In Phillipsburg, Kansas, we own a processing center and an advertising center. The advertising center also houses our facilities teams and the home office of Brooke Savings Bank. We own a building in Dallas, Texas that houses a regional office and service center. We lease additional regional offices in Englewood, Colorado, Nashville, Tennessee, and Sacramento, California, as well as brokerage underwriting offices, and franchise customer service centers in other locations in the United States. During the first quarter of 2007, Brooke Credit Corporation opened a loan participation office in Nashville, Tennessee. We, or our subsidiaries, may acquire or lease real estate for use in our subsidiaries’ operations and for lease, sublease or license to franchisees.
The following income statement data for the years ended December 31, 2007, 2006 and 2005 and balance sheet data as of December 31, 2007 and 2006 are derived from our audited financial statements, which are included elsewhere in this report. The following income statement data for the years ended December 31, 2004 and 2003 and balance sheet data as of December 31, 2005, 2004 and 2003 are derived from our audited financial statements not included in this report. You should read this data together with our financial
Based on net income available to common stockholders (diluted) of $1,401, $10,548, and $9,511 for the years ended December 31, 2007, 2006 and 2005, respectively. Net income available to common stockholders (diluted) is equal to net income less dividends on non-convertible preferred stock of $194, $194 and $194 for the years ended December 31, 2007, 2006 and 2005, respectively. However, if the conversion of the preferred stock shares is anti-dilutive the income available to common shareholders (basic) is used.
Includes special dividend of $0.15 per share paid on August 30, 2004.
Amounts in this section have been rounded to the nearest thousand, except percentages, ratios, per share data, numbers of franchise locations and numbers of businesses. Unless otherwise indicated, or unless the context otherwise requires, references to years in this section mean our fiscal years ended December 31.
We are a holding company focusing on investments in the insurance, banking and financial services industries with holdings in two public companies, Brooke Capital Corporation (AMEX: BCP) and Aleritas Capital Corp., a d/b/a of Brooke Credit Corporation, (OTCBB: BRCR), and two wholly-owned private companies, Brooke Bancshares, Inc. and Brooke Brokerage Corporation.
Brooke Bancshares, Inc. Brooke Bancshares, a wholly owned subsidiary, owns Brooke Savings Bank, which sells banking products and services primarily through contracted banker agents who are paid commissions for customer referrals.
Brooke Brokerage Corporation. Brooke Brokerage, a wholly owned subsidiary owns CJD & Associates, LLC which brokers hard-to-place property and casualty insurance policies and life insurance policies on a wholesale basis primarily through independent insurance agents.
If the Delta Plus Holdings acquisition by Brooke Capital close as planned, the activities and ownership of Brooke Corporation’s primary direct subsidiaries will correspond to the following chart.
Operating revenue, excluding Aleritas revenue if deconsolidated, is expected to continue to increase in 2008 primarily as a result of bank and insurance company growth and less from opening new franchise locations. The increases in total operating revenues in recent years, and most of the individual revenue categories that make up total operating revenues, are primarily attributable to the continued expansion of franchise operations. The increases in interest income (net) primarily resulted from increased loan origination activities, increases in the amount of loans held in inventory for eventual sale and increases in retained interest from loans sold. Increases in revenues from insurance premiums earned and increases in expenses from insurance loss and loss expense incurred were the result of acquiring Delta Plus and Brooke Capital.
Expenses are also expected to continue to increase in 2008 primarily as a result of bank and insurance company growth and less as a result of opening new franchise locations. The increases of commission expense are primarily attributable to increases in insurance commissions received from insurance companies, because a share of insurance commissions is typically paid to franchisees.
Depreciation and amortization expense also increased primarily as a result of acquiring Delta Plus, Brooke Savings Bank and Brooke Capital.
We consider interest expense, other than line of credit, to be a non-operating expense. Interest expense increased primarily as a result of increased debt to commercial banks, which was incurred primarily to capitalize our operating subsidiaries and to fund the over-collateralization of our warehouse facilities and securitizations. Also contributing to the increase was the interest expense associated with the private placement of debt by Aleritas in the fourth quarter of 2006.
Net income and net income per share for 2007 and the fourth quarter of 2007, decreased primarily as the result of less than expected earnings in our lending segment and higher than expected expenses for lender, or collateral preservation, assistance in our insurance segment. Net income per share also decreased as the result of adjusting the diluted earnings per share calculation to reflect the anticipated issuance of 1,176,000 shares of common stock that may result from our offering of perpetual convertible preferred stock that took place in the third quarter of 2006.
Our acquisition of a controlling interest in Brooke Capital Corporation in December 2006 and January 2007 has resulted in a new asset category for investments and a new liability category for policy and contract liabilities to account for the life insurance and annuity operations of First American Capital Corporation’s life insurance company subsidiary. A balance sheet account has also been established to reflect the interests of Brooke Capital and Aleritas’ minority shareholders. The acquisition of Brooke Savings Bank in January 2007 has resulted in a new liability category for deposits, the bank’s primary source of funding.
Customer receivables primarily include amounts owed to Brooke Capital by our franchisees and increased primarily from continued expansion of our franchise operations, especially the producer development program typically associated with start up franchises. A loss allowance exists for Brooke Capital’s credit loss exposure to these receivable balances from franchisees (See Insurance Services Segment, below).
The securities balance result from loan sales activities to qualifying special purpose entities and primarily consist of three types of securities (or retained residual assets): interest-only strip receivables in the loans sold; retained over-collateralization interests in the loans sold; and cash reserves. When Aleritas sells notes receivable to qualifying special purpose entities it retains an over-collateralization interest in the loans sold and cash reserves. As cash is received for the interest-only strip receivable as well as the principal attributable to our over-collateralization retained interest, the securities balance declines. The securities balance increased primarily as the result of loans previously held in loan inventory being sold to Brooke Warehouse Funding, LLC, in connection with the off-balance-sheet financing secured through Fifth Third Bank in March 2007.
For the years ended December 31, 2007, 2006 and 2005, we incurred income tax expenses of $474,000, $5,992,000 and $5,261,000, respectively, resulting in effective tax rates of 23%, 36% and 35% (including Brooke Capital Corporation which files a separate tax return). As of December 31, 2007 and 2006, we had current income tax liabilities of $826,000 and $4,293,000, respectively, and deferred income tax liabilities of $8,117,000 and $7,594,000, respectively. The deferred tax liability is primarily due to the deferred recognition of revenues, for tax purposes, on loans sold until interest payments are actually received.
Revenues, expenses, assets and liabilities for reportable segments were extracted from financial statements prepared for Brooke Savings Bank (Banking Segment), CJD & Associates (Brokerage Segment), Brooke Capital Corporation and Delta Plus Holdings, Inc. (Insurance Segment) and Aleritas Capital Corp. (Lending Segment), and as such, consolidating entries are excluded.
Each segment was assessed a shared services expense which is an internal allocation of legal, accounting, human resources and information technology expenses based on our estimate of usage. Because consolidating entries are excluded, the other operating expense category for reportable segments include internal allocations for shared services expense during the years ended December 31, 2007 and 2006, of $30,000 and $0, respectively, for the Banking Segment, $60,000 and $1,800,000, respectively, for the Brokerage Segment, $2,850,000 and $4,800,000, respectively, for the Insurance Segment; and $2,250,000 and $1,800,000, respectively, for the Lending Segment.
The following financial information relates to our Banking Segment and includes the financial information of the Brooke Savings Bank subsidiary of Brooke Bancshares, Inc. (in thousands, except percentages). Financial information for 2006 has been included for comparative purposes.
On January 8, 2007, Brooke Brokerage acquired a 100% interest in Brooke Savings Bank from Kansas City Life Insurance Company (“KC Life”). Upon closing of the acquisition, Brooke Savings Bank had total deposits of $41,493,000. Included in the acquired deposits were $28,000,000 in individual transaction accounts resulting from the deposit of death benefit proceeds from KC Life policies. Brooke Savings Bank has typically paid relatively low deposit rates of 0.10% to 0.34% on these types of accounts. After KC Life sold its interest in Brooke Savings Bank, it discontinued depositing death benefit proceeds into Brooke Savings Bank accounts and the deposit balances from death benefits previously deposited by KC Life have consistently declined. At
Income Before Income Taxes Income reduced primarily as the result of reduction in deposits from death benefit proceeds, Brooke Savings Bank’s cost of funds has increased significantly from approximately 1.07% at December 31, 2006 to approximately 2.70% at December 31, 2007. As a result of acquiring significantly more deposits liabilities than loan assets from the Bank of the West transaction, the banking segment is not expected to generate much, if any, earnings until the loan portfolio is increased in accordance with its business plans.
The following financial information relates to our Brokerage Segment and includes the financial information of CJD & Associates, L.L.C., a wholly-owned subsidiary of Brooke Brokerage (in thousands, except percentages).
Beginning in November 2005, Brooke Brokerage, through its wholly owned subsidiary, CJD & Associates, L.L.C., began using its industry contacts and expertise in insurance brokerage to consult with general insurance agencies borrowers specializing in hard-to-place insurance sales. A growing emphasis on borrower consulting in 2006 resulted in an increase in consulting fees. Brooke Brokerage did not record any consulting fees in 2007 related to borrower consulting because as part of an agreement closed in December 2006 to acquire stock in Brooke Capital Corporation, Brooke Brokerage agreed not to engage in any new managing general agent borrower consulting business and to provide support and assistance to Brooke Capital Corporation to enable it to conduct that business.
Net commission refund expense is our estimate of the amount of Brooke Brokerage’s share of wholesale commission refunds due to policyholders resulting from future policy cancellations. On December 31, 2007 and 2006, Brooke Brokerage recorded corresponding total commission refund liabilities of $89,000 and $110,000, respectively.
Other operating expenses decreased in 2007 primarily as the result of discontinuance of the borrower consulting business.
Income Before Income Taxes Brooke Brokerage’s income before income taxes decreased during in 2007 primarily as the result of discontinuing its borrower consulting business.
Life Insurance Company Expenses Death claim expenses incurred by First Life America totaled $1,049,000 during 2007 as compared to $737,000 and $507,000 during 2006 and 2005, respectively. Policy reserve expense was $926,000 during 2007 as compared to $841,000 and $1,119,000 during 2006 and 2005, respectively. Interest credited on annuities and premium deposits increased to $799,000 during 2007 compared to $579,000 and $406,000 during 2006 and 2005, respectively, primarily as the result of deposits received related to the increased number of policies in force.
