Bancinsurance (BCIS) - Description of business
Bancinsurance Corporation is an Ohio insurance holding company primarily engaged in the underwriting of specialized property/casualty insurance products through our wholly-owned subsidiary, Ohio Indemnity Company (Ohio Indemnity), an Ohio corporation. Ohio Indemnity is licensed to transact business in 48 states and the District of Columbia. Until August 31, 2006, the Company also had a municipal code publishing business segment. On August 31, 2006, the Company sold its municipal code publishing segment as more fully described in General/Overview-Sale of Affiliate below and in Note 1 to the Consolidated Financial Statements. In addition, our wholly-owned subsidiary, Ultimate Services Agency, LLC (USA), an Ohio limited liability company which we formed in July 2002, is a property/casualty insurance agency. Financial information for our business segments for the three years ended December 31, 2006 is included in Note 24 to the Consolidated Financial Statements included in this Annual Report on Form 10-K. Unless the context indicates otherwise, all references herein to Bancinsurance, we, Registrant, us, its, our or the Company refer to Bancinsurance Corporation and its consolidated subsidiaries.
General information about Bancinsurance is available on the Companys website, www.bancins.com. Information on our website is not and should not be considered part of this Annual Report on Form 10-K.
PRODUCTS AND SERVICES
Ohio Indemnity Company
The majority of our net premiums written and premiums earned are derived from three distinct product lines offered by Ohio Indemnity: (1) automobile lender/dealer; (2) unemployment compensation; and (3) waste industry. In 2006, we had net premiums earned of $49,106,653 with 79% attributable to our lender/dealer products, 12% attributable to our unemployment compensation products and 9% attributable to our waste industry products.
Automobile Lender/Dealer Products . Our automobile lender/dealer line offers three types of products. First, ULTIMATE LOSS INSURANCE ® (ULI), a blanket vendor single interest coverage, is sold to lending institutions, such as banks, savings and loan associations, credit unions, automobile dealers and finance companies. ULI insures against damage to pledged collateral in cases where the collateral is not otherwise insured. Our standard ULI policy covers physical damage to the collateral in an amount not to exceed the lesser of the collaterals fair market value or the outstanding loan balance. This blanket vendor single interest policy is generally written to cover the lending institutions complete portfolio of collateralized personal property loans, which generally consists of automobile loans. Certain ULI policies are eligible for experience rated and retrospective rated refunds based on loss experience. We also offer supplemental insurance coverages, at additional premium cost, for losses resulting from unintentional errors in lien filings and conversion, confiscation and skip risks. Conversion risk coverage protects the lender from unauthorized and wrongful taking of the lenders collateral. Skip risk coverage protects the lender when a delinquent debtor disappears with the loan collateral. During 2006, we provided ULI coverage to approximately 400 lending institutions. The premiums charged for ULI are based on claims experience, loan volumes and general market conditions. ULI products represented 53%, 56% and 69% of our net premiums earned during 2006, 2005 and 2004, respectively.
Second, creditor placed insurance (CPI) provides an alternative to our traditional blanket vendor single interest product. While both products cover the risk of damage to uninsured collateral in a lenders automobile loan portfolio, CPI covers an automobile lenders loan portfolio through tracking individual borrowers insurance coverage. The lender purchases physical damage coverage for loan collateral after a borrowers insurance has lapsed. The lender then charges the premium to the borrower. The National Association of Insurance Commissioners (NAIC) developed a model act for CPI in 1996 and several states have adopted its provisions. The model act helped to clarify program parameters that are acceptable to regulators. Our CPI product complies with the model act. During 2006, we provided CPI coverage to approximately 35 lending institutions. CPI products represented 3%, 5% and 4% of our net premiums earned during 2006, 2005 and 2004, respectively.
Third, guaranteed auto protection insurance (GAP) pays the difference or gap between the amount owed by the customer on a lease or loan contract and the amount of primary insurance company coverage in the event a vehicle is damaged beyond repair or stolen and never recovered. The gap results from the way loans and leases amortize compared to depreciation patterns of vehicles. Leasing, low or no down payment loans, long-term loans (60-84 months) and low trade-in prices contribute to such gap amounts. GAP insurance policies insure lenders, lessors and auto dealers who waive gap amounts and elect to purchase GAP insurance to cover the risk assumed by making the waiver. We offer two primary forms of GAP insurance products. First, voluntary GAP insurance policies are sold to lenders, lessors and auto dealers who in turn sell such policies directly to the borrower when a vehicle is purchased or leased. Second, blanket GAP insurance policies are sold to lessors who typically waive gap amounts on all of their leases. During 2006, we provided GAP coverage to approximately 800 lenders, lessors and auto dealers. GAP products represented 23%, 19% and 11% of our net premiums earned during 2006, 2005 and 2004, respectively.
