A discussion of our principal products and services is set forth in Item 1 above under the caption “Products and Services” and is incorporated herein by reference.
During the second quarter of 2008, we received an invoice from Harco for approximately $0.2 million representing our proportionate share of additional claims paid by Harco. We requested that Harco provide us a detailed accounting of its payment activity. Although Harco indicated that it will provide us this information, we have not received such information as of the date of this report. We also requested that Harco provide us information regarding any recoveries that Harco has received with respect to paid claims and its expected future recoveries. Harco responded that it has received and continues to receive recoveries but does not believe the reinsurers are entitled to a proportionate share of such recoveries under the terms of the Final Order. We disagree with this position. Based on recovery information provided by Harco during the fourth quarter of 2008, we estimate that our proportionate share of Harco’s recoveries that we believe we are entitled to receive under the Final Order is approximately $0.2 million. We do not intend to pay any current or future Harco invoices until Harco provides us the requested accounting and we resolve with Harco the reinsurers’ rights to a proportionate share of Harco’s recoveries.
As of December 31, 2008, we are reserving for Harco losses based on amounts invoiced by Harco for claims paid and on our proportionate share of Harco’s estimate of its future losses under the program as reflected in the most recent loss information provided to us by Harco (with $0.2 million offset for recoveries as noted above).
It should also be noted that Harco has reported to us that it has received an updated invoice from the Department of Homeland Security (“DHS”) for breached immigration bonds and, that as of December 31, 2008, Harco’s immigration bond reserve was less than the amount of the DHS invoice. As noted above, we are reserving for future Harco losses based on our proportionate share of Harco’s estimate of its future losses under the program. If Harco is required to pay the full amount of the DHS invoice, it could result in additional losses to us of approximately $0.6 million (based on the difference between our proportionate share of Harco’s reserve as of December 31, 2008 and the updated DHS invoice).
Pending Arbitration. Highlands participated as an insurer in the discontinued bond program for the 2000, 2001 and 2002 program years, and we were one of its reinsurers for the 2001 and 2002 program years. Highlands was placed in receivership during 2003 (which receivership remains pending). On August 31, 2005, the Highlands’ Receiver demanded a single consolidated arbitration for the 2000, 2001 and 2002 program years against us and its other reinsurers. In November 2005, we responded to this demand by requesting a separate arbitration for the 2001 and 2002 program years and seeking rescission of the reinsurance agreement for the 2001 and 2002 program years, monetary damages for claims that were paid by us and other appropriate relief. Highlands is seeking to recover certain of its losses from us under the reinsurance agreement for the 2001 and 2002 program years. No arbitration panel has yet been constituted. On April 10, 2008, the Highlands’ Receiver filed a petition in a Texas state court seeking to compel a single consolidated arbitration for the 2000, 2001 and 2002 program years against its reinsurers, including us, and other relief. On June 5, 2008, we responded to the petition. As of the date of this report, the court has not ruled on the petition.
See “Business Outlook-Expenses” below for information regarding our anticipated legal costs associated with the Highlands’ arbitration.
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 did not have a material impact on our consolidated financial statements.
During 2001, we 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. We have 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. We are obligated to pay a claim only if a Provider fails to do so. Under two reinsurance arrangements, we cede 100% of the business produced to two different insurance carriers. In addition, we obtained collateral 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
Because we believe our estimated liability for claims under this program is fully collateralized and our loss exposure is 100% reinsured, we do not believe the events described above will have a material adverse impact to us. However, if the Provider that is not in bankruptcy defaults on its obligations, and if our actual liability for claims under this program exceeds the collateral held by us and if we are unable to collect on the reinsurance, then this program could have a material adverse effect on our business, financial condition and/or operating results.
Net premiums earned for CPI increased 42.0%, or $398,771, to $1,348,755 in 2008 from $949,984 a year ago primarily due to one of our CPI insurance agents placing more business with us during 2008.
Net premiums earned for GAP decreased 11.7%, or $1,287,934, to $9,759,859 in 2008 from $11,047,793 a year ago primarily due to a decrease in lending volume for certain financial institution customers.
For more information concerning impairment charges, see “Business Outlook-Investments” and “Critical Accounting Policies-Other-Than-Temporary Impairment of Investments” below and Note 2 to the Consolidated Financial Statements.
GAP losses and LAE remained relatively flat at $5,788,882 in 2008 compared to $5,757,007 a year ago. The decrease in losses caused by the decline in business was offset by an increase in losses for a poor performing financial institution customer that was cancelled in the second quarter of 2008.
UC losses and LAE increased 25.7%, or $238,500, to $1,165,647 in 2008 from $927,147 a year ago primarily due to the settlement of a dispute with a prior UC customer during the third quarter of 2008. Also see Note 20 to the Consolidated Financial Statements for information concerning the settlement of this dispute.
WIP losses and LAE decreased 14.3%, or $92,721, to $554,092 in 2008 from $646,812 a year ago primarily due to a decrease in losses and LAE for waste surety bonds which was partially offset by an increase in losses and LAE for contract surety bonds due to growth in that business. For WIP, we record loss and LAE reserves using an expected loss ratio reserving method as recommended by the primary insurance carrier and reviewed by our independent actuary. For waste surety bonds, loss and LAE reserves are based on a certain percentage of net premiums earned over the trailing thirty six months. For contract surety bonds, loss and LAE reserves are based on a certain percentage of total net premiums earned.
primarily due to (1) an increase in premium taxes due to growth in our direct earned premiums combined with an increase in our effective premium tax rate based on the mix of states in which we write business and their respective premium tax rates and (2) an increase in administrative expenses for our UCassure® product due to its premium growth.
