As of February 2, 2009, we leased approximately 11,700 square feet in Columbus, Ohio for our headquarters pursuant to a lease that commenced on January 1, 2009 and expires on December 31, 2015. The lease provides for monthly rent of $16,134.
During 2004 and 2005, we entered into arbitrations with the following four insurance carriers that participated in the discontinued bond program: 1) Aegis Security Insurance Company (“Aegis”); 2) Sirius America Insurance Company (“Sirius”); 3) Harco National Insurance Company (“Harco”); and 4) Highlands Insurance Company (“Highlands”). During 2006, the arbitrations with Aegis, Sirius and Harco concluded. For Aegis and Sirius, we entered into settlement agreements with these insurance carriers resolving all disputes between us and these carriers relating to the discontinued bond program. These settlement agreements also relieved us from any potential future liabilities with respect to bonds issued by Aegis and Sirius.
For Harco, in August 2006, the Harco arbitration panel issued its Final Decision and Order ordering each of the reinsurers participating in the arbitration, including us, to pay its proportionate share of past and future claims paid by Harco, subject to certain adjustments, offsets and credits (the “Final Order”). Pursuant to the terms of the Final Order, we have paid Harco for our proportionate share of all past claims paid by Harco which it has invoiced to us through December 31, 2008, except as noted below.
We believe there is potential for us to mitigate our ultimate liability to Highlands through the arbitration proceeding with Highlands. In accordance with SFAS No. 5, “Accounting for Contingencies,” we are reserving to our best estimate of the ultimate liability on the program at December 31, 2008 without any adjustment for a positive arbitration outcome or a potential settlement amount with Highlands. If we obtain information to determine an estimate of a final arbitration value or estimate a settlement value, we will record changes in our reserves, if any, in the period that an estimate is made. We do not intend to pay 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 our ultimate liability.
For 2008, we recorded a benefit of $101,904 for the discontinued bond program which was primarily attributable to Harco providing sufficient information for us to estimate recoveries that we believe we are entitled to under the Final Order. Discontinued bond program losses and LAE were $749,575 for 2007 primarily due to an increase in reported losses from Highlands which was partially offset by a decrease in reported losses from Harco.
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. For more information concerning fair value measurements, see Note 18 to the Consolidated Financial Statements
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115.” SFAS No. 159 permits all entities to choose to measure and report many financial instruments and certain other items at fair value at specified election dates. If such an election is made, any unrealized gains and losses on items for which the fair value option has been elected are required to be reported in earnings at each subsequent reporting date. In addition, SFAS No. 159 establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. We were required to adopt the provisions of SFAS No. 159 for financial statements issued for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 159 did not have a material impact on our consolidated financial statements.
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.
On August 24, 2007, we drew on the $4.3 million letter of credit, of which approximately $2.7 million was attributable to our obligations in connection with the Provider that is in bankruptcy and approximately $1.6 million was attributable to our obligations in connection with the Provider that is not in bankruptcy, and we subsequently obtained an additional $0.5 million from the Provider that is not in bankruptcy to further secure our insurance obligations. On December 2, 2008, the Bankruptcy Court entered a ruling approving a settlement and release agreement between us and the Provider that is in bankruptcy. Under the terms of this settlement and release agreement, we released from the collateral attributable to the Provider that is in bankruptcy and held by us approximately $1.0 million to that Provider’s bankruptcy estate (the “settlement payment”) In exchange for the release of this collateral, the bankruptcy trustee, on behalf of the Provider that is in bankruptcy, agreed to release us from any claims by such Provider and any third party, other than those defined contract claims that are scheduled on the settlement and release agreement (the “scheduled claims”). As of December 31, 2008, after the settlement payment and all claims paid by us during 2007 and 2008, we retained approximately $1.4 million of collateral attributable to such Provider which we believe is sufficient to pay for the $1.4 million in estimated liability for the scheduled claims. As a result of the settlement and release agreement, the liability associated with the Provider that is in bankruptcy was transferred to “reserve for unpaid losses and loss adjustment expenses” in our accompanying balance sheet (previously reported as “funds held for account of others” as of September 30, 2008) and the $1.4 million collateral attributable to such Provider and retained by us was transferred into our operating assets during the fourth quarter of 2008 (previously reported as “restricted short-term investments” as of September 30, 2008).
