During the first quarter of 2005 the Company entered into a lease for 20,337 square feet of office space in Austin, Texas, under an eight year, triple net lease. The base rent is $0 in the first year (June 1, 2005 to May 31, 2006), $157,612 in the second year and payments escalate to $264,384 in the final year of the lease. The Company’s net outlay for leasehold improvements of $559,000 plus the landlord’s share of $203,000, made the total leasehold improvements approximately $762,000 on the new lease space that was occupied in December 2005. Leasehold improvements are being amortized over the lease term. Deferred rent credits of approximately $320,000 are included in other liabilities at December 31, 2005. This amount is comprised of $117,000 relating to the initial rent holiday and $203,000 of landlord funded leasehold improvements as negogiated in the lease agreement. The rent credits will reduce rent expense over the lease term.
During the first half of 1998 the Company leased 12,150 square feet of office space in Austin, Texas, under a seven year, triple net lease. In July 2002 the Company expanded its offices in an adjacent building and increased the space it leases by 1,596 square feet. The annual base rent for the 12,150 square feet was $137,578 a year and the cost for the additional space is $19,152 per year. Effective January 1, 2003, the Company leased an additional 798 square feet in the adjacent building at a rate of $9,576 per year. The lease rate remained in affect until the term of the lease expired. The Company terminated lease payments at the end of February 2006.
BNLE leases approximately 1,400 square feet of office space in Sherwood, Arkansas at a rental of $18,120 per year. BNLAC incurs 100% of the rental expense.
BNLAC leases 288 square feet of office space in Des Moines, IA at a rental of $7,230 per year. The rent includes the services of a secretary that is shared with other tenants of the building.
The selected consolidated financial data presented below as of the end of and for each of the years in the five-year period ended December 31, 2005 are derived from the Company's consolidated financial statements. The consolidated financial statements as of December 31, 2005 and 2004, and for each of the years in the three-year period ended December 31, 2005 are included elsewhere in this Form 10-K.
In this section, we review the consolidated financial condition of the Company at December 31, 2005, 2004 and 2003 and the consolidated results of operations for the periods ended December 31, 2005, 2004 and 2003. Please read this discussion in conjunction with the accompanying consolidated financial statements and notes.
Reserves for unpaid policy claims are a sensitive accounting estimate unique to the insurance industry. Management uses an independent actuary to formulate this estimate. Differences in the estimates and actual results may result in revised claims expense which is recognized in the period in which the difference is determined. See Note 11 to our financial statements for the effect on the year 2005.
In the life and accident and health insurance industry, the liabilities for claims and the related expensing of those liabilities are evaluated and recorded using estimates of claim reserves. The Company estimates its claim reserves using the general methodology described herein.
It is common in the life and accident and health insurance industry for a consulting actuary to give either (A) a reserve certification where the reserves are expressed as a range of numbers for each relevant reserve (the “Range Estimate”), or (B) a reserve certification where the reserves are expressed as a single number for each relevant reserve (the “Single Point Estimate”).
Where the Range Estimate method is used, the management of an insurance company makes its own choice to reserve an amount within the range. The Company does not use the Range Estimate for any of its insurance products. Instead, for all of its insurance products, the Company uses the Single Point Estimate.
For the Company’s group and individual dental insurance, the Company’s financial personnel develop and make a Single Point Estimate for the reserves which work results in the Company’s Single Point Estimate for the end of each fiscal quarter and year end. The Company’s independent consulting actuary develops and makes its separate Single Point Estimate for such reserves. The Company’s financial personnel and independent consulting actuary compare their Single Point Estimates, reconcile any differences and agree on a Single Point Estimate for such reserves. Annually, the Company’s independent consulting actuary gives a Single Point Estimate reserve certification to the Company with the agreed amount and the Company uses such certified amount without change.
For the Company’s group and individual life and annuity insurance, the Company’s financial personnel make the Single Point Estimate for each such reserve. Annually, the Company’s consulting actuary independently reviews the Single Point Estimates. If the independent consulting actuary agrees with the Single Point Estimates, he gives a reserve certification to the Company.