SEC Investigation Expenses. SEC investigation expenses increased 31.4%, or $785,340, to $3,289,462 in 2008 from $2,504,122 a year ago primarily due to legal services rendered during the period combined with an increase in estimated future legal costs associated with the undertaking agreements. See “Regulation-Ongoing SEC Investigation” in Item 1 above, “Business Outlook-Expenses,” “Liquidity and Capital Resources” and “Critical Accounting Policies-Guarantee Liabilities” below, Note 4 to the Consolidated Financial Statements and Items 13 and 14 for more information concerning the SEC investigation.
Federal Income Taxes. The Company’s effective federal income tax rate was (162.7)% in 2008 compared to 13.6% a year ago. This improvement is attributable to the ratio of tax-exempt investment income when compared to income from operations for each period. Income from operations declined in 2008 compared to 2007 primarily due to an increase in other-than-temporary impairments. For more information concerning our federal income taxes, see Note 8 to the Consolidated Financial Statements.
The credit markets suffered a severe upheaval during the third quarter of 2008 which continued in the fourth quarter of 2008. Credit spreads expanded due to increased fears of mounting mortgage losses across the financial sector and caused the market’s liquidity crisis to intensify. Higher borrowing rates and fears of outsized losses led to the federal government takeover of Fannie Mae and Freddie Mac in September 2008. This was followed in rapid succession by the bankruptcy of Lehman Brothers, the merger of Merrill Lynch and Bank of America, the bailout of AIG, the failure of Washington Mutual, and Wachovia putting itself up for sale. After the federal government’s $700 billion bailout plan was approved, the focus of attention shifted from the banking crisis to economic fundamentals around the world and fears about the state of the world economy. These are unprecedented times that are still unfolding. As a result, it is extremely difficult to predict how the global financial crisis will impact us on both a short-term and longer-term basis. Our outlook for 2009 is very cautious.
Our lender service premium volume is primarily based on new loans made by our banking customers for consumer automobile purchases. The credit crisis is impacting automobile sales as consumers are struggling to qualify for loans and automakers are scaling back leasing. In addition, many consumers are not willing to make big purchases, such as for a new automobile. The auto industry capped off 2008 with its worst sales results in 15 years. In December 2008, Ford, Toyota, General Motors and Honda all reported U.S. sales drops of over 30 percent and Chrysler reported a U.S. sales drop of 53 percent. Through December 31, 2008, certain of our banking customers have experienced declines in lending volume. Based on the current economic conditions, it is likely that our lender service premium volume will decline in 2009 when compared to 2008; however, it is difficult for us to predict how much of a decline we will experience. In addition, one of our larger ULI financial institution customers exited the auto lending market during the fourth quarter of 2008. During 2008, this ULI customer had net premiums earned of $2.3 million and its combined ratio was 70%. We expect little, if any, earned premiums from this customer in 2009.
increased premium volumes and new business may not be seen in our results immediately and may take several years to fully develop.
Effective January 1, 2007, we entered into a producer-owned reinsurance arrangement with a new EPD customer whereby 100% of that customer’s premiums (along with the associated risk) were ceded to its PORC. For this reinsurance arrangement, we have obtained collateral in the form of funds held and a letter of credit to secure our obligations. Under the provisions of the reinsurance agreement, the collateral must be equal to or greater than 102% of the reinsured reserves and we have immediate access to such collateral if necessary. This program reduced our commission expense by $0.8 in 2008 compared to $0.3 million in 2007. We expect this program to reduce our commission expense by approximately $1.3 million during fiscal year 2009. As of December 31, 2008, we had approximately $1.7 million of deferred ceded commissions for this program that will be earned over approximately four years. Prior to first quarter of 2008, EPD was reported within our CPI product line.
As previously disclosed, the Company concluded three of the discontinued bond program arbitrations during 2006, and only the Highlands’ arbitration remains pending. Because there was little activity in the Highlands’ arbitration during 2008 and 2007, we incurred minimal legal costs during such periods for the Highlands’ arbitration. We are not certain how much activity there will be in 2009 for the Highlands’ arbitration. As a result, we cannot predict with reasonable certainty the amount or range of amounts of legal costs that will be incurred during fiscal year 2009 for the Highlands’ arbitration; however, it is possible that the amount of such legal
costs could be material to our results of operations if the arbitration proceeding takes place in 2009. See “Overview-Discontinued Bond Program” above and “Discontinued Bond Program” in Note 15 to the Consolidated Financial Statements for more information regarding the discontinued bond program arbitrations.
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, we incurred the following expenses during the last five quarters related to the SEC investigation:
We expect to continue to incur costs for the SEC investigation during 2009. Due to the inherent uncertainties of the SEC investigation, we cannot predict with reasonable certainty the amount or range of amounts of costs that will be incurred during 2009 for the SEC investigation (other than the FIN 45 liability related to the undertaking agreements as discussed in Note 4 to the Consolidated Financial Statements); however, we believe that the amount of costs that will be incurred in 2009 could be material to our results of operations. See “Regulation-Ongoing SEC Investigation” in Item 1 above, “Liquidity and Capital Resources” and “Critical Accounting Policies-Guarantee Liabilities” below, Note 4 to the Consolidated Financial Statements and Items 13 and 14 for more information regarding the ongoing SEC investigation.
As interest rates rise (fall), it can increase (decrease) the level of interest expense on our trust preferred debt and any borrowings under our bank line of credit. Interest rates have declined during 2008 when compared to a year ago. On March 31, 2008, we drew $2.5 million on our bank line of credit and that amount remains outstanding at December 31, 2008. See “Liquidity and Capital Resources” below and Notes 5 and 7 to the Consolidated Financial Statements for more information concerning our bank line of credit and trust preferred debt.