Unemployment Compensation Products. Our unemployment compensation (UC) products are utilized by qualified entities that elect not to pay the unemployment compensation taxes and instead reimburse state unemployment agencies for benefits paid by the agencies to the entities former employees. Through our UCassure ® and excess of loss products, we indemnify the qualified entity for liability associated with their reimbursing obligations. In addition, we underwrite surety bonds that certain states require employers to post in order to obtain reimbursing status for their unemployment compensation obligations. Our bonded service program was discontinued at the end of 2003 and replaced by our UCassure ® program.
During 2006, we provided UC insurance coverage to approximately 100 customers. UC products represented 12%, 11% and 10% of our net premiums earned during 2006, 2005 and 2004, respectively.
Waste Industry Products . Our waste industry products (WIP) consist of certain surety bonds produced and administered by a general insurance agent. Under this program, the Company both assumes and cedes certain waste surety bond business under two quota share reinsurance arrangements. In the second quarter of 2004, the Company entered into a 50% quota share reinsurance arrangement whereby the Company assumed 50% of all waste surety bonds with liability limits up to $4.0 million from two insurance carriers. Effective January 1, 2005, the reinsurance arrangement was amended whereby the Companys assumed participation was reduced from 50% to 25%. Effective August 1, 2006, the reinsurance arrangement was further amended whereby the Company assumed 50% of all waste surety bonds with liability limits up to $1.2 million. In addition to assuming business, the Company also writes on a direct basis waste surety bonds with liability limits up to our Treasury limit ($3.6 million during 2006). The Company then cedes 50% of that business to an insurance carrier under a reinsurance arrangement. All surety bonds written directly and assumed under this program are produced and administered by a general insurance agent that is affiliated with one of the insurance carriers participating in the program. The majority of the surety bonds under the program satisfy the closure/post-closure financial responsibility obligations 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.
During 2006, we provided WIP coverage to approximately 80 customers. WIP represented 9%, 9% and 4% of our net premiums earned during 2006, 2005 and 2004, respectively.
The Company has certain other specialty products which consist primarily of service contracts and other surety products. Net premiums earned for these products were $251,191, $258,798 and $159,439 during 2006, 2005 and 2004, respectively. In addition, from 2001 until the end of the second quarter of 2004, the Company participated in a bail and immigration bond program. This program was discontinued in the second quarter of 2004. For a more detailed description of this program, see Managements Discussion and Analysis of Financial Condition and Results of Operations, Overview-Discontinued Bond Program below and Note 16 to the Consolidated Financial Statements.
We sell our insurance products through multiple distribution channels, including three managing general agents, approximately thirty-five independent agents and direct sales.
American Legal Publishing Corporation
On August 31, 2006, the Company sold its wholly-owned subsidiary, American Legal Publishing Corporation (ALPC), which codifies, publishes, supplements and distributes ordinances for municipalities and counties nationwide in addition to state governments. Ordinance codification is the process of collecting, organizing and publishing legislation for state and local governments. ALPC also provides information management services which includes electronic publishing, document imaging and internet hosting services. ALPC represented 4%, 6% and 7% of our total revenues during 2006, 2005 and 2004, respectively. See General/Overview-Sale of Affiliate below and Note 1 to the Consolidated Financial Statements for more information concerning this transaction.
Ultimate Services Agency, LLC
In July 2002, we formed Ultimate Services Agency, LLC (USA), a wholly-owned subsidiary. We formed USA to act as an agency for placing and servicing property/casualty insurance policies offered and underwritten by Ohio Indemnity and by other property/casualty insurance companies.
SALE OF AFFILIATE
On August 31, 2006, the Company entered into a Stock Purchase Agreement (the Agreement) with A.L.P. Acquisition Co., Inc., an Ohio corporation (the Purchaser), whereby the Company sold 100% of the issued and outstanding common shares of ALPC to the Purchaser for $4,620,000 subject to customary post-closing adjustments (the Sale). The Company received cash of $4,150,000 and a promissory note in the principal amount of $470,000 (the Promissory Note) from the Purchaser at the closing in connection with the Sale. On September 1, 2006, the Purchaser made a principal payment to the Company on the Promissory Note in the amount of $345,000, bringing the remaining principal balance of the Promissory Note to $125,000 which is to be repaid in six monthly installments and bears interest at an annual rate of 8.0%. As of December 31, 2006, the principal balance of the promissory note was $62,500.
The Purchaser was organized by Steven G. Wolf, who has served as President of ALPC since 1984 and as a director of ALPC since 2000. Mr. Wolf and certain other employees of ALPC collectively own a significant equity interest in the Purchaser.
In conjunction with the Sale, on August 31, 2006, the Company also made an investment (the Investment) in the Purchaser in the amount of $250,000, consisting of (1) a $137,500 cash purchase of equity securities of the Purchaser and (2) a $112,500 loan to the Purchaser in the form of a subordinated convertible promissory note (the Convertible Note). The Convertible Note is to be repaid on August 31, 2016 (if not previously converted), bears interest at an annual rate of 8.0% and is convertible at any time at the option of the Company into additional equity securities of the Purchaser.
In connection with the Sale and the Investment, the Company recorded a net realized gain of approximately $2.5 million ($1.7 million after tax) for the period ended December 31, 2006.
