**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

**FORM 10-Q**

 

**ý****Quarterly Reportpursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**

 

**For the quarterlyperiod ended September 30, 2003**

 

**or**

 

**o****Transition Report pursuant to Section 13 or 15(d) ofthe Securities Exchange Act of 1934**

 

**for the transitionperiod from                              to                               **

 

**Commission filenumber 0-13972**

 

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**PENN TREATY AMERICAN CORPORATION**

**3440 Lehigh Street, Allentown, PA 18103****(610) 965-2222**

 

| Incorporated in **Pennsylvania** |   | I.R.S. Employer ID No. |
|----------------------------------|--------|------------------------|
|                             |   | **23-1664166**         |

 

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Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. YES ýNO o

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).    Yes o  No ý

 

The number of sharesoutstanding of the Registrant’s common stock, par value $.10 per share, as ofNovember 11, 2003 was 24,784.

 

 

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**PART I****                                                                                            FINANCIALINFORMATION**

 

**Item1.****          **FinancialStatements

 

Penn Treaty American Corporation is one ofthe leading providers of long-term nursing home and home health care insurance.Our unaudited Consolidated Balance Sheets, Statements of Income andComprehensive Income and Statements of Cash Flows and Notes thereto requiredunder this item are contained on pages 3 through 17 of this report. Ourfinancial statements represent the consolidation of our operations and those ofour subsidiaries: Penn Treaty Network America Insurance Company, AmericanNetwork Insurance Company, American Independent Network Insurance Company ofNew York, Penn Treaty (Bermuda) Ltd., United Insurance Group Agency, Inc.,Network Insurance Senior Health Division and Senior Financial ConsultantsCompany, which are underwriters and marketers of long-term care insurance,Medicare supplement and other senior-market products.

 

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PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIESConsolidated Balance Sheets(amounts in thousands, except per share data)

 
|                                                                                                                              |   | **September 30,  2003** |      | **December 31,  2002** |   |
|-----------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|-----------|-----------------------------|--------|
|                                                                                                                              |   | **(unaudited)**              |      |                        |   |
| ASSETS                                                                                                                            |   |                         |      |                        |   |
| Investments:                                                                                                                      |   |                         |      |                        |   |
| Bonds, available for sale  at market (cost of $55,452 and $26,775, respectively) (1)                                              |   | $                            | 57,036    |                        | $      | 28,454 |   |
| Policy loans                                                                                                                      |   | 306                          |      | 238                         |   |
| Total investments                                                                                                                 |   | 57,342                       |      | 28,692                      |   |
| Cash and cash equivalents  (1)                                                                                                    |   | 13,688                       |      | 29,206                      |   |
| Property and equipment, at  cost, less accumulated depreciation of $ 9,214 and $7,925, respectively                               |   | 15,658                       |      | 13,611                      |   |
| Unamortized deferred policy  acquisition costs                                                                                    |   | 162,293                      |      | 171,357                     |   |
| Receivables from agents,  less allowance for uncollectible amounts of $395 and $119, respectively                                 |   | 1,482                        |      | 1,654                       |   |
| Accrued investment income                                                                                                         |   | 778                          |      | 414                         |   |
| Goodwill                                                                                                                          |   | 20,360                       |      | 20,360                      |   |
| Receivable from reinsurers                                                                                                        |   | 25,613                       |      | 26,218                      |   |
| Corporate owned life  insurance                                                                                                   |   | 59,313                       |      | 57,773                      |   |
| Experience account due from  reinsurer                                                                                            |   | 777,674                      |      | 708,982                     |   |
| Other assets                                                                                                                      |   | 20,200                       |      | 21,933                      |   |
| Total assets                                                                                                                      |   | $                            | 1,154,401 |                        | $      | 1,080,200 |   |
|                                                                                                                              |   |                         |      |                        |   |
| LIABILITIES                                                                                                                       |   |                         |      |                        |   |
| Policy reserves:                                                                                                                  |   |                         |      |                        |   |
| Accident and health                                                                                                               |   | $                            | 493,495   |                        | $      | 464,318 |   |
| Life                                                                                                                              |   | 12,881                       |      | 12,553                      |   |
| Claim reserves                                                                                                                    |   | 346,472                      |      | 329,944                     |   |
| Accounts payable and other  liabilities                                                                                           |   | 21,784                       |      | 18,859                      |   |
| Long-term debt, less  discount of $1,791 and $0, respectively                                                                     |   | 94,623                       |      | 76,245                      |   |
| Preferred interest on early  conversion                                                                                           |   | 2,305                        |      | —                      |   |
| Deferred income taxes                                                                                                             |   | 23,035                       |      | 23,101                      |   |
| Total liabilities                                                                                                                 |   | 994,595                      |      | 925,020                     |   |
| Commitments and  contingencies                                                                                                    |   | —                       |      | —                      |   |
| SHAREHOLDERS’ EQUITY                                                                                                         |   |                         |      |                        |   |
| Preferred stock, par value  $1.00; 5,000 shares authorized, none outstanding                                                      |   | —                       |      | —                      |   |
| Common stock, par value  $.10; 150,000 and 40,000 shares authorized, respectively;  22,511 and 20,340 shares issued, respectively |   | 2,251                        |      | 2,034                       |   |
| Additional paid-in capital                                                                                                        |   | 100,755                      |      | 97,058                      |   |
| Accumulated other  comprehensive income                                                                                           |   | 1,029                        |      | 1,090                       |   |
| Retained earnings                                                                                                                 |   | 62,476                       |      | 61,703                      |   |
|                                                                                                                              |   | 166,511                      |      | 161,885                     |   |
| Less 915 common shares held  in treasury, at cost                                                                                 |   | (6,705                       | )         | (6,705                      | )      |
|                                                                                                                              |   | 159,806                      |      | 155,180                     |   |
| Total liabilities and  shareholders’ equity                                                                                  |   | $                            | 1,154,401 |                        | $      | 1,080,200 |   |

 

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(1)Cash and investments of $26,690 and $22,022, respectively, are restricted as touse.

 

Seeaccompanying notes to consolidated financial statements.

 

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PENN TREATY AMERICANCORPORATION AND SUBSIDIARIES

Consolidated Statements ofIncome and Comprehensive Income(unaudited)(amounts in thousands, except per share data)

 
|                                                                                                            |   | **Three Months Ended September 30,** |    | **Nine Months Ended September 30,** |   |
|-----------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|---------|------------------------------------------|--------|
|                                                                                                            |   | **2003**                                  |    | **2002**                                 |   | **2003** |   | **2002** |   |
| Revenues:                                                                                                       |   |                                      |    |                                     |   |   |   |   |   |
| Premium revenue                                                                                                 |   | $                                         | 81,471  |                                     | $      | 83,635 |   | $ | 243,756 |   | $ | 251,777 |   |
| Net investment income                                                                                           |   | 11,144                                    |    | 10,122                                   |   | 32,064 |   | 29,829 |   |
| Net realized capital gains                                                                                      |   | 16                                        |    | 85                                       |   | 265 |   | 14,649 |   |
| Market (loss) gain on  notional experience account                                                              |   | (34,540                                   | )       | 62,747                                   |   | 8,726 |   | 56,745 |   |
| Change in preferred  interest on early conversion liability                                                     |   | (354                                      | )       | —                                   |   | (267 | ) | — |   |
| Other income                                                                                                    |   | 1,719                                     |    | 4,361                                    |   | 6,162 |   | 9,523 |   |
|                                                                                                            |   | 59,456                                    |    | 160,950                                  |   | 290,706 |   | 362,523 |   |
|                                                                                                            |   |                                      |    |                                     |   |   |   |   |   |
| Benefits and expenses:                                                                                          |   |                                      |    |                                     |   |   |   |   |   |
| Benefits to policyholders                                                                                       |   | 63,763                                    |    | 164,170                                  |   | 188,803 |   | 306,872 |   |
| Commissions                                                                                                     |   | 10,234                                    |    | 11,527                                   |   | 31,198 |   | 36,034 |   |
| Net policy acquisition  costs amortized                                                                         |   | 3,870                                     |    | 3,403                                    |   | 9,065 |   | 7,854 |   |
| General and administrative  expense                                                                             |   | 14,118                                    |    | 13,344                                   |   | 44,222 |   | 34,929 |   |
| Expense and risk charges on  reinsurance                                                                        |   | 2,768                                     |    | 3,577                                    |   | 8,305 |   | 10,731 |   |
| Excise tax expense                                                                                              |   | 961                                       |    | 812                                      |   | 2,136 |   | 2,185 |   |
| Interest expense                                                                                                |   | 2,225                                     |    | 1,195                                    |   | 5,807 |   | 3,585 |   |
|                                                                                                            |   | 97,939                                    |    | 198,028                                  |   | 289,536 |   | 402,190 |   |
| (Loss) income before  federal income taxes and cumulative effect of change in accounting principle              |   | (38,483                                   | )       | (37,078                                  | )      | 1,170 |   | (39,667 | ) |
| Federal income tax  (benefit) provision                                                                         |   | (13,085                                   | )       | (12,607                                  | )      | 398 |   | (13,487 | ) |
| Net (loss) income before  cumulative effect of change in accounting principle                                   |   | (25,398                                   | )       | (24,471                                  | )      | 772 |   | (26,180 | ) |
| Cumulative effect of change  in accounting principle                                                            |   | —                                    |    | —                                   |   | — |   | (5,151 | ) |
| Net (loss) income                                                                                               |   | (25,398                                   | )       | (24,471                                  | )      | 772 |   | (31,331 | ) |
| Other comprehensive (loss)  income:                                                                             |   |                                      |    |                                     |   |   |   |   |   |
| Unrealized holding (loss)  gain arising during period                                                           |   | (853                                      | )       | 890                                      |   | 170 |   | 347 |   |
| Income tax benefit (provision)  from unrealized holdings                                                        |   | 298                                       |    | (302                                     | )      | (58 | ) | (118 | ) |
| Reclassification of gains  included in net (loss) income                                                        |   | (16                                       | )       | (85                                      | )      | (265 | ) | (14,649 | ) |
| Income tax provision from  reclassification adjustment                                                          |   | 5                                         |    | 28                                       |   | 92 |   | 4,981 |   |
| Comprehensive (loss) income                                                                                     |   | $                                         | (25,964 | )                                        | $      | (23,940 | ) | $ | 711 |   | $ | (40,770 | ) |
|                                                                                                            |   |                                      |    |                                     |   |   |   |   |   |
| Basic earnings per share  from net (loss) income before cumulative effect of change in accounting  principle    |   | $                                         | (1.20   | )                                        | $      | (1.26 | ) | $ | 0.04 |   | $ | (1.36 | ) |
| Basic earnings per share  from net (loss) income                                                                |   | $                                         | (1.20   | )                                        | $      | (1.26 | ) | $ | 0.04 |   | $ | (1.63 | ) |
|                                                                                                            |   |                                      |    |                                     |   |   |   |   |   |
| Diluted earnings per share  from net (loss) income before cumulative effect of change in accounting  principle* |   | $                                         | (1.20   | )                                        | $      | (1.26 | ) | $ | 0.04 |   | $ | (1.36 | ) |
| Diluted earnings per share  from net (loss) income*                                                             |   | $                                         | (1.20   | )                                        | $      | (1.26 | ) | $ | 0.04 |   | $ | (1.63 | ) |
|                                                                                                            |   |                                      |    |                                     |   |   |   |   |   |
| Weighted average number of  shares outstanding                                                                  |   | 21,099                                    |    | 19,376                                   |   | 20,026 |   | 19,194 |   |
| Weighted average number of  shares and share equivalents                                                        |   | 21,099                                    |    | 19,376                                   |   | 20,026 |   | 19,194 |   |

 

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*Basic and diluted earnings per share are the same because all securities areanti-dilutive for the periods presented.

 

Seeaccompanying notes to consolidated financial statements.