Commission expense increased because insurance commission revenues increased and franchisees are typically paid a share of insurance commission revenue. Commission expense represented approximately 78%, 79% and 80%, respectively, of Brooke Capital’s insurance commission revenue for the years ended December 31, 2007, 2006 and 2005.
Franchise Operating Expenses Payroll expense increased partially as the result of acquiring Delta Plus Holdings in March 2007. Payroll expense also increased partially as the result of the provision by Brooke Capital of additional collateral preservation assistance to franchisees coping with financial stress resulting from less commission revenues from reduction of premium rates by insurance companies.
Marketing allowances expense is incurred primarily for the purpose of providing collateral preservation assistance. Marketing allowances made to franchisees increased $1,269,000, or 28%, to $5,802,000 in 2007 from $4,533,000 in 2006. Marketing allowances made to franchisees increased $901,000, or 25%, to $4,533,000 in 2006 from $3,632,000 in 2005.
Advertising expenses decreased $29,000 to $8,276,000 in 2007 from $8,305,000 in 2006. Advertising expenses increased $2,085,000, or 34%, to $8,305,000 in 2006 from $6,220,000 in 2005.
Expenses for write off of franchise balances increased $1,065,000, or 30%, to $4,628,000 in 2007. Write off expenses increased $730,000, or 26%, to $3,563,000 in 2006 from $2,833,000 in 2005. Total write off expenses were reduced in 2007 primarily as the result of an agreement with Brooke Corporation to guarantee franchise balances pursuant to the merger agreement.
Basic Services A certain level of basic services is initially provided to all franchisees, whether they acquire an existing business and convert it into a Brooke franchise, start up a new Brooke franchise location or acquire a company developed franchise location. These basic services include services usually provided by other franchisors, including a business model, a license to use registered trademarks, access to suppliers and a license for an Internet-based information system. The amount of the initial franchise fees typically paid for basic services is currently $165,000
A total of 234 and 227 new franchise locations were added during the years ended December 31, 2007 and 2006, respectively. The rate of new franchise location growth has slowed primarily as the result of Brooke
Capital’s “New Era” initiative beginning in the fourth quarter of 2007 to emphasize quality of franchisees over quantity of franchisees.
Buyers Assistance Plan Services Buyer assistance plans provide assistance to franchisees for the initial acquisition and conversion of businesses. These services include, for example, compilation of an inspection report. The amount of the fee charged franchisees for these services typically varies based on the level of assistance, which in turn is largely determined by the size of the acquisition. We therefore typically base our fees for buyer assistance plans on the estimated revenues of the acquired business. All initial franchise fees (for both basic services and for buyer assistance plans) are paid to Brooke Capital when an acquisition closes. A significant part of Brooke Capital’s commission growth has come from such acquisitions of existing businesses that are subsequently converted into Brooke franchises.
Brooke Capital performs substantially all of the buyer assistance plan services before an acquisition closes and, therefore, typically recognizes all of the initial franchise fee revenue for buyer assistance plan services at the time of closing.
Buyer assistance plan services are not applicable to the purchase by franchisees of company-developed or already-franchised businesses. In addition, buyer assistance plan services are not typically provided to franchisees selling to other franchisees and are not provided to franchisees purchasing businesses that were purchased by Brooke Capital in the preceding 24 months. Businesses that were converted into Brooke franchises and received buyer assistance plan services totaled 3, 16 and 87 of new franchise locations in 2007, 2006 and 2005, respectively.
Income Before Income Taxes Income before income taxes increased $1,441,000, or 34%, to $2,771,000 in 2007 from $4,212,000 in 2006. Income before income taxes decreased $3,384,000, or 45%, to $4,212,000 in 2006 from $7,596,000 in 2005. The increase in income in 2007 primarily resulted from an increase in consulting fees, especially borrower consulting fees. Income in 2007 was adversely impacted from an increase in collateral preservation expenses incurred to assist lenders with borrower rehabilitation and monitoring.
Company-owned stores identified as inventoried, franchisor-developed or auto insurance stores are generally related to recruitment of new franchisees or the expansion of locations that is essential to the continued growth of insurance commissions and premiums. Inventoried stores include businesses purchased for resale to franchisees. Franchisor-developed stores include business locations developed by us that have not been previously owned by a franchisee. Because the store has been developed by us instead of purchased from third parties, all income and expenses associated with development and operation of the store are recorded as income and expenses, but a corresponding asset is not recorded on the balance sheet. Company-owned stores identified as managed, pending or franchisee-developed stores are generally related to assisting lenders in the preservation of collateral. Managed stores are subject to agreements between franchisees and us for management of the stores for purposes of lender collateral preservation, as the result of the disability or death of the franchisee or under other circumstances. Pending stores include businesses that franchisees have contracted to sell, but the transactions have not yet closed, and we are managing the store to reduce the likelihood of asset deterioration prior to closing. Managed and pending stores are not recorded as an asset on our balance sheet. However, because we are entitled by agreement to the income and are responsible for the expenses of the business (excluding owner’s compensation) until the agreement terminates or ownership is transferred, income and expenses of managed and pending stores are recorded to our income statement and are therefore included in our discussion of company-owned stores. Franchisee-developed stores include franchise businesses for which franchisees have paid part or all of the expenses associated with location development during the
The number of businesses twice-purchased into inventory within twenty-four months is an important indicator of our success in recruiting qualified buyers. There were 1, 0 and 1 businesses twice-purchased during 2007, 2006 and 2005, respectively. Some franchisees have experienced an adverse affect on profitability and cash flow from increased loan interest rates on agency acquisition loans and lower commissions resulting from the effect of decreased premium rates. Otherwise, we are not aware of any systemic adverse profitability or cash flow trends being experienced by buyers of businesses from our inventory.
the start up period to qualify for an insurance agency business loan based on historical revenues) is approximately 60%. Correspondingly, about 40% of all start up franchisees do not have the personal attributes required for success, but have developed a business location which meets our demographic criteria and a location for which investments in advertising, signage and other marketing activities have been made by the franchisee and us. As such, these franchisee-developed locations typically represent good opportunities for other start up franchisees. The number of franchisee-developed stores has increased temporarily because more start up periods are expiring during any given month as the result of decreasing the length of the start up period.
Same store sales performance has been adversely affected by the “soft” property and casualty insurance market, which is characterized by a flattening or decreasing of premiums by insurance companies. Our franchisees predominately sell personal lines insurance with more than 50% of our total commissions resulting from the sale of auto insurance policies and Brooke Capital believes that the insurance market has been particularly soft with regards to premiums on personal lines insurance policies.
Reserve for Doubtful Accounts As part of the agreement to merge Brooke Franchise into Brooke Capital, we have agreed to guaranty the repayment of franchise balances outstanding as of June 30, 2007, and Brooke Capital has accordingly reduced its reserve for doubtful accounts to $1,114,000 on December 31, 2007 from $1,466,000 on December 31, 2006. Franchise balances outstanding as of December 31, 2007 totaled $19,460,000.
As of December 31, 2007, loan balances were comprised of approximately 348,119,000, or 51%, in loans made to retail insurance agencies that are franchisees of Brooke Capital Corporation, approximately $85,638,000, or 13%, in loans made to retail insurance agencies that are not franchisees of Brooke Capital Corporation, approximately $162,005,000 or 24% in loans made to managing general agencies, approximately $76,658,000 or 11% in loans made to independent funeral homes and $5,826,000, or 1%, in miscellaneous loans. As of December 31, 2006, loan balances were comprised of approximately $278,971,000, or 58% in loans made to retail insurance agencies that are franchisees of Brooke Capital Corporation, approximately $54,031,000, or 11%, in loans made to retail insurance agencies that are not franchisees of Brooke Capital Corporation, approximately $89,433,000, or 18%, in loans made to managing general agencies, approximately $56,016,000 or 12% in loans made to independent funeral homes and $4,827,000, or 1%, in miscellaneous loans.
A majority of Aleritas’ loans are variable rate loans and are based on the New York Prime rate (“Prime”) as published in the Wall Street Journal. However, Aleritas has fixed rates on approximately 1% of its portfolio. Typically the interest rate adjusts daily based on Prime; however, approximately 4% of Aleritas’ portfolio as of December 31, 2007 adjusts annually based on Prime and an immaterial amount of its loans adjust monthly based on Prime. As of December 31, 2007, Aleritas’ variable loan portfolio had a weighted average index rate of approximately 3.78% above Prime, compared to approximately 3.79% above Prime as of December 31, 2006.
In recent years, Aleritas’ results of operations have been significantly impacted by the growth of its portfolio, the expansion of its loan funding sources, the development of a securitization model and the expansion of its lending programs. The following table shows income and expenses (in thousands, except percentages) for the years ended December 31, 2007, 2006 and 2005, and the percentage change from period to period.
Provision for Credit Losses A loan loss reserve of $1,655,000 was established during 2007. This reserve, intended to provide for losses inherent in loans held on the balance sheet, was established because Aleritas now retains loans on its balance sheet for up to twelve months, longer than the six to nine months it has historically held loans. Also, as the portfolio seasons, Aleritas is experiencing increased delinquencies. At December 31, 2007, approximately $13,301,000 in loan balances held on its balance sheet were more than 60 days delinquent as compared to $1,931,000 in loan balances more than 60 days delinquent at December 31,
Participating Interest Expense A portion of the interest income that Aleritas receives on its loans is paid out to the holders of the participation interests and asset-backed securities. Payments to these holders are accounted for as participating interest expense, which is netted against interest income in the consolidated statements of operations. Participating interest expense increased primarily as a result of the increase in participation interests and asset-backed securities that were sold. Participation interest expense represented approximately 58%, 56% and 54%, respectively, of Aleritas’ interest income for the year ended December 31, 2007, 2006 and 2005.
Gain on Sales of Notes Receivable When the sale of a loan is classified as a true sale pursuant to the criteria established by SFAS 140, gains or losses are recognized, loans are removed from the balance sheet and residual assets are recorded. Aleritas estimates the value of the residual assets by estimating the present value of the expected future cash flows from the interest and servicing spread, reduced by its estimate of credit losses and note receivable prepayments. The interest and servicing spread is the difference between the rate Aleritas pays to participating lenders and investors and the rate received from its borrowers. Over time, as Aleritas receives cash from the payment of interest and servicing income, it reduces the value of the residual asset by writing down the interest asset and amortizing the servicing assets. Revenues from gain on sales of notes receivable increased in 2007 as compared to 2006 primarily because more notes receivable off-balance sheet were sold during 2007. This largely resulted from the sale of loans in connection with the off-balance sheet facility provided by Fifth Third Bank during March 2007. Revenues from gain on sales of notes receivable declined slightly in 2006 as compared to 2005 primarily because more loans were sold to qualifying special-purpose entities in 2005 than 2006, and these entities issued asset-backed securities.
