In April 2009, the FASB issued FSP FAS 141(R)-1 (Codification reference ASC 805), “Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies.” This FSP requires that assets acquired and liabilities assumed in a business combination that arise from contingencies be recognized at fair value if fair value can be reasonably estimated. If fair value cannot be reasonably estimated, the asset or liability would generally be recognized in accordance with SFAS No. 5 (Codification reference ASC 450), “Accounting for Contingencies” and FASB Interpretation No. 14 (Codification reference ASC 450), “Reasonable Estimation of the Amount of a Loss.” Further, this FSP removed the subsequent accounting guidance for assets and liabilities arising from contingencies from SFAS No. 141(R) (Codification reference ASC 805). The requirements of this FSP carry forward without
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 during the fourth quarter of 2008. 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”). We believe the collateral retained by us attributable to such Provider is sufficient to pay for the approximately $0.7 million in estimated liability for the scheduled claims as of December 31, 2009. As a result of the settlement and release agreement, the $0.7 million liability associated with the Provider that is in bankruptcy is reported as “reserve for unpaid losses and loss adjustment expenses” in our accompanying balance sheet.
A discussion of the SEC investigation is set forth in Item 1 above under the caption “Regulation-SEC Investigation,” and is incorporated herein by reference.
Net premiums earned for CPI increased 148.9%, or $2,008,358, to $3,357,113 in 2009 from $1,348,755 a year ago primarily due to one of our CPI insurance agents placing more business with us.
Net premiums earned for UC products increased 10.8%, or $712,224, to $7,332,977 in 2009 from $6,620,753 a year ago primarily due to pricing increases and new customers added for our UCassure® product combined with an increase in audit premium for our excess of loss product.
Net Realized Gains on Investments. Net realized gains on investments increased 299.9%, or $720,829, to $961,197 in 2009 from $240,368 a year ago primarily due to the timing of sales of available for sale securities. We generally decide whether to sell securities based upon investment opportunities and tax consequences. During 2009, we recorded $961,197 of net realized gains on investments primarily due to sales of equity securities that had previously been written down as an other-than-temporary impairment and then had subsequent recovery in value. In order to utilize tax capital loss carrybacks prior to their expiration, we sold securities during 2009 that had previously been written down and then had subsequent recovery in value. Sales of these securities generated realized losses for tax purposes but generated realized gains for book purposes.
For more information concerning impairment charges, see “Business Outlook” and “Critical Accounting Policies-Other-Than-Temporary Impairment of Investments” below and Note 2 to the Consolidated Financial Statements.
an increase in 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. For more information concerning management fees, see “Business Outlook” below.
ULI losses and LAE decreased 24.1%, or $4,017,540, to $12,629,310 in 2009 from $16,646,850 a year ago primarily due to the decline in premium described above.
Policy Acquisition Costs. Policy acquisition costs decreased 5.2%, or $603,696, to $11,100,497 in 2009 from $11,704,193 a year ago primarily due to a decrease in commission expense for our ULI and GAP product lines as a result of the decline in premium described above. This decrease was partially offset by an increase in commission expense for our CPI product line primarily due to the growth in premium described above.
Interest Expense. Interest expense decreased 33.8%, or $416,836, to $815,419 in 2009 from $1,232,255 a year ago primarily due to declining interest rates on our trust preferred debt. See “Business Outlook” and “Liquidity and Capital Resources” below and Note 7 to the Consolidated Financial Statements for a discussion of the Company’s trust preferred debt issued to affiliates (which makes up the majority of the Company’s interest expense).
Federal Income Taxes. The Company’s effective federal income tax rate was 20.3% in 2009 compared to (162.7)% a year ago. This increase was primarily attributable to the ratio of tax-exempt investment income when compared to income from operations for each period. For more information concerning our federal income taxes, see Note 8 to the Consolidated Financial Statements.
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 increased premium volumes, pricing increases and/or new business may not be seen in our results immediately and may take several years to fully develop.
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 in the future. 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. 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. However, as noted above, rate increases for our longer duration policies may take several years to have an impact as the rate increase is only for new business while run off of the older business at the old rate will take place for a number of years.
As discussed in “Overview-Products and Services” above, effective August 1, 2009, our participation was changed from 5% to 12.5% for one of the reinsurance arrangements under our WIP program. We estimate that this change in participation should increase our net premiums earned by approximately $1.0 million for fiscal year 2010 when compared to fiscal year 2009.
As interest rates rise (fall), it can increase (decrease) the level of interest expense on our trust preferred debt and any borrowings under our bank line of credit. Interest rates declined during 2009 when compared to a year ago which resulted in a decrease in interest expense of approximately $0.4 million for 2009 when compared to 2008. On December 30, 2009, we drew $3.0 million on our bank line of credit which was paid down on February 3, 2010. See “Liquidity and Capital Resources” below and Notes 5 and 7 to the Consolidated Financial Statements for more information concerning our trust preferred debt and revolving line of credit.
