As of February 7, 2006, we leased a total of approximately 19,771 square feet of office space in two locations. We lease 11,868 square feet in Columbus, Ohio for our headquarters pursuant to a lease that commenced on January 1, 2001 and expires on December 31, 2008. The lease provides for monthly rent of $13,230. ALPC leases 7,903 square feet in Cincinnati, Ohio pursuant to a lease that expires on February 28, 2010. The lease provides for monthly rent of $7,903, net of reimbursements payable to the lessor for cost of maintenance and operation of the building.
The selected consolidated financial data set forth below should be read together with the consolidated financial statements and the related notes to those statements, as well as “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” appearing elsewhere in this Annual Report on Form 10-K. Results for past accounting periods are not necessarily indicative of the results to be expected for any future accounting periods.
In addition to the above product lines, beginning in 2001, the Company entered into a reinsurance program covering bail and immigration bonds issued by several insurance carriers and sold by a bail bond agency. This program was discontinued in the second quarter of 2004. For a more detailed description of this program, see “Discontinued Bond Program” below and Note 16 to the Consolidated Financial Statements.
The Company sells its insurance products through multiple distribution channels, including three managing general agents, approximately thirty independent agents and direct sales.
In April 2005, the Company was advised of a global settlement agreement entered into on April 15, 2005 between the U.S. Department of Homeland Security (“DHS”) and Aegis. The agreement has an effective date of January 14, 2005 and covers past and future losses for immigration bonds issued by Aegis. This settlement agreement resulted in an increase in loss and LAE reserves of $3.9 million during the first quarter of 2005. In connection with the Aegis arbitration, on December 8, 2005, the Company filed a motion for partial summary judgment requesting that the Panel limit the Company’s immigration bond obligations to Aegis to the Company’s proportionate share (15%) of the amount Aegis is obligated to pay to DHS under the Aegis and DHS settlement agreement ($4.0 million). On December 23, 2005, the Panel granted the Company’s motion. This ruling by the Panel resulted in a decrease in loss and LAE reserves of $5.5 million during the fourth quarter of 2005. The above events combined resulted in a net decrease to loss and LAE reserves of $1.6 million during 2005.
On August 30, 2005, the Company received notice from the Highlands’ Receiver of a global settlement with NJAG on its remaining bail bond obligations. This settlement agreement resulted in an increase in loss and LAE reserves of $2.8 million during the third quarter of 2005.
The Company records its loss and LAE reserves for the discontinued bond program based primarily on loss reports received by the Company from the insurance carriers. The Company relies heavily on the insurance carriers’ estimates of ultimate incurred losses included in these reports. Based on information received by the Company, management believes that certain insurance carriers would settle with the Company for less than their respective estimates of ultimate incurred losses as set forth in their loss reports. As a result, management has adjusted its loss and LAE reserves for the discontinued bond program based on the estimated settlement values. This resulted in a reduction of $3.6 million to our loss and LAE reserves at December 31, 2005 when compared to the applicable insurance carriers’ respective estimates of ultimate incurred losses at that date.
In consultation with one of our large lender/dealer customers during 2003, we provided the customer with a variety of risk management solutions. This resulted in our customer making a decision to move its coverage to another one of our lender/dealer products that better fit its changing needs. In conjunction with this change in products, we ceded 100% of this customer’s premiums (along with the associated risk) to its PORC beginning in fourth quarter of 2003 (the “Reinsurance Transaction”).
See “Discontinued Bond Program” above and Note 16 to the Consolidated Financial Statements for a description of the Company’s discontinued bond program.
Net income (loss) for 2005 was $6,294,074, or $1.26 per diluted share, compared to $(8,500,620), or $(1.72) per diluted share, in 2004. The most significant factor contributing to the increase in net income was a decrease in losses and LAE of approximately $19.7 million for the discontinued bond program. See “Overview-Discontinued Bond Program” above and Note 16 to the Consolidated Financial Statements for additional information concerning of the discontinued bond program. In addition, the Company benefited from an increase in profitability for its CPI, GAP, UC and WSB product lines and an increase in investment income when compared to last year. These positive factors were partially offset by an increase in legal, auditing and federal income tax expenses incurred during the year when compared to the same period last year.
