UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

Commission file number 0-25679

 

 

 

 

BROOKE CAPITAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

 

 

8500 College Boulevard,

Overland Park, Kansas 66210

(Address of principal executive offices) (Zip Code)

 

 

 

 

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(d) 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.  o

 

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,” “non-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 $6,570,491.*

 

* Based on a private transaction.

 

The number of shares of registrant’s common stock, $.01 par value, outstanding on February 29, 2008 was 8,475,817.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain specified portions of our definitive information 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.

 

 

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.

 

EXPLANATORY NOTE

 

On November 15, 2007, Brooke Capital Corporation completed a merger pursuant to an Agreement and Plan of Merger dated August 31, 2007, as amended (the “Merger Agreement”), by and among Brooke Capital Corporation, Brooke Corporation and Brooke Franchise Corporation. Pursuant to the Merger Agreement, Brooke Franchise Corporation was merged with and into Brooke Capital Corporation, with Brooke Capital Corporation continuing as the surviving corporation.

 

At the time of the merger transaction, both Brooke Franchise Corporation and Brooke Capital Corporation were under the common control of Brooke Corporation. For this reason, the combination of the two merged entities has been accounted for in a manner similar to the pooling of interest method (with assets and liabilities transferred at their then-current carrying amounts). Consistent with this method of accounting, Brooke Capital Corporation’s results of operations for 2007 are reported as if the Merger had occurred on January 1, 2007. Financial statements for prior years are presented in a similar manner for the period of time during which the entities were under common control (December 8, 2006 to December 31, 2006). For all periods prior to December 8, 2006, Brooke Franchise is deemed to be the predecessor and only its results of operation, and not those of Brooke Capital Corporation, are presented.

 

Where deemed relevant for comparative purposes, the results of operations for Brooke Capital Corporation prior to December 8, 2006, have been included here and in our Management’s Discussion and Analysis of Financial Condition and Results of Operations. Such information is identified as “pro forma.”

 

 

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

 

General

 

Our company’s core business is the operation of insurance companies that issue policies sold by independent insurance agents. As the result of our merger with Brooke Franchise Corporation in November 2007, our insurance company business is now supported by a large independent insurance agency that distributes, or sells, policies issued by insurance companies.

 

As such, we conduct business within two primary business segments. The first segment consists of our insurance company operations, including the issuance of life insurance policies and annuity products by First Life America Corporation, a Kansas life insurance company, and the proposed issuance of auto insurance policies by Traders Insurance Company, a Missouri property and casualty insurance company which we have agreed to acquire. The second segment consists of our insurance agency operations, including our insurance agency franchising business and our insurance agency consulting activities through Brooke Capital Advisors, Inc.

We were incorporated under the laws of the State of Kansas on July 10, 1996, under the name of First American Capital Corporation. In 2007, we amended our articles of incorporation, changing our name to Brooke Capital Corporation.

 

We are a majority owned subsidiary of Brooke Corporation; a NASDAQ Global Market listed company trading under the symbol “BXXX.” Brooke Corporation is a Kansas corporation that acts as a holding company, including its ownership of approximately 81% of our common stock and 100% of the common stock of Delta Plus Holdings, Inc. (“Delta Plus”), which owns 100% of Traders Insurance Company (“TIC”). Brooke also has a 62% ownership of Brooke Credit Corporation d/b/a Aleritas Capital Corporation (OTCBB:BRCR) (“Aleritas”) and 100% ownership of Brooke Bancshares, Inc., the parent company of Brooke Savings Bank.

 

We are the parent company of First Life America Corporation, a life insurance company (“First Life”), and Brooke Capital Advisors, Inc. (“BCA”), a loan broker and consultant for general insurance agencies specializing in the sale of hard-to-place and niche insurance policies. Subject to the closing of our agreement to acquire Delta Plus, we expect to become the parent company of Delta Plus and the indirect owner of TIC.

 

Insurance Company Operations

 

Life Insurance and Annuity Product Sales.

 

First Life 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 First Life.  The primary insurance products currently being marketed by First Life are as follows:

 

Golden Eagle Final Expense is permanent whole life insurance available on a simplified issue or graded death benefit basis. The simplified issue product is issued for issue ages 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 for issue ages 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 death benefit upon terminal illness or permanent confinement to a qualified nursing home. Premiums are level for life and vary by risk class, sex and issue age. First Life is in the process of modifying the premiums from unismoker to non-tobacco/tobacco rates. First 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 year 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 up to five times the initial face amount 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, 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.  First Life’s marketing strategy is to provide life insurance and annuity products that are beneficial to the consumer and profitable. As such, First Life is continually seeking new markets for its products primarily by utilizing its existing and new insurance agents to promote the sales of its products. First Life sells its products through agents. These agents receive commissions and, subject to qualification, promotional incentives from First Life based on premiums collected on the products sold. First Life 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 First Life on products sold by the agents. The IMOs recruit, train, contract and provide other support functions to the independent agents.

 

First Life 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 for expanding its marketing presence.

 

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

 

Amounts of Insurance (1)

 

 

 

 

The following table provides certain information about First Life’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 First Life 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 First Life.

 

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. First Life has entered into agreements with Optimum Re Insurance Company (“Optimum Re”) of Dallas, Texas, and Wilton Reassurance Company (“Wilton Re”) of Wilton, Connecticut, to reinsure portions of the life insurance risks it underwrites. Pursuant to the terms of the reinsurance agreements, First Life 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, First Life remains primarily liable for the entire amount at risk.

 

First Life 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. First Life’s maximum exposure on any one insured under the Reinsurance Pool is $50,000.

 

Underwriting.  First Life 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.  First Life 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 First Life. Brooke Capital Corporation is not subject to the limitations, which restrict only the investments made by First Life. Currently, investments of First Life 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 First Life, but also attempts to match the investment mix to others within First Life’s industry peer group.

 

Financial Information.  See Note 11 to Item 8 “Financial Statements” in this Form 10-K for financial information regarding our insurance company operations.

 

Contemplated Non-Standard Automobile Insurance

 

We plan to offer proprietary non-standard automobile insurance through independent insurance agencies. For this reason, we intend to consummate the transactions contemplated in an Exchange Agreement dated August 31, 2007 among us, Brooke Corporation, and Delta Plus (the “Exchange Agreement”). Under the Exchange Agreement, Brooke Corporation will contribute to us all of the outstanding stock of Delta Plus in exchange for consideration equal to 500,000 shares of the Company’s common stock, with an opportunity to receive additional shares of the Company’s 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 currently generates a very insignificant part of Delta Plus’s revenues.

 

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

 

Insurance Company Activities of TIC.  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 17% 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 the independent agency system, 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. Carriers like Phoenix Indemnity and Bristol West continue their expansion into TICs’ 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 TICs’ commission expenses. However, we believe non-

standard auto writers are demonstrating a more disciplined pricing and underwriting response to this softening market than they did 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” is also designed to protect 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 that 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 and 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 completed its migration from its legacy policy administration system to PTS and anticipates completing development of the claims administration during 2008. PTS includes a point of sale module that 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 non-renewal 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 Connection.  Connection is generally delegated the 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 but is not limited to: selling, underwriting, accepting, issuing, declining and canceling risks; collecting premiums and paying return premiums on policies of insurance; entering into agreements with insurance agents and producers properly licensed by an insurance company, and 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 $4,247,379 in commissions from insurance companies of which $4,124,135 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 $2,140,242 of the commissions it received from insurance companies.

 

Managing General Agency Activities of PCI.  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.

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

 

We are one of the largest franchisors of property and casualty insurance agencies in the United States, based on number of locations. We offer our franchisees network association with an emerging brand identity, use of our business model, access to the products of many leading insurance carriers, and use of our web-based information management system. According to Entrepreneur Magazine, January 2007, and January 2008, we were ranked first in our industry category of franchisors of miscellaneous financial services based on factors such as financial strength, stability, growth rate and size of system.

