In the second quarter of 2004, the Company came to believe that the discontinued bond program was not being operated as it had been represented to the Company by agents of the insurance carriers who had solicited the Company’s participation in the program, and the Company began disputing certain issues with respect to the program, including but not limited to: 1) inaccurate/incomplete disclosures relating to the program; 2) improper supervision by the insurance carriers of the bail bond agency in administering the program; 3) improper disclosures by the insurance carriers through the bail bond agency and the reinsurance intermediaries during the life of the program; and 4) improper premium and claims administration. Consequently, during the second quarter of 2004, the Company ceased paying claims on the program and retained outside legal counsel to review and defend its rights under the program.
See “Business Outlook-Expenses and Investments” below for information regarding the Company’s anticipated legal costs associated with the discontinued bond program arbitrations.
Net income for 2007 was $3,003,709, or $0.59 per diluted share, compared to $5,474,901, or $1.08 per diluted share, in 2006. The most significant factors that influenced the period-over-period comparison was (1) $2.5 million of legal expenses recorded during 2007 related to the SEC investigation, (2) $1.2 million in impairment charges on our investment portfolio in 2007, (3) $2.5 million net realized gain recorded in the prior year for the sale of our publishing subsidiary and (4) a $1.0 million decrease in discontinued bond program losses.
The combined ratio, which is the sum of the loss ratio and the expense ratio, is the traditional measure of underwriting experience for property/casualty insurance companies. The Company’s specialty insurance products are underwritten by Ohio Indemnity, whose results represent the Company’s combined ratio. The statutory combined ratio is the sum of the ratio of losses to premiums earned plus the ratio of statutory underwriting
expenses less management fees 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 less management fees to premiums earned. The following table reflects Ohio Indemnity’s loss, expense and combined ratios on both a statutory and a GAAP basis for the years ended:
Net Premiums Earned. Net premiums earned declined 4.3%, or $2,133,395, to $46,973,258 in 2007 from $49,106,653 a year ago principally due to a decrease in premiums for our ULI product line.
ULI net premiums earned decreased 11.1%, or $2,900,866, to $23,117,118 in 2007 from $26,017,984 a year ago primarily due to the cancellation of a ULI customer at the end of second quarter 2006 (the “Cancelled Account”) combined with a decrease in premiums due to a general agent transferring a portion of its business to other insurance carriers in 2005 (the “Transferred Business”).
Net premiums earned for CPI decreased 41.5%, or $673,510, to $949,984 in 2007 from $1,623,494 a year ago primarily due to a decrease in volume for certain financial institution customers.
Net premiums earned for WIP remained relatively flat at $4,487,206 in 2007 compared to $4,505,250 a year ago.
Net premiums earned for other specialty products increased 406.3%, or $1,020,551, to $1,271,742 in 2007 from $251,191 a year ago primarily due to an increase in contract and escrow surety bond premiums, which the Company began writing in the second half of 2006.
Management Fees. Our management fees decreased 45.9%, or $381,430, to $448,899 in 2007 from $830,329 a year ago primarily due to a rise in unemployment levels. We expect management fees to vary from period to period depending on unemployment levels and benefit charges.
Net Realized Gain on Sale of Affiliate. In connection with the sale of ALPC on August 31, 2006, the Company recorded a net realized gain of approximately $2.5 million ($1.7 million after tax or $0.33 per diluted share) during 2006. In 2007, the Company realized $62,500 of the previously deferred gain on sale of affiliate as we received final cash payments from the Purchaser in the first quarter of 2007 in connection with the sale of ALPC. See “Sale of Affiliate” in Note 1 to the Consolidated Financial Statements and “Sale of Affiliate” in Item 1 above for more information regarding this transaction.
Losses and Loss Adjustment Expenses. Losses and LAE decreased 4.0%, or $1,030,513, to $24,543,730 in 2007 from $25,574,243 a year ago primarily due to a decline in discontinued bond program losses. Discontinued bond program losses and LAE decreased 57.6%, or $1,017,921, to $749,575 in 2007 from $1,767,496 a year ago. See “Overview-Discontinued Bond Program” above and “Discontinued Bond Program” in Note 15 to the Consolidated Financial Statements for a discussion of the discontinued bond program. Excluding the discontinued bond program, losses and LAE remained flat at $23,794,155 in 2007 compared to $23,806,747 a year ago.
