Interest Expense. Interest expense increased to $894,463 in 2004 from $541,248 in 2003 principally due to a full year’s interest expense in 2004 compared to a partial year in 2003 associated with the Company’s trust preferred debt transaction in September 2003 that raised $7.2 million. Rising interest rates also contributed to the increase in interest expense. See “Liquidity and Capital Resources” for a more detailed discussion of the Company’s trust preferred debt transactions.
Net premiums earned for CPI rose significantly to $5,439,426 in 2003 from $163,729 a year ago. CPI was introduced in the fourth quarter 2002 and particularly benefited from new policies added during 2003. Net premiums earned for GAP increased to $2,733,170 in 2003 compared with $939,014 the prior year. This increase is due to purchases of GAP coverage by two large financial institution customers in 2003 and increased volume with existing customers. Net premiums earned for UC products grew to $5,296,766 in 2003 from $4,471,133 in 2002 primarily due to rate increases with existing customers.
These increases were partially offset by a decrease in ULI net premiums earned of 1.3% from $36,567,538 in 2002 to $36,077,514 in 2003. This decline was principally due to a decrease in net premiums earned during 2003 associated with the Reinsurance Transaction combined with a decrease in net premiums earned as a result of an increase in experience rating adjustments when compared to a year ago. Experience rating adjustments increased primarily due to premium growth for the ULI product line during 2003. These decreases were partially offset by ULI premium growth due to rate and volume increases with existing customers. Higher levels of automobile lending by some of our large financial institution customers, driven by aggressive financing offers, was the primary cause of the increased volume.
Net premiums earned for the discontinued bond program were $525,089 for 2003 compared to $495,256 a year ago. This increase was primarily the result of additional premiums being reported to the Company by the insurance carriers during 2003 compared to a year ago.
Investment Income. At December 31, 2003, our $73,979,835 investment portfolio was allocated as follows: fixed maturity securities (45.7%); equity securities (13.8%); short-term investments (39.1%); and other invested assets (1.4%). Net investment income increased 29.4% to $1,599,064 in 2003 from $1,236,138 in 2002 due to an increase in invested assets, which was partially offset by lower interest rates and yields on the investment portfolio.
During 2003, we recorded a net realized gain on investments of $822,161 compared with a net realized loss on investments of $1,220,477 in 2002. This increase was a combination of the timing of the sale of individual securities and other-than-temporary impairment write downs on investments. There was $129,729 in impairment charges included in net realized gain (loss) on investments in 2003 compared to $931,531 in 2002. For more information concerning impairment charges, see “Other-Than-Temporary Impairment of Investments” below.
Management Fees. Our management fees in 2003 decreased 84.8% to $114,094 from $749,442 in 2002 as a result of rising unemployment compensation obligations related to the increased level of unemployment.
ULI losses and LAE increased 2.1% to $25,934,642 in 2003 from $25,393,581 in 2002. ULI losses and LAE were impacted by the $2,946,616 of ceded losses and LAE associated with the Reinsurance Transaction. Excluding the impacts of the Reinsurance Transaction, ULI losses and LAE increased 13.7% from 2002. We attribute these increases primarily to our growth in premiums combined with higher frequency of losses and LAE. With the continued slowdown in the U.S. economy and high consumer debt at that time, financial institutions experienced a rise in delinquency dollars. As loan defaults, bankruptcies and automobile repossessions increased, we experienced a higher frequency of losses and LAE.
Codification and Subscription Expenses. Codification and subscription expenses incurred by ALPC increased 13.1% to $3,269,714 in 2003 from $2,889,981 in 2002. These increases were consistent with growth in codification and subscription revenues and were primarily attributable to increases in salaries, outside printing, supplies and consulting fees.
Federal Income Taxes. The Company’s effective income tax rate was 29.2% and 28.4% in 2003 and 2002, respectively. The increase in the effective tax rate was primarily due to declining yields on tax exempt interest income.
GAAP Combined Ratio. For 2003, the combined ratio improved to 92.4% from 93.3% in 2002. The loss ratio declined to 66.1% for 2003 from 67.0% principally due to improvements in our loss ratio for ULI and GAP. The expense ratio remained flat at 26.3% for 2003 and 2002.
