As of February 7, 2006, we leased 11,868 square feet in Columbus, Ohio for our headquarters pursuant to a lease that commenced on January 1, 2001 and expires on December 31, 2008. The lease provides for monthly rent of $13,230.
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 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) automobile lender/dealer; (2) unemployment compensation; and (3) waste industry.
Our waste industry products (“WIP”) consist of certain surety bonds produced and administered by a general insurance agent. Under this program, the Company both assumes and cedes certain waste surety bond business under two quota share reinsurance arrangements. In the second quarter of 2004, the Company entered into a 50% quota share reinsurance arrangement whereby the Company assumed 50% of all waste surety bonds with liability limits up to $4.0 million from two insurance carriers. Effective January 1, 2005, the reinsurance arrangement was amended whereby the Company’s assumed participation was reduced from 50% to 25%. Effective August 1, 2006, the reinsurance arrangement was further amended whereby the Company assumed 50% of all waste surety bonds with liability limits up to $1.2 million. In addition to assuming business, the Company also writes on a direct basis waste surety bonds with liability limits up to our Treasury limit ($3.6 million during 2006). 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 (“RCRA”). Closure/post-closure bonds cover future costs to close and monitor a regulated site such as a landfill. All of the surety bonds are indemnified by the principal and collateral is maintained on the majority of the bonds. The indemnifications and collateralization of this program reduces the risk of loss.
The Company has certain other specialty products which consist primarily of service contracts and other surety products. 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 “Overview-Discontinued Bond Program” below and Note 16 to the Consolidated Financial Statements.
The Company sells its insurance products through multiple distribution channels, including three managing general agents, approximately thirty five independent agents and direct sales.
Municipal Code Publishing. On August 31, 2006, the Company sold its wholly-owned subsidiary, American Legal Publishing Corporation (“ALPC”), which codifies, publishes, supplements and distributes ordinances for municipalities and counties nationwide in addition to state governments. Ordinance codification is the process of collecting, organizing and publishing legislation for state and local governments. ALPC also provides information management services which includes electronic publishing, document imaging and internet hosting services. See “Overview-Sale of Affiliate” below and Note 1 to the Consolidated Financial Statements for more information concerning this transaction.
On August 31, 2006, the Company entered into a Stock Purchase Agreement (the “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 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. On September 1, 2006, the Purchaser made a principal payment to the Company on the Promissory Note in the amount of $345,000, bringing the remaining principal balance of the Promissory Note to $125,000 which is to be repaid in six monthly installments and bears interest at an annual rate of 8.0%. As of December 31, 2006, the principal balance of the promissory note was $62,500.
The Purchaser was organized by Steven G. Wolf, who has served as President of ALPC since 1984 and as a director of ALPC since 2000. Mr. Wolf and certain other employees of ALPC collectively own a significant equity interest in the Purchaser.
Pending Arbitration. During 2004 and 2005, the Company entered into arbitrations with all four insurance carriers that participated in the
discontinued bond program. As discussed below, during 2006, arbitrations with three of the insurance carriers concluded. The following is a description of the last pending arbitration proceeding as of December 31, 2006:
Aegis Arbitration. During 2004, the Company entered into an arbitration proceeding with Aegis Security Insurance Company (“Aegis”), one of the insurance carriers. Through this arbitration, the Company was seeking rescission of the reinsurance agreements, monetary damages for the claims that were paid by the Company under the agreements and other appropriate relief. Aegis was seeking to recover certain of its losses from the Company under the reinsurance agreements. On January 18, 2006, the Company entered into a settlement agreement with Aegis resolving all disputes between the Company and Aegis relating to the discontinued bond program. The settlement also relieved the Company from any potential future liabilities with respect to bonds issued by Aegis. As a result of this settlement agreement, the Company recorded reserve redundancies of approximately $0.2 million during 2006.
Sirius Arbitration. During 2004, the Company entered into an arbitration proceeding with Sirius America Insurance Company (“Sirius”), one of the insurance carriers. Through this arbitration, the Company was seeking rescission of the reinsurance agreement, monetary damages for claims that were paid by the Company under the agreement and other appropriate relief. Sirius was seeking to recover certain of its losses from the Company under the reinsurance agreement. On July 26, 2006, the Company entered into a settlement agreement with Sirius resolving all disputes between the Company and Sirius relating to the discontinued bond program. The settlement also relieved the Company from any potential future liabilities with respect to bonds issued by Sirius. As a result of this settlement agreement, the Company recorded reserve deficiencies of approximately $0.1 million during 2006.
