The selected consolidated financial data for 2001 has been derived from our unaudited consolidated financial statements which have been prepared on the same basis as our audited financial statements.
In addition to the above product lines, beginning in 2001, the Company entered into a reinsurance program covering bail and immigration bonds issued by several insurance carriers and sold by a bail bond agency. This program was discontinued in the second quarter of 2004 and no new bonds were issued after June 23, 2004. For a more detailed description of this program, see “Discontinued Bond Program” below and Note 16 to the Consolidated Financial Statements.
The Company sells its insurance products through a network of distribution channels, including three managing general agents, approximately thirty independent agents and direct sales.
Insurance Agency. In July 2002, we formed Ultimate Services Agency, LLC (“USA”), a wholly-owned subsidiary. We formed USA to act as an agency for placing property/casualty insurance policies offered and underwritten by Ohio Indemnity and by other property/casualty insurance companies. In the fourth quarter of 2002, we dissolved our wholly-owned subsidiary, Paul Boardway and Associates, Inc., which previously acted as a property/casualty insurance agency.
During the second quarter of 2004, Harco National Insurance Company (“Harco”), the then current insurance carrier, asserted control over the bail bond agency. The program was then discontinued by Harco during the second quarter of 2004 and no new bonds were issued after June 23, 2004.
In the second quarter of 2004, the Company came to believe that the discontinued bond program was not being operated as it had been represented to the Company by agents of the insurance carriers who had solicited the Company’s participation in the program. Consequently, during the second quarter of 2004, the Company ceased paying claims on the program and retained outside legal counsel to review and defend its rights under the program. There are certain issues that the Company is disputing with respect to the discontinued bond program, including but not limited to: 1) inaccurate/incomplete disclosures relating to the program; 2) improper supervision by the insurance carriers of the bail bond agency in administering the program; 3) improper disclosures by the insurance carriers through the bail bond agency and the reinsurance intermediaries during the life of the program; and 4) improper premiums and claims administration. During the second half of 2004, the Company entered into arbitrations with three of the four insurance carriers participating in the discontinued bond program. During the fourth quarter of 2005, the Company entered into arbitration with the fourth insurance carrier.
In addition to claims received by the Company, the Company also received reports from the insurance carriers regarding potential future liabilities on the program. Based on these reports and claims received by the Company through year end 2004, the Company recorded estimated loss and loss adjustment expense (“LAE”) reserves of $19.2 million for the program at December 31, 2004. These reserves include loss and LAE reserve estimates as provided by all four insurance carriers participating in the discontinued bond program. These reserves consisted of $6.9 million of case reserves and $12.3 million of incurred but not reported (“IBNR”) reserves. Of the $19.2 million of total loss and LAE reserves for the program at December 31, 2004, $15.6 million was for bail bonds and $3.6 million was for immigration bonds. At December 31, 2003, discontinued bond program loss and LAE reserves, net of anticipated recoveries, were $.4 million.
Based on the above, the Company recorded discontinued bond program losses and LAE of $20.2 million in 2004, which consisted of $1.4 million of net paid losses and an $18.8 million increase in loss and LAE reserves during 2004.
The Company is recording its ultimate loss and LAE reserves for the discontinued bond program based primarily on loss reports received by the Company from the insurance carriers. The Company relies heavily on the insurance carriers’ estimates of ultimate incurred losses included in these reports. As of December 31, 2004, these reported ultimate incurred losses do not include any adjustment for positive arbitration outcomes or potential settlement amounts. The Company does not intend to pay for any of the losses on the discontinued bond program unless and until the arbitrations are settled on a mutually agreeable basis and/or a final binding judgment is made as to the Company’s liability. Given the uncertainties of the outcome of the arbitrations, potential settlements with the insurance carriers or other potential recoveries, uncertainties as to the prospective settlement amounts between certain insurance carriers and the U.S. Department of Homeland Security and the New Jersey Attorney General, uncertainties in the future loss information provided by the insurance carriers, and the inherent volatility in assumed reinsurance, actual losses incurred for the discontinued bond program could be materially different from our estimated reserves. As a result, future loss development on the discontinued bond program could have a material effect on the Company’s results of operations and/or financial condition.
See Notes 16 and 25 to the Consolidated Financial Statements and the 2005 Form 10-Qs for additional discussion (including discussion of developments and subsequent events) concerning the discontinued bond program.
The Company’s results of operations have historically varied from quarter to quarter principally due to fluctuations in underwriting results and timing of investment sales. The Company’s primary source of revenue and cash is derived from premiums collected and investment activity. The majority of our premium revenues are dependent on the demand for our customers’ automobile financing programs. Increased automobile sales generally cause increased demand for automobile financing and, in turn, our lender/dealer products. Our ULI and CPI claims experience is impacted by the rate of loan defaults, bankruptcies and automobile repossessions among our customers. As delinquency dollars rise, our claims experience is expected to increase. In addition, the state of the used car market has a direct impact on our GAP claims. As used car prices decline, there is a larger gap between the balance of the loan/lease and the actual cash value of the automobile, which results in higher severity of GAP claims. Our unemployment compensation products are directly impacted by the nation’s unemployment levels. As unemployment levels rise, we would anticipate an increase in the frequency of claims. In addition, the interest rate and market rate environment can have an impact on the yields and valuation of our investment portfolio.