ULI losses and LAE decreased 3.8%, or $648,987, to $16,225,537 in 2007 from $16,874,524 a year ago primarily due to the Cancelled Account and the Transferred Business.
GAP losses and LAE increased 6.9%, or $373,682, to $5,757,007 in 2007 from $5,383,325 a year ago primarily due to an increase in loss frequency for one of our financial institution customers which was partially offset by a decrease in losses related to the Transferred Business.
Loss and LAE for other specialty products increased $391,456 in 2007 compared to a year ago primarily due to the increase in premiums for the contract and escrow surety bond business as the Company records loss and LAE reserves for these products using an expected loss ratio reserving method, which is based on a certain percentage of net premiums earned.
For more information concerning losses and LAE, see “Critical Accounting Policies-Loss and Loss Adjustment Expense Reserves” below.
increase in ceded commissions for certain lender service reinsurance arrangements. Other insurance operating expenses and general and administrative expenses combined increased 5.5%, or $599,416, to $11,481,455 in 2007 from $10,882,039 a year ago due primarily to an increase in legal expenses associated with the SEC investigation which was partially offset by a decrease in legal expenses related to the discontinued bond program arbitrations. As previously disclosed, the Company concluded three of the arbitrations during 2006 and the Highlands arbitration is pending. See Note 4 and “Discontinued Bond Program” in Note 15 to the Consolidated Financial Statements, “Overview-Discontinued Bond Program” above and “Regulation-Ongoing SEC Investigation” in Item 1 above for more information concerning the Highlands arbitration and the SEC investigation.
Codification and Subscription Expenses. Codification and subscription expenses declined to zero in 2007 from $1,936,384 a year ago as the Company sold its publishing subsidiary on August 31, 2006. See “Sale of Affiliate” in Note 1 to the Consolidated Financial Statements and “Sale of Affiliate” in Item 1 above for more information regarding this transaction.
Interest Expense. Interest expense increased 3.1%, or $43,606, to $1,472,692 in 2007 from $1,429,086 a year ago as a result of rising interest rates. See “Liquidity and Capital Resources” below for a discussion of the Company’s trust preferred debt issued to affiliates, which makes up the majority of the Company’s interest expense.
Federal Income Taxes. The Company’s effective income tax rate was 13.6% in 2007 compared to 19.8% a year ago. This improvement is attributable to the ratio of tax-exempt income when compared to income from operations for each period.
During the third quarter of 2005, one of our managing general agents moved a portion of its ULI and GAP premium in an effort to more evenly distribute its business with existing insurance carriers. As a result, the Company expects a decline in premiums earned of $1.2 million and a decline in losses, commissions and premium taxes incurred of approximately $1.0 million for this managing general agent for fiscal year 2008 when compared to fiscal year 2007.
Premiums and ceded commissions for our insurance products are earned over the related contract period. For GAP and certain of our ULI and CPI products, the contract period averages approximately five years. As a result, the impacts of decreased premium volumes and cancelled business can persist for a number of years. Conversely, the impacts of increased premium volumes and new business may take several years to fully develop.
If the rate of loan defaults, bankruptcies and automobile repossessions increases for our ULI customers, we would anticipate an increase in the frequency of losses for this product line. Incentives offered on new cars by dealers and manufacturers can depress the value of the used car market. In addition, the higher level of gas prices could lower the market value of less fuel-efficient vehicles. If used car prices decline, the “gap” between the value of the vehicle and the outstanding loan balance would increase and thus the severity and frequency of our GAP losses would increase. The Company has taken pricing actions to help mitigate the effect of these trends.
Since the Company began participating in the waste surety bond program in 2004 there have not been any claims to date. If the Company were to have claims experience on this program during fiscal year 2008, such claims experience could have an impact on our financial performance if our reserves prove to be deficient.
As discussed above in “Overview-Automobile Service Contract Program,” this program could have a material adverse impact on our 2008 financial performance if our actual liability exceeds the collateral held and we cannot collect on the reinsurance.