The insurance business is highly competitive with over 3,000 property/casualty insurance companies in the United States. The majority of such property/casualty insurers are not engaged in the specialty lines of property/casualty insurance which we underwrite. Some of our competitors may: (1) offer more diversified insurance coverage; (2) have greater financial resources; (3) offer lower premiums; (4) have more complete and complex product lines; (5) have greater pricing flexibility; (6) have different marketing techniques; (7) have a higher financial rating; and/or (8) provide better agent compensation. Management believes that one of our competitive advantages is specializing in limited insurance lines. This specialization allows us to refine our underwriting and claims techniques, which in turn, provides agents and insureds with superior service.
The Company assumes and cedes reinsurance with other insurers and reinsurers. Such arrangements serve to enhance the Companys capacity to write business, provide greater diversification, align business partners with the Companys interests, and/or limit the Companys maximum loss arising from certain risks. Although reinsurance does not discharge the original insurer from its primary liability to its policyholders, it is the practice of insurers for accounting purposes to treat reinsured risks as risks of the reinsurer. The primary insurer would reassume liability in those situations where the reinsurer is unable to meet the obligations it assumed under the reinsurance agreement. The ability to collect reinsurance is subject to the solvency of the reinsurers and/or collateral provided under the contract.
Several of our lender/dealer insurance producers have formed sister reinsurance companies, commonly referred to as a producer-owned reinsurance company (PORC). The primary reason for an insurance producer to form a PORC is to realize the underwriting profits and investment income from the insurance premiums generated by that producer. In return for ceding business to the PORC, the Company receives a ceding commission, which is based on a percentage of the premiums ceded. Such arrangements align business partners with the Companys interests while preserving valued customer relationships. All of the Companys lender/dealer ceded reinsurance transactions are PORC arrangements.
Effective January 1, 2003, the Company entered into a producer-owned reinsurance arrangement with a new lender/dealer producer whereby 100% of that producers premiums (along with the associated risk) was ceded to its PORC. This reinsurance arrangement was cancelled effective December 31, 2003. For this reinsurance arrangement, the Company has obtained collateral in the form of a letter of credit from the reinsurer to secure its obligations. Under the provisions of the reinsurance agreement, the collateral must be equal to or greater than 102% of the reinsured reserves and the Company has immediate access to such collateral if necessary. Under this arrangement, the Company ceded premiums earned of $67,969, $115,790 and $4,435,659 for the years ended December 31, 2006, 2005 and 2004, respectively.
Effective October 1, 2003, the Company entered into a producer-owned reinsurance arrangement with an existing lender/dealer customer whereby 100% of that customers premiums (along with the associated risk) was ceded to its PORC. For this reinsurance arrangement, the Company has obtained collateral in the form of a trust from the reinsurer to secure its obligations. Under the provisions of the reinsurance agreement, the collateral must be equal to or greater than 102% of the reinsured reserves and the Company has immediate access to such collateral if necessary. Under this arrangement, the Company ceded premiums earned of $2,266,090, $1,727,303 and $894,717 for the years ended December 31, 2006, 2005 and 2004, respectively.
Beginning in the second quarter of 2004, the Company entered into a quota share reinsurance arrangement with certain insurance carriers whereby the Company assumed and ceded 50% of certain waste surety bond business. Effective January 1, 2005, the reinsurance arrangement was amended whereby the Companys assumed participation was reduced from 50% to 25%. Effective August 1, 2006, the reinsurance arrangement was further amended whereby the Companys assumed participation was increased from 25% to 50%. Under this program, the Company assumed premiums earned of $3,283,690, $4,302,509 and $1,980,492 during 2006, 2005 and 2004, respectively. Also, the Company ceded premiums earned of $1,235,624, $679,563 and $131,051 for the years ended December 31, 2006, 2005, and 2004, respectively.
Effective January 1, 2005, the Company entered into a producer-owned reinsurance arrangement with a guaranteed auto protection insurance agent whereby 100% of that agents premiums (along with the associated risk) were ceded to its PORC. For this reinsurance arrangement, the Company has obtained collateral in the form of a letter of credit to secure its obligations. Under the provisions of the reinsurance agreement, the collateral must be equal to or greater than 102% of the reinsured reserves and the Company has immediate access to such collateral if necessary. Under this arrangement, the Company ceded premiums earned of $1,987,640, $734,435 and $0 for the years ended December 31, 2006, 2005 and 2004, respectively.
In addition to the above, the Company has other reinsurance arrangements including two automobile lender/dealer PORC quota share arrangements, several quota share arrangements for certain contract and escrow surety bond business and a reinsurance arrangement for a vehicle service contract program. Under these arrangements, the Company ceded premiums earned of $708,430, $927,455 and $1,113,639 for the years ended December 31, 2006, 2005 and 2004, respectively. Also, the Company assumed premiums earned of $60,535, $0 and $0 for the years ended December 31, 2006, 2005 and 2004, respectively.