Many of the securities within our equity portfolio have also been negatively impacted by the current financial crisis. During 2008, we recorded approximately $3.7 million of impairment charges for our investment portfolio ($1.8 million for equity securities and $1.9 million for fixed maturity securities). Based on the current economic conditions and our other-than-temporary impairment accounting policy, additional impairment charges within our investment portfolio are possible during 2009. As disclosed in Note 2 to the Consolidated Financial Statements and “Critical Accounting Policies-Other-Than-Temporary Impairment of Investments” below, we begin to monitor a security for other-than-temporary impairment when its fair value to book value ratio falls below 80%. As shown in Note 2 to the Consolidated Financial Statements, as of December 31, 2008, we had approximately $1.3 million of unrealized losses on equity securities where their fair value to book value ratio was below 80%. Assuming the estimated fair value for these securities remained the same during 2009 as they were at December 31, 2008, we would likely record other-than-temporary impairment charges of approximately $1.3 million for these securities during 2009. For all of the fixed maturity securities having a fair value to book value ratio below 80% as shown in Note 2 to the Consolidated Financial Statements, all of these securities are investment grade and we would likely not have an other-than-temporary impairment charge on these securities during 2009 unless they were to fall below investment grade. Due to the inherent uncertainties of the investment markets, we cannot predict with reasonable certainty the amount or range of amounts of other-than-temporary impairment charges that will be recorded during 2009; however, we believe that the amount of such other-than-temporary impairment charges could be material to our results of operations. For more information concerning the unrealized loss position of our investment portfolio and impairment charges, see “Critical Accounting Policies-Other-Than-Temporary Impairment of Investments” below and Note 2 to the Consolidated Financial Statements.
Based on the factors discussed above, our outlook for the 2009 fiscal year is very cautious.
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. BIC Trust I also issued $248,000 of floating rate common securities to Bancinsurance Corporation. 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 II also issued $217,000 of floating rate common securities to Bancinsurance Corporation. 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 Bancinsurance Corporation. In connection with the issuance of the trust preferred capital securities, Bancinsurance Corporation 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. Bancinsurance Corporation 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 Bancinsurance Corporation 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 capital 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 (6.21% and 9.13% at December 31, 2008 and 2007, 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 (5.51% and 8.88% at December 31, 2008 and 2007, respectively), are redeemable at par on or after September 30, 2008 and mature on September 30, 2033. The proceeds from the junior subordinated debentures were used for general corporate purposes and provided additional financial flexibility to the Company. The terms of the junior subordinated debentures contain various covenants. As of December 31, 2008, Bancinsurance Corporation was in compliance with all such covenants.
As of December 31, 2008, we had $14,571,987 of available for sale fixed maturity and equity securities that were in an unrealized gain position that, if necessary, we could sell without recognizing a loss to meet liquidity needs. After satisfying our cash requirements and meeting our desired cash and short-term investment position, any excess cash flows from our operating and/or investment activities are used to build our investment portfolio and thereby increase future investment income. For more information concerning our investment portfolio, see “Critical Accounting Policies-Other-Than-Temporary Impairment of Investments” below and Note 2 to the Consolidated Financial Statements.
The following table sets forth our cash and short-term investment position at December 31, 2008 and December 31, 2007:
Given the additional expenses associated with the ongoing SEC investigation and given the current economic conditions, we increased our cash and short-term investment position during 2008 when compared to 2007.
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 $6.6 million at December 31, 2008. Ultimate payment on the discontinued bond program may result in a material increase in cash outflows from operations. We consider the discontinued bond program liabilities and the related Highlands’ arbitration 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 maturity 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 and LAE reserves for the discontinued bond program.
As the parent company, Bancinsurance Corporation generates no funds from operations. Bancinsurance Corporation’s principal assets are the common shares of Ohio Indemnity and the membership interests in USA, and its primary sources of funds are (1) dividends from Ohio Indemnity and USA, (2) borrowings under its bank line of credit and (3) payments received from Ohio Indemnity and USA under cost and tax sharing agreements. Historically, Bancinsurance Corporation’s expenses have primarily consisted of payment of principal and interest on borrowings and legal and audit expenses directly related to Bancinsurance Corporation, and it has been able to pay these expenses primarily through use of its cash and invested assets, dividends from its subsidiaries, cost and tax sharing payments from its subsidiaries and, since August 2006, excess cash generated from the sale of its publishing subsidiary.
During 2008, Bancinsurance Corporation experienced a significant increase in expenses and cash outflow as a result of expenses associated with the ongoing SEC investigation. Based on management’s expectation that Bancinsurance Corporation would continue
Ohio Indemnity is restricted by the insurance laws of the State of Ohio as to amounts that can be transferred to Bancinsurance Corporation in the form of dividends without the prior approval of the Department. Ohio Indemnity may pay dividends without such prior approval only from earned surplus and only to the extent that all dividends in the trailing twelve months do not exceed the greater of 10% of its statutory surplus as of the end of the prior fiscal year or statutory net income for the prior calendar year. During 2009, the maximum amount of dividends that may be paid to Bancinsurance Corporation by Ohio Indemnity without such prior approval is $4,516,755. For more information concerning dividend restrictions see “Regulation-Ohio Insurance Holding Company System Regulation” in Item 1 above.
Net cash (used in) provided by operating activities was $(5,064,235) and 11,940,540 in 2008 and 2007, respectively. The decrease in cash provided by operating activities was primarily due to the following: (1) approximately $5.0 million in expenses paid during 2008 related to the ongoing SEC investigation; (2) a decrease of approximately $4.9 million in net premiums collected; (3) an increase of approximately $2.6 million in net commissions and premium taxes paid; and (4) obtaining $4.8 million in cash as funds held for account of others during 2007 in connection with one of our automobile service contract programs (see “Automobile Service Contract Program” above and “Automobile Service Contract Program” in Note 15 to the Consolidated Financial Statements).