The combined ratio, which is the sum of the loss ratio and the expense ratio, is the traditional measure of underwriting experience for property/casualty insurance companies. Our specialty insurance products are underwritten by Ohio Indemnity, whose results represent the Company’s combined ratio. The statutory combined ratio is the sum of the ratio of losses to premiums earned plus the ratio of statutory underwriting expenses less management fees to premiums written after reducing both premium amounts by dividends to policyholders. Statutory accounting principles differ in certain respects from GAAP. Under statutory accounting principles, policy acquisition costs and other underwriting expenses are recognized immediately, not at the same time premiums are earned. To convert underwriting expenses to a GAAP basis, policy acquisition 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:
ULI net premiums earned remained relatively flat at $23,047,041 in 2008 compared to $23,117,118 a year ago as we experienced an increase in lending volume for certain financial institution customers which was offset by a decrease in lending volume for certain other financial institution customers.
Net premiums earned for UC products increased 8.5%, or $521,338, to $6,620,753 in 2008 from $6,099,415 a year ago primarily due to pricing increases for our UCassure® product.
Net premiums earned for WIP increased 29.5%, or $1,629,517, to $7,146,767 in 2008 from $5,517,250 a year ago primarily due to (1) an increase in assumed waste surety bonds as a result of a 5% quota share reinsurance arrangement that was entered into in the second quarter of 2007, (2) an increase in direct waste surety bond premiums due to the general insurance agent increasing its placement of business with us and (3) an increase in contract surety bond premiums, which we began writing in the second half of 2006.
Net Realized Losses on Investments. Net realized losses on investments increased 182.6%, or $2,237,284, to $3,462,577 in 2008 from
$1,225,293 a year ago primarily due to a $2,459,819 increase in impairment charges which was partially offset by a $222,535 increase in net realized gains recorded on the sales of equity and bond securities. 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.
Management Fees. Our management fees decreased 17.8%, or $80,058, to $368,841 in 2008 from $448,899 a year ago primarily due to an increase in unemployment benefit charges. Our current benefit charges may not necessarily correlate with the current national unemployment experience as the non-profit entities that utilize our UC coverage may have different factors that are affecting their unemployment rates. We expect management fees to vary from period to period depending on our customers’ unemployment levels and benefit charges.
Losses and Loss Adjustment Expenses. Losses and LAE decreased slightly to $24,454,597 in 2008 from $24,543,730 a year ago.
ULI losses and LAE increased 2.6%, or $421,313, to $16,646,850 in 2008 from $16,225,537 a year ago primarily due to (1) an increase in loan defaults, bankruptcies and automobile repossessions for certain financial institution customers and (2) growth in business for certain financial institution customers. Theses increases were partially offset by a decrease in losses for certain financial institution customers due to a decline in their lending volume.
Discontinued bond program losses and LAE decreased 113.6%, or $851,479, to $(101,904) in 2008 from $749,575 a year ago. See “Overview-Discontinued Bond Program” above and “Discontinued Bond Program” in Note 15 to the Consolidated Financial Statements for more information concerning losses and LAE for the discontinued bond program.
Policy Acquisition Costs. Policy acquisition costs increased 6.7%, or $730,813, to $11,704,193 in 2008 from $10,973,380 a year ago
Interest Expense. Interest expense decreased 16.3%, or $240,437, to $1,232,255 in 2008 from 1,472,692 a year ago as a result of declining interest rates on our trust preferred debt which was partially offset by an increase in interest expense for our bank line of credit as a result of our $2.5 million draw on the line of credit in the first quarter of 2008. See “Liquidity and Capital Resources” below and Notes 5 and 7 to the Consolidated Financial Statements for a discussion of our bank line of credit and the Company’s trust preferred debt issued to affiliates (which makes up the majority of the Company’s interest expense).
GAAP Combined Ratio. For 2008, the combined ratio increased to 93.3% from 92.9% a year ago. The loss ratio improved to 53.0% in 2008 from 53.9% a year ago primarily due to the decrease in discontinued bond program losses. The expense ratio increased to 40.3% in 2008 compared to 38.3% a year ago primarily due to the increase in other operating expenses and policy acquisition costs as described above.