Aleritas estimates the value of interest-only strip receivables, servicing assets and interest-only strip receivables portion of securities balances by calculating the present value of the expected future cash flows from the interest and servicing spread, reduced by an estimate of credit losses and note receivable prepayments. The interest and servicing spread is the difference between the rate on the loans sold and the rate paid to participating lenders or the rate paid to investors and lenders to qualifying special-purpose entities. Over time, as cash is received from the payment of interest and servicing income, the value of the residual asset is reduced by writing down the interest asset and amortizing the servicing assets. When the sale of a loan is not classified as a true sale pursuant to the criteria established by SFAS 140, the sale is classified as a secured borrowing, no gain on sale is recognized, and the note receivable and the corresponding payable under participation agreement remain on the balance sheet.
associated with the interest income received. The gain on sale of notes receivable and its three components are detailed below.
The first component of the gain on sale of notes receivable is the gain on sale recorded associated with the over collateralization benefit based on a present value calculation of future expected cash flows from the retained portion of loans sold, net of prepayment and credit loss assumptions. Fluctuations in these gains, year-to-year, reflected the changing volume of loans sold to qualifying special-purpose entities. In addition, the spread for loans sold to qualifying special-purpose entities increased from 3.56% in 2006 to 4.72% in 2007.
Gains (losses) from servicing and interest benefits are typically non-cash gains (losses), as Aleritas receives cash equal to the carrying value of the loans sold. A corresponding adjustment has been made on the Statement of Cash Flows to reconcile net income to net cash flows from operating activities. Gain-on-sale accounting requires Aleritas to make assumptions regarding prepayment speeds and credit losses for participated loans and asset-backed securities. The performances of these loans are monitored, and adjustments to these assumptions will be made if necessary. Underlying assumptions used in the initial determination of future cash flows on the participation loans and asset-backed securities accounted for as sales include the following:
loans of $14,572,000 as of December 31, 2007 and $5,858,000 as of December 31, 2006. The increased level of off-balance sheet assets is primarily the result of a larger loan portfolio and the continued sale of loan participations and the sale of loans to qualifying special-purpose entities including the Fifth Third Bank facility established in March 2007.
when the income allocated to its servicing responsibilities exceeds its cost of servicing, which Aleritas typically estimates at 0.25% of the loan value being serviced. Components of the servicing asset as of December 31, 2007 were as follows (in thousands):
In connection with the recognition of non-cash losses for the servicing liabilities of loan participation sales, the present value of future cash flows was recorded as a servicing liability. Components of the servicing liability as of December 31, 2007 were as follows (in thousands):
Loans Sold to Qualifying Special-Purpose Entities - Interest-Only Strip Receivable Asset The terms of Aleritas’ securitizations and off-balance-sheet bank debt require the over-collateralization of the pool of loan assets that back the securities issued to investors and off-balance-sheet debt secured. Aleritas retains ownership of the over-collateralization interests in loans sold, which is included in its securities balances, and has historically borrowed money from commercial banks to fund this investment. The fair value of the over-collateralization interest in the loans sold to qualifying special-purpose entities that have issued asset-backed securities has been estimated at the par value of the underlying loans less the asset-backed securities sold. The fair value of the over-collateralization interest in the loans sold to qualifying special-purpose entities that have secured bank debt, is based on the present value of future expected cash flows using management’s best estimates of key assumptions, credit losses (0.50% annually), prepayment speed (12.00% annually) and
The carrying values of securities, resulting from loan sale activities to qualifying special-purpose entities were $87,763,000 and $50,320,000 at December 31, 2007, and December 31, 2006, respectively. As of December 31, 2007, these securities were comprised of $28,144,000 in interest-only strip receivables, $58,769,000 in retained over-collateralization interest in loans sold and $850,000 in cash reserves. As of December 31, 2006, these securities were comprised of $12,094,000 and interest-only strip receivables, $37,003,000 in retained over-collateralization interests in loans sold and $1,223,000 in cash reserves. Securities balances increased at December 31, 2007 as compared to December 31, 2006 primarily as a result of selling more loans off balance sheet with the close of the Fifth Third facility during the first quarter 2007. The securities are subject to credit and prepayment risks on the transferred financial assets.
Components of the interest receivable portion of securities as of December 31, 2007 were as follows (in thousands):
Other Operating Interest Expense Operating interest expense decreased in 2007 primarily as a result of fewer loans being held on the balance sheet as compared to 2006. This reduction was primarily the result of using the off-balance sheet facility from Fifth Third Bank which closed in March 2007 and replaced the previous on-balance sheet facility with Fifth Third Bank. Aleritas retained more loans on its balance sheet in 2006 compared to 2005 due to increased utilization of lines of credit, thus other operating interest expense rose in 2006 compared to 2005.
Other Operating Expenses The increase in other operating expenses in 2007 and 2006 is partially attributable to an increase in fees paid to consultants for assistance in monitoring borrower performance, consulting with borrowers and otherwise assisting Aleritas in the preservation of collateral and improvement of
Interest Expense Interest expense increased in 2007 and 2006 primarily as a result of increased bank debt and a private placement debt offering in the fourth quarter of 2006, which was incurred to fund the over-collateralization of the warehouse facilities and securitizations, to retire bank debt with less favorable repayment terms and to fund the loan portfolio growth.
Loan Quality For the year ended December 31, 2007 and 2006, $3,194,000 and $525,000, respectively, in credit losses occurred on loans in our portfolio. Of these credit losses, for the year ended December 31, 2007, $1,893,000 were associated with on-balance sheet loans, $1,347,000 associated with off-balance sheet loans which have been securitized and $0 associated with off-balance sheet loans which have been sold to participating lenders. As the loan tranche that Aleritas holds in the securitized loans is subordinate to the asset-backed security investors, it did realize a write-down of its securities balance as a result of the credit losses in the securitized loans. Of the credit losses realized by Aleritas as of December 31, 2007, other than the establishment of a reserve for credit losses of $1,655,000, 87% were associated with retail agency loans to franchisees of Brooke Capital, approximately 10% were associated with retail agency loans that are not franchisees of Brooke Capital, and the remainder were associated with loans to funeral homes. Credit losses incurred increased in 2007 compared to the prior years due to an increase in the size of the loan portfolio and greater seasoning of the loans in the portfolio. Additionally, Aleritas is beginning to experience the impact of Brooke Capital’s plan to reduce its expenses associated with rehabilitating poorly performing franchisees, resulting in credit losses on some of these agencies.
At December 31, 2007 and December 31, 2006, $22,542,000 and $2,291,000, respectively, loan balances were delinquent 60 days or more. Of these delinquent loans as of December 31, 2007, $13,301,000 were on-balance sheet loans, $7,343,000 were off-balance sheet loans which have been sold to participating lenders and $1,898,000 were of-balance sheet loans sold in securitizations. Of these delinquent loans as of December 31, 2007, 91% were associated with retail agency loans to franchisees of Brooke Capital and 9% were associated with independent funeral home owners. More specifically, as of December 31, $16,993,000 of delinquent loans were associated with loans made to start up franchisees (which typically carry a loan term of eight months) of Brooke Franchise as compared to $955,000 at December 31, 2006. These start up franchise loans mostly represent franchisees that did not meet the required commission threshold in order to quality for a longer amortizing franchise loan. The increase in delinquencies associated with these loans is primarily attributable to the significant increase in start up loans that reached loan maturity during the third quarter of 2007 as compared to prior periods. As a result of this significant increase in start up franchise loan delinquencies, Aleritas has restricted the funding of start up franchise loans associated with non peer-to-peer financing transactions until these delinquencies are significantly reduced or eliminated.
Aleritas believes one important factor which has resulted in favorable credit performance for the Company, its participating lenders and investors, results from the cash management feature imposed by Aleritas on its retail agency borrowers, which represents approximately 64% of on and off-balance sheet loans at December 31, 2007, excluding related party loans. Under this cash management feature, debt servicing associated with these loans are typically submitted directly to Aleritas from insurance companies or deducted from commissions received by Brooke Capital prior to payment of commissions to the borrower and most other creditors. Aleritas believes that credit problems associated with retail agency loans are more likely to be identified when it monitors borrower revenues on a monthly or quarterly basis rather than by monitoring Aleritas loan delinquencies.
preservation services. These services assist the lender in monitoring borrower performance, advising borrowers and otherwise assisting Aleritas in the preservation of collateral and improvement of borrower financial performance.
The level of credit losses and payment delinquencies increased during 2006 and 2007. Aleritas believes that this increase is primarily attributable to increased strain placed on its borrowers resulting from conditions in which Aleritas had little or no control, such as increasing interest rates and a softening premium insurance market. Many of its borrowers are primarily engaged in insurance agency and brokerage activities and derive revenues from commissions paid by insurance companies, which commissions are based in large part on the amount of premiums paid by their customers to such insurance companies. Premium rates are determined by insurers based on a fluctuating market. Historically, property and casualty insurance premiums have been cyclical in nature, characterized by periods of severe price competition and excess underwriting capacity, or soft markets, which generally have an adverse effect upon the amount of commissions earned by Aleritas’ insurance agency borrowers, followed by periods of high premium rates and shortages of underwriting capacity, or hard markets. The current insurance market generally may be characterized as “soft,” with a flattening or decreasing of premiums in most lines of insurance. Aleritas expects increased levels of payment delinquencies and credit loss for Aleritas, its participating lenders and investors as the full impact of these market conditions are felt by its borrowers.
As a result of the challenging insurance market and increasing interest rate environment of the last several years, Collateral Preservation Providers have provided increased levels of collateral preservation and loss mitigation support. If conditions persist, Collateral Preservation Providers may demand increased collateral preservation fees in exchange for providing additional collateral preservation support or rehabilitation services during these challenging market conditions, which could impact Aleritas’ level of collateral preservation expense in the future. Additionally, collateral preservation providers may be less inclined to provide rehabilitation support of a struggling borrower business and more inclined to liquidate collateral associated with struggling borrowers, which could impact payment delinquencies, defaults and credit losses. If the latter occurs, Aleritas expects increased levels of payment delinquencies and credit losses for Aleritas, and purchasers of its loans.