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, 2009, our capital structure consisted of trust preferred debt issued to affiliates, bank line of credit and shareholders’ equity and is summarized in the following table:
In December 2002, we organized BIC Statutory Trust I (“BIC Trust I”), a Connecticut special purpose business trust, which issued $8,000,000 of floating rate trust preferred capital securities in an exempt private placement transaction. BIC Trust I also issued $248,000 of floating rate common securities to Bancinsurance Corporation. In September 2003, we organized BIC Statutory Trust II (“BIC Trust II”), a Delaware special purpose business trust, which issued $7,000,000 of floating rate trust preferred capital securities in an exempt private placement transaction. BIC Trust II also issued $217,000 of floating rate common securities to Bancinsurance Corporation. BIC Trust I and BIC Trust II (collectively, the “Trusts”) were formed for the sole purpose of issuing and selling the floating rate trust preferred capital securities and investing the proceeds from such securities in junior subordinated debentures of Bancinsurance Corporation. In connection with the issuance of the trust preferred capital securities, Bancinsurance Corporation issued junior subordinated debentures of $8,248,000 and $7,217,000 to BIC Trust I and BIC Trust II, respectively. The floating rate trust preferred capital securities and the junior subordinated debentures have substantially the same terms and conditions. Bancinsurance Corporation has fully and unconditionally guaranteed the obligations of the Trusts with respect to the floating rate trust preferred capital securities. The Trusts distribute the interest received from Bancinsurance Corporation on the junior subordinated debentures to the holders of their floating rate trust preferred capital securities to fulfill their dividend obligations with respect to such trust preferred capital securities. BIC Trust I’s floating rate trust preferred capital securities, and the junior subordinated debentures issued in connection therewith, pay dividends and interest, as applicable, on a quarterly basis at a rate equal to three month LIBOR plus four hundred basis points (4.26% and 6.21% at December 31, 2009 and 2008, respectively), are redeemable at par 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 (4.30% and 5.51% at December 31, 2009 and 2008, respectively), are redeemable at par and mature on September 30, 2033. The proceeds from the junior subordinated debentures were used for general corporate purposes and provided additional financial flexibility to the Company. The terms of the junior subordinated debentures contain various covenants. As of December 31, 2009, Bancinsurance Corporation was in compliance with all such covenants.
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, 2009 and December 31, 2008, the outstanding balance under the line of credit was $3,000,000 and $2,500,000, 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, 2009 and 2008). The terms of the revolving credit agreement contain various restrictive covenants. As of December 31, 2009, Bancinsurance Corporation was in compliance with all such covenants. We utilize the bank line of credit from time to time based on short-term cash flow needs, the then current prime rate, Ohio Indemnity’s capital position and the dividend limitations on Ohio Indemnity as discussed below. We are in the process of negotiating with our existing lender to replace our current credit facility. Given the changes in the credit markets since we entered into our existing credit facility, we believe that the terms of the new credit facility may not be as favorable as our existing credit facility. However, we do not believe that the change in terms, or in the event we are unable to enter into a new credit facility, will have a material adverse effect on our financial condition, results of operations or liquidity based on our historical use of the credit facility and expected cash flows from operating and investing activities.
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 $4,450,000 at December 31, 2009. Pursuant to the Harco and Highlands settlement agreements, in January 2010, the Company paid $1,450,000 to Harco and $3,000,000 to Highlands. On December 30, 2009, the Company drew $3.0 million on its bank line of credit primarily in anticipation of the Highlands settlement payment of $3.0 million. Given our projected cash flows and the low interest rate on the bank line of credit (2.50%) as compared to the average yield on our fixed income portfolio (4.80%), the Company made the decision to draw on the bank line of credit as opposed to selling fixed income securities for the Highlands payment. On February 3, 2010, the Company paid off the $3.0 million outstanding bank line of credit using excess cash flows from operating and investing activities. Although the settlement payments resulted in a material increase in the Company’s cash outflows from operations during 2010, these payments did not have a material impact on the Company’s liquidity.
As the parent company, Bancinsurance Corporation generates no funds from operations. Bancinsurance Corporation’s principal assets are the common shares of Ohio Indemnity and the membership interests in USA, and its primary sources of funds are (1) dividends from Ohio Indemnity and USA, (2) borrowings under its bank line of credit and (3) payments received from Ohio Indemnity and USA under cost and tax sharing agreements. Historically, Bancinsurance Corporation’s expenses have primarily consisted of payment of principal and interest on borrowings and legal and audit expenses directly related to Bancinsurance Corporation, and it has been able to pay these expenses primarily through use of its cash and invested assets, dividends from its subsidiaries and cost and tax sharing payments from its subsidiaries.