 

Currently, we franchise businesses that primarily sell property and casualty insurance, such as automobile, homeowners and business owners insurance products. We have also franchised a limited number of 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, we generated approximately 71% of our retail commission income from personal lines insurance, such as auto and homeowner’s insurance, and approximately 26% from commercial lines insurance such as commercial general liability and business owners insurance.

 

Franchisees.  Our franchisees are typically entrepreneurial individuals with experience in the sale of insurance. We believe 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, we believe that our franchises will perform better than their competitors. Our franchisees generally either form a new start up insurance agency or convert an existing insurance agency to a franchise. In January 2006, we 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 us and then sold to a franchisee or set up by us for operation, with the franchisee commencing operations and assuming the operating expenses. As of December 31, 2007, 2006 and 2005, we had 882, 737 and 552 franchised and company-owned locations, respectively.

The following table shows the states that have more than fifteen of our franchised and company-owned locations as of December 31, 2007.

 

 

The other 12 states in which we operate had a total of 74 franchised and company-owned 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 our 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 Company 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 our franchisees. If Aleritas is unable or unwilling to make loans to our franchisees, our growth strategy will be negatively impacted. We are monitoring this situation and seeking additional funding sources.

 

Support for our franchisees.  We believe we offer to our 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 frequently 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 agents’ ability to offer a variety of insurance products to their customers. We aggregate the insurance premium volumes generated by our 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.  We have an advertising center facility on our 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 our franchisees in identifying potential customers, developing marketing programs, coordinating advertising purchases, and measuring marketing effectiveness. Our lead generation system, which includes referrals from insurance companies, lead brokers, e-mail solicitations and our online quote request system, helps our franchisees identify prospective customers. We employ a total of 41 marketing professionals to serve our 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. We have a total of 28 employees on our facilities support teams.

 

Business administration.  We provide a range of administrative support services to our franchisees that enhance operating efficiency. First, we provide cash management services such as daily consolidation of all cash collected by franchisees and allocation of sales commissions and other revenue to the franchisee’s account statement. As part of our cash management services, in order to assist our franchisees with the monthly fluctuation of revenues, we also make short-term commission advances to our franchisees, which are expected to be repaid within a 30-day franchise statement cycle. Any commission advances that remain unpaid after 120 days are placed on “Watch” status. As of December 31, 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. We also make 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 31, 2007, there were approximately $9,798,000 of commission advances outstanding for the longer-term non-statement balances. Second, through our Brooke Information System, a document-based information system, our 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, we have established buying groups to assist our franchisees in the purchase of office equipment, supplies and services at bulk discounted rates that may otherwise be unavailable to them.

 

Financial discipline.  We work with our franchisees to devise budgets and action plans to help enhance agency performance. We monitor our franchisees’ performance and work with our franchisees to address negative operating trends. As a result, we generally can identify those franchisees who may have difficulty in meeting their obligations to lenders or who may become unable to repay short-term commission advances from us within the specified 120-day period. In cases where we identify financial or operational problems, we 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.

 

We believe that these resources and systems provide our 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. We believe that our franchisees have significantly greater resources, including greater access to insurance products, than many other independently owned property and casualty insurance agencies. Further, we believe our 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.  We generate revenues through our network of franchise locations in the following ways:

 

Share of ongoing revenues.  We receive commission payments from the insurance companies that write the policies sold by our franchisees through our affiliated company, BASC LLC. BASC LLC, accounts to us for the commissions earned and we then remit to our franchisees the balance of these commissions, net of any loan payments to us or to lenders, franchise fees, and other fees or amounts owed to us. As part of our franchise relationship, we also receive a monthly franchise fee in the form of a percentage of the ongoing revenues of each franchisee, which is generally 15% of our insurance agency franchisees’ revenues. In late 2007, we instituted a “bonus back” of a portion of the monthly franchise fee, which effectively lowers the percentage generally paid by franchisees to 10%. We receive an additional share of our franchisees’ commissions in payment for a franchisee’s optional use of our 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.  We earn 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.  We consult with 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. We help 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 we received from our franchisees for the years ended December 31, 2007, 2006 and 2005 (in thousands):

 

 

 

 

Loan Consulting Fees.

 

Beginning in December 2006, our wholly owned subsidiary 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 its MGA and Funeral 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 Loan Programs originated their 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 approximately $11,609,000 of which approximately $9,246,000 was generated through the Loan Brokerage segment as a result of collateral preservation fees. 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.

 

Financial Information.

 

See Note 11 to Item 8 “Financial Statements” in this Form 10-K for financial information regarding our insurance agency operations.

 

Competition

 

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 First Life. 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 we operate.

 

Insurance Agency Operations.  As a franchisor of property and casualty insurance agencies, we seek to grow our network of franchises primarily through start up franchise agencies, company developed agencies and conversions of existing insurance agencies to franchises. Our 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 than we are and have greater financial resources than we do. Because the larger insurance brokers and agents generally seek to acquire agencies with revenues greater than those we acquire, we believe that our franchising strategy offers an attractive alternative for smaller insurance agencies. We also face 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.

 

Our 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. Our 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, our 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. We believe that our industry contacts and the limited markets in which we compete for loans distinguish us from other brokers and lenders.

 

Service Marks, Trademarks and Patents

 

We sell our services and products under certain service marks and trademarks owned by Brooke Corporation, which licenses the use of these marks to us as the franchisor. Brooke Corporation authorizes the franchisor to sub license selected marks to our franchisees. Brooke Corporation has filed for protection of these marks through their 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” design mark and other marks that utilize the “Brooke” name.

 

Employees

 

We employed 513 people as of December 31, 2007, of which 478 were employed on a full-time equivalency basis (work 37.5 hours or more per week). As of December 31, 2007, Delta Plus employed 53 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. As such, our primary suppliers are insurance companies, and we have direct and indirect agency relationships with several hundred insurance companies, including several of the leading writers of personal and commercial lines insurance in the United States and our own Life and Property and Casualty insurance companies. Our largest suppliers include Progressive, Safeco, Travelers, AIG and The Hartford, which together account for approximately 31% of the commissions generated by our franchisees.

 

Government Regulation

 

Insurance Agency Operations.  We are subject to licensing or regulatory approval by the state insurance department in each state in which we do business. Each of our franchise agencies also is subject to licensing or regulatory approval in the state in which it conducts business. Our operations depend on the validity of, and our continued good standing under, the licenses and approvals under which we operate. 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.

 

We and our 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. Specific state statutes and regulations regarding rebating may extend to transactions that involve an agent or agency giving anything of value to a customer to induce the purchase of a policy.

 

We 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 we furnish prospective franchisees with a franchise offering circular containing information prescribed by the Trade Regulation Rule on Franchising and applicable state laws and regulations.

 

We 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.

 

We are subject to the unfair trade practices acts of the various states in which we do 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.

 

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 or deception, or registration.

Insurance Company Operations.  First Life 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 First Life may restrict its ability to dividend or otherwise transfer funds from it to the Company, even if its operations are profitable and creating positive cash flow, restrict its ability to raise capital other than by contributions from the Company, and require that the Company contribute additional capital to it.

 

As a result of our ownership of First Life, we are subject to Kansas laws regulating insurance holding company systems, including acquisitions, extraordinary dividends, the terms of affiliate transactions, and other related matters.

 

Other Regulations.  Federal, state, local and foreign governments and some self-regulatory organizations have enacted statutes and ordinances, and/or adopted rules and regulations, regulating other aspects of the businesses in which we are involved. We seek to determine the applicability of such statutes, ordinances, rules and regulations (collectively, “Laws”) and comply with those Laws that apply to our activities. We believe that we are currently in material compliance with all Laws and government commitments to which we are subject and we are unaware of any pending or threatened investigation, action or proceeding by any state, federal or foreign regulatory agency involving us that would have a material adverse effect on us. We cannot predict what effect future Laws, changes in interpretations of existing Laws, or the results of any regulator inquiries with respect to the applicability of Laws may have on us or our financial results.