 

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PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows(unaudited)(amounts in thousands)

 
|                                                                        |   | **Nine  Months Ended September 30,** |   |
|-----------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                        |   | **2003**                                  |   | **2002** |   |
| Cash flow from operating  activities:                                       |   |                                      |   |   |   |
| Net income (loss)                                                           |   | $                                         | 772    |   | $ | (31,331 | ) |
| Adjustments to reconcile  net income (loss) to cash provided by operations: |   |                                      |   |   |   |
| Amortization of intangible  assets                                          |   | 697                                       |   | 1,313 |   |
| Cumulative effect of change  in accounting principle                        |   | —                                    |   | 5,151 |   |
| Amortization of deferred  reinsurance premium                               |   | 1,982                                     |   | 1,980 |   |
| Amortization of gain on  assumption of reinsurance                          |   | 79                                        |   | 1,952 |   |
| Amortization of discount on  long-term debt                                 |   | 247                                       |   | — |   |
| Change in preferred  interest on early conversion liability                 |   | 267                                       |   | — |   |
| Policy acquisition costs,  net                                              |   | 9,065                                     |   | 7,854 |   |
| Deferred income taxes                                                       |   | (33                                       | )      | (11,988 | ) |
| Depreciation expense                                                        |   | 1,289                                     |   | 1,274 |   |
| Net realized capital gains                                                  |   | (265                                      | )      | (14,649 | ) |
| Equity issued for interest  expense from long-term debt conversions         |   | 491                                       |   | — |   |
| Increase (decrease) due to  change in:                                      |   |                                      |   |   |   |
| Receivables from agents                                                     |   | (104                                      | )      | 779 |   |
| Receivable from reinsurers                                                  |   | 1,472                                     |   | 430 |   |
| Notional experience account  due from reinsurer                             |   | (27,451                                   | )      | (79,429 | ) |
| Claim reserves                                                              |   | 16,528                                    |   | 110,180 |   |
| Policy reserves                                                             |   | 28,637                                    |   | 63,238 |   |
| Accounts payable and other  liabilities                                     |   | 2,925                                     |   | (1,519 | ) |
| Federal income taxes  recoverable                                           |   | —                                    |   | (1,071 | ) |
| Accrued investment income                                                   |   | (364                                      | )      | 7,476 |   |
| Other, net                                                                  |   | (543                                      | )      | (2,475 | ) |
| Cash provided by operations                                                 |   | 35,691                                    |   | 59,165 |   |
|                                                                        |   |                                      |   |   |   |
| Cash flow from investing  activities:                                       |   |                                      |   |   |   |
| Proceeds from sales of  bonds                                               |   | 22,818                                    |   | 473,554 |   |
| Proceeds from sales of  equity securities                                   |   | —                                    |   | 9,547 |   |
| Proceeds from maturities of  bonds                                          |   | 2,934                                     |   | 3,672 |   |
| Purchase of bonds                                                           |   | (54,230                                   | )      | (25,523 | ) |
| Purchase of equity  securities                                              |   | —                                    |   | (20 | ) |
| Increase in corporate owned  life insurance                                 |   | (1,540                                    | )      | (2,576 | ) |
| Deposits to notional experience  account due from reinsurer                 |   | (41,241                                   | )      | (606,693 | ) |
| Acquisition of property and  equipment                                      |   | (3,336                                    | )      | (1,450 | ) |
| Cash used in investing                                                      |   | (74,595                                   | )      | (149,489 | ) |
|                                                                        |   |                                      |   |   |   |
| Cash flow from financing  activities:                                       |   |                                      |   |   |   |
| Proceeds from stock  offering                                               |   | —                                    |   | 2,351 |   |
| Issuance of long-term debt                                                  |   | 32,421                                    |   | — |   |
| Repayment of long-term debt                                                 |   | (9,035                                    | )      | (2,924 | ) |
|                                                                        |   |                                      |   |   |   |
| Cash provided by (used in)  financing                                       |   | 23,386                                    |   | (573 | ) |
| Decrease in cash and cash  equivalents                                      |   | (15,518                                   | )      | (90,897 | ) |
| Cash balances:                                                              |   |                                      |   |   |   |
| Beginning of period                                                         |   | 29,206                                    |   | 114,600 |   |
| End of period                                                               |   | $                                         | 13,688 |   | $ | 23,703 |   |
|                                                                        |   |                                      |   |   |   |
| Non-cash transactions:                                                      |   |                                      |   |   |   |
|                                                                        |   |                                      |   |   |   |
| Equity issued for long-term  debt conversions                               |   | $                                         | 3,217  |   | $ | — |   |
|                                                                        |   |                                      |   |   |   |
| Equity issued for interest  expense from long-term debt conversions         |   | $                                         | 491    |   | $ | — |   |
|                                                                        |   |                                      |   |   |   |
| Equity issued for financial  advisor fees                                   |   | $                                         | 207    |   | $ | 393 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

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**PENNTREATY AMERICAN CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSSeptember 30, 2003**(unaudited)(amounts in thousands, except per share data)

 

TheConsolidated Financial Statements should be read in conjunction with theseNotes and with the Notes to Consolidated Financial Statements included in theAnnual Report on Form 10-K for the year ended December 31, 2002 of PennTreaty American Corporation (the “Company”). Certain amounts in the September 30, 2002 and December 31,2002 financial statements have been reclassified to conform to the presentationin the September 30, 2003 financial statements.

 

In the opinion of management, the summarized financial informationreflects all adjustments (consisting only of normal recurring adjustments) thatare necessary for a fair presentation of the financial position and results ofoperations, comprehensive income and cash flows for the interim periods.

 

1.                                       NewAccounting Principles:

 

InMay 2003, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards No.150, “Accounting for Certain FinancialInstruments with Characteristics of Both Liabilities and Equity” (“SFAS No.150”).  SFAS No. 150 specifies thatinstruments within its scope embody obligations of the issuer and that,therefore, the issuer must classify them as liabilities.  SFAS No. 150 represents phase one of theFASB’s broader project on (1) distinguishing between liability and equityinstruments and (2) accounting for instruments that have characteristics ofboth types of instruments.  SFAS No. 150covers a limited number of instruments that are to be classified as liabilitiesand is effective at the beginning of the first interim period beginning afterJune 15, 2003.  The implementationof certain provisions related to mandatorily redeemable financial instrumentshas been deferred.  The adoption of SFASNo. 150 will not have any impact on the Company’s consolidated financialstatements.

 

InDecember 2002, the FASB issued Statement of Financial Accounting StandardsNo. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure”(“SFAS No. 148”), which amends Statement of Financial Accounting StandardsStatement No. 123, “Accounting for Stock-Based Compensation” (“SFAS No.123”).  SFAS No. 148 does not change theprovisions of SFAS No. 123 that permit entities to continue to apply theintrinsic value method of Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees” (“APB No. 25”). In addition, SFASNo. 148 amends the disclosure requirements of SFAS No. 123 to require prominentdisclosures in both annual and interim financial statements about the method ofaccounting for stock-based employee compensation and the effect of the methodused on reported results. The objective of SFAS No. 148 is to providealternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation. The Companycontinues to maintain its accounting for stock-based compensation in accordancewith APB No. 25, but has adopted the disclosure provisions of SFAS No. 148.

 

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The following table reflects net income, basic and diluted earnings pershare as reported and pro-forma as if the Company had adopted the fair valuebased method of accounting for its stock-based employee compensation awards:

 
|                                                                                                                                          |   | **Three Months Ended September 30,** |    | **Nine Months Ended September 30,** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|---------|------------------------------------------|--------|
|                                                                                                                                          |   | **2003**                                  |    | **2002**                                 |   | **2003** |   | **2002** |   |
|                                                                                                                                          |   |                                      |    |                                     |   |   |   |   |   |
| Net (loss) income, as  reported                                                                                                               |   | $                                         | (25,398 | )                                        | $      | (24,471 | ) | $ | 772 |   | $ | (31,331 | ) |
| Add: Stock-based employee  compensation income included in reported net income, net of related tax  effects                                   |   | —                                    |    | (44                                      | )      | — |   | (284 | ) |
| Deduct: Total stock-based  employee compensation expense determined under fair value based method for  all awards, net of related tax effects |   | (66                                       | )       | (4                                       | )      | (129 | ) | (160 | ) |
| Pro forma net (loss) income                                                                                                                   |   | $                                         | (25,464 | )                                        | $      | (24,519 | ) | $ | 643 |   | $ | (31,775 | ) |
|                                                                                                                                          |   |                                      |    |                                     |   |   |   |   |   |
| Earnings per share:                                                                                                                           |   |                                      |    |                                     |   |   |   |   |   |
| Basic - as reported                                                                                                                           |   | $                                         | (1.20   | )                                        | $      | (1.26 | ) | $ | 0.04 |   | $ | (1.63 | ) |
| Basic - pro forma                                                                                                                             |   | $                                         | (1.21   | )                                        | $      | (1.27 | ) | $ | 0.03 |   | $ | (1.66 | ) |
| Diluted - as reported                                                                                                                         |   | $                                         | (1.20   | )                                        | $      | (1.26 | ) | $ | 0.04 |   | $ | (1.63 | ) |
| Diluted - pro forma                                                                                                                           |   | $                                         | (1.21   | )                                        | $      | (1.27 | ) | $ | 0.03 |   | $ | (1.66 | ) |

 

2.                                       RegulatoryDevelopments:

 

*Pennsylvania Corrective Action Plan*

 

The Company’s Pennsylvania insurance subsidiaries are required to holdstatutory surplus that is, at a minimum, above a calculated authorized controllevel at which the Pennsylvania Insurance Department (the “Department”) mayplace them under regulatory control, leading to rehabilitation or liquidation.At December 31, 2000, the Company’s primary insurance subsidiary, PennTreaty Network America Insurance Company (“PTNA”), which represented 94% of theCompany’s direct premium, had statutory surplus which, while above theauthorized control level, was at an amount that required PTNA to file aCorrective Action Plan (the “Plan”) with the insurance commissioner.  In addition, American Network InsuranceCompany (“ANIC”), which is owned 100% by PTNA, is also subject to theprovisions of the Plan.

 

OnFebruary 12, 2002, the Department approved the Plan which, among otherthings:

 

a)              requiredthe Company to enter into a reinsurance agreement with Centre Solutions(Bermuda) Limited (the “2001 Centre Agreement”) for substantially all of itsexisting business at December 31, 2001 (See Note 3 – Reinsurance Agreements);

b)             limitsnew investments to those rated by the National Association of InsuranceCommissioners (“NAIC”) as 1 or 2;

c)              limitsand requires Department approval for affiliated transactions; and

d)             requiresa $125,000 increase in statutory reserves over a three-year period, of which a$28,000****increaseremains to be made before the end of 2004.

 

The 2001 Centre Agreement is accounted for as reinsurance for statutoryaccounting purposes, but does not qualify as reinsurance under generallyaccepted accounting principles (“GAAP”) (See Note 3). As the agreement istreated as reinsurance for statutory accounting purposes, it results in theceding (or removal) of substantially all of PTNA’s and ANIC’s policy reserveand claim reserve liabilities for statutory accounting purposes. Furthermore,subject to certain limitations, any adverse development of the 2001 and priorpolicy and claim reserves, including the $125,000 of reserve increasesmentioned above, is ceded to the reinsurer and is not

 

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reflected on PTNA’s or ANIC’sstatutory financial statements.

 

The agreement is subject to certain coverage limitations, including anaggregate limit of liability that is a function of certain factors and that maybe reduced in the event that the premium rate increases that the reinsuranceagreement may require are not obtained. The Company is required to performannual comparisons of its actual to expected claims experience. If the Companyhas reason to believe, whether from this analysis or other availableinformation, that at least a 5% premium rate increase is necessary, the Companyis obligated to file and obtain such premium rate increases in order to complywith the requirements of the agreement. If the Company does not file and obtainsuch premium rate increases, the aggregate limit of liability would be reducedby 50% of the premium amount that would have otherwise been received.

 

In the event the statutory policy and claim reserves for the reinsuredpolicies ultimately exceed the limit of liability established in thereinsurance agreement, either as a result of additions to reserves orreductions in the amount of the reinsurer’s limit of liability, PTNA or ANICwould have to retain any reserve liabilities in excess of the limit ofliability, which could have a materially adverse impact upon their statutorysurplus.

 

The estimation of policy reserves for statutory accounting purposesdiffers from that utilized in GAAP. For statutory accounting purposes, theassumptions utilized and the methodology applied may be at the discretion ofthe Department in its interpretation of its regulations. As noted above, aspart of the Plan, the Department has provided the Company with guidelines forestablishing its statutory policy reserves. Because PTNA and ANIC have limitedstatutory capital and the 2001 Centre Agreement has a limit of liability, anychanges in the Department’s interpretation or view of how the Company’sinsurance subsidiaries determine their statutory policy reserves could have amaterial adverse impact on PTNA or ANIC, possibly resulting in regulatorycontrol or liquidation.

 

*New Policy Sales*

 

The Company is licensed and receives renewal premium revenue frompolicyholders in all states, but is currently prohibited from issuing newpolicies in 14 states. In March 2003, the Company agreed on terms for therecommencement of sales in California, which is pending subject to certainconditions. California renewal premiums represented approximately 14% of theCompany’s premium revenue for the nine months ended September 30, 2003.The Company is approved for sales in Florida and Pennsylvania (subject toCorrective Action Plan), which accounted for approximately 17% and 12%respectively, of the Company’s premium revenue for the nine months endedSeptember 30, 2003. No other state’s sales accounted for more than 10% ofthe Company’s premium revenue for the nine months ended September 30,2003.