Premiums and ceded commissions for our insurance products are earned over the related contract periods. For GAP and certain of our ULI and EPD products, the contract period averages approximately five years. As a result, the impacts of decreased premium volumes and cancelled business may not be seen in our results immediately and can persist for a number of years. Conversely, the impacts of
Due to the current weak economic conditions, certain of our lender service customers have experienced an increase in loan defaults, bankruptcies and automobile repossessions. As the rate of loan defaults, bankruptcies and automobile repossessions increases for our ULI and CPI customers, we experience an increase in the frequency of losses for these product lines. As the national economy remains unstable and unemployment levels remain high, our financial institution customers could experience an increase in loan defaults, bankruptcies and automobile repossessions. Incentives offered on new cars by dealers and manufacturers have depressed the value of the used car market. In addition, the higher level of gas prices has lowered the market value of less fuel-efficient vehicles. As used car prices decline, the “gap” between the value of the vehicle and the outstanding loan balance increases and thus the severity of our GAP losses increases. In addition, higher gas prices are expected to continue to impact the value of less fuel-efficient vehicles. Where possible, we have taken actions to help mitigate the effects of these trends, including monitoring the pricing of our products and taking rate actions when necessary. One of the actions included changing policy types in the second quarter of 2008 for a poor performing ULI financial institution customer that we believe will improve its future underwriting performance. Another action included cancelling a poor performing GAP customer in the second quarter of 2008. During 2008 and 2007, this GAP customer had net premiums earned of $2.4 million and $2.6 million, respectively, and its combined ratio was 134% and 120%, respectively. As noted above, it will take a number of years for this block of business to fully run-off.
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. During 2008 and 2007, this program reduced our commission expense by approximately $0.2 million and $0.4 million, respectively, and we expect little earned ceded commission for fiscal year 2009.
Since we began participating in the WIP program in 2004 there have not been any claims to date, other than some minor contract surety bond claims. If we were to have significant claims experience on this program during fiscal year 2009, such claims experience could have a material impact on our financial performance if our reserves prove to be materially deficient. As of December 31, 2008, our net loss and LAE reserves for the WIP program were approximately $2.4 million. We currently do not believe that our reserves will be materially deficient. For more information concerning losses and LAE, see “Critical Accounting Policies-Loss and Loss Adjustment Expense Reserves” below.
As of December 31, 2008, approximately 95% of our fixed maturity portfolio was invested in tax-exempt municipal bonds. Market liquidity for such bonds has been significantly affected by the current financial crisis and recent changes on Wall Street. Trading desks at firms such as Bear Stearns, Lehman Brothers, Merrill Lynch, and Wachovia had significant roles in supplying liquidity in the bond markets. With these brokers gone or merging and other financial institutions accumulating capital, the municipal bond markets have witnessed a dramatic widening in bid/ask spreads and a decrease in trading volume. Municipal bond returns from September through December of 2008 were the worst of any such period in the past 20 years. Higher municipal bond yields and widening yield spreads, along with a general lack of liquidity in the municipal bond market, resulted in the weakest annual returns since 1994. Redemptions from municipal bond mutual funds, forced selling from leveraged municipal bond investors and repositioning by some insurance companies toward taxable investments combined to produce a highly over-sold municipal bond market during the third and fourth quarters of 2008. As a result, the gross unrealized loss for our bond portfolio increased from $1.2 million at December 31, 2007 and June 30, 2008 to $7.8 million at December 31, 2008. The fair value of our fixed maturity portfolio could also be impacted by credit rating actions and related financial uncertainty associated with insurance companies that guarantee the obligations of some of our bonds. While municipal credits continue to demonstrate relative credit quality stability, market conditions are not likely to improve until the current liquidity crisis has passed.
We are organized in a holding company structure with Bancinsurance Corporation being the parent company and all of our operations being conducted by Bancinsurance Corporation’s wholly-owned subsidiaries, Ohio Indemnity and USA. As of December 31, 2008 and December 31, 2007, our capital structure consisted of trust preferred debt issued to affiliates, a bank line of credit and shareholders’ equity and is summarized in the following table:
Bancinsurance Corporation also has a $10,000,000 unsecured revolving bank line of credit with a maturity date of June 30, 2010. At December 31, 2008 and December 31, 2007, the outstanding balance under the line of credit was $2,500,000 and $0, respectively. The line of credit provides for interest payable quarterly at an annual rate equal to the prime rate less 75 basis points (2.50% at December 31, 2008). The terms of the revolving credit agreement contain various restrictive covenants. As of December 31, 2008, Bancinsurance Corporation was in compliance with all such covenants. We utilize the line of credit from time to time based on short-term cash flow needs, the then current prime rate and expected changes in the prime rate, Ohio Indemnity’s capital position and the dividend limitations on Ohio Indemnity as discussed below.
