UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

 

 

Commission file number 001-31698

 

BROOKE CORPORATION

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number:

(913) 661-0123

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered under Section 12(g) of the Act:
None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act of 1933.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(c) of the Securities Exchange Act of 1934.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

The aggregate market value of the registrant’s common stock held by non-affiliates, computed by reference to the price at which the stock was last sold, as of June 30, 2007, was $114,818,260.

 

The number of shares of registrant’s common stock, $.01 par value, outstanding on March 14, 2008 was 14,224,021.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain specified portions of our definitive proxy statement relating to the registrant’s Annual Meeting of Stockholders, to be held on April 24, 2008, are incorporated by reference in Part III to the extent described therein. In addition, information required by Item 701 of Regulation S-K with respect to the unregistered sale of equity to institutional accredited investors as provided in our Current Report on Form 8-K dated June 28, 2007 is incorporated by reference.

 

 

TABLE OF CONTENTS

 

 

We caution you that this annual report on Form 10-K includes “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 and is subject to the safe harbor created by that Act. Among other things, these statements relate to our financial condition, results of operations and business. These forward-looking statements are generally identified by the words or phrases “will,” “will allow,” “will continue,” “would,” “would be,” “expect,” “expect to,” “intend,” “intend to,” “anticipate,” “is anticipated,” “foresee,” “estimate,” “plan,” “may,” “believe,” “implement,” “build,” “project” or similar expressions and references to strategies or plans.

 

While we provide forward-looking statements to assist in the understanding of our anticipated future financial performance, we caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date that we make them. Forward-looking statements are subject to significant risks and uncertainties, many of which are beyond our control. Although we believe that the assumptions underlying our forward-looking statements are reasonable, any of the assumptions could prove to be inaccurate. Actual results may differ materially from those contained in or implied by these forward-looking statements for a variety of reasons. These risks and uncertainties are discussed in more detail under “Business,” “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report and include, but are not limited to:

 

 

We expressly disclaim any obligation to update or revise any of these forward-looking statements, whether because of future events, new information, a change in our views or expectations, or otherwise. We make no prediction or statement about the market performance of our shares of common stock.

 

 

References in this report to “we,” “us” and “our” are to Brooke Corporation and one or more of our subsidiaries, as the context requires.

 

General

 

We are a provider of banking, insurance, and other financial services with operations throughout the United States. Through our subsidiaries, we provide clients with analysis, advice and transactional capabilities across four operating segments: Banking Services; Brokerage Services; Insurance Services; and Lending Services. In addition, we operate certain captive insurance companies that self-insure portions of the professional insurance agents’ liability exposure of Brooke Capital Corporation, its affiliated companies and its franchisees and provide financial guaranty policies to Aleritas Capital Corp. (a d/b/a of Brooke Credit Corporation).

 

We were incorporated in Kansas on January 22, 1986 under the name of Brooke Financial Services, Inc. We later changed our company name to Brooke Corporation. We own, directly or indirectly through another subsidiary, 100% of all our subsidiaries, except for Brooke Capital and Aleritas, in which we are the majority shareholder. (See the diagram below.) Brooke Capital (AMEX: BCP) and Aleritas (OTCBB: BRCR) are publicly traded companies. Brooke Capital operates our Insurance Services business. Aleritas operates our Lending Services business. We operate our Banking Services business through Brooke Bancshares, Inc., a wholly-owned subsidiary, and we operate our Brokerage Services business through another wholly-owned subsidiary, Brooke Brokerage Corporation.

 

 

Brooke Bancshares, Inc.

 

The Agent Bank conducts its banking products and services operations primarily through contracted banker agents who are paid commissions for customer referrals. The Agent Bank’s main retail banking office is in Phillipsburg, Kansas and its agent training and support offices are in Overland Park, Kansas. The Agent Bank is a member of the Federal Home Loan Bank of Topeka (“FHLB”) and is subject to regulation, examination and supervision by the Office of Thrift Supervision (“OTS”) and the Federal Deposit Insurance Corporation (“FDIC”). The Agent Bank’s deposits are insured by the FDIC through the Deposit Insurance Fund (“DIF”).

Recent Developments

 

On January 8, 2007, following approval by the OTS and satisfaction of other closing conditions, Brooke Bancshares completed the acquisition of Generations Bank, a federal savings bank, by purchasing for $10.1 million in cash all of the issued and outstanding capital stock of Generations Bank from Kansas City Life Insurance Company pursuant to a Stock Purchase Agreement dated January 23, 2006. Generations Bank now operates under the name Brooke Savings Bank (the “Agent Bank”), and the main retail banking office for the Agent Bank has relocated from Kansas City, Missouri, to Phillipsburg, Kansas, and the agent training and support offices of the Agent Bank has relocated from Kansas City, Missouri to Overland Park, Kansas. The Agent Bank’s business plan is centered on the sale of bank products and services to consumers through referrals from Brooke Brokerage’s life insurance agents, Brooke Capital’s property and casualty insurance agents and other independent agents.

 

The Agent Bank entered into a purchase and assumption agreement with Bank of the West (“BOW”), a California state chartered bank located in San Francisco, California, on August 29, 2007, to purchase a network of 42 Kansas-based banker agents who refer deposit and loan business to the Agent Bank (the “Network”). The OTS approved the transaction on December 13, 2007. The transaction became effective as of the close of business on January 18, 2008 and added approximately $100 million in deposits and $7.5 million in loans to the Agent Bank’s balance sheet. The Agent Bank paid a deposit premium of approximately $2.9 million. On January 18, 2008, all checking, savings, money market, certificate of deposit and IRA accounts, and selected consumer loan accounts, such as auto loans, home equity loans, and home equity line of credit loans that were opened through the Network were transferred to the Agent Bank. As a result of this transaction, the Agent Bank reported total assets of approximately $141 million, total deposits of $125 million and total stockholders equity of $15.4 million as of January 31, 2008.

 

The Network’s banker agents are located in forty-two rural Kansas communities and have been providing banker agent services for many years. Railroad Savings Bank, located in Newton, Kansas and later relocated to Wichita, Kansas began forming the Network shortly after it was state chartered in 1896. Railroad Savings Bank converted to a federal savings bank charter in 1989 and its regulator, the Federal Home Loan Bank (predecessor to the OTS), grandfathered the Network under the federal regulations. Railroad Savings Bank was acquired by Commercial Federal Bank of Omaha, Nebraska in October 1995. Commercial Federal Bank was acquired by Bank of the West in December 2005.

 

Communities Served

 

The Agent Bank has designated Phillips and Johnson counties in Kansas as its primary lending assessment area, but these designations will be re-assessed on an annual basis as additional loan origination data becomes available. The Agent Bank provides services universally to its current customers and future customers in all regions of the United States. Brooke Brokerage and Brooke Capital have agents located in 29 states and it is anticipated that the Agent Bank will eventually enter into banker agent agreements with many of those agents. Thus, it is expected that the Agent Bank’s lending territory will continue to cover a wide geographic and diverse economic area.

 

Banking Services by Agent Bank

 

The Agent Bank intends to provide customers with a combination of products and service that engenders strong, mutually beneficial, long-term relationships, while also generating a reasonable return. The Agent Bank sells bank products and services to consumers through referrals from independent agents. The Agent Bank also sells bank products and services directly to consumers from its main banking office in Phillipsburg, Kansas and from its branch operation office in Overland Park, Kansas.

 

Agent Bank Lending

 

All loan underwriting and loan pricing decisions are made centrally by Agent Bank officers and employees. The Agent Bank relies on agent bankers to gather customer information and provide local background information, but agent bankers are not involved in loan underwriting or loan pricing decisions.

 

Agent Bank Deposits

 

All deposit product and pricing decisions are made centrally by Agent Bank officers and employees. The Agent Bank relies on agent bankers to gather application information, but agent bankers are not involved in deposit product or pricing decisions.

 

 

Banking Services by Community Banks

 

We plan to eventually leverage our banking expertise with acquisition of reasonably priced community banks. Unlike the Agent Bank where all underwriting and pricing decisions are controlled centrally, these types of decisions will be made locally by the management of any community bank that we may acquire. Acquiring or starting a community bank is consistent with our “local entrepreneur” philosophy, provided that local bank management has significant ownership in the bank (up to 20%) and marketing is focused on the local community.

 

Brooke Brokerage Corporation

 

Brooke Brokerage is our wholly-owned subsidiary that generates revenues from the sale of hard-to-place property and casualty insurance policies and life insurance policies on a wholesale basis by its CJD & Associates, LLC subsidiary.

 

Property and Casualty Insurance Brokerage

 

Brooke Brokerage serves as a wholesale insurance broker and has binding authority on behalf of certain insurance companies. Brooke Brokerage assists both Brooke Capital’s franchise agents and unaffiliated agents in finding property and casualty insurance coverage for hard-to-place and niche risks. We place business with

approximately ten major carriers and syndicates including Scottsdale Insurance Company, ACE European, Penn America and Penn Select Insurance Companies, United National Insurance Company, Burlington Insurance Group, Inc., Sagamore Insurance Company, Founders Insurance Company and Lloyds of London syndicates.

 

The following table shows wholesale commissions received by Brooke Brokerage through its subsidiaries for the years ended December 31, 2007, 2006 and 2005 (in thousands):

 

 

Life Insurance Brokerage

 

Since we transferred the property and casualty insurance agency to Brooke Capital on November 15, 2007, Brooke Brokerage expanded its activities to include life insurance sales on a wholesale basis. Brooke Brokerage and the Agent Bank together offer life insurance agents the opportunity to use our trade name and become banker agents. Unlike Brooke Capital’s property and casualty insurance agency franchise, Brooke Brokerage does not provide life insurance agents with administrative, cash management, document management or other such support and instead relies on life insurance agents to calculate and pay to us our share of monthly sales commissions.

 

Loan Brokerage and Consulting

 

On December 8, 2006, in connection with our acquisition of an ownership interest in Brooke Capital, Brooke Brokerage entered into a Brokerage Agreement by which, as of that date, First Life Brokerage, Inc. (now Brooke Capital Advisors, Inc.), a subsidiary of Brooke Capital, began operating a business providing loan consulting services to managing general agency borrowers and collateral preservation services to lenders. As a result, Brooke Brokerage is no longer engaged in this business.

 

Brooke Capital Corporation

 

Our insurance company operations and property and casualty insurance agency operations have been organizationally consolidated into Brooke Capital, a publicly-traded company listed on the American Stock Exchange of which we own 81%. Brooke Capital generates revenues from the sale of life insurance and annuity products by independent insurance agents through First Life America Corporation, a Kansas-domiciled life insurance company subsidiary. On November 15, 2007, Brooke Franchise Corporation, a wholly-owned subsidiary, was merged with and into Brooke Capital, resulting in Brooke Capital becoming a property and casualty insurance agency franchisor. These franchise activities are being consolidated into Brooke Investments, Inc., which is a subsidiary of Brooke Capital as a result of this merger. Thus, Brooke Capital now generates revenues from sales commission paid by insurance companies for the sale of property and casualty insurance policies by franchised agents.

 

Brooke Capital has also agreed to accept our contribution of all of the common stock of Delta Plus Holdings, Inc. (a transaction that is expected to be completed in the second quarter of 2008), which will result in the consolidation of virtually all of our insurance-related activities into Brooke Capital. Delta Plus, which we acquired on March 30, 2007, is the parent company of Traders Insurance Company, a Missouri-domiciled property and casualty insurance company. See below under “Contemplated Non-Standard Automobile Insurance” for more information.

 

Brooke Capital’s business is separated into two categories. The first category includes its operation of insurance companies including the issuance of life insurance policies by First Life America Corporation, a Kansas life insurance company (“FLAC”) and the issuance of auto insurance policies by Traders Insurance Company, a Missouri property and casualty insurance company (“TIC”). (TIC won’t actually become a subsidiary of Brooke Capital until the completion of the Delta Plus transaction as described above; pending that event, TIC’s business is only organizationally part of Brooke Capital.) The second category includes its

insurance agency operations which are being consolidated into Brooke Investments, Inc., dba Brooke Franchise (“Franchise”) and its insurance agency consulting activities conducted through Brooke Capital Advisors (“BCA”).

 

Insurance Company Operations

 

Life Insurance and Annuity Product Sales

 

FLAC sells life insurance and annuity products in eight states throughout the Midwest and brokers life, health, disability and annuity products of unrelated insurance companies.

 

Products of FLAC

 

The primary insurance products currently being marketed by FLAC are as follows:

 

Golden Eagle Whole Life (Final Expense) is available on a simplified issue or graded death benefit basis. The simplified issue product is issued from age 50 to 85 with death benefit coverage ranging from a minimum of $2,500 to a maximum of $25,000. The graded death benefit product is issued from age 50 to 80 with death benefit coverage ranging from a minimum of $2,000 to a maximum of $10,000. The policy includes a living benefit rider that pays the actuarial present value of the death benefit upon terminal illness or nursing home confinement. Premiums are level for life and vary by risk class, sex and issue age. First Life is in the process of modifying the premiums on this policy from unismoker to non-tobacco/tobacco rates. Fist Life expects to bring these new premium rates to the market in 2008.

 

First Whole Life is a permanent whole life insurance product with guaranteed level premiums and death benefits. Issue ages are 0 (30 days) to age 80. Rate classes include preferred non-tobacco, non-tobacco and tobacco. The product is non-participating. Available riders include accidental death, accelerated living benefit, waiver of premium, terminal illness and long-term care.

 

First Term is a level term life insurance product with term periods of 10, 15, 20 and 30 years. Both fully guaranteed and partially guaranteed premium options are available. For the partially guaranteed option, premiums are level for 5 years on the 10 year term, 10 years on the 15 year term, 13 years on the 20 year term and 17 years on the 30 year term, increasing annually thereafter. Rate classes include non-tobacco, preferred tobacco and tobacco. Issue ages for the 10, 15 and 20 are 18 to 60 for all classes. Issue ages for 30 year non-tobacco are 18 to 50, and issue ages for 30 year preferred tobacco and tobacco are 18 to 45. Available riders include return of premium, accidental death, accelerated death benefit and waiver of premium.

 

Value Builder is a modified payment whole life insurance policy with a flexible premium deferred annuity rider. The policy requires premium payments to be made for a certain number of years after which time the policyholder is entitled to policy benefits without making future payments. The product combines both a ten and twenty payment period based on the issue age of the insured. Issue ages from age 0 (30 days) to 20 and 66 to 80 are ten pay policies and issue ages from 21 to 65 are twenty pay policies. Premium payments are split between life and annuity based on percentages established in the product design. First year premium payments are allocated 100% to life insurance and renewal payments are split 50% to life and 50% to annuity. The product is being sold in premium units with the ability to purchase either fractional or multiple units. At the end of the required premium paying period, the policyholder may continue to make full premium payments into the annuity rider to provide for greater annuity accumulations.

 

First Step is a juvenile term product issued from age 0 (30 days) to age 15. Coverage is sold in units. One unit, consisting of a single premium payment of $100 purchases $5,000 of death benefit coverage, while two units, consisting of a single premium payment of $200 purchases $10,000 of coverage. The product contains a conversion provision allowing it to be converted to a whole life policy prior to age 21.

First Flex I is a flexible premium deferred annuity for ages 0 to 84. The initial interest rate is guaranteed for one contract year with a minimum guaranteed interest rate of 3%. The surrender charge period is seven years and up to 15% of the account value can be withdrawn each year without incurring a surrender charge. If the owner becomes confined to an extended care facility or hospital, the surrender charge may be waived up to a certain limit. The minimum deposit is $100.

 

First Max I is a single premium deferred annuity for ages 0 to 90. The initial interest rate is guaranteed for one contract year with a minimum guaranteed interest rate of 3%. The surrender charge period is five years and up to 15% of the account value can be withdrawn each year without incurring a surrender charge. If the owner becomes confined to an extended care facility or hospital, the surrender charge may be waived up to a certain limit. The minimum deposit is $500.