Net income (loss) for 2004 was $(8,500,620), or $(1.72) per diluted share, compared to $3,909,817, or $0.77 per diluted share, in 2003. The most significant factor contributing to the decrease in net income (loss) was an increase in losses and loss adjustment expenses of approximately $20.2 million on the discontinued bond program. See “Discontinued Bond Program” above and Note 16 to the Consolidated Financial Statements for disclosure of the discontinued bond program loss. This decrease was partially offset by federal income tax benefits of $6.7 million related to the discontinued bond program loss.
Net Premiums Earned. Net premiums earned remained relatively flat at $50.1 million compared to the prior year. Net premiums earned benefited from growth in our GAP, WSB and discontinued bond program product lines, which was offset by decreases in our ULI, CPI and UC products.
Net premiums earned for GAP grew to $5,713,867 in 2004 from $2,733,170 in 2003. This growth was due to the purchase of GAP coverage by two large financial institution customers in the second half of 2003, rate increases, volume increases with existing customers and new customers added in 2004.
Net premiums earned for the discontinued bond program were $588,801 for 2004 compared to $525,089 a year ago. This increase was primarily the result of additional premiums being reported to the Company by the insurance carriers during 2004 compared to a year ago.
Net premiums earned for UC products decreased 6.0% to $4,978,993 in 2004 from $5,296,766 in 2003 due primarily to the cancellation of an excess of loss policy at the end of 2003. This decrease was partially offset by growth in the Company’s UCassure® product and rate increases.
Codification and Subscription Fees. ALPC’s codification and subscription fees increased 4.9% to $4,005,415 in 2004 compared to $3,819,221 in 2003 principally due to an increase in customer volume compared to the prior year.
Management Fees. Through our UCassure® and bonded service products (bonded service program was discontinued at the end of 2003), we insure the payment of certain unemployment compensation benefit charges to be paid from contract funds on deposit. We have agreements with a cost containment service firm to control the unemployment compensation costs of certain qualified entities. Any
remaining funds after the payment of all benefit charges are shared between the Company and the cost containment firm as management fees. Our management fees in 2004 decreased 70.1% to $33,710 from $114,094 in 2003 as a result of rising unemployment compensation obligations related to increased levels of unemployment. We expect management fees to vary from period to period depending on unemployment levels and benefit charges.
Discontinued bond program losses and LAE of $20.2 million in 2004 consisted of $1.4 million of net paid losses and an $18.8 million increase in loss and LAE reserves during 2004. See “Discontinued Bond Program” above and Note 16 to the Consolidated Financial Statements for more information concerning the discontinued bond program losses during 2004.
Codification and Subscription Expenses. Codification and subscription expenses incurred by ALPC increased 8.6% to $3,551,544 in 2004 from $3,269,714 in 2003 principally due to higher salaries and an impairment write down of a database which resulted from cancellation of a state customer during 2004.
Goodwill Impairment. As part of its annual goodwill impairment testing in the fourth quarter of 2004, the Company concluded that an impairment of goodwill existed at its property/casualty insurance segment. The Company performed impairment testing in accordance with SFAS No. 142. The Company, with the assistance of an independent appraisal firm, determined that the carrying value of the reporting segment exceeded the fair value of the reporting segment, resulting in a non-cash impairment charge. The fair value of the reporting segment was estimated using the expected present value of future cash flows. As a result of this impairment, the Company recorded non-cash impairment charges in the fourth quarter of 2004 in the aggregate amount of $753,737.
Federal Income (Benefit)/Taxes. The Company had an income tax (benefit) of $(4,767,432) in 2004 compared to income tax expense of $1,614,165 in 2003. The benefit in 2004 was primarily caused by losses from the discontinued bond program.
26.3% in 2003 primarily due to an increase in commission expense and other insurance operating expenses as described above. The commission expense increase in relation to net premiums earned for 2004 when compared to 2003 was attributable to 1) growth in GAP and WSB commissions which have a higher commission rate when compared to our ULI product line and 2) a decrease in ceding commissions associated with the lender/dealer reinsurance agreement that was cancelled at the end of 2003.
Net Premiums Earned. Net premiums earned increased 17.6% to $50,071,966 in 2003 from $42,590,321 in 2002. Net premiums earned for 2003 benefited from strong growth in our CPI and GAP products and was also influenced by the Reinsurance Transaction.
Codification and Subscription Fees. ALPC’s codification and subscription fees increased 14.9% to $3,819,221 in 2003 compared to $3,324,037 in 2002 principally due to new state, city and municipal customers added since fourth quarter 2002 and the provision of additional services, including specialized codification and integrated product offerings.
Losses and Loss Adjustment Expenses. Losses and LAE increased 16.8% to $33,083,172 in 2003 from $28,314,256 in 2002 primarily due to loss experience in our CPI, UC and GAP products.
Losses and LAE related to our CPI products increased $1,648,722 to $1,768,674 in 2003 from $119,952 in 2002 principally due to premium growth as the product was introduced in the fourth quarter of 2002. UC losses and LAE increased to $2,318,940 in 2003 from $741,489 in 2002 as a result of reserve strengthening and increased benefit payments associated with rising unemployment compensation obligations. GAP losses and LAE rose 71.7% to $2,637,004 from $1,535,892 in 2002. We attribute this increase primarily to our growth in GAP premiums combined with increased severity of GAP claims. The lower residual value for used automobiles contributed to the increased severity of claims by creating a larger difference between the outstanding balance of a customer’s loan or lease and the amount of primary insurance coverage.