The short-term cash requirements of our property/casualty business primarily consist of paying losses and LAE, reinsurance premiums and day-to-day operating expenses. Historically, we have met those requirements through (1) cash receipts from operations, which consist primarily of insurance premiums collected, ceded commissions received and investment income and (2) our cash and short-term investment portfolio. In addition, our fixed maturity investment portfolio has historically generated additional cash flows through bond maturities and calls (over 90% of our fixed maturity portfolio has call features). When a bond matures or is called by the issuer, the resulting cash flows are generated without selling the security at a loss. We utilize these cash flows to either build our cash and short-term investment position or reinvest in other securities, depending on our liquidity needs. To the extent our cash from operations, cash and short-term investments and cash flows from bond maturities or calls are not sufficient to meet our liquidity needs, our investment portfolio is a source of additional liquidity through the sale of readily marketable fixed maturity and equity securities.
Because of the nature of the risks we insure on a direct basis, losses and LAE emanating from the insurance policies that we issue are generally characterized by relatively short settlement periods and quick development of ultimate losses compared to claims emanating from other types of insurance products. Therefore, we believe we can estimate our cash needs to meet our policy obligations and utilize cash flows from operations and our cash and short-term investment position to meet these obligations. We consider the relationship between the duration of our policy obligations and our expected cash flows from operations in determining our cash and short-term investment position. We maintain a level of cash and liquid short-term investments which we believe will be adequate to meet our anticipated policy obligations without being required to liquidate intermediate-term and long-term investments at a loss.
We believe that both liquidity and interest rate risk can be minimized by such asset/liability management described above. With this strategy, we believe we can pay our policy obligations as they become due without being required to use our line of credit or liquidate intermediate-term and long-term investments at a loss; however, in the event that such action is required, it is not anticipated to have a material impact on our results of operations, financial condition and/or future liquidity.
USA derives its funds principally from commissions and fees which are currently sufficient to meet its operating expenses. USA dividends all of its excess funds to Bancinsurance Corporation on a quarterly basis. Because USA is not an insurance company and is an Ohio limited liability company, it is not subject to any restrictions on the payment of dividends other than laws affecting the rights of creditors generally.
to incur significant expenses and have significant cash outflows related to the SEC investigation during 2008, Bancinsurance Corporation drew $2.5 million on its bank line of credit on March 31, 2008. At December 31, 2008, September 30, 2008, June 30, 2008 and March 31, 2008, Bancinsurance Corporation had total cash and invested assets of $3.8 million, $1.9 million, $2.1 million and $3.2 million, respectively. The $1.9 million increase in the fourth quarter of 2008 was primarily due to a $2.0 million dividend payment from Ohio Indemnity to Bancinsurance Corporation in December 2008. Due to the inherent uncertainties associated with 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). However, management believes that Bancinsurance Corporation will be able to meet its cash flow requirements during this period from (1) its cash, (2) the liquidation of its invested assets, (3) dividends from Ohio Indemnity and/or USA, (4) tax and cost sharing payments from Ohio Indemnity and/or USA and/or (5) additional draws on its bank line of credit. Management currently plans to cause Ohio Indemnity to declare and pay dividend(s) during future period(s) to Bancinsurance Corporation to enable it to maintain its liquidity, including repayment of any outstanding balance on its bank line of credit. Management has not determined at this time the timing or amount of any such dividend(s) from Ohio Indemnity, but does not believe that the amount of any such dividend(s) during 2009 will exceed the annual maximum limit described below. See “Regulation-Ongoing SEC Investigation” in Item 1 above, “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 a property/casualty insurer, Ohio Indemnity is subject to a risk-based capital test adopted by the NAIC and the Department. This test serves as a benchmark of an insurance enterprise’s solvency 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, 2008.
the financial condition and future prospects of the issuer, including any specific events that may influence the issuer’s operations;
Under our investment guidelines, we employ what we believe are stringent diversification rules and balance our investment credit risk and related underwriting risks to minimize total potential exposure to any one security or type of security. Our fixed maturity and closed-end mutual fund portfolio is managed by an outside investment manager that operates under investment guidelines approved by our board of directors. Under our investment guidelines, fixed maturity securities are required to be investment grade at the time of purchase to protect investments. As of December 31, 2008, approximately 99% of our fixed maturity portfolio was rated investment grade. Our outside investment manager also monitors the underlying credit of our fixed maturity portfolio. In performing our other-than-temporary impairment analysis for our fixed maturity securities and closed-end mutual funds, we rely on the analysis of our outside investment manager regarding the outlook and credit quality of the investment.