 

First Max III is a single premium deferred annuity for ages 0 to 90. The initial interest rate is guaranteed for three contract years with a minimum guaranteed interest rate of 3%. The surrender charge period is three years. If the owner becomes confined to an extended care facility or hospital, the surrender charge may be waived up to a certain limit. The minimum deposit is $500.

 

Easy Pack contains short form applications for simplified underwriting and quick issue. Products included in the Easy Pack are First Whole Life, First Term, First Step, Golden Eagle Final Expense and First Flex I, First Max I and First Max III. The Easy Pack is designed for the agent and consumer to receive quick underwriting decisions on the small face policies.

 

Product Marketing and Sales  FLAC’s marketing strategy is to provide life insurance and annuity products that are beneficial to the consumer and profitable. FLAC is therefore continually seeking new markets for its products primarily by utilizing its existing and new insurance agents to promote the sales of its products. FLAC sells its products through agents. These agents receive commissions and, subject to qualification, promotional incentives from FLAC based on premiums collected on the products sold. FLAC contracts the independent agents directly or through independent marketing organizations referred to as IMOs. IMOs generally are organizations that align multiple independent agents with specific insurers and products. The IMOs receive a portion of the overall commissions paid by FLAC on products sold by the agents. The IMOs recruit, train, contract and provide other support functions to the independent agents.

 

FLAC is currently licensed to transact life and annuity business in the states of Kansas, Texas, Ohio, Illinois, Oklahoma, North Dakota, Kentucky and Nebraska. Due to the varied processes of obtaining admission to write business in new states, management cannot reasonably estimate the time frame of expanding its marketing presence.

 

Insurance Inforce  The following table provides certain information about FLAC’s volume of life insurance coverage inforce for each of the last three years:

 

 

 

 

The following table provides certain information about FLAC’s policy count for each of the last three years:

 

 

As evidenced by the tables above, the average face amount per policy issued has approximated $10,500, $8,700 and $9,000 during 2005, 2006 and 2007, respectively. The relatively small face amount issued is directly related to increased focus being placed on production of FLAC Final Expense product over the past three years. The Final Expense product has a maximum face amount of $25,000, a level significantly less than the other products historically marketed by FLAC.

 

Reinsurance  In order to reduce the financial exposure to adverse underwriting results, insurance companies generally reinsure a portion of their risks with other insurance companies. FLAC has entered into agreements with Generali USA Life Reassurance Company (“Generali”) of Kansas City, Missouri, Optimum Re Insurance Company (“Optimum Re”) of Dallas, Texas, and Wilton Reassurance Company (“Wilton Re”) of Wilton, CT, to reinsure portions of the life insurance risks it underwrites. Pursuant to the terms of the reinsurance agreements, FLAC retains a maximum coverage exposure of $50,000 on any one insured. In the event that the reinsurance companies are unable to fulfill their obligations under the reinsurance agreements, FLAC remains primarily liable for the entire amount at risk.

 

FLAC is party to an Automatic Retrocession Pool Agreement (the “Reinsurance Pool”) with Optimum Re, Catholic Order of Foresters, American Home Life Insurance Company and Woodmen of the World. The agreement provides for automatic retrocession of coverage in excess of Optimum Re’s retention on business ceded to Optimum Re by the other parties to the Reinsurance Pool. FLAC’s maximum exposure on any one insured under the Reinsurance Pool is $50,000.

 

Underwriting  FLAC follows underwriting procedures designed to assess and quantify insurance risks before issuing life insurance policies. Such procedures require medical examinations (including blood tests, where permitted) of applicants for policies of life insurance in excess of certain policy limits. These requirements are graduated according to the applicant’s age and vary by policy type. The life insurance subsidiary also relies upon medical records and upon each applicant’s written application for insurance, which is generally prepared under the supervision of a trained agent.

 

Actuarial Services  FLAC has a contract with a consultant to provide actuarial services.

 

Investments  The Kansas Insurance Code restricts the investments of insurance companies by the type of investment, the amount that an insurance company may invest in one type of investment, and the amount that an insurance company may invest in the securities of any one issuer. The restrictions of the Kansas Insurance Code are not expected to have a material effect on the investment return of FLAC. Brooke Capital is not subject to the limitations, which restrict the investments made by FLAC. Currently, investments of FLAC are held in both short-term, highly liquid securities and long-term, higher yield securities. The investment strategy is focused primarily on matching maturities to the anticipated cash needs of FLAC, but also attempts to match the investment mix to others within FLAC’s industry peer group.

 

Financial Information  See Note 9 to Item 8 “Financial Statements” in this Form 10-K for financial information regarding our insurance company operations.

Contemplated Non-Standard Automobile Insurance

 

Brooke Capital plans to offer proprietary non-standard automobile insurance through its distribution network. For this reason, it intends to consummate the transactions contemplated in that certain Exchange Agreement dated August 31, 2007 among us, Brooke Capital, and Delta Plus (the “Exchange Agreement”). Under the Exchange Agreement, we will contribute to Brooke Capital all of the outstanding stock of Delta Plus in exchange for consideration equal to 500,000 shares of Brooke Capital common stock, with an opportunity to receive additional shares of Brooke Capital common stock pursuant to an earn-out.

 

Overview.  Delta Plus is a holding company based in Kansas City, Missouri that directly or indirectly owns 100% of Traders Insurance Connection, Inc. (“Connection”), Traders Insurance Company (“TIC), Professional Claims, Inc. (“PCI”), and Christopher Joseph & Company (“CJC”). TIC is Delta Plus’s primary operating subsidiary and the revenues of Connection and PCI are primarily derived from providing management, professional and administrative services to TIC.

 

TIC is a Missouri-domiciled property casualty insurance company that writes non-standard private passenger auto liability and physical damage business in the states of Arkansas, Missouri, Kansas, Oklahoma and New Mexico. TIC’s auto insurance policies are marketed through independent agents. Connection provides management services to TIC, including marketing, sales, risk selection and policy administration services. PCI operates as an independent claims management company for TIC and other unrelated insurance companies, providing for the management, investigation and adjusting of insurance claims. CJC is a retail insurance agency that does not currently generate a significant part of Delta Plus’s revenues.

 

Brooke Corporation acquired 100% of Delta Plus on March 30, 2007.

 

Insurance Company Activities of Traders Insurance Company.  TIC underwrites and sells non-standard personal automobile insurance policies that provide coverage to drivers who find it difficult to obtain insurance from standard automobile insurance companies due to lack of prior insurance, age, driving record, limited financial resources or other factors. Non-Standard personal automobile insurance policies generally require higher premiums than standard automobile insurance policies for comparable coverage. The highest limits of liability coverage written by TIC are $25,000 per bodily injury incident with aggregate payments of $50,000 and $25,000 property damage liability coverage. In addition to liability coverage, TIC offers collision coverage and comprehensive coverage.

 

During 2007, approximately 83% of all premiums written by TIC were for liability coverage and approximately 7% were for physical damage coverage. During 2007, approximately 41% of total premiums were written in Oklahoma, 24% in Missouri and 26% in Kansas.

 

TIC encounters a very competitive environment in its target personal auto insurance market. TIC distributes exclusively through independent insurance agents, but it also competes with direct writers such as Progressive Direct and GEICO and captive standard carriers that typically relax their underwriting standards during softening markets. New carriers like Phoenix Indemnity and Bristol West continue their expansion into TIC’s markets, while current competitors such as Progressive Direct, Unitrin, Infinity, Dairyland, and Viking implement moderate pricing reductions. Falling premiums and the resulting adverse affect on agents’ top line commission revenues, creates upward pressure on TIC’s commission expenses. However, non-standard auto insurance underwriters are demonstrating a more disciplined pricing and underwriting response to this softening market than they have in prior cycles. It is difficult to predict whether this discipline will continue throughout the cycle or whether top-line growth goals will cause them to abandon the pricing discipline in exchange for sales.

 

TIC remains conservatively invested with 94% of its 2007 net admitted invested assets in U.S. Government or U.S. Government guaranteed obligations, investment grade corporate bonds or cash. U.S. Government obligations represented more than 56% of TIC’s total bond portfolio at December 31, 2007. TIC utilizes a “step-ladder strategy” with its bond portfolio to stagger maturities to ensure available cash to meet its obligations. The “step ladder strategy” also protects TIC’s investment return from volatile swings in interest rates. A relatively small portion of TIC’s total bond portfolio is allocated to equity securities.

TIC utilizes “Quota-Share” reinsurance which allows it to reduce underwriting risk and increase underwriting capacity. TIC has utilized the same reinsurance carrier since 1995 and transfers about 30% of its underwriting exposure, through reinsurance arrangements. The amount of the cession is reviewed annually and is increased or decreased based on projected premium writings and capital & surplus.

 

TIC is in the second year of a development contract with Information Distribution and Marketing Inc. (“IDMI”) for a web based policy and claims administration system known as PTS. IDMI granted TIC the right to use the system pursuant to a Licensing Agreement. TIC hosts PTS on its network while IDMI provides support and maintenance pursuant to a Maintenance Agreement. TIC has recently completed a migration from its legacy policy administration system and anticipates completing development of the claims administration during the first quarter of 2008. PTS includes a point of sale module which includes automated underwriting functionality that enables policy issuance at point of sale.

 

The Missouri Insurance Department completed its last Market Conduct Examination of TLC and issued its Report and Order covering the period of July 1, 2004 through June 30, 2005 wherein its sole findings involved a claim that TIC did not provide a sufficiently descriptive reason for its nonrenewal of certain policies. The Department did not make any significant findings of violations or exceptions and did not assess any fines, settlements or recoveries against TIC. The Missouri Insurance Department completed a full scope association financial examination of TIC covering the period of January 1, 2003 through December 31, 2005 wherein it made no adverse notes, comments or recommendations.

 

Managing General Agency Activities of Traders Insurance Connection, Inc.  Connection is typically delegated authority to do all things necessary and incidental to conduct, on behalf of an insurance company (such as TIC), the sale, underwriting and servicing of insurance policies. Such authority includes without limitation (1) selling, underwriting, accepting, issuing, declining and canceling risks; (2) collecting premiums and paying return premiums on policies of insurance; (3) entering into agreements with insurance agents and producers properly licensed by an insurance company, and (4) paying commissions to agents and producers for the sale of insurance policies. Connection also provides the reports required by insurance companies for their accounting and regulatory compliance needs.

 

Connection is paid a commission or a percentage of written premiums and related fees. From the commissions received from an insurance company, Connection pays commissions to agents and producers. For the calendar year 2007, Connection received $4,247,000 in commissions from insurance companies of which $4,124,000 was related to premiums produced on behalf of TIC. The remainder of the commissions was generated on a book of business produced in the state of Arkansas under a contract with an unrelated insurance company. Connection paid agents and producers approximately 50%, or $2,140,000 of the commissions it received from insurance companies.

 

Managing General Agency Activities of Professional Claims, Inc.  TIC compensates PCI for claims management services on a cost pass through basis by assessing a percentage of the compensation, third party vendor adjusting expenses and other claims related expenses to TIC based on the ratio that Traders’ claims represents the total claims under PCI’s administration. The precise compensation terms are outlined in a Claims Management Agreement and Expense Sharing Agreement filed with and approved by the Department of Insurance Financial Institutions and Professional Registration.

 

Delta Plus’s philosophy on settling claims is to conduct an early evaluation based upon a thorough investigation. Delta Plus emphasizes immediate contact with insureds and claimants, sound fundamental claim handling skills as well as completion of the initial investigation within 15 days. Workloads are kept at a manageable level, which permits the individual claim handler to devote sufficient time to all assigned claims and assure prompt and fair claim settlements and payments. It is the Company’s goal to settle claims in which its insureds are clearly liable if an agreement can be reached regarding the damages. While the Company prefers a rigorous defense on claims where liability is questionable or the damages sought are outside the realm of reasonableness, the Company does evaluate many factors on each file and makes what it ultimately believes to be the best decision for it and its policyholders. Working with PCI, Delta Plus makes every effort to evaluate all claims carefully and fairly considering the issues of liability, injuries, damages, cost of defense and compliance with the Unfair Claim Practices Act.

Insurance Agency Operations

 

Franchise Operations

 

Brooke Capital is one of the largest franchisors of property and casualty insurance agencies in the United States, based on number of locations. Brooke Capital offers to its franchise network access to the products of many leading insurance carriers, marketing and business management support, back office assistance, financial management tools and association with an emerging brand identity. According to Entrepreneur Magazine, January 2008, Brooke Capital was ranked first in its industry category of franchisors of miscellaneous financial services based on factors such as financial strength, stability, growth rate and size of system.

 

Currently, it franchises businesses that primarily sell property and casualty insurance, such as automobile, homeowners and business owners insurance products. Brooke Capital has also franchised businesses that primarily sell group and individual health insurance, life insurance, annuities and securities, such as mutual funds.

 

Based on commission revenue for the year ended December 31, 2007, Brooke Capital generated approximately 71% of its retail commission income from personal lines insurance, such as auto and homeowners insurance, and approximately 26% from commercial lines insurance such as commercial general liability and business owners insurance.

 

Franchisees.  Brooke Capital franchisees are typically entrepreneurial individuals with experience in the sale of insurance. Brooke Capital believes that these entrepreneurial individuals and the businesses they operate will benefit from the business, operational and marketing support that we offer. Because they are locally-owned and operated by motivated entrepreneurs, Brooke Capital believes that its franchises will perform better than their competitors. The franchisees generally either form a new start up insurance agency or convert an existing insurance agency to a franchise. In January 2006, Brooke Capital began developing business locations that had not been previously owned by a franchisee or independent insurance agency. These company developed stores may be operated by Brooke Capital and then sold to a franchisee or set up by Brooke Capital for operation, with the franchisee commencing operations and assuming the operating expenses. As of December 31, 2007, 2006 and 2005, Brooke Capital had 882, 737 and 552 franchise locations, respectively.

 

The following table shows the states that have more than fifteen franchise locations as of December 31, 2007.

 

The other 12 states in which Brooke Capital operates had a total of 74 franchise locations as of December 31, 2007, of which 74 were property and casualty insurance agencies. For these 74 agencies, 44 were conversion franchisees, 30 were start up franchisees, and none were company developed locations.

 

Dependence on the availability of funding for acquisition and operating needs of Brooke Capital franchisees.  Our continued growth is dependent upon a number of factors, including the availability of funding for acquisitions and operating needs of our franchisees. Aleritas has historically provided loans to our new franchisees for these purposes.

 

The ability of Aleritas to be a lending source is dependent upon a number of factors including: the ability of its borrowers to repay loans made to them, the willingness of its funding sources to make loans to Aleritas, its perception with rating agencies and collateral providers, and other factors, many of which may be beyond the control of Aleritas. In addition, Aleritas has announced that it is transitioning from a franchise lender to an industry lender. Aleritas has also reported that it restricted the financing of new start up franchise loans during the fourth quarter of 2007 unless such loans were made in connection with the sale of an inventory franchise business. Aleritas has advised the Brooke Capital that it expects to originate a greater percentage of new loans for non-franchise retail agencies than franchise agencies in the future.

 

Although it is an affiliated company, Aleritas is not required to make loans to Brooke Capital franchisees. If Aleritas is unable or unwilling to make loans to Brooke Capital franchisees, our growth strategy will be negatively impacted. We are monitoring this situation and seeking additional funding sources.

 

Support for our franchisees.  Brooke Capital offers to its franchisees the business opportunities, efficiencies and other resources more typical of a large company. These include:

 

Access to the products of leading insurance carriers.  As a general matter, insurance companies require their independent agents to produce specified minimum premium volumes in order to continue selling their products. While smaller insurance agencies may be able to meet such minimum premium volumes for one or even a few carriers, it is often difficult for such insurance agencies to meet these minimum requirements for many carriers, thereby limiting the agent’s ability to offer a variety of insurance products to their customers. Brooke Capital aggregates the insurance premium volumes generated by its franchisees, approximately $880,000,000 for the year ended December 31, 2007, in order to gain access to the insurance products of hundreds of insurance companies, including 14 of the 20 largest property and casualty insurers in the United States, as measured by net premiums written, such as Progressive, AIG, Chubb, Travelers and The Hartford, and other national carriers such as Safeco, Zurich and Liberty Mutual Companies Insurance. This consolidated purchasing power generally allows our franchisees to offer more insurance products than they would have on their own.