 

3.                                       ReinsuranceAgreements:

 

*2001Centre Agreement*

 

As a primary component ofthe Plan, effective December 31, 2001, the Company entered the 2001 CentreAgreement to reinsure, on a quota share basis, substantially all of itsrespective long-term care insurance policies then in-force.

 

This agreement does not qualify for reinsurance treatment in accordancewith GAAP because it does not result in the reasonable possibility that thereinsurer may realize a significant loss. This is due to a number of factorsrelated to the agreement, including experience refund provisions, expense andrisk charges due to the reinsurer and the aggregate limit of liability.Accordingly, the contract is being accounted for in accordance with depositaccounting for reinsurance contracts. However, this agreement meets therequirements to qualify for reinsurance

 

8

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treatment under statutoryaccounting rules.

 

The initial premium paid under the agreement was approximately$619,000, comprised of $563,000 in cash and qualified securities transferred inFebruary 2002, and $56,000 in funds held due to the reinsurer. The initialpremium and future cash flows from the reinsured policies, less claimspayments, ceding commissions and risk charges, are credited to a notionalexperience account, which is held for the Company’s benefit in the event ofcommutation and recapture on or after December 31, 2007. The notionalexperience account balance receives an investment credit based upon the totalreturn from a series of benchmark indices and derivative hedges that areintended to match the duration of the Company’s reserve liability.

 

The notionalexperience account represents a hybrid instrument, containing both a fixed debthost contract and an embedded derivative. The economic characteristics andrisks of the embedded derivative instrument are not clearly and closely relatedto the economic characteristics and risks of the fixed debt host contract. TheCompany is accounting for the investment credit received on the notionalexperience account as follows:

 

a)              The fixed debt host yields a fixed returnbased on the yield to maturity of the underlying benchmark indices. The returnon the fixed debt host is reported as investment income in the Statements ofIncome and Comprehensive Income.

b)             The change in fair value of the embeddedderivative represents the percentage change in the underlying indices appliedto the notional experience account, similar to that of an unrealized gain/losson a bond. The change in the fair value of the embedded derivative is reportedas market (loss) gain on notional experience account in the Statements ofIncome and Comprehensive Income.

 

The benchmark indices are comprised of US treasury strips, agencies andinvestment grade corporate bonds, with weightings of approximately 25%, 15% and60%, respectively, and have a duration of approximately 11 years. The hybridinstrument subjects the Company to significant volatility as the estimatedvalue of the embedded derivative is highly sensitive to changes in interestrates. A 100 basis point increase in interest rates would reduce the currentnotional experience account balance by approximately $77,000.

 

For the periods ended September 30, 2003 and 2002, respectively,the notional experience account activity was as follows:

 
|                                          |   | **Three Months Ended September 30,** |    | **Nine Months Ended September 30,** |   |
|-----------------------------------------------|--------|-------------------------------------------|---------|------------------------------------------|--------|
|                                          |   | **2003**                                  |    | **2002**                                 |   | **2003** |   | **2002** |   |
|                                          |   |                                      |    |                                     |   |   |   |   |   |
| Beginning balance                             |   | $                                         | 791,853 |                                     | $      | 594,449 |   | $ | 708,982 |   | $ | — |   |
| Initial premium                               |   | —                                    |    | —                                   |   | — |   | 563,300 |   |
| Premiums, net of claims and  ceding allowance |   | 12,612                                    |    | 22,705                                   |   | 38,103 |   | 48,417 |   |
| Investment credit:                            |   |                                      |    |                                     |   |   |   |   |   |
| Investment income                             |   | 10,627                                    |    | 9,798                                    |   | 30,633 |   | 28,391 |   |
| Market (loss) gain                            |   | (34,540                                   | )       | 62,747                                   |   | 8,726 |   | 56,745 |   |
| Expense and risk charges                      |   | (2,768                                    | )       | (3,577                                   | )      | (8,305 | ) | (10,731 | ) |
| Broker/custodian/trustee  fees                |   | (110                                      | )       | —                                   |   | (465 | ) | — |   |
| Ending balance                                |   | $                                         | 777,674 |                                     | $      | 686,122 |   | $ | 777,674 |   | $ | 686,122 |   |

 

The reinsurance agreement contains commutation provisions and allowsthe Company to recapture the reserve liabilities and the current notionalexperience account balance as of December 31, 2007, or on December 31of any year thereafter. The Company intends, but is not required, to commutethe agreement on December 31, 2007. In the event the Company does not

 

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commute the agreement onDecember 31, 2007, the expense and risk charges applied to the notionalexperience account will increase significantly. Additionally, the reinsuranceagreement contains covenants and conditions that, if breached, may result inthe immediate commutation of the agreement and the payment of $2,500 perquarter from the period of the breach through December 31, 2007.

 

The Company’s current modeling and actuarial projections suggest thatit is likely to be able to commute the agreement, as planned, onDecember 31, 2007. In order to commute the agreement, PTNA’s and ANIC’sstatutory surplus following commutation must be sufficient to support thereacquired business in compliance with all statutory requirements. Uponcommutation, the Company will receive cash or other liquid assets equaling thevalue of the notional experience account from the reinsurer. The Company wouldalso record the necessary reserves for the business in PTNA’s and ANIC’sstatutory financial statements. Accordingly, the Company’s ability to commutethe agreement is highly dependent upon the value of the notional experienceaccount exceeding the level of required statutory reserves recorded uponcommutation. As of September 30, 2003, the statutory basis reserve liabilitiesof $959,086 exceeded the combination of the notional experience account valueand funds held due to the reinsurer of $836,922.  Based upon the Company’s current modeling and actuarialprojections, management expects the value of the notional experience account toexceed the reserve liabilities at December 31, 2007. In addition to theperformance of the reinsured policies from now through 2007, the notionalexperience account value is susceptible to market interest rate changes. Amarket interest rate increase of 100 basis points could reduce the value of thecurrent notional experience account by approximately $77,000 and jeopardize theCompany’s ability to commute as planned. As the intended commutation dateapproaches, the sensitivity of the notional experience account to marketinterest rate movement will decline as the duration of the benchmark indicesbecomes shorter; however, the amount of assets susceptible to such interestsensitivity will continue to grow as additional net cash flows are added to thenotional experience account balance prior to commutation.

 

As part of the reinsurance agreement, the reinsurer was granted fourtranches of warrants to purchase shares of non-voting convertible preferredstock. The first three tranches of warrants are exercisable throughDecember 31, 2007 at common stock equivalent prices ranging from $4.00 to$12.00 per share. If exercised and converted, the convertible preferred stockwould represent approximately 15% of the then outstanding shares of our commonstock on a fully diluted basis. If the agreement is not commuted onDecember 31, 2007, the reinsurer may exercise the fourth tranche ofconvertible preferred stock purchase warrants at a common stock equivalentprice of $2.00 per share, and the convertible preferred stock would represent,if converted, an additional 20% of the then outstanding common stock on a fullydiluted basis.

 

The warrants are part of the consideration for the reinsurance contractand are recognized as reinsurance premiums over the anticipated life of thecontract, which is six years. The warrants were valued at the issuance dateusing a Black-Scholes model with the following assumptions: 6.0 years expectedlife, volatility of 70.9% and a risk free interest rate of 4.74%. The $15,855value of the warrants was recorded as a deferred premium as ofDecember 31, 2001. Of the original $15,855 value, $661 of deferred premiumwas amortized during each of the three months ended September 30, 2003 and2002 and $1,982****of deferred premium was amortized during each of the ninemonths ended September 30, 2003 and 2002. The unamortized value of the warrants at September 30, 2003 andDecember 31, 2002 is $11,230 and $13,213, respectively.  These amounts are included in other assetson the Consolidated Balance Sheets.

 

As a result of the Company’s intention to commute, it considered onlythe expense and risk charges anticipated prior to the commutation date in itsunamortized deferred acquisition costs (“DAC”) recoverability analyses and hasnot recorded the potential of future escalating charges.  In the event the Company determines thatcommutation of the reinsurance agreement on

 

10

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December 31, 2007 isunlikely, but likely at some future date, it will include additional annualreinsurer expense and risk charges in its DAC recoverability analysis. As aresult, it could impair the value of its DAC asset and record the impairment inits financial statements at that time. However, the Company currently believes thatPTNA and ANIC will have sufficient statutory capital and surplus to commute theagreement on December 31, 2007 or that sufficient alternatives, such asadditional capital issuance or new reinsurance opportunities, will be availableto enable it to commute the agreement on December 31, 2007.

 

*2002 Centre Agreement*

 

The 2001 Centre Agreement granted the reinsurer an option toparticipate in reinsuring new business sales on a quota share basis. InAugust 2002, the reinsurer exercised its option to reinsure up to 50% offuture sales, subject to a limitation of the reinsurer’s risk. The reinsurermay continue this level of participation on the first $100,000 in new policypremium issued after January 1, 2002. The final agreement, which wasentered into in December 2002, further provides the reinsurer the optionto reinsure a portion of the next $1,000,000 in newly issued long-term careannual insurance premium, subject to maximum quota share amounts of up to 40%as additional policies are written.

 

This agreement does not qualify for reinsurance treatment in accordancewith GAAP because it does not result in the reasonable possibility that thereinsurer may realize a significant loss. This is due to an aggregate limit ofliability that reduces the likelihood of the reinsurer realizing a significantloss on the agreement. Accordingly, the contract is being accounted for inaccordance with deposit accounting for reinsurance contracts. However, thisagreement meets the requirements to qualify for reinsurance treatment understatutory accounting rules.

 

4.                                       Contingencies:

 

*Litigation*

 

 TheCompany and certain of its key executive officers are defendants inconsolidated actions that were instituted on April 17, 2001 in the UnitedStates District Court for the Eastern District of Pennsylvania by itsshareholders, on their own behalf and on behalf of a putative class ofsimilarly situated shareholders who purchased shares of the Company’s commonstock from July 23, 2000 through and including March 29, 2001. Theconsolidated amended class action complaint seeks damages in an unspecifiedamount for losses allegedly incurred as a result of misstatements and omissionsallegedly contained in the Company’s periodic reports filed with the SEC,certain press releases issued by the Company, and in other statements made bythe Company’s officials. The alleged misstatements and omissions relate, amongother matters, to the statutory capital and surplus position of its largestsubsidiary, PTNA. On July 1, 2002, the defendants filed an answer to thecomplaint, denying all liability.  Plaintiffs filed a motion for classcertification on August 15, 2002, which is currently pending. OnFebruary 26, 2003, the parties reached an agreement in principle to settlethe litigation for $2,300, to be paid entirely by the Company’s directors’ andofficers’ liability insurance carrier.  The settlement remains subject todocumentation and court approval.

 

The Companyand its subsidiary, PTNA, are defendants in an action in the Fifth JudicialCircuit of the State of Florida in and for Marion County, Civil Division. Plaintiffs filed this matter on January 10, 2003 in Florida State Court,on behalf of themselves and a class of similarly situated Florida long-termcare policyholders. The Company removed this case from the Florida State Courtto United States District Court, Middle District of Florida, OcalaDivision.  Plaintiffs’ motion to remandthe case to Florida State Court was granted on June 25, 2003. Plaintiffsclaim wrongdoing in connection with the sale of long-term care insurancepolicies to the Plaintiffs and the class. Plaintiffs allege claims forreformation, breach of fiduciary duty,

 

11

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breach of the implied duty ofgood faith and fair dealing, negligent misrepresentation, fraudulentmisrepresentation, and restitution. The Company has filed motions to dismissfor failure to state a claim, lack of personal jurisdiction against theCompany, and to strike certain allegations of the complaint as irrelevant andimproper.  A hearing on these motions had been originally scheduled forOctober 9, 2003 and is in the process of being rescheduled.  While the Company cannot predict the outcomeof this case, it could have a material adverse impact upon its financialcondition and results of operations. However, the Company believes that thecomplaint is without merit and intends to continue to defend the mattervigorously.