We utilize our internal staff, reports from ceding insurers under assumed reinsurance and an independent consulting actuary in establishing our loss and LAE reserves. Our independent consulting actuary reviews our reserves for losses and LAE on a quarterly basis and we consider this review in establishing the amount of our reserves for losses and LAE.
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. Given the uncertainties of the outcome of the Highlands’ arbitration and receivership proceeding, uncertainties in the future loss information provided by Harco and Highlands, and the inherent volatility in assumed reinsurance, actual losses incurred for the discontinued bond program could be materially different from our estimated reserves. As a result, future loss development on the discontinued bond program could have a material effect on our results of operations and/or financial condition.
Direct Business. For our direct business, estimates of ultimate loss and LAE reserves are based on our historical loss development experience. In using this historical information, we assume that past loss development is predictive of future loss development. Our assumptions allow for changes in claims and underwriting operations, as now known or anticipated, which may impact the level of required reserves or the emergence of losses. We do not currently anticipate any extraordinary changes in the legal, social or economic environments that could affect the ultimate outcome of claims or the emergence of claims from causes not currently recognized in our historical data. However, it is possible that we may experience an increase in the frequency for ULI and CPI losses and an increase in the severity for GAP losses as discussed in “Business Outlook-Lender Service Products” above. Such extraordinary changes or claims emergence may impact the level of required reserves in ways that are not presently quantifiable. Thus, while we believe our reserve estimates are reasonable given the information currently available, actual emergence of losses could deviate materially from our estimates and from amounts recorded by us.
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, average claim paid or average claim reserve that would be inconsistent with the types of risks we insured in the respective periods.
In performing our loss reserve analysis, we select a single loss reserve estimate for each product line that represents management’s “best estimate” based on facts and circumstances then known to us. Prior to the second quarter of 2008, we also calculated high and low estimates for our lender service product lines; however, we no longer perform such high and low estimates as the lender service product lines do not exhibit significant volatility and such additional information is not considered useful to management.
Loss and LAE Reserves at Year End. As of December 31, 2008 and 2007, gross loss and LAE reserves by product line were split between incurred but not reported (“IBNR”) and case reserves as follows:
The fair value of stock options granted by us are estimated on the date of grant using the Black-Scholes option pricing model (“Black-Scholes model”). The Black-Scholes model utilizes ranges and 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 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 expected volatility of the common shares in the future. Dividend yield is based on historical dividends. See Note 10 to the Consolidated Financial Statements for more information concerning our equity-based compensation expense.
We are involved in various legal proceedings arising in the ordinary course of business. An estimate is made to accrue for a loss contingency relating to any of these legal proceedings if we believe 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 our financial condition and/or results of operations, such estimates are considered to be critical accounting estimates. See Note 20 to the Consolidated Financial Statements for information concerning the Company’s commitments and contingencies.
As disclosed in Note 4 to the Consolidated Financial Statements, we account for guarantees in accordance with FIN 45. We have determined that the undertaking agreements as described in Note 4 are within the scope of FIN 45. Due to the inherent uncertainties of the SEC investigation, actual future payments related to the undertaking agreements may be materially different than the FIN 45 liability as recorded at December 31, 2008. Because of the subjective nature inherent in assessing the estimated future costs associated with the undertaking agreements and because of the potential that our estimated future costs may be materially different than our actual future costs, such estimates are considered to be critical accounting estimates. See “Regulation-Ongoing SEC Investigation,” in Item 1 above, “Liquidity and Capital Resources” above, Note 4 to the Consolidated Financial Statements and Items 13 and 14 for more information regarding the ongoing SEC investigation.
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, 2008 and 2007 and the results of their operations and their cash flows for the two 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.
Bancinsurance Corporation is a specialty property/casualty insurance holding company incorporated in the State of Ohio in 1970. The Company has two reportable business segments: (1) property/casualty insurance; and (2) insurance agency. Unless the context indicates otherwise, all references herein to “Bancinsurance,” “we,” “Registrant,” “us,” “its,” “our,” or the “Company” refer to Bancinsurance Corporation and its consolidated subsidiaries.