In December 2002, we organized BIC Statutory Trust I (“BIC Trust I”), a Connecticut special purpose business trust, which issued $8,000,000 of floating rate trust preferred capital securities in an exempt private placement transaction. In September 2003, we organized BIC Statutory Trust II (“BIC Trust II”), a Delaware special purpose business trust, which issued $7,000,000 of floating rate trust preferred capital securities in an exempt private placement transaction. BIC Trust I and BIC Trust II (collectively, the “Trusts”) were formed for the sole purpose of issuing and selling the floating rate trust preferred capital securities and investing the proceeds from such securities in junior subordinated debentures of the Company. In connection with the issuance of the trust preferred capital securities, the Company issued junior subordinated debentures of $8,248,000 and $7,217,000 to BIC Trust I and BIC Trust II, respectively. The floating rate trust preferred capital securities and the junior subordinated debentures have substantially the same terms and conditions. The Company has fully and unconditionally guaranteed the obligations of the Trusts with respect to the floating rate trust preferred capital securities. The Trusts distribute the interest received from the Company on the junior subordinated debentures to the holders of their floating rate trust preferred capital securities to fulfill their dividend obligations with respect to such trust preferred securities. BIC Trust I’s floating rate trust preferred capital securities, and the junior subordinated debentures issued in connection therewith, pay dividends and interest, as applicable, on a quarterly basis at a rate equal to three month LIBOR plus four hundred basis points (6.44% and 5.18% at December 31, 2004 and 2003, respectively), are redeemable at par on or after December 4, 2007 and mature on December 4, 2032. BIC Trust II’s floating rate trust preferred capital securities, and the junior subordinated debentures issued in connection therewith, pay dividends and
We also have a $10,000,000 unsecured revolving line of credit with a maturity date of June 30, 2007 with a $500,000 outstanding balance at December 31, 2004 ($0 at December 31, 2003). The revolving line of credit provides for interest payable quarterly at an annual rate equal to the prime rate less 75 basis points (4.52% and 3.25% at December 31, 2004 and 2003, respectively). The Company utilizes the line of credit from time to time based on short-term cash flow needs. Under the terms of the revolving credit agreement, our consolidated shareholders’ equity must not fall below $20,000,000 and Ohio Indemnity’s ratio of net premiums written to policyholders surplus cannot exceed three to one. At December 31, 2004, the Company was in compliance with all such covenants.
Because of the nature of the risks we insure on a direct basis, losses and LAE emanating from the insurance policies that we issue are generally characterized by relatively short settlement periods and quick development of ultimate losses compared to claims emanating from other types of insurance products. Therefore, we believe we can estimate our cash needs to meet our policy obligations and utilize cash flows from operations and cash and short-term investments to meet these obligations. The Company considers the relationship between the duration of our policy obligations and our expected cash flows from operations in determining our cash and short-term investment position. We maintain a level of cash and liquid short-term investments which we believe will be adequate to meet our anticipated cash needs without being required to liquidate intermediate-term and long-term investments. At December 31, 2004, total cash and short-term investments were approximately $16.5 million and net loss and LAE reserves, excluding the discontinued bond program, were approximately $9.7 million.
As discussed in “Discontinued Bond Program” above and in Note 16 to the Consolidated Financial Statements, the Company recorded $19.2 million in loss and LAE reserves for its discontinued bond program at December 31, 2004. The Company is currently disputing these losses in ongoing arbitration proceedings. The Company does not intend to pay for any of the losses on the discontinued bond program unless and until the arbitrations are settled on a mutually agreeable basis and/or a final binding judgment is made as to the Company’s liability. Given the uncertainties of the outcome of the arbitrations, potential settlements with the insurance carriers or other potential recoveries, uncertainties as to the prospective settlement amounts between certain insurance carriers and the U.S. Department of Homeland Security and the New Jersey Attorney General, uncertainties in the future loss information provided by the insurance carriers, and the inherent volatility in assumed reinsurance, actual losses incurred for bail and immigration bonds could be materially different from our estimated reserves. Ultimate payment on the discontinued bond program may result in an increase in cash outflows from operations when compared to trends of prior periods and may impact our financial condition by reducing our invested assets. We consider the discontinued bond program liabilities and related arbitrations as we manage our assets and liabilities. In selecting the maturity of securities in which we invest, we consider the relationship between the duration of our fixed-income investments with the expected payout of our liabilities for the discontinued bond program. There are no significant variations between the maturity of our investments and the expected payout of our loss reserves for the discontinued bond program.