 

Professional marketing.  Brooke Capital has an advertising center facility on its Phillipsburg, Kansas campus and specialized teams of marketing professionals with expertise in traditional advertising, direct-mail advertising, yellow pages advertising, public relations, lead generation and office location analysis. These professionals assist the franchisees in identifying potential customers, developing marketing programs, coordinating advertising purchases, and measuring marketing effectiveness. Brooke Capital’s lead generation system, which includes referrals from insurance companies, lead brokers, e mail solicitations and the online quote request system, helps our franchisees identify prospective customers. Brooke Capital employed a total of 41 marketing professionals to serve its growing network of insurance franchisees.

 

Facilities support.  Facilities support is provided by professionals who assist franchisees with office location selection, office setup and ongoing office support. Brooke Capital has a total of 28 employees on its facilities support teams.

 

Business administration.  Brooke Capital provides a range of administrative support services to the franchisees that enhance operating efficiency. First, Brooke Capital provides cash management services such as daily consolidation of all cash collected by franchisees and reconciliation of sales commissions and other revenue to the franchisee’s account statement. As part of its cash management services, in order to assist the franchisees with the monthly fluctuation of revenues, Brooke Capital also makes short-term

commission advances to the franchisees, which it generally expects to be repaid within 120 days. As of December 2007, there was approximately $9,662,000 of principal amount of these commission advances outstanding, of which $9,077,000 had been outstanding for more than 120 days. Brooke Capital also makes advances to franchisees for long-term producer development, including hiring and training of new franchise employees, and for other reasons not related to monthly fluctuations of revenues. As of December 2007, there were approximately $9,798,000 of commission advances outstanding for the longer-term non-statement balances. Second, through the Brooke Information System, franchisees access an information and communication system that is capable of providing authorized users an online virtual office and, among other things, facilitates franchisee/franchisor communications regarding documentation, receipt of premium, commission allocation, customer ownership identification and record retention. Third, Brooke Capital has established buying groups to assist franchisees in the purchase of office equipment, supplies and services at bulk discounted rates that may otherwise be unavailable to them.

 

Financial discipline.  Brooke Capital works with franchisees to devise budgets and action plans to help enhance agency performance. Brooke Capital monitors its franchisees’ performance and work with franchisees to address negative operating trends. As a result, Brooke Capital generally can identify those franchisees who may have difficulty in meeting their obligations to Aleritas or who may become unable to repay short-term commission advances within the specified 120 day period. In cases where Brooke Capital identified financial or operational problems, it generally can help instill greater financial discipline by establishing expense controls, making changes in management or, in severe cases, assuming day-to-day management of the franchise pursuant to a management agreement.

 

Brooke Capital believes that these resources and systems provide franchisees the ability to compete favorably against both independent agencies and “captive” insurance agencies controlled by large insurance companies, such as Allstate Insurance Group, State Farm, Farmers Insurance and Nationwide Group. Brooke Capital believes that franchisees have significantly greater resources, including greater access to insurance products, than many other independently owned property and casualty insurance agencies. Further, Brooke Capital believes franchisees’ ability to offer their customers more insurance products provides them with a competitive advantage over “captive” insurance agencies, who generally can offer their customers only the products of their affiliated insurance carrier.

 

Business model.  Brooke Capital generates revenues through our network of franchise locations in the following ways:

 

Share of ongoing revenues.  Brooke Capital receives commission payments from the insurance companies that write the policies sold by franchisees through its affiliated company, Brooke Agency Services Company LLC (“BASC”). BASC accounts to Brooke Capital for the commissions earned and it then remits to franchisees the balance of these commissions, net of any loan payments, franchise fees, and other fees or amounts owed to us. As part of the franchise relationship, Brooke Capital also receives a franchise fee in the form of a percentage of the ongoing revenues of each franchisee, which is generally 15% of insurance agency franchisees’ revenues. In late 2007, Brooke Capital instituted a “bonus back” of a portion of the monthly franchise fee, which effectively lowers the percentage generally paid by franchisees to 10%. Brooke Capital receives an additional share of franchisees’ commissions in payment for a franchisee’s optional use of the service centers. At such centers, a franchisee shares the use of office space, customer service representatives, telephone answering and receptionist services, and general office management with other franchisees.

 

Franchise fees.  Brooke Capital earns initial franchise fees from franchisees starting up a new franchise location, from franchisees acquiring a company developed franchise location, and from franchisees converting an existing agency into a new franchise location. These fees include:

 

 

 

Seller consulting fees.  Brooke Capital advises the owners of insurance agencies and, to a lesser extent, other businesses, on the sale of their businesses to our franchisees and, in a limited number of cases, to unaffiliated third parties. Brooke Capital helps sellers develop business profiles and tabulate revenues, share sample sales agreements and assist with general sale preparation. These consulting fees usually equal 10% of the total purchase price of the agency to be sold.

 

The following table shows the revenues and fees Brooke Capital received from franchisees for the years ended December 31, 2007, 2006 and 2005 (in thousands):

 

 

 

 

Borrower consulting fees.  Through its wholly-owned subsidiary, BCA, Brooke Capital provides consulting services to managing general agencies and collateral preservation services relating to such agencies’ loans. BCA expanded such business in 2007 to include similar services for funeral home businesses and loans related thereto. Brooke Brokerage has not engaged in this business since December 2006.

 

Beginning in December 2006, BCA began operating a business of (1) consulting with managing general agents and agencies regarding (a) acquisitions of such agencies, (b) financing of such acquisitions or other activities or needs of such agencies, and (c) other borrower’s assistance services; (2) referring such managing general agents and agencies to affiliated and non-affiliated lenders for the purpose of obtaining commercial loans from such lenders for such acquisitions, activities or needs; and (3) providing collateral preservation services to such lenders through BCA’s managing general agency (“MGA”) and funeral home loan programs with respect to such loans for which BCA receives a fee. These fees may be funded by the loans of such lenders to the borrowers and/or compensation from such lenders for collateral preservation services.

 

BCA’s originated its first loans in December 2006. Revenue from this business segment is derived from commissions and fees generated through the loan brokerage and collateral preservation activities. Income received by BCA in 2007 was $11,609,000 of which $9,246,000 was generated through the Loan Brokerage segment. Aleritas’ ability and willingness to be a funding source for loans to managing general agencies has been an important factor in BCA’s ability to broker loans to these borrowers and its ability to generate collateral preservation fees.

 

Aleritas Capital Corp.

 

In July 2007, Brooke Credit Corporation merged with Oakmont Acquisition Corp., a public shell company. In connection with the merger, Oakmont Acquisition Corp. changed its name to Brooke Credit Corporation. In January 2008 Brooke Credit adopted the trade name of Aleritas Capital Corp. (“Aleritas”) as part of a re-branding effort and expects to accordingly change its corporate name in April 2008. We currently own approximately 62% of the common stock of Aleritas, a publicly-traded company traded on the over-the-counter bulletin board, through which we manage our lending operations. Aleritas is a finance company that lends to businesses that sell insurance and related services. Aleritas generates most of its revenues from

interest income resulting from loans held on Aleritas’ balance sheet in the form of inventory loans held for sale and from gains on sale of loans when they are removed from Aleritas’ balance sheet.

 

Aleritas is a specialty finance company that lends primarily to locally-owned businesses that sell insurance, including franchisees of Brooke Franchise. Aleritas’ target market consists of retail insurance agencies, and managing general agencies, where the sale of insurance is their primary business. In addition, Aleritas loans money to funeral home owners, where insurance is often an important, although not primary, part of their business. Aleritas started its lending programs in 1996 to serve as a finance company for the capital needs (primarily for business acquisitions) of the franchisees of Brooke Franchise. In subsequent years, Aleritas leveraged its expertise of loaning money to Brooke Franchise franchisees to lend money to other insurance-related businesses that are not franchisees of Brooke Franchise, including non-franchise retail insurance agencies, managing general agencies and funeral homes.

 

Lending Programs

 

Aleritas is focused on lending to small “main street businesses” across America, primarily in insurance-related industries, which have historically been underserved by traditional lenders. Aleritas lends to four types of borrowers:

 

 

Sourcing

 

Aleritas has established itself as a premier lender in its target markets. Aleritas’ credit applications are primarily generated from referrals from its proprietary loan sourcing network and the results of internal marketing efforts. In many cases, industry participants that are part of Aleritas’ sourcing network also provide collateral preservation and loss mitigation services during the life of a loan. This provides for a symbiotic

relationship where referral sources are strategically aligned and economically motivated to forward high quality loan opportunities to Aleritas and provide high quality value added support to address credit problems as they arise.

 

Underwriting

 

Over the years, Aleritas has acquired an underwriting expertise in loaning money to insurance and funeral home professionals, which includes detailed risk profiling, personality testing, revenue analysis, supplier relationships, marketing activities, producer relationships and customer retention. In addition to the repayment, financial condition, and collateral analyses of each application, Aleritas emphasizes the analysis of an applicant’s human capital and focuses on loaning money to individuals with a successful track record, demonstrable financial commitment and experience in their profession.

 

Collateral Preservation Services

 

Aleritas utilizes industry consultants (including Brooke Capital and its subsidiaries) to perform upfront and ongoing collateral preservation services. These consultants assist Aleritas in performing due diligence, monitoring the borrowers’ business performance, identifying negative operating trends and providing management expertise to address such negative trends. In instances where the borrowers have failed to perform, Aleritas, with the assistance of these consultants, works to assume management of the business, address any relevant operating problems and then sell or facilitate the sale of the business to another interested party. In addition, as noted in the “Sourcing” section above, because of their contacts and reputation in their respective industries, these consultants represent a valuable source of referrals for loan applications. These consultants receive an ongoing collateral preservation fee over the term of the loan which is a percentage of the outstanding loan balance. Aleritas utilizes these sources of loan applications because the consultants have a monetary incentive as a result of the ongoing fee to refer quality credit applications to us. Furthermore, Aleritas feels that these consultants are more likely to refer loans to Aleritas as most of its competitors are less likely to purchase post-funding collateral preservation services.

 

Aleritas generally utilizes three levels of collateral preservation services. The first level of collateral preservation includes protections that are a natural result of a franchise or agency relationship, such as the franchise program offered by Brooke Capital or an agency program offered by a captive insurance company. The collateral preservation benefits offered by enrollment in such a program include (1) access to large company resources such as branding and administrative support; (2) a lock box arrangement facilitated by the franchisor or captive carrier that helps ensure loan payments are made on a timely basis; (3) access to franchisor or captive carrier generated revenue trend reports; and (4) a franchisor and captive insurer with a vested interest in the success of their agents. The second level of collateral preservation includes initial due diligence of an applicant, such as borrower interviews and inspection reports, and ongoing routine contact with borrowers, collection of information for credit reviews and periodic collateral inspections. The third level is specialized consulting in instances where the borrowers have defaulted on payment or have breached other loan covenants. These consultants assist Aleritas in management of the business of the affected borrower, addressing relevant operating problems and selling or facilitating the sale of the business to another interested party. Brooke Capital has been a major provider of collateral preservation services for franchise loans. Brooke Capital recently communicated to Aleritas its intent to significantly reduce its rehabilitative support to certain franchise locations which are underperforming. Aleritas expects this reduction to have a negative impact on its franchise portfolio and is closely monitoring this situation to assess the impact of Brooke Capital’s action on the quality of the loan portfolio and the adequacy of the loan loss reserves. Aleritas is actively sourcing additional collateral preservation providers, although the cost of the services could be higher than Aleritas’ historical cost.

 

No compensation is paid by Aleritas for the first level of collateral preservation, since it is the natural result of an existing relationship the borrower has with a franchisor or captive insurance company. However, consultants are paid up to 1% of the original principal balance of the loan to assist Aleritas with initial due diligence and, until the loan is repaid, up to 1/12 of 1% of the current loan balance on a monthly basis to assist

in the ongoing monitoring of borrower performance. Additional fees which vary on a case by case basis may be paid to consultants for management and liquidation services.

 

Loan Funding

 

Aleritas funds its loans through a combination of the following three funding mechanisms.

 

 

Portfolio Performance

 

As a specialty lender, Aleritas believes its critical benchmark is the performance of its underlying loan portfolio. It believes it has a sourcing platform, experienced and disciplined underwriting, and an innovative collateral preservation platform. In Aleritas’ opinion, these help it to better measure, monitor and control credit quality. However, during the second half of 2007, Aleritas experienced an increase in impaired loans, the majority of which related to Brooke Capital franchise loans. These impaired loans included an increase in loan delinquencies, an increase in defaulted loans, and an increase in agencies with loans under management by Brooke Capital. The insurance industry continues to be impacted by a soft insurance market, which is having a direct impact on credit quality within Aleritas’ franchise loan portfolio. To compound this industry condition, during the fourth quarter of 2007, Brooke Capital communicated to Aleritas its intent to significantly reduce rehabilitation support of certain franchise locations which are underperforming. This cost reduction measure may result in more lender losses as there will be less emphasis on rehabilitating poorly performing franchisees and more emphasis on moving poorly performing franchises out of the franchise system. As a result of this philosophy change by Brooke Capital, Aleritas expects that certain franchise loans, in which Brooke Capital has historically provided rehabilitation support, will likely result in liquidations and potential credit losses. Delinquencies of start up franchise loans continue to increase as more start-up businesses reach scheduled maturity and the underlying agency has not reached the required minimum monthly threshold. During the fourth quarter of 2007, Aleritas restricted the financing of new start-up franchise loans, unless such loans were made in connection with the sale of an inventory franchise business. Franchise loans comprised approximately 51% of the loan portfolio at December 31, 2007. During 2008, the Company expects to originate a greater percentage of new loans from non-franchise retail agencies than franchise agencies.

 

Bermuda Captive Insurance Companies

 

We own Bermuda captive insurance companies, which self insures a portion of our errors and omissions insurance for insurance agency operations and financial guaranty policies on loans Aleritas makes. DB Indemnity, Ltd., a Class 1 Bermuda Captive Insurer that may only insure our risks, and not those of unaffiliated third parties, issues financial guaranty policies on loans we make. As of December 31, 2007, DB Indemnity had statutory capital and surplus of $487,000. The DB Group, Ltd., a Class 3 Bermuda Captive

Insurer, replaced DB Indemnity, Ltd. in 2006 as the self-insurer of a portion of our errors and omissions insurance. As of December 31, 2007, The DB Group, Ltd. had statutory capital and surplus of $1,000,000. During 2006, the captive insurance companies were owned by Brooke Investments, Inc., which acquired them from Brooke Brokerage at the end of 2005. During 2007, the captive insurance companies were purchased by Brooke Bancshares, Inc., our wholly-owned subsidiary.

 

The following table shows premiums received by the captive insurance companies through its subsidiaries for the years ended December 31, 2007, 2006 and 2005 (in thousands):

 

 

Competition

 

Brooke Bancshares, Inc.

 

The Agent Bank faces intense competition from a significant number of other banks and financial service providers. The Agent Bank competes with federal and state banks, savings and loan associations, and credit unions for deposit and loan products and services. In addition, we compete with other financial intermediaries such as securities brokers and dealers, personal loan companies, insurance companies and finance companies. The methods of competition center around various factors, such as customer services, interest rates on loans and deposits and customer convenience.

 

Brooke Brokerage Corporation

 

Our insurance brokerage product line competes for business with a large number of brokerage companies, some of which are independently owned and others of which are owned by major retail insurance agency companies. Many independent insurance agents and insurance brokers have developed insurance programs for specific market niches and provide significant competition.

 

Brooke Capital Corporation

 

Insurance Company Operations.  The life insurance industry is extremely competitive. There are a large number of insurance companies that are substantially larger, offer more diversified product lines and have larger selling organizations and customer bases than FLAC. The life insurance sector of the financial services industry is highly competitive with respect to pricing, selection of products and quality of service. No single competitor or any small group of competitors dominates any of the markets in which Brooke Capital operates.