The following discussions of reserve methodology are separated by the Company’s product types as indicated by the section headings.
For the Company’s group and individual dental insurance policies, the Company and its independent consulting actuary use a completion factor approach (sometimes referred to as the development method) which provides best estimates of the factors to determine claim reserves.
Management reviews trends in loss ratios and claims per insured per month in determining its estimate for the most recent months. Generally, while fluctuations do occur, the Company’s loss ratio and claims per insured per month are stable. In estimating claim reserves (the policy claims payable on the Company’s balance sheet), the Company consistently uses the assumptions of loss ratio and claims per insured per month which are based on actual, historical data. See, the discussion in the section herein entitled “Trends in Completion Factors, Loss Ratio, and Claims Per Insured Per Month”.
Claim reserves for the Group Dental line are the most significant part of the Company’s claim liability. As stated above, the Company uses the completion factor method for calculating the liability. Two main assumptions are made in this approach. First, for months the claims are incurred where the completion factor is credible, the Company uses that completion factor to calculate the liability associated with that month the claim occurred. Second, for the most recent months before the Company’s financial statement date where it is determined that the completion factors are not fully credible, the Company reviews loss ratios and claims per insured per month to determine the reserve for those months.
The discussion in this paragraph relates to the months where the completion factors are deemed to be fully credible which are typically the months prior to November and December. The completion factors have been relatively stable in the recent past. In the future, there could be changes in the trend of completion factors. The Company and its independent consulting actuary review the trends in the completion factors and when necessary make judgments as to the Single Point Estimate value for these items. Such estimates are based on observable trends and would also reflect any known major changes. Professional judgments are made based on the experience of the actuary and Company’s financial personnel and management. To observe the possible sensitivity of assuming 100% reliance on completion factors for claims incurred during the months for which completion factors are believed to be fully credible, if the associated claim reserves for those months had increased by 5%, the year end December 31, 2005, claim reserves would have been increased by approximately $21,000.
The discussion in this paragraph relates to the months where the completion factors are deemed to be not fully credible which are typically the months of November and December. The choice of the loss ratio assumption or claims per insured per month assumption for the most recent month of the claim was incurred may also have an impact on the reserve estimate. These assumptions are monitored for trends. The Company and its consulting actuary monitor the loss ratio and claims per insured month and override the completion factor approach for the most recent months before the Company’s financial statement date where the completion factors are not fully credible, i.e. November and December. To observe the possible
sensitivity of assuming 100% reliance on loss ratio or claims per insured per month factors for claims incurred during the months for which completion are believed to be not fully credible (typically November and December of a fiscal year), if the loss ratio or claims per insured per month had increased by 3% for those months (a multiple of 1.03), the associated claim reserves for those months and the year end December 31, 2005, claim reserve would have been increased by approximately $126,000.
The reconciliation of income taxes computed at the federal statutory income tax rate to total income taxes for the years ended December 31, 2005, 2004 and 2003 is as follows:
The statutory capital and surplus of insurance subsidiary decreased in 2005 primarily due to $2,950,000 of dividends paid to the Company.
Approximately $600,756 of the bond portfolio is classified as Available for Sale and carried on the Balance Sheet at market value with the unrealized gain or loss recorded in the surplus section of the Balance Sheet. The bonds include; automobile bonds, government agencies and U. S. Treasury Bonds that have unrealized profits. The Company may sell these bonds before they mature.
The Company’s investments are primarily in U.S. Government and Government Agencies ($16,623,363 amortized book value), other investment grade bonds ($2,107,307 amortized book value) and less than investment grade ($593,603 amortized book value).