As disclosed above, during the fourth quarter of 2007, the Company and certain of its current officers received the Notice from the SEC staff and the Company entered into undertaking agreements with such officers. As a result of these events, the Company incurred approximately $2.5 million of legal expenses during the fourth quarter of 2007 related to the SEC investigation. The Company anticipates it will continue to incur legal costs for the SEC investigation during 2008. Due to the inherent uncertainties of the SEC investigation, the Company cannot predict with reasonable certainty the amount or range of amounts of legal costs that will be incurred during fiscal year 2008 for the SEC investigation; however, the Company believes that the amount of such legal costs will be material to our results of operations in 2008. See “Overview-Ongoing SEC Investigation,” “Liquidity and Capital Resources” and “Critical Accounting Policies-Guarantee Liabilities” above and Note 4 to the Consolidated Financial Statements for more information regarding the ongoing SEC investigation.
If interest rates rise (fall), it would increase (decrease) the level of interest expense on the Company’s trust preferred debt and any borrowings under our revolving line of credit. See “Liquidity and Capital Resources” below for more information concerning our trust preferred debt and revolving line of credit. In addition, a rise or fall in
Based on the factors discussed above, our outlook for the 2008 fiscal year is cautious.
We also have a $10,000,000 unsecured revolving line of credit with a maturity date of June 30, 2010 with no outstanding balance at December 31, 2007 and December 31, 2006. The revolving line of credit provides for interest payable quarterly at an annual rate equal to the prime rate less 75 basis points. The Company utilizes the line of
credit from time to time based on short-term cash flow needs. The terms of the revolving credit agreement contain various restrictive covenants. As of December 31, 2007, the Company was in compliance with all such covenants.
The short-term cash requirements of our property/casualty business primarily consist of paying losses and LAE, reinsurance premiums and day-to-day operating expenses. Historically, we have met those requirements through short-term investments and cash receipts from operations, which consist primarily of insurance premiums collected, ceded commissions received and investment income. Our investment portfolio is a source of additional liquidity through the sale of readily marketable fixed maturities, equity securities and short-term investments. After satisfying our cash requirements, excess cash flows from our underwriting and investment activities are used to build the investment portfolio and thereby increase future investment income.
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 facility 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, financial condition and/or future liquidity.
USA derives its funds principally from commissions and fees which are currently sufficient to meet its operating expenses.
Cash flows provided by (used in) operating activities totaled $11,940,540 and $(11,014,388) for 2007 and 2006, respectively. The increase in cash provided by operating activities was primarily the result of a decrease in net paid losses, an increase in ceded commissions received and an increase in funds held for account of others which were partially offset by a decrease in net premiums collected when compared to a year ago. The decrease in net paid losses was primarily due to payments made in 2006 associated with the Aegis and Sirius settlements and the Harco
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 was in excess of all required action levels as of December 31, 2007.
the degree to which any appearance of impairment is attributable to an overall change in market conditions (e.g., interest rates);
See Note 2 to the Consolidated Financial Statements for a table that summarizes the estimated fair value and gross unrealized losses (pre-tax) for all securities in an unrealized loss position at December 31, 2007 and December 31, 2006, distinguishing between those securities which have been continuously in an unrealized loss position for less than twelve months and twelve months or greater.
The Company utilizes its internal staff, reports from ceding insurers under assumed reinsurance and an independent consulting actuary in establishing its loss and LAE reserves. The Company’s independent consulting actuary reviews the Company’s reserve for losses and LAE on a quarterly basis. The Company considers this review in establishing the amount of its reserves for losses and LAE.
Our projection of ultimate loss and LAE reserves are estimates of future events, the outcomes of which are unknown to us at the time the projection is made. Considerable uncertainty and variability are inherent in the estimation of loss and LAE reserves. As a result, it is possible that actual experience may be materially different than the estimates reported. The Company continually revises reserve estimates as experience develops and further claims are reported and resolved. The Company reflects adjustments to reserves in the results of the periods in which such adjustments are made.
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 process can be quite long, unexpected events are more difficult to predict. Ultimate loss reserve estimates for assumed reinsurance are dependent upon and based
As discussed in “Overview-Discontinued Bond Program” above and in “Discontinued Bond Program” in Note 15 to the Consolidated Financial Statements, discontinued bond program loss and LAE reserves were $6.7 million at December 31, 2007. Given the uncertainties of the outcome of the Highlands arbitration and Highlands receivership proceeding, uncertainties in the future loss information provided by Harco and Highlands, and the inherent volatility in assumed reinsurance, actual losses incurred for the discontinued bond program 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 condition.