In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements.” This Statement defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and expands disclosures about fair value measurements. The Statement clarifies the rule that fair value be based on the assumptions that market participants would use when pricing an asset or liability, and establishes a fair value hierarchy that prioritizes the framework and information used to develop those assumptions. The Company is required to adopt the provisions of SFAS No. 157 for financial statements issued for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 157 is not expected to have a material impact on the Company’s Consolidated Financial Statements.
Effective October 1, 2003, the Company entered into a producer-owned reinsurance arrangement with an existing lender/dealer customer whereby 100% of that customer’s premiums (along with the associated risk) was ceded to its PORC. For this reinsurance arrangement, the Company has obtained collateral in the form of a trust from the reinsurer 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 $2,266,090, $1,727,303 and $894,717 for the years ended December 31, 2006, 2005 and 2004, respectively.
Beginning in the second quarter of 2004, the Company entered into a quota share reinsurance arrangement with certain insurance carriers whereby the Company assumed and ceded 50% of certain waste surety bond business. Effective January 1, 2005, the reinsurance arrangement was amended whereby the Company’s assumed participation was reduced from 50% to 25%. Effective August 1, 2006, the reinsurance arrangement was further amended whereby the Company’s assumed participation was increased from 25% to 50%. Under this program, the Company assumed premiums earned of $3,283,690, $4,302,509 and $1,980,492 during 2006, 2005 and 2004, respectively. Also, the Company ceded premiums earned of $1,235,624, $679,563 and $131,051 for the years ended December 31, 2006, 2005, and 2004, respectively.
In addition to the above, the Company has other reinsurance arrangements including two automobile lender/dealer PORC quota share arrangements, several quota share arrangements for certain contract and escrow surety bond business and a reinsurance arrangement for a vehicle service contract program. Under these arrangements, the Company ceded premiums earned of $708,430, $927,455 and $1,113,639 for the years ended December 31, 2006, 2005 and 2004, respectively. Also, the Company assumed premiums earned of $60,535, $0 and $0 for the years ended December 31, 2006, 2005 and 2004, respectively.
Net income for 2006 was $5,474,901, or $1.08 per diluted share, compared to $6,294,074, or $1.26 per diluted share, in 2005. The decrease was primarily attributable to an increase in losses and LAE for the discontinued bond program and an increase in losses and LAE due to favorable loss development in 2005. These losses were partially offset by the $2.5 million net realized gain on the sale of ALPC during 2006. See “Overview - Discontinued Bond Program” above and Note 16 to the Consolidated Financial Statements for additional information concerning the discontinued bond program. See “Overview-Sale of Affiliate” above and Note 1 to the Consolidated Financial Statements for additional information concerning the sale of ALPC.
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 costs 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 decreased 5.0%, or $2,610,292, to $49,106,653 in 2006 from $51,716,945 the prior year due to a decline in premiums for ULI, CPI, WIP and the discontinued bond program which were partially offset by growth in our GAP and UC product lines.
Net premiums earned for WIP declined 6.9%, or $333,998, to $4,505,250 in 2006 from $4,839,248 in 2005, due primarily to the general insurance agent changing its distribution of business with the insurance carriers participating in this program.
Net realized gains on investments decreased 95.7%, or $1,226,036, to $55,719 in 2006 from $1,281,755 a year ago due to the timing of sales of equity securities. We generally decide whether to sell securities based upon investment opportunities and tax consequences. We regularly evaluate the quality of our investment portfolio. When we believe that a specific security has suffered an other-than-temporary decline in value, the difference between cost and estimated fair value is charged to income as a realized loss on investments. Impairment
Codification and Subscription Fees. ALPC’s codification and subscription fees decreased 35.1%, or $1,219,110, to $2,255,558 in 2006 from $3,474,668 in 2005. The decrease was primarily due to the sale of ALPC on August 31, 2006 (8 months in 2006 compared to 12 months in 2005). See Overview-Sale of Affiliate” above and Note 1 to the Consolidated Financial Statements for more information concerning this transaction.
CPI losses and LAE decreased 32.8%, or $262,098, to $536,367 in 2006 from $798,465 a year ago which is consistent with the decline in business.
WIP losses and LAE decreased 7.0%, or $34,028, to $449,897 in 2006 from $483,925 a year ago. This decrease is consistent with the decrease in net premiums earned as the Company records loss and LAE reserves for WIP using an expected loss ratio reserving method, which is based on a certain percentage of net premiums earned.