Net cash provided by (used in) investing activities was $3,912,994 and $(9,215,118) in 2008 and 2007, respectively. The increase from 2007 to 2008 was primarily due to the use of certain investment proceeds to fund operating cash requirements during 2008, whereas in 2007, excess cash from operations was used to purchase investments during that period.
Net cash provided by (used in) financing activities was $2,500,000 and $(397,525) in 2008 and 2007, respectively. The increase in 2008 was due to a $2,500,000 draw on our bank line of credit during the first quarter of 2008. The net cash used in financing activities during 2007 was primarily attributable to the repurchase of common shares under our common share repurchase program which was partially offset by cash received from stock option exercises.
significant estimates, assumptions and judgments and are critical to an understanding of our consolidated financial statements.
We continually monitor the credit quality of our fixed maturity investments to gauge our ability to be repaid principal and interest. We consider price declines of fixed maturity securities in our other-than-temporary impairment analysis where such price declines provide evidence of declining credit quality, and we distinguish between price changes caused by credit deterioration, as opposed to rising interest rates. In our evaluation of credit quality, we consider, among other things, credit ratings from major rating agencies, including Moody’s and Standard & Poor’s (“S&P”).
See Note 2 to the Consolidated Financial Statements for information regarding our securities that were in an unrealized loss position at December 31, 2008 that were not considered to be other-than-temporarily impaired. For more information concerning other-than-temporary impairment charges, see “Results of Operations-Net Realized Losses on Investments,” “Business Outlook-Investments” and “Liquidity and Capital Resources” above and Note 2 to the Consolidated Financial Statements.
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. Our ultimate loss reserve estimates for assumed reinsurance are dependent upon and based primarily on information received by us from the underlying ceding insurers.
For our assumed WIP program, we record loss and LAE reserves using a loss ratio reserving methodology as recommended by the primary insurance carrier and reviewed by our independent actuary. The loss ratio method calculates a reserve based on expected losses in relation to premiums earned. For waste surety bonds, loss and LAE reserves are based on a certain percentage of net premiums earned over the trailing thirty six months. For contract and escrow surety bonds, loss and LAE reserves are based on a certain percentage of total net premiums earned.
As of December 31, 2008, 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 reserves using annual accident year loss development triangles for the following products:
For our EPD, UC and WIP product lines, we prepared estimates of loss and LAE reserves using primarily the expected loss ratio method. The estimated loss ratio is based on historical data and/or loss assumptions related to the ultimate cost expected to settle such claims.
During 2008, reserves for incurred losses and LAE attributable to insured events of prior years decreased by approximately $1.4 million as a result of re-estimation of unpaid losses and LAE principally on our lender service product line. An analysis of this change in reserves is provided below.
GAP experienced reserve redundancies of approximately $0.5 million during 2008. The improvement in loss experience primarily related to the 2007 accident year. At December 31, 2008 and 2007, our ultimate selected loss ratio for the 2007 accident year was 53.4% and 58.1%, respectively. Changes in this key assumption occurred primarily during the second and third quarters of 2008 as the majority of our GAP losses are settled within six to nine months from the date of loss. When estimating the ultimate loss ratio at December 31, 2007, we selected an ultimate loss ratio for the 2007 accident year that was equal to the then current indicated paid loss ratio. During the first nine months of 2008, our 2007 accident year loss experience was more favorable than previously estimated at December 31, 2007. In accordance with SFAS No. 60, we recorded this change in reserves as a change in estimate during 2008.
ULIL experienced reserve redundancies of approximately $0.6 million during 2008. The improvement in loss experience primarily related to the 2007 accident year. At December 31, 2008 and 2007, our ultimate selected loss ratio for the 2007 accident year was 63.7% and 66.7%, respectively. Changes in this key assumption occurred primarily during the first quarter of 2008 as the majority of our ULIL losses are settled within three to six months from the date of loss. When estimating the ultimate loss ratio at December 31, 2007, we selected an ultimate loss ratio for the 2007 accident year that was equal to the then current indicated paid loss ratio. During the first quarter of 2008, our 2007 accident year loss experience was more favorable than previously estimated at December 31, 2007. In accordance with SFAS No. 60, we recorded this change in reserves as a change in estimate during 2008. It should be noted that the ULIL product is subject to premium adjustments based on loss experience (i.e., experience-rated policies or retrospective-rated policies), and therefore this prior year loss development had no impact on net income.
We accrue for federal income taxes based on amounts we believe we ultimately will owe. Inherent in the provision for federal income taxes are estimates regarding the deductibility of certain items and the realization of certain tax credits. In the event the ultimate deductibility of certain items or the realization of certain tax credits differs from estimates, we may be required to significantly change the provision for federal income taxes recorded in the consolidated financial statements. Any such change could significantly affect the amounts reported in the consolidated statements of income.
We utilize the asset and liability method of accounting for income tax. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established when necessary to reduce the deferred tax assets to the amounts more likely than not to be realized. In accordance with FIN 48, the Company must also adjust its financial statements to reflect only those tax positions that are more-likely-than-not to be sustained. For more information concerning our federal income taxes, see Note 8 to the Consolidated Financial Statements.
We have audited the accompanying consolidated balance sheets of Bancinsurance Corporation and subsidiaries (the “Company”) as of December 31, 2008 and 2007, and the related consolidated statements of operations, shareholders’ equity and cash flows for the two years then ended. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
Notes to Consolidated Financial Statements - December 31, 2008 and 2007
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. Ohio Indemnity’s premiums are derived from three distinct product lines: (1) lender service; (2) unemployment compensation; and (3) waste industry.