From 2001 until the end of the second quarter of 2004, the Company participated in a bail and immigration bond program. This program was discontinued in the second quarter of 2004. For a more detailed description of this program, see Managements Discussion and Analysis of Financial Condition and Results of Operations, Overview-Discontinued Bond Program below and Note 16 to the Consolidated Financial Statements.
For more information concerning the Companys reinsurance transactions, see Managements Discussion and Analysis of Financial Condition and Results of Operations and Note 16 to the Consolidated Financial Statements.
Insurance Company Regulation
Ohio Indemnity, as an Ohio property/casualty insurance corporation, is subject to the regulatory supervision of the Ohio Department of Insurance (the Department). In addition, Ohio Indemnity is subject to regulation in each jurisdiction in which it is licensed to write insurance.
Such regulation relates to, among other matters: licensing of insurers and their agents, authorized lines of business, capital and surplus requirements, rate and form approvals, claims practices, mandated participation in shared markets, reserve requirements, insurer solvency, investment criteria, underwriting limitations, affiliate transactions, dividend limitations, changes in control and a variety of other financial and non-financial components of our business.
All insurance companies must file annual financial statements (statutory basis) in states where they are authorized to do business and are subject to regular and special examinations by the regulatory agencies of those states. In March and April of 2005, the Department conducted a targeted on-site examination of Ohio Indemnitys discontinued bond program and statutory financial condition at December 31, 2004. On September 12, 2005, the Department issued its targeted on-site examination report and no adjustments to the statutory financial statements were required as a result of the examination. In December 2006, the Department initiated its regular examination of Ohio Indemnity which is currently ongoing.
Numerous states require deposits of assets by insurance companies to protect policyholders. Such deposits must consist of securities which comply with standards established by the particular states insurance department. As of December 31, 2006, we have securities with a carrying value of $4,538,220 deposited with eleven state insurance departments. The deposits, typically required by a states insurance department on admission to do insurance business in such state, may be increased periodically as mandated by applicable statutory or regulatory requirements.
Ohio Insurance Holding Company System Regulation
We are also subject to the Ohio Insurance Holding Company System Regulatory Act, as amended (the Ohio Insurance Holding Company Act), which requires that notice of the proposed payment of any dividend or other distribution by Ohio Indemnity be given to the Ohio Superintendent of Insurance within five business days of its declaration and at least ten days prior to payment. If such dividend or distribution is paid from other than earned surplus or the dividend or distribution, together with any other dividends or distributions made within the preceding 12 months, exceed the greater of: (1) 10% of Ohio Indemnitys statutory surplus as of the immediately preceding December 31, or (2) the statutory net income of Ohio Indemnity for the immediately preceding calendar year, notice of the proposed dividend or distribution must be given to the Superintendent at least 30 days prior to payment, and the Superintendent may disapprove the dividend or distribution within the 30 day period following receipt of such notice.
Pursuant to the Ohio Insurance Holding Company Act, no person may acquire, directly or indirectly, 10% or more of the outstanding voting securities of Bancinsurance or Ohio Indemnity, unless the Ohio Superintendent of Insurance has approved such acquisition. The determination of whether to approve any such acquisition is based on a variety of factors, including an evaluation of the acquirers financial condition, the competence of its management and whether competition in Ohio would be reduced. In addition, under the Ohio Insurance Holding Company Act, certain other material transactions involving Ohio Indemnity and its affiliates must be disclosed to the Ohio Superintendent of Insurance not less than 30 days prior to the effective date of the transaction. The Superintendent may elect not to approve such transaction within such 30-day period if it does not meet the required standards. Transactions requiring approval by the Superintendent include: sales, purchases, or exchanges of assets; loans and extensions of credit; and investments not in compliance with statutory guidelines. Ohio Indemnity is also required under the Ohio Insurance Holding Company Act to file periodic and updated statements reflecting the current status of its holding company system, the existence of any related-party transactions and certain financial information relating to any person who directly or indirectly controls (presumed to exist with 10% voting control) Ohio Indemnity. We believe that we are in compliance with the Ohio Insurance Holding Company Act and the related regulations.
National Association of Insurance Commissioners
All states have adopted the financial reporting form of the National Association of Insurance Commissioners (NAIC), which form is typically referred to as the NAIC annual statement. In addition, most states, including Ohio, generally defer to NAIC with respect to statutory accounting practices and procedures. In this regard, NAIC has a substantial degree of practical influence and is able to accomplish quasi-legislative initiatives through amendments to the NAIC annual statement and applicable statutory accounting practices and procedures. The Department requires that insurance companies domiciled in the State of Ohio prepare their statutory basis financial statements in accordance with the NAIC Accounting Practices and Procedures Manual.
The NAIC applies a risk-based capital test to property/casualty insurers. Ohio also applies the NAIC risk-based capital test. The risk-based capital test serves as a benchmark of an insurance enterprises solvency by establishing statutory surplus targets which will require certain company level or regulatory level actions. Ohio Indemnitys total adjusted capital was in excess of all required action levels as of December 31, 2006.