On November 13, 2009, Bancinsurance Corporation’s board of directors declared a cash dividend of $0.50 per share (approximately $2.6 million in the aggregate) payable on December 14, 2009 to holders of record of its common shares as of the close of business on November 30, 2009. While Bancinsurance Corporation has not historically paid cash dividends, we paid this dividend after determining that, based on our then current capital levels in relation to our then current cash requirements, the dividend provided a return on capital to our shareholders without compromising our capital structure or materially impacting our liquidity. The declaration and payment of future dividends (if any) are subject to the discretion of Bancinsurance Corporation’s board of directors and will depend upon our results of operations, financial condition, capital levels and requirements, cash requirements and future prospects, any legal, tax, regulatory and contractual restrictions and other factors deemed relevant by the board of directors. Accordingly, there can be no assurance that Bancinsurance Corporation will declare and pay any future dividends.
Ohio Indemnity is restricted by the insurance laws of the State of Ohio as to amounts that can be transferred to Bancinsurance Corporation in the form of dividends without the prior approval of the Department. Ohio Indemnity may pay dividends without such prior approval only from earned surplus and only to the extent that all dividends in the trailing twelve months do not exceed the greater of 10% of its statutory surplus as of the end of the prior fiscal year or statutory net income for the prior calendar year. On October 26, 2009, Ohio Indemnity’s board of directors declared a cash dividend in an aggregate amount of $2.5 million that was paid to Bancinsurance Corporation during the fourth quarter of 2009. On December 17, 2009, Ohio Indemnity’s board of directors declared a cash dividend in an aggregate amount of $4.9 million that was paid to Bancinsurance Corporation during the first quarter of 2010. Of the $4.9 million dividend, $2.9 million required and received approval by the Department. These dividends did not have a material adverse impact on the Company’s liquidity. During 2010, the maximum amount of dividends that may be paid to Bancinsurance Corporation by Ohio Indemnity without such prior approval is $5,300,961. For more information concerning dividend restrictions see “Regulation-Ohio Insurance Holding Company System Regulation” in Item 1 above.
Net cash provided by (used in) operating activities was $5,070,508 and $(5,064,235) during 2009 and 2008, respectively. The increase in cash provided by operating activities was primarily due to the following: (1) an approximately $4.6 million decrease in legal expenses paid during 2009 when compared to a year ago related to the SEC investigation; (2) an increase in net premiums collected of approximately $1.2 million primarily attributable to $4.5 million of retrospective premium adjustment payments that were made in 2008 compared to zero in 2009 and a $0.8 million increase in net premiums collected for our UC product line. These increases in premium were partially offset by a $4.1 million decrease in net premiums collected for our lender service product line; and (3) a decrease of approximately $3.7 million in net losses and policy acquisition costs paid during 2009 compared to a year ago primarily due to the decline in lender service premium.
Net cash provided by investing activities was $1,100,265 and $3,912,994 during 2009 and 2008, respectively. The decrease was primarily due to the use of certain investment proceeds to fund operating cash requirements during 2008, whereas during 2009, more excess cash from operations was used to purchase investments.
The preparation of the consolidated financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, revenues, liabilities and expenses and related disclosures of contingent assets and liabilities. We regularly evaluate these estimates, assumptions and judgments. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances. Actual results may differ materially from these estimates, assumptions and judgments under different assumptions or conditions. Set forth below are the critical accounting policies that we believe require significant estimates, assumptions and judgments and are critical to an understanding of our condensed consolidated financial statements.
We continually monitor the difference between the book value and the estimated fair value of our investments, which involves judgment as to whether declines in value are temporary in nature. If we believe a decline in the value of a particular available for sale investment is temporary, we record the decline as an unrealized loss in our shareholders’ equity. If we believe the decline in any investment is “other-than-temporarily impaired,” we record the decline as a realized loss through the income statement. If our judgment changes in the future, we may ultimately record a realized loss for a security after having originally concluded that the decline in value was temporary. We begin to monitor a security for other-than-temporary impairment when its fair value to book value ratio falls below 80%. The following discussion summarizes our process and factors considered when evaluating a security for potential impairment.
Fixed Maturity Securities. On a monthly basis, we review our fixed maturity securities for impairment. We consider the following factors when evaluating potential impairment:
the degree to which an issuer is current or in arrears in making principal and interest/dividend payments on the securities in question;
We continually monitor the credit quality of our fixed maturity investments to gauge our ability to be repaid principal and interest. We consider price declines of fixed maturity securities in our other-than-temporary impairment analysis where such price declines provide evidence of declining credit quality, and we distinguish between price changes caused by credit deterioration, as opposed to rising interest rates. In our evaluation of credit quality, we consider, among other things, credit ratings from major rating agencies, including Moody’s Investors Services and Standard & Poor’s.
Equity Securities. On a monthly basis, we review our equity securities for impairment. We consider the following factors when evaluating potential impairment:
our ability and intent to hold the security for a period of time sufficient to allow for recovery in the estimated fair value.
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.
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 factors 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” 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.