Other long term investments of $1,543,441 consists of, in part, a convertible debenture loan in the amount of $1,357,407 from the Company, to EPSI Benefits, Inc. (EBI), a Texas Corporation. The loan bears interest at an annual rate of 14%, payable monthly, with principal payments commencing September 15, 2008 and a maturity date of August 15, 2015. To protect its interest, BNLF may convert the debenture into 51% of the outstanding common stock of EBI, subject to regulatory approval. The note is one of several agreements entered into by the Company's subsidiaries which expand the business relationship with EBI and its subsidiary, Employer Plan Services, Inc. (EPSI), which provides substantially all of the A&H claims processing and adjudication for the Company's insurance subsidiary, BNLAC. BNLF receives a marketing fee from EBI under a related marketing agreement.
On November 5, 2001 the Company’s Board of Directors approved a settlement of the class action lawsuit (see "Legal Proceedings"). One term of the settlement was the issuance of Company bonds in the principal amount of $1.50 in exchange for each share of the Company’s common stock owned by the members of the class. The bonds have a 12-year term and bear interest at the rate of 6% per annum, effective December 15, 2002 payable annually from the previous fiscal year’s earnings. The total principal amount of bonds payable at December 31, 2005 is $1,747,178 compared to $2,007,339 at December 31, 2004. Bond interest expense was $116,920, and $115,101 in 2005 and 2004; respectively. BNLAC will pay dividends to BNL Financial Corporation for the payment of interest to the bondholders. The maximum amount of dividends, which can be paid by Arkansas domiciled insurance companies to shareholders without prior approval of the insurance commissioner, is subject to restrictions relating to statutory surplus. The Arkansas Insurance Commissioner has reviewed and approved the settlement. The Company does not expect the dividend restrictions to impact its ability to meet its cash needs. The Company has no plan to start a sinking fund for payment of the principal at maturity.
In 2005, BNLAC paid dividends totaling $2,950,000 to BNLF for the purchase of Company stock and bonds and for other general operating funds compared to $1,150,000 dividends paid in 2004. In 2005, the Company negotiated with Universal Guaranty Life Insurance Company to purchase 2,216,776 shares of BNL Financial Corporation’s common stock for $2,300,000.
The data, information and presentation in this Long-term Contractual Obligations Table relating to the Company’s Liabilities for Future Policy Benefits, Policy Claims Payable, Annuity Deposits and Supplementary Contracts are all, separately and collectively, forward looking statements and are given full safe harbor protection.
In calculating the payments above, BNLAC used models of the business created for statutory asset adequacy analysis. The modeled life block was assumed to surrender for its reserve at the end of 20 years. Health blocks tested were projected using approximate means beyond 20 years. Payments on blocks not initially modeled were projected on an approximate basis. The total estimated future payments to be made relating to the Liability for Future Policy Benefits is stated as $11,390,774 which does not match the balance sheet liability total of $2,591,479 and the difference is $8,799,295. This is primarily due to the fact that the estimated future payments presented in the long term contractual obligations table for Future Policy Benefits includes consideration for future premiums, investment income and maintenance expenses and such assumptions, and perhaps other assumptions, may differ from the assumptions initially used to establish the balance sheet liability. The estimated future payments presented in the long term contractual obligations table are based on current assumptions while the balance sheet liability is based on assumptions locked in at the date the policy was approved for issue. Assumptions for estimating future payments are made regarding such items as interest earnings, mortality, morbidity, and persistency. It is likely that the actual experience will deviate from these assumptions - sometimes materially. A number of factors can have an effect such as economic conditions, changes in policyholder actions regarding premium payments and withdrawals, mortality and morbidity improvement or deterioration, and inflation. Random fluctuation in experience could also have an effect. The determination of the amount of the future payments is based upon estimates and the timing and amount of future payments is not always reasonably fixed and determinable. Because of the above considerations, the amounts and timing of future payments will likely vary from that presented in the above table.