Commissions and Other Insurance Expenses. Commission expense rose 9.1% to $7,891,016 in 2003 from $7,230,636 in 2002 principally due to the growth in premiums which was partially offset by ceding commissions associated with several reinsurance transactions entered into in 2003. Other insurance operating expenses increased 31.0% to $4,982,456 in 2003 from $3,803,457 in 2002 as a result of an increase in premium taxes, salaries and benefits.
Interest Expense. Interest expense grew to $541,248 in 2003 from $131,323 in 2002 as a result of the Company’s two trust preferred debt transactions in December 2002 and September 2003 that raised $8.2 million and $7.2 million, respectively. The increase in interest expense from the trust preferred debt was partially offset by lower borrowing levels on the Company’s revolving credit line during 2003. See “Liquidity and Capital Resources” for a more detailed discussion of the Company’s trust preferred debt transactions.
For information regarding the Company’s financial condition, results of operations and business outlook for fiscal year 2005, see the Company’s Quarterly Report on Form 10-Q for the quarterly periods ended March 31, June 30, and September 30, 2005, which are being filed contemporaneously with the filing of this Annual Report on Form 10-K.
Liquidity and capital resources demonstrate the Company’s ability to generate sufficient cash flows from its operations and borrow funds at competitive rates to meet operating and growth needs. As of December 31, 2004 the Company’s capital structure consists of trust preferred debt issued to affiliates, borrowings from our revolving line of credit and shareholders’ equity and is summarized in the following table:
interest, as applicable, on a quarterly basis at a rate equal to three month LIBOR plus four hundred and five basis points (6.61% and 5.21% at December 31, 2004 and 2003, respectively), are redeemable at par on or after September 30, 2008 and mature on September 30, 2033. The proceeds from the junior subordinated debentures were used for general corporate purposes and provided additional financial flexibility to the Company. The terms of the junior subordinated debentures contain various restrictive covenants. As of December 31, 2004, the Company was in compliance with all such covenants.
Ohio Indemnity is restricted by the insurance laws of the State of Ohio as to amounts that can be transferred to Bancinsurance in the form of dividends without the approval of the Department. During 2005, the maximum amount of dividends that may be paid to Bancinsurance by Ohio Indemnity without prior approval is limited to $3,087,967. Bancinsurance receive d cash dividends of $1,290,000 from Ohio Indemnity during 2002 (none during 2003 and 2004).
The preparation of the consolidated financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, revenues, liabilities and expenses and related disclosures of contingent assets and liabilities. We regularly evaluate these estimates, assumptions and judgments. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. The Company’s significant accounting policies are more fully described in Note 1 to the Consolidated Financial Statements. Set forth below are the critical accounting policies that we believe require significant estimates, assumptions and judgments and are critical to an understanding of our consolidated financial statements.
Fixed Maturities. On a monthly basis, we review our fixed maturity securities for impairment. We consider the following factors when evaluating potential impairment:
In addition to the monthly valuation procedures described above, we continually monitor developments affecting our invested assets, paying particular attention to events that might give rise to impairment write-downs. There were $535,487, $129,729 and $931,531 in impairment charges included in net realized gain (loss) on investments for the years ended December 31, 2004, 2003 and 2002, respectively. Included in impairment charges for 2004 is a write down of $334,136 related to a private equity investment due to its financial uncertainty. Additional impairments within the portfolio during 2005 are possible if current economic and financial conditions worsen. See Note 2 to the Consolidated Financial Statements for analysis and discussion with respect to securities in an unrealized loss position at December 31, 2004.
The Company utilizes its internal staff, reports from ceding insurers under assumed reinsurance and an independent consulting actuary in establishing its loss and LAE reserves. The Company’s independent consulting actuary reviews the Company’s reserves for losses and LAE at the end of each fiscal year and prepares a report that includes a recommended level of reserves. The Company considers this recommendation in establishing the amount of its reserves for losses and LAE.
These reported ultimate incurred losses are the primary basis for the Company’s reserving estimates. The Company relies heavily on the insurance carriers’ estimates of ultimate incurred losses included in these reports.
In establishing our reserves, we tested our data for reasonableness, such as ensuring there are no case outstanding reserves on closed claims, and consistency with data used in our previous estimates. We found no material discrepancies or inconsistencies in our data. We did not experience any significant change in the number of claims paid (other than for growth in our business and claims related to the discontinued bond program), average claim paid or average claim reserve that would be inconsistent with the types of risks we insured in the respective years.
Loss and LAE Reserves at Year End. As of December 31, 2004 and 2003, gross loss and LAE reserves by product line were split between incurred but not reported (“IBNR”) and case reserves as follows:
During 2004, reserves for incurred losses and LAE attributable to insured events of prior years decreased by approximately $5.4 million as a result of re-estimation of unpaid losses and LAE principally on the Company’s ULI product line. An analysis of this decrease is provided below.