Other Regulatory Matters
Broker Contingent Commission . In 2004, the New York attorney general began an investigation into insurance broker activities connected with contingent commission agreements. The investigation led to lawsuits and prompted other attorney generals and state insurance departments to conduct further investigations. We have not received any formal inquiries from any state attorney general and/or insurance department. The NAIC has proposed a model act on these agreements for agents and brokers, and several states have indicated they will adopt the model act or some variation of the proposed act. We continue to closely monitor all proposals.
Federal Insurance Charter . The Commerce Committee of the United States Senate has held hearings on federal involvement in the regulation of the insurance industry. The hearings included a discussion of a proposed federal charter that would allow companies to operate under federal, rather than state, regulation. Any proposed legislation could have a significant impact on the insurance industry, and we continue to monitor all proposals. We anticipate there will be further legislative activity during 2007.
As of February 7, 2007, we employed approximately 33 full-time employees and one part-time employee. None of our employees are represented by a collective bargaining agreement, and we are not aware of any efforts to unionize our employees.
Our service marks ULTIMATE LOSS INSURANCE, UTIMATE GAP and UCASSURE, are registered with the United States Patent and Trademark Office and the State of Ohio. We have also developed common law rights in BI BANCINSURANCE CORPORATION (stylized letters) in each state in which Bancinsurance is operating. While these service marks are important to us, we do not believe our business is materially dependent on any one of them.
ITEM 1A. RISK FACTORS
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS
The following cautionary discussion of risks and uncertainties relevant to our business include factors we believe could cause our actual results to differ materially from expected and historical results. Other factors beyond these listed below, including factors unknown to us and factors known to us which we have currently determined not to be material, could adversely affect us.
Economic Factors Impacting our Specialty Insurance Products
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 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 our GAP claims. Our UC products are impacted by unemployment levels. As unemployment levels rise, we could experience an increase in the frequency of claims. Such economic factors could have a material adverse effect on our business, financial condition and/or operating results.
Concentration in Specialty Insurance Products
Due to our focus on insuring specialty risks, such as lender collateral protection, unemployment compensation and waste industry bonds, our operations could be more exposed than our more diversified competitors to the effects of changes in economic, competitive or regulatory conditions affecting such specialty markets. These changes may include, but are not limited to, economic downturns, increased competition and the enactment and enforcement of federal and state regulations that may adversely impact these markets. Such factors could have a material adverse effect on our business, financial condition and/or operating results.
We are licensed to operate in 48 states and the District of Columbia. The percentage of our direct premiums written that related to policies issued to customers in Ohio, Rhode Island, Connecticut, Michigan, California, Massachusetts and New York were 28.2%, 11.9%, 9.5%, 7.2%, 6.7%, 6.7% and 5.6%, respectively, for the year ended December 31, 2006. Therefore, a significant percentage of our revenues (75.8%) are concentrated in a small number of states, and our revenues and profitability are subject to prevailing regulatory, legal, economic, demographic, competitive and other conditions in these states. Changes in any of these conditions could make it less profitable for us to do business in Ohio, Rhode Island, Connecticut, Michigan, California, Massachusetts, New York and the other states in which we operate.
Historically, we have used reinsurance to increase our underwriting capacity and align the interests of our business partners with the Companys interests. Our reinsurance facilities generally are subject to annual renewal. We are subject to credit risk with respect to our reinsurers, as the ceding of risk to reinsurers does not relieve us of our primary liability to our insureds. Although we place our reinsurance with reinsurers we believe to be financially stable and/or obtain collateral on our reinsurance, a significant reinsurers inability or unwillingness to make payment under the terms of a reinsurance treaty could have a material adverse effect on our business, financial condition and/or operating results.
Possible Inadequacy of Loss Reserves
We record reserve liabilities for the estimated future payment of losses and loss adjustment expenses (LAE) for both reported and unreported claims. The establishment of appropriate reserves is an inherently uncertain process, involving actuarial and statistical projections of what we expect to be the cost of the ultimate settlement and administration of claims based on historical claims information, estimates of future trends in claims severity and other variable factors such as inflation. Due to the inherent uncertainty in estimating reserves, it has been necessary in the past, and may continue to be necessary in the future, to revise estimated liabilities
as reflected in our reserves for claims and related expenses. To the extent our reserves are deficient and are increased, the amount of such increase is treated as a charge to earnings in the period in which the deficiency is recognized.
Ability to Price the Risks We Underwrite Accurately
Our results of operations and financial condition depend on our ability to underwrite and set premium rates accurately for the risks we underwrite. Rate adequacy is necessary to generate sufficient premiums to pay losses, LAE and underwriting expenses and to earn a profit. To set our premium rates accurately, we must collect and properly analyze a substantial amount of data; develop, test and apply appropriate rating formulas; closely monitor and timely recognize changes in trends; and project both severity and frequency of losses with reasonable accuracy. Our ability to undertake these efforts successfully, and as a result set our premium rates accurately, is subject to a number of risks and uncertainties, some of which are outside our control, including but not limited to:
the availability of sufficient reliable data and our ability to properly analyze available data;
the uncertainties that inherently characterize estimates and assumptions;
our selection and application of appropriate rating and pricing techniques; and
changes in legal standards and claim settlement practices.