On loans sold to qualifying special purpose entities in which Aleritas retains over-collateralization interest in loans sold and the loan participations sold with recourse, the 0.50% credit loss assumption used to calculate retained interest reduced Aleritas’ expected retained interest associated with these loans by approximately $5,296,000 and $3,278,000 as of December 31, 2007 and 2006 to allow for credit losses, which also reduced the amount of gain on sale revenue recognized at the time of each loan sale and resulted in a reduction of the carrying value of the corresponding asset on Aleritas’ balance sheet.
On loans held on Aleritas’ balance sheet, a loan loss reserve of $1,655,000, which equates to approximately 1.2% of the $136.3 million in on-balance-sheet loans, was established during 2007. This reserve, intended to provide for losses inherent in loans held on the balance sheet, was established because Aleritas now retains loans on its balance sheet for up to twelve months, longer than the six to nine months it has historically held loans. Also, the Company experienced an increase in delinquencies of its loans held on balance sheet during 2007 as compared to prior periods.
Perhaps a greater risk to Aleritas is the indirect exposure to credit losses that may be incurred by participating lenders, loan pool investors and warehouse loan providers. In those cases in which Aleritas does not bear direct exposure to credit loss, if losses by participating lenders, loan pool investors and warehouse loan providers reach unacceptable levels, then Aleritas may not be able to sell or fund loans in the future. Aleritas’ business model requires access to funding sources to originate new loans, so the inability to sell loans would have a significant adverse effect on Aleritas.
proper levels, then over a long-term period, DB Indemnity expects the amount of claims expense incurred to be approximately the same as the amount of premium revenue recorded.
Aleritas Aleritas is traded on the over-the-counter bulletin board market and has responsibility for meeting its requirements for capital without assistance from us. Aleritas’ lending activities have been funded primarily through loan participation sales, loan sales to qualifying special-purpose entities, on-balance-sheet bank lines of credit and private placement debt offerings. To fund anticipated loan growth, additional common equity, or alternative types of equity, may be required to improve capital-to-asset ratios, fund collateral margin requirements of bank lines of credit, fund increases in loan inventory or fund purchases of securities associated with loans sold to qualifying special-purpose entities. However, Aleritas does not intend to rely on additional equity capital investments from us and has solicited capital investments from other investors.
Brooke Bancshares We contributed $10,000,000 to Brooke Bancshares’ equity in January 2007 to fund the purchase of Brooke Savings Bank (formerly Generations Bank). Brooke Savings Bank acquired a banker agent network in January, 2008 that significantly increased Brooke Savings Bank assets and which required an additional $5,000,000 capital contribution which was funded by issuance of debt by Brooke Bancshares. We have committed to the Office of Thrift Supervision that we will ensure that Brooke Savings Bank meets certain minimum capital standards and additional capital contributions from us may be required for this purpose. Brooke Bancshares and Brooke Capital mutually agreed to terminate the previously announced agreement for Brooke Capital to acquire Brooke Savings Bank because part of the rationale for the proposed acquisition was negated by the merger of Brooke Franchise into Brooke Capital.
The following summarizes our contractual obligations as of December 31, 2007 and the effect those obligations are expected to have on our liquidity and cash flow in future periods (in thousands):
Includes interest on short-term and long-term borrowings. For additional information on the debt associated with these interest payments see footnotes 4 and 5 to our consolidated financial statements.
We believe that the following accounting policies are critical. These accounting policies are more fully explained in the referenced footnote 1 to our consolidated financial statements for the years ended December 31, 2007, 2006 and 2005.
The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and expenses. The following discussions summarize how we identify critical accounting estimates, the historical accuracy of these estimates, sensitivity to changes in key assumptions, and the likelihood of changes in the future. The following discussions also indicate the uncertainties in applying these critical accounting estimates and the related variability that is likely to result in 2008.
An estimate of franchisees’ shares of undistributed commissions is made based on historical rates of commission payout, management’s experience and the trends in actual and forecasted commission payout rates. Although commission payout rates will vary, we do not expect significant variances from year to year. We regularly analyze and, if necessary, immediately change the estimated commission payout rates based on the actual average commission payout rates. The commission payout rate used in 2007 to estimate franchisees’ share of undistributed commissions was 85% and the actual average commission payout rate to franchisees (net of profit sharing commissions) was 79% for the year ended December 31, 2007. We believe that these estimates will not change substantially during 2008.
revenues have experienced a significant decline resulting in inadequate repayment ability and/or collateral support, the amount of loans in which material change in an obligor’s or guarantor’s financial condition has occurred or is expected to occur, the amount of start up franchise loans that have matured and the borrower has not achieved the required minimum monthly commission benchmark, and management’s experience. Claim payments will vary and significant growth in the issuance of financial guaranty insurance policies or changes in policy underwriting could accelerate those variances. The effect of any such variances can be significant. The estimated reserve for insurance claims as of December 31, 2007 was $600,000. For the years ended December 31, 2007 and 2006, DB Indemnity incurred $826,000 and $260,000, respectively in claims or loss expense. No prior claims or loss expense were incurred since beginning operations in 2003.
Discount, Prepayment and Credit Loss Rates Used to Record Loan Participation Sales and Loan Sales to Qualifying Special-Purpose Entities We regularly sell the loans that we originate to banks, finance companies and qualifying special-purpose entities. Accounting for the sale of these loans and the subsequent tests for impairment are summarized in footnote 2 to our consolidated financial statements for the years ended December 31, 2007, 2006 and 2005.
Loan participations and the sale of loans to qualifying special-purpose entities represent the transfer of notes receivable, by sale, to participating lenders or qualifying special-purpose entities. The fair value of retained interests and servicing assets resulting from the transferred loans are recorded in accordance with SFAS 140. Most of our loans are adjustable rate loans. When we sell notes receivable to qualifying special-purpose entities, it retains all over-collateralization interest in loans sold and cash reserves. The fair value of the over-collateralization interests in loans sold to qualifying special purpose entities that have issued asset-backed securities has been estimated at the par value (carrying value) of the underlying loans less the asset-backed securities sold. The fair value of the over-collateralization interests in loans sold to qualifying special purpose entities that have secured bank debt is based on the present value of future expected cash flows using management’s best estimates of key assumptions, which at December 31, 2007, were: credit losses (0.50% annually), prepayment speed (12.00% annually) and discount rate (11.00%) commensurate with the risk involved. The fair value of the cash reserves is estimated at the cash value of the reserve account.
We tested retained interests for impairment as of December 31, 2007. The securitized pools of loans experienced an increase in the prepayment rate, and as a result, management determined that an “other than temporary” impairment occurred. An impairment loss of $778,000 was recorded for the year then ended. During 2006 the securitized pools of loans experienced an increase in the prepayment rate as well and an impairment loss of $329,000 was recorded for the year. The effect of variances in the assumptions can be significant and the impact of changes in these estimates is discussed in Note 3 to the Consolidated Financial Statements in Item 8 of this Form 10-K.
However, given the rapid growth that we have experienced over the past two years, the seasoning of the loan portfolio, an increase in delinquencies of on-balance sheet loans and management’s expectation that loans will be held longer than previously (for nine to twelve months) before being sold; we established a reserve for potential loan losses on the on-balance sheet loans in the third quarter of 2007. The reserve for credit losses includes two key components: (1) loans that are impaired under SFAS No. 114, “Accounting by Creditors for Impairment of a Loan - an amendment of FASB Statements No. 5 and 15” and (2) reserves for estimated losses inherent in the rest of the portfolio based upon historical and projected credit risk. A reserve of $1,655,000 was established with an offsetting charge to credit loss expense. Management will evaluate the adequacy of the reserve on an ongoing basis in the future utilizing the credit metrics underlying the reserve.
The rates of amortization of servicing assets are based on our estimate of repayment rates, and the resulting estimated maturity dates, of the loans that we service. Loan repayment rates are determined using assumptions about credit losses, prepayment speed and discount rates as outlined in the discussion above about the fair values of servicing assets. As of December 31, 2007, an analysis of prepayment speeds and credit losses indicated that our assumptions were historically accurate and the maturity date estimates were reasonable. Although significant changes in estimates are not expected, because of the relatively large
Loan Origination Expenses Aleritas typically sells loans soon after origination and retains responsibility for loan servicing. Loan origination fees charged to borrowers are offset against loan origination expenses incurred during the underwriting and placement of loans and are, therefore, not recorded as revenues. If in the event loan originations fees exceed direct loan origination expenses, the excess will be reported as income. Loan origination fees reimburse Aleritas for cash outflows associated with the up-front issuance costs such as financial guaranty policy premiums, travel expenses for location inspections or meetings with borrowers, and placement of the loans to outside investors.
Income Tax Expense An estimate of income tax expense is based primarily on historical rates of actual income tax payments. The estimated effective income tax rate used in 2007 to calculate income tax expense was 38%. Although not expected, significant changes in our estimated tax rate could significantly impact our results. We believe this estimate will not change significantly during 2008.
Revenue Recognition Policies Revenue recognition is summarized in footnote 1(e) to our consolidated financial statements for the years ended December 31, 2007 and 2006.
With respect to the previously described critical accounting policies, we believe that the application of judgments and assumptions is consistently applied and produces financial information which fairly depicts the results of operations for all years presented.
At December 31, 2007, 2006 and 2005, we had transferred assets with balances totaling $541,948,000, $319,125,000 and $233,473,000, respectively, that were accounted for as true sales, resulting in pre-tax gains for the years ended December 31, 2007, 2006 and 2005 of $14,379,000, $7,423,000 and $7,435,000, respectively. Purchasers of these notes receivable obtained full control over the transferred assets (i.e. notes receivable) and obtained the right, free of conditions that constrain it from taking advantage of that right, to pledge or exchange the notes receivable. Furthermore, the agreements to transfer assets do not entitle, or obligate, us to repurchase or redeem the notes receivable before their maturity except in the event of an uncured breach of a representation or warranty.
At December 31, 2007 and 2006, we recorded the value of the servicing asset at $6,025,000 and $4,512,000, respectively, and the value of the servicing liability at $16,000 and $24,000, respectively. At
Components of the loan servicing asset, servicing liability, interest receivable asset relating to loan participation sales as of December 31, 2007 were as follows (in thousands):
Retained Securities The terms of Aleritas’ securitizations require the over-collateralization of the pool of loan assets that back the securities sold to investors. Aleritas retains ownership of the resulting subordinate interest in the loan pool and borrows money from commercial banks to fund this investment. As such, our retained interest is subject to credit and prepayment risks on the transferred assets. As of December 31, 2007, Aleritas had subordinate investment interest in loan pools totaling $34,318,000, part of which is the carrying value of our retained interest in asset-backed securities.