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 loss 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.
For our UC, WIP and other specialty 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.
In establishing our reserves, we tested our data for reasonableness, such as ensuring there are no outstanding case reserves on closed claims, and consistency with data used in our previous estimates. We found no material discrepancies
The Company calculates a reserve range for its lender service product lines (ULI, CPI and GAP) and calculates point estimates for UC, WIP and other specialty product lines. As of December 31, 2007, our indicated gross loss and LAE reserve range for lender service products was $5.2 million to $6.7 million and our recorded loss and LAE reserves were $6.3 million.
GAP experienced reserve redundancies of approximately $0.7 million during 2007. The improvement in loss experience primarily related to the 2006 accident year. At December 31, 2007 and 2006, the Company’s ultimate selected loss ratio for the 2006 accident year was 45.5% and 54.2%, respectively. Changes in this key assumption occurred primarily during the first half of 2007 as the majority of our GAP losses are settled within six months from the date of loss. When estimating the ultimate loss ratio at December 31, 2006, the Company selected an ultimate loss ratio for the 2006 accident year that was comparable to prior year actual loss ratios and the then current indicated paid and incurred loss ratios. During the first half of 2007, our 2006 accident year loss experience was more favorable than previously estimated at December 31, 2006. In accordance with SFAS No. 60, the Company recorded this change in reserves as a change in estimate during 2007.
For the discontinued bond program, the Company recorded reserve deficiencies of approximately $0.7 million during 2007. The reserve deficiencies were primarily attributable to an increase in reported losses from Highlands which was partially offset by a decrease in reported losses from Harco. See “Overview-Discontinued Bond
Program” above and “Discontinued Bond Program” in Note 15 to the Consolidated Financial Statements for additional information concerning the discontinued bond program losses.
The Company is involved in various legal proceedings arising in the ordinary course of business, some of which involve claims for substantial amounts. An estimate is made to accrue for a loss contingency relating to any of these legal proceedings if management believes it is probable that a liability was incurred as of the date of the financial statements and the amount of loss can be reasonably estimated. Because of the subjective nature inherent in assessing the outcome of litigation and because of the potential that an adverse outcome in a legal proceeding could have a material impact on the Company’s financial position and/or results of operations, such estimates are considered to be critical accounting estimates. See Note 20 to the Consolidated Financial Statements for information concerning the Company’s commitments and contingencies.
Property/Casualty Insurance. Our wholly-owned subsidiary, Ohio Indemnity Company (“Ohio Indemnity”), is a specialty property/casualty insurance company. Our principal sources of revenue are premiums and ceded commissions for insurance policies and income generated from our investment portfolio. Ohio Indemnity, an Ohio corporation, is licensed in 48 states and the District of Columbia. As such, Ohio Indemnity is subject to the regulations of The Ohio Department of Insurance (the “Department”) and the regulations of each state in which it operates. The majority of Ohio Indemnity’s premiums are derived from three distinct product lines: (1) lender service; (2) unemployment compensation; and (3) waste industry.
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 its reimbursing obligations. In addition, we underwrite surety bonds that certain states require employers to post in order to obtain reimbursing status for their unemployment compensation obligations.
Treasury limit ($4.0 million as of July 1, 2007). The Company then cedes 50% of that business to an insurance carrier under a reinsurance arrangement. All surety bonds written directly and assumed under this program are produced and administered by a general insurance agent that is affiliated with one of the insurance carriers participating in the program. The majority of the surety bonds under the program satisfy the closure/post-closure financial responsibility obligations 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. 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.
In addition, from 2001 until the end of the second quarter of 2004, the Company participated in a bail and immigration bond program. This program was discontinued in the second quarter of 2004. For a more detailed description of this program, see “Discontinued Bond Program” in Note 15 to the Consolidated Financial Statements.