We believe that both liquidity and interest rate risk can be minimized by such asset/liability management described above. With this strategy, management believes we can pay our policy liabilities as they become due without being required to use our credit facilities or liquidate intermediate-term and long-term investments; however, in the event that such action is required, it is not anticipated to have a material impact on our results of operations or future liquidity.
ALPC derives its funds principally from codification and subscription fees which are currently sufficient to meet its operating expenses. USA derives its funds principally from commission fees which are currently sufficient to meet its operating expenses.
Cash flows provided by operating activities totaled $8,657,804, $13,755,991 and $6,447,381 for 2004, 2003 and 2002, respectively. The decrease in 2004 (as compared to 2003) was primarily the result of an increase in paid commissions and other insurance expenses of $9.1 million and a decrease in net cash flows from contract funds on deposit and funds held under reinsurance treaties of $4.4 million. These decreases in cash flows were partially offset by an increase in net premiums collected of $5.4 million and a decrease in net paid losses and LAE of $3.1 million. The increase in cash flows provided by operating activities in 2003 (as compared with 2002) was primarily the result of growth in net premiums collected of $10.2 million which was partially offset by an increase in net paid losses and LAE of $3.5 million.
Ohio Indemnity is subject to a Risk Based Capital test applicable to property/casualty insurers. The Risk Based Capital test serves as a benchmark of an insurance enterprise’s solvency by state insurance regulators by establishing statutory surplus targets which will require certain company level or regulatory level actions. Ohio Indemnity’s total adjusted capital is in excess of all required action levels as of December 31, 2004.
Given the Company’s historic cash flows and current financial condition, management believes that the cash flow from operating and investing activities over the next year will provide sufficient liquidity for the operations of the Company.
The following table sets forth the Company’s contractual obligations at December 31, 2004:
Assumed Business. Assumed reinsurance is a line of business with inherent volatility. Since the length of time required for the losses to be reported through the reinsurance system can be quite long, unexpected events are more difficult to predict. Ultimate loss reserve estimates for assumed reinsurance are based primarily on reports received by the Company from the underlying ceding insurers.
As disclosed in “Discontinued Bond Program” above and in Note 16 to the Consolidated Financial Statements, the Company is disputing the discontinued bond program losses in ongoing arbitration proceedings. The discontinued bond program loss and LAE reserves of $19.2 million at December 31, 2004 do not include any adjustment for positive arbitration outcomes or potential settlement amounts. The Company does not intend to pay for any of the losses on the discontinued bond program unless and until the arbitrations are settled on a mutually agreeable basis and/or a final binding judgment is made as to the Company’s liability. Given the uncertainties of the outcome of the arbitrations, potential settlements with the insurance carriers or other potential recoveries, uncertainties as to the prospective settlement amounts between certain insurance carriers and the U.S. Department of Homeland Security and the New Jersey Attorney General, uncertainties in the future loss information provided by the insurance carriers, and the inherent volatility in assumed reinsurance, actual losses incurred for bail and immigration bonds could be materially different from our estimated reserves. As a result, future loss development on the discontinued bond program could have a material effect on the Company’s results of operations and/or financial
Direct Business. For our direct business, estimates of ultimate loss and LAE reserves are based on our historical loss development experience. In using this historical information, we assume that past loss development is predictive of future development. Our assumptions allow for changes in claims and underwriting operations, as now known or anticipated, which may impact the level of required reserves or the emergence of losses. However, we do not anticipate any extraordinary changes in the legal, social or economic environments that could affect the ultimate outcome of claims or the emergence of claims from causes not currently recognized in our historical data. Such extraordinary changes or claims emergence may impact the level of required reserves in ways that are not presently quantifiable. Thus, while we believe our reserve estimates are reasonable given the information currently available, actual emergence of losses could deviate materially from our estimates and from amounts recorded by us.
We conducted a reserve study using historical losses and LAE by product line or coverage within product line. We prepared our estimates of the gross and net loss and LAE liabilities using annual accident year loss development triangles for the following products:
For our UC and other product lines, the Company prepared estimates of loss and LAE reserves based on certain actuarial and other assumptions related to the ultimate cost expected to settle such claims.