The actual prepayment rate on our loans increased to approximately 12.9% during the year ended December 31, 2007 primarily due to the increased asset ownership transfers to other borrowers within Aleritas’ portfolio, new loan documents being executed on existing loans to improve security interests and the increasing interest rate environment. The Company expects that, over the remaining life of the loan portfolio, several cycles of increasing and decreasing prepayment rates will likely occur, primarily resulting from fluctuations in key interest rates and changes in the marketplace. The securitized pools of loans experienced an increase in the prepayment rate, and as a result, management determined that an “other than temporary” impairment occurred. An impairment loss of $778,000 was recorded for the year then ended. During 2006 the securitized pools of loans experienced an increase in the prepayment rate as well and an impairment loss of $329,000 was recorded for the year.
In addition, we conduct sensitivity analysis to evaluate the potential impact of a 10% to 20% change in the key economic assumptions used in valuing our retained interest and servicing assets. These key economic assumptions include prepayment speed, expected credit losses and discount rate. As of December 31, 2007, an increase in these key economic assumptions by 10% to 20% generally results in decreases of 1% to 7% in the value of the retained interest and servicing assets. More drastic changes to economic and market conditions than those we have modeled would likely lead to greater diminution in the value of the retained interest and servicing assets.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Brooke Corporation as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Brooke Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Brooke Capital Corporation, formerly First American Capital Corporation, is a Kansas corporation. The primary business purpose of this majority-owned subsidiary is franchising insurance and related businesses and providing services to its franchisees through its network of regional offices, service centers and sales centers. In addition, it provides consulting services to business sellers and collateral preservation assistance to lenders. Through its wholly-owned subsidiary, Brooke Capital Advisors, it uses its industry contacts and expertise in insurance brokerage to broker loans for, and consult with, managing general agencies and those that own insurance companies, specializing in hard-to-place insurance sales, captive insurance agencies and funeral homes. The Company will also use its expertise to preserve collateral and monitor insurance agency borrowers on behalf of lenders. Its wholly-owned life insurance subsidiary, First Life America Corporation, a licensed insurance company, distributes a broad range of individual life and annuity insurance products to individuals in eight states. First Capital Venture, Inc. is a shell company with no operations and no plans for operations at this time. The operations and results of Brooke Capital Corporation are included in the insurance services business segment. The Company owns 81% of Brooke Capital Corporation which has been listed on the American Stock Exchange since August 30, 2007 under the symbol, “BCP”. On November 15, 2007, Brooke Capital Corporation completed a merger pursuant to an Agreement and Plan of Merger dated August 31, 2007, as amended (the “Merger Agreement”), by and among Brooke Capital Corporation, Brooke Corporation and Brooke Franchise Corporation. Pursuant to the Merger Agreement, Brooke Franchise Corporation was merged with and into Brooke Capital Corporation, with Brooke Capital Corporation continuing as the surviving corporation.
The DB Group, Ltd. and DB Indemnity, Ltd. subsidiaries were incorporated in the country of Bermuda as captive insurance companies. Separate financial statements are prepared for Bermuda subsidiaries as required by the Bermuda government. The captive insurance company subsidiaries are wholly owned by Brooke Brokerage and profits are not typically distributed as dividends.
insurance claims. Christopher Joseph & Company operated retail insurance offices in Missouri, Kansas, Florida and Oklahoma, marketing personal and commercial products for Traders Insurance Company and other non-affiliated insurance companies. Such retail offices have been or are planned to be franchised as Brooke franchise offices.
Subsidiaries have been established for contractual operations but, during 2007, any revenues generated by these subsidiaries are assigned to one of the operating subsidiaries for performance of any associated obligations. These subsidiaries include Brooke Life and Health, Inc., The American Heritage, Inc., The American Agency, Inc., Brooke Credit Funding LLC, Brooke Canada Funding, Inc., Brooke Warehouse Funding, LLC, and First Brooke Insurance and Financial Services, Inc.
Changes in assumptions related to policy and contract liabilities and related deferred acquisition costs
Allocation of payroll and operating expenses associated with the origination and servicing of loans
The credit metrics employed to establish the reserve for potential credit losses.
It is at least reasonably possible these estimates will change in the near term.
The allowance for loan losses is maintained at a level believed to be appropriate by management to provide for probable loan losses inherent in the portfolio as of the balance sheet date. While management uses available information to recognize probable losses on loans in the portfolio, future additions to the allowances may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. Such agencies may require Brooke Savings Bank to recognize additions to the allowance based on their judgments of information available to them at the time of their examination.
The Company estimates that a certain level of accounts receivable, primarily franchisee account balances, will be uncollectible; therefore, allowances of $1,114,000 and $1,466,000 at December 31, 2007 and December 31, 2006, respectively, have been established. The Company’s franchise subsidiary regularly assists its franchisees by providing commission advances during months when commissions are less than expected, but expects repayment of all such advances within four months. At December 31, 2007, the amount of allowance was determined after analysis of several specific factors, including franchise advances classified as “watch” status.
strip receivables resulting from loans that are sold. Historically, no reserve for credit losses has been made for on-balance sheet loans held in inventory for eventual sale for two reasons. First, these loans were typically held for six to nine months before being sold to investors and, therefore, had a short-term exposure to loss. Second, commissions received by the affiliated company, Brooke Capital Corporation, are typically distributed to Brooke Credit Corporation for loan payments prior to distribution of commissions to the franchisee borrower and most other creditors. However, given the rapid growth that Brooke Credit Corporation has experienced over the past eighteen months, the seasoning of the loan portfolio, an increase in delinquencies of on-balance sheet loans and management’s expectation that loans will be held longer than previously (for nine to twelve months) before being sold; Brooke Credit Corporation has established a reserve for potential loan losses on the on-balance sheet loans. The reserve for credit losses includes two key components: (1) loans that are impaired under SFAS 114, “Accounting by Creditors for Impairment of a Loan - an amendment of FASB Statements No. 5 and 15” and (2) reserves for estimated losses inherent in the rest of the portfolio based upon historical and projected credit risk. A reserve of $1,655,000 was established with an offsetting charge to loan loss expense. Management will evaluate the adequacy of the reserve on an ongoing basis in the future utilizing the credit metrics underlying the reserve.
In the event of cancellation or reduction in premiums, for policies billed by an insurance carrier, a percentage of the commission revenue is often returned to the insurance carrier and revenues are correspondingly reduced. The commission refunds are calculated by the insurance carriers and are typically deducted
Interest income, net. The Company recognizes interest income when earned. A portion of the interest income received on loans is paid to the holders of its participation interests and qualifying special purpose entities. Payments to these holders are accounted for as participating interest expense, which is netted against gross interest income. Participating interest expense was $32,362,000, $23,581,000, and $12,432,000 for the years ended December 31, 2007, 2006 and 2005, respectively. Cash received from the off-balance sheet facility is recorded as interest income by pool using the interest yield of each pool. Any excess cash received over the yield is applied to the securities balance or other comprehensive income.
Premiums. Premiums are recorded on the written basis and recorded as revenues over the term of the policies. Unearned premium reserves are established to cover the unexpired portion of premiums written and assumed and revenues are correspondingly reduced.
For limited payment and other traditional life insurance policies, premium income is reported as earned when due. Profits are recognized over the life of these contracts by associating benefits and expenses with insurance in force for limited payment policies and with earned premiums for other traditional life policies. This association is accomplished by a provision for liability for future policy benefits and the amortization of policy acquisition costs.
On July 1, 2002, the Company acquired 100% of the outstanding ownership interests of CJD & Associates, L.L.C. and $1,417,000 of the initial purchase price was allocated to renewal rights. The sellers may be entitled to an increase of the initial purchase price based on the amount of monthly net revenues received in future periods. In accordance with FAS 141, “Business Combinations,” any such payments for an increased purchase price will be recorded as Amortizable Intangible Assets when made. Additional payments of the purchase price have been made in the amount of $3,283,000 since the initial purchase.
As a result of the acquisition of CJD & Associates, L.L.C. on July 1, 2002, the Company recorded additional Amortizable Intangible Assets of $26,000 (net of accumulated amortization of $169,000).
On November 30, 2003, CJD & Associates, L.L.C. acquired 100% of the outstanding shares of Texas All Risk General Agency, Inc. and T.A.R. Holding Co., Inc. which collectively owned 100% of the outstanding shares of All Risk General Agency, Inc. and $1,000,000 of the initial purchase price was allocated to Amortizable Intangible Assets. The sellers were entitled to an increase of the initial purchase price based on the amount of monthly net revenues received in future periods. In accordance with FAS 141, “Business Combinations,” any such payments for an increased purchase price will be recorded as Amortizable Intangible Assets when made. Additional payments of the purchase price have been made in the amount of $1,352,000 since the initial purchase. On November 30, 2005, CJD & Associates, L.L.C. sold 100% of the outstanding shares of Texas All Risk General Agency, Inc. and T.A.R. Holding Co., Inc. to an unrelated purchaser. See footnote 11 for additional disclosure regarding this sale.
In February 2004, the Company acquired insurance agency renewal rights from Brent and Haeley Mowery for $499,000. This agency was subsequently sold to a franchisee in July 2005 for $499,000, which resulted in a gain on sale of $68,000 from amortization recorded in prior periods.
entire business unit. Fair value estimations are based on comparable sales information that takes into consideration business characteristics such as customer type, customer account size, supplier size and billing methods.
value $1.00 per share, which are convertible initially into 1,176,471 shares of the Company’s common stock at a price of $17.00 per share, subject to anti-dilution adjustments. The stated value per share is $1,000. The gross proceeds of the offering were $14,600,000, before expenses and underwriter commissions and after a discount of $5,400,000.
On March 30, 2007 the Company purchased Delta Plus Holdings, Inc. The balance sheet accounts at December 31, 2007 and results of operations since March 30, 2007 are included in the Company’s consolidated financial statements.
The accompanying consolidated financial statements have been prepared on the basis of accounting principles generally accepted in the United States of America (GAAP). All significant intercompany accounts and transactions have been eliminated in consolidation of the financial statements.
The Company has purchased certain lottery prize cash flows, representing the assignments of the future payment rights from lottery winners at a discounted price. Payments on these cash flows will be made by state run lotteries and as such are backed by the general credit of the respective states. At December 31, 2007 and 2006, the carrying value of these other assets was approximately $3,527,000 and $3,067,000, respectively.