The combined ratio, which is the sum of the loss ratio and the expense ratio, is the traditional measure of underwriting experience for insurance companies. The statutory combined ratio is the sum of the ratio of losses to net premiums earned plus the ratio of statutory underwriting expenses to net premiums written after reducing both premium amounts by dividends to policyholders. Statutory accounting principles differ in certain respects from GAAP. Under statutory accounting principles, policy acquisition costs and other underwriting expenses are recognized immediately, not at the same time premiums are earned. To convert underwriting expenses to a GAAP basis, policy acquisition expenses are deferred and recognized over the period in which the related premiums are earned. Therefore, the GAAP combined ratio is the sum of the ratio of losses to net premiums earned plus the ratio of underwriting expenses to net premiums earned. The Company’s specialty insurance products are underwritten by Ohio Indemnity, whose results represent the Company’s combined ratio. The following table reflects Ohio Indemnity’s loss, expense and combined ratios on both a statutory and a GAAP basis for the years ended:
Investment Income. We seek to invest in investment-grade obligations of states and political subdivisions because the majority of the interest income from such investments is tax-exempt and such investments have generally resulted in more favorable net yields. Net investment income increased 52.6%, or $1,138,544, to $3,302,659 in 2005 from $2,164,115 a year ago. This improvement was due to growth in fixed income investments combined with a higher after-tax yield. Higher yields resulted from the Company’s reallocation of a portion of its portfolio from short-term investments to fixed maturities during 2004, which provided a better matching of the Company’s invested assets to its product liability duration and enhanced the Company’s investment return.
Management Fees. 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 a cost containment service firm 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 firm as management fees. Management fees are recognized when earned based on the
Losses and Loss Adjustment Expenses. Losses and LAE represent claims associated with insured loss events and expenses associated with adjusting and recording policy claims, respectively. Losses and LAE decreased 50.6%, or $23,901,695, to $23,335,620 in 2005 from $47,237,315 a year ago. This decline was mostly due to a decrease in losses and LAE of $19,738,370 for the discontinued bond program. See “Overview-Discontinued Bond Program” above and Note 16 to the Consolidated Financial Statements for a discussion of the discontinued bond program. Excluding the discontinued bond program, losses and LAE declined 15.4%, or $4,163,325, to $22,912,887 in 2005 from $27,076,212 a year ago primarily due to a decrease in ULI losses and LAE which was partially offset by an increase in losses and LAE for our CPI, GAP, UC and WSB business.
Losses and LAE for our UC products increased 98.6%, or $422,214, to $850,405 in 2005 compared to $428,191 a year ago due to favorable loss development in 2004 on an excess of loss policy that was cancelled at the end of 2003 as well as unfavorable loss development on our bonded service program during 2005.
Commissions, Other Insurance Operating Expenses and General and Administrative Expenses. Commission expense increased 21.9%, or $2,465,946, to $13,750,996 in 2005 from $11,285,050 in 2004 principally due to the growth in GAP and WSB premiums combined with improved loss performance for one of our ULI general agents, which resulted in an increase to contingent commissions. Other insurance operating expenses and general and administrative expenses combined rose 64.3%, or $4,466,521, to $11,417,186 in 2005 from $6,950,665 a year ago primarily due to legal fees related to the Audit Committee’s independent investigation of E&Y’s withdrawal of its audit reports, the SEC private investigation and the discontinued bond program arbitrations, as well as an increase in audit fees. We believe a significant portion of this increase represents one-time expenses; however, the Company anticipates it will continue to incur legal costs in 2006 for the SEC private investigation and the discontinued bond program arbitrations.
Federal Income Taxes. Federal income tax expense was $1,876,571 in 2005 compared to federal income tax (benefit) of $(4,767,432) last year. The benefit in 2004 was primarily caused by tax losses arising from the discontinued bond program losses.
Net premiums earned for WSB were $2,111,543 in 2004 compared to zero in 2003 as this program began in the second quarter of 2004.
ULI net premiums earned decreased 4.5% to $34,447,702 in 2004 from $36,077,514 in 2003. This decline was primarily due to a decrease in net premiums earned associated with the Reinsurance Transaction combined with a decrease in lending volume by two of our large financial institution customers. These decreases were partially offset by an increase in lending volume by several of our other financial institution customers, new customers added in 2004 and a decrease in experience rating adjustments. Experience rating adjustments decreased during 2004 when compared to 2003 primarily due to the Reinsurance Transaction combined with the decrease in lending volume mentioned above. Management anticipates that experience rating adjustments will fluctuate in future periods based upon loss experience and premium growth.
Investment Income. Net investment income increased 35.3% to $2,164,115 in 2004 from $1,599,064 in 2003. This improvement was due to growth in invested assets combined with a higher after-tax yield. Higher yields resulted from the Company’s reallocation of its portfolio from short-term investments to fixed maturities during the second and third quarters of 2004, which provided a better matching of the Company’s invested assets to its product liability duration and enhanced the Company’s investment return.
Management Fees. Our management fees in 2004 decreased 70.1% to $33,710 from $114,094 in 2003 as a result of rising unemployment compensation obligations related to increased levels of unemployment. We expect management fees to vary from period to period depending on unemployment levels and benefit charges.
ULI losses and LAE declined 16.8% to $21,568,897 in 2004 from $25,934,642 in 2003. This decrease was due to favorable loss development during 2004 when compared to 2003 as a result of fewer loan defaults, bankruptcies and automobile repossessions among our ULI customers.