ULI - limited liability (“ULIL”) represented approximately $2.7 million of the overall $5.4 million reserve decrease. The improvement in loss experience primarily related to the 2003 accident year. The amount of re-estimated reserves as of the beginning of 2004 was approximately $4.6 million. At December 31, 2004 and 2003, the Company’s ultimate selected loss ratio for the 2003 accident year was 68.1% and 77.6%, respectively. Changes in this key assumption occurred primarily during the first quarter of 2004 as the majority of our ULIL losses are settled within three months from the date of loss. When estimating the ultimate loss ratio at December 31, 2003, the Company selected an ultimate loss ratio for the 2003 accident year that was comparable to previous accident years’ ultimate loss ratios. During the first quarter of 2004, our 2003 accident year loss experience was more favorable than estimated at December 31, 2003. For example, our average paid claim for 2003 accident year losses decreased from $2,323 in 2003 to $1,718 in the first quarter of 2004. In accordance with SFAS No. 60, the Company recorded this change in reserves as a change in estimate during 2004. It should be noted that the ULIL product is subject to premium adjustments based on loss experience (i.e., experience-rated policies and retrospective-rated policies), and therefore, this prior year loss development had no impact on net income.
ULI - non-limited liability (“ULIN”) represented approximately $2.3 million of the overall $5.4 million reserve decrease. The improvement in loss experience primarily related to the 2003 accident year. The amount of re-estimated reserves as of the beginning of 2004 was approximately $3.8 million. At December 31, 2004 and 2003, the Company’s ultimate selected loss ratio for the 2003 accident year was 54.0% and 72.0%, respectively. Changes in this key assumption occurred primarily during the first quarter of 2004 as the majority of our ULIN losses are settled within three months from the date of loss. During the fourth quarter of 2003, loss severity increased for our ULIN product line. The Company considered this factor in selecting its ULIN ultimate loss ratio at December 31, 2003. During the first quarter of 2004, 2003 accident year loss experience was more favorable than estimated at December 31, 2003. For example, our average paid claim for 2003 accident year losses increased from $1,997 in the third quarter of 2003 to $2,356 in the fourth quarter of 2003 and then decreased to $2,070 in the first quarter of 2004. In accordance with SFAS No. 60, the Company recorded this change in reserves as a change in estimate during 2004.
The Company accounts for goodwill in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142, we no longer amortize goodwill and intangibles which have indefinite lives. SFAS No. 142 requires that we assess goodwill and intangibles with indefinite lives for impairment at least annually, based on the fair value of the related reporting unit. Our annual impairment assessment is performed in the fourth quarter, or earlier if deemed necessary.
Certain statements made in this Annual Report on Form 10-K are forward-looking and are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements convey our current expectations or forecast future events. All statements contained in this Annual Report on Form 10-K, other than statements of historical fact, are forward-looking statements. Forward-looking statements include statements regarding our future financial position, business strategy, budgets, projected costs and plans and objectives of management for future operations. The words “may,” “continue,” “estimate,” “intend,” “plan,” “will,” “believe,” “project,” “expect,” “anticipate” and similar expressions generally identify forward-looking statements but the absence of these words does not necessarily mean that a statement is not forward-looking. The forward-looking statements are not guarantees of future performance and involve risks and uncertainties that may cause actual results to differ materially from those statements. Factors that might cause actual results to differ from those statements include, without limitation, changes in underwriting results affected by adverse economic conditions, fluctuations in the investment markets, changes in the retail marketplace, changes in the laws or regulations affecting the operations of the Company, changes in the business tactics or strategies of the Company, the financial condition of the Company’s business partners, changes in market forces, litigation, developments in the discontinued bond program and related arbitrations, the ongoing SEC investigation, the concentrations of ownership of the Company’s common shares by members of the Sokol family, and the other risk factors identified in the Company’s filings with the SEC, any one of which might materially affect the operations of the Company. Any forward-looking statements speak only as of the date made. We undertake no obligation to update any forward-looking statements to reflect events or circumstances arising after the date on which they are made.