In calculating the payments above, BNLAC used models of the business created for statutory asset adequacy analysis. The modeled annuity block was assumed to surrender for its reserve at the end of 20 years. The total estimated future payments to be made relating to the Annuity Deposits liability is stated as $6,540,153 which does not match the balance sheet liability total of $2,835,552 and the difference is $3,704,601. The balance sheet Annuity Deposit liability represents such items as deposits, premiums, investment income, expenses, and withdrawals which have already occurred while the total estimated future payments presented in this long term contractual obligations table are estimated using assumptions for future occurrences of such factors and other factors. The estimated future payments are based on many significant assumptions regarding future occurrences such as future premium payments, interest earnings, mortality, and persistency. It is likely that the actual experience will deviate from these assumptions - sometimes materially. A number of factors can have an effect such as economic conditions, changes in policyholder actions regarding annuity deposits and withdrawals, mortality improvement or deterioration, and inflation. Random fluctuation in experience could also have an effect. The determination of the Annuity Deposit estimated future payments are based upon estimates and the timing and amount of estimated future payments is not always reasonably fixed and determinable. Because of the above considerations, the amounts and timing of estimated future payments will likely vary from that presented in the above table.
We believe liquid assets, along with investment income, premium income and marketing fees will be sufficient to meet our long and short-term liquidity needs. We do not have any current plans to borrow money for operations.
Net investment income was $1,003,613 in 2005, $975,485 in 2004 and $970,382 in 2003, an increase of 3% in 2005, and an increase of 1% in 2004. The increases in and 2004 were due to an increase in investment in fixed maturities and an increase in interest rates. Continued profitability and stable or increased interest rates in subsequent years, will permit the Company to invest its profits in fixed maturities and continue the trend of increased investment income.
Policy benefits and other insurance costs increased from $30,108,152 in 2003, to $31,766,217 in 2004 and increased to $33,317,136 in 2005. The increase in 2004 was due to an increase in claims and commissions resulting from the increase in group and individual dental premium collected and commissions paid. The increase in 2005 was primarily due to an increase in claims ($1.3 million) resulting from an increase in group and individual dental business. The claims ratio on group dental insurance, which represents the ratio of claims incurred to premium earned, was 63.1% in 2005, 62.3% in 2004 and 62.7% in 2003. As a result of renewal rate adjustments, the claims ratio has steadily decreased over the last three years prior to 2005. In 2005, the slight claims ratio increase on group dental business was primarily due to increased utilization by policyholders. Management closely monitors claims ratios on group and individual dental business
Operating expenses were $8,558,205 in 2005, $7,957,447 in 2004 and $7,664,081 in 2003. The 7.5% increase in expenses in 2005 was due primarily to an increase in payroll expense, claims administration expense and office lease expense due to the increase in the number of group and individual policies in force. The increase in 2005 operating expenses was also due to an increase in professional fees, including actuarial, independent public accounting fees and legal fees incurred to assist management in replying to the Securities and Exchange Commission comments on the Company’s 2004 10K. The 4% increase in expenses in 2004 was primarily due to an increase in payroll expenses, employee benefits and actuarial expense, which increased due to an increase in business in force, new plans of insurance available for sale and increased state filings.
Taxes other than on income were $1,577,775 in 2005, $1,344,723 in 2004 and $1,326,826 for 2003. The increase in 2005 was due to an increase in premium taxes on additional premiums collected and from prior year accrual adjustments. The increase in 2004 was due to premium taxes on the increase in collected premiums. The decrease in 2003 was due to a decrease in premium taxes on fewer premiums collected.
The provision for income taxes was $527,041 in 2005, $468,183 in 2004 and $604,985 in 2003. For the periods ended December 31, 2005, 2004 and 2003, the Company had $448,040, $355,183 and $519,949 of current tax expense and $79,001, $113,000 and $85,036 of deferred tax expense; respectively. Fluctuations in tax expense are primarily due to changes in taxable income, limitations on net operating losses utilized and adjustments in estimates for income taxes in prior years.
BNLAC plans to apply for authority to market insurance products in additional states in the upcoming year. In 2005 we applied for a certificate of authority in California and we have an application pending for a certificate of authority in Wisconsin.