During 2003, reserves for incurred losses and LAE attributable to insured events of prior years decreased by approximately $2.8 million as a result of re-estimation of unpaid losses and LAE principally on the Company’s lender/dealer products. ULIL represented approximately $2.0 million of the overall $2.8 million reserve decrease. The improvement in loss experience primarily related to the 2002 accident year. The amount of re-estimated reserves as of the beginning of 2003 was approximately $4.1 million. At December 31, 2003 and 2002, the Company’s ultimate selected loss ratio for the 2002 accident year was 73.0% and 81.3%, respectively. Changes in this key assumption occurred primarily during the first quarter of 2003 as the majority of our ULIL losses are settled within three months from the date of loss. When estimating the ultimate loss ratio at December 31, 2002, the Company selected an ultimate loss ratio for the 2002 accident year that was comparable to previous accident years’ ultimate loss ratios. During the first quarter of 2003, our 2002 accident year loss experience was more favorable than estimated at December 31, 2002. For example, our average paid claim for 2002 accident year losses decreased from $2,477 during 2002 to $2,080 in the first quarter of 2003. In accordance with SFAS No. 60, the Company recorded this change in reserves as a change in estimate during 2003. It should be noted that the ULIL product is subject to premium
adjustments based on loss experience (i.e., experience-rated policies and retrospective-rated policies), and therefore, this prior year loss development had no impact on net income.
For our direct business, the majority of our losses are short-tail in nature and adjustments to reserve amounts occur rather quickly. Conditions that affected the above redundancies in reserves may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate this redundancy to future periods.
In conducting the impairment test, the fair value of each reporting segment is compared to its carrying value including goodwill. If the fair value exceeds the carrying amount, then no impairment exists. If the carrying amount exceeds the fair value, further analysis is performed to assess impairment. Fair values are determined by discounting estimated future cash flows.
As part of its annual goodwill impairment testing in the fourth quarter of 2004, the Company concluded that an impairment of goodwill existed at its property/casualty insurance segment. The Company, with the assistance of an independent appraisal firm, determined that the carrying value of the reporting segment exceeded the fair value of the reporting segment, resulting in a non-cash impairment charge. As a result of this impairment, the Company recorded non-cash impairment charges in the fourth quarter of 2004 in the aggregate amount of $753,737 (after tax).
We have audited the accompanying consolidated balance sheets of Bancinsurance Corporation and subsidiaries (the “Company”) as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity and cash flows for the three years then ended. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Bancinsurance Corporation and subsidiaries at December 31, 2004 and 2003 and the results of their operations and their cash flows for the three years then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Property/Casualty Insurance. Our wholly-owned subsidiary, Ohio Indemnity Company (“Ohio Indemnity”), is a specialty property insurance company. Our principal sources of revenue are premiums for insurance policies written by and income generated from our investment portfolio. Ohio Indemnity, an Ohio corporation, is licensed in 48 states and the District of Columbia. As such, Ohio Indemnity is subject to the regulations of the Ohio Department of Insurance (the “Department”) and the regulations of each state in which it operates. The majority of Ohio Indemnity’s premiums are derived from three distinct lines of business: (1) products designed for automobile lenders/dealers; (2) unemployment compensation products; and (3) other specialty products.
Our automobile lender/dealer line offers three types of products. First, ULTIMATE LOSS INSURANCE® (“ULI”), a blanket vendor single interest coverage, is the primary product we offer to financial institutions nationwide. This product insures banks and financial institutions against damage to pledged collateral in cases where the collateral is not otherwise insured. A ULI policy is generally written to cover a lender’s complete portfolio of collateralized personal property loans, typically automobiles. Second, creditor placed insurance (“CPI”) is an alternative to our traditional blanket vendor single interest product. While both products cover the risk of damage to uninsured collateral in a lender’s automobile loan portfolio, CPI covers the portfolio through tracking individual borrowers’ insurance coverage. The lender purchases physical damage coverage for loan collateral after a borrower’s insurance has lapsed. Third, our guaranteed auto protection insurance (“GAP”) pays the difference or “gap” between the amount owed by the customer on a loan or lease and the amount of primary insurance company coverage in the event a vehicle is damaged beyond repair or stolen and never recovered. The GAP product is sold to automobile dealers, lenders and lessors and provides coverage on either an individual or portfolio basis.
Other specialty products consists primarily of our waste surety bond program. In the second quarter of 2004, the Company entered into a quota share reinsurance arrangement with a waste surety bond underwriter whereby the Company assumed and ceded 50% of the applicable business. During 2005, the reinsurance arrangement was amended whereby the assumed participation was reduced from 50% to 25%. The majority of these surety bonds satisfy the closure/post-closure financial responsibility imposed on hazardous and solid waste treatment, storage and disposal facilities pursuant to Subtitles C and D of the Federal Resource Conservation and Recovery Act (“RCRA”). Closure/post-closure bonds cover future costs to close and monitor a regulated site such as a landfill. All of the surety bonds are indemnified by the principal and collateral is maintained on the majority of the bonds. The indemnifications and collateralization of this program reduces the risk of loss.
In December 2002, we organized BIC Statutory Trust I (“BIC Trust I”), a Connecticut special purpose business trust. In September 2003, we organized BIC Statutory Trust II (“BIC Trust II”), a Delaware special purpose business trust. BIC Trust I and BIC Trust II were formed for the sole purpose of issuing and selling floating rate trust preferred capital securities in exempt private placement transactions and investing the proceeds from such securities in junior subordinated debentures of the Company.
Our accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) which vary in certain respects from accounting practices prescribed or permitted by the Ohio Department of Insurance (the “Department”).
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.
In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-01 provides guidance on other-than-temporary impairment models for marketable debt and equity securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and non-marketable equity securities accounted for under the cost method. The EITF developed a basic three-step model to evaluate whether an investment is other-than-temporarily impaired. In September 2004, the FASB issued FASB Staff Position EITF 03-01-1, which delays the effective date until additional guidance is issued for the application of the recognition and measurement provisions of EITF 03-01 to investments in securities that are impaired; however, the disclosure requirements are effective for annual periods ending after June 15, 2004. The adoption of the disclosure provisions of EITF 03-01 did not have a material effect on the Company’s results of operations or financial condition.