Our lender service product line offers four types of products. First, ULTIMATE LOSS INSURANCE® (“ULI”), a blanket vendor single interest coverage, is the primary product we offer to financial institutions nationwide. This product insures banks and financial institutions against damage to pledged collateral in cases where the collateral is not otherwise insured. A ULI policy is generally written to cover a lender’s complete portfolio of collateralized personal property loans, typically automobile loans. Second, creditor placed insurance (“CPI”) is an alternative to our ULI product. While both products cover the risk of damage to uninsured collateral in a lender’s automobile loan portfolio, CPI covers the portfolio through tracking individual borrower’s insurance coverage. The lender purchases physical damage coverage for loan collateral after a borrower’s insurance has lapsed. Third, our guaranteed auto protection insurance (“GAP”) pays the difference or “gap” between the amount owed by the customer on a loan or lease and the amount of primary insurance company coverage in the event a vehicle is damaged beyond repair or stolen and never recovered. Our GAP product is sold to auto dealers, lenders and lessors and provides coverage on either an individual or portfolio basis. Fourth, equipment physical damage insurance (“EPD”) is an all risk policy written to cover agricultural, construction and commercial equipment vehicles. EPD was introduced in 2007 and offers insurance protection for financed equipment purchases. This policy protects both lenders and consumers against the risk of physical damage or theft of their financed equipment and is available for the term of the loan or an annual basis. Prior to first quarter of 2008, we reported EPD within our CPI product line.
We have certain other specialty products which consist primarily of two vehicle service contract programs and two contract surety bonds not produced under our WIP program. The premiums produced under other specialty products are not considered material to our results of operations. Our two contract surety bonds are for one contractor and are indemnified by the principal which reduces our risk of loss. For our two vehicle service contract programs, we maintain reinsurance and/or collateral in excess of our estimated claim obligations, which reduces our risk of loss. For more information concerning one of the vehicle service contract programs, see “Automobile Service Contract Program” in Note 15.
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.
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. It applies to other pronouncements that require or permit fair value measurements but does not require any new fair value measurements. The statement defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” SFAS No. 157 establishes a fair value hierarchy to increase consistency and comparability in fair value measurements and disclosures. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. In February 2008, the FASB issued FASB Staff Position 157-2, “Effective Date of FASB Statement No. 157” (“FSP SFAS 157-2”), which permits a one-year deferral of the application of SFAS No. 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The Company adopted SFAS No. 157 and FSP SFAS 157-2 effective January 1, 2008 for financial assets and liabilities. The adoption of SFAS No. 157 did not have a material impact on our consolidated financial statements. The Company adopted SFAS No. 157 for non-financial assets and non-financial liabilities effective January 1, 2009 which did not have a material impact on the Company’s consolidated financial statements. In October 2008, the FASB issued FASB Staff Position 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active” (“FSP SFAS 157-3”), which clarifies the application of SFAS No. 157 in a market that is not active. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements.
In May 2008, the FASB issued SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts.” SFAS No. 163 clarifies how SFAS No. 60, “Accounting and Reporting by Insurance Enterprises,” applies to financial guarantee insurance contracts issued by insurance enterprises, including the recognition and measurement of premium revenue and claim liabilities. SFAS No. 163 also requires expanded disclosures about financial guarantee insurance contracts. SFAS No. 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years, except for disclosures about the insurance enterprise’s risk-management activities. Disclosures about the insurance enterprise’s risk-management activities are effective the first period beginning after issuance of SFAS No. 163. The adoption of SFAS No. 163 is not expected to have a material impact on our consolidated financial statements because the Company does not provide financial guarantee insurance contracts.
In the ordinary course of business, we cede and assume reinsurance with other insurers and reinsurers. We report balances pertaining to reinsurance transactions “gross” on the balance sheet, meaning that reinsurance recoverables on unpaid losses and LAE and ceded unearned premiums are not deducted from insurance reserves but are recorded as assets (reinsurance recoverables and prepaid reinsurance premiums, respectively). Ceded reinsurance transactions for the Company include quota share arrangements for certain lender service producers. The Company also participates in several quota share arrangements under its WIP program in which the Company assumes and cedes business. Lastly, the Company assumed bail and immigration bond business from 2001 through the second quarter of 2004, after which time the program was discontinued. See Note 15 for more information concerning the Company’s reinsurance transactions.
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 cash and short-term investments to support its claim obligations under the programs. As of December 31, 2008, 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.
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.
The amortized cost, gross unrealized gains and losses and estimated fair value of investments in held to maturity and available for sale securities at December 31, 2008 and 2007 were as follows:
The amortized cost and estimated fair value of fixed maturity investments in held to maturity and available for sale securities at December 31, 2008, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because
Pre-tax net realized gains (losses) on investments and changes in unrealized gains (losses) on available for sale investments were as follows for each of the years ended December 31:
We continually monitor the difference between the book value and the estimated fair value of our investments, which involves judgment as to whether declines in value are temporary in nature. If we believe a decline in the value of a particular available for sale investment is temporary, we record the decline as an unrealized loss in our shareholders’ equity. If we believe the decline in any investment is “other-than-temporarily impaired,” we record the decline as a realized loss through the income statement. If our judgment changes in the future, we may ultimately record a realized loss for a security after having originally concluded that the decline in value was temporary. We begin to monitor a security for other-than-temporary impairment when its fair value to book value ratio (“fair value to book ratio”) falls below 80%. Our assessment as to whether a security is other-than-temporarily impaired depends on, among other things: (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; (3) our current judgment as to the financial condition and future prospects of the entity that issued the investment security; and (4) our ability and intent to hold the security for a period of time sufficient to allow for recovery in the estimated fair value.