 

The Companyand two of its subsidiaries, PTNA and Senior Financial Consultants Company, aredefendants in an action instituted on June 5, 2002 in the United StatesDistrict Court for the Eastern District of Pennsylvania by National HealthcareServices, Inc. The complaint seeks compensatory damages in excess of $150 andpunitive damages in excess of $5,000 for an alleged breach of contract andmisappropriation. The claims arise out of a joint venture related to theAllRisk Healthcare program, which was marketed first by PTNA and then later bySenior Financial Consultants Company. The parties completed the depositions offact witnesses on October 30, 2003 and the Company intends to file amotion for summary judgment.  The court has set forth a schedule forthe filing of summary judgment briefs, and has scheduled oral argument on themotions for February 26, 2004.  Thedefendants have denied the allegations of the complaint and will continue todefend the matter vigorously. While the Company cannot predict the outcome ofthis case, the Company believes that any resolution of this action will nothave a material impact on its financial condition or results of operations.

 

The Company’ssubsidiaries are parties to various other lawsuits generally arising in thenormal course of their business. The Company does not believe that the eventualoutcome of any of the other suits to which it is a party will have a materialadverse effect on its financial condition or results of operations. However,the outcome of any single event could have a material impact upon the quarterlyor annual financial results of the period in which it occurs.

** **

*Reinsurance*

 

PTNA is a party to a reinsurance agreement to cede therisk of certain home health care claims that extend beyond 36 months.Reinsurance recoverables related to this treaty were $10,629 and $10,175 atSeptember 30, 2003 and December 31, 2002, respectively. The reinsurerhas notified PTNA that it believes that the Company is in breach of its currentagreement as a result of entering the 2001 Centre Agreement without the priorwritten approval of the reinsurer. PTNA has contested this assertion of breachbased upon its verbal and written notification to the reinsurer prior toentering the 2001 Centre Agreement.   PTNA further believes that the2001 Centre Agreement substantially improved PTNA’s financial strength and furtherprotected the reinsurer. The ultimate resolution of this dispute cannot bedetermined at this time.

 

5.                                       Investments:

 

Management hascategorized all of its investment securities as available for sale because theymay be sold in response to changes in interest rates, prepayments and similarfactors. Investments in this category are reported at their current marketvalue, with net unrealized gains and losses, net of the applicable deferredincome tax effect, being added to or deducted from the Company’s totalshareholders’ equity on the balance sheet. As of September 30, 2003,shareholders’ equity was increased by $1,029 due to unrealized gains of $1,584in the investment portfolio. As of December 31, 2002, shareholders’ equitywas increased by $1,090 due to unrealized gains of $1,679 in the investmentportfolio.

 

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The amortizedcost and estimated market value of the Company’s available for sale investmentportfolio as of September 30, 2003 and December 31, 2002 are asfollows:

 
|                                                                                  |   | **September 30,  2003** |   | **December 31,  2002** |   |
|---------------------------------------------------------------------------------------|--------|------------------------------|--------|-----------------------------|--------|
|                                                                                  |   | **Amortized  Cost**          |   | **Estimated  Market Value** |   | **Amortized  Cost** |   | **Estimated  Market Value** |   |
| U.S. Treasury securities  and obligations of U.S. Government authorities and agencies |   | $                            | 27,216 |                        | $      | 28,142 |   | $ | 15,689 |   | $ | 16,861 |   |
|                                                                                  |   |                         |   |                        |   |   |   |   |   |
| Mortgage backed securities                                                            |   | 2,273                        |   | 2,322                       |   | 1,603 |   | 1,681 |   |
|                                                                                  |   |                         |   |                        |   |   |   |   |   |
| Debt securities issued by  foreign governments                                        |   | 338                          |   | 346                         |   | 205 |   | 216 |   |
|                                                                                  |   |                         |   |                        |   |   |   |   |   |
| Corporate securities                                                                  |   | 25,625                       |   | 26,226                      |   | 9,278 |   | 9,696 |   |
|                                                                                  |   |                         |   |                        |   |   |   |   |   |
| Policy loans                                                                          |   | 306                          |   | 306                         |   | 238 |   | 238 |   |
|                                                                                  |   |                         |   |                        |   |   |   |   |   |
| Total investments                                                                     |   | $                            | 55,758 |                        | $      | 57,342 |   | $ | 27,013 |   | $ | 28,692 |   |
|                                                                                  |   |                         |   |                        |   |   |   |   |   |
| Net unrealized gain                                                                   |   | $                            | 1,584  |                        |   |   | $ | 1,679 |   |   |   |

 

The majority of the Company’s investment portfolio was transferred tothe reinsurer as part of the initial premium paid for the 2001 CentreAgreement. The reinsurer maintains a notional experience account for theCompany’s benefit in the event of future commutation of the reinsuranceagreement. The Company receives an investment credit equal to the total returnof a series of benchmark indices and derivative hedges. The notional experienceaccount balance at September 30, 2003 and December 31, 2002 was$777,674 and $708,982, respectively (See Note 3).

 

Pursuant to certain statutory licensing requirements, as ofSeptember 30, 2003 and December 31, 2002, the Company had on depositbonds with an estimated market value aggregating $12,399 and $10,848,respectively, in Insurance Department special deposit accounts. The Company isnot permitted to remove the bonds from these accounts without approval of theregulatory authority.

 

The Company maintains assets in a trust account under a reinsuranceagreement with an unaffiliated insurer. The Company is required to hold assets equal to 102% of the reserves forthe policies assumed under this agreement. At September 30, 2003 and December 31, 2002, the market valueof the assets in the trust was $14,291 and $11,174, respectively.

 

6.                                       Reconciliationof Earnings Per Share:

 

A reconciliation of thenumerator and denominator of the basic earnings per share computation to thenumerator and denominator of the diluted earnings per share computationfollows. Basic earnings per share excludes dilution and is computed by dividingincome available to common shareholders by the weighted average number ofcommon shares outstanding for the period. Diluted earnings per share reflectthe potential dilution that could occur if securities or other contracts toissue common stock were exercised or converted into common stock. Anti-dilutiveeffects are not included. At September 30, 2003, the Company has $94,997 ofconvertible, subordinated notes due 2008 (see Note 10), which are convertibleprior to maturity into common shares at $1.75 per share.  The effect of the conversion of these sharesis included for purposes of calculating diluted earnings per share, unless theeffect is anti-dilutive.

 

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|                                                                                                           |   | **Three Months Ended September 30,** |    | **Nine Months Ended September 30,** |   |
|----------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|---------|------------------------------------------|--------|
|                                                                                                           |   | **2003**                                  |    | **2002**                                 |   | **2003** |   | **2002** |   |
| Net (loss) income before  cumulative effect of change in accounting principle                                  |   | $                                         | (25,398 | )                                        | $      | (24,471 | ) | $ | 772 |   | $ | (26,180 | ) |
| Weighted average common  shares outstanding                                                                    |   | 21,099                                    |    | 19,376                                   |   | 20,026 |   | 19,194 |   |
| Basic earnings per share  from net (loss) income before cumulative effect of change in accounting  principle   |   | $                                         | (1.20   | )                                        | $      | (1.26 | ) | $ | 0.04 |   | $ | (1.36 | ) |
|                                                                                                           |   |                                      |    |                                     |   |   |   |   |   |
| Net (loss) income before  cumulative effect of change in accounting principle                                  |   | $                                         | (25,398 | )                                        | $      | (24,471 | ) | $ | 772 |   | $ | (26,180 | ) |
| Cumulative effect of change  in accounting principle                                                           |   | —                                    |    | —                                   |   | — |   | (5,151 | ) |
| Net (loss) income                                                                                              |   | $                                         | (25,398 | )                                        | $      | (24,471 | ) | $ | 772 |   | $ | (31,331 | ) |
| Basic earnings per share  from net (loss) income                                                               |   | $                                         | (1.20   | )                                        | $      | (1.26 | ) | $ | 0.04 |   | $ | (1.63 | ) |
|                                                                                                           |   |                                      |    |                                     |   |   |   |   |   |
| Adjustments net of tax:                                                                                        |   |                                      |    |                                     |   |   |   |   |   |
| Interest expense on  convertible debt                                                                          |   | $                                         | —  |                                     | $      | — |   | $ | — |   | $ | — |   |
| Amortization of debt  offering costs                                                                           |   | —                                    |    | —                                   |   | — |   | — |   |
| Diluted net (loss) income  before cumulative effect of change in accounting principle                          |   | $                                         | (25,398 | )                                        | $      | (24,471 | ) | $ | 772 |   | $ | (26,180 | ) |
| Diluted net (loss) income                                                                                      |   | $                                         | (25,398 | )                                        | $      | (24,471 | ) | $ | 772 |   | $ | (31,331 | ) |
|                                                                                                           |   |                                      |    |                                     |   |   |   |   |   |
| Weighted average common  shares outstanding                                                                    |   | 21,099                                    |    | 19,376                                   |   | 20,026 |   | 19,194 |   |
| Common stock equivalents  due to dilutive effect of stock options/warrants                                     |   | —                                    |    | —                                   |   | — |   | — |   |
| Shares converted from  convertible debt                                                                        |   | —                                    |    | —                                   |   | — |   | — |   |
| Total outstanding shares  for diluted earnings per share computation                                           |   | 21,099                                    |    | 19,376                                   |   | 20,026 |   | 19,194 |   |
|                                                                                                           |   |                                      |    |                                     |   |   |   |   |   |
| Diluted earnings per share  from net (loss) income before cumulative effect of change in accounting  principle |   | $                                         | (1.20   | )                                        | $      | (1.26 | ) | $ | 0.04 |   | $ | (1.36 | ) |
| Diluted earnings per share  from net (loss) income                                                             |   | $                                         | (1.20   | )                                        | $      | (1.26 | ) | $ | 0.04 |   | $ | (1.63 | ) |

 

Securitiesthat could potentially dilute basic earnings per share in the future that werenot included in the computation of diluted earnings per share, because to do sowould have been anti-dilutive, were 95,794 and 14,588 at September 30,2003 and December 31, 2002, respectively. These securities includeoptions, warrants (see Note 3) and convertible debt securities (see Note 10)that have exercise prices above the current period market price or theinclusion of which would result in a lower net loss per share.

 

7.                                       ClaimReserves:

 

The Company establishes reserves for the future payment of allcurrently incurred claims. The amount of reserves relating to reported andunreported claims incurred is determined by periodically evaluating historicalclaims experience and statistical information with respect to the probablenumber and nature of such claims. Claim reserves reflect actual experiencethrough the most recent time period. Claim reserves include current assumptionsas to type and duration of care, remaining policy benefits, and interest rates.The Company compares actual experience with estimates and adjusts its reserveson the basis of such comparisons.

 

During the period ended September 30, 2002, in order to estimatereserves for future claims payments more precisely, the Company refined its assumptionsand process for developing these reserves. As a result of this analysis, theCompany’s actuarial modeling suggested that future claim payments would likelyexceed its past assumptions, which, if unaddressed, could continue to causefuture adverse deviation, and, as a result of these changes the Companystrengthened its claim reserves by $83,000 in the period endedSeptember 30, 2002.

 

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8.                                       PolicyReserves and Deferred Policy Acquisition Costs:

 

The Company alsomaintains reserves for policies that are not currently on claim based uponactuarial expectations that a policy may go on claim in the future. Benefitreserves are determined by evaluating future claims less premium payments todetermine the present value of the Company’s anticipated future liability.These reserves are calculated based on factors that include estimates formortality, morbidity, interest rates, premium rate increases and persistency.Factor components generally include assumptions that are consistent with bothour experience and industry practices.

 

In connection with the sale of its insurance policies, the Companydefers and amortizes a portion of the policy acquisition costs over the relatedpremium paying periods of the life of the policy. These costs include allexpenses that are directly related to, and vary with, the acquisition of thepolicy, including commissions, underwriting and other policy issue expenses.The amortization of deferred policy acquisition costs (“DAC”) is determinedusing the same projected actuarial assumptions used in computing policyreserves. DAC can be affected by unanticipated terminations of policiesbecause, upon such terminations, the Company is required to expense fully theDAC associated with the terminated policies.

 

At September 30,2002, the Company reviewed the appropriateness and recoverability of itsexisting DAC. From this review, it determined to recognize a DAC impairmentloss of $1,100 during the period ended September 30, 2002, primarily as aresult of the incorporation of certain assumptions related to the futureprofitability of its current business in force. These assumptions included theuse of a lower discount rate, which reflects the current interest rateenvironment, higher anticipated claims costs due to newly estimated claimduration and expected future premium rate increases on policies for which theCompany has already filed or anticipates filing. Also, these new assumptionsare utilized in the determination of the Company’s claim reserves. In the eventthat premium rate increases cannot be obtained as needed, or actual experiencediffers from the Company’s assumptions, DAC could be further impaired and theCompany would incur an expense in the amount of the impairment.