The carrying values of securities were $89,634,000 and $50,322,000 at December 31, 2007 and 2006, respectively, and consisted primarily of three types of securities (or retained residual assets): interest-only strip
In March 2007, the Company purchased 748,000 shares of Northern Capital, Inc. Class B Convertible Preferred Stock at a price of $2.50 per share for a carrying value of $1,870,000. Northern Capital, Inc. is a managing general agent that owns a Florida insurance company. In June 2007, the Company purchased 850,000 shares of Oakmont Acquisition Corp. common stock at an average price per share of $5.76 for a carrying value of $4,894,000. In July of 2007, Oakmont merged with Brooke Credit Corporation.
Upon the sale of financial assets to qualifying special purpose entities, the unaffiliated trustees over the qualifying special purpose entities and the investors and lenders to the qualifying special purpose entities obtain full control over the assets and obtain the right to freely pledge or transfer the notes receivable. Servicing associated with the transferred assets is primarily the responsibility of unaffiliated servicing companies, which are compensated directly from cash flows generated from the transferred assets. The Company is retained as a secondary or sub-servicer. No servicing asset or servicing liability is recorded because servicing income is offset by servicing expense and represents the adequate compensation as determined by the market.
Although the Company does not provide recourse on the transferred notes and is not obligated to repay amounts due to investors and creditors of the qualifying special purpose entities, its retained assets are subject to loss, in part or in full, in the event credit losses exceed initial and ongoing management assumptions used in the fair market value calculation. Additionally, a partial loss of retained assets could occur in the event actual prepayments exceed management’s initial and ongoing assumptions used in the fair market calculation. In the fourth quarter of 2007, the Company wrote down the value of the securities balance by $5,517,000 due to expected credit losses on loans in its securitizations, actual prepayments exceeding assumed prepayments, and an increase in the prepayment assumption going forward.
Subsequent to the initial calculation of the fair value of retained interest, the Company utilizes a fair market calculation methodology (utilizing the same methodology used to establish the initial fair value) to determine the ongoing fair market value of the retained interest. Ongoing fair value is calculated using the then current outstanding principal of the transferred notes receivable and the outstanding balances due unaffiliated purchasers, which are reflective of credit losses and prepayments prior to the fair value recalculation. Additionally, the Company completes an ongoing analysis of key assumptions used in the fair market value calculation to ensure that such assumptions used in the calculation are viable, based on current and historical prepayments and credit loss trends within similar asset types. Based upon this analysis and due to recent prepayment trends, the prepayment rate assumption used in the asset valuation was increased from 10% to 12% annually in the fourth quarter of 2007. All other assumptions remained the same. Management may make necessary adjustments to key assumptions based on current and historical trends, which may result in an immediate reduction or impairment loss in the fair market value of retained interest. During 2007 and 2006, the securitized pools of loans experienced an increase in the prepayment rate, and as a result, management determined that an “other than temporary” impairment occurred. The Company recorded an impairment losses related to the prepayment rate of $778,000 and $329,000, respectively, for the years ended December 31, 2007 and 2006. Summarized in footnote 2 is a sensitivity analysis or stress test on retained interests to determine the impact of a 10% and 20% variance in key assumptions currently used by management to calculate the fair value of retained interests.
The Company classifies the investment securities portfolios between those securities intended to be held to maturity, those securities available-for-sale, and those securities held for trading purposes.
Investment securities classified as held-to-maturity are those securities which the Company has the ability and positive intent to hold to maturity regardless of changes in market condition, liquidity needs, or changes in general economic conditions. These securities are stated at cost, adjusted for amortization of premiums and accretion of discounts, over the period to maturity using the interest method.
Investment securities classified as available-for-sale are those securities that the Company intends to hold for an indefinite period of time, but not necessarily to maturity. Any decision to sell a security classified as available-for-sale would be based on various factors, including significant movements in interest rates, liquidity needs, regulatory capital considerations, and other similar factors. These securities are carried at fair value with unrealized gains or losses reported as increases or decreases in accumulated other comprehensive income, net of the related deferred tax effect.
Operating interest expense includes interest paid by the Company’s finance subsidiary to DZ BANK AG Deutsche Zentral-Genossenschaftsbank, Fifth Third Bank, and Home Federal Savings and Loan Association of Nebraska on line of credit loans for the purpose of originating insurance agency loans, originating funeral home loans and financing the over-collateralization portion of loans funded with the other lines of credit, and is, therefore, an operating expense. The interest paid on these lines of credit for the years ending December 31, 2007, 2006 and 2005 was $2,919,000, $3,125,000, and $1,675,000, respectively. The finance subsidiary also paid interest to bondholders until the bonds were called in August 2005 and paid in full. The funds received from the sale of the bonds were for the purpose of originating loans and the associated interest expense is, therefore, an operating expense. Bond interest expenses for the years ended December 31, 2007, 2006 and 2005 were $0, $0 and $245,000, respectively. The Company also paid interest to debenture holders until the debentures were called and paid in full in December 2005. The funds received from the sale of debentures were used by the finance subsidiary to originate loans and the associated interest expense is, therefore, an operating expense. The debenture interest expenses for the years ended December 31, 2007, 2006 and 2005 were $0, $0 and $202,000, respectively.
value of the stock option: expected stock volatility of 10%; risk-free interest rate of 5%; and dividend rate of 1%. See footnote 12 for additional disclosures.
The aggregate carrying values of interest-only-strip receivables were $7,749,000 and $4,497,000 at December 31, 2007 and 2006, respectively. Interest-only strip receivables represent the fair value of an asset resulting from the sale of notes receivable to a participating bank. The amount of unrealized gain (loss) on the interest-only strip receivable was $273,000 and $94,000 and ($93,000) at December 31, 2007, 2006 and 2005, respectively. The interest-only strip receivables have varying maturities ranging from the second quarter of 2010 to the fourth quarter of 2026.
The fair values for investments in fixed maturities are based on quoted market prices.
Brooke Savings Bank has blanket collateral agreements with the Federal Home Loan Bank in order to obtain advances. At December 31, 2007, overnight advances of $9,522,000 were outstanding and secured by qualifying mortgage-backed securities, with fair values of approximately $13,293,000.
Included in investments are securities, which have been pledged to various state insurance departments. The fair values of these securities were $4,842,000 and $2,061,000 at December 31, 2007 and 2006, respectively.
There are a number of significant risks and uncertainties inherent in the process of monitoring impairments and determining if an impairment is other-than-temporary. These risks and uncertainties include: (1) the risk that the Company’s assessment of an issuer’s ability to meet all of its contractual obligations will change based on changes in the credit characteristics of that issuer, (2) the risk that the economic outlook will
The Company owned 191 and 68 securities that were in an unrealized loss position at December 31, 2007 and 2006 respectively. The following tables provide information regarding unrealized losses on investments available for sale, as of December 31, 2007 and 2006.
Policy claim liabilities represent the estimated liabilities for claims reported plus claims incurred but not yet reported. The liabilities are subject to the impact of actual payments and future changes in claim factors.
Policyholder premium deposits represent premiums received for payment of future premiums on existing policyholder contracts. Interest was credited on these deposits at a rate of 4 percent in 2007 and 2006,
respectively. The premium deposits are recognized as an increase in a liability rather than premium income. Interest credited on the premium deposits is recognized as an expense.
SFAS 150 requires the detachable warrants issued to the noteholders to be classified as a liability since warrants incorporated a put option. The holders of these warrants could exercise their rights to force Brooke Credit Corporation to repurchase the warrants and/or warrant shares at the appraised value of the common stock, less the warrant exercise price of $0.01 per share. The fair market value of the warrants at the close of the offering, on November 1, 2006, was $2,737,000, using a valuation model obtained from a third-party valuation expert.
As of December 31, 2007, scheduled maturities of certificates of deposit and IRA accounts are shown below:
As of December 31, 2007, there were 26 certificate of deposit accounts of $100,000 or more totaling $4,627,000. These deposits are insured up to $100,000 by the Deposit Insurance Fund (DIF), which is administered by the Federal Deposit Insurance Corporation and is backed by the full faith and credit of the U.S. government.
Regulations of the Federal Reserve System require reserves to be maintained by all banking institutions according to the types and amounts of certain deposit liabilities. These requirements restrict usage of a portion of Brooke Savings Bank’s available cash balances from everyday usage in its operations. The minimum reserve requirements as of December 31, 2007 totaled $157,000.
At December 31, 2007 and 2006, accounts and notes receivable consist of the following:
The transfers that do not meet the criteria established by SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” are classified as secured borrowings and the balances are recorded as both a note receivable asset and participation payable liability. At December 31, 2007 and December 31, 2006, secured borrowings totaled $39,452,000 and $26,849,000, respectively.
In April 2003, Brooke Credit Corporation sold $15,825,000 of loans to qualifying special purpose entity Brooke Acceptance Company LLC. This sale represents a loan securitization for which an interest receivable was retained. Of the loans sold, $13,350,000 of asset-backed securities were issued to accredited investors by Brooke Acceptance Company LLC. Brooke Credit Corporation received servicing income of $3,000, $6,000 and $8,000, respectively, from the primary servicer for the years ended December 31, 2007, 2006 and 2005. The fair value of the interest-only strip receivable retained, the fair value of the difference between loans sold
In July 2006, the Company sold $65,433,000 of loans to qualifying special purpose entity Brooke Securitization Company 2006-1, LLC. The sale represents a loan securitization in which an interest receivable was retained. Of the loans sold, $52,346,000 of asset-backed securities were issued to an accredited investor by Brooke Securitization Company 2006-1, LLC. The Company received servicing income of $59,000 and $28,000, respectively, from the primary servicer for the years ending December 31, 2007 and 2006. The fair value of the interest-only strip receivable retained, the fair value of the difference between loans sold and securities issued to the accredited investor (or the retained equity) and the fair value of cash reserves were recorded on the Company’s books as a security with a balance of $13,977,000 and $16,660,000, respectively, on December 31, 2007 and 2006. At December 31, 2007, this security is comprised of retained interest-only strip receivables totaling $3,227,000, retained equity in the special purpose entity totaling $10,575,000 and cash reserves totaling $175,000.