We continually monitor the credit quality of our fixed maturity investments to gauge our ability to be repaid principal and interest. We consider price declines of securities in our other-than-temporary impairment analysis where such price declines provide evidence of declining credit quality, and we distinguish between price changes caused by credit deterioration, as opposed to rising interest rates. In our evaluation of credit quality, we consider, among other things, credit ratings from major rating agencies, including Moody’s and Standard & Poor’s (“S&P”). The following table shows the composition of fixed maturity securities in an unrealized loss position at December 31, 2008 by the National Association of Insurance Commissioners (“NAIC”) rating and the generally equivalent S&P and Moody’s ratings. Not all of these securities are rated by S&P and/or Moody’s.
As of December 31, 2008, we had approximately 99 fixed maturity securities and 4 equity securities that have been in an unrealized loss position for 12 months or longer. All 99 of the fixed maturity securities are investment grade (rated BBB and Baa or higher by S&P and Moody’s, respectively). All 99 of the fixed maturity securities are current on interest and principal and we believe that it is probable that all contract terms of each security will be satisfied. All 4 equity securities relate to investments in closed-end mutual funds. Each of these investments continues to pay its regularly scheduled monthly dividend and we believe there have been no material changes in credit quality for any of these funds over the past twelve months. The increase in unrealized loss position for investments as of December 31, 2008 is primarily due to our fixed maturity portfolio as a result of the changes in the interest rate environment and/or current capital market conditions, and we believe we have the positive intent and ability to hold these securities until they mature or substantially recover in value.
Impairment charges included in net realized losses on investments in 2008 and 2007 were $3,702,945 and $1,243,126, respectively. The impairment charges during 2008 were primarily due to the following: (1) $1,176,989 in impairment charges for floating rate municipal bond securities of ten issuers whose fair values were adversely affected primarily by the decline in short-term interest rates during 2008; (2) $746,019 in impairment charges for equity securities of seven financial institutions whose fair values were adversely affected primarily by the credit markets; (3) $420,414 in impairment charges for non-investment grade fixed maturity securities of five issuers; (4) $332,000 in impairment charges for a corporate fixed maturity security of a lending institution (SLM Corp. or Sallie Mae) whose fair value was adversely affected by uncertainty in its investment ratings by certain bond rating agencies; (5) $273,549 in impairment charges for equity securities of four other companies whose fair values were adversely affected by current market conditions; (6) $231,601 in impairment charges for an equity security of a financial institution (AIG) who suffered a liquidity crisis following the downgrade of its credit rating; (7) $200,477 in impairment charges for an equity security of a financial institution (Lehman Brothers) who filed for bankruptcy due to losses in the credit markets; (8) $182,119 in impairment charges for two closed-end mutual funds whose fair values were adversely affected by current market conditions; and (9) $139,777 in impairment charges for equity securities of a communications company whose fair value was adversely affected primarily by a recession in the Florida real estate market.
At December 31, 2008, investments having an amortized cost of $5,027,450 were on deposit with various state insurance departments to meet their respective regulatory requirements.
As previously reported, on February 14, 2005, the Company received notification from the U.S. Securities and Exchange Commission (“SEC”) that it was conducting an informal, non-public inquiry regarding the Company. The inquiry generally concerned the chronology, events and announcements relating to Ernst & Young LLP (“E&Y”), the Company’s former independent registered public accounting firm, 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 had been converted into a formal private investigation. On October 23, 2007, the Company and certain of its current officers (Chief Executive Officer, Chief Financial Officer and Vice President of Specialty Products) each received a “Wells Notice” (the “Notice”) from the staff of the SEC indicating that the staff is considering recommending that the SEC bring a civil action against each of them for possible violations of the federal securities laws. The Notice provides the Company and each officer the opportunity to present their positions to the staff before the staff recommends whether any action should be taken by the SEC. The Company continues to cooperate fully with the SEC in an effort to resolve this matter.
Pursuant to separate undertaking agreements dated November 12, 2007 between the Company and each officer who received the Notice, the Company has agreed to advance reasonable legal fees and expenses incurred by each officer in connection with the ongoing SEC investigation. The undertaking agreements require each officer to repay the amounts advanced if it is ultimately determined, in accordance with Article Five of the Company’s Amended and Restated Code of Regulations (the “Regulations”), that the officer did not act in good faith or in a manner he reasonably believed to be in or not opposed to the best interests of the Company with respect to the matters covered by the SEC investigation. Under the Company’s Regulations and Ohio law, the Company may also be required to indemnify each officer in connection with the SEC investigation.
December 31, 2008 and 2007 was $75,676 and $0, respectively. The bank that provides the line of credit is also a policyholder of the Company.
We routinely lease premises for use as administrative offices, vehicles and office equipment under operating leases for varying periods. Management expects that in the normal course of business, leases will be renewed or replaced by other leases. Effective January 1, 2009, we entered into a new lease for our Columbus, Ohio office space. Under the provisions of this lease, no cash payments are due until June 1, 2009. Rent expense is recognized evenly over the lease term ending December 31, 2015. Rental expenses under our operating lease that expired on December 31, 2008 were $191,749 and $177,839 for the years ended December 31, 2008 and 2007, respectively.