On August 31, 2006, the Company entered into a Stock Purchase Agreement with A.L.P. Acquisition Co., Inc., an Ohio corporation (the “Purchaser”), whereby the Company sold 100% of the issued and outstanding common shares of American Legal Publishing Corporation (“ALPC”) to the Purchaser for $4,620,000 subject to customary post-closing adjustments (the “Sale”). The Company received cash of $4,150,000 and a promissory note in the principal amount of $470,000 (the “Promissory Note”) from the Purchaser at the closing in connection with the Sale. As of December 31, 2007, the Purchaser had repaid the entire $470,000 principal amount of the Promissory Note to the Company.
In connection with the Sale and the Investment, the Company recorded a net realized gain of approximately $2.5 million ($1.7 million after tax) during the period ended December 31, 2006. In connection with the principal payments received by the Company on the Promissory Note during 2007, the Company realized $62,500 of the previously deferred gain on sale of affiliate during the period ended December 31, 2007.
In October 2005, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (“SOP 05-1”). SOP 05-1 provides accounting guidance for deferred policy acquisition costs associated with internal replacements of insurance and investment contracts other than those already described in Statement of Financial Accounting Standards (“SFAS”) No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of a feature or coverage within a contract. The provisions of SOP 05-1 became effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The adoption of SOP 05-1 did not have an effect on the Company’s consolidated financial statements.
In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” This Bulletin addresses quantifying the financial statement effects of misstatements, including how the effects of prior year uncorrected errors must be considered in quantifying misstatements in the current year financial statements. This Bulletin is effective for fiscal years ending after November 15, 2006 and allows for a one-time transitional cumulative effect adjustment to beginning retained earnings in the fiscal year adopted for errors that were not previously deemed material, but are material under the guidance in SAB No. 108. The adoption of SAB No. 108 could have an impact on the assessment of the financial statement effects of any potential future misstatements.
In March 2007, the FASB ratified Emerging Issues Task Force Issue No. 06-10, “Accounting for Collateral Assignment Split-Dollar Life Insurance Agreements” (“EITF 06-10”). EITF 06-10 provides guidance for determining a liability for the postretirement benefit obligation as well as recognition and measurement of the associated asset on the basis of the terms of the collateral assignment agreement. EITF 06-10 is effective for fiscal years beginning after December 15, 2007. The adoption of EITF 06-10 is not expected to have a material impact on the Company’s consolidated financial statements.
Loss and loss adjustment expense (“LAE”) reserves represent our best estimate of the ultimate net cost of all reported and unreported losses incurred through December 31. We do not discount loss and LAE reserves. The reserves for unpaid losses and LAE are estimated using individual case-basis valuations, statistical analyses and reports received from ceding insurers under assumed reinsurance. Those estimates are subject to the effects of trends in loss severity and frequency. Although considerable variability is inherent in such estimates, we believe the reserves for losses and LAE are adequate. The estimates are regularly reviewed and adjusted as necessary as experience develops or new information becomes known. Such adjustments are included in results of operations in the period such adjustments are made.
Certain ULI policies are eligible for premium adjustments based on loss experience. For certain policies, return premiums are calculated and settled on an annual basis. These balances are presented in the accompanying balance sheets as retrospective premium adjustments payable. Certain other policies are eligible for an experience rating adjustment that is calculated and adjusted from period to period and settled upon cancellation of the policy. These balances are presented in the accompanying balance sheets as experience rating adjustments payable. These adjustments are included in the calculation of net premiums earned.
The balances reflected in these accounts relate primarily to the Company’s automobile service contract programs. For these programs, the Company has obtained collateral in the form of short-term investments to support its claim obligations under the programs. As of December 31, 2007, the collateral held by the Company exceeds our estimated claim obligations. As a result, the restricted short-term investments and the funds held amounts are the same as any excess collateral remaining after the payment of all claim obligations would be returned to the respective service contract provider.
Certain prior year amounts have been reclassified in order to conform to the 2007 presentation.
The amortized cost and estimated fair value of fixed maturity investments in held to maturity and available for sale securities at December 31, 2007, 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 the estimated fair value and gross unrealized losses (pre-tax) for all securities in an unrealized loss position at December 31, 2007 and December 31, 2006, distinguishing between those securities which have been continuously in an unrealized loss position for less than twelve months and twelve months or greater.