 

9.                                       EquityPlacement:

 

In March 2002, the Company completed a private placement of 510shares of common stock for net proceeds of $2,352. The common stock was sold toseveral institutional investors at $4.65 per share, a 10 percent discount tothe 30-day average price of the Company’s common stock prior to the issuance ofthe new shares. The proceeds of the private placement provided additionalliquidity to the parent company to meet its current year debt serviceobligations.

 

Throughout 2002 and 2003, the Company issued shares ofits common stock to its financial advisor as compensation for its assistance invarious capital markets transactions. The dates, number of shares and compensation expense as a result of theissuances were:

 
| **Date**          |   | **Shares** |   | **Compensation** |   |
|-------------------|--------|------------|--------|------------------|--------|
|              |   |       |   |             |   |
| April 2002   |   | 60         |   | $                | 325    |   |
| October 2002 |   | 20         |   | 68               |   |
| January 2003 |   | 20         |   | 34               |   |
| May 2003     |   | 100        |   | 173              |   |
|                   |        |            |        |                  |        |  |

 

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10.                                 Long-TermDebt:

 

During the first quarter of 2003, the Company issued $32,421 in 6.25% convertiblesubordinated notes due 2008 (the “2008 Notes”).  The primary terms of the 2008 Notes are:

 

1.               the 2008 Notes canbe converted by the holder into shares of the Company’s common stock at $1.75per share;

2.               the 2008 Notes maynot be called by the Company or forced to convert into shares of common stockprior to October 2005;

3.               afterOctober 2005, the 2008 Notes will mandatorily convert into shares of theCompany’s common stock if at any time thereafter the average market price forfifteen trading days of the common stock exceeds $1.93; and,

4.               holders of the 2008Notes are entitled to convert their notes into shares of the Company’s commonstock before October 2005 and receive a discounted amount of interest thatthey would have otherwise received until October 2005.  The Company may elect to pay this interestin cash or in newly issued shares of common stock priced at a 10% discount tothe then fair market value of traded shares.

 

In conjunction with the issuance of the new 2008 Notes, the Companymodified the terms of its existing $65,793 of 2008 Notes to make them identicalto those of the new 2008 Notes.

 

Asnoted above, holders of the 2008 Notes are entitled to convert theirnotes into shares of the Company’s common stock before October 2005 andreceive a discounted amount of interest that they would have otherwise receiveduntil that date.  The Company may electto pay this interest in cash or in newly issued shares of common stock.  If the Company elects to pay in newly issuedshares of common stock, the stock is priced at a 10% discount to the then fairmarket value of traded shares.  TheCompany has determined that this feature is an embedded derivative as definedin Statement of Financial Accounting Standards No. 133 “Accounting for DerivativeInstruments and Hedging Activities.” This embedded derivative is not clearly and closely related to the hostcontract, the 2008 Notes, because it could at least double the investor’sinitial rate of return on the host contract and could also result in a rate ofreturn that is at least twice what otherwise would be the market return for acontract that has the same terms as the host contract and that involves adebtor with a similar credit quality.

 

As a result ofthis determination, the Company concluded that the embedded derivative shouldbe separately valued and bifurcated from the host contract, the 2008 Notes,upon the date that the option to receive discounted interest was granted.  At each balance sheet date, the embeddedderivative must be recorded at fair value, with any change in fair valuerecognized in current operations. Additionally, due to the bifurcation of the embedded derivative from thehost contract, the Company’s long-term debt is recorded at a discounted amountin the Consolidated Balance Sheet.  Thisdiscount will be amortized through October 2008 using the effectiveinterest method and an adjusted effective yield of 6.69%.

 

The Companydetermined that the fair value of the embedded derivative as of the date thatthe option to receive discounted interest was granted was $2,038.  This amount was separately classified aspreferred interest on early conversion and also recorded as a discount onlong-term debt in the Consolidated Balance Sheets.  As of September 30, 2003, the Company adjusted the embeddedderivative to its then fair value of $2,305 by recognizing a loss of $354 and$267 for the three months and nine months ended September 30, 2003,respectively.  The Company recorded $138and $247 of additional interest expense during the three months and nine monthsended September 30, 2003, respectively, due to the amortization of thediscount on the long-term debt.  As ofSeptember 30, 2003, the remaining discount on the long-term debt is$1,791.

 

16

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In determiningthe fair value of the embedded derivative, the Company makes certainassumptions, including the future volatility and liquidity of the Company’scommon stock.  If actual experiencedeviates from current assumptions, the Company may be subject to significantvolatility in future periods.

 

Holders of $3,217 of 2008 Notes elected to convert their notes duringthe nine months ended September 30, 2003 in exchange for 2,051 shares ofcommon stock, including shares issued for the preferred interest on earlyconversion.  Subsequent toSeptember 30, 2003, holders of approximately $3,565 elected to converttheir 2008 Notes in exchange for approximately 2,273 shares of common stock,including shares issued for the preferred interest on early conversion.  As a result of the conversions prior toSeptember 30, 2003, the Company recorded additional interest expense ofapproximately $490 related to the preferred interest on early conversion, forboth the three and nine months ended September 30, 2003.

 

17

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**Item 2.**Management’sDiscussion and Analysis of Financial Condition and Results of Operations.(amounts in thousands, except per share data)

 

***Overview***

 

Our principal productsare individual, defined benefit accident and health insurance policies thatconsist of nursing home care, home health care and Medicare supplement. Weexperienced significant reductions in new premium sales beginning in 2001 dueto the cessation of new business generation in all states and as a result ofmarket concerns regarding our Pennsylvania insurance subsidiaries’ statutorysurplus. Under our Corrective Action Plan (the “Plan”), which was approved bythe Pennsylvania Insurance Department (the “Department”) in February 2002,we recommenced sales in certain states, but intend to limit new business growthto levels that will allow us to maintain sufficient statutory surplus.

 

Our insurancesubsidiaries are subject to the insurance laws and regulations of the states inwhich they are licensed to write insurance. These laws and regulations governmatters such as payment of dividends, settlement of claims and loss ratios.State regulatory authorities must approve premiums charged for insuranceproducts. In addition, our insurance subsidiaries are required to establish andmaintain reserves with respect to reported and incurred but not reportedclaims, as well as estimated future benefits payable under our insurancepolicies. These reserves must, at a minimum, comply with mandated standards.Our reserves are certified annually by our consulting actuary as to standardsrequired by the insurance departments for our domiciliary states and for theother states in which we conduct business. We believe we maintained adequatereserves as mandated by each state in which we are currently writing businessat September 30, 2003. For a description of current regulatory mattersaffecting our insurance subsidiaries, see *“Liquidity and Capital Resources - SubsidiaryOperations.”*

 

Our financial conditionand results of operations are affected significantly by the following factors:

 

*Level of required reserves for policies in-force*.Our insurance policies are accounted for as long duration contracts. As aresult, there are two components of policyholder liabilities. The first is apolicy reserve liability for future policyholder benefits, represented by thepresent value of future benefits less a portion of future premium collection.These reserves are calculated based on assumptions that include estimates formortality, morbidity, interest rates, premium rate increases and policypersistency. The assumptions are based on our past experience, industryexperience and current trends.

 

The second is a reserve for incurred, either reported or not yetreported, policy claims. The amount of reserves relating to reported andunreported claims incurred is determined by periodically evaluating statisticalinformation with respect to the number and nature of historical claims. Wecompare actual experience with estimates and adjust our reserves in the currentperiod on the basis of such comparisons to the extent that our analysissuggests that the estimates utilized differ from actual experience.

 

Additions to, or reductions in, reserves are recognized in our currentConsolidated Statements of Income and Comprehensive Income as expense orincome, respectively, through benefits to policyholders and are a materialcomponent of our net income or loss. A portion of premium collected in eachperiod is set aside to establish reserves for future policy benefits. Reservesare established based upon current assumptions and we cannot assure you thatactual experience will not differ materially from the assumptions used in theestablishment of our reserves. Any variance from these assumptions could affectour profitability in future periods.

 

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*Deferred policy acquisition costs*. Inconnection with the sale of our insurance policies, we defer and amortize aportion of the policy acquisition costs over the related premium paying periodsfor the life of the policy. These costs include all expenses that are directlyrelated to, and vary with, the acquisition of the policy, includingcommissions, underwriting and other policy issue expenses. The amortization ofdeferred policy acquisition costs (“DAC”) is determined using the sameprojected actuarial assumptions used in computing policy reserves. DAC can beaffected by unanticipated terminations of policies because, upon such terminations,we are required to expense fully the DAC associated with the terminatedpolicies. In addition, the assumptions underlying DAC and our policy benefitreserves are periodically reviewed and updated to reflect current assumptions,including planned premium rate increases. In the event planned premium rateincreases are not achieved, or our actual experience differs from ourassumptions, we could recognize an impairment of our DAC in the future.  Whenever we determine that our DAC is notfully recoverable, we impair the carrying value of our DAC through an expenseto our Consolidated Statements of Income and Comprehensive Income.

* *

*Policy premium levels*. We attempt to setpremium levels to maintain planned profit margins. Premium levels on newproducts, as well as rate increases on existing products, are subject togovernment review and regulation.  Wemay be limited in our ability to gain approval for premium rate increases suchthat future profit margins could be reduced or prior losses may not be recouped.

 

*Investment income and notional experience account*.Our investment portfolio, excluding our notional experience account, consistsprimarily of investment grade fixed income securities. Income generated fromthis portfolio is largely dependent upon prevailing levels of interest rates.Due to the duration of our investments (approximately 3.3 years), investmentincome does not immediately reflect changes in market interest rates.

 

In connection with our 2001 reinsurance agreement with Centre Solutions(Bermuda) Limited (the “2001 Centre Agreement”) (see “*Liquidity and Capital Resources –Subsidiary Operations*”), we transferred substantially all of ourinvestment portfolio to the reinsurer as the initial premium payment. Theinitial and future premium for the reinsured policies, less claims payments,ceding commissions and risk charges, is credited to a notional experienceaccount, the balance of which also receives an investment credit based upon thetotal market return of a series of benchmark indices and derivative hedges. Thenotional experience account balance represents an amount to be paid to us inthe event of commutation of the agreement. We believe that the notionalexperience account represents a hybrid instrument, containing both a fixed debthost contract and an embedded derivative. The economic characteristics andrisks of the embedded derivative instrument are not clearly and closely relatedto the economic characteristics and risks of the fixed debt host contract. Weare accounting for the investment credit received on the notional experienceaccount as follows:

 

a)              Thefixed debt host yields a fixed return based upon the yield to maturity of theunderlying benchmark indices. The return on the fixed debt host is reported asinvestment income in the Statements of Income and Comprehensive Income.

b)             Thechange in fair value of the embedded derivative represents the percentagechange in the underlying indices applied to the notional experience account,similar to that of an unrealized gain/loss on a bond. The change in the fairvalue of the embedded derivative is reported as market (loss) gain on notionalexperience account in the Statements of Income and Comprehensive Income.

 

As a result, our results of operations are subject to significantvolatility. Recorded market value gains or losses, although recognized incurrent earnings, are expected to be partially offset in future periods fromthe receipt of the most recent market interest rates for all subsequentperiods. The benchmark indices are comprised of U.S. Treasury strips, agenciesand investment

 

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grade corporate bonds, with weightings of approximately 25%, 15% and60%, respectively, and have a duration of approximately 11 years.

 

*Lapsation and persistency*. Our financialcondition and results of operations may be effected by lapsation andpersistency, both of which relate to the renewal of insurance policies.Lapsation is the termination of a policy by non-renewal. Lapsation is automaticif and when premiums become more than 31 days overdue, although, in some cases,a lapsed policy may be reinstated within six months. Persistency represents thepercentage of policies renewed, which we calculate by dividing the total numberof policies in-force at the end of each year (less new policies added duringthe year) by the total number of policies in-force at the end of the prioryear.  Prior to December 31, 2002,we calculated persistency by dividing the total annual premiums at the end ofeach year (less first year premiums for that year) by the total annual premiumsin-force for the prior year. For purposes of these calculations, a decrease intotal policies in-force or the annual premiums in-force at the end of any yearwould be the result of non-renewal of policies, including policies that haveterminated by reason of death, lapsed due to nonpayment of premiums and/or havebeen converted to other policies we offered. The calculation was changed atDecember 31, 2002 due to the impact of rate increases on the annualpremiums in-force at the end of December 31, 2002.  We believe that using the number of policiesin-force will provide a more accurate measure of persistency and will continueto utilize that method of calculation in the future.

 

Policies renew or lapse for a variety of reasons, both internal andexternal. We believe that our efforts to address policyholder concerns orquestions help to ensure policy renewals. We work closely with our licensedagents, who play an integral role in policy persistency and policyholdercommunication.