 

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.

 

 

Risks Related to Our Business Operations

 

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

 

Our expansion strategy consists primarily of adding new franchise locations. 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. We cannot assure you that we will be able to continue to 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.

 

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

 

We have credit exposure with respect to our franchisees’ monthly statement balances. To fund long-term producer development of our franchisees, including hiring and training costs, we also extend credit to our franchisees that we refer to as “non-statement balances.” Our franchisees depend on commission income to pay amounts due to us with respect of their statement, and non-statement balances. If our franchisees are not successful, our franchisees may be unable to pay statement or non-statement balances to us 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.

 

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 the insurance companies and ourselves. 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 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 have 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 part. 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 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 impacted by the cyclical pricing of property and casualty insurance, which may adversely affect our franchisees’ performance and, thus, our financial performance.

 

Our franchisees 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 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, 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, those insurance carriers may seek to further decrease 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 our profitability and that of our franchisees. 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, 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 existing agencies into new franchises.

 

Our ability to successfully identify suitable acquisition candidates, complete acquisitions, convert acquired businesses into 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 are dependent on key personnel.

 

We are dependent upon the continued services of senior management, particularly the services of Kyle L. Garst and Dane Devlin and Michael Hess. 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.

 

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.

 

If we fail to maintain an effective system of internal controls, including those internal controls impacted by the upgrade of our information technology, we may not be able to accurately report our financial results or prevent fraud. As a result, current and potential stockholders could lose confidence in our financial reporting, which could harm our business and the trading price of our stock.

 

Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. If we cannot provide reliable financial reports or prevent fraud, our brand and operating results could be harmed. We have undertaken to upgrade our information technology systems, which in some instances are integral to the maintenance and effectiveness of our internal controls. Any failure to implement these new controls or ongoing controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to meet our reporting obligations or to find our internal controls over financial reporting to be effective. Failure to achieve and maintain an effective system of internal controls could have a material adverse effect on our stock price.

 

Our dependence on initial franchise fees creates an incentive for us to extend credit to borrowers that may not meet our 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 us or Aleritas. Our dependence on these initial fees creates an incentive for us to extend credit to borrowers that may not meet our underwriting criteria. Our failure to follow underwriting guidelines could adversely affect the quality of the loans we make and adversely affect our financial condition and results of operations.

 

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’ revenue and profitability 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.

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 to meet or project growth. 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, some of which are beyond our control, 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; and (vi) maintaining and attracting customers. Accordingly, we may not achieve the same levels of growth in revenues and profits as we have historically.

 

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. 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 regulatory agencies with broad administrative powers with respect to, among other things, licensing to transact business, licensing of agents and unfair trade practices.

 

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 extensive regulatory requirements than those under 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.

 

A significant factor of our business strategy involves the ability and willingness of our affiliate, Aleritas, in funding loans to our franchisees.

 

Our expansion strategy consists principally of adding new franchise locations. Continued growth is dependent upon a number of factors, including the availability of funding for acquisitions and operating needs of our franchisees. Historically, Aleritas has provided such funding in the form of loans for new franchisees. 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 preservation providers, and other factors, many of which may be beyond the control of Aleritas. Although Aleritas is an affiliate company, it is not required to make loans to our franchisees. We cannot assure you that Aleritas will be able or willing to continue to provide loans to our franchisees. The inability or unwillingness of Aleritas to originate loans for acquisitions and franchise operating needs would negatively impact our ability to grow our business and our profitability.

 

We share brand name identity with Brooke Corporation and other affiliates.

 

In the event of circumstances involving any of these entities that have a negative effect on the “Brooke” brand, we could likewise suffer if the negative impact harms our reputation or credibility in the marketplace, which could reduce the number of independent agencies willing to join our franchise network or otherwise reduce the number of our franchisees contracting for our services. In such event, our profitability and growth prospects would be reduced.

 

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

 

Our advances and extensions of credit are made primarily to small and medium-sized, privately owned businesses. Compared to larger, publicly owned firms, these companies generally have limited access to capital and higher funding costs. They 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 franchisees to make scheduled payments of interest and principal on our advances. Accordingly, advances and extensions of credit made to these types of franchisees entails higher risks than advances made to companies that are able to access traditional credit sources.

 

The expansion of our insurance company operations will be dependent upon the availability of outside financing.

 

We plan to expand our insurance company operations by distributing non-standard auto, life and annuity insurance products through our franchise network. While we intend to internally fund a portion of these

expansion costs, we anticipate that outside financing will be required for the expansion. There can be no assurance that outside financing will be available to us on terms and conditions acceptable to us.

 

Insurance company operations could be disrupted by the failure of their information technology and telecommunications systems because they are dependent on these systems.

 

First Life and Delta Plus’s business is highly dependent upon the successful and uninterrupted functioning of our current information technology and telecommunications systems as well as current and/or future integrated policy and claims system. These systems are relied upon to process new and renewal business, provide customer service, make claims payments and facilitate collections and cancellations, as well as to perform actuarial and other analytical functions necessary for pricing and product development. As a result, the failure of these systems could interrupt operations and adversely affect financial results. Because information technology and telecommunications systems interface with and depend on third-party systems, service denials could be experienced if demand for such service exceeds capacity or such third-party systems fail or experience interruptions. If sustained or repeated, a system failure or service denial could result in a deterioration of our insurance company’s ability to write and process new and renewal business and provide customer service or compromise its ability to pay claims in a timely manner. This could result in a material adverse effect on our insurance company’s operations.

 

Our insurance company’s ability to earn profits may be restricted by comprehensive regulation.

 

First Life and Delta Plus are subject to comprehensive regulation and supervision by government agencies in Kansas and Missouri, respectively, where each insurance company subsidiary is domiciled, as well as in the states where First Life and Delta Plus’s insurance companies sell insurance products, issue policies and handle claims. Certain states impose restrictions or require prior regulatory approval of certain corporate actions, which may adversely affect First Life and Delta Plus’s ability to operate, innovate, obtain necessary rate adjustments in a timely manner or grow its business profitably. These regulations provide safeguards for policy owners and are not intended to protect the interests of stockholders. First Life’s and Delta Plus’s ability to comply with these laws and regulations and to obtain necessary regulatory action in a timely manner is and will continue to be critical to their success.

 

Compliance with laws and regulations addressing these and other issues often will result in increased administrative costs. In addition, these laws and regulations may limit First Life and Delta Plus’s ability to underwrite and price risks accurately, preventing them from obtaining timely rate increases necessary to cover increased costs and may restrict their ability to discontinue unprofitable relationships or exit unprofitable markets. These results, in turn, may adversely affect First Life and Delta Plus’s profitability or their ability or desire to grow their business in certain jurisdictions. The failure to comply with these laws and regulations may also result in actions by regulators, fines and penalties, and in extreme cases, revocation of First Life’s or Delta Plus’s ability to do business in that jurisdiction. In addition, First Life and Delta Plus may face individual and class action lawsuits by policyholders and other parties for alleged violations of certain of these laws or regulations.

 

Insurance company operations could be adversely affected if regulation becomes more extensive in the future.

 

New or more restrictive regulation in any state in which First Life and Delta Plus conducts business could make them more expensive for them to conduct their business, restrict the premiums they are able to charge or otherwise change the way they do business. In such events, First Life and Delta Plus may seek to reduce their writings in, or to withdraw entirely, from these states. In addition, from time to time, the United States Congress and certain federal agencies investigate the current condition of the insurance industry to determine whether federal regulation is necessary. First Life or Delta Plus are unable to predict whether and to what extent new laws and regulations that would affect their business will be adopted in the future, the timing of any such adoption and what effects, if any, they may have on their operations, profitability and financial condition.