Interest Expense. Interest expense increased to $894,463 in 2004 from $541,248 in 2003 principally due to a full year’s interest expense in 2004 compared to a partial year in 2003 associated with the Company’s trust preferred debt transaction in September 2003 that raised $7.2 million. Rising interest rates in 2004 also contributed to the increase in interest expense. See “Liquidity and Capital Resources” for a more detailed discussion of the Company’s trust preferred debt issued to affiliates, which makes up the majority of the Company’s interest expense.
Goodwill Impairment. As part of its annual goodwill impairment testing in the fourth quarter of 2004, the Company concluded that an impairment of goodwill existed at its property/casualty insurance segment. The Company performed impairment testing in accordance with SFAS No. 142, “Goodwill and Intangible Assets.” The Company, with the assistance of an independent appraisal firm, determined that the carrying value of the reporting segment exceeded the fair value of the reporting segment, resulting in a non-cash impairment charge. The fair value of the reporting segment was estimated using the expected present value of future cash flows. As a result of this impairment, the Company recorded non-cash impairment charges in the fourth quarter of 2004 in the aggregate amount of $753,737.
GAAP Combined Ratio. For 2004 the combined ratio increased to 129.7% from 92.1% in 2003. The loss ratio increased to 95.1% in 2004 from 66.1% in 2003 principally due to the increase in losses and LAE for the discontinued bond program. Excluding the discontinued bond program losses and LAE, the Company’s loss ratio was 54.8% in 2004 compared to 65.3% in 2003. This decrease was attributable to the decreases in losses and LAE for ULI, CPI and UC products described above. The expense ratio increased to 34.6% in 2004 from 26.0% in 2003 primarily due to an increase in commission expense and other insurance operating expenses as described above. The commission expense increase in relation to net premiums earned for 2004 when compared to 2003 was attributable to 1) growth in GAP and WSB commissions which have a higher commission rate when compared to our ULI product line and 2) a decrease in ceding commissions associated with the lender/dealer reinsurance agreement that was cancelled at the end of 2003.
During 2005, the Company experienced positive underwriting results in its lender/dealer products which was partly attributable to tighter lending standards by our customers and pricing actions taken by the Company. This positive underwriting experience resulted in favorable loss development, primarily within our ULI product line. However, the national economy still appears to be unstable. The Company does not expect to continue to experience the same level of favorable loss development for its ULI product line that was experienced during 2005. If loan defaults, bankruptcies and automobile repossessions increase, we would anticipate an increase in the frequency of losses for our ULI and CPI products.
During 2005, two major insurance providers discontinued offering GAP coverage which could lead to additional sales opportunities for the Company as lenders and dealers look to replace these insurance carriers.
The Company believes that there has been a stabilization of benefit charge levels in our UC product customer base; however if unemployment levels rise, we could experience lower management fees and/or increased losses for our UC products. Furthermore, any developments on the discontinued bond program and related arbitrations could have a material impact on our results of operations and/or financial condition.
The Company experienced a higher level of expenses during 2005 partly due to legal fees related to the Audit Committee’s independent investigation of E&Y’s withdrawal of its audit reports as well as audit fees related to the re-audits of the Company’s 2002 through 2004 financial statements. We believe these represent one-time expenses. As a result, the Company would anticipate a decline in expenses in 2006; however, it should be noted that the Company anticipates it will continue to incur legal costs for the SEC private investigation and the discontinued bond program arbitrations.
Over the past several years, the Company has benefited from net realized gains from sales of investments which is mostly attributable to sales of equity securities. As the Company’s has reduced its net unrealized gain position in its equity portfolio, we do not anticipate the same level of net realized gains on investments that have been experienced in the past few years.
Liquidity and capital resources demonstrate the Company’s ability to generate sufficient cash flows from its operations and borrow funds at competitive rates to meet operating and growth needs. As of December 31, 2005 the Company’s capital structure consists of trust preferred debt issued to affiliates 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. 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 (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 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 the Trusts with respect to the floating rate trust preferred capital securities. The Trusts 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 (8.44% and 6.44% at December 31, 2005 and 2004, respectively), are redeemable at par on or after December 4, 2007 and mature on December 4, 2032. BIC Trust II’s floating rate trust preferred capital securities, and the junior subordinated debentures issued in connection therewith, pay dividends and interest, as applicable, on a quarterly basis at a rate equal to three month LIBOR plus four hundred and five basis points (8.58% and 6.61% at December 31, 2005 and 2004, respectively), are redeemable at par on or after September 30, 2008 and mature on September 30, 2033. The proceeds from the junior subordinated debentures were used for general corporate purposes and provided additional financial flexibility to the Company. The terms of the junior subordinated debentures contain various restrictive covenants. As of December 31, 2005, the Company was in compliance with all such covenants.