Loss and LAE Reserves at Year End. As of December 31, 2009 and 2008, gross loss and LAE reserves by product line were split between incurred but not reported (“IBNR”) and case reserves as follows:
During 2009, reserves for incurred losses and LAE attributable to insured events of prior years decreased by approximately $4.5 million primarily as a result of re-estimation of unpaid losses and LAE on our discontinued bond program, lender service, other specialty and WIP product lines. An analysis of this change in reserves is provided below.
One of our automobile service contract programs within other specialty products experienced reserve redundancies of approximately $0.6 million during 2009 primarily due to favorable run off of claims. See “Results of Operations” and “Automobile Service Contract Program” above and “Automobile Service Contract Program” in Note 15 to the Consolidated Financial Statements for more information concerning this program.
ULIN experienced reserve redundancies of approximately $0.5 million during 2009. The improvement in loss experience primarily related to the 2008 accident year. At December 31, 2009 and 2008, our ultimate selected loss ratio for the 2008 accident year was 59.9% and 65.3%, respectively. Changes in this key assumption occurred primarily during the first and second quarters of 2009 as the majority of our ULIN losses are settled within three to six months from the date of loss. When estimating the ultimate loss ratio at December 31, 2008, we selected an ultimate loss ratio for the 2008 accident year that was based on indicated loss information combined with historical development data. During the first six months of 2009, our 2008 accident year loss experience was more favorable than previously estimated at December 31, 2008. In accordance with GAAP, we recorded this change in reserves as a change in estimate during 2009.
ULIL experienced reserve redundancies of approximately $0.4 million during 2009. The improvement in loss experience primarily related to the 2008 accident year. At December 31, 2009 and 2008, our ultimate selected loss ratio for the 2008 accident year was 81.1% and 83.5%, respectively. Changes in this key assumption occurred primarily during the first quarter of 2009 as the majority of our ULIL losses are settled within three to six months from the date of loss. When estimating the ultimate loss ratio at December 31, 2008, we selected an ultimate loss ratio for the 2008 accident year that was equal to the then current indicated paid loss ratio. During the first quarter of 2009, our 2008 accident year loss experience was more favorable than previously estimated at December 31, 2008. In accordance with GAAP,
we recorded this change in reserves as a change in estimate during 2009. It should be noted that the ULIL product is subject to premium adjustments based on loss experience (i.e., experience-rated policies or retrospective-rated policies), and therefore this prior year loss development had no impact on net income.
The majority of our losses are short-tail in nature and adjustments to reserve amounts occur rather quickly. Conditions that affected the above redundancies in reserves may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate this redundancy to future periods.
We have audited the accompanying consolidated balance sheet of Bancinsurance Corporation and subsidiaries (the “Company”) as of December 31, 2009, and the related consolidated statements of income, shareholders’ equity and cash flows for the year then ended. Our audit also included the financial statement schedules listed in the index at Item 15(a) pertaining to the 2009 fiscal year. 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 audit.
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, 2009 and the results of their operations and their cash flows for the year 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 lender service product line offers four types of products. First, ULTIMATE LOSS INSURANCE® (“ULI”), a blanket vendor single interest coverage, is the primary product we offer to financial institutions nationwide. This product insures banks and financial institutions against damage to pledged collateral in cases where the collateral is not otherwise insured. A ULI policy is generally written to cover a lender’s complete portfolio of collateralized personal property loans, typically automobile loans. Second, creditor placed insurance (“CPI”) is an alternative to our ULI product. While both products cover the risk of damage to uninsured collateral in a lender’s automobile loan portfolio, CPI covers the portfolio through tracking individual borrower’s insurance coverage. The lender purchases physical damage coverage for loan collateral after a borrower’s insurance has lapsed. Third, our guaranteed auto protection insurance (“GAP”) pays the difference or “gap” between the amount owed by the customer on a loan or lease and the amount of primary insurance company coverage in the event a vehicle is damaged beyond repair or stolen and never recovered. Our GAP product is sold primarily to lenders and lessors and provides coverage on either an individual or portfolio basis. Fourth, equipment physical damage insurance (“EPD”) is an all risk policy written to cover agricultural, construction and commercial equipment vehicles. EPD was introduced in 2007 and offers insurance protection for financed equipment purchases. This policy protects both lenders and consumers against the risk of physical damage or theft of their financed equipment and is available for the term of the loan or an annual basis.
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, write on a direct basis, and cede certain waste surety bond business under three quota share reinsurance arrangements. First, effective August 1, 2006, the 50% quota share reinsurance arrangement we entered into in the second quarter of 2004 was amended whereby we assumed 50% of waste surety bonds with liability limits up to $1.2 million from two insurance carriers. Second, effective August 1, 2007, we entered into a 5% quota share reinsurance arrangement whereby we assumed 5% of waste surety bonds with liability limits over $1.2 million up to $10.0 million from two insurance carriers. This reinsurance arrangement is renegotiated annually and was renewed with similar terms on August 1, 2008. For the August 1, 2009 renewal, our participation was changed to 12.5%. 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. In addition to the quota share arrangements, we also participate in several facultative reinsurance arrangements. 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. Effective October 1, 2009, we increased our participation from 25% to 33% for our contract surety assumed reinsurance arrangement. The contract and escrow surety bond 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
In addition, from 2001 until the end of the second quarter of 2004, the Company participated in a bail and immigration bond reinsurance program. This program was discontinued in the second quarter of 2004. For a more detailed description of this program, see “Discontinued Bond Program” in Note 15.