Insurance company operations’ failure to meet minimum capital and surplus requirements could subject them to regulatory action.

 

First Life and Delta Plus’s insurance companies are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable state laws, including the laws of their states of domicile. The risk-based capital standards, based upon the Risk-Based Capital Model Act adopted by the National Association of Insurance Commissioners, or NAIC, require insurance companies to report their results of risk-based capital calculations to state departments of insurance and the NAIC. These risk-based capital standards provide for different levels of regulatory attention depending upon the ratio of an insurance company’s total adjusted capital, as calculated in accordance with NAIC guidelines, to its authorized control level risk-based capital. Authorized control level risk-based capital is the number determined by applying the NAIC’s risk-based capital formula, which measures the minimum amount of capital that an insurance company needs to support its overall business operations.

 

Failure to meet applicable risk-based capital requirements or minimum statutory capital requirements could subject First Life and/or Delta Plus to further examination or corrective action imposed by state regulators, including limitations on writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require First Life’s and/or Delta Plus’s insurance company to increase its statutory capital levels.

 

Insurance company operations’ profitability could be adversely affected by negative developments and cyclical changes in the non-standard personal automobile industry because it has a concentration in this industry.

 

Substantially all of First Life’s gross premiums are generated from the sale of life insurance and fixed annuity insurance products. All of Delta Plus’s gross premiums are generated from sales of non-standard personal automobile insurance policies. As a result of a concentration in these lines of business, negative developments in the business or economic, competitive or regulatory conditions affecting the industry could have a negative effect on profitability. Examples of such negative developments would be increasing trends in automobile repair costs, automobile parts costs, used car prices and medical care expenses, increased regulation, as well as increased litigation of claims and higher levels of fraudulent claims. All of these events can result in reduced profitability.

 

In addition, Delta Plus’s non-standard personal automobile insurance industry historically has been cyclical in nature, characterized by periods of severe price competition and excess underwriting capacity followed by periods of high premium rates and shortages of underwriting capacity. These fluctuations in the non-standard personal automobile insurance business cycle may negatively impact our profitability.

 

Our insurance company operations’ profitability could be adversely affected by competition.

 

Both the life and non-standard personal automobile insurance lines of business are highly competitive and, except for capital and regulatory considerations, there are relatively few barriers to entry. Our insurance companies compete with other insurance companies that sell the same or similar lines of insurance through independent agencies as well as with insurance companies that sell such policies directly to their customers. Some competitors have substantially greater financial and other resources than our insurance companies have and may offer a broader range of products or competing products at lower prices. In addition, existing competitors may attempt to increase market share by lowering rates and new competitors may enter this market, particularly larger insurance companies that do not presently write standard life, final expense, fixed annuity or non-standard personal automobile insurance. In this environment, First Life and Delta Plus may experience a reduction in underwriting margins or sales of insurance policies may decrease as individuals purchase lower-priced products from other insurance companies. A loss of business to competitors offering similar insurance products at lower prices or having other competitive advantages could negatively affect revenues and net income.

Insurance company operational success depends on their abilities to price accurately the risks they underwrite.

 

The results of our operations and the financial condition of our insurance companies depend on our ability to underwrite and set premium rates accurately for a wide variety of risks. Rate adequacy is necessary to generate sufficient premiums to pay losses, loss adjustment expenses and underwriting expenses and to earn a profit. In order to price products accurately, First Life and Delta Plus must collect and properly analyze a substantial amount of data; develop, test and apply appropriate rating formulas; closely monitor and timely recognize changes in trends and project both severity and frequency of losses with reasonable accuracy. First Life’s and Delta Plus’s ability to undertake these efforts successfully, and as a result price their products accurately, is subject to a number of risks and uncertainties, some of which are outside their control. Consequently, each company could underprice risks, which would negatively affect profit margins, or each could overprice risks, which could reduce sales volume and competitiveness. In either event, the profitability of our insurance companies could be materially and adversely affected.

 

Insurance company operations could incur additional charges to earnings if its actual losses and loss adjustment expenses exceed loss and loss adjustment expense reserves.

 

Both First Life and Delta Plus maintain reserves to cover their estimated liability for losses and the related loss adjustment expenses for reported and unreported claims on insurance policies issued by our insurance company subsidiaries. The establishment of appropriate reserves is an inherently uncertain process, involving actuarial and statistical projections of what our insurance company operations expect to be the cost of the ultimate settlement and administration of claims. These projections are based upon historical claims information, estimates of future trends in claims severity and other variable factors such as inflation. Due to the inherent uncertainty of estimating reserves, it has been necessary, and will continue to be necessary, to revise estimated future liabilities of each insurance company subsidiary’s reserves for claims and related expenses.

 

Our insurance company subsidiaries cannot be sure that their ultimate losses and loss adjustment expenses will not materially exceed their reserves. To the extent that reserves prove to be inadequate in the future, our insurance company subsidiaries would be required to increase reserves for losses and the related loss adjustment expenses and incur a charge to earnings in the subsequent period during which such reserves are increased, which could have a material and adverse impact on our financial condition and results of operations in the subsequent period.

 

Insurance company operations, financial condition and results of operations could be adversely affected if they are not successful in reducing risk and increasing underwriting capacity through reinsurance arrangements.

 

In order to reduce underwriting risk and increase underwriting capacity, our insurance company subsidiaries may choose to transfer portions of its insurance risk to other insurers through reinsurance contracts. Historically, Delta Plus has ceded a portion of its non-standard automobile insurance premiums and losses to unaffiliated reinsurers in accordance with these contracts. The availability, cost and structure of reinsurance protection is subject to changing market conditions that are outside of our insurance subsidiaries’ control. In order for these contracts to qualify for reinsurance accounting and thereby provide the additional underwriting capacity that may be needed, the reinsurer generally must assume significant risk and have a reasonable possibility of a significant loss.

 

Although the reinsurer is liable to the insurance company to the extent it transfers, or “cedes,” risk to the reinsurer, the insurance company remains ultimately liable to the policyholder on all risks reinsured. As a result, ceded reinsurance arrangements do not limit our insurers’ ultimate obligation to their policyholders to pay claims. Our insurance company subsidiaries are subject to credit risks with respect to the financial strength of their reinsurers. They are also subject to the risk that their reinsurers may dispute their obligations to pay claims. As a result, our insurance company subsidiaries may not recover claims made to their reinsurers in a timely manner, if at all. In addition, if insurance departments deem that under Delta Plus’s existing or future reinsurance contracts the reinsurer does not assume significant risk and has a reasonable possibility of

significant loss, our insurance company subsidiary may not be able to increase its ability to write business based on this reinsurance. Any of these events could have a material adverse effect on our insurance company’s business, financial condition and results of operations.

 

Insurance company revenues and business operations could be adversely affected by new pricing, claim and coverage issues emerging in the automobile insurance industry.

 

As insurance industry practices and regulatory, judicial and consumer conditions change, unexpected and unintended issues related to claims, coverages, business practices and premium financing plans may emerge. These issues can have an adverse effect on Delta Plus’s business by changing the way it prices products, by extending coverage beyond underwriting intent, or by increasing the size of claims. The effects and costs of these and other unforeseen emerging issues could negatively affect Delta Plus’s revenues and business operations.

 

Insurance company operations, financial results and capital requirements could be adversely affected if they fail to pay claims accurately.

 

Our insurance company subsidiaries must accurately evaluate and pay claims that are made under their respective policies. Many factors affect our company’s ability to pay claims accurately, including the training and experience of claims representatives, the claims organization culture, the effectiveness of management, the ability to develop or select and implement appropriate procedures and systems to support claims functions and other factors. Our insurance company subsidiaries’ failure to pay claims accurately could lead to material litigation, undermine their reputation in the marketplace, impair their image and negatively affect their financial results.