Commissions, Other Insurance Operating Expenses and General and Administrative Expenses. Commission expense decreased 12.4%, or $1,709,942, to $12,041,054 in 2006 from $13,750,996 in 2005 primarily due to the decline in ULI commissions associated with the Transferred Business. Other insurance operating expenses and general and administrative expenses combined decreased 4.7%, or $535,147, to $10,882,039 in 2006 from $11,417,186 a year ago primarily due to a decrease in audit and legal expenses associated with the withdrawal by the Company’s former independent registered public accounting firm in 2005 combined with a decrease in legal expenses associated with the discontinued bond program arbitrations. These decreases were partially offset by an increase in compensation expense and an increase in reserves for contingent liabilities.
Codification and Subscription Expenses. Codification and subscription expenses incurred by ALPC decreased 31.1%, or $873,316, to
$1,936,384 in 2006 from $2,809,700 a year ago, as the Company sold APLC on August 31, 2006 (8 months in 2006 compared to 12 months in 2005). See “Overview-Sale of Affiliate” above and Note 1 to the Consolidated Financial statements for more information concerning this transaction.
Interest Expense. Interest expense increased 24.0%, or $276,723, to $1,429,086 in 2006 from $1,152,363 a year ago as a result of rising interest rates. See “Liquidity and Capital Resources” for 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 19.8% and 23.0% for 2006 and 2005, respectively. This improvement is attributable to the ratio of tax-exempt income when compared to income from operations for each year.
GAAP Combined Ratio. For 2006, the combined ratio increased to 97.9% from 93.6% a year ago. The loss ratio increased to 53.2% in 2006 from 45.8% a year ago partly due to an increase in losses and LAE for the discontinued bond program. Excluding the discontinued bond program, the Company’s loss ratio was 49.6% in 2006 compared to 45.0% a year ago. This increase was primarily attributable to prior year favorable loss development for our ULI product line. The expense ratio improved to 44.7% in 2006 from 47.8% a year ago primarily due to the decrease in ULI commissions associated with the Transferred Business.
Net premiums earned for CPI increased 11.8%, or $243,304, to $2,307,144 in 2005 from $2,063,840 in 2004 principally due to new customers added.
Net premiums earned for GAP grew 70.7%, or $4,038,540, to $9,752,407 in 2005 from $5,713,867 in 2004. This growth was due to purchases of GAP coverage by new customers, as well as rate and volume increases with existing customers.
Net premiums earned for UC products increased 11.8%, or 589,895, to $5,568,888 in 2005 from $4,978,993 in 2004 due to growth in the Company’s UCassure® product and rate increases.
Net premiums earned for WIP increased 129.2%, or $2,727,705, to $4,839,248 in 2005 from $2,111,543 in 2004, as we participated in this program for a full year in 2005 compared to a partial year in 2004.
Investment Income. Net investment income increased 52.6%, or $1,138,544, to $3,302,659 in 2005 from $2,164,115 a year ago. This improvement was due to growth in fixed income investments combined with a higher after-tax yield. Higher yields resulted from the Company’s reallocation of a portion of its portfolio from short-term investments to fixed maturities during 2004, which provided a better matching of the Company’s invested assets to its product liability duration and enhanced the Company’s investment return.
Losses and Loss Adjustment Expenses. Losses and LAE decreased 50.6%, or $23,901,695, to $23,335,620 in 2005 from $47,237,315 in 2004. This decline was mostly due to a decrease in losses and LAE of $19,738,370 for the discontinued bond program. See “Overview-Discontinued Bond Program” above and Note 16 to the Consolidated Financial Statements for a discussion of the discontinued bond program. Excluding the discontinued bond program, losses and LAE declined 15.4%, or $4,163,325, to $22,912,887 in 2005 from $27,076,212 in 2004 primarily due to a decrease in ULI losses and LAE which was partially offset by an increase in losses and LAE for our CPI, GAP, UC and WIP business.
ULI losses and LAE decreased 27.3%, or $5,883,795, to $15,685,102 in 2005 from $21,568,897 in 2004. The decrease was due primarily to favorable loss development during 2005 as a result of fewer loan defaults, bankruptcies and automobile repossessions among our ULI customers combined with a decrease in business.