Our accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) which vary in certain respects from accounting practices prescribed or permitted by the Department.
In June 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 168 (Codification reference ASC 105), “The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles-a replacement of FASB Statement No. 162.” SFAS No. 168 sets forth the FASB Accounting Standards Codification (the “Codification”) as the single source of authoritative nongovernmental GAAP. The Codification was launched on July 1, 2009 and is the official source of authoritative, nongovernmental U.S. GAAP, superseding existing FASB, American Institute of Certified Public Accountants (AICPA), EITF, and related literature. After the Codification was launched on July 1, 2009, only one level of authoritative U.S. GAAP exists, other than guidance issued by the Securities and Exchange Commission (the “SEC”). All other accounting literature excluded from the Codification will be considered non-authoritative. The Codification is effective for interim and annual periods ending after September 15, 2009. The Company has included references to the Codification in the notes to the consolidated financial statements.
In May 2008, the FASB issued SFAS No. 163 (Codification reference ASC 944), “Accounting for Financial Guarantee Insurance Contracts.” SFAS No. 163 clarifies how SFAS No. 60 (Codification reference ASC 944), “Accounting and Reporting by Insurance Enterprises,” applies to financial guarantee insurance contracts issued by insurance enterprises, including the recognition and measurement of premium revenue and claim liabilities. SFAS No. 163 also requires expanded disclosures about financial guarantee insurance contracts. SFAS No. 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years, except for disclosures about the insurance enterprise’s risk-management activities, which are effective the first period beginning after issuance of SFAS No. 163. The adoption of SFAS No. 163 did not have a material impact on the Company’s consolidated financial statements.
have an impact on the Company’s results of operations. This FSP also requires extensive new interim and annual disclosure for both fixed maturities and equities to provide further disaggregated information as well as information about how the credit loss component of the OTTI charge was determined and requiring a roll forward of such amount for each reporting period.
In June 2009, the FASB issued two other new FASB statements: (1) SFAS No. 166 (Codification reference ASC 860), “Accounting for Transfers of Financial Assets,” and (2) SFAS No. 167 (Codification reference ASC 810), “Amendments to FASB Interpretation No. 46(R).” These FASB statements establish new criteria governing whether transfers of financial assets are accounted for as sales and are expected to result in more variable interest entities being consolidated. These FASB statements are effective for annual periods beginning after November 15, 2009. The Company adopted these FASB statements effective December 31, 2009, which did not have a material impact on the Company’s consolidated financial statements.
Investments in held to maturity fixed maturities where we have the ability and intent to hold to maturity are carried at amortized cost. Investments in fixed maturities held as available for sale, which include bonds and redeemable preferred stock, are carried at fair value. The unrealized holding gain or loss, net of applicable deferred taxes and reclassification adjustment, is reflected in other comprehensive income.
that a decline in the value of an investment is other-than-temporary.
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 recoverable on unpaid losses and LAE and ceded unearned premiums are not deducted from insurance reserves but are recorded as assets (reinsurance recoverable and prepaid reinsurance premiums, respectively). See Note 15 for more information concerning the Company’s reinsurance transactions.
The balances reflected in these accounts relate primarily to the Company’s automobile service contract programs. For these programs, the Company has obtained collateral in the form of cash and short-term investments to support its claim obligations under the programs. As of December 31, 2009 and 2008, the collateral held by the Company exceeded its estimated claim obligations. As a result, the restricted short-term investments and the funds held amounts are the same as any excess collateral remaining after the payment of all claim obligations would be returned to the respective service contract provider.
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
The amortized cost, gross unrealized gains and losses and estimated fair value of investments in held to maturity and available for sale securities at December 31, 2009 and 2008 were as follows:
The amortized cost and estimated fair value of fixed maturity investments in held to maturity and available for sale securities at December 31, 2009, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The proceeds from sales of available for sale securities (excluding bond calls, prepayments and maturities) were $22,804,967 and $20,809,894 for the years ended December 31, 2009 and 2008, respectively, which includes $10,556,527 and $10,087,674, respectively, from sales of our money market mutual fund which we buy and sell regularly as part of our liquidity management.