 

Our ability to implement our business strategy could be adversely affected by our insurance company subsidiaries’ inability to retain and recruit qualified personnel.

 

Our insurance company subsidiaries’ success depends in part on their ability to attract and retain qualified personnel. The inability to recruit and retain qualified personnel could prevent them from fully implementing their business strategies and could materially and adversely affect its business, growth and profitability.

 

Insurance company operations’ financial results could be adversely affected by litigation.

 

Delta Plus is named as a defendant in a number of lawsuits. Currently, First Life is not a named defendant in any litigation. Litigation, by its very nature, is unpredictable and the outcome of these cases is uncertain. The precise nature of the relief that may be sought or granted in any lawsuits is uncertain and may, if these lawsuits are determined adversely to Delta Plus, negatively impact its earnings.

 

In addition, potential litigation involving new claim, coverage and business practice issues could adversely affect our insurance company subsidiaries’ business by changing the way products are priced, extending coverage beyond underwriting intent or increasing the size of claims. The effects of unforeseen emerging claims, coverage and business practice issues could negatively impact their profitability and methods of doing business.

 

Insurance company operations’ investment portfolios could be adversely affected by adverse securities market conditions.

 

Each of our insurance company subsidiaries’ results of operations depends in part on the safety and performance of its invested assets. As of December 31, 2007, virtually all of our insurance company subsidiaries’ investment portfolios were invested in fixed income securities. Certain risks are inherent in connection with fixed maturity securities including loss upon default and price volatility in reaction to changes in interest rates and general market factors. In general, the fair value of a portfolio of fixed income securities increases or decreases inversely with changes in the market interest rates, while net investment income realized from future investments in fixed income securities increases or decreases along with interest rates.

Severe weather conditions and other catastrophes may result in an increase in the number and amount of claims filed against insurance company operations.

 

First Life and Delta Plus’s business is exposed to the risk of severe weather conditions and other catastrophic events, such as rainstorms, snowstorms, hail and ice storms, hurricanes, tornadoes, earthquakes, fires and other events such as explosions, terrorist attacks and riots. The incidence and severity of catastrophes and severe weather conditions are inherently unpredictable. Such conditions generally result in higher incidence of automobile accidents and an increase in the number of claims filed, as well as the amount of compensation sought by claimants.

 

Policy lapses in excess of those actuarially anticipated would have a negative impact on our financial performance.

 

If our insurance company subsidiaries’ policy lapse and surrender rates were to exceed the assumptions upon which we priced our insurance policies, our business could be adversely affected. The prices and expected future profitability of our insurance products are based in part upon expected patterns of premiums, expenses and benefits, using a number of assumptions, including those related to persistency, which is the probability that a policy or contract will remain in-force from one period to the next. Lapses occur when premium payments are not made. Surrender of a policy occurs by an affirmative act of the policyholder and is usually accompanied by an economic benefit for the policyholder because the policy has accumulated value. Policy acquisition costs are deferred and recognized over the life of a policy. Actual persistency that is lower than our persistency assumptions could have an adverse impact on profitability, especially in the early years of a policy or contract, primarily because we would be required to accelerate the amortization of expenses we deferred in connection with the acquisition of the policy or contract.

 

Sales of our products may be reduced if we are unable to attract and retain marketing representatives or develop and maintain distribution sources.

 

Our insurance company subsidiaries distribute insurance products through a variety of distribution channels, including independent marketing consultants, employee agents and third-party marketing organizations. Our relationships with these persons are significant both for our revenues and profits. Strong competition exists among insurers to form relationships with marketers of demonstrated ability. We compete with other insurers for representatives and consultants primarily on the basis of our compensation and support services. Any diminishment in our inability to attract and retain effective sales representatives could materially adversely affect our results of operations and financial condition.

 

We may be required to accelerate the amortization of deferred acquisition costs which would increase our expenses and reduce profitability.

 

Deferred acquisition costs, or DAC, represent costs that vary with and are primarily related to the sale and issuance of our insurance policies that are deferred and amortized over the estimated life of the related insurance policies. These costs include commissions in excess of ultimate renewal commissions, solicitation and printing costs, sales material and some support costs, such as underwriting and contract and policy issuance expenses. Under U.S. GAAP, DAC is amortized to income over the lives of the underlying policies, in relation to the anticipated recognition of premiums. Our amortization of DAC generally depends upon anticipated profits from investments, surrender and other policy charges, mortality, morbidity and maintenance expense margins. Unfavorable experience with regard to expected expenses, investment returns, mortality, morbidity, withdrawals or lapses may cause us to increase the amortization of DAC or to record a charge to increase benefit reserves.

 

We regularly review DAC quality to determine if they are recoverable from future income. If these costs are not recoverable, they are charged to expenses in the financial period in which we make this determination. For example, if we determine that we are unable to recover DAC from profits, or if withdrawals or surrender charges associated with early withdrawals do not fully offset the unamortized acquisition costs related to that line of business, we would be required to recognize the additional DAC amortization as a current-period expense.

DAC costs are amortized primarily over the estimated premium paying period of the related policies in proportion to the ratio of the annual premium recognized to the total premium revenue anticipated, using the same assumptions as were used in computing liabilities for future policy benefits. Excess policy lapses, however, would cause the immediate expensing or amortizing of deferred policy acquisition costs, which would adversely affect our profitability.

 

Failure to protect confidential information and privacy could result in the loss of customers and reductions in our profitability and subject us to fines and penalties.

 

Our insurance subsidiaries are subject to privacy regulations and to confidentiality obligations. We also have legal obligations to protect certain confidential information we obtain from our existing vendors. These obligations generally include protecting confidential information in the same manner and to the same extent as we protect our own confidential information. The actions we take to protect confidential information include among other things: monitoring our record retention plans and any changes in state or federal privacy and compliance requirements; maintaining secure storage facilities for tangible records; and limiting access to electronic information in order to safeguard certain current information.

 

In addition, we deliver a notice regarding our privacy policy both at the delivery of the insurance policy and annually thereafter. Certain exceptions are allowed for sharing of information under joint marketing agreements. However, certain state laws may require individuals to opt in to information sharing instead of being immediately included. Additionally, when final U.S. Treasury Department regulations are promulgated in connection with the USA Patriot Act, we will likely have to expend additional resources to tailor our existing efforts to the new rules.

 

If we do not comply with privacy regulations and protect confidential information, we could experience adverse consequences, including regulatory problems, loss of reputation and litigation.

 

General economic, financial market and political conditions may adversely affect our results of operations and financial condition.

 

Our results of operations and financial condition may be materially adversely affected from time to time by general economic, financial market and political conditions. These conditions include economic cycles such as:

 

 

Fluctuations in interest rates, monetary policy, demographics, and legislative and competitive factors also influence our performance. During periods of economic downturn, individuals and businesses may choose not to purchase our insurance products and other related products and services, may terminate existing policies or contracts, permit them to lapse or may choose to reduce the amount of coverage purchased.

 

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

 

Certain of the agreements we have governing indebtedness contain financial covenants that impose ratios, tests and restrictions on us and our subsidiaries, such as maximum prepayment rate, maximum loan loss rate, minimum fixed charge coverage ratio, maximum cash leverage ratio, and maximum total leverage ratio. These contain other restrictions on us and our subsidiaries, including but not limited to: incurrence of indebtedness and liens; restrictions on the reorganization, transfer and merger; disposition of 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 by us and our subsidiaries, except in limited circumstances. Our ability and the ability of our subsidiaries to comply with these 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 the indebtedness.

 

Risks Related to Our Common Stock

 

Brooke Corporation is able to exert significant control over us and may act in a manner that is adverse to our other stockholders’ interests.