Commissions, Other Insurance Operating Expenses and General and Administrative Expenses. Commission expense increased 21.9%, or $2,465,946, to $13,750,996 in 2005 from $11,285,050 in 2004 principally due to the growth in GAP and WIP premiums combined with improved loss performance for one of our ULI general agents, which resulted in an increase to contingent commissions. Other insurance operating expenses and general and administrative expenses combined rose 64.3%, or $4,466,521, to $11,417,186 in 2005 from $6,950,665 in 2004 primarily due to legal fees related to the Audit Committee’s independent investigation of E&Y’s withdrawal of its audit reports, the SEC private investigation and the discontinued bond program arbitrations, as well as an increase in audit fees. We believe a significant portion of this increase represents one-time expenses.
Codification and Subscription Expenses. Codification and subscription expenses incurred by ALPC decreased 20.9%, or $741,844, to $2,809,700 in 2005 from $3,551,544 a year ago. This decrease was consistent with the decline in codification and subscription revenues and was primarily attributable to the completion of a one-time project during 2004 that generated additional expenses for last year as well as an impairment write-down of a database in the second quarter of 2004.
We believe the national economy remains unstable. National automobile sale volumes were down in 2006 compared to 2005 which resulted in a decline in lending volumes for many our automobile lender/dealer customers. As a result, our premium volume was down in 2006 compared to 2005. If this trend continues, we could experience a premium decline in 2007 as well.
The Company believes that there has been a stabilization of benefit charge levels in our UC product customer base; however, if unemployment levels rise, we could experience lower management fees and/or increased losses for our UC products. Furthermore, any developments on the discontinued bond program and related Highlands arbitration could have a material impact on our results of operations and/or financial condition.
During 2006, the Company experienced a high level of legal expenses associated with the discontinued bond program arbitrations. The Company anticipates it will continue to incur legal costs during 2007 for the Highlands arbitration; however, the Company believes its total bond program arbitration costs will be significantly reduced in 2007 when compared to 2006.
If interest rates continue to rise during 2007, it would increase the level of interest expense on the Company’s trust preferred debt and any borrowings under its revolving line of credit. See “Liquidity and Capital Resources” below for more information concerning our trust
We also have a $10,000,000 unsecured revolving line of credit with a maturity date of June 30, 2009 with no outstanding balance at December 31, 2006 and December 31, 2005. 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, 2006, the Company was in compliance with all such covenants.
As discussed in “Overview-Discontinued Bond Program” above and in Note 16 to the Consolidated Financial Statements, discontinued bond program loss and LAE reserves were $6.4 million at December 31, 2006. Ultimate payment on the discontinued bond program may result in an increase in cash outflows from operations and may impact our financial condition by reducing our invested assets. We consider the discontinued bond program liabilities and 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-income investments with the expected payout of our liabilities for the discontinued bond program. There are no significant variations between the maturity of our investments and the expected payout of our loss and LAE reserves for the discontinued bond program.
Cash flows (used in) provided by operating activities totaled $(11,014,388), $14,813,168 and $8,657,804 for 2006, 2005 and 2004, respectively. The increase in cash used in 2006 (as compared to 2005) was primarily the result of an increase in paid losses for the discontinued bond program, ceded reinsurance payments and management fee payments to our cost containment service firms, which were partially offset by a decrease in commissions paid as well as a decrease in audit and legal expenses related to the withdrawal by the Company’s former independent registered public accounting firm in 2005. The increase in paid losses for the discontinued bond program was primarily due to the Aegis and Sirius settlements and the Harco Final Order (see “Overview-Discontinued Bond Program” and Note 16 to the Consolidated Financial Statements for additional information concerning these arbitrations). The increase in cash provided in 2005 (as compared to 2004) was primarily the result of an increase in investment income collected, an increase in net cash flows from contract funds on deposit and funds held under reinsurance arrangements, a decrease in paid losses and LAE and federal income taxes recovered during 2005 compared to federal income taxes paid during 2004. These increases in cash flows in 2005 were partially offset by an increase in commissions and other expenses paid and a decrease in net premiums collected compared to 2004.
Ohio Indemnity is restricted by the insurance laws of the State of Ohio as to amounts that can be transferred to Bancinsurance in the form of dividends without the approval of the Department. During 2007, the maximum amount of dividends that may be paid to Bancinsurance by Ohio Indemnity without prior approval is limited to $4,915,331.
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, 2006.