We also have a $10,000,000 unsecured revolving line of credit with a maturity date of June 30, 2007 with no outstanding balance at December 31, 2005 ($500,000 at December 31, 2004). The revolving line of credit provides for interest payable quarterly at an annual rate equal to the prime rate less 75 basis points (6.50% and 4.52% at December 31, 2005 and 2004, respectively). The Company utilizes the line of credit from time to time based on short-term cash flow needs. Under the terms of the revolving credit agreement, our consolidated shareholders’ equity must not fall below $20,000,000 and Ohio Indemnity’s ratio of net premiums written to policyholders surplus cannot exceed three to one. At December 31, 2005, the Company was in compliance with all such covenants.
The short-term cash requirements of our property/casualty business primarily consist of paying losses and LAE, reinsurance premiums and day-to-day operating expenses. Historically, we have met those requirements through cash receipts from operations, which consist primarily of insurance premiums collected, reinsurance recoveries and investment income. Our investment portfolio is a source of additional liquidity through the sale of readily marketable fixed maturities, equity securities and short-term investments. After satisfying our cash requirements, excess cash flows from these underwriting and investment activities are used to build the investment portfolio and thereby increase future investment income.
Cash flows provided by operating activities totaled $14,813,169, $8,657,804 and $13,755,991 for 2005, 2004 and 2003, respectively. The increase in 2005 (as compared to 2004) was primarily the result of 1) an increase in investment income collected, 2) an increase in net cash flows from contract funds on deposit and funds held under reinsurance arrangements, 3) a decrease in paid losses and LAE and 4) federal income taxes recovered during 2005 compared to federal income taxes paid during 2004. These increases in cash flows were partially offset by an increase in commissions and other expenses paid and a decrease in net premiums collected compared to a year ago. The decrease in 2004 (as compared to 2003) was primarily the result of an increase in paid commissions and other expenses and a decrease in net cash flows from contract funds on deposit and funds held under reinsurance arrangements. These decreases in cash flows were partially offset by an increase in net premiums collected and a decrease in net paid losses and LAE during 2004 when compared to 2003.
The following table sets forth the Company’s contractual obligations at December 31, 2005:
The preparation of the consolidated financial statements are dependent upon and sensitive to accounting methods, 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 under different assumptions or conditions. The Company’s significant accounting policies are more fully described in Note 1 to the Consolidated Financial Statements. Set forth below are the critical accounting estimates and related assumptions and uncertainties inherent in our accounting policies which we believe are essential to an understanding of the underlying financial reporting risks and the effect that these accounting estimates, assumptions and judgments have on our consolidated financial statements.
We continually monitor the difference between our cost and the estimated fair value of our investments, which involves uncertainty 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 write down the carrying value of the investment and record a realized loss on investments. Our assessment of a decline in value includes our current judgment as to the financial position and future prospects of the entity that issued the investment security. If that judgment changes in the future, we may ultimately record a realized loss after having originally concluded that the decline in value was temporary.
whether the decline appears to be related to general market or industry conditions or is issuer-specific;
Assumed Business. Assumed reinsurance is a line of business with inherent volatility. Since the length of time required for the losses to be reported through the reinsurance process can be quite long, unexpected events are more difficult to predict. Ultimate loss reserve estimates for assumed reinsurance are dependent upon and based primarily on reports received by the Company from the underlying ceding insurers. These reported ultimate incurred losses are the primary basis for the Company’s reserving estimates. The Company relies heavily on the insurance carriers’ estimates of ultimate incurred losses included in these reports.
As disclosed in “Overview-Discontinued Bond Program” above and in Note 16 to the Consolidated Financial Statements, the Company is disputing the discontinued bond program losses in ongoing arbitration proceedings. The Company does not intend to pay for any of the losses on the discontinued bond program unless and until the arbitrations are settled on a mutually agreeable basis and/or a final binding judgment is made as to the Company’s liability. Given the uncertainties of the outcome of the arbitrations, settlements with the insurance carriers or other potential recoveries, uncertainties as to the prospective settlement amount between Highlands and DHS for Highlands’ immigration bond obligations, uncertainties in the future loss information provided by the insurance carriers, and the inherent volatility in assumed reinsurance, actual losses incurred for the discontinued bond program could be materially different from our estimated reserves. As a result, future loss development on the discontinued bond program could have a material effect on the Company’s results of operations and/or financial condition.
For the Company’s assumed WSB program, the Company is recording loss and LAE reserves using a loss ratio reserving methodology. The loss ratio method calculates a reserve based on expected losses in relation to premiums earned. The expected loss ratio for the program was selected using loss information provided by the ceding insurer.