In March 2007, Brooke Credit Corporation initiated a $150,000,000 facility to sell, on a revolving basis, a pool of its loans, while retaining residuals assets such as interest-only strip receivables and a subordinated over-collateralization interest in the receivables. The eligible receivables are sold to Brooke Warehouse Funding, LLC, a wholly owned bankruptcy-remote special purpose entity, without legal recourse to Brooke Credit Corporation. Brooke Warehouse Funding, LLC then entered into a participation agreement with Brooke Acceptance Company 2007-1, LLC to sell an undivided senior participation interest in all of the assets of Brooke Warehouse Funding, LLC. Brooke Acceptance Company 2007-1, LLC entered into an amended and restated receivables financing agreement with Fifth Third Bank which extended a credit facility to Brooke Acceptance Company 2007-1 LLC to provide funds to acquire such participation interests with a facility line of credit of $150,000,000. The facility qualifies for true sale treatment under SFAS 140. As of December 31, 2007, the outstanding balance of sold accounts receivable held by Brooke Warehouse Funding, LLC and participated to Brooke Acceptance Company 2007-1, LLC totaled $181,093,000 which were removed from the consolidated balance sheet at that date. The fair value of the difference between loans sold and advanced portion on the facility, or the fair value of retained residual assets, were recorded on the Company’s books as a security with balances of $53,445,000 on December 31, 2007. This retained security is comprised of retained interest-only strip receivable totaling $18,937,000 and retained over-collateralization interests in the special purpose entity totaling $34,508,000. The Company received servicing income as sub-servicer of the facility of $150,000 for the year ended December 31, 2007. The facility contains the following financial covenants: minimum stockholders’ equity of $80 million, positive consolidated net income for the four fiscal quarter period then ending, maximum prepayment rate on the Company’s loan portfolio of 20%; maximum loan loss rate of 1.5%; minimum fixed charge coverage ratio as scheduled; maximum cash leverage ratio as scheduled; and maximum total leverage ratio as scheduled. The facility contains other restrictions, including but not limited to: the incurrence of indebtedness and liens; the reorganization, transfer and merger of the Company; the disposal of its properties other than in the ordinary course of business; entering into transactions with affiliates or into material agreements other than in the ordinary course of business; entering into pledge and negative pledge agreements; and the declaration of dividends, except in limited circumstances.
$7,749,000 was listed as interest-only strip receivable on the Company’s balance sheet and $28,144,000 in retained interest-only strip receivable carried in the Company’s securities. Of the totals at December 31, 2006, $4,497,000 was listed as interest-only strip receivable on the Company’s balance sheet and $12,094,000 in retained interest-only strip receivables carried in the Company’s securities.
Of the business and real estate loans at December 31, 2007 and December 31, 2006, $130,000 and $2,247,000, respectively, in loans were sold to various participating lenders with recourse to Brooke Credit Corporation. Such recourse is limited to the amount of actual principal and interest loss incurred and any such loss is not due for payment to the participating lender until such time as all collateral is liquidated, all actions against the borrower are completed and all liquidation proceeds applied. However, participating lenders may be entitled to periodic advances from Brooke Credit Corporation against liquidation proceeds in the amount of regular loan payments. At December 31, 2007, all such recourse loans: a) had no balances more than 60 days past due; and b) had adequate collateral. No recourse loan participations were in default at December 31, 2007.
During the fourth quarter of 2005 the discount rate assumption was changed from 8.50% to 11.00%.
During the fourth quarter of 2005, the discount rate assumption was changed from 8.50% to 11.00%.
The following table presents quantitative information about the Company managed portfolio, including balances, delinquencies and net credit losses at and for the years ended December 31, 2007 and December 31, 2006. At and for the years ended December 31, 2007 and December 31, 2006, the related party notes did not have any principal amounts 60 or more days past due, nor were there any credit losses on the related party notes.
The note payable to Home Federal Savings and Loan Association of Nebraska contains the following covenant: maintain a minimum stockholders’ equity of $40,000,000 in Brooke Credit Corporation.
(a) regulatory status, (b) outstanding litigation, (c) liquidity and (d) solvency; and (2) the Company and certain of its subsidiaries shall maintain minimum tangible net worth, as defined in the relevant agreement.
Interest incurred on bank loans, notes payable and other long-term obligations for the years ended December 31, 2007, 2006 and 2005 was $14,585,000, $9,834,000 and $5,842,000, respectively.
For the year ended December 31, 2007, income of $519,000 was earned in Bermuda and is included in the Company’s income tax calculation.
The Company has a defined contribution retirement plan in which substantially all employees are eligible to participate. Employees may contribute up to the maximum amount allowed pursuant to the Internal Revenue Code, as amended. The Company provided a 50% matching contribution, up to a maximum contribution per individual of $3,000 for the plan year. During 2007, the Company recorded $348,000 in employer
The tables below reflect summarized financial information concerning the Company’s reportable segments for the years ended December 31, 2007, 2006 and 2005:
Michael S. Lowry, President and Chief Executive Officer of Brooke Credit Corporation, is a co-member of First Financial Group, LC. Kyle L. Garst, Chairman and Chief Executive Officer of Brooke Capital, is the sole manager and sole member of American Financial Group, LLC. In October 2001, First Financial Group, LC and American Financial Group, LLC each guaranteed 50% of a Brooke Credit Corporation loan to The Wallace Agency, LLC of Wanette, Oklahoma and each received a 7.50% profit interest in The Wallace Agency. The loan was originated on October 15, 2001, and is scheduled to mature on January 1, 2014. At December 31, 2007, $88,000 of the principal balance of $283,000 was sold to unaffiliated lenders, leaving the Company with a loss exposure of $195,000. First Financial Group, LC and American Financial Group, LLC each sold its ownership interest in The Wallace Agency back to The Wallace Agency, LLC in March 2007.
On December 8, 2006 the Company closed on a Stock Purchase and Sale Agreement (“2006 Stock Purchase Agreement”) whereby the Company committed, through a series of steps, to acquire an approximate 55% interest in the outstanding shares of First American Capital Corporation (now Brooke Capital Corporation) in exchange for $3,000,000 in cash and execution of a Brokerage Agreement. At closing, the Company acquired an approximate 47% interest in First American’s then authorized, issued and outstanding common stock, for $2,552,000 and executed and delivered the Brokerage Agreement. As part of the closing, Brooke Capital Corporation issued Brooke Corporation a warrant to purchase the additional shares of common stock for $448,000, such shares to be authorized for issuance pursuant to forthcoming amendments to its Articles of Incorporation. Brooke Capital Corporation’s Articles of Incorporation were amended on January 31, 2007 and Brooke Corporation exercised the Warrant on the same day. On November 15, 2007, the Company completed a merger with Brooke Franchise Corporation (“Brooke Franchise”) which was then a wholly-owned subsidiary of Brooke Corporation. Pursuant to the Merger Agreement, Brooke Franchise was merged with and into the
Coincident with the closing of the 2006 Stock Purchase Agreement, other warrants previously issued by First American Capital Corporation and held by Brooke Corporation were cancelled.
The Bank operates under the name Brooke Savings Bank and its operations are conducted through contracted bank agents, who leverage existing relationships with Brooke Capital Corporation franchisees and other independent insurance agents and professionals by providing products and services. The Bank’s main retail banking office was relocated from Kansas City, Missouri to Phillipsburg, Kansas, and its administrative offices were relocated to Overland Park, Kansas.
On January 8, 2007, the fair values of the major assets and liabilities acquired in this transaction are as follows (in thousands):
As previously indicated, the Bank’s results of operations have been included in the accompanying consolidated financial statements since its acquisition on January 8, 2007. Accordingly, the following information as reported for the year ended December 31, 2007 is presented along with pro forma information for the year ended December 31, 2006, assuming the acquisition took place on January 1, 2006:
In March 2007, the Company purchased 100% of the common stock of Delta Plus Holdings, Inc. for a total purchase price of $13,500,000, plus net tangible book value at closing.
During May 2007, Brooke Capital acquired a 100% interest in Brooke Investments, Inc., from Brooke Corporation. Brooke Investments acquires real estate for lease to franchisees, for corporate use and other purposes. See Note 5 for more information regarding the Company’s operating leases.
binomial option pricing model. The weighted-average assumptions used and the estimated fair value are as follows:
At December 31, 2007, there were no additional shares available for the grant of stock options under the Brooke Corporation 2001 Compensatory Stock Option Plan (“2001 Plan”), as the 2001 Plan terminated on April 27, 2006, except with respect to stock options then outstanding, upon the adoption on that date by the Company’s shareholders of the 2006 Brooke Corporation Equity Incentive Plan (“2006 Plan”). The 2006 Plan includes stock options, incentive stock options, restricted shares, stock appreciation rights, performance shares, performance units and restricted share units as possible equity compensation awards. The 2006 Plan provides that a maximum of 500,000 shares of common stock may be issued pursuant to awards granted under such Plan. Awards of 59,570 restricted shares and incentive stock options to purchase 64,750 shares of common stock are outstanding under the 2006 Plan and accordingly, at December 31, 2007 there were 375,680 shares available for granting of stock-based awards under the 2006 Plan.
52,602 options to purchase shares were exercisable at December 31, 2007. The following table summarizes information concerning outstanding and exercisable options at December 31, 2007.
for impairment. There were no other intangible assets with indefinite useful lives as of December 31, 2007, and December 31, 2006. The intangible assets with definite useful lives had a value of $18,781,000 and $11,538,000 at December 31, 2007, and December 31, 2006, respectively. Of these assets, $6,025,000 and $4,512,000, respectively, were recorded as a servicing asset on the balance sheet. The remaining assets were included in “Other Assets” on the balance sheet. Amortization expense was $2,649,000, $1,204,000 and $1,612,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
Amortization expense for amortizable intangible assets for the years ended December 31, 2008, 2009, 2010, 2011 and 2012 is estimated to be $1,904,000, $1,566,000, $1,338,000, $1,153,000 and $990,000, respectively.
Business inventory increased from December 31, 2006 to December 31, 2007. During the years ended December 31, 2007, 2006 and 2005, the statements of cash flows reflect the purchase of businesses into inventory provided by sellers totaling $12,926,000, $12,221,000 and $14,318,000, respectively, the write down to realizable value of inventory of $300,000, $975,000 and $0, respectively, and the change in inventory of $7,080,000, $2,725,000 and $4,036,000, respectively. Payments on seller notes were $12,541,000 and $16,211,000 in 2007 and 2006, respectively.