The following table sets forth the Company’s contractual obligations at December 31, 2006:
In accordance with the provisions of the debt agreements, the BIC Trust I and BIC Trust II debt obligations are redeemable at par on December 4, 2007 and September 30, 2008, respectively. The table above assumes payout at maturity date rather than redemption date.
For the Company’s assumed WIP program, the Company is recording loss and LAE reserves using a loss ratio reserving methodology. The loss ratio method calculates a reserve based on expected losses in relation to premiums earned. The expected loss ratio for the program was selected using expected loss information provided by the ceding insurer.
Historical “age-to-age” loss development factors (“LDF”) were calculated to measure the relative development for each accident year from one maturity point to the next. Based on the historical LDF, we selected age-to-age LDF that we believe are appropriate to estimate the remaining future development for each accident year. These selected factors are used to project the ultimate expected losses for each
accident year. The validity of the results from using a loss development approach can be affected by many conditions, such as claim department processing changes, a shift between single and multiple payments per claim, legal changes or variations in our mix of business from year to year. Also, because the percentage of losses paid for immature years is often low, development factors are volatile. A small variation in the number of claims paid can have a leveraging effect that can lead to significant changes in estimated ultimate losses. Therefore, ultimate values for immature accident years may be based on alternative estimation techniques, such as expected loss ratio method, or some combination of acceptable actuarial methods.
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 or inconsistencies in our data. We did not experience any significant change in the number of claims paid that was inconsistent with our business (other than claims related to the discontinued bond program), average claim paid or average claim reserve that would be inconsistent with the types of risks we insured in the respective years.
For the discontinued bond program, the Company recorded reserve deficiencies of approximately $1.8 million during 2006. The reserve deficiencies were primarily attributable to the Harco Final Order combined with an increase in reported losses from Harco. See “Overview-Discontinued Bond Program” and Note 16 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.
We do not have any off-balance sheet arrangements that either have, or are reasonably likely to have, a current or future effect on our financial condition, changes in financial condition, results of operations, liquidity, capital expenditures and/or capital resources that are considered material.
Certain statements made in this Annual Report on Form 10-K are forward-looking and are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. In addition, we may make other written or oral communications from time to time that contain forward-looking statements. Forward-looking statements convey our current expectations or forecast future events. All statements contained in this Annual Report on Form 10-K, other than statements of historical fact, are forward-looking statements.
Forward-looking statements include statements regarding our future financial position, results of operations, business strategy, budgets, projected costs and plans and objectives of management for future operations. The words “may,” “continue,” “estimate,” “intend,” “plan,” “will,” “believe,” “project,” “expect,” “anticipate” and similar expressions generally identify forward-looking statements but the absence of these words does not necessarily mean that a statement is not forward-looking. Forward-looking statements are not guarantees of future performance and involve risks and uncertainties that may cause actual results to differ materially from those statements. Risk factors that might cause actual results to differ from those statements include, without limitation, changes in underwriting results affected by adverse economic conditions, fluctuations in the investment markets, changes in the retail marketplace, changes in the laws or regulations affecting the operations of the Company, changes in the business tactics or strategies of the Company, the financial condition of the Company’s business partners, changes in market forces, litigation, developments in the discontinued bond program and related Highlands arbitration, the ongoing SEC private investigation and the concentrations of ownership of the Company’s common shares by members of the Sokol family, and other risk factors identified in our filings with the SEC, any one of which might materially affect our financial condition and/or results of operations. Any forward-looking statements speak only as of the date made. We undertake no obligation to update any forward-looking statements to reflect events or circumstances arising after the date on which they are made.
We have audited the accompanying consolidated balance sheets of Bancinsurance Corporation and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity and cash flows for the three 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.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Bancinsurance Corporation and subsidiaries at December 31, 2006 and 2005 and the results of their operations and their cash flows for the three years then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Our automobile lender/dealer product line offers three 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 traditional blanket vendor single interest 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 borrowers’ 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.
Municipal Code Publishing. On August 31, 2006, the Company sold its wholly-owned subsidiary, American Legal Publishing Corporation (“ALPC”), which codifies, publishes, supplements and distributes ordinances for municipalities and counties nationwide in addition to state governments. Ordinance codification is the process of collecting, organizing and publishing legislation for state and local governments. ALPC also provides information management services which include electronic publishing, document imaging and internet hosting services. See “Sale of Affiliate” below for more information concerning this transaction.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates.
In June 2006, the Financial Accounting Standards Board (“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. The effective date of FIN 48 for the Company is January 1, 2007. The adoption of FIN 48 is not expected to have a material impact on the Company’s Consolidated Financial Statements .