The Company continually monitors developments affecting our invested assets, paying particular attention to events that might give rise to impairment write-downs, including but not limited to: (1) the length of time and extent to which the estimated fair value has been less than book value; (2) whether the decline appears to be related to general market or industry conditions or is issuer-specific; and (3) our ability and intent to hold the security for a period of time sufficient to allow for recovery in the estimated fair value. There were $1,243,126 and $7,310 in impairment charges included in net realized losses on investments for the years ended December 31, 2007 and 2006, respectively. The increase in impairment charges during 2007 was primarily due to the following: (1) $506,134 in impairment charges for equity securities of five financial institutions whose fair values were adversely affected by exposure to subprime mortgage markets; (2) $202,710 in impairment charges for an equity security of a homebuilder whose fair value was adversely affected by the housing market; and (3) $480,099 in impairment charges for a corporate fixed income security whose fair value was adversely affected by uncertainty in its investment ratings by certain bond rating agencies. As part of the Company’s normal assessment of other-than-temporary impairments of investments, the securities listed in the table above were evaluated and no further impairments were deemed necessary as of December 31, 2007.
At December 31, 2007, investments having a carrying value of $5,019,407 were on deposit with various state insurance departments to meet their respective regulatory requirements.
We have a $10,000,000 unsecured revolving line of credit with a maturity date of June 30, 2010 with no outstanding balance at December 31, 2007 and December 31, 2006. The revolving line of credit provides for interest payable quarterly at an annual rate equal to the prime rate less 75 basis points. The Company utilizes the line of credit from time to time based on short-term cash flow needs. The terms of the revolving credit agreement contain various restrictive covenants. As of December 31, 2007, the Company was in compliance with all such covenants. The bank that provides the line of credit is also a policyholder of the Company.
The future minimum lease payments required under operating leases for the next five fiscal years are as follows:
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 (9.13% and 9.37% at December 31, 2007 and 2006, 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 interest, as applicable, on a quarterly basis at a rate equal to three month LIBOR plus four hundred and five basis points (8.88% and 9.41% at December 31, 2007 and 2006, respectively), are redeemable at par on or after September 30, 2008 and mature on September 30, 2033. Interest on the junior subordinated debentures is charged to income as it accrues. Interest expense related to the junior subordinated debentures for the years ended December 31, 2007 and 2006 was $1,472,459 and $1,427,241, respectively. The terms of the junior subordinated debentures contain various covenants. As of December 31, 2007, the Company was in compliance with all such covenants.
In June 2006, the FASB issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,” which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In accordance with FIN 48, the Company must adjust its financial statements to reflect only those tax positions that are more-likely-than-not to be sustained as of the adoption date. We adopted the provisions of FIN 48 on January 1, 2007. The adoption of FIN 48 did not have a material impact on our financial condition or results of operations.
Based on our evaluation, we have concluded that there are no significant uncertain tax positions requiring recognition in our consolidated financial statements. Our evaluation was performed for the tax years ended December 31, 2003, 2004, 2005 and 2006, the tax years which remain subject to examination by major tax jurisdictions as of December 31, 2007. In addition, we do not believe the Company would be subject to any interest or penalties relative to any open tax years and, therefore, have not accrued any such amounts. If the Company was to incur any interest and/or penalties in connection with income tax deficiencies, the Company would classify interest in the “interest expense” category and classify penalties in the “other insurance operating expenses” category within the consolidated statements of income.
The Company maintains two equity compensation plans (collectively, the “Plans”) for the benefit of certain of its officers, directors, employees, consultants and advisors. During the first quarter of 2006, the Company adopted SFAS No. 123(R), “Share-Based Payment,” applying the modified prospective method. SFAS No. 123(R) requires all equity-based payments to employees and directors, including grants of stock options, to be recognized in net income based on the grant date fair value of the award. Under the modified prospective method, the Company is
The Company has stock options and restricted stock outstanding at December 31, 2007 under two equity compensation plans, each of which has been approved by our shareholders. The Company will issue authorized but unissued shares or treasury shares to satisfy any future restricted stock awards or the exercise of stock options.
All stock options: (1) have been granted with an exercise price equal to the closing price of the Company’s common shares on the date of grant; (2) have a 10-year contractual term; (3) with respect to officers and employees, vest and become exercisable at the rate of 20% per year over a five-year period (subject to the applicable officer’s and employee’s continued employment with the Company); and (4) with respect to non-employee directors, vest and become exercisable on the first anniversary of the date of grant.