 

Insurance Agency Operations.  As a franchisor of property and casualty insurance agencies, Brooke Capital seeks to grow its network of franchises primarily through start up franchise agencies, company developed agencies and conversions of existing insurance agencies to franchises. Competition for these agencies and experienced agents includes large insurance companies that recruit insurance agents and agencies into their systems, such as Allstate Insurance Group, Nationwide Group and State Farm, all of which are larger and have greater financial resources than Brooke Capital. Because the larger insurance brokers and agents generally seek to acquire agencies with revenues greater than those Brooke Capital acquires, it believes that the franchising strategy offers an attractive alternative for smaller insurance agencies. Brooke Capital also faces competition from regional franchisors of insurance agencies, such as Fed USA Insurance/Financial Services and DCAP Group, Inc., and networks of independently owned insurance agencies, such as Strategic Independent Agents Alliance and The Iroquois Group.

 

Franchisees primarily compete against independent insurance agencies located in their communities, against the locally-placed “captive” insurance agencies of large insurance companies and against large insurance agencies and brokers. Franchisees compete against these companies for the insurance business of the individual and small business end-customers. The popularity of Internet sales and the passage of the Financial

Services Modernization Act also have increased the number of potential insurance and financial services competitors. In the sale of other financial services, Brooke Capital’s competitors include independent securities representatives, life insurance agents and securities dealers.

 

There are many independent loan brokers that compete for the loan brokerage and consulting business sought by BCA. Brooke Capital believes that its industry contacts and the limited markets in which it competes for loans distinguish it from other brokers and lenders.

 

Aleritas Capital Corp.

 

Aleritas faces limited competition within its target markets. Because lender specialization or specialized underwriting expertise is typically required in order to make credit worthy loans to insurance-related businesses, most lenders generally shy away from these loan types because they lack this expertise. For the insurance sector, Oak Street Funding, a specialty finance company, serves as Aleritas’ primary competitor and for the death care industry, Midwest Bankers, a specialty finance company, serves as its primary competitor.

 

Service Marks, Trademarks and Patents

 

We sell our services and products under service marks and trademarks, license the use of certain marks to our franchisees, and attempt to obtain protection for these marks by registration with the United States Patent and Trademark Office. We consider these service marks and trademarks, in the aggregate, to be of material importance to our business, particularly our business segments providing services and products under the “B BROOKE” and design marks and other marks that utilize our “Brooke” name. We have no registered patents that are material to our business.

 

Employees

 

We employed 671 people as of December 31, 2007, of which 632 were employed on a full-time equivalency basis (work 37.5 hours or more per week). Of these employees, Brooke Corporation employed 33 people, CJD & Associates employed 28 people, Brooke Savings Bank employed 9 people, Delta Plus employed 53 people, Brooke Capital employed 516 people and Aleritas employed 32 people. We have never had a work stoppage, and none of our employees are currently represented under collective bargaining agreements. We consider our relations with our employees to be good.

 

Suppliers

 

Most of our revenues currently result from our franchisees’ sales of insurance policies. Our primary suppliers are therefore insurance companies, and we have direct and indirect agency relationships with several hundred insurance companies, including several of the leading writers of personal lines and commercial insurance in the United States. Our largest suppliers include Progressive, Safeco, AIG, Travelers and GMAC Insurance, which together account for approximately 31% of the commissions generated by our franchisees. We have agency agreements with each of the suppliers listed above.

 

Government Regulation

 

Brooke Bancshares, Inc.

 

The Agent Bank is subject to regulation by the OTS. Brooke Bancshares, Brooke Corporation and Brooke Holdings, Inc. are also under OTS supervision since they are direct and indirect savings and loan holding companies under OTS regulations. The Agent Bank is also a member of the FHLB and its deposits are insured by the FDIC through the DIF. Accordingly, it is subject to an extensive regulatory framework which imposes activity restrictions, minimum capital requirements, lending and deposit restrictions and numerous other requirements primarily intended for the protection of depositors, federal deposit insurance funds and the banking system as a whole, rather than for the protection of shareholders and creditors. Many of these laws and regulations have undergone significant changes in recent years and are likely to change in the future.

Future legislative or regulatory change, or changes in enforcement practices or court rulings, may have a significant and potentially adverse impact on our operations and financial condition.

 

Capital Adequacy

 

The Agent Bank must maintain a minimum amount of capital to satisfy various regulatory capital requirements under OTS regulations and federal law. Federal law and regulations establish five levels of capital compliance: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. As of December 31, 2007, management believes that the Agent Bank meets the requirements to be categorized as “well capitalized” under the regulatory framework. Since its acquisition on January 8, 2007, the Agent Bank has not received notification from the OTS regarding its categorization.

 

On November 1, 2007, the OTS and the other U.S. banking agencies issued final regulations implementing the new risk-based regulatory capital framework developed by The Basel Committee on Banking Supervision, which is a working committee established by the central bank governors of certain industrialized nations, including the United States. The new risk-based regulatory capital framework, commonly referred to as Basel II, includes several methodologies for determining risk-based capital requirements, and the U.S. banking agencies have so far only adopted methodology known as the “advanced approach.” The implementation of the advanced approach is mandatory for the largest U.S. banks and optional for other U.S. banks.

 

For those other U.S. banks, the U.S. banking agencies had issued an advance rulemaking notices through December 2006 that contemplated possible modifications to the risk-based capital framework applicable to those domestic banking organizations that would not be affected by Basel II. These possible modifications, known colloquially as Basel 1A, were intended to avoid future competitive inequalities between Basel I and Basel II organizations. However, the U.S. banking agencies withdrew the proposed Basel 1A capital framework in late 2007. Instead, in 2008, the U.S. banking agencies announced that they would issue a proposed rule that would allow all U.S. banks not subject to the advanced approach under Basel II with the option of adopting a “standardized approach” under Basel II. The Agent Bank is assessing the potential impact of proposed rule on its business practices as well as the rule’s potential broader competitive effects within the industry.

 

Commercial Real Estate Lending Guidelines

 

In January 2006, federal banking regulators issued a joint interagency proposal on lending guidelines for commercial loans secured by real estate. Under the proposal, an institution would need to hold additional capital for regulatory purposes if its origination and holding of commercial real estate loans rose above certain asset levels and contained certain risk characteristics. In December 2006, the OTS issued its final version of those guidelines, which did not contain the asset level limits but were otherwise substantially unchanged. We do not believe these guidelines will materially affect our current operations.

 

Non-Traditional Lending Guidelines

 

In December 2005, the federal banking agencies, including the OTS, issued proposed lending guidelines that would effectively require increased capital for holding loans in its portfolio that were considered “non-traditional.” These guidelines were finalized in 2007 in substantially the same form. Under these guidelines, such loans included interest-only loans and payment option adjustable rate mortgage loans, which permit a borrower to make regular payments less than the amount of the scheduled principal amortization, thereby increasing the loan balance (known as negative amortization). At December 31, 2007, none of our residential mortgage loans that we held for investment were comprised of either adjustable rate loans with interest-only payments or payment option adjustable rate mortgage loans. We do not anticipate that these guidelines will materially affect our current operations.

 

FDIC Assessment

 

The FDIC insures the deposits of the Agent Bank and such insurance is backed by the full faith and credit of the United States government. Through March 31, 2006, the FDIC administered two separate deposit insurance funds, the Agent Bank Insurance Fund (the “BIF”) and the Savings Association Insurance Fund (the

“SAIF”). The SAIF was the deposit insurance fund for most savings associations, including the Agent Bank. In February 2006, President Bush signed into law the Federal Deposit Insurance Reform Conforming Amendments Act of 2005, which among other things allowed for the merger of the BIF and the SAIF to form the DIF. Under FDIC guidelines issued in November 2006, the Agent Bank’s premiums increased to increase the capitalization of the DIF. For 2007, the assessment was approximately $12,000, before any credits.

 

Affiliate Transaction Restrictions

 

The Agent Bank is subject to the affiliate and insider transaction rules applicable to member banks of the Federal Reserve System as well as additional limitations imposed by the OTS. These provisions prohibit or limit a banking institution from extending credit to, or entering into certain transactions with, affiliates, principal stockholders, directors and executive officers of the banking institution and its affiliates.

 

Federal Reserve

 

Numerous regulations promulgated by the Federal Reserve affect the business operations of the Agent Bank. These include regulations relating to equal credit opportunity, electronic fund transfers, collection of checks, truth in lending, truth in savings and availability of funds. Under Federal Reserve Board regulations, the Agent Bank is required to maintain a reserve against its transaction accounts (primarily interest-bearing and non-interest-bearing checking accounts). Because reserves must generally be maintained in cash or in non-interest-bearing accounts, the effect of the reserve requirement is to increase the Agent Bank’s cost of funds.

 

Patriot Act

 

The USA PATRIOT Act, which was enacted following the events of September 11, 2001, includes numerous provisions designed to detect and prevent international money laundering and to block terrorist access to the U.S. financial system. We have established policies and procedures intended to fully comply with the USA PATRIOT Act’s provisions, as well as other aspects of anti-money laundering legislation and the Agent Bank Secrecy Act.

 

Consumer Protection Laws and Regulations

 

Examination and enforcement by bank regulatory agencies for non-compliance with consumer protection laws and their implementing regulations have become more intense in nature. Federal regulations require extra disclosures and consumer protections to borrowers for certain lending practices. The term “predatory lending,” much like the terms “safety and soundness” and “unfair and deceptive practices,” is far-reaching and covers a potentially broad range of behavior. It therefore does not lend itself to a concise or a comprehensive definition.

 

The federal Gramm-Leach-Bliley Act includes provisions that protect consumers from the unauthorized transfer and use of their non-public personal information by financial institutions. Privacy policies are required by federal banking regulations which limit the ability of banks and other financial institutions to disclose non-public personal information about consumers to nonaffiliated third parties. These privacy protections affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors. In addition, states are permitted under the Gramm-Leach-Bliley Act to have their own privacy laws, which may offer greater protection to consumers than the Gramm-Leach-Bliley Act.

 

The Fair Credit Reporting Act, as amended by the Fair and Accurate Credit Transactions Act, or FACT Act, requires financial firms to help deter identity theft, including developing appropriate fraud response programs, and gives consumers more control of their credit data. It also reauthorizes a federal ban on state laws that interfere with corporate credit granting and marketing practices. In connection with FACT Act, financial institution regulatory agencies proposed rules that would prohibit an institution from using certain information about a consumer it received from an affiliate to make a solicitation to the consumer, unless the consumer has been notified and given a chance to opt out of such solicitations. A consumer’s election to opt out would be applicable for at least five years.

The Check Clearing for the 21st Century Act, or Check 21, facilitates check truncation and electronic check exchange by authorizing a new negotiable instrument called a “substitute check,” which is the legal equivalent of an original check. Check 21 does not require banks to create substitute checks or accept checks electronically; however, it does require banks to accept a legally equivalent substitute check in place of an original. In addition to its issuance of regulations governing substitute checks, the Federal Reserve has issued final rules governing the treatment of remotely created checks (sometimes referred to as “demand drafts”) and electronic check conversion transactions (involving checks that are converted to electronic transactions by merchants and other payees).

 

The Equal Credit Opportunity Act, or ECOA, generally prohibits discrimination in any credit transaction, whether for consumer or business purposes, on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), receipt of income from public assistance programs, or good faith exercise of any rights under the Consumer Credit Protection Act.

 

The Truth in Lending Act, or TILA, is designed to ensure that credit terms are disclosed in a meaningful way so that consumers may compare credit terms more readily and knowledgeably. As a result of the TILA, all creditors must use the same credit terminology to express rates and payments, including the annual percentage rate, the finance charge, the amount financed, the total of payments and the payment schedule, among other things.

 

The Fair Housing Act, or FH Act, regulates many practices, including making it unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap or familial status. A number of lending practices have been found by the courts to be, or may be considered illegal under the FH Act, including some that are not specifically mentioned in the FH Act itself.

 

The Home Mortgage Disclosure Act, or HMDA, grew out of public concern over credit shortages in certain urban neighborhoods and provides public information that will help show whether financial institutions are serving the housing credit needs of the neighborhoods and communities in which they are located. The HMDA also includes a “fair lending” aspect that requires the collection and disclosure of data about applicant and borrower characteristics as a way of identifying possible discriminatory lending patterns and enforcing anti-discrimination statutes. In 2004, the Federal Reserve Board amended regulations issued under HMDA to require the reporting of certain pricing data with respect to higher-priced mortgage loans. This expanded reporting is being reviewed by federal banking agencies and others from a fair lending perspective.

 

The Real Estate Settlement Procedures Act, or RESPA, requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements. Also, RESPA prohibits certain abusive practices, such as kickbacks, and places limitations on the amount of escrow accounts.

 

Penalties under the above laws may include fines, reimbursements and other penalties. Due to heightened regulatory concern related to compliance with the FACT Act, ECOA, TILA, FH Act, HMDA and RESPA generally, the Agent Bank may incur additional compliance costs or be required to expend additional funds for investments in its local community.

 

Regulatory Enforcement

 

Our primary federal banking regulator is the OTS. Both the OTS and the FDIC may take regulatory enforcement actions against any of their regulated institutions that do not operate in accordance with applicable regulations, policies and directives. Proceedings may be instituted against any banking institution, or any “institution-affiliated party,” such as a director, officer, employee, agent or controlling person, who engages in unsafe and unsound practices, including violations of applicable laws and regulations. Both the OTS and the FDIC have authority under various circumstances to appoint a receiver or conservator for an insured institution that it regulates to issue cease and desist orders, to obtain injunctions restraining or prohibiting unsafe or unsound practices, to revalue assets and to require the establishment of reserves. The FDIC has additional authority to terminate insurance of accounts, after notice and hearing, upon a finding that the insured institution is or has engaged in any unsafe or unsound practice that has not been corrected, is

operating in an unsafe or unsound condition or has violated any applicable law, regulation, rule, or order of, or condition imposed by, the FDIC.

 

Federal Home Loan Bank System

 

The primary purpose of the Federal Home Loan Banks (the “FHLBs”) is to provide loans to their respective members in the form of collateralized advances for making housing loans as well as for affordable housing and community development lending. The FHLBs are generally able to make advances to their member institutions at interest rates that are lower than the members could otherwise obtain. The FHLB System consists of 12 regional FHLBs, each being federally chartered but privately owned by its respective member institutions. The Federal Housing Finance Board, a government agency, is generally responsible for regulating the FHLB System. The Agent Bank is currently a member of the Federal Home Loan Bank of Topeka.

 

Brooke Capital Corporation

 

Insurance Agency Operations.  Brooke Capital is subject to licensing or regulatory approval by the state insurance department in each state in which it does business. Each franchise agency also is subject to licensing or regulatory approval in the state in which it conducts business. Operations depend on the validity of, and the continued good standing under, the licenses and approvals under which Brooke Capital operates. Licensing laws and regulations vary from jurisdiction to jurisdiction. In all jurisdictions, the applicable licensing laws and regulations are subject to amendment or interpretation by regulatory authorities, and generally, these authorities are vested with broad discretion as to grant, renewal and revocation of licenses and approvals.

 

Brooke Capital and its franchisees are subject to state laws and regulations pertaining to the charging of fees by insurance agents and brokers and the rebating of premiums and/or commissions. The charging of fees and/or rebating may be prohibited in some states or permitted in others with or without certain limitations. Where permitted, the charging of fees may require that certain disclosures be given to customers and/or that customers agree to the fees in writing. Subject to specific state statute, regulations regarding rebating extend to transactions that involve an agent or agency giving anything of value to a customer to induce the purchase of a policy.

 

Brooke Capital must comply with regulations adopted by the Federal Trade Commission and with several state laws that regulate the offer and sale of franchises. The Federal Trade Commission’s Trade Regulation Rule on Franchising and certain state laws require that it furnish prospective franchisees with a franchise offering circular containing information prescribed by the Trade Regulation Rule on Franchising and applicable state laws and regulations.