Available for sale equity securities, which include common stock, non-redeemable preferred stock and mutual funds, are reported at fair value with unrealized gains or losses, net of applicable deferred taxes and reclassification adjustment, reflected in other comprehensive income. Short-term investments are reported at cost which approximates fair value. Other invested assets are reported at cost or using the equity method.
Commission and fee revenues for USA are recognized when earned based on contractual rates and services provided.
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. Ceded reinsurance transactions for the Company include quota share arrangements for certain lender/dealer producers. The Company also participates in a waste surety bond program and certain other surety bond programs under several quota share arrangements in which the Company assumes and cedes business. In addition, the Company cedes certain service contract business under a reinsurance arrangement. Lastly, the Company assumed bail and immigration bond business through the second quarter of 2004 after which the program was discontinued. See Note 16 to the Consolidated Financial Statements for more information concerning the Company’s reinsurance transactions.
Real estate is stated at cost and depreciated using the straight-line method over thirty-nine years. Property, equipment and internally-developed computer software are stated at cost and depreciated using the straight-line method over the estimated useful life, ranging from three to five years. Leasehold improvements are capitalized and amortized over the remaining office lease term. Maintenance and repairs are charged directly to expense as incurred. As of December 31, 2006 and 2005, property, equipment, computer software and leasehold improvements, net of accumulated depreciation, was $636,966 and $484,525, respectively. These balances are presented in the accompanying balance sheets as other assets.
Prior to the first quarter of 2006, the Company accounted for equity-based awards under the intrinsic value method, which followed the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Therefore, no compensation expense was recognized in net income, as all options granted had an exercise price equal to the fair value of the underlying stock on the date of grant. The following table illustrates the effect on net income and income per share if the Company had adopted the fair value recognition provisions of SFAS No. 123(R), “Share-Based Payment,” for 2005 and 2004:
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, 2006 and December 31, 2005, distinguishing between those securities which have been continuously in an unrealized loss position for less than twelve months and greater than twelve months.
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 $7,310, $0 and $535,487 in impairment charges included in net realized gains on investments for the years ended December 31, 2006, 2005 and 2004, respectively. Included in impairment charges for 2004 is a write down of $334,136 related to a private equity investment due to its financial uncertainty. As part of the Company’s normal assessment of other-than-temporary impairments of investments, the securities listed above were evaluated and no further impairments were deemed necessary as of December 31, 2006.
At December 31, 2006, investments having a carrying value of $4,538,220 were on deposit with various state insurance departments to meet their respective regulatory requirements.
Revenues earned on uncompleted codification contracts by ALPC were $0 and $1,452,739 and billings to date on those contracts were $0 and $1,279,812 at December 31, 2006 and 2005, respectively. The excess of costs and estimated earnings over billings were $0 and $248,035 at December 31, 2006 and 2005, respectively. On August 31, 2006, the Company sold its municipal code publishing segment as more fully described above in Note 1 to the Consolidated Financial Statements.
As part of its annual goodwill impairment testing in the fourth quarter of 2004, the Company concluded that an impairment of goodwill existed at its property/casualty insurance segment. The Company performed impairment testing in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” The Company, with the assistance of an independent appraisal firm, determined that the carrying value of the reporting segment exceeded the fair value of the reporting segment, resulting in a non-cash impairment charge. The fair value of the reporting segment was estimated using the expected present value of future cash flows. As a result of this impairment, the Company recorded a non-cash impairment charge in the fourth quarter of 2004 in the aggregate amount of $753,737.
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 2001, we entered into a new lease for our Columbus, Ohio office space. Under its provisions, no cash payments were due until April 1, 2002. Rent expense is recognized evenly over the lease term ending December 31, 2008. Rental expenses under operating leases were $251,768, $265,852 and $274,300 for the years ended December 31, 2006, 2005 and 2004, respectively.
As of December 31, 2006, the Company does not have any uncertain tax positions under FIN 48. As a result, there are no unrecognized tax benefits as of December 31, 2006. The Company’s 1999 through 2005 federal tax returns still remain subject to examination by the Internal Revenue Service.
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 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.
All stock options (1) are granted with an exercise price equal to the market 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; and (4) with respect to non-employee directors, vest and become exercisable after one full year of continuous service.