 

As of February 29, 2008, Brooke Corporation owned approximately 81% of our outstanding common stock. As a result, Brooke Corporation is able to exert significant influence over:

 

 

Brooke Corporation’s interests may conflict with the interests of other holders of our common stock and it may take actions affecting us with which other stockholders may disagree. For example, in order to retain control in the controlling group, it may decide not to enter into a transaction in which our stockholders 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 Brooke Corporation may make at some future time will be in its absolute discretion.

 

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

 

Although shares of our common stock are listed on the American Stock Exchange, our average daily trading volume has been approximately 1,356 shares during the three months ended February 29, 2008. As a result of this low trading volume, stockholders 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 stockholders to resell common stock when they want or at a price they find attractive.

 

Since September 2007, our common stock has traded at prices ranging between $2.80 and $7.20 on the American Stock Exchange. 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 stockholders 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 stockholders 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 stockholders, 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.

 

 

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. In addition to serving as our principal executive offices, this facility will be used to house a center for training franchisees and employees, and a service center for our franchise operations. We also lease space in an additional office building in Overland Park, Kansas.

 

In Phillipsburg, Kansas, we lease from Brooke Corporation a processing center and own an advertising center. The advertising center also houses our facilities teams. We own a building in Dallas, Texas that houses a regional office and service center. We lease additional 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. 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 owns a 20,000 square foot office building on approximately six and one-half acres of land located in Topeka, Kansas. First Life occupies 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 combined results of operations or financial position.

 

 

A special meeting of our stockholders was held on November 5, 2007. At the meeting, our stockholders approved (i) the proposal (the “Merger Proposal”) to adopt the Agreement and Plan of Merger dated as of August 31, 2007, as amended, among us, Brooke Corporation and Brooke Franchise Corporation (“Brooke Franchise”); (ii) the proposal (“Exchange Proposal”) to adopt the Exchange Agreement, dated as of August 31, 2007, as amended, among us, Delta Plus. and Brooke Corporation; and (iii) approved an amendment to the Brooke Capital Corporation 2007 Equity Incentive Plan (the “Equity Incentive Plan Amendment Proposal”) to

increase the total number of shares of common stock that may be awarded under the plan from 400,000 shares to 2,400,000 shares.

 

Final tabulations of the vote at the special meeting of stockholders was as follows:

 

Approval of the Merger Proposal:

 

 

The shares voted for the Merger Proposal represented approximately 62% of the shares of common stock outstanding and entitled to vote on the Merger Proposal.

 

Approval of the Exchange Proposal:

 

 

Approval of the Equity Incentive Plan Amendment Proposal:

 

 

The shares voted for the Exchange Proposal and the Equity Incentive Plan Amendment Proposal represented 100% of the shares present in person or represented by proxy and entitled to vote on these matters. No proxies were solicited in connection with the matters voted on at the special meeting.

 

 

Market Information.

 

Our common stock, $.01 par value, has traded under the symbol “BCP” on the American Stock Exchange (“AMEX”) since August 30, 2007. Prior to that date, there was no public trading market for our common stock.

 

During the most recently completed fiscal year, the high and low prices for our common stock for each of the last two quarters have been as follows:

 

 

On February 29, 2008, the closing price for our common stock on the AMEX was $3.10 per share.

 

Holders of Common Stock.

 

On February 29, 2008, there were 4,945 stockholders of record of our common stock and an indeterminate number of stockholders whose shares are held by brokers or “nominees” in street name.

 

Dividends.

 

We have not paid any cash dividends. We anticipate that for the foreseeable future any and all earnings will be retained to fund the growth of our insurance business and for other working capital purposes and that as a result no dividends are currently planned. We are restricted from paying dividends by our debt instruments.

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 Company’s existing equity compensation plans as of December 31, 2007.

 

Equity Compensation Plan Information

 

 

 

 

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 COMBINED FINANCIAL DATA

 

The following table sets forth selected historical combined 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 represent the financial position and results of operations for Brooke Franchise Corporation and are derived from that company’s separate audited financial statements not included in this report. As discussed in an earlier “Explanatory Note,” the periods prior to December 8, 2006, represent those of Brooke Franchise Corporation as the “deemed predecessor” prior to its merger with and into the Company on November 15, 2007 and have been restated accordingly. 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.”

 

 

 

 

 

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

 

Insurance company revenues are generated from the issuance of life insurance and annuity policies sold by independent insurance agents through First Life America Corporation (First Life), a Kansas domiciled life insurance company subsidiary.

 

Insurance agency revenues are also generated from commissions paid on the sale of property and casualty insurance policies issued through third party insurance companies, but sold through independent insurance agents. Commission revenues typically represent a percentage of insurance premiums paid by policyholders. Premium amounts and commission percentage rates are established by third party insurance companies, so we have little or no control over the commission amount generated from the sale of a specific insurance policy. Revenues are also generated from initial franchise fees, seller consulting fees and borrower consulting fees.

 

Results of Operation

 

A merger between Brooke Capital Corporation and Brooke Franchise Corporation occurred November 15, 2007, with Brooke Capital being the surviving corporation. This merger represented a transaction between entities under common control. Accordingly, we have recorded the assets and liabilities of Brooke Franchise Corporation at their carrying amounts at the date of transfer as if the transaction had taken place as of the beginning of the period. In addition, our results of operations and other changes in financial position for the current year have been reported as if the merger had occurred at the beginning of the period.

 

Prior years’ financial statements and related disclosures have been restated to furnish comparative information for the period during which Brooke Franchise and Brooke Capital have been under common control. As Brooke Corporation (parent to both Brooke Franchise and Brooke Capital) acquired its controlling interest in us on December 8, 2006, the combined financial statements and other information presented for periods prior to December 8, 2006 represent those of Brooke Franchise Corporation only.

Our combined results of operations have been significantly impacted by expansion of franchise locations in recent years. 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.

 

 

A more detailed description of our financial condition and operating results as reported by the insurance company operations, insurance agency operations and corporate activities segments follows. The significant changes in revenues, expenses and net income from the above table are primarily attributable to our insurance agency segment. (See Insurance Agency Operation Segment)

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.

 

 

Investments increased as a result of investing premiums generated from the sale of annuity and other life insurance products.

 

Accounts and notes receivable primarily include amounts owed 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 reserve exists for our credit loss exposure to these receivable balances from franchisees (See Insurance Agency Operation Segment, below).

 

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 combined balance sheet.

 

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

 

Property and equipment increased from the purchase of franchise related equipment from the parent company Brooke Corporation in June of 2007.

 

Deferred charges include primarily the fees associated with the costs of acquiring life insurance by First Life. Policy and contract liabilities increased with the sale of annuities and other life insurance products

 

Accounts payable, which includes franchise payables, payroll payables and other accrued expenses, increased primarily from the continued expansion of our franchise operations.

 

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 decreased primarily from temporary fluctuations in agent billed activity.

 

Debt increased primarily as the result of expansion of the franchise operations.

 

Analysis by Segment

 

Our two reportable segments are Insurance Company Operations and Insurance Agency Operations.

 

Our insurance company operations include the issuance of life insurance policies by First Life America Corporation (First Life). First Life sells life insurance and annuity products in eight states throughout the Midwest.

Our insurance agency operations include our franchise agency operations and our insurance agency consulting activities. Our franchise agency operations include the sale of insurance, financial and credit services on a retail basis through franchisees.

 

Revenues, expenses, assets and liabilities that are not allocated to one of the two reportable segments are categorized as “Corporate.” Activities associated with Corporate include functions such as accounting, auditing, legal, human resources and investor relations.