 

Brooke Capital also must comply with a number of state laws that regulate certain substantive aspects of the franchisor-franchisee relationship. These laws may limit a franchisor’s business practices in a number of ways, including limiting the ability to: (1) terminate or not renew a franchise without good cause; (2) interfere with the right of free association among franchisees; (3) disapprove the transfer of a franchise; and (4) discriminate among franchisees with regard to charges, royalties and other fees.

 

Brooke Capital is subject to the unfair trade practices acts of the various states in which it does business. They each define and prohibit unfair methods of competition or unfair or deceptive acts or practices, including misrepresentation of policy terms, false advertising, making false statements, and defamation. Failure to comply with such acts or insurance regulations could have a material adverse effect on us.

 

Insurance Agency Consulting Operations.  There are many states that have statutes regulating the activities of brokering loans to individuals or businesses. Such laws may pertain to the receipt of advance fees, misrepresentations or omissions to state any material facts in connection with loans or services, engagement in fraud, deception or registration.

 

Insurance Company Operations.  FLAC is subject to regulation and supervision by the Kansas Insurance Department and other states in which it operates. The insurance laws of Kansas give the Insurance Department broad regulatory authority, including powers to: (1) grant and revoke licenses to transact business; (2) regulate

and supervise trade practices and market conduct; (3) establish guaranty associations; (4) license agents; (5) approve policy forms; (6) approve premium rates for some lines of business; (7) establish reserve requirements; (8) prescribe the form and content of required financial statements and reports; (9) determine the reasonableness and adequacy of statutory capital and surplus; and (10) regulate the type and amount of permitted investments. Without limiting the foregoing, the effect of the regulatory powers of the Kansas Insurance Department over FLAC may restrict its ability to dividend or otherwise transfer funds from it to Brooke Capital, even if its operations are profitable and creating positive cash flow, restrict its ability to raise capital other than by contributions from Brooke Capital, and require that Brooke Capital contribute additional capital to it.

 

Aleritas Capital Corp.

 

Aleritas’ lending activities are targeted to businesses and are generally unregulated. However, usury and other laws may apply. There are many states that have statutes regulating the activities of brokering loans or providing credit services to individuals or businesses. Such laws may pertain to the receipt of advance fees, misrepresentations or omissions to state any material facts in connection with loans or services, engagement in fraud or deception or registration.

 

Brooke Brokerage Corporation

 

We are subject to Kansas laws regulating insurance holding company systems, including acquisitions, extraordinary dividends, the terms of affiliate transactions, and other related matters. We manage highly sensitive customer information in all of our operating businesses, which is regulated by law. Many states’ laws require us to make certain disclosures to our customers regarding our privacy policies and take precautionary steps to protect the confidentiality of customer information.

 

Bermuda Captive Insurance

 

Pursuant to the Bermuda Insurance Act of 1978, our Bermuda captive insurance companies are regulated by the Supervisor of Insurance of the Bermuda Monetary Authority. Our captive insurance companies must appoint and maintain a principal representative in Bermuda, appoint an auditor to report on financial statements, meet minimum capital and solvency requirements, maintain certain liquid assets compared to liabilities, file annual statutory financial returns, and comply with other provisions of the Act, as amended, and with applicable Bermuda regulations.

 

 

Risks Related to Brooke Corporation

 

A significant part of our business strategy involves adding new franchise locations, originating new loans, and providing collateral preservation services, and our failure to grow may adversely affect our business, prospects, results of operations and financial condition.

 

Our expansion strategy consists principally of adding new franchise locations, originating new loans and providing collateral preservation services for such loans. Our continued growth is dependent upon a number of factors, including the availability of adequate financing and suitable franchise locations on acceptable terms, experienced management employees, the ability to obtain required government permits and licenses and other factors, some of which are beyond our control. In addition, we compete for acquisition and expansion opportunities with entities that have substantially greater resources than us. We cannot assure you that we will be able to continue to provide effective collateral preservation services or grow our business successfully through adding new franchise locations or by growing the operations of existing franchisees. Our failure to grow could have a material adverse effect on our business, prospects, results of operations and financial condition.

Borrowers’ financial performance may adversely affect their ability to repay amounts due to us.

 

We have credit exposure with respect to loans made to franchisees and other borrowers and with respect to the franchisees’ monthly statement balances. We lend money to franchisees, other insurance agencies and funeral home owners to start up or acquire businesses and we may assist these borrowers by loaning working capital. In addition, we assist franchisees by financing long-term producer development, cyclical fluctuations of revenues, receivables and payables. We make loans to help franchisees with monthly fluctuations of revenues and record these advances on franchisees’ monthly statements. We also grant temporary extensions of due dates for franchisee statement balances owed by franchisees to us. To fund long-term producer development of franchisees, including hiring and training costs, we also extend credit to franchisees, which we refer to as “non-statement balances.” Franchisees and other borrowers depend on commission income to pay amounts due to us in respect of their loans, in respect of their statement balances, and in respect of their non-statement balances used to finance long-term producer development. If franchisees and other borrowers are not successful, franchisees may be unable to pay statement or non-statement balances to us and our borrowers may be unable to repay their loans, any of which would have a detrimental effect on us.

 

Our credit loss reserves are determined primarily by our watch statement balances. Other factors we consider in determining credit loss reserves are statement loss experience, management’s evaluation of the potential for future losses and management’s evaluation of the potential for future recoveries. We may not be able to accurately predict credit losses and, as a result, the amount we have budgeted for credit losses may not be sufficient to cover future losses, in which case, our financial condition and results of operations will be adversely affected. In addition, our borrower’s adverse financial performance may result in a downgrade or withdrawal of ratings given to securities previously issued in our securitizations, or keep us from getting favorable ratings on future securitized pools of our loans.

 

The ability of borrowers to repay loans made to them by Aleritas may be adversely affected by an increase in market interest rates.

 

Loans made to franchisees and other borrowers by Aleritas typically bear interest at a variable or floating interest rate. To the extent that market interest rates increase, borrowers may be unable to make debt service payments. As a result, an increase in market interest rates will increase the risk of default on the loans made by us. The risk associated with rising interest rates will increase with respect to our insurance agency borrowers if coupled with a flattening or decreasing of property and casualty insurance premiums, and thus commissions. As well, an increase in interest rates could cause certain insurance companies to reduce their premium rates in an effort to sell more insurance and invest the resulting premiums in fixed-income securities to get the benefit of these higher rates. In such event, the amount of commissions our franchisees and other insurance agency borrowers earn could be adversely affected, further increasing the risk of default on loans made by us to these borrowers.

 

Our financial condition could be adversely affected if we are unable to fund our loans through sales to third parties.

 

In an effort to broaden our funding sources and to provide an additional source of liquidity, we have sold participation interests in our loans and have accessed, and intend to attempt to continue to access, the asset-backed securitization and warehouse funding markets.

 

Under a typical asset-backed securitization, we sell a “pool” of secured loans to a special-purpose entity, generally a limited liability company. The special-purpose entity, in turn, typically issues securities that are collateralized by the pool and the holders of the securities are entitled to participate in certain pool cash flows. Several factors will affect our ability to sell participation interests in our loans, to fund our financing through warehouse facilities, and to complete securitizations, including:

 

 

 

We make certain assumptions regarding the profitability of our securitizations, participations, warehouse lines and other funding vehicles which may not prove to be accurate.

 

In a securitization, participation or warehouse sale transaction, we may recognize a gain on sale resulting from related retained interest and/or servicing rights when we sell the assets. The value assigned to the retained interest and/or servicing asset depends upon certain assumptions we make about future performance of the sold loans, including the level of credit losses and the rate of prepayments. If actual credit losses or prepayment rates differ from the original assumptions, the value of the retained interest and/or servicing asset may decrease materially. The value of the retained interest and/or servicing asset may also decrease materially as a result of changes in market interest rates.

 

In addition, changes in the volume of loans sold due to our inability to access the asset-backed securitization markets, or other funding sources, could have a material adverse effect on our business, financial condition and results of operations. Decreases in the value of the retained interests and/or servicing asset in securitizations or warehouses that we have completed or loan participations we have sold due to market interest rate fluctuations or higher than expected credit losses on prepayments also could have a material adverse effect on our business, financial condition and results of operations.

 

The value of the collateral securing our loans to borrowers may be adversely affected by our borrowers’ actions.

 

We make loans to franchisees, other insurance agency borrowers, funeral home owners, and other borrowers primarily for the purpose of allowing them to acquire businesses. These loans are secured by, among other things, the business value, such as insurance agency assets. These assets in most cases are intangible, and the value of these assets may rapidly deteriorate if our borrowers do not adequately serve their customers or if the products and services they offer are not competitively priced. Reduction in the value of such assets could result in these loans being inadequately secured, which could adversely affect us in the event of a default on these loans.

 

Carrier override and contingent or profit sharing commissions are difficult to predict, and any decrease in our receipt of such payments will adversely affect us.

 

We derive a portion of our revenues from carrier override and contingent or profit sharing commissions based upon the terms of the contractual relationships between our insurance companies and us. Carrier override commissions are commissions paid by insurance companies in excess of the standard commission rates on specific classes of business. These amounts may be, but are not always, contingent on achieving a specific premium volume or profitability of the business. Contingent or profit sharing commissions are commissions paid by insurance companies based on the estimated profit that the companies make on the overall volume of business that we place with such companies. We generally receive these contingent commissions in the first and second quarters of each year. We do not account for carrier overrides separately. However, contingent or profit sharing commissions accounted for approximately three percent of our total revenues for the year ended December 31, 2007.

 

Due to the nature of these commissions, it is difficult for us to predict their payment. Increases in loss ratios experienced by insurance companies will result in a decreased profit to them and may result in decreases in payments of contingent or profit sharing commissions to us. Furthermore, we have no control over insurance companies’ ability to estimate loss reserves, which affects our profit sharing calculation. In addition, tightening of underwriting criteria by certain insurance companies, due in part to high loss ratios, may result in a lower volume of business that we are able to place with them. Our company override and contingent or profit

sharing commissions affect our revenues, and decreases in their payment to us may have an adverse effect on our results of operations.

 

Potential litigation and regulatory proceedings regarding commissions, fees, contingency payments, profit sharing and other compensation paid to brokers or agents could materially adversely affect our financial condition.

 

The insurance industry has in recent years come under a significant level of scrutiny by various regulatory bodies, including state Attorneys General and the departments of insurance for various states, with respect to contingent compensation and other volume or profit based compensation arrangements. Attorneys General have issued subpoenas to various insurance brokerages and insurance companies. Certain of these investigations have led to complaints being filed against brokerages and insurance companies and some brokerages and insurance companies have stated that they will discontinue accepting or making, respectively, volume based and profit based payments. In addition to government investigations, class action lawsuits relating to these business practices have been filed against various members of the insurance industry. Negative publicity associated with these investigations, lawsuits and resulting settlements have precipitated increased volatility in the prices of securities issued by companies throughout the insurance industry. We received inquiries from departments of insurance which were related to such compensation arrangements or were related to unethical or unlawful sales practices. These inquiries were not related to specific or general allegations of wrongdoing on our behalf. Rather, these inquiries were sent to numerous agents and brokers based upon their status as a licensed agent or broker, the volume of business they produce or other factors unrelated to allegations of wrongdoing. We cannot predict whether we will receive further inquiries or will receive subpoenas, or will become subject to investigations, regulatory actions, proceedings or lawsuits. The outcome of any such subpoena, investigation, regulatory action, proceeding or lawsuit could have a material adverse effect on our business or financial condition.

 

The insurance industry has also recently come under a significant level of scrutiny by consumer advocacy groups, and certain media reports have advocated governmental action with respect to contingent and other volume or profit based compensation arrangements. The consumer groups and media reports typically characterize these payments as creating an unacceptable conflict of interest and adding an unnecessary or even unfair consumer cost. If negative characterizations of such compensation arrangements become accepted by consumers, this could have a material adverse effect on the demand for our franchisees’ products and services and could materially adversely affect our results of operations and financial condition. Negative perception of such compensation arrangements or other activities could also result in us being subject to more restrictive laws and regulations as well as increased litigation, which may increase further our costs of doing business and adversely affect our profitability by impeding our ability to market our products and services, requiring us to change our marketing practices, products or services and increasing the regulatory burdens under which we operate.

 

Our business is dependent on the cyclical pricing of property and casualty insurance, which may adversely affect our franchisees’ performance and, thus, our financial performance.

 

Our franchisees and other borrowers are primarily engaged in insurance agency and brokerage activities and derive revenues from commissions paid by insurance companies, which commissions are based in large part on the amount of premiums paid by their customers to such insurance companies. In turn, we earn fees from our franchisees based upon the amount of such commissions payable by insurance companies, which fees make up a substantial portion of our revenues. Neither we nor our franchisees or other insurance agency borrowers determine insurance premiums. Premium rates are determined by insurers based on a fluctuating market. Historically, property and casualty insurance premiums have been cyclical in nature, characterized by periods of severe price competition and excess underwriting capacity, or soft markets, which generally have an adverse effect upon the amount of commissions earned by our franchisees or other insurance agency borrowers, followed by periods of high premium rates and shortages of underwriting capacity, or hard markets. The current insurance market generally may be characterized as “soft,” with a flattening or decreasing of premiums in most lines of insurance. As insurance carriers continue to outsource the production of premium

revenue to independent brokers or agents, such as our franchisees, those insurance carriers may seek to reduce further their expenses by reducing the commission rates payable to such brokers or agents. The reduction of these commission rates, along with general volatility and/or declines in premiums, may significantly undermine the profitability of our franchisees and other insurance agency borrowers, and our profitability. A reduction in commission rates may significantly undermine our borrowers’ ability to repay loans to us. Because we do not determine the timing and extent of premium pricing changes, we cannot accurately forecast our commission revenues, including whether they will significantly decline. As a result, our budgets for future acquisitions, capital expenditures, credit loss reserves, dividend payments, loan repayments and similar items may have to be adjusted to account for unexpected changes in revenues.

 

We may not be able to successfully convert new franchises.

 

Our ability to successfully identify suitable acquisition candidates, complete acquisitions, convert acquired businesses into our franchisees, and expand into new markets will require us to continue to implement and improve our operations, financial and management information systems. Our new franchises may not achieve levels of revenue, profitability, or productivity comparable to our existing franchises, or otherwise perform as expected. In addition, when we make an acquisition and effect a conversion, we are subject to a number of special risks, such as entry into unfamiliar markets and unanticipated problems or legal liabilities, some or all of which could have a material adverse effect on our results of operations and financial condition.

 

We may be required to repurchase loans sold with recourse or make payments on guarantees.

 

In some instances, Aleritas has sold loans to investors with full or partial recourse, which may adversely affect our financial condition or results of operations in the event Aleritas is required to repurchase loans of poor quality. In addition, in connection with our activities of matching business purchasers and sellers, we have sometimes guaranteed payments from purchasers to sellers, which may adversely affect us in the event such a purchaser defaults on its obligations to such a seller.

 

We will be adversely affected if we do not have alternative sources of funds to repay our obligations as they mature.

 

Loans made by Aleritas are usually amortized for a period of between twelve years and fifteen years. We have funded a portion of our loan portfolio with funding facilities which will require all or partial repayment by us prior to the time that loans made by us are scheduled to be repaid, and we will be adversely affected if we do not have alternative sources of funds to repay these obligations as they mature.

 

We are dependent on key personnel.

 

We are dependent upon the continued services of senior management, particularly the services of Robert D. Orr, Leland G. Orr, Michael S. Hess, Michael S. Lowry, Kyle L. Garst and Anita F. Larson. We have entered into an employment agreement with each of them. The loss of the services of any of these key personnel, by termination, death or disability, or our inability to identify, hire and retain other highly qualified personnel in the future, could have a material adverse effect on us. We currently do not maintain key employee insurance with respect to any of our officers or employees.

 

With our method of funding our loans, our leverage may increase.

 

If we fund more of our loans with our cash or warehouse facilities that do not qualify as true sales pursuant to the criteria established by SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities,” our current liabilities will increase. Our network of participating lenders and other business partners may become uncomfortable with such an increase in current liabilities. As a result, we may not be able to sell loans we originate on terms acceptable to us or at all, which would have a material adverse effect on our operations and prospects for growth.