We conducted a reserve study using historical losses and LAE by product line or coverage within product line. We prepared our estimates of the gross and net loss and LAE reserves using annual accident year loss development triangles for the following products:
Historical “age-to-age” loss development factors (“LDF”) were calculated to measure the relative development for each accident year from one maturity point to the next. Based on the historical LDF, we selected age-to-age LDF that we believe are appropriate to estimate the remaining future development for each accident year. These selected factors are used to project the ultimate expected losses for each accident year. The validity of the results from using a loss development approach can be affected by many conditions, such as claim department processing changes, a shift between single and multiple payments per claim, legal changes or variations in our mix of business from year to year. Also, because the percentage of losses paid for immature years is often low, development factors are volatile. A small variation on the number of claims paid can have a leveraging effect that can lead to significant changes in estimated ultimate losses. Therefore, ultimate values for immature accident years may be based on alternative estimation techniques, such as expected loss ratio method, or some combination of acceptable actuarial methods.
For our UC and other specialty product lines, the Company prepared estimates of loss and LAE reserves based on certain actuarial and other assumptions related to the ultimate cost expected to settle such claims.
The Company calculates a reserve range for its lender/dealer product lines (ULI, CPI and GAP) and calculates point estimates for UC and other specialty product lines. As of December 31, 2005, our indicated gross loss and LAE reserve range for lender/dealer products was $5.1 million to $6.3 million and our recorded loss and LAE reserves were $5.8 million.
During 2005, reserves for incurred losses and LAE attributable to insured events of prior years decreased by approximately $3.7 million as a result of re-estimation of unpaid losses and LAE principally on the Company’s ULI product line. An analysis of this decrease is provided below.
ULI - limited liability (“ULIL”) represented approximately $1.3 million of the overall $3.7 million reserve decrease. The improvement in loss experience primarily related to the 2004 accident year. At December 31, 2005 and 2004, the Company’s ultimate selected loss
ULI - non-limited liability (“ULIN”) represented approximately $1.8 million of the overall $3.7 million reserve decrease. The improvement in loss experience primarily related to the 2004 accident year. At December 31, 2005 and 2004, the Company’s ultimate selected loss ratio for the 2004 accident year was 50.8% and 56.5%, respectively. Changes in this key assumption occurred primarily during the first half of 2005 as the majority of our ULIN losses are settled within four months from the date of loss. When estimating the ultimate loss ratio at December 31, 2004, the Company selected an ultimate loss ratio for the 2004 accident year that was comparable to previous accident years’ ultimate loss ratios. During the first half of 2005, our 2004 accident year loss experience was more favorable than previously estimated at December 31, 2004. In accordance with SFAS No. 60, the Company recorded this change in reserves as a change in estimate during 2005.
Revenue from municipal code contracts is recognized on the percentage-of-completion method: completion is measured based on the percentage of direct labor costs incurred to date compared to estimated direct labor costs for each contract. While we use available information to estimate total direct labor costs on each contract, actual experience may vary from estimated amounts. Under this method, the costs incurred and the related revenues are included in the income statement as work progresses. Adjustments to contract cost estimates are made in the periods in which the facts which require such revisions become known. If a revised estimate indicates a loss, such loss is provided for in its entirety. The amount by which revenues are earned in advance of contractual collection dates is an unbilled receivable and the amount by which contractual billings exceed earned revenues is deferred revenue which is carried as a liability.
Notes to Consolidated Financial Statements - December 31, 2005, 2004 and 2003
Property/Casualty Insurance. Our wholly-owned subsidiary, Ohio Indemnity Company (“Ohio Indemnity”), is a specialty property/casualty insurance company. Our principal sources of revenue are premiums for insurance policies written and income generated from our investment portfolio. Ohio Indemnity, an Ohio corporation, is licensed in 48 states and the District of Columbia. As such, Ohio Indemnity is subject to the regulations of the Ohio Department of Insurance (the “Department”) and the regulations of each state in which it operates. The majority of Ohio Indemnity’s premiums are derived from three distinct lines of business: (1) products designed for automobile lenders/dealers; (2) unemployment compensation products; and (3) other specialty products.
In addition to the above product lines, beginning in 2001, the Company entered into a reinsurance program covering bail and immigration bonds issued by several insurance carriers and sold by a bail bond agency. This program was discontinued in the second quarter of 2004. For a more detailed description of this program, see Note 16 to the Consolidated Financial Statements.
codification is the process of collecting, organizing and publishing legislation for state and local governments. ALPC also provides information management services which includes electronic publishing, document imaging and internet hosting services.
In December 2002, we organized BIC Statutory Trust I (“BIC Trust I”), a Connecticut special purpose business trust. In September 2003, we organized BIC Statutory Trust II (“BIC Trust II”), a Delaware special purpose business trust. BIC Trust I and BIC Trust II were formed for the sole purpose of issuing and selling floating rate trust preferred capital securites in exempt private placement transactions and investing the proceeds from such securities in junior subordinated debentures of the Company.
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from these estimates.