The fair value of options granted by the Company during 2006 was 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 was 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 analyzed 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 were 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, 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 was used in the Black-Scholes model based on historical dividends. The following table provides the range of assumptions used for options valued during the years ended December 31:
The compensation expense recognized for all equity-based awards is net of forfeitures and is recognized over the awards’ service period. In accordance with Staff Accounting Bulletin (“SAB”) No. 107, the Company recorded equity-based compensation expense for the year ended December 31, 2006 in the amount of $217,958 ($143,852 net of tax), which is classified within other insurance operating expenses to correspond with the same line item as cash compensation paid to employees. During 2006, the Company received cash of $38,880 from the exercise of stock options and realized a tax benefit of $3,101 from such option exercises.
The following table summarizes all stock option activity for the Company under the Plans from January 1, 2006 through December 31, 2006:
The aggregate intrinsic value represents the total pretax intrinsic value, based on the Company’s last reported bid quotation for the common shares in the “Pink Sheets” as of December 31, 2006 ($6.05), which would have been received by the option holders had all option holders exercised their options as of that date.
The following table summarizes nonvested stock option activity for the Company under the Plans from January 1, 2006 through December 31, 2006:
As of December 31, 2006, the total compensation cost related to nonvested stock options not yet recognized was $771,528. The weighted-average period over which this cost is expected to be recognized is approximately 3.4 years.
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 2007, dividends, loans or advances in excess of $4,915,331 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, 2006.
Ohio Indemnity is statutorily required to file financial statements with state and other regulatory authorities. The accounting principles used to prepare such statutory financial statements follow prescribed or permitted accounting practices as defined in the National Association of Insurance Commissioners Accounting Practices and Procedures Manual, which principles may differ from GAAP. Permitted statutory accounting practices encompass all accounting practices not so prescribed, but allowed by the Department. Ohio Indemnity has no permitted statutory accounting practices.
As a result of changes in estimates of insured events in prior years, the provision for unpaid loss and LAE increased (decreased) by approximately $136,000, $(3,697,000) and $(5,383,000) for the years ended December 31, 2006, 2005 and 2004, respectively. The increase in 2006 was due to unfavorable loss development for the discontinued bond program which was partially offset by favorable loss development in our automobile lender/dealer and waste industry product lines. The decrease in 2005 and 2004 was attributed primarily to favorable loss development in the Company’s ULI product line.
Several of our lender/dealer insurance producers have formed sister reinsurance companies, commonly referred to as a producer-owned reinsurance company (“PORC”). The primary reason for an insurance producer to form a PORC is to realize the underwriting profits and investment income from the insurance premiums generated by that producer. In return for ceding business to the PORC, the Company receives a ceding commission, which is based on a percentage of the premiums ceded. Such arrangements align business partners with the Company’s interests while preserving valued customer relationships. All of the Company’s lender/dealer ceded reinsurance transactions are PORC arrangements.
Beginning in the second quarter of 2004, the Company entered into a quota share reinsurance arrangement with certain insurance carriers whereby the Company assumed and ceded 50% of certain waste surety bond business. Effective January 1, 2005, the reinsurance arrangement was amended whereby the Company’s assumed participation was reduced from 50% to 25%. Effective August 1, 2006, the reinsurance arrangement was further amended whereby the Company’s assumed participation was increased from 25% to 50%. Under this program, the Company assumed premiums earned of $3,283,690, $4,302,509 and $1,980,492 during 2006, 2005 and 2004, respectively. Also, the Company ceded premiums earned of $1,235,624, $679,563 and $131,051 for the years ended December 31, 2006, 2005 and 2004, respectively.
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” below.
Beginning in 2001 and continuing into the second quarter of 2004, the Company participated as a reinsurer in a program covering bail and immigration bonds issued by four insurance carriers and produced by a bail bond agency (collectively, the “discontinued bond program” or the “program”). The liability of the insurance carriers was reinsured to a group of reinsurers, including the Company. The Company assumed 15% of the business from 2001 through 2003 and 5% of the business during the first half of 2004. This program was discontinued in the second quarter of 2004.
Based on the design of the program, the bail bond agency was to obtain and maintain collateral and other security and to provide funding for bond losses. The bail bond agency and its principals were responsible for all losses as part of their program administration. The insurance carriers and, in turn, the reinsurers were not required to pay losses unless there was a failure of the bail bond agency. As the bonds were to be 100% collateralized, any losses paid by the reinsurers were to be recoverable through liquidation of the collateral and collections from third party indemnitors.