We continually monitor the difference between the book value and the estimated fair value of our investments, which involves judgment as to whether declines in value are temporary in nature. If we believe a decline in the value of a particular available for sale investment is temporary, we record the decline as an unrealized loss in our shareholders’ equity. If we believe the decline in any investment is “other-than-temporarily impaired,” we record the decline as a realized loss through the income statement. If our judgment changes in the future, we may ultimately record a realized loss for a security after having originally concluded that the decline in value was temporary. We begin to monitor a security for other-than-temporary impairment when its fair value to book value ratio falls below 80%. Our assessment as to whether a security is other-than-temporarily impaired depends on, among other things: (1) the length of time and extent to which the estimated fair value has been less than book value; (2) whether the decline appears to be
related to general market or industry conditions or is issuer specific; (3) our current judgment as to the financial condition and future prospects of the entity that issued the investment security; and (4) our intent to sell the security or the likelihood that we will be required to sell the security before its anticipated recovery.
Other-than-temporary impairments on investments during 2009 and 2008 were $3,168,291 and $3,702,945, respectively. The impairment charges recorded during 2009 were primarily due to the following: (1) $1,316,177 in impairment charges for four closed-end mutual funds whose fair values were adversely affected by the current market conditions; (2) $797,619 in impairment charges for equity securities of seven financial institutions whose fair values were adversely affected primarily by the credit markets; (3) $572,020 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; (4) $208,004 in impairment charges for two fixed maturity securities that were downgraded below investment grade; (5) $150,713 in impairment charges for ten fixed maturity securities that we intend to sell before their anticipated recovery in order to utilize capital loss carrybacks for tax purposes; and (6) $62,157 in impairment charges for an equity security of an insurance company whose fair value was adversely affected by the current market conditions.
As previously reported, on February 14, 2005, the Company received notification from the SEC that it was conducting an informal, non-public inquiry regarding the Company. On March 29, 2005, the Company was notified by the SEC that the informal, non-public inquiry had been converted into a formal private investigation. On October 23, 2007, the Company and certain of its current officers (Chief Executive Officer, Chief Financial Officer and Vice President of Specialty Products) each received a “Wells Notice” (the “Notice”) from the staff of the SEC indicating that the staff was considering recommending that the Commission bring a civil action against each of them for possible violations of the federal securities laws. The Notice provided the Company and each officer the
opportunity to present their positions to the staff before the staff recommends whether any action should be taken by the Commission.
On February 3, 2010, the Company was informed that the staff of the SEC had completed its investigation as to the Chief Financial Officer and Vice President of Specialty Products and does not intend to recommend to the Commission any enforcement action against either officer.
Bancinsurance Corporation has a $10,000,000 unsecured revolving bank line of credit with a maturity date of June 30, 2010, having a $3,000,000 and $2,500,000 outstanding balance at December 31, 2009 and December 31, 2008, respectively. On February 3, 2010, the Company paid the $3,000,000 million outstanding balance under the bank line of credit using excess cash flows from operating and investing activities. The terms of the revolving credit agreement contain various restrictive covenants. As of December 31, 2009, Bancinsurance Corporation was in compliance with all such covenants. The bank 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, 2009 and 2008). Interest expense related to the bank line of credit for the years ended December 31, 2009 and 2008 was $30,519 and $75,676, respectively. The bank that provides the line of credit is also a policyholder of the Company.
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 (4.26% and 6.21% at December 31, 2009 and 2008, respectively), are redeemable at par 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 (4.30% and 5.51% at December 31, 2009 and 2008, respectively), are redeemable at par 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, 2009 and 2008 was $783,843 and $1,156,567, respectively. The terms of the junior subordinated debentures contain various covenants. As of December 31, 2009, the Company was in compliance with all such covenants.
GAAP requires the consolidation of certain entities considered to be variable interest entities (“VIEs”). An entity is considered to be a VIE when it has equity investors who lack the characteristics of having a controlling financial interest or its capital is insufficient to permit it to finance its activities without additional subordinated financial support. Consolidation of a VIE by an investor is required when it is determined that the investor will absorb a majority of the VIE’s expected losses if they occur, receive a majority of the VIE’s expected residual returns if they occur, or both. BIC Trust I and BIC Trust II are not considered to be VIEs and are not included in the Company’s condensed consolidated financial statements. If they were included in the condensed consolidated financial statements, there would be no change to net income, only changes in the presentation of the financial statements.
Based on our evaluation, we have concluded that there are no significant uncertain tax positions requiring recognition in our consolidated financial statements. Our evaluation was performed for the tax years ended December 31, 2006, 2007, 2008 and 2009, the tax years which remain subject to examination by major tax jurisdictions as of December 31, 2009. In addition, we do not believe the Company would be subject to any interest or penalties relative to any open tax years and, therefore, have not accrued any such amounts. If we were to incur any interest and/or penalties in connection with income tax deficiencies, we would classify interest in the “interest expense” category and classify penalties in the “other operating expenses” category within our consolidated statements of income.
We maintain two equity compensation plans for the benefit of certain of our officers, directors, employees, consultants and advisors. GAAP requires all equity-based payments to employees and directors, including grants of stock options and restricted stock, to be recognized in net income based on the grant date fair value of the award. We are required to record equity-based compensation expense for all awards granted after January 1, 2006 and the nonvested portion of previously granted awards outstanding as January 1, 2006.