In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-01 provides guidance on other-than-temporary impairment models for marketable debt and equity securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and non-marketable equity securities accounted for under the cost method. The EITF developed a basic three-step model to evaluate whether an investment is other-than-temporarily impaired. In September 2004, the FASB issued FASB Staff Position EITF 03-01-1, which delays the effective date until additional guidance is issued for the application of the recognition and measurement provisions of EITF 03-01 to investments in securities that are impaired; however, the disclosure requirements are effective for annual periods ending after June 15, 2004. The adoption of the disclosure provisions of EITF 03-01 did not have a material effect on the Company’s results of operations and/or financial condition.
Accounts receivable is comprised of ALPC’s municipal code contract billings. We estimate our allowance for doubtful accounts and bad debts based upon our assessment of the collectibility of receivables and prior experience.
As part of its annual goodwill impairment testing in the fourth quarter of 2004, the Company concluded that an impairment of goodwill existed at its property/casualty insurance segment. The Company, with the assistance of an independent appraisal firm, determined that the carrying value of the reporting segment exceeded the fair value of the reporting segment, resulting in a non-cash impairment charge. The fair value of the reporting segment was estimated using the expected present value of future cash flows. As a result of this impairment, the Company recorded non-cash impairment charges in the fourth quarter of 2004 in the aggregate amount of $753,737.
Intangible assets represent databases acquired by ALPC and a non-compete agreement. The databases are comprised of municipal code data and related files, which are amortized on a straight-line basis over the estimated economic useful lives of twenty years. The non-compete agreement is amortized on a straight-line basis over the contractual life of five years.
calculated and settled on an annual basis. These balances are presented in the accompanying balance sheets as retrospective premium adjustments payable. Certain other policies are eligible for an experience rating adjustment that is calculated and adjusted from period to period and settled upon cancellation of the policy. These balances are presented in the accompanying balance sheets as experience rating adjustments payable. These adjustments are included in the calculation of net premiums earned.
Real estate is stated at cost and depreciated using the straight-line method over thirty-nine years. Property, equipment and 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, 2005 and 2004, property, equipment, computer software and leasehold improvements, net of accumulated depreciation, was $484,525 and $512,435, respectively. These balances are presented in the accompanying balance sheets as other assets.
We use the “intrinsic value method” under APB No. 25 and related interpretations in accounting for stock options issued to employees, officers and directors under our equity compensation plans. SFAS No. 123 requires the “fair value method” for recognition of cost on equity compensation plans similar to those used by the Company. Adoption of SFAS No. 123 is optional in 2005 (required in 2006, see Note 1(c) to the Consolidated Financial Statements); however, pro forma disclosures as if we had adopted the fair value method under SFAS No. 123 in 2005, 2004 and 2003 are presented below.
Certain prior year amounts have been reclassified in order to conform to the 2005 presentation.
All of the above 99 fixed maturity securities had a fair value to cost ratio equal to or greater than 97% as of December 31, 2005. Out of the 14 equity securities listed above, 11 securities had a fair value to cost ratio equal to or greater than 86%, 1 security had a fair value to cost ratio of 77%, 1 security had a fair value to cost ratio of 71% and 1 security had a fair value to cost ratio of 66% as of December 31, 2005.
At December 31, 2005, investments having a carrying value of $4,536,478 were on deposit with various state insurance departments to meet their respective regulatory requirements.
Revenues earned on uncompleted codification contracts by ALPC were $1,452,739 and $1,829,586 and billings to date on those contracts were $1,279,812 and $1,707,372 at December 31, 2005 and 2004, respectively. The excess of costs and estimated earnings over billings were $248,035 and $182,441 at December 31, 2005 and 2004, respectively.
As part of its annual goodwill impairment testing in the fourth quarter of 2004, the Company concluded that an impairment of
goodwill existed at its property/casualty insurance segment. The Company performed impairment testing in accordance with SFAS No. 142. The Company, with the assistance of an independent appraisal firm, determined that the carrying value of the reporting segment exceeded the fair value of the reporting segment, resulting in a non-cash impairment charge. The fair value of the reporting segment was estimated using the expected present value of future cash flows. As a result of this impairment, the Company recorded non-cash impairment charges in the fourth quarter of 2004 in the aggregate amount of $753,737.
Amortization expense related to amortizable intangible assets was $74,518, $74,517 and $74,518 during 2005, 2004 and 2003, respectively. The estimated amortization expense of intangible assets for the next five fiscal years is as follows:
As of December 31, 2005, we had an unsecured $10,000,000 revolving line of credit with a maturity date of June 30, 2007 with no outstanding balance ($500,000 at December 31, 2004). The revolving credit agreement provides for interest payable quarterly, at an annual rate equal to 0.75% less than the prime rate (6.50% and 4.52% per annum at December 31, 2005 and 2004, respectively). The Company was in compliance with all provisions of our debt covenants under the agreement at December 31, 2005. The bank that provides the credit line is also a policyholder of the Company.