The fair value of options granted by the Company is estimated on the date of grant using the Black-Scholes option pricing model (“Black-Scholes model”). The Black-Scholes model incorporates ranges of assumptions such as risk-free rate, expected life, expected volatility and dividend yield. The risk-free rate is based on the United States Treasury strip curve at the time of the grant with a term approximating that of the expected option life. The Company analyzes historical data regarding option exercise behaviors, expirations and cancellations to calculate the expected life of the options granted, which represents the length of time in years that the options granted are expected to be outstanding. Expected volatilities are based on historical volatility over a period of time using the expected term of the option grant (6 years) and using weekly stock prices of the Company; however, for options granted after February 4, 2005, the Company excluded from its historical volatility the period from February 4, 2005 through January 25, 2006 (the period in which shareholders could not obtain current financial information for the Company and could not rely on the Company’s 2003, 2002, and 2001 financial statements) as the Company believes that its stock price during that period is not relevant in evaluating the expected volatility of its common shares in the future. A 0% dividend yield is used in the Black-Scholes model based on historical dividends. For the year ended December 31, 2007, the Company granted 12,000 stock options to non-employee directors which were valued at $2.65. The following table provides the range of assumptions used for options valued during the years ended December 31:
As of December 31, 2007, the total pretax equity-based compensation cost related to nonvested stock options and nonvested restricted stock not yet recognized was $818,352. The weighted-average period over which this cost is expected to be recognized is approximately 2.7 years.
The following table summarizes weighted-average information by range of exercise prices for stock options outstanding and stock options exercisable at December 31, 2007:
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
As a result of changes in estimates of insured events in prior years, the provision for unpaid loss and LAE increased (decreased) by approximately $(254,000) and $136,000 for the years ended December 31, 2007 and 2006, respectively. The decrease in 2007 was primarily due to favorable loss development in our automobile lender service product line which was partially offset by unfavorable loss development for the discontinued bond program.
For more information concerning loss and LAE reserves for the discontinued bond program, see “Discontinued Bond Program” in Note 15 to the Consolidated Financial Statements.
The Company assumes and cedes reinsurance with other insurers and reinsurers. Such arrangements serve to enhance the Company’s capacity to write business, provide greater diversification, align the interests of our business partners with the Company’s interests, and/or limit the Company’s maximum loss arising from certain risks. Although reinsurance does not discharge the original insurer from its primary liability to its policyholders, it is the practice of insurers for accounting purposes to treat reinsured risks as risks of the reinsurer. The primary insurer would reassume liability in those situations where the reinsurer is unable to meet the obligations it assumed under the reinsurance agreement. The ability to collect reinsurance is subject to the solvency of the reinsurers and/or collateral provided under the contract.
Several of our lender service insurance producers have formed sister reinsurance companies, each of which is 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. Such arrangements align the interests of our business partners with the Company’s interests while preserving valued customer relationships. All of the Company’s lender service ceded reinsurance transactions are PORC arrangements.
Effective January 1, 2005, the Company entered into a producer-owned reinsurance arrangement with a guaranteed auto protection insurance agent whereby 100% of that agent’s premiums (along with the associated risk) were ceded to its PORC. For this reinsurance arrangement, the Company has obtained collateral in the form of a letter of credit to secure its obligations. Under the provisions of the reinsurance agreement, the collateral must be equal to or greater than 102% of the reinsured reserves and the Company has immediate access to such collateral if necessary. Under this arrangement, the Company ceded premiums earned of $3,560,054 and $1,987,640 for the years ended December 31, 2007 and 2006, respectively.
Effective January 1, 2007, the Company entered into a producer-owned reinsurance arrangement with a new CPI customer whereby 100% of that customer’s premiums (along with the associated risk) were ceded to its PORC. For this program, the CPI coverage is voluntary and is primarily for tractors and residential/commercial mowers as opposed to automobiles. The Company receives a ceding commission based on a percentage of the premiums ceded. For this reinsurance arrangement, the Company has obtained collateral in the form of funds held and a letter of credit to secure its obligations. Under the provisions of the reinsurance agreement, the collateral must be equal to or greater than 102% of the reinsured reserves and the Company has immediate access to such collateral if necessary. Under this arrangement, the Company ceded premiums earned of $4,424,122, and $0 for the years ended December 31, 2007 and 2006, respectively.