As an initial step in the SFAS No. 142 implementation process, we assigned goodwill and intangibles to our property/casualty insurance, municipal code publishing and insurance agency reporting segments. Following such assignment, the fair value of each reporting segment was compared to its carrying value. Fair values were determined by discounting estimated future cash flows. Based on our initial impairment testing, a non-cash impairment charge of $1,481,858 (after tax) was recognized as a cumulative effect of change in accounting principle in the first quarter of 2002. The impairment charge was associated with the August 1999 acquisition of Paul Boardway and Associates, Inc.
We dissolved Paul Boardway and Associates, Inc. in the fourth quarter of 2002. As a result, the remaining goodwill of $179,000 (after tax) was recorded as a non-cash impairment charge to income in the third quarter of 2002.
As part of its annual goodwill impairment testing in the fourth quarter of 2004, the Company concluded that an impairment of goodwill existed at its property/casualty insurance segment. The Company, with the assistance of an independent appraisal firm, determined that the carrying value of the reporting segment exceeded the fair value of the reporting segment, resulting in a non-cash impairment charge. The fair value of the reporting segment was estimated using the expected present value of future cash flows. As a result of this impairment, the Company recorded non-cash impairment charges in the fourth quarter of 2004 in the aggregate amount of $753,737 (after tax).
Revenue from ALPC municipal code contracts is recognized on the percentage-of-completion method. Completion is measured based on the percentage of direct labor costs incurred to date compared to estimated direct labor costs for each contract. While we use available information to estimate total direct labor costs on each contract, actual experience may vary from estimated amounts. Revenue from code supplements is recognized on the completed-contract method because the typical supplement is completed in a few months.
Loss and loss adjustment expense reserves represent our best estimate of the ultimate net cost of all reported and unreported losses incurred through December 31. We do not discount loss and loss adjustment expense reserves. The reserves for unpaid losses and loss adjustment expenses are estimated using individual case-basis valuations, statistical analyses and reports received from ceding insurers under assumed reinsurance. Those estimates are subject to the effects of trends in loss severity and frequency. Although considerable variability is inherent in such estimates, we believe the reserves for losses and loss adjustment expenses are adequate. The estimates are regularly reviewed and adjusted as necessary as experience develops or new information becomes known. Such adjustments are included in current operations.
Pursuant to the terms of certain surety bonds issued by the Company that guarantee the payment of reimbursable unemployment compensation benefits, certain monies are held by the Company in contract funds on deposit and are used for the payment of benefit charges. The Company has agreements with a cost containment service firm designed to control the unemployment compensation costs of the employers enrolled in the program. Any remaining funds after the payment of all benefit charges are shared between the Company and the cost containment firm as management fees. Management fees are recognized when earned based on the development of benefit charges. Management fees of $33,710, $114,094 and $749,442 were recognized in 2004, 2003 and 2002, respectively, as a result of this arrangement.
We use the “intrinsic value method” under APB No. 25 and related interpretations in accounting for stock options issued to employees, officers and directors under our equity compensation plans. SFAS No. 123 “Accounting for Stock-Based Compensation,” as amended, was issued by the FASB in 1995 and requires the “fair value method” for recognition of cost on equity compensation plans similar to those used by the Company. Adoption of SFAS No. 123 is optional in 2005 (required in 2006, see Note 1(c) to the Consolidated Financial Statements); however, pro forma disclosures as if we had adopted the fair value method under SFAS No. 123 in 2004, 2003 and 2002 are presented below.
In accordance with SFAS No. 60, the statement of operations reflects experience rating adjustments as part of net premiums earned rather than as a separate expense item on the income statement, as was previously reported during 2003 and 2002. Certain other prior year amounts have been reclassified in order to conform to the 2004 presentation.
Net investment income for the year ended December 31 is summarized below:
As of December 31, 2004, the Company had unrealized losses on 11 equity securities of $55,914, including 3, 4, and 4 securities that maintained an unrealized loss position for 0-6 months, 7-12 months, and greater than 12 months, respectively. All 11 equity securities had a fair value to cost ratio equal to or greater than 90% as of December 31, 2004.
The Company continually monitors developments affecting our invested assets, paying particular attention to events that might give rise to impairment write-downs, including but not limited to: (1) the length of time and extent to which the estimated fair value has been less than book value; (2) whether the decline appears to be related to general market or industry conditions or is issuer-specific; and (3) our ability and intent to hold the security for a period of time sufficient to allow for recovery in the estimated fair value. There were $535,487, $129,729 and $931,531 in impairment charges included in net realized gain (loss) on investments for the years ended December 31, 2004, 2003 and 2002, respectively. Included in impairment charges for 2004 is a write down of $334,136 related to a private equity investment due to its financial uncertainty. As part of the Company’s normal assessment of other-than-temporary impairments of investments, the securities listed above were evaluated and no further impairments were deemed necessary as of December 31, 2004.
At December 31, 2004, investments having a carrying value of $4,513,580 were on deposit with various state insurance departments to meet their respective regulatory requirements.