 

Economic cycles can influence a policyholder’s ability to continue thepayment of insurance premiums when due. We believe that publicity regardingFederal and state tax legislation allowing medical deductions for certainlong-term care insurance premiums has raised public awareness of the escalatingcosts of long-term care and the value provided to the consumer by long-termcare insurance. The ratings assigned to our insurance subsidiaries byindependent rating agencies also influence consumer decisions.

 

Lapsation and persistency can both positively and adversely affectfuture earnings. Reduced lapsation and higher persistency generally result inhigher renewal premiums and lower amortization of DAC, but may lead to increasedclaims in future periods. Higher lapsation can result in reduced premiumcollection, a greater percentage of higher-risk policyholders, and acceleratedexpensing of DAC. However, higher lapsation may also lead to decreased claimsin future periods.

 

***Results of Operations***

 

**ThreeMonths Ended September 30, 2003 and 2002**

 

*Premiums*. Effective September 10, 2001, wedetermined to discontinue the sale nationally of all new long-term careinsurance policies until the Plan was completed and approved by the Department.This decision resulted from our concern about further depletion of statutorysurplus from new policy sales prior to the completion and approval of the Planand from increasing concern with respect to the status of the Plan expressed bymany states in which we are licensed to conduct business. Upon the Department’sapproval of the Plan in February 2002, we recommenced new policy sales in23 states, including Pennsylvania. We are now approved to recommence new policysales in 13 additional states.  These 36states represented approximately 71% in aggregate of our total premium revenuein the three month period ended September 30, 2003 (the “2003quarter”).  In March, we agreed uponterms for the recommencement of sales in California,

 

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whichis pending subject to certain conditions, which we remain hopeful can besatisfied during the fourth quarter of 2003. We believe new sales in California are likely to recommence in the firstquarter of 2004.  California renewalpremiums represented 14% of our premium revenue in the 2003 quarter. We areactively working with the remaining states to recommence new policy sales inall jurisdictions.

 

Totalpremium revenue earned in the 2003 quarter, including long-term care, Medicaresupplement, disability and life decreased 2.59% to $81,471, compared to $83,635in the same period in 2002 (the “2002 quarter”).

 

Totalfirst year premium revenue in the 2003 quarter increased 61.85% to $2,070,compared to $1,279 in the 2002 quarter. First year long-term care premiumrevenue in the 2003 quarter increased 75.24% to $1,833, compared to $1,046 inthe 2002 quarter.   We anticipate thatfirst year premium revenue will continue to increase as independent agents thatsold our policies prior to the cessation of sales are reengaged and independentagents that had not previously sold our policies are recruited.  In addition to this increase in states inwhich we have recommenced sales, we anticipate that we will recommence sales inadditional states in which we are currently not writing new business.

 

Totalrenewal premium revenue in the 2003 quarter decreased 3.59% to $79,401 comparedto $82,356 in the 2002 quarter. Renewal long-term care premium revenue in the2003 quarter decreased 3.99% to $76,397, compared to $79,575 in the 2002quarter. We may continue to experience reduced renewal premium revenue in thefuture, primarily driven by the reduced level of new premium revenue in recentprior periods as discussed above and the lapsation of existing policies.

 

*Netinvestment income.*Net investment income earned for the 2003 quarter increased 10.10% to $11,144,from $10,122 for the 2002 quarter.

 

Asa result of our 2001 Centre Agreement, substantially all of our investableassets from business written prior to December 31, 2001, were transferredto the reinsurer. The reinsurer maintains a notional experience account on ourbehalf in the event that the reinsurance agreement is later commuted. Asdiscussed above in “*Overview*,” the notional experience accountis credited with an investment credit equal to the most recent yield tomaturity on a series of benchmark indices and derivative hedges, which aredesigned to closely match the duration of our liabilities.

 

Our average yield on invested assets at cost,including cash and cash equivalents, was 5.21% and 6.10% in the 2003 and 2002quarters, respectively. The investment income component of our notionalexperience account investment credit generated $10,627 and $9,798 in the 2003and 2002 quarters, respectively.  Theyield on our notional experience account was 5.59% and 6.40% in the 2003 and2002 quarters, respectively. The decrease in our average yield is due to adecline over the past year in market interest rates, which has the greatest impacton our notional experience account.  Thenotional experience account yields a fixed return based upon the yield tomaturity of the underlying benchmark indices, which are comprised of U.S.Treasury strips, agencies and investment grade corporate bonds, with weightingsof approximately 25%, 15% and 60%, respectively, and have a duration ofapproximately 11 years.

 

*Market(loss) gain on notional experience account*. We recorded a market loss on our notionalexperience account balance of $34,540 in the 2003 quarter compared to a marketgain of $62,747 in the 2002 quarter.

 

Asdiscussed in “*Overview*” and *“Net investment income”* above, thereinsurer maintains a notional experience account for our benefit in the eventof future recapture of the reinsured business. The notional experience accountreceives an investment credit based upon the total

 

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returnof a series of benchmark indices and derivative hedges, which are designed toclosely match the duration of our reserve liabilities. Periodic changes in themarket values of the benchmark indices and derivative hedges are recorded inour financial statements as a realized gain or loss in the period in which theyoccur. The notional experience account is susceptible to market interest ratechanges.  As a result, our futurefinancial statements are subject to significant volatility.  During the 2003 quarter, market interestrates increased, leading to a market loss on the notional experience account ascompared to the 2002 quarter, where market interest rates decreased, leading toa market gain on the notional experience account.

** **

*Other income*. We recorded $1,719 in other income duringthe 2003 quarter, down from $4,361 in the 2002 quarter. The decrease is attributableprimarily to the recognition in the 2002 quarter of a deferred gain ofapproximately $2,000 from the 2001 sale of our disability business.  In addition there was a decrease ofapproximately $420 in the income generated from our ownership of corporateowned life insurance policies.

 

*Benefitsto policyholders*.Total benefits to policyholders in the 2003 quarter decreased 61.16% to$63,763, compared to $164,170 in the 2002 quarter. Our loss ratio, orpolicyholder benefits to premium revenue, was 78.26% in the 2003 quarter,compared to 196.3% in the 2002 quarter.

 

Duringthe 2002 quarter we refined our assumptions and processes for developing ourclaim reserves.  This includedredefining certain “multiple” claims as a single claim and employing new assumptionsand processes for predicting the continuance, or the likelihood of a claimcontinuing in the future.  This resultedin an increase to claims reserves of approximately $83,000 in the 2002 quarter.

 

Further,we employed a lower discount rate of 5.7% in the 2002 quarter, which increasedour claims reserves by approximately $5,000. We believe that, as a result oflower market interest rates, the lower discount rate more closely matched ouranticipated return from the investment of assets supporting these reserves. Wecontinue to use the 5.7% discount rate in the 2003 quarter.

 

Claimsexperience can differ from our expectations due to numerous factors, includingmortality rates, duration of care and type of care utilized. When we experiencedeviation from our estimates, we typically seek premium rate increases that aresufficient to offset future deviation. In 2001 and 2002, we filed for premiumrate increases on the majority of our policies in-force. These rate increaseswere necessary because we expected higher loss ratios as a result of higherclaims expectations than existed at the time of the original premium ratefilings. We have filed additional premium rate increases on many policiesin-force as result of new claim assumptions we established in the third quarterof 2002.  We have been generallysuccessful in the past in obtaining state insurance department approvals forincreases. If we are unsuccessful in obtaining the recently filed or futurepremium rate increases when deemed necessary, or if we do not pursue premiumrate increases when actual claims experience exceeds our expectations, we wouldsuffer a financial loss.

 

Historically, we have observed variations throughout theyear in the payment or incurrals of new claims.  Management employs seasonal assumptions throughout the year,based upon observed historical trends, in the establishment of its claimreserves so that it can more consistently monitor loss ratio variances from itsexpectations based upon other significant factors such as claims duration andincidence.  We reduced our claimsreserves by $3,278 and $2,594 as of September 30, 2003 and 2002,respectively, to reflect this seasonal variation.

 

Ourpolicy reserves, which are held for policyholders not currently on claim, arehighly dependent upon several factors, including policyholder persistency andthe mix of policies with varying benefit amounts or types.  We project the growth of our policy reservesbased upon the

 

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currentand projected mix of policies in-force. Variances from our expectations result from future changes in this mixthat differs from our assumptions.

 

*Commissions*. Commissions to agents decreased 11.22% to$10,234 in the 2003 quarter, compared to $11,527 in the 2002 quarter.

 

Firstyear commissions on accident and health business in the 2003 quarter increased94.99% to $1,129, compared to $579 in the 2002 quarter, due to the increase infirst year accident and health premium revenue. The ratio of first yearaccident and health commissions to first year accident and health premiumrevenue was 54.5% in the 2003 quarter and 45.3% in the 2002 quarter. The firstyear commission ratio for both the 2003 and 2002 quarters is lower than thefirst year commission ratio prior to the cessation of sales in 2001 due to theincreased portion of premium revenue attributable to the sale of our SecuredRisk, Medicare Supplement and franchise group policies. All of these policiespay a lower commission as a percentage of premium revenue to agents than ourindividual long-term care policies.   Webelieve that sales of these policies as a percentage of new sales are likely toremain at this level as we recommence sales in many states.  We believe that the sale of long-term carepolicies has declined as a percentage of sales as a result of our lowerfinancial ratings with A.M. Best and Standard and Poor’s rating services andcontinued consumer and agent concerns regarding our financial strength.

 

Renewalcommissions on accident and health business in the 2003 quarter decreased 6.22%to $9,642, compared to $10,282 in the 2002 quarter, due to the decrease inrenewal accident and health premium revenue. The ratio of renewal accident andhealth commissions to renewal accident and health premiums was 12.2% in the2003 quarter and 12.6% in the 2002 quarter. We have implemented premium rateincreases on a majority of policies written prior to December 31,2001.  We do not pay commissions on theadditional premium collected as a result of a rate increase, which reduces theratio of renewal commissions to renewal premium revenue.

 

*Net policyacquisition costs amortized*.  The net policy acquisitioncosts amortized in the 2003 quarter increased to $3,870, compared to $3,403 inthe 2002 quarter.

 

Deferredcosts are typically all costs that are directly related to, and vary with, theacquisition of new premiums. The deferred costs include the variable portion ofcommissions, which are defined as the first year commissions less ultimaterenewal commissions, and variable general and administrative expenses relatedto policy sales, underwriting and issuance. Deferred costs are amortized overthe life of the policy based on actuarial assumptions, including persistency ofpolicies in-force. In the event a policy lapses prematurely due to death ortermination of coverage, the remaining unamortized portion of the deferredamount is immediately recognized as expense in the current period.

 

Thenet amortization of deferred policy acquisition costs is affected by new businessgeneration, imputed interest on prior reserves and policy persistency. Theamortization of deferred costs is generally offset largely by the deferral ofcosts associated with new premium generation. However, lower new premiumrevenue throughout 2002 and continuing through the 2003 quarter producedsignificantly less expense deferral to offset amortized costs.

 

AtSeptember 30, 2002, we reviewed the appropriateness and recoverability ofDAC. From this review, we determined to recognize a DAC impairment charge of$1,100 during the third quarter of 2002 primarily as a result of theincorporation of certain assumptions related to the future profitability of ourcurrent business in force. These assumptions included the use of a lowerdiscount rate, which reflects the current interest rate environment, higheranticipated claims costs due to newly estimated claim duration and reasonablyexpected future premium rate increases on policies for which we have alreadyfiled or anticipate filing. In the event that premium rate increases cannot beobtained as needed, or our actual experience differs from our

 

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assumptions,our DAC could be further impaired and we would incur an expense in the amountof the impairment.

* *

*Generaland administrative expenses*. General and administrative expenses in the 2003 quarter increased5.80% to $14,118, compared to $13,344 in the 2002 quarter. The ratio of totalgeneral and administrative expenses to premium revenues was 17.33% in the 2003quarter, compared to 15.96% in the 2002 quarter.

 

Duringthe 2003 quarter, our expenses related to selling new policies increasedapproximately $840 as compared to the 2002 quarter due to the marketingexpenses associated with the recommencement of sales in certain keystates.  Salaries and employee benefitsincreased approximately $840 in the 2003 quarter compared to the 2002quarter.  This increase is due to salaryincreases, increased health insurance premiums, the addition of employees inthe marketing, actuarial and accounting functions, and severance paymentsaccrued for recently terminated employees. Legal expenses increased approximately $540 in the 2003 quarter comparedto the 2002 quarter due to expenses associated with the ongoing discovery processand the completion of depositions in the National Healthcare Services, Inc.litigation and expenses associated with numerous motions filed and thepreliminary discovery conducted in litigation related to the sale of long-termcare policies.  These additionalexpenses were offset by certain expenses that we incurred in the 2002 quarterthat we did not incur in the 2003 quarter, including approximately $650 relatedto the settlement of a lawsuit and approximately $200 for costs related to theexchange of our convertible debt.