We routinely lease premises for use as administrative offices, vehicles and office equipment under operating leases for varying periods. Management expects that in the normal course of business, leases will be renewed or replaced by other leases. Effective January 2001, we entered into a new lease for our Columbus, Ohio office space. Under its provisions, no cash payments were due until April 1, 2002. Rent expense is recognized evenly over the lease term ending December 31, 2008. During 2004, ALPC renewed a lease in Cincinnati, Ohio for office space, which will expire on February 28, 2010. Rental expenses under operating leases were $265,852, $274,300 and $271,656 during 2005, 2004 and 2003, respectively.
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
As of December 31, 2005, the Company has a net operating loss carryforward of $2,156,347 which originated in 2004 and will expire in 2024.
The provision for federal income taxes for the period ended December 31 consists of the following:
We have stock options outstanding and exercisable at December 31, 2005 under two equity compensation plans, each of which has been approved by our security holders.
The 1994 Stock Option Plan (the “1994 Stock Option Plan”) provides 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 are eligible to participate in the 1994 Stock Option Plan. The 1994 Stock Option Plan is administered by the Company’s Compensation Committee which determines to whom and when options will be granted along with the terms and conditions of the options. Under the 1994 Stock Option Plan, options for 284,500 common shares were outstanding at December 31, 2005 and expire at various dates from 2006 to 2013 and range in option price per share from $3.375 to $6.75. Of the options for 284,500 common shares outstanding, 40,000 have been granted to our non-employee directors and 244,500 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 2002 Stock Incentive Plan (the “2002 Plan”) provides for awards, including grants of options, covering up to an aggregate of 600,000 common shares. Key employees, officers and directors of, and consultants and advisors to, the Company are eligible to participate in the 2002 Plan. The 2002 Plan is administered by the Compensation Committee which determines to whom and when awards will be granted as well as the terms and conditions of the award. Under the 2002 Plan, options for 329,000 common shares were outstanding at December 31, 2005 and expire at various dates from 2012 to 2014 and range in option price per share from $4.50 to $8.00. All of the options outstanding were granted to employees for compensatory purposes.
A summary of the status of our stock options as of December 31, 2005, 2004 and 2003 and changes during the year ended on those dates is presented below:
Generally, Ohio Indemnity is restricted by the insurance laws of the State of Ohio as to amounts that can be transferred to the parent in the form of dividends, loans, or advances without the approval of the Department. Under these restrictions, during 2006, dividends, loans or advances in excess of $3,478,274 will require the approval of the Department.
Ohio Indemnity is statutorily required to file financial statements with state regulatory authorities. The accounting principles used to prepare such statutory financial statements follow prescribed or permitted accounting practices as defined in the National Association of Insurance Commissioners Accounting Practices and Procedures Manual, which principles may differ from GAAP. Permitted statutory accounting practices encompass all accounting practices not so prescribed, but allowed by the Department. Ohio Indemnity has no permitted statutory accounting practices.
As of and for the period ended December 31, Ohio Indemnity’s statutory surplus and net income determined in accordance with accounting practices prescribed by the Department differed from shareholder’s equity and net income determined in accordance with GAAP by the following:
For more information concerning loss and LAE reserves for the discontinued bond program, see Note 16 to the Consolidated Financial Statements.
The Company assumes and cedes reinsurance with other insurers and reinsurers. Such arrangements serve to enhance the
Effective January 1, 2003, the Company entered into a producer-owned reinsurance arrangement with a new lender/dealer producer whereby 100% of that producer’s premiums (along with the associated risk) was ceded to its PORC. This reinsurance arrangement was cancelled effective December 31, 2003. Under this arrangement, the Company ceded premiums earned of $115,790, $4,435,659 and $13,331,861 during 2005, 2004 and 2003, respectively.
The amounts of recoveries pertaining to reinsurance that were deducted from losses and LAE incurred during 2005, 2004 and 2003 were $1,789,439, $2,465,643 and $9,917,371, respectively. During 2005, 2004 and 2003, ceded reinsurance decreased commission expense incurred by $1,054,259, $597,927 and $6,155,335, respectively.
Aegis Arbitration. On August 23, 2004, the Company instituted arbitration against Aegis Security Insurance Company (“Aegis”), one of the insurance carriers. On August 25, 2004, Aegis made a counter-demand for arbitration whereby a request was made that the Company join an arbitration that was already pending between Aegis and Lloyds Syndicate 1245, one of the other reinsurers participating in the discontinued bond program. On October 15, 2004, the Company agreed to consolidate arbitrations with Aegis and Lloyds Syndicate 1245. During April 2005, Lloyds Syndicate 0183, Lloyds Syndicate 0205 and Lloyds Syndicate 0727, other reinsurers participating in the discontinued bond program, were added to the consolidated arbitration. On August 11, 2005 and December 29, 2005, two other reinsurers participating in the program, The Philadelphia Contributionship for the Insurance of Houses from Loss by Fire (“Contributionship”) and American Healthcare Insurance Company (“AHIC”), respectively, were ordered to participate in the consolidated arbitration. Through this arbitration, the Company is seeking rescission of the reinsurance agreements, monetary damages for claims that were paid by the Company under the agreements and other appropriate relief. Aegis is seeking to recover certain of its losses from the Company under the reinsurance agreements. This arbitration is proceeding and a hearing is currently scheduled to begin in January 2006. See Note 25 to the Consolidated Financial Statements for subsequent events related to the Aegis arbitration.