Consequently, we could under price risks, which would negatively affect our profit margins, or we could overprice risks, which could reduce our sales volume and competitiveness. Such factors could have a material adverse effect on our business, financial condition and/or operating results.
Reliance on General Agents
Approximately $15.2 million (27.4%) of our direct premiums written for 2006 were distributed amongst four general agents as follows: $5.8 million (10.5%), $4.7 million (8.5%), $3.0 million (5.4%) and $1.7 million (3.0%). These general agents are not obligated to promote the Companys insurance programs and may sell competitors insurance programs. As a result, our business depends in part on the marketing efforts of these general agents and on our ability to offer insurance programs and services that meet the requirements of the clients and customers of these agents. In addition, these relationships may be discontinued, or if they do continue, they may not remain profitable for us. A loss of all or substantially all the business produced by one or more of these general agents could have a material adverse effect on our business, financial condition and/or operating results.
General Agents May Exceed Their Authority
One of our general agents underwrites policies on a binding authority basis. This agent produced $3.0 million (5.4%) of our direct premiums written during 2006. Binding authority business poses the risk that policies may be quoted and bound by the general agent prior to our underwriting review. If the general agent exceeds this authority by binding us on a risk that does not comply with our underwriting guidelines, we are at risk for claims that occur under that policy during the period from its issue date until we review the policy and cancel it. Such risks could have a material adverse effect on our business, financial condition and/or operating results.
Risk of Fraud or Negligence with our Insurance Agents
We rely, in part, on insurance agents to sell our insurance products and services. During 2006, our insurance agents produced approximately 44% of our direct premiums written. Because we use independent insurance agents, we are at risk that the agents will engage in negligent or fraudulent acts, including:
binding Ohio Indemnity and not reporting the policies and related premium to Ohio Indemnity;
failing to accurately report premiums and/or claims to Ohio Indemnity;
failing to obtain collateral and/or monitor insurance risk;
failing to return commissions to Ohio Indemnity in situations where commissions have been advanced and should be returned to Ohio Indemnity based on the financial performance of the agents business; and
financial hardship (i.e. liquidity problems, bankruptcy, liquidation, etc.) of the agent which could lead to lost business and/or increased loss exposure for Ohio Indemnity.
Any such negligent or fraudulent acts could have a material adverse effect on our business, financial condition and/or operating results.
Importance of Industry Ratings
Ohio Indemnity received an A- (Excellent) annual rating in December 2006 from A.M. Best. A.M. Best generally assigns ratings based on an insurance companys ability to pay policyholder obligations (not based on protection of investors) and focuses on capital adequacy, loss and loss expense reserve adequacy and operating performance. If our performance in these areas decline, A.M. Best could downgrade our rating. A downgrade of our rating could cause our current and future insurance agents and insureds to choose other, more highly rated competitors. In addition, we believe that not having an A- rating or better could impact an agents or customers willingness to place business with Ohio Indemnity.
Importance of Treasury Listing
Ohio Indemnity is currently listed on the United States Treasury Departments listing of approved surety companies (Treasury Listing). This listing is required for all surety companies who issue or reinsure surety bonds naming the United States government or any branch or agency of the United States government as the obligee. The Treasury Listing also establishes a companys maximum underwriting amount on any one surety bond based on its capital and surplus. Many governmental entities, both federal and non-federal, that issue landfill licenses and permits will accept surety bonds only from insurance companies that are on the Treasury Listing. If Ohio Indemnitys Treasury Listing were revoked, or if its surety bond limit were reduced, it would eliminate or reduce the Companys ability to write and assume business under the waste surety bond program and certain other surety bond programs. This could have a material adverse effect on our business, financial condition and/or operating results.
General . Ohio Indemnity is subject to regulation by governmental agencies in Ohio, its domiciliary state, and the 48 other states and the District of Columbia in which Ohio Indemnity is licensed or admitted to sell insurance. Most insurance regulations are designed to protect the interests of insurance policyholders, as opposed to the interests of shareholders. These regulations generally are administered by a department of insurance in each state and relate to, among other things, licensing of insurers and their agents, authorized lines of business, capital and surplus requirements, rate and form approvals, claims practices, mandated participation in shared markets, reserve requirements, insurer solvency, investment criteria, underwriting limitations, affiliate transactions, dividend limitations, changes in control and a variety of other financial and non-financial matters. Significant changes in these laws and regulations could adversely affect our ability to operate and/or make it more expensive to conduct our business. State insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to financial condition, holding company issues and other matters. These regulatory requirements may adversely affect our ability to achieve some or all of our business objectives. We are unable to predict what additional laws and regulations, if any, affecting our business may be promulgated in the future or how they might be interpreted.