We have stock options and restricted stock outstanding at December 31, 2009 under two equity compensation plans (collectively, the “Plans”), each of which has been approved by our shareholders. We will issue authorized but unissued shares or treasury shares to satisfy any future restricted stock awards or the exercise of stock options.
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 fair value of options granted by the Company is estimated on the date of grant using the Black-Scholes option pricing model (“Black-Scholes model”). The Black-Scholes model utilizes ranges of assumptions such as risk-free rate, expected life, expected volatility and dividend yield. The risk-free rate is based on the United States Treasury strip curve at the time of the grant with a term approximating that of the expected option life. We analyze historical data regarding option exercise behaviors, expirations and cancellations to calculate the expected life of the options granted, which represents the length of time in years that the options granted are expected to be outstanding. Expected volatilities are based on historical volatility over a period of time using the expected term of the option grant and using weekly stock prices of the Company; however, for options granted after February 4, 2005, we exclude from our historical volatility the period from February 4, 2005 through January 25, 2006 (the period in which shareholders could not obtain current financial information for the Company and could not rely on the Company’s 2003, 2002, and 2001 financial statements) as we believe that our stock price during that period is not relevant in evaluating the expected volatility of the common shares in the future. A 0% dividend yield is used in the Black-Scholes model based on the then current historical dividends. For the year ended December 31, 2009, the Company granted 12,000 stock options to non-employee directors which were valued at $2.26 per share. The following table provides the range of assumptions used for options valued during each of the years ended December 31:
The following table summarizes all stock option activity under the Plans from January 1, 2009 through December 31, 2009:
The aggregate intrinsic value represents the total pre-tax intrinsic value, based on the closing price of our common shares on the OTC Bulletin Board on December 31, 2009 ($5.94), which would have been received by the option holders had all option holders exercised their options and sold the underlying common shares as of that date (only includes options that were in-the-money at December 31, 2009 (i.e., the closing price of our common shares exceeded the exercise price of such options)). There were no stock options exercised during the year ended December 31, 2009.
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, 2009 and 2008 of $516,022 and $395,054 ($340,574 and $260,736 net of tax), respectively. 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.
The following table summarizes weighted-average information by range of exercise prices for stock options outstanding and stock options exercisable at December 31, 2009:
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 2010, dividends, loans or advances in excess of $5,300,961 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, 2009.
Activity in the reserve for unpaid losses and LAE for the years ended December 31, 2009 and 2008 is summarized as follows (dollars in thousands):
As a result of changes in estimates of insured events in prior years, the provision for unpaid loss and LAE decreased by approximately $4.5 million and $1.4 million for the years ended December 31, 2009 and 2008, respectively. The decrease in 2009 was primarily due to favorable loss development for our discontinued bond program, lender service, other specialty and WIP product lines. The majority of our losses are short-tail in nature and adjustments to reserve amounts occur rather quickly. Conditions that affected redundancies in reserves may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate this redundancy to future periods.
For more information concerning loss and LAE reserves for the discontinued bond program, see “Discontinued Bond Program” in Note 15.
Several of our lender service insurance producers have formed sister reinsurance companies, each of which is commonly referred to as a producer-owned reinsurance company (“PORC”). The primary reason for an insurance producer to form a PORC is to realize the underwriting profits and investment income from the insurance premiums generated by that producer. In return for ceding business to the PORC, we receive a ceding commission, which is based on a percentage of the premiums ceded. Such arrangements align the interests of our business partners with our interests while preserving valued customer relationships. All of our lender service ceded reinsurance transactions are PORC arrangements.
Effective January 1, 2005, we entered into a producer-owned reinsurance arrangement with a GAP insurance agent whereby 100% of
In addition to the reinsurance arrangements discussed above, we have other reinsurance arrangements, including two lender service PORC quota share reinsurance arrangements, one UC facultative reinsurance arrangement, and three reinsurance arrangements for our vehicle service contract programs. For more information concerning one of our vehicle service contract programs, see “Automobile Service Contract Program” below. Under these arrangements, we ceded premiums earned of $554,078 and $618,788 for the years ended December 31, 2009 and 2008, respectively.
From 2001 until the end of the second quarter of 2004, we also participated in a bail and immigration bond reinsurance program. This program was discontinued in the second quarter of 2004. For more information concerning this program, see “Discontinued Bond Program” below.
The amounts of recoveries pertaining to reinsurance that were deducted from losses and LAE incurred for the years ended December 31, 2009 and 2008 were $12,724,228 and $11,113,690, respectively. For the years ended December 31, 2009 and 2008, ceded reinsurance decreased commission expense incurred by $3,559,810 and $3,182,210, respectively.