2005 Reserve Developments. The Company recorded discontinued bond program losses and LAE of $0.4 million and $20.2 million during 2005 and 2004, respectively. The $20.2 million of losses and LAE recorded in 2004 consisted of $1.4 million of net paid losses and an $18.8 million increase in loss and LAE reserves. The $0.4 million of losses and LAE recorded in 2005 consisted of the following: 1) a $2.8 million net increase in loss and LAE reserves during 2005 based on revised estimates of potential future liabilities
The Company has received revised estimates of potential future liabilities from the insurance carriers. These revised estimates resulted in a net increase in loss and LAE reserves of $2.8 million during 2005, of which $2.5 million was recognized during the fourth quarter of 2005.
It should be noted that there is potential for the Company to mitigate its ultimate liability on the program through the arbitrations with the insurance carriers; however, because of the subjective nature inherent in assessing the final outcome of the arbitrations, management can not estimate the probability of an adverse or favorable outcome as of December 31, 2005. In addition, while outside counsel believes we have legal defenses under the reinsurance agreements, they are unable to assess whether an adverse outcome is probable or remote in the arbitrations as of December 31, 2005. In accordance with SFAS No. 5 “Accounting for Contingencies,” the Company is reserving to its best estimate of the ultimate liability on the program at December 31, 2005 taking into account the estimated settlement values with certain insurance carriers (as described above) but not taking into account the final
outcome of the arbitrations. If the Company obtains information to revise its estimate of potential settlement values or determine an estimate of final arbitration values, the Company will record such reserve changes, if any, in the period that the revised estimate is made in accordance with SFAS No. 60, “Accounting and Reporting by Insurance Enterprises.” The Company does not intend to pay for any of the losses on the discontinued bond program unless and until the arbitrations are settled on a mutually agreeable basis and/or a final binding judgment is made as to the Company’s ultimate liability.
Given the uncertainties of the outcome of the arbitrations, potential settlements with the insurance carriers or other potential recoveries, uncertainties as to the prospective settlement amount between Highlands and DHS for Highlands’ immigration bond obligations, uncertainties in the future loss information provided by the insurance carriers, and the inherent volatility in assumed reinsurance, actual losses incurred for the discontinued bond program could be materially different from our estimated reserves. As a result, future loss development on the discontinued bond program could have a material effect on the Company’s results of operations and/or financial condition.
During 2003, we agreed to repurchase common shares of the Company from an officer and director of the Company concurrent with the issuance of such common shares through exercise of stock options. The $10,812 of payments in 2003 to settle the option grants were recorded as compensation expense.
On April 25, 2002, the Board of Directors adopted a common share repurchase program. On May 23, 2002, the Board of Directors increased the aggregate number of common shares available for repurchase under the repurchase program to 700,000 common shares from 600,000 common shares originally approved. The repurchase program expired on December 31, 2003. Through December 31, 2003, we repurchased 699,465 common shares at an average price per share of $5.00 under this program. Repurchases were funded by cash flows from operations and financing activities.
Accounts receivable: The carrying amounts are reasonable estimates of fair value.
As discussed in Notes 16 and 25 to the Consolidated Financial Statements, the Company is a party to various arbitration proceedings arising from claims made under reinsurance contracts relating to the discontinued bond program.
In addition to the above, we are involved from time to time in ordinary routine litigation incidental to our business. We do not believe any of this litigation will have a material adverse effect on the Company’s financial condition and/or results of operations.
As described in Note 1 to the Consolidated Financial Statements, the Company has three reportable business segments: (1) property/casualty insurance; (2) municipal code publishing; and (3) insurance agency. There are intersegment management and commission fees. The allocations of certain general expenses within segments are based on a number of assumptions, and the reported operating results would change if different methods were applied. Depreciation and capital expenditures are not considered material. Segment results for 2005, 2004 and 2003 are as follows:
On January 18, 2006, the Company entered into a settlement agreement with Aegis resolving all disputes between the Company and Aegis relating to the discontinued bond program. The settlement also relieves the Company from any potential future liabilities with respect to bail and immigration bonds issued by Aegis. As a result of this settlement agreement, the Company reduced its loss and LAE reserves for the discontinued bond program by $0.2 million during the first quarter of 2006. In accordance with SFAS No. 60, management recorded this change in reserves during the first quarter of 2006 as a change in estimate.