There were no changes in the carrying amount of goodwill during 2003. The changes in the carrying amount of goodwill by reporting unit for the year ended December 31, 2004 are as follows:
Amortization expense related to amortizable intangible assets was $74,517, $74,518 and $80,240 during 2004, 2003 and 2002, respectively. The estimated amortization expense of intangible assets for the next five fiscal years ending December 31 is as follows:
We routinely lease premises for use as administrative offices, vehicles and office equipment under operating leases for varying periods. Management expects that in the normal course of business, leases will be renewed or replaced by other leases. Effective January 2001, we entered into a new lease for our Columbus, Ohio office space. Under its provisions, no cash payments were due until April 1, 2002. Rent expense is recognized evenly over the lease term ending December 31, 2008. During 2004, ALPC renewed a lease in Cincinnati, Ohio for office space, which will expire on February 28, 2010. Rental expenses under operating leases were $274,300, $271,656 and $303,781 during 2004, 2003 and 2002, respectively.
In December 2002, we organized BIC Statutory Trust I (“BIC Trust I”), a Connecticut special purpose business trust, which issued $8,000,000 of floating rate trust preferred capital securities in an exempt private placement transaction. In September 2003, we organized BIC Statutory Trust II (“BIC Trust II”), a Delaware special purpose business trust, which issued $7,000,000 of floating rate trust preferred capital securities in an exempt private placement transaction. BIC Trust I and BIC Trust II were formed for the sole purpose of issuing and selling the floating rate trust preferred capital securities and investing the proceeds from such securities in junior subordinated debentures of the Company. In connection with the issuance of the trust preferred capital securities, the Company issued junior subordinated debentures of $8,248,000 and $7,217,000 to BIC Trust I and BIC Trust II, respectively. The floating rate trust preferred capital securities and the junior subordinated debentures have substantially the same terms and conditions. The Company has fully and unconditionally guaranteed the obligations of BIC Trust I and BIC Trust II with respect to the floating rate trust preferred capital securities. BIC Trust I and BIC Trust II distribute the interest received from the Company on the junior subordinated debentures to the holders of their floating rate trust preferred capital securities to fulfill their dividend obligations with respect to such trust preferred securities. BIC Trust I’s floating rate trust preferred capital securities, and the junior subordinated debentures issued in connection therewith, pay dividends and interest, as applicable, on a quarterly basis at a rate equal to three month LIBOR plus four hundred basis points (6.44% and 5.18% at December 31, 2004 and 2003, respectively), are redeemable at par on or after December 4, 2007 and mature on December 4, 2032. BIC Trust II’s floating rate trust preferred capital securities, and the junior subordinated debentures issued in connection therewith, pay dividends and interest, as applicable, on a quarterly basis at a rate equal to three month LIBOR plus four hundred and five basis points (6.61% and 5.21% at December 31, 2004 and 2003, respectively), are redeemable at par on or after September 30, 2008 and mature on September 30, 2033. Interest on the junior subordinated debentures is charged to income as it accrues. Interest expense related to the junior subordinated debentures for the period ended December 31, 2004, 2003 and 2002 was $862,256, $538,056 and $33,748, respectively. The Company was in compliance with all provisions of our debt covenants at December 31, 2004.
In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” which requires the consolidation of certain entities considered to be variable interest entities (“VIEs”). An entity is considered to be a VIE when it has equity investors who lack the characteristics of having a controlling financial interest, or its capital is insufficient to permit it to finance its activities without additional subordinated financial support. Consolidation of a VIE by an investor is required when it is determined that the investor will absorb a majority of the VIE’s expected losses if they occur, receive a majority of the VIE’s
contribution was $224,548, $164,057 and $133,353 for the years ended December 31, 2004, 2003 and 2002, respectively.
The 1994 Stock Option Plan (the “1994 Stock Option Plan”) provides for the grants of options covering up to an aggregate of 500,000 common shares, with a 100,000 common share maximum for any one participant. Key employees, officers and directors of, and consultants and advisors to, the Company are eligible to participate in the 1994 Stock Option Plan. The 1994 Stock Option Plan is administered by the Company’s Compensation Committee which determines to whom and when options will be granted along with the terms and conditions of the options. Under the 1994 Stock Option Plan, options for 321,400 common shares were outstanding at December 31, 2004 and expire at various dates from 2005 to 2013 and range in option price per share from $2.50 to $6.75. Of the options for 321,400 common shares outstanding, 40,000 have been granted to our non-employee directors and 281,400 have been granted to employees. All of the options outstanding were granted to employees and directors for compensatory purposes.
The 2002 Stock Incentive Plan (the “2002 Plan”) provides for awards, including grants of options covering up to an aggregate of 600,000 common shares. Key employees, officers and directors of, and consultants and advisors to, the Company are eligible to participate in the 2002 Plan. The 2002 Plan is administered by the Compensation Committee which determines to whom and when awards will be granted as well as the terms and conditions of the award. Under the 2002 Plan, options for 329,000 common shares were outstanding at December 31, 2004 and expire at various dates from 2012 to 2014 and range in option price per share from $4.50 to $8.00. All of the options outstanding were granted to employees for compensatory purposes.
A summary of the status of our stock options as of December 31, 2004, 2003 and 2002 and changes during the year ended on those dates is presented below:
The fair value of each option granted during 2004, 2003 and 2002 is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions: (1) expected volatility of 27.10 % for 2004, 27.44 % for 2003 and 28.97% for 2002; (2) risk-free interest rate of 4.26% for options granted May 17, 2004, 3.88% for options granted December 21, 2004, 3.09% for options granted March 14, 2003, 2.82% for options granted May 16, 2003, 2.74% for options granted June 2, 2003, 2.64% for options granted June 3, 2003, 5.00% for options granted May 17, 2002, 4.71% for options granted June 4, 2002, 3.86% for options granted July 26, 2002, 3.48% for options granted October 28, 2002, 3.41% for options granted November 4, 2002,; (3) expected life of six years for all years; and (4) 0% dividend yield for all years.