During 2004 and 2005, the Company entered into arbitrations with the following four insurance carriers that participated in the discontinued bond program: 1) Aegis Security Insurance Company (“Aegis”); 2) Sirius America Insurance Company (“Sirius”); 3) Harco National Insurance Company (“Harco”); and 4) Highlands Insurance Company (“Highlands”). During 2006, the arbitrations with Aegis, Sirius and Harco concluded. For Aegis and Sirius, the Company entered into settlement agreements with these insurance carriers resolving all disputes between the Company and these carriers relating to the discontinued bond program. These settlement agreements also relieved the Company from any potential future liabilities with respect to bonds issued by Aegis and Sirius. For Harco, in August 2006, the Harco arbitration panel issued its Final Decision and Order ordering each of the reinsurers participating in the arbitration, including the Company, to pay its proportionate share of past and future claims paid by Harco, subject to certain adjustments, offsets and credits (the “Final Order”). Pursuant to the terms of the Final Order, the Company has paid Harco for its proportionate share of all past claims reported by Harco. As of December 31, 2007, the Company is reserving to its best estimate of future Harco losses based on the Final Order and the most recent loss information received from Harco. It should be noted that Harco has received an invoice from the Department of Homeland Security for breached immigration bonds and Harco’s best reserve estimate is less than the amount of the invoice by approximately $0.4 million (this represents the Company’s proportionate share).
Pending Arbitration. Highlands was placed in receivership during 2003 (which receivership remains pending). On August 31, 2005, the Highlands’ Receiver demanded arbitration against the Company and other reinsurers, including The Philadelphia Contributionship for the Insurance of Houses from Loss by Fire, American Healthcare Insurance Company and various Lloyds Syndicates. In November 2005, the Company responded to this demand by seeking rescission of the reinsurance agreement, monetary damages for claims that were paid by the Company under the agreement and other appropriate relief. Highlands is seeking to recover certain of its losses from the Company under the reinsurance agreement. No arbitration panel has yet been constituted.
arbitration outcome or a potential settlement amount with Highlands. If the Company obtains information to determine an estimate of a final arbitration value or estimate a settlement value, the Company will record changes in its reserves, if any, in the period that an estimate is made in accordance with SFAS No. 60, “Accounting and Reporting by Insurance Enterprises.” The Company does not intend to pay for any of the Highlands losses unless and until the arbitration is settled on a mutually agreeable basis and/or a final binding judgment is made as to the Company’s ultimate liability.
During 2001, the Company began issuing insurance policies which guarantee the performance obligations of two automobile service contract providers (the “Providers”). The Providers are owned by a common parent. The Company has issued insurance policies covering business produced by the Providers in five states. Our insurance policies guarantee the fulfillment of the Providers’ obligations under the service contracts. Under the program, the Providers maintain the reserves and related assets and are responsible for the claims administration. The Company is obligated to pay a claim only if a Provider fails to do so. Under a reinsurance arrangement, the Company cedes 100% of this business to another insurance carrier. In addition, the Company obtained collateral from the Providers in the form of a $4.3 million letter of credit to secure our obligations under the program. On February 15, 2007, one of the Providers entered into an Assignment for the Benefit of Creditors liquidation proceeding. On March 2, 2007, the Illinois Department of Insurance moved for, and obtained, an Order of Conservation, which granted the Illinois Department of Insurance the authority to ascertain the condition and conserve the assets of that Provider. On
See Note 4 to the Consolidated Financial Statements for information concerning the undertaking agreements by and between the Company and certain executive officers.
We have two reportable business segments: (1) property/casualty insurance; and (2) insurance agency. Until August 31, 2006, we also had a municipal code publishing segment. On August 31, 2006, we sold the municipal code publishing segment as more fully described in “Sale of Affiliate” in Note 1 to the Consolidated Financial Statements. The following table provides financial information regarding our reportable business segments. 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 assumptions
As discussed in Note 1 to the Consolidated Financial Statements, the Company sold ALPC, its municipal code publishing segment, on August 31, 2006. The municipal code publishing segment in the above table includes results through August 31, 2006.