Notes to Consolidated Financial Statements - December 31, 2004, 2003 and 2002
Our unemployment compensation (“UC”) products are utilized by qualified entities that elect not to pay the unemployment compensation taxes and instead reimburse state unemployment agencies for benefits paid by the agencies to the entities’ former employees. Through our UCassure® and excess of loss products, we indemnify the qualified entity for liability associated with their reimbursing obligations. Previously our bonded service products insured a national cost containment firm for their program service responsibilities. Our bonded service product was discontinued at the end of 2003 and replaced by the UCassure® product, which provides direct insurance to the employer and the Company greater control in the distribution and expense management of the product. In addition, we underwrite surety bonds that certain states require employers to post in order to obtain reimbursing status for their unemployment compensation obligations.
In addition to the above product lines, beginning in 2001, the Company entered into a reinsurance program covering bail and immigration bonds issued by several insurance carriers and sold by a bail bond agency. This program was discontinued in the second quarter of 2004 and no new bonds were issued after June 23, 2004. For a more detailed description of this program, see Note 16 to the Consolidated Financial Statements.
Municipal Code Publishing. Our wholly-owned subsidiary, American Legal Publishing Corporation (“ALPC”), codifies, publishes, supplements and distributes ordinances for over 1,800 municipalities and counties nationwide in addition to state governments. Ordinance codification is the process of collecting, organizing and publishing legislation for state and local governments. ALPC also provides information management services which includes electronic publishing, document imaging and internet hosting services.
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard (“SFAS”) No. 123R, “Share-Based Payment” that will require compensation costs related to share-based payment transactions to be recognized in the financial statements. With limited exceptions, the amount of compensation cost will be measured based on fair value of the equity instrument issued on the grant-date. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. SFAS No. 123R replaces SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” the principles that the Company currently employs to account and report its employee stock option awards. SFAS No. 123R is effective at the beginning of the entity’s first fiscal year that begins after December 15, 2005. The Company will implement this standard in the first quarter of 2006. The Company cannot estimate the impact of implementing this standard on future net income (loss), but the standard would have decreased recent net income (loss) by approximately $0.01 - $0.02 per diluted share (see Note 1(r) to the Consolidated Financial Statements).
The accompanying financial statements include the Company’s accounts and our wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.
Realized gains and losses on disposal of investments are determined by the specific identification method. The carrying value of an investment is revised and the amount of revision is charged to net realized losses on investments when management determines that a decline in the value of an investment is other than temporary.
As a result of assigning goodwill and intangibles to our reporting segments, in connection with our SFAS No. 142 assessment in 2002, we identified a noncompete agreement in the amount of $120,000 that was included in goodwill and therefore subsequently reclassified to an intangible asset. Provision for amortization is based on a definite life of five years and is computed on the straight-line method.
Commission fee revenues for USA (and Paul Boardway and Associates prior to its dissolution) are recognized when earned based on contractual rates and services provided.
Real estate is stated at cost and depreciated using the straight-line method over thirty-nine years. Property, equipment and computer software are stated at cost and depreciated using the straight-line method over the estimated useful life, ranging from three to five years. Leasehold improvements are capitalized and amortized over the remaining office lease term. Maintenance and repairs are charged directly to expense as incurred.
We file a consolidated federal income tax return with our subsidiaries. Accordingly, deferred tax liabilities and assets have been recognized for the expected future tax consequences of events that have been included in the financial statements or tax returns. Deferred income taxes are recognized at prevailing income tax rates for temporary differences between financial statement and income tax bases of assets and liabilities for which income tax benefits will be realized in future years.
Cash and cash equivalents include all cash balances and highly liquid investments with an initial maturity of three months or less. Cash equivalents are stated at cost, which approximates fair value. The Company places its cash investments with high credit quality financial institutions. Accounts at each institution are insured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000. At December 31, 2004 the Company had uninsured cash of $2,941,671.
The amortized cost and estimated fair value of fixed maturity investments in held to maturity and available for sale securities at December 31, 2004, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The following table summarizes, for all securities in an unrealized loss position at December 31, 2004, the estimated fair value and pre-tax gross unrealized loss by length of time those securities have been continuously in an unrealized loss position.