Our waste industry products (“WIP”) consist of waste, contract and escrow surety bonds produced and administered by a general insurance agent. Under this program, we assume and cede certain waste surety bond business under three quota share reinsurance arrangements. First, in the second quarter of 2004, we entered into a 50% quota share reinsurance arrangement whereby we 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 our assumed participation was reduced from 50% to 25%. Effective August 1, 2006, the reinsurance arrangement was further amended whereby we assumed 50% of all waste surety bonds with liability limits up to $1.2 million. Second, effective August 1, 2007, we entered into a 5% quota share reinsurance arrangement whereby we assumed 5% of all waste surety bonds with liability limits over $1.2 million up to $10.0 million from one insurance carrier. Third, in addition to assuming business, we also write on a direct basis waste surety bonds with liability limits up to $5.0 million. We then cede 50% of that business to an insurance carrier under a reinsurance arrangement. The majority of the waste surety bonds under the program satisfy the closure/post-closure financial responsibility obligations imposed on solid waste treatment, storage and disposal facilities pursuant to Subtitles C and D of the Federal Resource Conservation and Recovery Act. Closure/post-closure bonds cover future costs to close and monitor a regulated site such as a landfill. In addition to waste surety bonds, our WIP program includes certain contract and escrow surety bond business which the Company writes directly, assumes and cedes under several quota share reinsurance arrangements. This business is included as part of our WIP program because it is produced by the same general agent that produces the waste surety bond business. All of the surety bonds under the WIP program are fully 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. 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 general insurance agent utilizes various insurance carriers, including the Company, in placing its surety bond business. Our direct premium volume for this program is determined by the general insurance agent’s decision to place business with the Company. Prior to the first quarter of 2008, contract and escrow surety bond business produced by this general insurance agent was reported within our other specialty products line.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115.” SFAS No. 159 permits all entities to choose to measure and report many financial instruments and certain other items at fair value at specified election dates. If such an election is made, any unrealized gains and losses on items for which the fair value option has been elected are required to be reported in earnings at each subsequent reporting date. In addition, SFAS No. 159 establishes presentation and disclosure requirements designed to facilitate
comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. We were required to adopt the provisions of SFAS No. 159 for financial statements issued for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 159 did not have a material impact on our 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.
For fixed maturity securities purchased at a premium or discount, amortization is calculated using the scientific (constant yield) interest method taking into consideration specified interest and principal provisions over the life of the security. Fixed maturity securities containing call provisions (where the security can be called away from the reporting entity at the issuer’s discretion) are amortized to the call or maturity value/date which produces the lowest asset value (yield to worst).
Acquisition expenses, mainly commissions and premium taxes, related to unearned premiums are deferred and amortized over the
period the coverage is provided. Anticipated losses and other expenses related to those premiums are considered in determining the recoverability of deferred acquisition costs.
Pursuant to the terms of certain surety bonds issued by the Company that guarantee the payment of reimbursable unemployment compensation benefits, certain monies are held by the Company in contract funds on deposit and are used for the payment of benefit charges. The Company has agreements with cost containment service firms designed to control the unemployment compensation costs of the employers enrolled in the program. Any remaining funds after the payment of all benefit charges are shared between the Company and the cost containment firms as management fees. Management fees are recognized when earned based on the development of benefit charges. Management fees of $368,841 and $448,899 were recognized in 2008 and 2007, respectively, as a result of this arrangement.
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, 2008 and 2007, the carrying value of property, equipment, computer software and leasehold improvements, net of accumulated depreciation, was $588,696 and $506,756, respectively. These balances are presented in the accompanying balance sheets as other assets.
borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The proceeds from sales of available for sale securities were $20,809,894 and $17,616,461 for the years ended December 31, 2008 and 2007, respectively, which includes $10,087,674 and $7,200,032, respectively, from sales of our money market mutual fund which we buy and sell regularly as part of our liquidity management.
The following table summarizes the fair value to book ratio for all securities in an unrealized loss position at December 31, 2008:
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, 2008 and December 31, 2007, distinguishing between those securities which have been continuously in an unrealized loss position for less than twelve months and twelve months or greater.
The Company accounts for guarantees in accordance with FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57 and 107 and rescission of FIN 34” (“FIN 45”). The Company has determined that the above referenced undertaking agreements are within the scope of FIN 45. In order to estimate the fair value of future obligations under these undertaking agreements, the Company periodically obtains estimates from each legal counsel representing the officers involved in the SEC investigation of the additional legal costs expected to be incurred for the officers to respond to the Notice under the SEC’s Wells Notice procedures. Based on these estimates, the Company recorded a FIN 45 liability of $0.4 million and $1.3 million as of December 31, 2008 and December 31, 2007, respectively, which is included within other liabilities in the accompanying consolidated balance sheets. The FIN 45 liability at December 31, 2008 as compared to the FIN 45 liability at December 31, 2007 reflects (a) a decrease of approximately $1.9 million as a result of actual legal fees and expenses incurred for services rendered through December 31, 2008 related to the undertaking agreements and (b) an increase of approximately $1.0 million as a result of a net increase in the estimated future legal costs related to the undertaking agreements. The Company cannot predict what actions, if any, the SEC will take after each officer has responded to the Notice. As a result, the Company cannot estimate any future obligations related to the undertaking agreements beyond the estimated costs to respond to the Notice. Due to the inherent uncertainties of the SEC investigation, actual future payments related to the undertaking agreements may be materially different from the $0.4 million estimated fair value of such future payments as recorded at December 31, 2008.