Required Licensing . We operate under insurance licenses issued by various state insurance authorities. Regulatory authorities have broad discretion to deny or revoke licenses for various reasons, including the violation of regulations. In some instances, where there is uncertainty as to the application of a regulation, we follow practices based on our interpretations of regulations or practices that we believe generally to be followed by the industry. These practices may turn out to be different from the interpretations of regulatory authorities. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or otherwise penalize us. This could adversely affect our ability to operate our business. Further, changes in the level of regulation of the insurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities could adversely affect our ability to operate our business.
Premium Rate Filings . Most states have insurance laws requiring that rate schedules and other information be filed with the states regulatory authority, either directly or through a rating organization with which the insurer is affiliated. The regulatory authority may disapprove of a premium rate filing if it finds that the rates are inadequate, excessive or unfairly discriminatory. Rates vary by class of business, hazard assumed and size of risk, and are not necessarily uniform for all insurers. Many states have recently adopted laws which limit the ability of insurance companies to increase rates. To date, such limitations have not had a material impact on us, and we have no knowledge of any such limitations that may materially affect our future results of operations. However, there can be no assurance that such limitations will not have a material adverse effect on our business, financial condition and/or operating results in the future.
Risk-Based Capital . The NAIC has adopted a system to test the adequacy of statutory capital, known as risk-based capital. This system establishes the minimum amount of risk-based capital necessary for a company to support its overall business operations. It identifies property/casualty insurers that may be inadequately capitalized by looking at certain inherent risks of each insurers assets and liabilities and its mix of net written premiums. Failure to meet applicable risk-based capital requirements or minimum statutory capital requirements could subject Ohio Indemnity to further examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision, rehabilitation or even liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require us to increase our statutory capital levels, which we may be unable to do, or could cause Ohio Indemnity to lose its regulatory authority to conduct its business.
Transactions Between Our Insurance Subsidiary and Affiliates . We operate as an insurance holding company. Transactions between Ohio Indemnity and other members of our holding company system generally must be disclosed to the state regulators, and prior approval of the applicable regulator generally is required before any material or extraordinary transaction may be consummated. State regulators may refuse to approve or delay approval of such a transaction, which may impact our ability to operate efficiently.
Dependence on Our Insurance Subsidiary to Meet Our Obligations
We are a holding company and a legal entity separate and distinct from our insurance subsidiary. As a holding company without significant operations of our own, our principal sources of our funds are dividends and other payments from our subsidiaries which include, among others, Ohio Indemnity. State insurance laws limit the ability of Ohio Indemnity to pay dividends and require Ohio Indemnity to maintain specified minimum levels of statutory capital and surplus. In general, these restrictions limit the aggregate amount of dividends or other distributions that Ohio Indemnity may declare or pay within any twelve-month period without advance regulatory approval. Generally, this limitation is the greater of statutory net income for the preceding calendar year or 10% of the statutory surplus at the end of the preceding calendar year. In addition, insurance regulators have broad powers to prevent reduction of statutory surplus to inadequate levels and could refuse to permit the payment of dividends of the maximum amounts calculated under any applicable formula. As a result, we may not be able to receive dividends from Ohio Indemnity at times and in amounts necessary to meet our debt service obligations or to pay dividends to our shareholders and/or corporate expenses. During 2006, the maximum amount of dividends that may be paid to Bancinsurance by Ohio Indemnity without prior approval is limited to $4,915,331.
Severe Weather Conditions and Other Catastrophes
Our property business is exposed to the risk of severe weather conditions and other catastrophes such as severe winter weather, tornadoes, windstorms, earthquakes, hail and ice storms, thunderstorms and fires, and other events such as explosions, terrorist attacks and riots. The incidence and severity of severe weather conditions and catastrophes are inherently unpredictable. Severe weather conditions and catastrophes can cause losses in all of our property lines and generally result in an increase in the number of claims incurred as well as the amount of reimbursement sought by claimants. During 2006, we were not materially impacted by severe weather. It is possible that a catastrophic event or multiple catastrophic events could have a material adverse effect on our business, financial condition and/or operating results.
Adverse Securities Market Conditions Can Impact Our Investment Portfolio
Our results of operations depend, in part, on the performance of our investments. We own fixed maturity and equity securities that are subject to:
credit risk, which is the risk that our investments will decrease in value due to unfavorable changes in the financial prospects and/or a downgrade in the credit rating of an entity in which we have invested;
equity price risk, which is the risk that we will incur economic loss due to a decline in share prices; and
interest rate risk, which is the risk that our investments may decrease in value due to changes in interest rates.
Fluctuations in interest rates affect our returns on and the fair value of fixed maturity securities. Unrealized gains and losses on fixed maturity securities are recognized in accumulated other comprehensive income, net of taxes, and increase or decrease our shareholders equity. An increase in interest rates could reduce the fair value of our investments in fixed maturity securities. In addition, defaults by third parties who fail to pay or perform obligations could reduce our investment income and realized investment gains and could result in investment losses in our portfolio.