Our business, results of operations, financial condition or liquidity may be materially adversely affected by errors and omissions.

 

Our franchisees are subject to claims and litigation in the ordinary course of business resulting from alleged errors and omissions. Because we are agent of record on policies written through our franchisees, claims against our franchisees may also allege liability against us for all or part of the amounts in question. Claimants may seek large damage awards and these claims may involve potentially significant defense costs. Errors and omissions could include, for example, our employees or sub-agents failing, whether negligently or intentionally, to place coverage or to notify insurance companies of claims on behalf of clients, to provide insurance companies with complete and accurate information relating to the risks being insured or to appropriately apply funds that we hold for our clients. It is not always possible to prevent and detect errors and omissions and the precautions we take may not be effective in all cases. While most of the errors and omissions claims made against us have been covered by our professional liability insurance, subject to our self-insured deductibles, our results of operations, financial condition or liquidity may be adversely affected if in the future our insurance coverage proves to be inadequate or unavailable or there is an increase in liabilities for which we self-insure. In addition, errors and omissions claims may harm our reputation or divert management resources away from operating our business.

 

Termination of our professional liability insurance policy would adversely impact our financial prospects and our ability to continue our relationships with insurance companies.

 

Without professional liability insurance, it is unlikely that we would be able to continue our relationships with insurance companies, which would adversely impact our financial prospects. Although we have an acceptable claims history, there can be no assurance that we will be able to maintain our professional liability insurance and in the event of the termination or non-renewal of our professional liability insurance policy, we may be unable to acquire this insurance on acceptable terms, or at all.

 

Insufficient internal controls may negatively impact our financial integrity, operations, financial reporting and, ultimately, have a material adverse effect on our stock price.

 

Effective internal controls over financial reporting are necessary for us to provide reliable financial reports, effectively prevent fraud and operate successfully as a public company. If we cannot provide reliable financial reports or prevent fraud, our reputation and operating results will be harmed. For example, we restated the presentation of our cash flow statements for years ended December 31, 2004, 2005 and 2006 as well as for the three months ended March 31, 2007 to record activity on securitization-related bank lines of credit as financing activities instead of operating activities. Correction of this accounting error resulted in no changes in our net cash flows, net income, assets, liabilities, retained earnings, or earnings per share. The restatement of our previously issued financial statements could expose us to legal and regulatory risk. The defense of any such actions could cause the diversion of management’s attention and resources, and we could be required to pay damages to settle such actions if any such actions are not resolved in our favor. Even if resolved in our favor, such actions could cause us to incur significant legal and other expenses. Moreover, we may be the subject of negative publicity focusing on the financial statement inaccuracies and resulting restatement and negative reactions from our stockholders, creditors or others with which we do business. The occurrence of any of the foregoing could harm our business and reputation and cause the price of our securities to decline.

 

Our dependence on initial franchise fees creates an incentive for us to extend credit to borrowers that may not meet our stringent underwriting guidelines.

 

A significant part of our revenues are derived from one-time initial fees we receive from assisting franchisees and others with the acquisition of businesses. Generating fees is largely dependent on our franchisees’ and others’ ability to obtain acquisition financing from Aleritas. Our dependence on these initial fees creates an incentive for us to extend credit to borrowers that may not meet our stringent underwriting criteria. Our failure to follow stringent underwriting guidelines could adversely affect the quality of the loans we make and adversely affect our financial condition and results of operations.

Some of the initiatives we have undertaken to improve franchisee quality and to reduce the time allowed for franchisees to demonstrate their success may reduce initial franchise fees, cash flow and profitability.

 

In October 2007, Brooke Capital announced a “New Era” initiative that emphasizes franchisee quality over location growth. As a result of the New Era initiative, the amount of initial franchise fees will likely be reduced in future years, which could have an adverse impact on cash flows and profitability. Furthermore, the New Era initiative provided for a decrease in the rate of monthly franchise fees, or royalties, assessed to franchisees which could also have an adverse impact on cash flows and profitability.

 

In the later part of 2005, Brooke Capital reduced, from 18 months to 8 months, the amount of time that start up franchisees were allowed to demonstrate their success. As a result, the number of franchisee developed locations has increased and lenders have experienced increased delinquencies related to loans to start up franchisees secured by locations. This may have an adverse impact on Brooke Capital’s ability to generate initial franchise fees from start up franchisees.

 

Because a significant part of our insurance-related revenues and loans derive from operations located in five states, our business may be adversely affected by conditions in these states.

 

A substantial portion of our insurance-related revenues and loans derive from operations located in the states of Texas, California, Kansas, Florida and Missouri. Our franchisees’ and our revenues and profitability are affected by the prevailing regulatory, economic, demographic, weather, competitive, industry and other conditions in these states. Changes in any of these conditions could make it more costly or difficult for our franchisees and us to conduct our business. Adverse regulatory or industry developments in these states, which could include fundamental changes to the design or implementation of the insurance regulatory framework, could have a material adverse effect on our results of operations and financial condition.

 

A significant part of Aleritas’ business strategy involves the success of its affiliate, Brooke Capital Advisors, Inc. (“Capital Advisors”), in sourcing managing general agency (“MGA”) and funeral home loans for us, and its failure to generate adequate lending opportunities may adversely affect our business, prospects, results of operations and financial condition.

 

Aleritas obtains a substantial portion of its business through loans to MGAs and funeral homes sourced by Capital Advisors and Capital Advisors provides, or contracts with third parties to provide, collateral preservation services with respect to these loans. We cannot assure you that Capital Advisors will be able to identify a sufficient number of loan opportunities to enable Aleritas to continue the rate of growth we have seen in our MGA and funeral home loan portfolio. Capital Advisors’ failure to identify and present lending opportunities to Aleritas or Capital Advisors’ failure to provide or contract with third parties to provide collateral preservation services with respect to these loans could have a material adverse effect on our business, prospects, results of operations and financial condition.

 

If we fail to effectively manage our growth, our financial results could be adversely affected.

 

We must continue to refine and expand our marketing capabilities, our management procedures, our network of suppliers, our internal controls and procedures, our access to financing sources and our technology. As we grow, we must continue to hire, train, supervise and manage new employees. We may not be able to hire and train sufficient personnel or develop management and operating systems to manage our expansion effectively. If we are unable to manage our growth effectively, our operations and financial results could be adversely affected.

 

We may not achieve the same levels of growth in revenues and profits in the future as we have in the past.

 

Our business has experienced rapid growth. Our ability to continue to grow our business will be subject to a number of risks and uncertainties and will depend in large part on, among other factors: (1) finding new opportunities in our existing and new markets; (2) hiring, training and retaining skilled managers and employees; (3) expanding and improving the efficiency of our operations and systems; (4) maintaining loan

quality; (5) maintaining and growing our funding sources and proprietary funding network; (6) growing and maintaining our network of proprietary loan sources; (7) maintaining and growing our network of collateral preservation providers; and (8) maintaining and attracting customers. Accordingly, we may not achieve the same levels of growth in revenues and profits as we have historically.

 

Aleritas has transferred a significant amount of assets and liabilities off balance sheet in reliance on Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” In the event transfer of such assets and liabilities is challenged by the SEC, or SFAS 140 is amended based on the provisions of the exposure draft, Aleritas’ current off-balance sheet assets and liabilities could be required to be consolidated in our financial statements.

 

In the ordinary course of business, Aleritas sells its loans to special purpose entities. Some of these sale transactions are classified as true sales pursuant to the FASB Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”). Transactions involving sales of assets classified as true sales under SFAS 140 have historically been subject to significant scrutiny by the Securities and Exchange Commission and have been an area of debate with the FASB. In August 2005, the FASB issued an exposure draft which amends SFAS 140. This exposure drafts seeks to clarify the derecognition requirements for financial assets and the initial measurement of interests related to transferred financial assets. During July 2006, the FASB continued re-deliberations on the August 2005 revised exposure draft. Aleritas has transferred a significant amount of assets and liabilities off balance sheet in reliance on SFAS 140. In the event our transfer of such assets and liabilities is challenged by the SEC, or SFAS 140 is amended based on the provisions of the exposure draft, Aleritas’ current off-balance sheet liabilities could be required to be consolidated in our financial statements.

 

Our debt instruments contain restrictive covenants and other requirements that may limit our business flexibility by imposing operating and financial restrictions on our operations.

 

Certain of our agreements governing indebtedness contain financial covenants that impose ratios, tests, and restrictions on us, such as maximum prepayment rate; a maximum loan loss rate; a minimum fixed charge coverage ratio; a maximum cash leverage ratio; and a maximum total leverage ratio. Some of our notes also contain other restrictions, including, but not limited to: the incurrence of indebtedness and liens; the disposal of our properties other than in the ordinary course of business; entering into transactions with affiliates or into material agreements other than in the ordinary course of business; entering into pledge and negative pledge agreements; and the declaration of dividends, except in limited circumstances. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. These covenants may prevent us from expanding our operations and executing our business strategy. In addition, a breach of any of these covenants, ratios or tests could result in a default under the agreements governing our indebtedness.

 

The cash flows we receive from the interests we retain in our securitizations could be delayed or reduced due to the requirements of the agreements we have signed, which could impair our ability to operate.

 

We retain a subordinate interest in our asset-backed securitization transactions. As a result, our receipt of future cash flows is governed by provisions that control the distribution of cash flows from the loans underlying our asset-backed securities. In some circumstances, cash flows from the underlying loans must be used to reduce the outstanding balance of the senior notes issued in the term debt transactions and are not available to us until the full principal balance of the senior notes has been repaid. On a monthly basis, cash flows from the underlying loans in our securitizations must first be used to pay the interest on the senior notes, to pay expenses of the term debt transaction, and to maintain certain required reserves. Poor performance of a pool of loans we securitize could affect future cash flows and, therefore, could impair our ability to operate.

When we sell loans classified as a true sale pursuant to the criteria established by SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities,” we record a retained interest and/or servicing asset on our balance sheet. The amount we record is determined based upon certain assumptions made by management. If these assumptions are materially inaccurate, we may be required to write down these assets.

 

Subsequent to the initial calculation of the fair value of retained interest and servicing assets, we utilize a fair market calculation methodology to determine their ongoing fair market value. Ongoing fair value is calculated using the then current outstanding principal of the transferred notes receivable and the outstanding balances due unaffiliated purchasers, which are reflective of credit losses and prepayments prior to the fair value recalculation. The rates of write down of the retained interest are based on the current interest revenue stream. This revenue stream is based on the loan balances at the date the impairment test is completed, which will include actual prepayments on loans and any credit losses for those loans. If the assumptions used by management in the initial recording of the retained interest or servicing asset prove to be materially inaccurate, the future fair value of the retained interest or servicing asset may be less than originally expected resulting in an impairment loss. Impairment is evaluated and measured annually. An impairment loss could have a material adverse effect on our business, prospects, results of operations and financial condition.

 

Most of the loans we make are to privately-owned small- and medium-sized companies, which present a greater risk of loss than loans to larger companies.

 

Aleritas’ portfolio consists primarily of commercial loans to small and medium-sized, privately owned businesses. Compared to larger, publicly owned firms, these companies generally have more limited access to capital and higher funding costs, may be in a weaker financial position and may need more capital to expand or compete. These financial challenges may make it difficult for our borrowers to make scheduled payments of interest or principal on our loans. Accordingly, advances made to these types of borrowers entail higher risks than advances made to companies who are able to access traditional credit sources.

 

The collateral securing a loan may not be sufficient to protect us from a partial or complete loss if the loan becomes non-performing, and we are required to foreclose.

 

While most of Aleritas’ loans are secured by a lien on specified collateral of the borrower, there is no assurance that the collateral securing any particular loan will protect us from suffering a partial or complete loss if the loan becomes non-performing and we move to foreclose on the collateral. The collateral securing our loans is subject to inherent risks that may limit our ability to recover the principal of a non-performing loan. Listed below are some of the risks that may affect the value of different types of collateral in which we typically take a security interest.

 

 

Our insurance agency and managing general agency loans are not generally secured by tangible assets. Furthermore, our funeral home loans are generally not fully secured by tangible assets. Consequently, if any of these loans becomes non-performing, we could suffer a loss of some or all of our value in the loan. Our lending involves lending money to a borrower based primarily on the expected cash flow, profitability and enterprise value of a borrower rather than on the value of its tangible assets. Thus, if one of our loans becomes non-performing, our primary recourse to recover some or all of the principal of our loan would be to force the

sale of the entire company as a going concern. The risks inherent in our type of lending include, among other things, the following:

 

 

Additionally, many of our borrowers use the proceeds of our loans to make acquisitions. Poorly executed or poorly conceived acquisitions can tax management, systems and the operations of the existing business, causing a decline in both the borrower’s cash flow as well as the value of its business as a going concern. In addition, many acquisitions involve new management teams taking over control of a business. These new management teams may fail to execute at the same level as the former management team, which could reduce the cash flow of the borrower to service the loan as well as reduce the value of the borrower as a going concern.

 

We may incur lender liability as a result of our lending activities.

 

In recent years, a number of judicial decisions have upheld the right of borrowers to sue lending institutions on the basis of various evolving legal theories, collectively termed “lender liability.” Generally, lender liability is founded on the premise that a lender has either violated a duty, whether implied or contractual, of good faith and fair dealing owed to the borrower or has assumed a degree of control over the borrower resulting in the creation of a fiduciary duty owed to the borrower or its other creditors or shareholders. We may be subject to allegations of lender liability. We cannot assure you that these claims will not arise or that we will not be subject to significant liability if a claim of this type did arise.

 

Aleritas’ loans to foreign borrowers may involve significant risks in addition to the risks inherent in loans to U.S. borrowers.

 

As of December 31, 2007, approximately $11.8 million of our on-balance sheet loan portfolio are balances of Canadian borrowers. These loans may expose us to risks not typically associated with loans to U.S. borrowers. These risks include changes in exchange control regulations, political and social instability, expropriation, imposition of foreign taxes, less liquid markets and less available information than is generally the case in the United States, higher transaction costs, less developed bankruptcy laws, difficulty in enforcing contractual obligations, lack of uniform accounting and auditing standards and greater price volatility. To the extent that any of our loans are denominated in foreign currency, they will be subject to the risk that the value of a particular currency will change in relation to one or more other currencies. Among the factors that may affect currency values are trade balances, the level of short-term interest rates, differences in relative values of similar assets in different currencies, long-term opportunities for investment and capital appreciation, and political developments. We do not currently employ hedging techniques to minimize these risks.

 

Many of Aleritas’ borrowers are captive insurance agents, and, therefore, are dependent on the continued success, competitiveness, credit quality and financial condition of the captive carrier they represent.

 

Many of our borrowers are captive agents and, therefore, represent primarily one insurance carrier and derive revenues from commissions paid by primarily one carrier. If this carrier’s products become uncompetitive, the carrier is subject to negative publicity, the carrier experiences regulatory concerns, the commission rate the carrier pays its agents is reduced, the premiums charged to the carriers customers is reduced and, correspondingly, the commissions based on such premiums are reduced, the rating of the carrier is lowered, or the carrier otherwise experiences a material adverse condition or event, our borrower may

likewise experience a material adverse effect which could have a material adverse effect on our results of operations and financial condition.

 

Losses sustained by our Bermuda captive insurance companies may adversely affect us.

 

Our captive insurance company subsidiaries, DB Indemnity, Ltd. and The DB Group, Ltd., domiciled in Bermuda, are directly liable for losses and loss adjustment expenses under the terms of the insurance policies that they write. DB Indemnity and The DB Group are required by Bermuda law to maintain minimum levels of statutory capital and surplus. In addition, each of DB Indemnity and The DB Group is required to maintain a minimum liquidity ratio whereby the value of its relevant assets is not less than a specified percentage of the amount of its relevant liabilities.