In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” which requires the consolidation of certain entities considered to be variable interest entities (“VIEs”). An entity is considered to be a VIE when it has equity investors who lack the characteristics of having a controlling financial interest, or its capital is insufficient to permit it to finance its activities without additional subordinated financial support. Consolidation of a VIE by an investor is required when it is determined that the investor will absorb a majority of the VIE’s expected losses if they occur, receive a majority of the VIE’s expected residual returns if they occur, or both. In accordance with FIN 46, BIC Trust I and BIC Trust II are not considered to be VIEs and are not included in the Company’s consolidated financial statements. If they were included in the consolidated financial statements, there would be no change to net income, only changes in the presentation of the financial statements.
Net deferred tax assets and liabilities and federal income tax expense in future years can be materially affected by changes in enacted tax rates or by unexpected adverse events.
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, we must adjust our 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, 2005, 2006 and 2007, the tax years which remain subject to examination by major tax jurisdictions as of December 31, 2008. 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 we were to incur any interest and/or penalties in connection with income tax deficiencies, we would classify interest in the “interest expense” category and classify penalties in the “other operating expenses” category within our consolidated statements of income.
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 contribution was $100,241 and $98,222 for the years ended December 31, 2008 and 2007, respectively.
We maintain two equity compensation plans for the benefit of certain of our officers, directors, employees, consultants and advisors. During the first quarter of 2006, we 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 and restricted stock, to be recognized in net income based on the grant date fair value of the award. Under the modified prospective method, we are required to record equity-based compensation expense for all awards granted after the date of adoption and for the nonvested portion of previously granted awards outstanding as of the date of adoption. The results for prior periods have not been restated.
We have stock options and restricted stock outstanding at December 31, 2008 under two equity compensation plans (collectively, the “Plans”), each of which has been approved by our shareholders. We will issue authorized but unissued shares or treasury shares to satisfy any future restricted stock awards or the exercise of stock options.
The Bancinsurance Corporation 2002 Stock Incentive Plan, as amended (the “2002 Plan”), provides for certain equity-based awards, including grants of stock options and restricted stock, covering up to an aggregate of 950,000 common shares. Key employees, officers and directors of, and consultants and advisors to, the Company are eligible to participate in the 2002 Plan. The 2002 Plan is administered by the Compensation Committee which determines to whom and when awards will be granted as well as the terms and conditions of the awards. Under the 2002 Plan, stock options for 583,000 common shares were outstanding at December 31, 2008, expire at various dates from 2012 to 2018 and range in option price per share from $4.50 to $8.00. Under the 2002 Plan, 122,443 restricted common shares were also outstanding at December 31, 2008. Of the total equity-based awards for 705,443 common shares outstanding under the 2002 Plan, 34,000 have been granted to our non-employee directors and 671,443 have been granted to employees. All of the equity-based awards outstanding were granted to employees and directors for compensatory purposes. As of December 31, 2008, there were 225,647 common shares available for future grant under the 2002 Plan.
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 utilizes 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. We analyze 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 and using weekly stock prices of the Company; however, for options granted after February 4, 2005, we exclude from our 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 we believe that our stock price during that period is not relevant in evaluating the expected volatility of the 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, 2008, the Company granted 12,000 stock options to non-employee directors which were valued at $2.72 per share. The following table provides the range of assumptions used for options valued during each of the years ended December 31:
The following table summarizes all stock option activity under the Plans from January 1, 2008 through December 31, 2008:
The aggregate intrinsic value represents the total pre-tax intrinsic value, based on the closing price of our common shares on the OTC Bulletin Board on December 31, 2008 ($3.65), which would have been received by the option holders had all option holders exercised their options and sold the underlying common shares as of that date. Because no options were in-the-money at December 31, 2008, the aggregate intrinsic value was zero. There were no stock options exercised during the year ended December 31, 2008.
The following table summarizes nonvested stock option activity under the Plans from January 1, 2008 through December 31, 2008:
Generally, Ohio Indemnity is restricted by the insurance laws of the State of Ohio as to amounts that can be transferred to its parent in the form of dividends, loans or advances without the approval of the Department. Under these restrictions, during 2009, dividends, loans or advances in excess of $4,516,755 will require the approval of the Department.
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 at December 31, 2008.
As of and for the periods ended December 31, Ohio Indemnity’s statutory surplus and net income determined in accordance with statutory accounting practices differed from shareholder’s equity and net income determined in accordance with GAAP by the following:
We assume and cede reinsurance with other insurers and reinsurers. Such arrangements serve to enhance our capacity to write business, provide greater diversification, align the interests of our business partners with our interests, and/or limit our 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
Effective October 1, 2003, we entered into a producer-owned reinsurance arrangement with a CPI customer whereby 100% of that customer’s premiums (along with the associated risk) were ceded to its PORC. For this reinsurance arrangement, we have obtained collateral in the form of a trust from the reinsurer to secure our obligations. Under the provisions of the reinsurance agreement, the collateral must be equal to or greater than 102% of the reinsured reserves and we have immediate access to such collateral if necessary. Effective April 1, 2008, the policy related to this arrangement was cancelled. The reinsurance agreement will remain in place until the business is fully run-off which is expected to be in second quarter of 2009. Under this arrangement, we ceded premiums earned of $1,958,377 and $3,450,688 for the years ended December 31, 2008 and 2007, respectively.
Effective January 1, 2005, we entered into a producer-owned reinsurance arrangement with a GAP insurance agent whereby 100% of that agent’s premiums (along with the associated risk) were ceded to its PORC. For this reinsurance arrangement, we have obtained collateral in the form of a letter of credit to secure our obligations. Under the provisions of the reinsurance agreement, the collateral must be equal to or greater than 102% of the reinsured reserves and we have immediate access to such collateral if necessary. Under this arrangement, we ceded premiums earned of $4,657,167 and $3,560,054 for the years ended December 31, 2008 and 2007, respectively.