As of December 31, 2004, the Company had unrealized losses on 58 fixed maturity securities of $141,759, including 31, 18, and 9 securities that maintained an unrealized loss position for 0-6 months, 7-12 months, and greater than 12 months, respectively. All 58 fixed maturity securities had a fair value to cost ratio equal to or greater than 95% as of December 31, 2004.
Revenues earned on uncompleted codification contracts by ALPC were $1,829,586 and $1,625,993 and billings to date on those contracts were $1,707,372 and $1,486,545 at December 31, 2004 and 2003, respectively. The excess of costs and estimated earnings over billings to date are presented in the accompanying balance sheets.
As part of its annual goodwill impairment testing in the fourth quarter of 2004, the Company concluded that an impairment of goodwill existed at its property/casualty insurance segment. The Company performed impairment testing in accordance with SFAS No. 142. The Company, with the assistance of an independent appraisal firm, determined that the carrying value of the reporting segment exceeded the fair value of the reporting segment, resulting in a non-cash impairment charge. The fair value of the reporting segment was estimated using the expected present value of future cash flows. As a result of this impairment, the Company recorded non-cash impairment charges in the fourth quarter of 2004 in the aggregate amount of $753,737 (after tax).
As of December 31, 2004, we had an unsecured $10,000,000 revolving line of credit with a maturity date of June 30, 2007 with a $500,000 outstanding balance ($0 at December 31, 2003). The revolving credit agreement provides for interest payable quarterly, at an annual rate equal to 0.75% less than the prime rate (4.52% and 3.25% per annum at December 31, 2004 and 2003, respectively). The Company was in compliance with all provisions of our debt covenants at December 31, 2004. The bank that provides the credit line is also a policyholder of the Company.
The future minimum lease payments required under these operating leases for the next five fiscal years ending December 31 are as follows:
The Company has a net operating loss carryforward of $6,394,369 which originated in 2004 and will expire in 2024.
The Ohio Indemnity Company Employee 401(k) and Profit Sharing Plan (the “401(k) Plan”) is available to full-time employees who meet the 401(k) Plan’s eligibility requirements. Under the 401(k) Plan, we match 100% of the qualified employee’s contribution up to 3% of salary and 50% of the qualified employee’s contribution between 3% and 5% of salary. The total cost of the matching
We have stock options outstanding and exercisable at December 31, 2004 under two equity compensation plans, each of which has been approved by our security holders.
Our 1984 Stock Option Plan (the “1984 Stock Option Plan”) was open to all employees of the Company. All options were granted to employees of the Company before May 17, 1994 and had a term of not more than ten years. Under the 1984 Stock Option Plan, no options were outstanding at December 31, 2004.
Ohio Indemnity is subject to a Risk Based Capital test applicable to property and casualty insurers. The Risk Based Capital test serves as a benchmark of an insurance enterprise’s solvency by state insurance regulators by establishing statutory surplus targets which will require certain company level or regulatory level actions. Ohio Indemnity’s total adjusted capital was in excess of all required action levels at December 31, 2004.
Ohio Indemnity is statutorily required to file financial statements with state regulatory authorities. The accounting principles used to prepare such statutory financial statements follow prescribed or permitted accounting principles as defined in the National Association of Insurance Commissioners Accounting Practices and Procedures Manual, which principles may differ from GAAP. Permitted statutory accounting practices encompass all accounting practices not so prescribed, but allowed by the Department. Ohio Indemnity has no permitted statutory accounting practices.
Several of our lender/dealer insurance producers have formed sister reinsurance companies, commonly referred to as a producer-owned reinsurance company (“PORC”). The primary reason for an insurance producer to form a PORC is to realize the underwriting profits and investment income from the insurance premiums generated by that producer. In return for ceding business to the PORC, the Company receives a ceding commission, which is based on a percentage of the premiums ceded.
Effective January 1, 2003, the Company entered into a producer-owned reinsurance arrangement with a new lender/dealer producer whereby 100% of that producer’s premiums (along with the associated risk) was ceded to its PORC. This reinsurance arrangement was cancelled effective December 31, 2003. Under this arrangement, the Company ceded premiums earned of $4,435,659 and $13,331,861 during 2004 and 2003, respectively.