The following table summarizes weighted-average information by range of exercise prices for stock options outstanding and exercisable at December 31, 2004:
Activity in the reserve for unpaid losses and loss adjustment expenses (“LAE”) is summarized as follows (dollars in thousands):
As a result of changes in estimates of insured events in prior years, the provision for unpaid loss and LAE decreased by approximately $5,383,000, $2,805,000 and $807,000 in 2004, 2003 and 2002, respectively, due to favorable development, primarily attributable to the Company’s ULI product line.
At December 31, 2003, discontinued bond program loss reserves, net of anticipated recoveries, were $.4 million. At December 31, 2004, the Company’s loss reserves for the discontinued bond program were approximately $19.2 million. For more information concerning loss and LAE reserves for the discontinued bond program, see Note 16 to the Consolidated Financial Statements.
Beginning in 2001, the Company entered into a reinsurance program covering bail and immigration bonds issued by several insurance carriers and sold by a bail bond agency. This program was discontinued in the second quarter of 2004 and no new bonds were issued after June 23, 2004. For a more detailed description of this program, see below.
A reconciliation of direct to net premiums, on both a written and earned basis, for the years ended December 31, 2004, 2003 and 2002 is as follows:
The amounts of recoveries pertaining to reinsurance that were deducted from losses incurred during 2004, 2003 and 2002 were $2,465,643, $9,917,371 and $231,998, respectively. During 2004, 2003 and 2002, ceded reinsurance decreased commission expense incurred by $597,927, $6,155,335 and $132,344, respectively.
Reinsurance Program. Beginning in 2001 and continuing into the second quarter of 2004, the Company participated as a reinsurer in a program covering bail and immigration bonds issued by four insurance carriers and produced by a bail bond agency (collectively, the “discontinued bond program” or the “program”). The liability of the insurance carriers was reinsured to a group of reinsurers, including the Company. The Company assumed 15% of the business from 2001 through 2003 and 5% of the business during the first half of 2004.
During 2004, the Company received multiple demands for payments on bonds from certain insurance carriers. During the first half of 2004, the Company paid net losses of approximately $1.4 million related to the discontinued bond program. In the second quarter of 2004, the Company came to believe that the discontinued bond program was not being operated as it had been represented to the Company by agents of the insurance carriers who had solicited the Company’s participation in the program. As a result, during the second quarter of 2004, the Company ceased paying claims on the discontinued bond program. Also during the second quarter of 2004, Harco National Insurance Company (“Harco”), the then current insurance carrier, asserted control over the bail bond agency. The program was then discontinued by Harco during the second quarter of 2004 and no new bonds were issued after June 23, 2004.
Arbitrations. During the second half of 2004, the Company entered into arbitrations with three of the four insurance carriers participating in the discontinued bond program. There are certain issues that the Company is disputing with respect to the discontinued bond program, including but not limited to: 1) inaccurate/incomplete disclosures relating to the program; 2) improper supervision by the insurance carriers of the bail bond agency in administering the program; 3) improper disclosures by the insurance carriers through the bail bond agency and the reinsurance intermediaries during the life of the program; and 4) improper premiums and claims administration. The arbitration proceedings are described in more detail below:
Aegis Arbitration. On August 23, 2004, the Company instituted arbitration against Aegis Security Insurance Company (“Aegis”), one of the insurance carriers. On August 25, 2004, Aegis made a counter-demand for arbitration whereby a request was made that the Company join an arbitration that was already pending between Aegis and Lloyds Syndicate 1245, one of the other reinsurers participating in the discontinued bond program. On October 15, 2004, the Company agreed to consolidate arbitrations with Aegis and Lloyds Syndicate 1245. During April 2005, Lloyds Syndicate 0183, Lloyds Syndicate 0205 and Lloyds Syndicate 0727 were added to the consolidated arbitration. On August 11, 2005, another reinsurer participating in the program referred to as The Philadelphia Contributionship for the Insurance of Houses from Loss by Fire (“Contributionship”) was ordered to participate in the consolidated arbitration. Through this arbitration, the Company is seeking rescission of the reinsurance agreements, monetary damages for claims that were paid by the Company under the agreements and other appropriate relief. Aegis is seeking to recover certain of its losses from the Company under the reinsurance agreements. This arbitration is proceeding and a hearing is currently scheduled to begin in January 2006.
Sirius Arbitration. On September 21, 2004, Sirius America Insurance Company (“Sirius”), one of the insurance carriers, instituted arbitration against the Company. At the time, Sirius was also in arbitration with Lloyds Syndicate 1245 and subsequently demanded arbitration with Contributionship. The Company and Contributionship advised Sirius that their two arbitrations should be consolidated. Sirius agreed to such consolidation. On June 1, 2005, Contributionship was dismissed from the arbitration based on resolution by settlement between Sirius and Contributionship. Through this arbitration, the Company is seeking rescission of the reinsurance agreement, monetary damages for claims that were paid by the Company under the agreement and other appropriate relief. Sirius is seeking to recover certain of its losses from the Company under the reinsurance agreement. This arbitration is proceeding and a hearing is currently scheduled to begin in August 2006.