Effective January 1, 2007, we entered into a producer-owned reinsurance arrangement with a new EPD customer whereby 100% of that customer’s premiums (along with the associated risk) were ceded to its PORC. For this reinsurance arrangement, we have obtained collateral in the form of funds held and a letter of credit to secure our obligations. Under the provisions of the reinsurance agreement, the collateral must be equal to or greater than 102% of the reinsured reserves and we have immediate access to such collateral if necessary. Under this arrangement, we ceded premiums earned of $11,785,400 and $4,424,122 for the years ended December 31, 2008 and 2007, respectively.
A reconciliation of direct to net premiums, on both a written and earned basis, for each of the years ended December 31 is as follows:
The amounts of recoveries pertaining to reinsurance that were deducted from losses and LAE incurred for the years ended December 31, 2008 and 2007 were $11,113,690 and $7,663,800, respectively. For the years ended December 31, 2008 and 2007, ceded reinsurance decreased commission expense incurred by $3,182,210 and $2,573,657, respectively.
Loss and LAE Reserves. The following compares our loss and LAE reserves for the discontinued bond program at December 31, 2008 and December 31, 2007 (dollars in millions):
During 2001, we 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. We have 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. We are obligated to pay a claim only if a Provider fails to do so. Under two reinsurance arrangements, we cede 100% of the business produced to two different insurance carriers. In addition, we obtained collateral 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 April 13, 2007, this Provider filed a voluntary petition under Chapter 11 of the Bankruptcy Code. On June 12, 2007, the Bankruptcy Court ruled that the Provider was an eligible debtor for purposes of the Bankruptcy Code. This Provider has not written any service contracts under our insurance policies after the commencement of the February 2007 liquidation proceeding. The other Provider has not written any service contracts under our insurance policies since December 31, 2007.
In 1994, we entered into a Split-Dollar Insurance Agreement with a bank, as trustee, for the benefit of an officer and his spouse. The trustee has acquired a second-to-die policy on the lives of the insureds, in the aggregate face amount of $2,700,000. On July 3, 2007, the officer passed away and he was survived by his spouse. At December 31, 2008 and 2007, we had loaned the trustee $1,060,743 and $1,004,372, respectively, under this agreement for payment of insurance premiums, which is included in loans to affiliates in the accompanying balance sheets. Amounts loaned by the Company to the trustee are to be repaid, in full, without interest, from any of the following sources: (1) cash surrender value of the underlying insurance policies; (2) death benefits; and/or (3) the sale of 15,750 common shares of the Company contributed by the officer to the trust.
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 had paid premiums of $30,000 relating to this agreement; however, the Company is no longer paying premiums under the agreement. At December 31, 2008 and 2007, $30,000 was included in loans to affiliates in the accompanying balance sheets for payment of insurance premiums in accordance with this agreement.
The Company validates the prices received from the pricing service by examining their reasonableness. The Company’s review process includes comparing the pricing service’s estimated fair values to the estimated fair values established by our investment custodian (for both equity and fixed maturity securities) and our outside fixed income investment manager (for fixed maturity securities). Our investment custodian utilizes the same pricing service as us, and our outside fixed income investment manager utilizes another nationally recognized pricing service for the municipal bond portfolio and utilizes the same pricing service as us for taxable bonds and closed-end mutual funds. Based on this review, any material differences are investigated and if we deem prices provided by our pricing service are materially unreasonable, we would use the estimated fair value established by our investment custodian and/or outside fixed income investment manager, depending on which prices seemed more reasonable. As of December 31, 2008, the Company did not adjust any prices received from its pricing service.
Available for Sale Fixed Maturity Securities. The fair values of our redeemable preferred stocks were based on observable market quotations for identical assets and therefore have been disclosed in Level 1 of the hierarchy. A number of the Company’s investment grade bonds are frequently traded in active markets and traded market prices for these securities existed at December 31, 2008. However, these securities were classified as Level 2 because the pricing service also utilizes valuation models, which uses observable market inputs, in addition to traded prices. Substantially all of these assumptions are observable in the marketplace or can be derived or supported by observable market data. The Level 2 category generally includes municipal and corporate bonds.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate fair value:
In addition, we are involved in other legal proceedings arising in the ordinary course of business which are routine in nature and incidental to our business. We currently believe that none of these matters, either individually or in the aggregate, is reasonably likely to have a material adverse effect on our financial condition, results of operations or liquidity. However, because litigation is subject to inherent uncertainties and the outcome of such matters cannot be predicted with certainty, future developments could cause any one or more of these matters to have a material adverse effect on our financial condition, results of operations and liquidity.
We also are a guarantor for performance on a bridge loan for a non-executive employee whereby the collateral held by us under the guaranty is the mortgage secured by residential real estate. Our risk under the guaranty is that the borrower defaults on the mortgage and the proceeds from the sale of the residential real estate are not sufficient to cover the amount of the mortgage. The original mortgage was $550,400. As of December 31, 2008, the principal balance of the mortgage was $492,360 and the borrower was current on all principal and interest payments. In the event of default by the borrower, we do not believe our fulfillment of the guaranty would have a material adverse effect on our financial condition, results of operations or liquidity.
We have two reportable business segments: (1) property/casualty insurance; and (2) insurance agency. The following table provides financial information regarding our reportable business segments, which includes 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 were applied. Segment results for each of the years ended December 31, 2008 and 2007 were as follows:
On March 7, 2007, the Board of Directors adopted a common share repurchase program authorizing the repurchase of up to 500,000 common shares of the Company. This repurchase program expired on December 31, 2008. Through December 31, 2008, the Company repurchased 117,348 common shares at an aggregate cost of $731,900 and at an average price per share of $6.24 under this program. These repurchases occurred during 2007.