 

Oneof our agency subsidiaries has expanded its regional office structure in orderto increase its ability to sell additional new long-term care policies that weand other companies offer.  As a resultof the staffing and costs associated with starting these offices, as well assales promotion expenses, we incurred approximately $450 of additional expensein the 2003 quarter.  We anticipate thatthese expenses will eventually be offset by additional revenue.

 

Duringthe 2003 quarter we terminated or elected not to fill 17 positions, which willresult in annual savings of approximately $650.  However, we believe that we currently have substantial capacityfor premium growth at our current staff levels, print inventories and other expensecategories.  We also believe that ourcurrent expense levels represent the minimum requirements necessary to reengagenew sales territories, design competitive product lines and properly underwritenew policy applications. However, we believe that if we remain unable to writenew business in certain states where we have ceased new production, or if weare unable to use our existing staff and infrastructure capacity to generateadditional premium revenue, we will need to decrease production expenses, whichcould result in decisions to reduce our staff or other operating functionsfurther.

* *

*Interestexpense. *Interest expense in the 2003 quarterincreased 86.19% to $2,225, compared to $1,195 in the 2002 quarter.  At September 30, 2003, we hadapproximately $95,000 in convertible debt outstanding compared to approximately$76,000 at September 30, 2002.  Inaddition we recorded interest expense of approximately $140 related to thediscount on our debt and $490 related to the preferred interest upon conversionprior to October 15, 2005 of approximately $3,200 of the debt during the2003 quarter.

 

***NineMonths Ended September 30, 2003 and 2002***

*** ***

*Premiums*. Total premium revenue earned in the ninemonth period ended September 30, 2003 (the “2003 period”), includinglong-term care, Medicare supplement, disability and life, decreased 3.19% to$243,756, compared to $251,777 in the same period in 2002 (the “2002 period”).

 

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Totalfirst year premium revenue in the 2003 period increased 9.83% to $5,305,compared to $4,830 in the 2002 period. First year long-term care premiumrevenue in the 2003 period increased 12.44% to $4,636, compared to $4,123 inthe 2002 quarter.   We anticipate thatfirst year premium revenue will continue to increase as independent agents thatsold our policies prior to the cessation of sales are reengaged and independentagents that had not previously sold our policies are recruited.  In addition to this increase in states inwhich we have recommenced sales, we anticipate that we will recommence sales inadditional states in which we are currently not writing new business.

 

Totalrenewal premium revenue in the 2003 period decreased 3.44% to $238,451 comparedto $246,947 in the 2002 period. Renewal long-term care premium revenue in the2003 period decreased 3.90% to $229,522, compared to $238,825 in the 2002period. We may continue to experience reduced renewal premium revenue in thefuture, primarily driven by the reduced level of new premium revenue in recentprior periods as discussed above and the lapsation of existing policies.

 

*Netinvestment income.*Net investment income earned for the 2003 period increased 7.49% to $32,064,from $29,829 for the 2002 period.

 

Our average yield on invested assets at cost,including cash and cash equivalents, was 5.35% and 6.30% in the 2003 and 2002periods, respectively. The investment income component of our notionalexperience account investment credit generated $30,633 and $28,391 in the 2003and 2002 periods, respectively.  Theyield on our notional experience account was 5.61% and 6.60% in the 2003 and2002 periods, respectively. The decrease in our average yield is due to adecline over the past year in market interest rates, which has the greatestimpact on our notional experience account. The notional experience account yields a fixed return based upon theyield to maturity of the underlying benchmark indices, which are comprised ofU.S. Treasury strips, agencies and investment grade corporate bonds with weightingsof approximately 25%, 15% and 60%, respectively, and have a duration ofapproximately 11 years.

 

*Netrealized capital gains*. During the 2003 period, we recognizedcapital gains of $265 compared to $14,649 in the 2002 period. The capital gainsin the 2003 period were recorded as a result of our normal investmentmanagement operations.  The gainsrecognized in the 2002 period resulted from the transfer of substantially allof our invested assets to our reinsurer.

 

*Marketgain on notional experience account*. We recorded a market gain on our notional experience account balanceof $8,726 in the 2003 period compared to a market gain of $56,745 in the 2002period.  The notional experience accountis susceptible to market interest rate changes.  As a result, our future financial results are subject tosignificant volatility.  During both the2003 and 2002 periods market rates decreased, leading to a market gain on thenotional experience account.

 

*Other income*. We recorded $6,162 in other income duringthe 2003 period, down from $9,523 in the 2002 period. The decrease isattributable primarily to the recognition in the 2002 period of a deferred gainof $2,000 from the 2001 sale of our disability business.  There was also a decrease of approximately$1,000 in the income generated from our ownership of corporate owned lifeinsurance policies.  In addition, netcommission payments earned by our agency subsidiaries were $100 less in the2003 period than in the 2002 period, primarily as a result of the payment of overwritecommissions to newly employed branch managers. Overwrite commissions represent a portion of commission income paid tomanagers for recruiting sales agents that write new policies.

 

*Benefitsto policyholders*.Total benefits to policyholders in the 2003 period decreased 38.47% to$188,803, compared to $306,872 in the 2002 period. Our loss ratio, orpolicyholder 

 

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benefitsto premium revenue, was 77.46% in the 2003 period, compared to 121.9% in the2002 period.

 

Duringthe 2002 quarter we refined our assumptions and processes for developing ourreserves.  This included redefiningcertain “multiple” claims as a single claim and employing new assumptions andprocesses for predicting the continuance, or the likelihood of a claimcontinuing in the future.  This resultedin an increase to claims reserves of approximately $83,000 in the 2002 period.

 

Historically, we have observed variations throughout theyear in the payment or incurrals of new claims.  Management employs seasonal assumptions throughout the year,based upon observed historical trends, in the establishment of its claimreserves so that it can more consistently monitor loss ratio variances from itsexpectations based upon other significant factors such as claims duration andincidence.  We reduced our claimsreserves by $3,278 and $2,594 as of September 30, 2003 and 2002,respectively, to reflect this seasonal variation.

 

*Commissions*. Commissions to agents decreased 13.42% to$31,198 in the 2003 period, compared to $36,034 in the 2002 period.

 

Firstyear commissions on accident and health business in the 2003 period increased2.25% to $2,816, compared to $2,754 in the 2002 period, primarily due to theincrease in first year accident and health premium revenue. The ratio of firstyear accident and health commissions to first year accident and health premiumrevenue was 53.1% in the 2003 period and 57.0% in the 2002 period. The firstyear commission ratio for both the 2003 and 2002 periods is lower than thefirst year commission ratio prior to the cessation of sales in 2001 due to theincreased sale of our Secured Risk, Medicare Supplement and franchise grouppolicies as a percentage of new sales. All of these policies pay a lowercommission as a percentage of premium revenue to agents than our individuallong-term care policies.   We believethat sales of these policies as a percentage of new sales are likely to remainat this level as we recommence sales in many states.  We believe that the sale of long-term care policies has declinedas a percentage of sales as a result of our lower financial ratings with A.M.Best and Standard and Poor’s rating services and continued consumer and agentconcerns regarding our financial strength.

 

Renewalcommissions on accident and health business in the 2003 period decreased 12.40%to $30,014, compared to $34,264 in the 2002 period, due to the decrease inrenewal accident and health premium revenue. The ratio of renewal accident andhealth commissions to renewal accident and health premiums was 12.7% in the2003 period and 14.0% in the 2002 period. We have implemented premium rateincreases on a majority of policies written prior to December 31,2001.  We do not pay commissions on theadditional premium collected as a result of a rate increase, which reduces theratio of renewal commissions to renewal premium revenue.

 

*Net policyacquisition costs amortized*.  The net policy acquisitioncosts amortized in the 2003 period increased to $9,065, compared to $7,854 inthe 2002 period.

 

Deferredcosts are typically all costs that are directly related to, and vary with, theacquisition of new premiums. The deferred costs include the variable portion ofcommissions, which are defined as the first year commissions less ultimaterenewal commissions, and variable general and administrative expenses relatedto policy sales, underwriting and issuance. Deferred costs are amortized overthe life of the policy based on actuarial assumptions, including persistency ofpolicies in-force. In the event a policy lapses prematurely due to death ortermination of coverage, the remaining unamortized portion of the deferredamount is immediately recognized as expense in the current period.

 

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Thenet amortization of deferred policy acquisition costs is affected by newbusiness generation, imputed interest on prior reserves and policy persistency.The amortization of deferred costs is generally offset largely by the deferralof costs associated with new premium generation. However, lower new premiumrevenue throughout 2002 and continuing through the 2003 quarter producedsignificantly less expense deferral to offset amortized costs.

 

*Generaland administrative expenses*. General and administrative expenses in the 2003 period increased26.61% to $44,222, compared to $34,929 in the 2002 period. The ratio of totalgeneral and administrative expenses to premium revenues was 18.14% in the 2003period, compared to 13.87% in the 2002 period.

 

Duringthe 2003 period, we recorded expense of approximately $2,500 related to theinitial recognition of future retirement benefits payable to our formerchairman and severance related expenses for certain managers and employeeswhose positions were eliminated.  Managementestimates that it will recognize future annual savings related to the salariesand benefits related to these positions of approximately $1,500.

 

Duringthe 2003 period, our expenses related to selling new product increasedapproximately $2,150 as compared to the 2002 period due to the marketingexpenses associated with the recommencement of sales in certain keystates.  Salaries and employee benefitsincreased approximately $2,500 in the 2003 period compared to the 2002period.  This increase is due to salaryincreases, increased health insurance premiums, the addition of employees inthe marketing, actuarial and accounting functions, and the accrual of bonusesfor executives and employees.  Legalexpenses increased approximately $1,300 in the 2003 period compared to the 2002period due to expenses associated with the ongoing discovery process and thecompletion of depositions in the National Healthcare Services, Inc. litigationand expenses associated with numerous motions filed and the preliminary discoveryconducted in litigation related to the sale of long-term care policies.

 

Oneof our agency subsidiaries has expanded its regional office structure in orderto increase its ability to sell additional new long-term care policies that weand other companies offer.  As a resultof the staffing and costs associated with starting these offices, we incurredapproximately $1,300 of additional expense in the 2003 period.  We anticipate that these expenses willeventually be offset by additional revenue, and that these offices will beprofitable within the next several quarters.

 

Webelieve that we currently have substantial capacity for premium growth at ourcurrent staff levels, print inventories and other expense categories.  We also believe that our current expenselevels represent the minimum requirements necessary to reengage new salesterritories, design competitive product lines and properly underwrite newpolicy applications.  However, webelieve that if we remain unable to write new business in certain states wherewe have ceased new production, or if we are unable to use our existing staffand infrastructure capacity to generate additional premium revenue, we willneed to decrease production expenses, which could result in decisions to reduceour staff or other operating functions further.

 

*Interestexpense. *Interest expense in the 2003 period increased61.98% to $5,807, compared to $3,585 in the 2002 quarter.  At September 30, 2003, we hadapproximately $95,000 in convertible debt outstanding compared to approximately$76,000 at September 30, 2002.  Inaddition we recorded interest expense of approximately $247 related to thediscount on our debt and $490 related to the preferred interest upon conversionprior to October 15, 2005 of approximately $3,200 of the debt during the2003 period.

 

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***Liquidity and Capital Resources***

 

Ourconsolidated liquidity requirements have historically been met from theoperations of our insurance subsidiaries, from our agency subsidiaries and fromfunds raised in the capital markets. Our primary sources of cash from normaloperations are premiums, investment income and maturities of investments. Wehave obtained, and may in the future obtain, cash through public and private offeringsof our common stock, the exercise of stock options and warrants and othercapital markets activities including the sale or exchange of debtinstruments.  Our primary uses of cashare policy acquisition costs (principally commissions), payments topolicyholders, investment purchases and general and administrative expenses.

 

Inthe 2003 period, our cash flows were attributable to cash provided byoperations, cash used in investing and cash provided by financing. Our cashdecreased $15,518 in the 2003 period primarily due to payments made to ourreinsurer of $41,241 and the purchase of $54,230 in bonds. In the 2003 period,our cash was also decreased as a result of the repayment of approximately$9,000 of convertible subordinated notes due 2003.  Our cash was increased during the period due primarily to $32,421in additional funds generated from the issuance of convertible subordinateddebt. This was supplemented by $35,691 from operations. The major source ofcash from operations was premium received.