DB Indemnity, Ltd. is also required to maintain a minimum liquidity ratio whereby the value of its relevant assets are not less than 75% of the amount of its relevant liabilities. Relevant assets include cash and deposits, investment income accrued and insurance balances receivable. Certain categories of assets do not qualify as relevant assets under the statute. The relevant liabilities are total general business insurance reserves
and total other liabilities, less sundry liabilities. DB Indemnity, Ltd. was required to maintain relevant assets of at least $3,123,000 and $2,017,000 at December 31, 2007, and 2006, respectively. At December 31, 2007 and 2006, relevant assets were $6,901,000 and $5,099,000, respectively. The minimum liquidity ratio was, therefore, met.
The DB Group, Ltd. was required to maintain relevant assets of at least $35,000 and $65,000 at December 31, 2007, and 2006, respectively. At December 31, 2007 and 2006, relevant assets were $1,520,000 and $1,349,000, respectively. The minimum liquidity ratio was, therefore, met.
First Life America Corporation (“FLAC”), the life insurance subsidiary of Brooke Capital Corporation prepares its statutory-basis financial statements in accordance with statutory accounting practices (“SAP”) prescribed or permitted by the Kansas Insurance Department (“KID”). Currently, “prescribed” statutory accounting practices include state insurance laws, regulations, and general administrative rules, as well as the National Association of Insurance Commissioners (“NAIC”) Accounting Practices and Procedures Manual and a variety of other NAIC publications. “Permitted” statutory accounting practices encompass all accounting practices that are not prescribed; such practices may differ from state to state, may differ from company to company within a state, and may change in the future. During 1998, the NAIC adopted codified statutory accounting principles (“Codification”). Codification replaced the NAIC Accounting Practices and Procedures Manual and was effective January 1, 2001. The impact of Codification was not material to FLAC’s statutory-basis financial statements.
Net income and capital and surplus at December 31, 2007 and 2006 for First Life America Corporation’s insurance operations as reported in these financial statements prepared in accordance with GAAP as compared to amounts reported in accordance with SAP prescribed or permitted by the KID are as follows (in thousands):
Principal differences between GAAP and SAP include: a) costs of acquiring new policies are deferred and amortized for GAAP; b) benefit reserves are calculated using more realistic investment, mortality and withdrawal assumptions for GAAP; c) statutory asset valuation reserves are not required for GAAP; and d) available-for-sale fixed maturity investments are reported at fair value with unrealized gains and losses reported as a separate component of shareholders’ equity for GAAP.
Statutory restrictions limit the amount of dividends, which may be paid by FLAC to Brooke Capital Corporation. Generally, dividends during any year may not be paid without prior regulatory approval, in excess
of the lesser of (a) 10% of statutory shareholders’ surplus as of the preceding December 31, or (b) statutory net operating income for the preceding year. In addition, FLAC must maintain the minimum statutory capital and surplus required for life insurance companies in those states in which it is licensed to transact life insurance business.
The KID imposes on insurance enterprises minimum risk-based capital (“RBC”) requirements that were developed by the NAIC. The formulas for determining the amount of RBC specify various weighing factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by ratio of the enterprises regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Enterprise’s below specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. FLAC has a ratio that is in excess of the minimum RBC requirements; accordingly, the Company’s management believes that FLAC meets the RBC requirements.
The Missouri Insurance Department recognizes only statutory accounting practices prescribed or permitted by the state of Missouri for determining and reporting the financial conditions and results of operation of an insurance company, for determining is solvency under the Missouri law. The National Association of Insurance Commissioners (“NAIC”) Accounting Practices and Procedures Manual version effective January 1, 2001 (“NAIC SAP”) has been adopted as a component of prescribed or permitted practices by the state of Missouri. The state has adopted certain prescribed accounting practices which differ from those found in NAIC SAP. Specifically, the practice which impacts Traders Insurance Company, 1) the state of Missouri does not allow for the admissibility of Electronic Data Processing Equipment unless the aggregate value exceeds $25,000. The Commissioner of Insurance has the right to permit other specific practices which deviate from prescribed practices.
Statutory accounting practices vary from accounting principles generally accepted in the United State (“GAAP”). The more significant variances from GAAP are as follows:
Policy acquisition costs are charged to operations in the year such costs are incurred, rather than being deferred and amortized as premiums are earned over the terms of the policies as would be required under GAAP.
Certain assets, including prepaid expenses, furniture and equipment, certain receivables and portions of the deferred income tax are non admitted for statutory purposes. Changes in non admitted assets are charged directly to surplus.
Reserves for losses, loss adjustment expenses and unearned premium ceded to reinsurers are reported as reductions of related reserves rather than as assets as would be required under GAAP.
Brooke Savings Bank (the “Bank”) is subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of tangible capital (as defined in the regulations) to total tangible assets (as defined), total and Tier 1 capital (as defined) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to adjusted tangible assets (as defined).
Bank management believes that, as of December 31, 2007, the Bank meets all capital adequacy requirements to which it is subject.
As of December 31, 2007, Bank management believes that the Bank meets the requirements to be categorized as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain tangible capital, core (leverage) capital, and total (risk-based) capital ratios as set forth in the table shown below. Since its acquisition on January 8, 2007, the Bank has not received notification from the Office of Thrift Supervision (OTS) regarding its categorization. The Bank’s actual capital amounts and ratios as of December 31, 2007 are also presented in the table:
In connection with its acquisition on January 8, 2007, the Bank committed to operating within the parameters of a three-year business plan and submitting quarterly business variance plan reports to the OTS during that timeframe. That business plan presumes that no dividends will be declared during the three-year
period. In addition, Brooke Corporation has committed to meeting certain minimum consolidated capital-to-assets ratios during the five-year period following the Bank’s acquisition.
The following table shows reconciliation between accounting principles generally accepted in the United States of America (GAAP) capital included in these financial statements and regulatory capital amounts as presented in the previous table:
Traders Insurance Company relies on ceded reinsurance to limit its retained insurance risk. In entering into reinsurance agreements, management considers a variety of factors including the creditworthiness of reinsurers. In preparing financial statements, management makes estimates of amounts receivable from reinsurers which includes considerations of amounts, if any, estimated to be uncollectible by management based on an assessment of factors including an assessment of the creditworthiness of the reinsurers. Management has determined that no provision for uncollectible reinsurance recoveries is necessary as of December 31, 2007.
The financial statements do not reflect various commitments and contingencies which arise in the normal course of Brooke Savings Bank’s business. These commitments and contingencies which represent credit risk, interest rate risk, and liquidity risk, consist of commitments to extend credit, unsecured lending, and litigation arising in the normal course of business.
Commitments to extend credit are agreements to lend to customers as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The same credit policies are used in granting lines of credit as for on-balance sheet instruments. As of December 31, 2007, the Bank had commitments to lend to customers’ unused consumer lines of credit of approximately $914,000.
Various lawsuits have arisen in the ordinary course of the Company’s business. In each of the matters and collectively, the Company believes the ultimate resolution of such litigation will not result in any material adverse impact to the financial condition, operations or cash flows of the Company.
The financial position and results of operations of the Canadian subsidiary are determined using local currency, Canadian dollars, as the functional currency. Assets and liabilities of the subsidiary are translated at the exchange rate in effect at each period end. Income statement accounts are translated at the weighted average rate of exchange during the period. Translation adjustments arising from the use of different exchange rates from period to period are included in the cumulative translation adjustment account which is a piece of the accumulated other comprehensive income within shareholders’ equity. The amount of the gross translation adjustment included in accumulated other comprehensive income at December 31, 2007 and 2006 was $300,000 and $179,000, respectively. The amount of the translation adjustment that was allocated to taxes was $100,000 in 2007 and $68,000 in 2006 which results in a net effect of $200,000 and $111,000 on accumulated other comprehensive income at December 31, 2007 and 2006, respectively.
In September 2006, the FASB issued SFAS 157, “Fair Value Measurements,” which provides enhanced guidance for using fair value measurements in financial reporting. While the standard does not expand the use of fair value in any new circumstance, it has applicability to several current accounting standards that require or permit entities to measure assets and liabilities at fair value. This standard defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. Application of this standard is required for the Company beginning in 2008. It is not anticipated that adoption of this Statement will have a material impact on the Company’s results of operations and financial position.
Pursuant to the Credit Agreement, Brooke Credit will make principal payments in the minimum amount of $875,000 per month over the course of the Loan with the remaining outstanding balance (including any accrued and unpaid interest) due February 28, 2013. Interest on the Loan will accrue at the rate equal to the greater of: (a) 7.25% or (b) the sum of the prime rate as published in the Wall Street Journal and 1.75% per annum.
Brooke Credit and its consolidated subsidiaries must maintain at all times a Tangible Net Worth (as defined in the Credit Agreement): (i) during the first two calendar quarters of 2008, equal to at least $97,500,000; and (ii) at all times thereafter, equal to at least $100,000,000. Brooke Credit must also maintain, at all times, stockholders’ equity determined in accordance with generally accepted account principles equal to at least $110,000,000. The Credit Agreement requires that the Brooke Credit maintain Net Loans (as defined in the Credit Agreement) in an amount not less than the lesser of: (a) the outstanding balance of the Loan and (b) $20,000,000.
Brooke Credit will repurchase the notes at 103.733% of par, or $46,680,000, plus interest accrued to the date of closing;
Brooke Credit and the Purchasers will mutually release each other from any and all claims, upon consummation of the transaction.
The senior notes that were repurchased carried a coupon interest rate of 12% while the term loan carries a coupon interest rate of Prime plus 1.75%, currently 7.75%, resulting in a significant expected future expense benefit. The refinancing will result in a first quarter 2008 pretax charge of $8.2 million, which is comprised of $1.7 million associated with a cash prepayment premium, $4.1 million associated with the non-cash realization of deferred financing costs associated with the refinanced debt, and $2.4 million associated with the non-cash discount recorded due to the warrants issued in connection with the refinanced debt.
The following provides debt and operating lease obligations for Brooke Credit Corporation followed by the pro forma debt and operating lease obligations as if the new financing had replaced the senior notes as of December 31, 2007:
On January 18, 2008, Brooke Savings Bank completed a transaction wherein it assumed approximately $100 million in deposits and $7.5 million in loans from Bank of the West. As part of the transaction, the Bank also acquired a network of 42 Kansas-based bank agents who refer deposit and loan business to the Bank. The Bank paid a deposit premium of approximately $2.9 million in connection with this transaction. To fund this purchase, the Bank received additional paid-in capital of $5 million from its Parent. As a result of this transaction, the Bank reported total assets of approximately $141 million, total deposits of $125 million and total stockholders equity of $15.4 million as of January 31, 2008.