 

Insurance Company Operations

 

 

As noted previously, the financial information reported for us includes the results of operations and cash flows for the insurance company operations conducted by First Life America Corporation (“First Life”) since December 8, 2006, the date that Brooke Corporation acquired its controlling interest in First Life. While our reported results of operations do not include activity related to insurance company operations prior to December 8, 2006, the discussion that follows makes reference to certain aspects of the results of operations as originally reported by First Life and included in the consolidated financial statements filed by us in prior years’ annual reports. This information is being provided for comparative purposes only, in connection with management’s discussion and analysis of the life insurance company’s operations during 2007 as compared to prior periods. Income and expenses reported in the table above do not include results of operations prior to December 8, 2006. Accordingly, no information is presented prior to December 8, 2006, including for the year ended December 31, 2005 and any % increase (decrease) of such values over 2005, as we did not control the operations of First Life during that period.

 

Net premium income levels of $3,710,000 and $3,677,000 reported during 2007 and 2006 were slightly lower than the $3,793,000 reported during 2005. Net first year premium income increased 10% to $464,000 in 2007 as compared to $422,000 in 2006 due largely to First Life’s ability to again write new policies in the state of Ohio. Gross first year premium income had declined during each of the last three years primarily due to First Life’s inability to write new business in the state of Ohio during 2005, 2006 and much of 2007 and due to capital restrictions that limited its ability to promote other new business. First Life was released from its Memorandum of Understanding with the Ohio Department of Insurance on May 3, 2007 and has now re-established relationships with agents in that market.

Net renewal year premium income reported of approximately $3,217,000 during 2007 was comparable to the $3,228,000 reported during 2006 with both years about 8% higher than the $2,973,000 reported during 2005. Renewal premiums reflect the premium collected in the current year for those policies that have surpassed their first policy anniversary. Gross renewal premiums will continue to increase unless premiums lost from surrenders, lapses, settlement options or application of the non-forfeiture options, exceed prior year’s first year premium.

 

Policy reserve expense of $926,000 during 2007 was 10% higher than the $841,000 reported during 2006 and significantly lower than the $1,119,000 reported during 2005. Life insurance reserves are actuarially determined based on such factors as insured age, life expectancy, mortality and interest assumptions. As more life insurance is written and existing policies reach additional durations, policy reserve requirements will continue to increase.

 

Our death claims expense has more than doubled in the past two years increasing by 42% to $1,049,000 during 2007. Death claims expense of $737,000 in 2006 was 45% higher than the $507,000 reported during 2005. Increases in death claims expense are reflective of the continued maturation of the final expense policies, which are generally purchased by consumers in their senior years.

 

Commissions, which totaled $886,000 during 2007 were 9% higher than the $810,000 reported during 2006; both years were significantly lower than the $1,201,000 reported during 2005. Commissions capitalized as part of deferred policy acquisitions totaled $720,000, $535,000 and $887,000 for 2007, 2006 and 2005, respectively. Commissions paid are based on a percentage of premiums and determined in the product design. Additionally, higher percentage commissions are paid for first year business than renewal year. The decreased levels of commissions paid during 2007 and 2006 as compared to 2005 are directly related to the decrease in gross first year whole life premiums reported during those years.

 

Policy acquisition costs deferred decreased by 35% during 2006 as compared to 2005 while increasing 13% during 2007 as compared to 2006. These acquisition costs result from the capitalization of costs related to the sales of life insurance and include commissions on first year business, medical exam and inspection report fees, and salaries of employees directly involved in the marketing, underwriting and policy issuance functions. The overall decline in the level of these costs deferred is directly related to reduced levels of gross first year whole life premiums reported during 2007 and 2006. Amortization of deferred policy acquisition costs were $724,000, $738,000 and $631,000 during 2007, 2006 and 2005, respectively. Management performs quarterly reviews of the recoverability of deferred acquisition costs based on current trends as to persistency, mortality and interest. These trends are compared to the assumptions used in the establishment of the original asset in order to assess the need for impairment. Based on the results of the aforementioned procedures performed by management, no impairments have been recorded against the balance of deferred acquisition costs.

 

Interest credited on annuities and premium deposits totaled $799,000, $579,000 and $406,000 during 2007, 2006 and 2005, respectively. These increases of 38% and 43% during 2007 and 2006, respectively, reflect the increases in annuity fund balances resulting from deposits of $5,484,000 and $3,549,000 during each of 2007 and 2006, less surrenders of $1,202,000 and $766,000 during those two years. Both interest credited on annuities and premium deposits have increased as a result of the increase in the number of policies in force (10,332; 9,974 and 9,856 as of December 31, 2007, 2006 and 2005, respectively). The average interest credit rate on annuities and premium deposits has ranged from 4.7% to 4.9% during 2005, 2006 and 2007. Management maintains efforts to more effectively manage the interest rate spread between the rate we earn on our investment portfolio and the rate being credited to policyholder accounts. Management introduced several new annuity products marketed during 2005, 2006 and 2007, which are deemed to be shorter in duration and thus credit interest at a lesser rate than other annuities which have historically been offered by us. Increases in our annuity and policy benefit liabilities are largely related to increased sales of our various annuity and life insurance products.

 

Our available-for-sale fixed maturity securities increased to $18,675,000 at December 31, 2007 as compared to $12,299,000 at December 31, 2006 as a result of its ability to invest funds generated from the sale of annuity and other insurance products and other sources. Purchases of available-for-sale fixed maturity

securities, net of maturities were $6,740,000 during 2007. Net investment income was 36% higher during 2007 as compared to 2006 primarily as a result of this growth in the portfolio. During 2007, the market value of our available-for-sale fixed maturity and equity securities decreased by $311,000, due primarily to changes in interest rates.

 

Other operating expenses recorded during 2007 (including salaries, wages and employee benefits expenses related to the life insurance operations) were similar to those reported during 2006.

 

Insurance Agency Operations

 

 

Commission Revenues are from sales commissions on policies sold by its franchisees that are written, or issued, by third-party insurance companies. Commission revenues typically represent a percentage of insurance premiums paid by policyholders. Premium amounts and commission percentage rates are established by independent insurance companies, so we have little or no control over the commission amount generated from the sale of a specific insurance policy written through a third-party insurance company. We primarily rely on the recruitment of additional franchisees to increase insurance commission revenues.

 

Retail insurance commissions have increased primarily as a result of continued expansion of franchise operations. However, these revenues are not sufficient to be considered material and are, therefore, combined with insurance commission revenues.

 

Commission expense increased because insurance commission revenues increased and franchisees are typically paid a share of insurance commission revenue. Commission expense represented approximately 78%, 79% and 80%, respectively, of insurance commission revenue for the years ended December 31, 2007, 2006 and 2005. We expect commission expenses to increase in 2008 due to the “bonus back” of a portion of monthly franchise fees implemented in late 2007.

 

We sometimes retain an additional share of franchisees’ commissions as payment for franchisee optional use of our service or sales centers. However, all such payments are applied to service center/sales center

expenses and not applied to commission expense. As of December 31, 2007 and 2006, service centers/sales centers totaled 10 and 20, respectively.

 

Profit sharing commissions, or our share of insurance company profits paid by insurance companies on policies written by franchisees, and other such performance compensation, decreased $303,000, or 5%, to $5,343,000 in 2007 and $607,000, or 12%, to $5,646,000 in 2006. Profit sharing commissions represented approximately 5%, 6% and 6%, respectively, of insurance commissions for the years ended December 31, 2007, 2006 and 2005. Franchisees do not receive any share of profit sharing commissions.

 

Net commission refund liability is our estimate of the amount of our share of retail commission refunds due to insurance companies resulting from future policy cancellations. As of December 31, 2007 and 2006, we recorded corresponding total commission refund liabilities of $481,000 and $535,000, respectively. Correspondingly, commission refund expense decreased in 2007 to reflect this lower estimate.

 

Other operating expenses represented approximately 27%, 25% and 22%, respectively, of total revenues for the years ended December 31, 2007, 2006 and 2005. Other operating expenses increased at a faster rate than total operating revenues primarily as the result of the provision of additional collateral preservation assistance to franchisees coping with financial stress resulting from less commission revenue from reduction of premium rates by insurance companies.