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. 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. BIC Trust I and BIC Trust II were formed for the sole purpose of issuing and selling the floating rate trust preferred capital securities and investing the proceeds from such securities in junior subordinated debentures of the Company. In connection with the issuance of the trust preferred capital securities, the Company issued junior subordinated debentures of $8,248,000 and $7,217,000 to BIC Trust I and BIC Trust II, respectively. The floating rate trust preferred capital securities and the junior subordinated debentures have substantially the same terms and conditions. The Company has fully and unconditionally guaranteed the obligations of BIC Trust I and BIC Trust II with respect to the floating rate trust preferred capital securities. BIC Trust I and BIC Trust II distribute the interest received from the Company on the junior subordinated debentures to the holders of their floating rate trust preferred capital securities to fulfill their dividend obligations with respect to such trust preferred securities. BIC Trust I’s floating rate trust preferred capital securities, and the junior subordinated debentures issued in connection therewith, pay dividends and interest, as applicable, on a quarterly basis at a rate equal to three month LIBOR plus four hundred basis points (6.21% 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. Interest on the junior subordinated debentures is charged to income as it accrues. Interest expense related to the junior subordinated debentures for the years ended December 31, 2008 and 2007 was $1,156,567 and $1,472,459, respectively. The terms of the junior subordinated debentures contain various covenants. As of December 31, 2008, the Company was in compliance with all such covenants.
The difference between federal income taxes provided at our effective tax rate and the 34% federal statutory rate for each of the periods ended December 31 was as follows:
The Bancinsurance Corporation 1994 Stock Option Plan (the “1994 Stock Option Plan”) provided for the grants of options covering up to an aggregate of 500,000 common shares, with a 100,000 common share maximum for any one participant. Key employees, officers and directors of, and consultants and advisors to, the Company were eligible to participate in the 1994 Stock Option Plan. The 1994 Stock Option Plan is administered by the Compensation Committee which determined to whom and when options were granted along with the terms and conditions of the options. Under the 1994 Stock Option Plan, options for 145,500 common shares were outstanding at December 31, 2008, expire at various dates from 2009 to 2013 and range in option price per share from $4.063 to $6.25. Of the options for 145,500 common shares outstanding, 16,000 have been granted to our non-employee directors and 129,500 have been granted to employees. All of the options outstanding were granted to employees and directors for compensatory purposes. No new options can be granted under the 1994 Stock Option Plan and the plan remains in effect only with respect to the outstanding options.
The following table summarizes restricted stock award activity under our 2002 Plan from January 1, 2008 through December 31, 2008:
All stock options: (1) have been granted with an exercise price equal to the closing price of our common shares on the date of grant;
(2) have a 10-year contractual term; (3) with respect to officers and employees, vest and become exercisable at the rate of 20% per year over a five-year period (subject to the applicable officer’s or employee’s continued employment with the Company); and (4) with respect to non-employee directors, vest and become exercisable on the first anniversary of the date of grant (subject to the applicable director’s continued service on the board of directors of the Company). Compensation expense for stock options is measured on the date of grant at fair value and is recognized over the respective service period, which matches the vesting period.
The compensation expense recognized for all equity-based awards is net of forfeitures and is recognized over the awards’ respective service periods. We recorded equity-based compensation expense for the years ended December 31, 2008 and 2007 of $395,054 and
$339,654 ($260,736 and $224,172 net of tax), respectively. In accordance with Staff Accounting Bulletin (“SAB”) No. 107, “Share-Based Payment,” the equity-based compensation expense is classified within other operating expenses in the accompanying statements of income to correspond with the same line item as cash compensation paid to employees.
As of December 31, 2008, the total pre-tax equity-based compensation cost related to nonvested stock options and nonvested restricted stock not yet recognized was $857,123. The weighted-average period over which this cost is expected to be recognized is approximately 2.1 years.