In the second quarter of 2004, we came to believe that the discontinued bond program was not being operated as it had been represented to us by agents of the insurance carriers who had solicited our participation in the program, and we began disputing certain issues with respect to the program, including but not limited to: 1) inaccurate/incomplete disclosures relating to the program; 2) improper supervision by the
insurance carriers of the bail bond agency in administering the program; 3) improper disclosures by the insurance carriers through the bail bond agency and the reinsurance intermediaries during the life of the program; and 4) improper premium and claims administration. Consequently, during the second quarter of 2004, we ceased paying claims on the program and retained outside legal counsel to review and defend our rights under the program.
For Harco, in August 2006, the Harco arbitration panel issued its Final Award 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”). On January 11, 2010, the Company entered into a written settlement agreement with Harco resolving all matters between the Company and Harco relating to the discontinued bond program and the Final Order. Pursuant to the settlement agreement, the Company agreed to pay $1,450,000 to Harco to resolve the entire matter, including any potential future liabilities with respect to bonds issued by Harco. As of December 31, 2008, the Company had reserved $1,858,574 for Harco. As a result of the settlement, the Company reduced its reserve to $1,450,000 at December 31, 2009 which resulted in an increase to pre-tax income of $408,574 ($269,659 after tax) during 2009.
For Highlands, in October 2009, the Company reached an agreement in principle with Highlands to resolve all matters between the Company and Highlands relating to the discontinued bond program. Pursuant to the settlement agreement, the Company agreed to pay $3,000,000 to Highlands to resolve the entire matter, including any potential future liabilities with respect to bonds issued by Highlands. Because Highlands is currently in receivership, the settlement agreement was subject to the approval of the Texas receivership court. On December 22, 2009, the Texas receivership court approved the settlement agreement, and on December 23, 2009, the Company entered into the written settlement agreement with Highlands. As of December 31, 2008, the Company had reserved $4,780,885 for Highlands. As a result of the settlement, the Company reduced its reserve to $3,000,000 at December 31, 2009 which resulted in an increase to pre-tax income of $1,780,886 ($1,175,385 after tax) during 2009.
During 2001, the Company began issuing insurance policies which guarantee the performance obligations of two automobile service contract providers (the “Providers”). The Providers are owned by a common parent. The Company has issued insurance policies covering business produced by the Providers in five states. Our insurance policies guarantee the fulfillment of the Providers’ obligations under the service contracts. Under the program, the Providers maintain the reserves and related assets and are responsible for the claims administration. The Company is obligated to pay a claim only if a Provider fails to do so. Under two reinsurance arrangements, the Company cedes 100% of the business produced to two different insurance carriers. In addition, the Company obtained collateral in the form of a $4.3 million letter of credit to secure our obligations under the program. On February 15, 2007, one of the Providers entered into an Assignment for the Benefit of Creditors liquidation proceeding. On March 2, 2007, the Illinois Department of Insurance moved for, and obtained, an Order of Conservation, which granted the Illinois Department of Insurance the authority to ascertain the condition and conserve the assets of that Provider. On April 13, 2007, this Provider filed a voluntary petition under Chapter 11 of the Bankruptcy Code. On June 12, 2007, the Bankruptcy Court ruled that the Provider was an eligible debtor for purposes of the Bankruptcy Code. This Provider has not written any service contracts under our insurance policies after the commencement of the February 2007 liquidation proceeding. The other Provider has not written any service contracts under our insurance policies since December 31, 2007.
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 during the fourth quarter of 2008. In exchange for the release of this collateral, the
See Note 4 for information concerning the undertaking agreements entered into by and between the Company and certain executive officers in connection with the SEC investigation.
In order to determine the proper disclosure classification for each financial asset, the Company obtains from its pricing service the pricing procedures and inputs used to price securities in our portfolio. For our fixed maturity portfolio, the Company also has its outside fixed income investment manager review its portfolio to ensure the disclosure classification is consistent with the information obtained from the pricing service.
Fixed maturities and equity securities: See “Valuation of Investments” above, which also applies to our held to maturity fixed maturities.
Trust preferred debt issued to affiliates and bank line of credit: Fair value is estimated using discounted cash flow calculations based on interest rates currently being offered for similar obligations with maturities consistent with the obligation being valued. As the interest rate adjusts regularly, the carrying amount is a reasonable estimate of fair value.
We are involved in legal proceedings arising in the ordinary course of business which are routine in nature and incidental to our business. We currently believe that none of these matters, either individually or in the aggregate, is reasonably likely to have a material adverse effect on our financial condition, results of operations or liquidity. However, because litigation is subject to inherent uncertainties and the outcome of such matters cannot be predicted with reasonable certainty, there can be no assurance that any one or more of these matters will not have a material adverse effect on our financial condition, results of operations and/or liquidity.
On November 13, 2009, the Board of Directors of Bancinsurance Corporation declared a cash dividend of $0.50 per share (approximately $2.6 million in the aggregate) payable on December 14, 2009 to holders of record of Bancinsurance Corporation’s common shares as of the close of business on November 30, 2009. There were no dividends declared for the period ended December 31, 2008.