 

Marketing allowance expense is incurred primarily for the purpose of providing collateral preservation assistance. Marketing allowances made to franchisees increased $1,269,000, or 28%, to $5,802,000 in 2007 from $4,533,000 in 2006. Marketing allowances made to franchisees increased $901,000, or 25%, to $4,533,000 in 2006 from $3,632,000 in 2005.

 

Company-owned stores expense is incurred primarily for the purpose of providing collateral preservation assistance. Operating expenses for company-owned stores increased $5,562,000, or 86%, to $12,056,000 in 2007 from $6,494,000 in 2006. Although operating expenses from company-owned stores represented a significant part of the overall increase in other operating expenses, these expenses were mostly offset by commission revenues generated by company-owned stores totaling $8,546,000 and $6,151,000, respectively, for the years ended December 31, 2007 and 2006. Company-owned stores revenues and expenses for years prior to 2005 are not available.

 

Advertising expenses decreased $29,000 to $8,276,000 in 2007 from $8,305,000 in 2006. Advertising expenses increased $2,085,000, or 34%, to $8,305,000 in 2006 from $6,220,000 in 2005.

 

Expenses for write off of franchise balances increased $1,065,000, or 30%, to $4,628,000 in 2007. Write off expenses increased $730,000, or 26%, to $3,563,000 in 2006 from $2,833,000 in 2005. Total write off expenses increased in 2007 primarily as the result of the provision of additional collateral preservation assistance to franchisees coping with financial stress resulting from less commission revenue from reduction of premium rates by insurance companies, but were reduced as the result of an agreement with Brooke Corporation to guarantee franchise balances pursuant to the merger agreement.

 

The following table summarizes information relating to revenues and expenses associated with insurance agent relationships primarily as defined in the franchise agreement.

 

Comparison of Net Commissions Breakdown to Corresponding Expenses Breakdown (in thousands)

 

Initial Franchise Fee Revenue

 

Basic Services  A certain level of basic services is initially provided to all franchisees, whether they acquire an existing business and convert it into a Brooke franchise, start up a new Brooke franchise location or acquire a company developed franchise location. These basic services include services usually provided by other franchisors, including a business model, a license to use registered trademarks, access to suppliers and a license for an Internet-based information system. The amount of the initial franchise fees typically paid for basic services is currently $165,000.

 

Revenues from initial franchise fees for basic services are recognized as soon as we deliver the basic services to the new franchisee, such as access to insurance company contracts, access to our information system, and access to our brand name. Upon completion of this commitment, we have no continuing obligation to the franchisee with regards to basic services.

 

A total of 234 and 227 new franchise locations were added during the years ended December 31, 2007 and 2006, respectively. The rate of new franchise location growth has slowed primarily as the result of our “New Era” initiative beginning in the fourth quarter of 2007 to emphasize quality of franchisees over quantity of franchisees.

 

The following table summarizes information relating to initial franchise fees for basic services.

 

Summary of Initial Franchise Fees for Basic Services
and the Corresponding Number of Locations

 

 

Buyers Assistance Plan Services  Buyer assistance plans provide assistance to franchisees for the initial acquisition and conversion of businesses. These services include, for example, compilation of an inspection report. The amount of the fee charged franchisees for these services typically varies based on the level of assistance, which in turn is largely determined by the size of the acquisition. We therefore typically base our fees for buyers assistance plans on the estimated revenues of the acquired business. All initial franchise fees (for both basic services and for buyer assistance plans) are paid when an acquisition closes. A significant part of our commission growth has come from such acquisitions of existing businesses that are subsequently converted into Brooke franchises.

 

The total amount of initial fees paid by a franchisee is first allocated to basic services, and if the franchise is of an acquired and converted business, the excess of such fees over the amount allocated to basic services is allocated to buyers assistance plan services. The initial franchisee fee for basic services tends to be uniform among franchisees, and the total initial franchisee fees can be limited by competitive pressures. The decrease in initial franchise fees for buyers assistance plans is primarily attributable to an increase in the amount charged for initial franchise fees for basic services and the establishment of a cap, or maximum amount, on initial franchise fees for buyers assistance plans that are charged for each acquisition.

 

We perform substantially all of the buyers assistance plan services before an acquisition closes and, therefore, typically recognizes all of the initial franchise fee revenue for buyers assistance plan services at the time of closing.

 

Buyers assistance plan services are not applicable to the purchase by franchisees of company-developed or already-franchised businesses. In addition, buyers assistance plan services are not typically provided to franchisees selling to other franchisees and are not provided to franchisees purchasing businesses that were

purchased by us in the preceding 24 months. Businesses that were converted into Brooke franchises and received buyers assistance plan services totaled 3, 16 and 87 of new franchise locations in 2007, 2006 and 2005, respectively.

 

Seller and Borrower-Related Revenues  Seller and borrower-related revenues typically are generated when a business is acquired for sale to a franchisee or when assisting a business in securing a loan. Seller and borrower-related revenues include consulting fees paid directly by sellers or borrowers, gains on sale of businesses from deferred payments, gains on sale of businesses relating to company-owned stores, and gains on sale of businesses relating to inventory. A primary aspect of our business is the buying and selling of businesses. Therefore, all seller and borrower-related revenues are considered part of normal business operations and are classified on our income statement as operating revenue. Seller and borrower-related revenues increased $6,690,000, or 116%, to $12,480,000, in 2007 and decreased $2,217,000, or 28%, to $5,790,000, in 2006. The significant increase in seller and borrower-related revenues from 2006 to 2007 is primarily attributable to an increase in borrower consulting fees generated.

 

Consulting fees.  We help sellers prepare their insurance agency businesses for sale by developing business profiles, tabulating revenues, sharing its document library and general sale preparation. We also generate revenues from consulting with insurance agency borrowers and assisting them in securing loans. The scope of consulting engagements is largely determined by the size of the business being sold or the loan being originated. Consulting fees are typically based on the transaction value, are contingent upon closing of the transaction, and are paid at closing. We complete consulting obligations at closing and are not required to perform any additional tasks for sellers or borrowers. Therefore, with no continuing obligation on our part, consulting fees paid directly by sellers or borrowers are immediately recognized as income. The significant increase in consulting fees from 2006 to 2007 is primarily attributable to an increase in borrower consulting fees generated.

 

Gains on Sale of Businesses from Deferred Payments.  Our business includes the buying and selling of insurance agencies and occasionally holding them in inventory. When purchasing an agency, we typically defer a portion of the purchase price, at a low or zero interest rate, to encourage the seller to assist in the transition of the agency to one of our franchisees. We carry our liability to the seller at a discount to the nominal amount we owe, to reflect the below-market interest rate. When we sell an acquired business to a franchisee (typically on the same day it is acquired), we generally sell it for the full nominal price (i.e. before the discount) paid to the seller. When the sale price of the business exceeds the carrying value, the amount in excess of the carrying value is recognized as a gain. Gains on sale resulting primarily from discounted interest rates increased $119,000, or 9%, to $1,449,000 in 2007 and increased $145,000, or 12%, to $1,330,000 in 2006.

 

We regularly negotiate below-market interest rates on the deferred portion of the purchase prices we pay sellers. We consider these below market interest rates to be a regular source of income related to the buying and selling of businesses. Although we have a continuing obligation to pay the deferred portion of the purchase price when due, we are not obligated to prepay the deferred portion of the purchase price or to otherwise diminish the benefit of the below-market interest rate upon which the reduced carrying value was based.

The calculation of the reduced carrying value, and the resulting gain on sale of businesses, is made by calculating the net present value of scheduled future payments to sellers at a current market interest rate. The following table provides information regarding the corresponding calculations:

 

Calculation of Seller Discounts Based On Reduced Carrying Values
(in thousands, except percentages and number of days)