 

If DB Indemnity and The DB Group fail to accurately assess the risks they assume, they may fail to establish appropriate premium rates and their reserves may be inadequate to cover their losses. Claim reserves represent estimates involving actuarial and statistical projections at a given point in time of expectations of the ultimate settlement and administrative costs of claims incurred. Captives use actuarial models as well as historical industry loss development patterns to assist in the establishment of appropriate claim reserves. For both casualty and property losses, actual claims and claim expenses paid may deviate, perhaps substantially, from the reserve estimates of DB Indemnity and The DB Group. If the claim reserves of DB Indemnity and/or The DB Group are determined to be inadequate, one or both of them will be required to increase claim reserves with a corresponding reduction in net income in the period in which the deficiency is rectified. Even though most insurance contracts have policy limits, the nature of property and casualty insurance and reinsurance is that losses can exceed policy limits for a variety of reasons and could significantly exceed the premiums received on the underlying policies. Our captives have not incurred any claims or claims expenses; however, claims, claims settlement patterns, legislative activity, social and economic patterns, and litigation and regulatory trends, all of which are difficult to predict, may have a substantial impact on the future loss experience of DB Indemnity and/or The DB Group. If the reserves of DB Indemnity and/or The DB Group are insufficient to cover claims, this could have a material adverse effect on future earnings DB Indemnity and/or The DB Group contribute to us and, accordingly, could have a material adverse effect on our prospects. In addition, if the reserves of DB Indemnity or The DB Group are insufficient to cover claims, because the risks insured are risks of the Company and its franchisees, in some instances, we may have to pay losses for which the reserves of DB Indemnity or The DB Group were not adequate to cover.

 

Our reliance on the Internet could have a material adverse effect on our operations and our ability to meet customer expectations.

 

We rely heavily on the Internet in conducting our operations. A main component of our franchise program is providing franchisees and their personnel access to documents and other data over the Internet. This service requires efficient operation of Internet connections from franchisees and franchisee personnel to our system. These connections, in turn, depend on efficient operation of web browsers, Internet service providers and Internet backbone service providers, all of which have experienced periodic operational problems or outages in the past and over which we have no control. Any system delays, failures or loss of data, whatever the cause, could reduce customer satisfaction with our services and products. Moreover, despite the implementation of security measures, our computer system may be vulnerable to computer viruses, program errors, attacks by third parties or similar disruptive problems. These events could have a material adverse effect on our operations and our ability to meet customer expectations.

 

Our network may be vulnerable to security breaches and inappropriate use by Internet users, which could disrupt or deter future use of our services.

 

Concerns over the security of transactions conducted on the Internet and the privacy of users may inhibit the growth of the Internet and other online services. Our failure to successfully prevent security breaches could significantly harm our business, reputation and results of operations and could expose us to lawsuits by state and federal consumer protection agencies, by governmental authorities in the jurisdictions in which we operate, and by consumers. Anyone who is able to circumvent our security measures could misappropriate

proprietary information, including personal customer data, cause interruptions in our operations or damage our brand and reputation. A breach of our security measures could involve the disclosure of personally identifiable information and could expose us to a material risk of litigation, liability or governmental enforcement proceedings. We cannot assure you that our financial systems and other technology resources are completely secure from security breaches, password lapses or sabotage, and we have occasionally experienced attempts at “hacking.” We may be required to incur significant additional costs to protect against security breaches or to alleviate problems caused by any of these types of breaches. Any well publicized compromise of our security or the security of any other Internet provider could deter people from using our services or the Internet to conduct transactions that involve transmitting confidential information or downloading sensitive materials, which could have a detrimental impact on our franchise network. Furthermore, computer viruses may affect our ability to provide our services and adversely affect our revenues. Moreover, if a computer virus affecting our system were highly publicized, our reputation could be significantly damaged, resulting in the loss of current and future franchisees and customers.

 

We are in highly competitive markets, which could result in reduced profitability.

 

We expect the historical success of our company to attract others to our target markets who will strive to compete directly or indirectly against us. Increased competition may reduce demand for our products and limit the amount of revenues and earnings we report.

 

Our franchisees face significant competition. The popularity of Internet sales and enactment of the Financial Services Modernization Act have increased the number of potential competitors and allow highly capitalized competitors, like banks, to offer certain kinds of insurance products and services which are competitive with the products and services of our franchisees and life insurance subsidiary. If our prediction that the number of agents will increase is accurate, we will face greater competition for the services we provide to our franchisees. The life insurance industry is extremely competitive. There are a large number of insurance companies that are substantially larger, offer more diversified product lines and have larger selling organizations and customer bases than First Life America Corporation. The banking industry is also highly competitive. Brooke Savings Bank competes with a large number of federal and state banks for deposits and loans, and with savings and loan associations and credit unions for deposits. There are many new changes in technology, product offerings and regulation in the industries in which we operate and many of our competitors in such industries have greater financial resources and market acceptance than we do. Competitors may develop or offer more attractive or lower cost products and services than ours which could erode our customer base.

 

Our management, facilities and labor force may be insufficient to accommodate expected growth.

 

If we grow more quickly than anticipated, our management, facilities and labor force may become insufficient to accommodate our expected growth. Also, although we have safeguards for emergencies and have arranged for back-up facilities to process information if the processing center in Phillipsburg, Kansas is not functioning, the occurrence of a major catastrophic event or other system failure at our processing center could interrupt document processing or result in the loss of stored data.

 

We compete in highly regulated industries, which may result in increased expenses or restrictions in our operations.

 

We conduct business in a number of states and are subject to comprehensive regulation and supervision by government agencies in many of the states in which we do business. The primary purpose of such regulation and supervision is to provide safeguards for policyholders rather than to protect the interests of shareholders. The laws of the various state jurisdictions establish supervisory agencies with broad administrative powers with respect to, among other things, licensing to transact business, licensing of agents and unfair trade practices.

 

We are a federal savings and loan holding company subject to regulation by the Office of Thrift Supervision and Federal Deposit Insurance Corporation, and subject to the laws and regulations of the State of

Kansas and other states relating to insurance holding companies. Regulation of holding companies includes reporting requirements, maintenance of capital and financial condition, restrictions on affiliate transactions, restrictions on dividends, corporate governance requirements and commitments made during the holding company application process.

 

Although we believe that we are currently in material compliance with statutes, regulations and ordinances applicable to our business and commitments made to government agencies, we cannot assure you that we will be able to maintain compliance without incurring significant expense, or at all. There is also no assurance that we have correctly determined the applicability of all statutes, regulations, ordinances and government commitments to our business, including, without limitation, the applicability of federal preemption of state law for activities believed by us to be subject to such preemption. In addition, our franchisees are also subject to comprehensive regulations and supervision and we cannot ensure their correct determination of the applicability of statutes, regulations and ordinances to their businesses and their material compliance therewith. Our failure to comply, or the failure of our franchisees to comply, with any current or subsequently enacted statutes, regulations, ordinances and commitments to government agencies could result in regulatory actions and negative publicity and have a material adverse effect on us.

 

Furthermore, the adoption of additional statutes, regulations and ordinances, the agreement to further commitments to government agencies, changes in the interpretation and enforcement of current statutes, regulations and ordinances, changes in our ability to exert federal preemption, or the expansion of our business into jurisdictions that have adopted more stringent regulatory requirements than those in which we currently conduct business, could have a material adverse effect on us.

 

We are subject to franchise law and regulations that govern our status as a franchisor and regulate some aspects of our franchise relationships. Our ability to develop new franchise locations and to enforce contractual rights against franchisees may be adversely affected by these laws and regulations, which could cause our franchise revenues to decline and adversely affect our growth strategy.

 

We are subject to federal and state laws and regulations, including the regulations of the Federal Trade Commission, as well as similar authorities in individual states, in connection with the offer, grant and termination of franchises and the regulation of the franchisor-franchisee relationship. Our failure to comply with these laws could subject us to liability to franchisees and to fines or other penalties imposed by governmental authorities. In addition, we may become subject to litigation with, or other claims filed with state or federal authorities by, franchisees based on alleged unfair trade practices, implied covenants of good faith and fair dealing, payment of royalties, location of stores, advertising expenditures, franchise renewal criteria or express violations of franchise agreements. We cannot assure you that we will not encounter compliance problems from time to time, or that material disputes will not arise with one or more franchisees. Accordingly, our failure to comply with applicable franchise laws and regulations, or disputes with franchisees, could have a material adverse effect on our results of operations, financial condition and growth strategy.

 

Risks Related to Our Common Stock

 

Our Chairman of the Board, Robert D. Orr, is able to exert significant control over us and may act in a manner that is adverse to our other shareholders’ interests.

 

As of February 29, 2008, Robert D. Orr, our Chairman of the Board, beneficially owned approximately 43% of our outstanding common stock. As a result, he is able to exert significant influence over:

 

 

Mr. Orr’s interests may conflict with the interests of other holders of our common stock and he may take actions affecting us with which other shareholders may disagree. For example, in order to retain his relative

ownership position in our common stock, Mr. Orr may decide not to enter into a transaction in which our shareholders would receive consideration for their shares that is much higher than the cost of their investment in our common stock or than the then current market price of our common stock. Any decision regarding the ownership of our company that Mr. Orr may make at some future time will be in his absolute discretion.

 

As we are no longer a controlled company, we must comply with the corporate governance requirements of the NASDAQ Global Market.

 

Until June 28, 2007, we were a controlled company because Brooke Holdings, Inc., Robert D. Orr, Leland G. Orr, Michael S. Lowry, Anita F. Larson and Kyle L. Garst owned approximately 51% of our outstanding common stock and had orally agreed to vote their shares of common stock together as a group. As a result of a private placement of units in 2007, this group owned approximately 45% of our outstanding common stock and it has since disbanded. Therefore, we are no longer a “controlled company” within the meaning of the NASDAQ Marketplace rules and, thus, are required to have a board of directors comprised of a majority of independent directors and nominating and compensation committees composed entirely of independent directors. If we are unable to comply with the corporate governance requirements of the NASDAQ Global Market, our common stock could be delisted from that stock exchange.

 

Our relatively low trading volume may limit shareholders’ ability to sell their shares.

 

Although shares of our common stock are listed on the NASDAQ Global Market, our average daily trading volume has been approximately 30,300 shares during the three months ended February 29, 2008. As a result of this low trading volume, shareholders may have difficulty selling a large number of shares of our common stock in the manner or at the price that might be attainable if our common stock were more actively traded.

 

The price of our common stock may fluctuate significantly, which may make it difficult for shareholders to resell common stock when they want or at a price they find attractive.

 

Since January 1, 2005, our common stock has traded at prices (adjusted for dividends and splits) ranging between $2.51 and $19.86 on the American Stock Exchange (until June 2005) and the NASDAQ Global Market. We expect that the market price of our common stock will continue to fluctuate. Our common stock price can fluctuate as a result of a variety of factors, many of which are beyond our control. These factors include:

 

 

Kansas law and our articles of incorporation and bylaws contain anti-takeover provisions that could delay or discourage takeover attempts that shareholders may consider favorable.

 

Certain provisions of our articles of incorporation and our bylaws and of Kansas law may discourage, delay or prevent transactions that our shareholders may consider favorable, including transactions that could

provide for payment of a premium over the prevailing market price of our common stock, and also may limit the price that investors are willing to pay in the future for our common stock. For example, our articles of incorporation contain provisions, such as allowing our board of directors to issue preferred stock with rights superior to those of our common stock without the consent of our shareholders, which could make it more difficult for a third party to acquire us without the consent of our board of directors. In addition, our bylaws establish that our independent directors have neither the right nor the obligation to vote for the nomination, election or removal of directors of our company; those rights and obligations rest solely with the representative of our controlling shareholder group.

 

 

Our principal executive offices are located in owned premises at 8500 College Boulevard, Overland Park, Kansas 66210, and our telephone number is (913) 661-0123. This facility also serves Brooke Capital Corporation as a center for training franchisees and employees and serves as the administrative offices of Brooke Savings Bank. Brooke Investments, Inc. leases offices at 10950 Grandview Drive, Overland Park, Kansas 66210 which serve as the principal executive offices, the national sales office, the Kansas City regional franchise sales office and a franchise customer service center for Brooke Capital. Aleritas Capital Corp. (a d/b/a of Brooke Credit Corporation) leases offices at 7400 College Boulevard, Overland Park, Kansas 66210 which serve as that company’s principal executive offices.

 

In Phillipsburg, Kansas, we own a processing center and an advertising center. The advertising center also houses our facilities teams and the home office of Brooke Savings Bank. We own a building in Dallas, Texas that houses a regional office and service center. We lease additional regional offices in Englewood, Colorado, Nashville, Tennessee, and Sacramento, California, as well as brokerage underwriting offices, and franchise customer service centers in other locations in the United States. During the first quarter of 2007, Brooke Credit Corporation opened a loan participation office in Nashville, Tennessee. We, or our subsidiaries, may acquire or lease real estate for use in our subsidiaries’ operations and for lease, sublease or license to franchisees.

 

First Life America Corporation, our indirect, majority-owned subsidiary, owns a 20,000 square foot office building on approximately six and one-half acres of land located in Topeka, Kansas. Brooke Capital, First Life America Corporation and Brooke Capital Advisors, Inc. occupy approximately 7,500 square feet of the building, and the remainder of the building is leased to agencies of the federal government.

 

The properties from which operations are conducted are not materially important to us. Management believes that our current leased and owned facilities are in good repair and adequate for current and proposed operations. In management’s opinion, adequate insurance has been purchased for each of the above-referenced properties.

 

 

We and our subsidiaries have from time-to-time been parties to claims and lawsuits that are incidental to our business operations. While ultimate liability with respect to these claims and litigation is difficult to predict, we believe that the amount, if any, that we are required to pay in the discharge of liabilities or settlements in these matters will not have a material adverse effect on our consolidated results of operations or financial position.

 

 

No matters were submitted to a vote of our security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year ended December 31, 2007.

 

 

Market Information.

 

Our common stock, $.01 par value, has traded under the symbol “BXXX” on the NASDAQ Global Market (“NASDAQ”) since June 20, 2005. Our common stock was traded on the American Stock Exchange (“AMEX”) from May 29, 2003 until June 17, 2005 under the symbol “BXX.” From November 1, 2002 until May 28, 2003, the common stock was traded on the OTC Bulletin Board (“OTCBB”). Prior to November 2002, there was no public trading market for our common stock.

 

During the two most recently completed fiscal years, the high and low prices (unadjusted for stock dividends or splits) for our common stock for each quarter have been as follows:

 

 

On February 29, 2008, the closing price for our common stock on the NASDAQ Global Market was $6.05 per share.

 

Holders of Common Stock.

 

On February 29, 2008, there were 449 shareholders of record of our common stock and an indeterminate number of shareholders whose shares are held by brokers or “nominees” in street name.

 

Dividends.

 

Our board of directors has declared regular cash dividends since the second quarter of 2000. We intend to continue to pay regular cash dividends on our common stock. Any decision to pay future dividends to holders of our common stock will be at the discretion of our board of directors and such decision will depend on many factors, including our financial condition, earnings, legal requirements and other factors as our board of directors deems relevant. The certificate of designations, preferences and rights of our Series 2006 preferred stock restricts our ability to pay dividends on our common stock in excess of amounts set forth therein, but allows us, subject to certain exceptions, to continue to pay dividends at our current rate.

 

During our last two fiscal years, we paid dividends per share on our common stock as follows:

 

Securities Authorized for Issuance under Equity Compensation Plans.

 

The following table shows information related to the stock options that have been granted and the number of shares remaining available for grant under the Plan as of December 31, 2007.

 

Equity Compensation Plan Information

 

 

 

 

Recent Sales of Unregistered Equity Securities.

 

We did not sell any unregistered equity securities during the fiscal year ended December 31, 2007, except for the sale on June 28, 2007 to institutional accredited investors of units consisting of 1,500,000 shares of common stock and warrants to purchase 750,000 shares of common stock, in a private placement transaction exempt from registration under the Securities Act of 1933, as amended, pursuant to Section 4(2) of such Act. Information required by Item 701 of Regulation S-K with respect to such transaction was included in and is incorporated by reference to our Current Report on Form 8-K dated June 28, 2007 and filed on July 2, 2007.

 

Purchases of Equity Securities by the Issuer and Affiliated Purchasers.