Our equity portfolio is subject to economic loss from the decline in preferred and common share prices. As a result, the value of these investments will be determined by the specific financial prospects of these individual companies, as well as the equity markets in general.
Changes in Interest Rates Could Impact our Debt Securities
Our trust preferred debt and revolving line of credit are subject to interest rate risk. The interest rate on the trust preferred debt is determined based upon three month LIBOR and the interest rate on the revolving line of credit is determined based upon the prime rate. Increases in the prevailing interest rates would result in an increase to our interest expense and could have a material adverse effect on our business, financial condition and/or operating results.
Default on Debt Covenants Could Impact our Financial Condition
A default under the terms of our trust preferred debt or revolving line of credit covenants could require us to make immediate payment on our outstanding debt. Such an event could have a material adverse effect on our business, financial condition and/or operating results.
Dependence on Key Executives
Our future success will depend, in large part, upon the efforts of our executive officers and other key personnel. We rely substantially upon our executive officers and other key personnel. Our future success will also depend on our ability to attract and retain additional executives and key personnel as necessary. The loss of any of these officers or other key personnel or our inability to attract and retain qualified personnel could prevent us from implementing our business strategies.
Reliance on Information Technology and Telecommunications Systems
Our business is dependent upon the successful and uninterrupted functioning of our information technology and telecommunications systems. We rely on these systems to process new and renewal business, provide customer service, make claims payments and facilitate
collections and cancellations. These systems also enable us to perform actuarial and other modeling functions necessary for underwriting and rate development. The failure of these systems could disrupt our operations and materially impact our ability to write and process new and renewal business, provide customer service or pay claims in a timely manner. These factors could have a material adverse effect on our business, financial condition and/or operating results.
Controlling Interest of the Sokol Family
Si Sokol, John S. Sokol and Saul Sokol, together with their immediate family members and a trust organized for the benefit of and controlled by the Sokol family, beneficially own approximately 61% of our common shares as of December 31, 2006. As a result, the Sokol family is able to control the election of our directors, determine our corporate and management policies and determine, without the consent of our other shareholders, the outcome of many corporate transactions or other matters submitted to our shareholders for approval. The interests of the Sokol family may differ from the interests of our other shareholders in some respects.
Ongoing SEC Investigation
As previously reported, on February 14, 2005, the Company received notification from the U.S. Securities and Exchange Commission (the SEC) that it was conducting an informal, non-public inquiry regarding the Company. The inquiry generally concerned the chronology, events and announcements relating to Ernst & Young LLP (E&Y), our former independent registered public accounting firm, withdrawing its audit reports for the years 2001 through 2003 for the Company. On March 29, 2005, the Company was notified by the SEC that the informal, non-public inquiry initiated in February 2005 was converted to a formal order of private investigation. The SEC stated in its notification letter that this private investigation should not be construed as an indication by the SEC or its staff that any violation of law has occurred nor should it be considered a reflection upon any person, entity or security. The investigation is ongoing and the Company continues to cooperate fully with the SEC.
The Company cannot predict the outcome of the SEC investigation. There can be no assurance that the scope of the SEC investigation will not expand. The outcome of and costs associated with the SEC investigation could have a material adverse effect on the Companys business, financial condition and/or operating results, and the investigation could divert the efforts and attention of management from the Companys ordinary business operations.
The Company is involved in various lawsuits and legal proceedings arising in the ordinary course of business, some of which involve claims for substantial amounts. We provide accruals for these items to the extent that we deem the losses probable and reasonably estimable. The outcome of litigation is subject to numerous uncertainties. As a result, the ultimate resolution of these legal proceedings could have a material adverse effect on our business, financial condition and/or operating results and could divert the efforts and attention of management from the Companys ordinary business operations.
Automobile Service Contract Program
During 2003, the Company began issuing insurance policies which guarantee the performance of two automobile service contract providers (the Providers). The Providers are owned and managed by a common group. The Company issues insurance policies for business produced by the Providers in five states. Our insurance policy guarantees the fulfillment of the Providers obligation under the service contract. Under the program, the Providers carry the related assets and reserves and are responsible for the premiums and claims administration. The Company is obligated to pay a claim only if a Provider fails to do so. Under a reinsurance arrangement, the Company cedes 100% of this business to another insurance carrier. In addition, the Company obtained collateral in the form of a letter of credit to secure its obligations under the program. In February 2007, the Company was notified that one of the Providers entered into an assignment for the benefit of creditors liquidation and that no new business is being produced by that Provider. The Company, with the assistance of its outside actuary, has estimated its potential exposure under the program to be approximately $3.0 million as of December 31, 2006. Because our estimated potential exposure is fully collateralized by a $4.3 million letter of credit and the loss exposure is 100% reinsured, we do not believe this event will have a material adverse impact to the Company. However, if the Company is required to pay claims under the program and it is unable to draw on the letter of credit and cannot collect on the reinsurance, then this program could have a material adverse effect on our business, financial condition and/or operating results.