Beginning in the second quarter of 2004, the Company entered into a quota share reinsurance arrangement with a waste surety bond underwriter whereby the Company assumed and ceded 50% of the applicable business. Effective January 1, 2005, the reinsurance arrangement was amended whereby the Company assumes 25% and cedes 75% of the applicable business. Under this program, the Company assumed premiums earned of $1,980,492 and ceded premiums earned of $131,051 during 2004.
The fourth insurance carrier, Highlands Insurance Company (“Highlands”), was placed in receivership during 2003. As of December 31, 2004, no arbitrations have been instituted between the Company and Highlands. If Highlands makes a payment to any bond holder and seeks reimbursement from the Company under the reinsurance agreement, the Company currently intends to assert all of its rights and defenses under the reinsurance agreement including without limitation the right to contest payment and its right to rescission.
It should be noted that there is potential for the Company to mitigate its ultimate liability on the program through the arbitrations with the insurance carriers and/or potential settlements with the insurance carriers; however, because of the subjective nature inherent in assessing the outcome of these matters, management can not estimate the probability of an adverse or favorable outcome as of December 31, 2004. In addition, while outside counsel believes we have legal defenses under the agreements, they are unable to assess whether an adverse outcome is probable or remote in the arbitrations as of December 31, 2004. As a result, in accordance with
SFAS No. 5, the Company is reserving to its best estimate of the ultimate liability on the program at December 31, 2004 without any adjustment for positive arbitration outcomes or potential settlement amounts.
See Note 25 to the Consolidated Financial Statements for subsequent events related to the discontinued bond program.
In February 2000, we entered into a Split-Dollar Insurance Agreement for the benefit of another officer in the face amount of $1,000,000. All premiums paid by the Company in accordance with this agreement are to be repaid, in full, without interest, upon the death, retirement or termination of the officer. The Company paid premiums of $30,000 relating to this agreement; however, the Company is no longer paying premiums under the agreement. At December 31, 2004 and 2003, $30,000 was included in loans to affiliates for payment of insurance premiums in accordance with this agreement.
We share the Company’s executive offices with certain of our consolidated subsidiaries. Rental, equipment and bookkeeping expenses are allocated among them pursuant to management fee agreements.
The Company has the following concentrations of net premiums earned with two separate managing general agents within our property/casualty insurance business segment for the years ended December 31:
Notes payable: Rates currently available to us for debt with similar terms and remaining maturities are used to estimate fair value of existing debt. As the interest rate adjusts regularly, the carrying amount is a reasonable estimate of fair value.
In addition to the above, we are involved from time to time in ordinary routine litigation incidental to our business that arises out of or is related to claims made in connection with our insurance policies. We do not believe any of this litigation will have a material adverse effect on the Company’s financial condition or results of operations.
As described in Note 1 to the Consolidated Financial Statements, the Company has three reportable business segments: (1) property/casualty insurance; (2) municipal code publishing; and (3) insurance agency. There are intersegment management and commission fees. The allocations of certain general expenses within segments are based on a number of assumptions, and the reported operating results would change if different methods were applied. Depreciation and capital expenditures are not considered material. Segment results for 2004, 2003 and 2002 are as follows:
On August 30, 2005, the Company received notice from the Highlands’ Receiver of a global settlement with the New Jersey Attorney General on its remaining bail bond obligations. At December 31, 2004, the Company recorded loss and LAE reserves of $.6 million for Highlands’ bail bonds based on estimated settlement amounts provided by Highlands. Based on actual settlement between Highlands and the New Jersey Attorney General, the Company’s loss and LAE reserves were $3.4 million at September 30, 2005 for Highlands’ bail bonds. In accordance with SFAS No. 60, management recorded the increase in loss and LAE reserves of $2.8 million in the third quarter of 2005 as a change in estimate.
On February 14, 2005, the Company received notification from the SEC that it was conducting an informal, non-public inquiry regarding the Company. The inquiry generally concerned the chronology, events and announcements relating to E&Y withdrawing its audit reports for the years 2001 through 2003 for the Company. On March 29, 2005, the Company was notified by the SEC that the informal, non-public inquiry initiated in February 2005 was converted to a formal order of private investigation. The SEC stated in its notification letter that this confidential inquiry should not be construed as an indication by the SEC or its staff that any violation of law has occurred nor should it be considered a reflection upon any person, entity or security. The investigation is ongoing and the Company continues to cooperate fully with the SEC.