Harco Arbitration. On November 3, 2004, Rosemont Reinsurance Ltd., one of the reinsurers participating in the discontinued bond program, instituted arbitration against Harco. On December 2, 2004, Harco made a request that the Company and Contributionship join in this arbitration. On December 22, 2004, the Company agreed to consolidate arbitrations with Rosemont Reinsurance Ltd. and Harco. The Contributionship also agreed to participate in the consolidated arbitration. Through this arbitration, the Company is seeking rescission of the reinsurance agreement and other appropriate relief. Harco is seeking to recover certain of its losses from the Company under the reinsurance agreement. This arbitration is proceeding and a hearing is currently scheduled to begin in June 2006.
Loss and LAE Reserves. At December 31, 2003, discontinued bond program loss reserves, net of anticipated recoveries, were $.4 million. At December 31, 2004, the Company’s loss and LAE reserves for the discontinued bond program were approximately $19.2 million ($15.6 million bail and $3.6 million immigration). As of December 31, 2004, the Company believed certain insurance carriers were in settlement negotiations with the U.S. Department of Homeland Security for their immigration bond obligations and one insurance carrier was in settlement negotiations with the New Jersey Attorney General for its bail bond obligations. The Company believes negotiated settlements are not uncommon for this type of program. The Company’s recorded loss and LAE reserves at December 31, 2004 take into consideration estimated settlement amounts with these parties as provided by the insurance carriers.
In 1994, we entered into a Split-Dollar Insurance Agreement with a bank, as trustee, for the benefit of an officer and his spouse wife. The bank has acquired a second-to-die policy on the lives of the insureds, in the aggregate face amount of $2,700,000. At December 31, 2004 and 2003, we had loaned the trustee $789,215 and $717,496, respectively, under this agreement for payment of insurance premiums, which is included in loans to affiliates in the accompanying balance sheet. Amounts loaned by the Company to the trustee are to be repaid, in full, without interest from any of the following sources: (1) cash surrender value of the underlying insurance policies; (2) death benefits; and/or (3) the sale of 15,750 common shares of the Company contributed by the officer to the trust.
Trust preferred debt issued to affiliates: Fair value is estimated using discounted cash flow calculations based on interest rates currently being offered for similar obligations with maturities consistent with the obligation being valued. As the interest rate adjusts regularly, the carrying amount is a reasonable estimate of fair value.
In April 2005, the Company was advised of a settlement agreement entered into on April 15, 2005 between the Department of Homeland Security, U.S. Immigration and Customs Enforcement (“DHS”) and Aegis. The agreement has an effective date of January 14, 2005 and covers past and future losses for immigration bonds issued by Aegis. As of December 31, 2004, the Company recorded loss and LAE reserves for immigration bonds in the amount of $3.6 million. Based on this settlement agreement, the Company’s estimated loss and LAE reserves for immigration bonds was $7.5 million at March 31, 2005. In accordance with SFAS No. 60, management recorded the increase in loss and LAE reserves of $3.9 million in the first quarter of 2005 as a change in estimate.
Based on information received during the third quarter of 2005, management believes that certain insurance carriers would settle with the Company for less than their respective estimates of ultimate incurred losses as set forth in their loss reports. As a result, at September 30, 2005, management adjusted its loss and LAE reserves for the discontinued bond program based on the estimated settlement values. This resulted in a reduction of $3.1 million to our loss and LAE reserves at September 30, 2005 when compared to the applicable insurance carriers’ respective estimates of ultimate incurred losses at that date. In accordance with SFAS No. 60, management recorded this change in reserves during the third quarter of 2005 as a change in estimate. If the Company obtains information to revise its estimate of potential settlement values or determine an estimate of final arbitration values, the Company will record such reserve changes, if any, in the period that the revised estimate is made in accordance with SFAS No. 60.
In connection with the Aegis arbitration discussed in Note 16 to the Consolidated Financial Statements, on December 8, 2005, the Company filed a motion for partial summary judgment with the Aegis Arbitration Panel (the “Panel”) requesting that the Panel limit the Company’s immigration bond obligation to Aegis to the Company’s proportionate share (15%) of the amount Aegis is obligated to pay to DHS under the Aegis and DHS settlement agreement entered into on April 15, 2005 ($4.0 million). On December 23, 2005, the Panel granted the Company’s motion. As a result, the Company reduced its loss and LAE reserves for the discontinued bond program by $5.5 million during the fourth quarter of 2005. In accordance with SFAS No. 60, management recorded this change in reserves during the fourth quarter of 2005 as a change in estimate.
As disclosed in Note 16 to the Consolidated Financial Statements and above, the Company is currently disputing the discontinued bond program losses in ongoing arbitration proceedings with certain insurance carriers. The Company does not intend to pay for any of the losses on the discontinued bond program unless and until the arbitrations are settled on a mutually agreeable basis and/or a final binding judgment is made as to the Company’s liability. Given the uncertainties of the outcome of the arbitrations, potential settlements with the insurance carriers or other potential recoveries, uncertainties as to the prospective settlement amount between Highlands and DHS for Highlands’ immigration bond obligations, uncertainties in the future loss information provided by the insurance carriers, and the inherent volatility in assumed reinsurance, actual losses incurred for the discontinued bond program could be materially different from our estimated reserves. As a result, future loss development on the discontinued bond program could have a material effect on the Company’s results of operations and/or financial condition.