 

During the fourth quarter of the fiscal year ended December 31, 2007, there were no purchases of equity securities by us or any affiliated purchaser of shares or other units of any class of equity securities registered by us pursuant to Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”).

 

 

SELECTED CONSOLIDATED FINANCIAL DATA

 

The following table sets forth selected historical consolidated financial information for the periods ended and as of the dates indicated.

 

The following income statement data for the years ended December 31, 2007, 2006 and 2005 and balance sheet data as of December 31, 2007 and 2006 are derived from our audited financial statements, which are included elsewhere in this report. The following income statement data for the years ended December 31, 2004 and 2003 and balance sheet data as of December 31, 2005, 2004 and 2003 are derived from our audited financial statements not included in this report. You should read this data together with our financial

statements and related notes included elsewhere in this report and the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

 

The weighted average number of shares has been adjusted to reflect a 2-for-1 stock split in 2004 and a 6-for-1 stock split in 2003.

 

 

 

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

Amounts in this section have been rounded to the nearest thousand, except percentages, ratios, per share data, numbers of franchise locations and numbers of businesses. Unless otherwise indicated, or unless the context otherwise requires, references to years in this section mean our fiscal years ended December 31.

 

General

 

We are a holding company focusing on investments in the insurance, banking and financial services industries with holdings in two public companies, Brooke Capital Corporation (AMEX: BCP) and Aleritas Capital Corp., a d/b/a of Brooke Credit Corporation, (OTCBB: BRCR), and two wholly-owned private companies, Brooke Bancshares, Inc. and Brooke Brokerage Corporation.

 

Despite the associated disadvantages, we prefer to hold investments in small public companies, instead of private companies, for the purposes of promoting entrepreneurial behavior by managers, diversifying risk, increasing accountability and increasing liquidity. Based on the range of BCP and BRCR closing stock prices during the fourth quarter, we had unrealized portfolio gains in our shares of BCP and BRCR stock ranging from a low of approximately $29,000,000 to a high of approximately $57,000,000.

Brooke Bancshares, Inc.  Brooke Bancshares, a wholly owned subsidiary, owns Brooke Savings Bank, which sells banking products and services primarily through contracted banker agents who are paid commissions for customer referrals.

 

Brooke Brokerage Corporation.  Brooke Brokerage, a wholly owned subsidiary owns CJD & Associates, LLC which brokers hard-to-place property and casualty insurance policies and life insurance policies on a wholesale basis primarily through independent insurance agents.

 

Brooke Capital Corporation.  Brooke Capital, an 81% owned subsidiary, owns First Life America Corporation which issues life insurance policies primarily through independent insurance agents. Brooke Capital has agreed to acquire Delta Plus Holdings, Inc., the owner of Traders Insurance Company, which issues auto insurance policies through independent insurance agents. Brooke Capital also owns Brooke Investments, Inc. an independent insurance agency franchisor and Brooke Capital Advisors, a consultant to insurance agency borrowers.

 

Aleritas Capital Corp. (a d/b/a of Brooke Credit Corporation).  Aleritas, a 62% owned subsidiary, is a finance company that lends to businesses that sell insurance and related services. Aleritas generates most of its revenues from interest income resulting from loans held on its balance sheet in the form of inventory loans held for sale and from gains on sale of loans when they are removed from its balance sheet. On March 14, 2008, a dividend of approximately 2,300,000 shares of Aleritas shares was declared payable to our shareholders. As a result, our ownership in Aleritas will be reduced to less than 50% and we do not expect to consolidate Aleritas results with our results in future accounting periods.

 

If the Delta Plus Holdings acquisition by Brooke Capital close as planned, the activities and ownership of Brooke Corporation’s primary direct subsidiaries will correspond to the following chart.

 

 

Results of Operations

 

Our consolidated results of operations have been significantly impacted by expansion of franchise locations in recent years and the acquisition of a bank and insurance companies. The following table shows

income and expenses (in thousands, except percentages and per share data) for the years ended December 31, 2007, 2006 and 2005, and the percentage change from year to year.

 

 

Operating revenue, excluding Aleritas revenue if deconsolidated, is expected to continue to increase in 2008 primarily as a result of bank and insurance company growth and less from opening new franchise locations. The increases in total operating revenues in recent years, and most of the individual revenue categories that make up total operating revenues, are primarily attributable to the continued expansion of franchise operations. The increases in interest income (net) primarily resulted from increased loan origination activities, increases in the amount of loans held in inventory for eventual sale and increases in retained interest from loans sold. Increases in revenues from insurance premiums earned and increases in expenses from insurance loss and loss expense incurred were the result of acquiring Delta Plus and Brooke Capital.

 

Expenses are also expected to continue to increase in 2008 primarily as a result of bank and insurance company growth and less as a result of opening new franchise locations. The increases of commission expense are primarily attributable to increases in insurance commissions received from insurance companies, because a share of insurance commissions is typically paid to franchisees.

 

Payroll expenses, which include wages, salaries, payroll taxes and compensated absences expenses increased primarily as a result of acquiring Delta Plus, Brooke Savings Bank, and Brooke Capital. Payroll

expenses, as a percentage of total operating revenue, were approximately 17% in 2007, 17% in 2006 and 20% in 2005.

 

Depreciation and amortization expense also increased primarily as a result of acquiring Delta Plus, Brooke Savings Bank and Brooke Capital.

 

Other operating expenses increased at a faster rate than total operating revenues during 2007 when compared to the same period in 2006 partially as the result of increases in collateral preservation expenses (See Insurance Segment, below). Other operating expenses which include advertising, rent, travel, lodging and office supplies, also increased as the result of acquiring Delta Plus, Brooke Savings Bank and Brooke Capital. Other operating expenses, as a percentage of total operating revenue, were approximately 28% in 2007, 21% in 2006 and 18% in 2005.

 

We consider interest expense, other than line of credit, to be a non-operating expense. Interest expense increased primarily as a result of increased debt to commercial banks, which was incurred primarily to capitalize our operating subsidiaries and to fund the over-collateralization of our warehouse facilities and securitizations. Also contributing to the increase was the interest expense associated with the private placement of debt by Aleritas in the fourth quarter of 2006.

 

Net income and net income per share for 2007 and the fourth quarter of 2007, decreased primarily as the result of less than expected earnings in our lending segment and higher than expected expenses for lender, or collateral preservation, assistance in our insurance segment. Net income per share also decreased as the result of adjusting the diluted earnings per share calculation to reflect the anticipated issuance of 1,176,000 shares of common stock that may result from our offering of perpetual convertible preferred stock that took place in the third quarter of 2006.

 

The following table shows selected assets and liabilities (in thousands, except percentages) as of December 31, 2007, 2006 and 2005, and the percentage change from year to year.

 

 

Our acquisition of a controlling interest in Brooke Capital Corporation in December 2006 and January 2007 has resulted in a new asset category for investments and a new liability category for policy and contract liabilities to account for the life insurance and annuity operations of First American Capital Corporation’s life insurance company subsidiary. A balance sheet account has also been established to reflect the interests of Brooke Capital and Aleritas’ minority shareholders. The acquisition of Brooke Savings Bank in January 2007 has resulted in a new liability category for deposits, the bank’s primary source of funding.

Investments increased as the result of investments held by Brooke Savings Bank and Traders Insurance Company which were acquired during the first quarter of 2007.

 

Customer receivables primarily include amounts owed to Brooke Capital by our franchisees and increased primarily from continued expansion of our franchise operations, especially the producer development program typically associated with start up franchises. A loss allowance exists for Brooke Capital’s credit loss exposure to these receivable balances from franchisees (See Insurance Services Segment, below).

 

Notes receivable include primarily loans made by Aleritas to franchisees and others. Notes receivable balances vary, sometimes significantly from period to period, as a result of our decision to temporarily retain more or fewer loans in our “held for sale” loan inventory based on the funds available to us. Notes receivable balances remained relatively the same from 2006 to 2007. A loan loss reserve has been established in 2007 totaling $1,655,000 which reduces the notes receivable balance. The loan loss reserve was established due to holding loans longer on the balance sheet than previously, and delinquencies are increasing as the loan portfolio grows and matures.

 

Customer receivables, notes receivables, interest earned not collected on notes and allowance for doubtful accounts are the items that comprise our accounts and notes receivable, net, as shown on our consolidated balance sheet.

 

Other receivables, increased primarily from amounts due from franchisees for purchase of insurance agencies.

 

The securities balance result from loan sales activities to qualifying special purpose entities and primarily consist of three types of securities (or retained residual assets): interest-only strip receivables in the loans sold; retained over-collateralization interests in the loans sold; and cash reserves. When Aleritas sells notes receivable to qualifying special purpose entities it retains an over-collateralization interest in the loans sold and cash reserves. As cash is received for the interest-only strip receivable as well as the principal attributable to our over-collateralization retained interest, the securities balance declines. The securities balance increased primarily as the result of loans previously held in loan inventory being sold to Brooke Warehouse Funding, LLC, in connection with the off-balance-sheet financing secured through Fifth Third Bank in March 2007.

 

Deferred charges includes primarily the fees associated with the issuance of long-term debt by Aleritas and the costs of acquiring life insurance by First Life America.

 

Accounts payable, which includes franchise payables, producer payables, payroll payables and other accrued expenses, increased partially from the continued expansion of our franchise operations, which increased the accrual for estimated commission expense due franchisees. Accounts payable also increased as the result of acquiring Delta Plus, Brooke Savings Bank and Brooke Capital.

 

Payable under participation agreements is the amount we owe to funding institutions that have purchased participating interests in loans pursuant to transactions that do not meet the true sale test of SFAS 140, “Accounting for Transfers and Services of Financial Assets and Extinguishments of Liabilities.” Payable under participation agreements increased because we sold more loans pursuant to transactions that did not meet the true sale test.

 

The premiums payable liability category is comprised primarily of amounts due to insurance companies for premiums that are billed and collected by our franchisees. Premiums payable increased primarily from the continued expansion of our franchise operations, including the acquisition of Delta Plus, which resulted in an increase of premiums billed and collected by our franchisees. Premiums payable also increase from temporary fluctuations in agent billed activity.

 

Debt decreased primarily as the result of elimination of the on-balance-sheet financing previously provided by Fifth Third Bank, which was modified and resulted in off-balance-sheet financing.

 

The following tables provide information regarding our Notes Receivable, Note Participations and asset-backed securities, and Notes Payable principal balances and the corresponding weighted interest rates as of the end of each quarter in 2007, 2006 and 2005 (excluding capitalized lease balances). Notes Receivable balances

include the loans originated by Aleritas to our franchisees and others, even though the notes may no longer be on our balance sheet. Note Participations and asset-backed securities are comprised of loan participation interests that we have sold to our funding institutions and securitization entities. The Note Participation balance includes participations sold that are classified as a true sale and those that are not classified as a true sale or payable under participation agreements. The asset-backed securities exclude the portion of the securitization pools that are retained by us of $58,769,000, $37,003,000 and $32,898,000 at December 31, 2007, 2006 and 2005, respectively. Notes Payable balances are comprised of borrowings to fund the loans that we have made to our franchisees and others and include primarily notes issued to sellers of agencies we have purchased, borrowings under our lines of credit and bank borrowings.

 

Notes Receivable (in thousands)

 

 

Note Participations and Asset-Backed Securities (in thousands)

 

 

Notes Payable (in thousands)

 

 

Income Taxes

 

For the years ended December 31, 2007, 2006 and 2005, we incurred income tax expenses of $474,000, $5,992,000 and $5,261,000, respectively, resulting in effective tax rates of 23%, 36% and 35% (including Brooke Capital Corporation which files a separate tax return). As of December 31, 2007 and 2006, we had current income tax liabilities of $826,000 and $4,293,000, respectively, and deferred income tax liabilities of $8,117,000 and $7,594,000, respectively. The deferred tax liability is primarily due to the deferred recognition of revenues, for tax purposes, on loans sold until interest payments are actually received.

 

Analysis by Segment

 

Our four reportable segments are Banking, Brokerage, Insurance and Lending.

 

Revenues, expenses, assets and liabilities for reportable segments were extracted from financial statements prepared for Brooke Savings Bank (Banking Segment), CJD & Associates (Brokerage Segment), Brooke Capital Corporation and Delta Plus Holdings, Inc. (Insurance Segment) and Aleritas Capital Corp. (Lending Segment), and as such, consolidating entries are excluded.

The Banking Segment includes the sale of banking services by Brooke Savings Bank through independent agents. The Brokerage Segment includes the brokering of hard-to-place property and casualty insurance policies and life insurance policies on a wholesale basis by CJD & Associates through independent agents. The Lending Segment includes the lending activities of Aleritas.

 

All insurance company and retail insurance agency activities currently conducted, or expected to be conducted, by Brooke Capital are discussed in the Insurance Segment. These activities include life insurance company activities (previously discussed in the Financial Services Segment), non-standard auto insurance company activities (previously discussed in the Brokerage Segment), and insurance agency franchise activities (previously discussed in the Franchise Segment).

 

Each segment was assessed a shared services expense which is an internal allocation of legal, accounting, human resources and information technology expenses based on our estimate of usage. Because consolidating entries are excluded, the other operating expense category for reportable segments include internal allocations for shared services expense during the years ended December 31, 2007 and 2006, of $30,000 and $0, respectively, for the Banking Segment, $60,000 and $1,800,000, respectively, for the Brokerage Segment, $2,850,000 and $4,800,000, respectively, for the Insurance Segment; and $2,250,000 and $1,800,000, respectively, for the Lending Segment.

 

Revenues, expenses, assets and liabilities that are not allocated to one of the four reportable segments are categorized as “Corporate.” Activities associated with Corporate include functions such as accounting, auditing, legal, human resources and investor relations. Activities associated with Corporate also include the operation of captive insurance companies that self-insure portions of the professional liability (errors and omissions) exposure of franchisee insurance agents and insurance agents employed by Brooke Capital and its affiliates and provide financial guaranty policies to Aleritas.

 

Banking Segment

 

The following financial information relates to our Banking Segment and includes the financial information of the Brooke Savings Bank subsidiary of Brooke Bancshares, Inc. (in thousands, except percentages). Financial information for 2006 has been included for comparative purposes.

 

 

On January 8, 2007, Brooke Brokerage acquired a 100% interest in Brooke Savings Bank from Kansas City Life Insurance Company (“KC Life”). Upon closing of the acquisition, Brooke Savings Bank had total deposits of $41,493,000. Included in the acquired deposits were $28,000,000 in individual transaction accounts resulting from the deposit of death benefit proceeds from KC Life policies. Brooke Savings Bank has typically paid relatively low deposit rates of 0.10% to 0.34% on these types of accounts. After KC Life sold its interest in Brooke Savings Bank, it discontinued depositing death benefit proceeds into Brooke Savings Bank accounts and the deposit balances from death benefits previously deposited by KC Life have consistently declined. At

December 31, 2007, these types of accounts represented $7,900,000 of Brooke Savings Bank’s total deposits of $26,403,000.

 

Brooke Savings Bank entered into a purchase and assumption agreement with Bank of the West to purchase a network of 42 Kansas-based banker agents who refer deposit and loan business to Brooke Savings Bank. The Office of Thrift Supervision approved the transaction on December 13, 2007 and the transaction became effective as of the close of business on January 18, 2008 As a result, Brooke Savings Bank reported total assets of approximately $141 million, total deposits of $125 million and total stockholders equity of $15.4 million as of January 31, 2008.

 

Income Before Income Taxes Income reduced primarily as the result of reduction in deposits from death benefit proceeds, Brooke Savings Bank’s cost of funds has increased significantly from approximately 1.07% at December 31, 2006 to approximately 2.70% at December 31, 2007. As a result of acquiring significantly more deposits liabilities than loan assets from the Bank of the West transaction, the banking segment is not expected to generate much, if any, earnings until the loan portfolio is increased in accordance with its business plans.

 

Brokerage Segment

 

The following financial information relates to our Brokerage Segment and includes the financial information of CJD & Associates, L.L.C., a wholly-owned subsidiary of Brooke Brokerage (in thousands, except percentages).