The following table summarizes weighted-average information by range of exercise prices for stock options outstanding and stock options exercisable at December 31, 2008:
The components of other comprehensive loss and the related federal income tax effects for the years ended December 31 2008 and 2007, were as follows:
As a result of changes in estimates of insured events in prior years, the provision for unpaid loss and LAE decreased by approximately $1,366,000 and $254,000 for the years ended December 31, 2008 and 2007, respectively. The decrease in 2008 was primarily due to favorable loss development for our lender service product line.
Under our WIP program, we assume and cede certain waste surety bond business under three quota share reinsurance arrangements. First, in the second quarter of 2004, we entered into a 50% quota share reinsurance arrangement whereby we 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 our assumed participation was reduced from 50% to 25%. Effective August 1, 2006, the reinsurance arrangement was further amended whereby we assumed 50% of all waste surety bonds with liability limits up to $1.2 million. Second, effective August 1, 2007, we entered into a 5% quota share reinsurance arrangement whereby we assumed 5% of all waste surety bonds with liability limits over $1.2 million up to $10.0 million from one insurance carrier. Third, in addition to assuming business, we also write on a direct basis waste surety bonds with liability limits up to $5.0 million. We then cede 50% of that business to an insurance carrier under a reinsurance arrangement. During 2006, we also began writing directly, assuming and ceding certain contract and escrow surety bond business under several quota share reinsurance arrangements. This business is included as part of our WIP program because it is produced by the same general insurance agent that produces the waste surety bond business. Under this program, we assumed premiums earned of $5,292,338 and $3,827,564 for the years ended December 31, 2008 and 2007, respectively, and ceded premiums earned of $2,438,384 and $1,934,920 for the years ended December 31, 2008 and 2007, respectively.
From 2001 until the end of the second quarter of 2004, we participated in a bail and immigration bond program. This program was discontinued in the second quarter of 2004. For more information concerning this program, see “Discontinued Bond Program” below.
Beginning in 2001 and continuing into the second quarter of 2004, we 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 us. We 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.
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).
program losses and LAE were $749,575 for 2007 primarily due to an increase in reported losses from Highlands which was partially offset by a decrease in reported losses from Harco.
Bancinsurance shares its executive offices and facilities with certain of its consolidated subsidiaries. Certain expenses are allocated among Bancinsurance and those subsidiaries pursuant to cost sharing agreements.
The Company’s estimates of fair value for financial assets and financial liabilities are based on the framework established in SFAS No. 157. The framework is based on the inputs used in valuation and gives the highest priority to quoted prices in active markets and requires that observable inputs be used in the valuations when available. The disclosure of fair value estimates in the SFAS No. 157 hierarchy is based on whether the significant inputs used in the valuation are observable. In determining the level of the hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority is given to unobservable inputs that reflect the Company’s significant market assumptions. The three levels of the hierarchy are as follows:
Level 3 - Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.
The following table presents the level within the fair value hierarchy at which the Company’s financial assets were measured at fair value on a recurring basis as of December 31, 2008:
As of December 31, 2008, the Company had no financial liabilities that were measured at fair value and no financial assets that were measured at fair value on a non-recurring basis. The Company also did not have any non-financial assets or non-financial liabilities that were measured at fair value on a recurring basis.
In order to determine the proper SFAS No. 157 classification for each financial asset, the Company obtains from its pricing service the pricing procedures and inputs used to price our securities. For our fixed maturity portfolio, the Company also has its outside fixed income investment manager review its portfolio to ensure the SFAS No. 157 classification is consistent with the information obtained from the pricing service.
SFAS No. 107, “Disclosures About Fair Value of Financial Instruments,” requires disclosure of fair values of financial instruments. The carrying amount and estimated fair value of financial instruments subject to SFAS No. 107 disclosure requirements were as follows at 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, operating expenses and/or realized gain (loss) activity. Consequently, quarterly results are not necessarily indicative of full year results, nor are they necessarily comparable to the results of other quarters. The following table sets forth certain unaudited quarterly consolidated financial and operating data:
Year-to-date income per share amounts may not foot when adding the quarterly income per share amounts due to rounding.
See Note 4 for information concerning the SEC investigation. See “Discontinued Bond Program” in Note 15 for information concerning the Highlands arbitration.
During 2008, we also were involved in two other legal proceedings arising in the ordinary course of business. During the third quarter of 2008, we settled both disputes which resulted in approximately $0.6 million of incurred expenses for the year ended December 31, 2008.