Pending Arbitration. During 2004 and 2005, the Company entered into arbitrations with all four insurance carriers that participated in the discontinued bond program. As discussed below, during 2006, arbitrations with three of the insurance carriers concluded. The following is a description of the last pending arbitration proceeding as of December 31, 2006:
Highlands Arbitration. Highlands Insurance Company (“Highlands”), one of the insurance carriers, was placed in receivership during 2003 (which receivership remains pending). On August 31, 2005, 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.
Harco Arbitration. During 2004, the Company entered into an arbitration proceeding with Harco National Insurance Company (“Harco”), one of the insurance carriers. Through this arbitration, the Company was seeking rescission of the reinsurance agreement and other appropriate relief. Harco was seeking to recover certain of its losses from the Company under the reinsurance agreement. The arbitration hearing concluded in July 2006. In August 2006, the 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”). Based on the Final Order and the most recent loss reports provided by Harco, the Company recorded reserve deficiencies of approximately $2.0 million and return premiums of approximately $0.3 million during 2006.
Highlands Development. During the third quarter of 2006, the Company received information indicating that Highlands and the U.S. Department of Homeland Security (“DHS”) reached a global settlement concerning Highlands’ immigration bond obligations, which settlement is subject to the approval of the court in which the receivership is pending. Based on this information, the Company recorded reserve redundancies of approximately $0.1 million during 2006.
Loss and LAE Reserves. As of December 31, 2006, the Company recorded its loss and LAE reserves for the discontinued bond program based primarily on loss reports received by the Company from Harco and Highlands. The following compares our loss and LAE reserves for the discontinued bond program at December 31, 2006 and December 31, 2005 (dollars in millions):
We believe there is potential for the Company to mitigate its ultimate liability to Highlands through the arbitration proceeding with Highlands; however, because of the subjective nature inherent in assessing the final outcome of this arbitration, management cannot estimate the probability of an adverse or favorable outcome as of December 31, 2006. In addition, while outside counsel believes we have legal defenses under the reinsurance agreement, they are unable to assess whether an adverse outcome is probable or remote in the arbitration as of December 31, 2006. In accordance with SFAS No. 5 “Accounting for Contingencies,” the Company is reserving to its best estimate of the ultimate liability on the program at December 31, 2006 without any adjustment for positive 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. 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.
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 bank has acquired a second-to-die policy on the lives of the insureds, in the aggregate face amount of $2,700,000. At December 31, 2006 and 2005, we had loaned the trustee $932,653 and $860,934, respectively, under this agreement for payment of insurance premiums, which is included in loans to affiliates in the accompanying balance sheet. 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.
The Company has the following concentrations of net premiums earned with one managing general agent within our property/casualty insurance business segment for the years ended December 31:
Our results of operations have varied, and in the future may vary, from quarter to quarter, principally because of fluctuations in our underwriting results and/or realized gain (loss) activity. Consequently, quarterly results are not necessarily indicative of full year results, nor are they comparable to the results of other quarters. The following table sets forth certain unaudited quarterly consolidated financial and operating data:
As discussed in Note 16 to the Consolidated Financial Statements, the Company is a party to the Highlands arbitration proceeding arising from claims made under a reinsurance contract relating to the discontinued bond program. In addition, the Aegis, Sirius and Harco arbitrations were resolved during 2006. See Note 16 to the Consolidated Financial Statements for additional information concerning the discontinued bond program arbitrations.
In October 2006, the Company commenced arbitration against Ernst & Young LLP (“E&Y”), the Company’s former independent registered public accounting firm, in accordance with the terms of the engagement letter between the Company and E&Y. In the arbitration, the Company alleges that E&Y improperly withdrew the Company’s audit reports for the 2001 through 2003 fiscal years. The Company is seeking monetary damages in excess of $21 million. E&Y has counterclaimed, seeking to recover in excess of $475,000 from the Company for unpaid invoices and additional costs. No arbitration panel has yet been constituted. The Company does not believe this dispute will have a material adverse effect on our financial condition or liquidity.
In addition, the Company is involved in various other lawsuits and legal proceedings arising in the ordinary course of business, some of which involve claims for substantial amounts. We provide accruals for these items to the extent that we deem the losses probable and reasonably estimable. The outcome of litigation is subject to numerous uncertainties. While the ultimate resolution of these legal proceedings could be material to the Company’s results of operations in a future quarter or annual period, in the opinion of Company’s management, none would likely have a material adverse effect on the Company’s financial condition or liquidity.
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 obtains 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.