 

Inthe 2002 period, our cash flows were attributable to cash provided byoperations, cash used in investing and cash provided by financing.  Our cash decreased $90,897 in the 2002period primarily due to payments made to our reinsurer of $606,693 and from thepurchase of $25,523 in bonds.  Cash wasprovided primarily from the maturity and sale of bonds and the sale of equitysecurities totaling $486,773.  Thesesources of funds were supplemented by $59,165 from operations.  The major source of cash from operations waspremium and investment income received.

 

We invest in securities and other investments authorized by applicablestate laws and regulations and follow an investment policy designed to maximizeyield to the extent consistent with liquidity requirements and preservation ofassets. As of September 30, 2003, shareholders’ equity was increased by$1,029 due to unrealized gains of $1,584 in the investment portfolio. As ofDecember 31, 2002, shareholders’ equity was increased by $1,090 due tounrealized gains of $1,679 in the investment portfolio.

 

*Parent company operations*

 

The parent company is a non-insurer that directly controls 100% of thevoting stock of our insurance subsidiaries. If we are unable to meet ourfinancial obligations, become insolvent or discontinue operations, thefinancial condition and results of operations of our insurance subsidiariescould be materially affected.

 

We have successfully engaged in capital markets activities, includingissuance of both debt and equity securities, over the past two years to fundour liquidity and subsidiary capital needs. These activities have included:

 

1)  In March 2002, wecompleted a private placement of 510 shares of common stock for net proceeds of$2,352. The common stock was sold to several then existing and newinstitutional investors, at $4.65 per share. The offering price was a 10percent discount to the 30-day average price of our common stock prior to theissuance of the new shares.

 

2)  In September 2002, wecommenced an offer of up to $74,750 in aggregate principal amount of 6.25%convertible subordinated notes due 2008 (the “2008 Notes”) in exchange for upto all of our then outstanding 6.25% convertible subordinated notes due

 

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2003 (the “2003 Notes”). Under the terms of the exchange offer, the2008 Notes would have terms similar to the 2003 Notes but mature inOctober 2008 and be convertible into shares of our common stock at aconversion price of $5.31.  We exchangedapproximately $65,793 of the 2003 Notes for 2008 Notes.

 

3)  In December 2002, wecommenced the sale of additional 2008 Notes. During the 2003 period, we completed the sale of 2008 Notes and receivedproceeds of $32,421. We used $16,000 of the proceeds to satisfy the premium tosurplus requirements of our voluntary consent order with the Florida InsuranceDepartment. We used the remaining proceeds to supplement parent liquidity, tocall and pay the entire obligation on our remaining 2003 Notes of $8,957 andfor general working capital purposes.

 

The primary terms of the 2008 Notes are:

 

1.               the 2008 Notes can be converted by theholder into shares of our common stock at $1.75 per share;

2.               the 2008 Notes may not be called by usor forced to convert into shares of our stock prior to October 2005;

3.               after October 2005, the 2008 Noteswill mandatorily convert into shares of our common stock if at any timethereafter the average market price for fifteen trading days of the commonstock exceeds $1.93; and,

4.               holders of the 2008 Notes are entitledto convert their notes into shares of our common stock before October 2005and receive a discounted amount of interest that they would have otherwisereceived until October 2005.  We mayelect to pay this interest in cash or in newly issued shares of commonstock.  If we choose to pay in newlyissued shares of common stock they would be priced at a 10% discount to thethen fair market value of traded shares.

 

In conjunction with the issuance of the new 2008 Notes, we modified theterms of our existing $65,793 of 2008 Notes to make them identical to those ofthe new 2008 Notes.

 

Holders of $3,217 of 2008 Notes elected to convert their notes duringthe nine months ended September 30, 2003 in exchange for 2,051 shares ofcommon stock, including shares issued for the preferred interest on earlyconversion.  Subsequent toSeptember 30, 2003, holders of approximately $3,565 elected to converttheir 2008 Notes in exchange for approximately 2,273 shares of common stock,including shares issued for the preferred interest on early conversion.

** **

Upon the further issuance of new shares ofcommon stock, including, but not limited to conversions of our 2008 Notes, wecould be required under Section 382 of the Internal Revenue Code of 1986, asamended, to defer or reduce certain of our tax attributes (such as credits,losses, etc.) and as a result may owe more in taxes in the future.  Any such deferral or reduction of these taxattributes could result in the recording of a valuation allowance on our net operatingloss carryforwards or could have an adverse impact upon our statutorysurplus.  It is not possible to quantifythe impact of such a deferral or reduction in tax attributes and we are notcertain that any such deferral or reduction will be required.

** **

We engaged a financial advisor to assist us in these capital marketsefforts.  Throughout 2002 and 2003, weprovided shares of common stock to our financial advisor as compensation forits assistance in various capital markets transactions.  The dates, number of shares and compensationexpense recorded as a result of the issuances were:

 
| **Date**          |   | **Shares** |   | **Compensation** |   |
|-------------------|--------|------------|--------|------------------|--------|
|              |   |       |   |             |   |
| April 2002   |   | 60         |   | $                | 325    |   |
| October 2002 |   | 20         |   | 68               |   |
| January 2003 |   | 20         |   | 34               |   |
| May 2003     |   | 100        |   | 173              |   |
|                   |        |            |        |                  |        |  |

 

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At September 30, 2003, our total principal payment and leaseobligations through 2008 were as follows:

 

|   |   | **Debt** |   | **Lease  Obligations** |   | **Total** |   |
|--------|--------|----------|--------|------------------------|--------|-----------|--------|
| 2003   |   | $        | 1,416  |                   | $      | 258       |   | $ | 1,674 |   |
| 2004   |   | —   |   | 252                    |   | 252       |   |
| 2005   |   | —   |   | 18                     |   | 18        |   |
| 2006   |   | —   |   | 18                     |   | 18        |   |
| 2007   |   | —   |   | 18                     |   | 18        |   |
| 2008   |   | 94,997   |   | 18                     |   | 95,015    |   |
| Total  |   | $        | 96,413 |                   | $      | 582       |   | $ | 96,995 |   |

 

Thedebt obligation in 2003 is a $1,416 mortgage obligation of our subsidiary,which was due in October 2003. This payment has been made using available funds at our subsidiary.Other amounts due after 2008 are immaterial.

 

Theparent company’s cash flow needs primarily include interest payments onoutstanding debt and operating expenses. The funding is primarily derived fromthe operating cash flow of our agency subsidiary operations and dividends fromthe insurance subsidiaries. However, the dividend capabilities of the insurancesubsidiaries are limited and we may need to rely upon the dividend capabilitiesof our agency subsidiaries to meet current liquidity needs. Our current cash onhand and these sources of funds are expected to be sufficient to meet ourliquidity needs through at least March 2004, but may be insufficientthereafter. If our available funds are insufficient to meet any interestpayments, we will need to raise additional capital to fully satisfy parentcompany liquidity needs, including interest payments in April andOctober of 2004.  We will also needto raise additional capital to further service our 2008 Notes and provide forother parent company liquidity needs after 2004.

 

AtSeptember 30, 2003, our anticipated cash needs for the remainder of 2003are as follows:

 

| Debt  interest payment                      | $   | 3,000 |
|---------------------------------------------|-----|-------|
| Other parent expenses, net of reimbursement | 200 |
|                                        | $   | 3,200 |

 

Our anticipated sources tomeet our 2003 obligations are:

 

| Cash  and investments on hand | $     | 2,900 |
|-------------------------------|-------|-------|
| Subsidiary  sources           | 1,200 |
|                          | $     | 4,100 |

 

There can be no assurance that we will be able toaccess the capital markets to raise funds necessary to meet our futureobligations or if we are able to do so that it will be on terms favorable oracceptable to us.  If we are unable toaccess capital markets it would have an adverse effect on our operations.  We paid our debt interest payment ofapproximately $3,000 on October 15, 2003.

 

*Subsidiaryoperations*

* *

Ourinsurance subsidiaries are regulated by various state insurance departments.The National Association of Insurance Commissioners (“NAIC”) has Risk-BasedCapital (“RBC”) requirements for insurance companies to evaluate the adequacyof statutory capital and surplus in

 

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relationto investment and insurance risks, such as asset quality, mortality andmorbidity, asset and liability matching, benefit and loss reserve adequacy, andother business factors. The RBC formula is used by state insurance regulatorsas an early warning tool to identify, for the purpose of initiating regulatoryaction, insurance companies that potentially are inadequately capitalized. Inaddition, the formula defines minimum capital standards that an insurer mustmaintain. Regulatory compliance is determined by a ratio of the enterprise’sregulatory Total Adjusted Capital to its Authorized Control Level RBC, asdefined by the NAIC. Companies below specific trigger points or ratios are classifiedwithin certain levels, each of which may require specific corrective actiondepending upon the insurer’s state of domicile.

 

Ourinsurance subsidiaries, PTNA, American Network Insurance Company (“ANIC”), andAmerican Independent Network Insurance Company of New York (“AmericanIndependent”) (representing approximately 94%, 5% and 1% of our direct in-forcepremium, respectively) are required to hold statutory surplus that is above acertain required level. At December 31, 2000, PTNA had Total AdjustedCapital at the Regulatory Action level, which required it to file a Plan withthe Department.

 

OnFebruary 12, 2002, the Department approved the Plan. As a primarycomponent of the Plan, effective December 31, 2001, PTNA and ANIC entereda reinsurance transaction to reinsure, on a quota share basis, substantiallyall of our long-term care insurance policies then in-force. The agreement issubject to certain coverage limitations, including an aggregate limit ofliability that is a function of certain factors and that may be reduced in theevent that the rate increases that the reinsurance agreement may require arenot obtained. We are required to perform annual comparisons of our actual toexpected claims experience. If we have reason to believe, whether from thisanalysis or other available information, that at least a 5% premium rateincrease is necessary, we are obligated to file and obtain such premium rateincreases in order to comply with the requirements of the agreement. If we donot file and obtain such premium rate increases, our aggregate limit ofliability would be reduced by 50% of the premium amount that would haveotherwise been received.

 

Thisagreement does not qualify for reinsurance treatment in accordance with GAAPbecause the agreement does not result in the reasonable possibility that thereinsurer may realize a significant loss. This is due to a number of factorsrelated to the agreement, including experience refund provisions, the expenseand risk charges credited to the notional experience account by the reinsurerand the aggregate limit of liability. However, this agreement meets therequirements to qualify for reinsurance treatment under statutory accountingrules.

 

Theinitial premium paid under the reinsurance agreement was approximately$619,000, comprised of $563,000 in cash and qualified securities transferred inFebruary 2002, and $56,000 in funds held due to the reinsurer. The initialpremium and future cash flows from the reinsured policies, less claimspayments, ceding commissions and risk charges, are credited to a notionalexperience account, which is held for our benefit in the event of commutationand recapture on or after December 31, 2007. The notional experienceaccount balance receives an investment credit based upon the total return froma series of benchmark indices and derivative hedges that are intended to matchthe duration of our reserve liability.

 

Ourcurrent modeling and actuarial projections suggest that we are likely to beable to commute the agreement, as planned, on December 31, 2007. In orderto commute the agreement, our statutory capital following commutation must besufficient to support the reacquired business in compliance with all statutoryrequirements. Upon commutation, we would receive cash or other liquid assetsequaling the market value of our notional experience account from thereinsurer. We would also record the necessary reserves for the business in ourstatutory financial statements. Our ability to commute the agreement is highlydependent upon the market value of the notional experience account exceedingthe level of required reserves to be established. As of

 

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September 30,2003, the statutory basis reserve liabilities of $959,086 exceed thecombination of the notional experience account value and funds held due to thereinsurer of $836,922.  Based upon ourcurrent modeling and actuarial projections, management expects the value of thenotional experience account to exceed the reserve liabilities atDecember 31, 2007.  In addition tothe performance of the reinsured policies from now until 2007, the notionalexperience account value is susceptible to market interest rate changes. Amarket interest rate increase of 100 basis points could reduce the market valueof the current notional experience account by approximately $77,000 andjeopardize our ability to commute as planned. As we approach the intendedcommutation date, the sensitivity of our notional experience account to marketinterest rate movement will decline as the duration of the benchmark indicesbecomes shorter, however the amount of assets susceptible to such interestsensitivity will continue to grow as additional net cash flows are added to theexperience account balance prior to commutation. When we become highlyconfident of our ability to support the reinsured policies, we will notify thereinsurer of our intention to commute the agreement on December 31,2007.  The reinsurer has agreed to fixthe market value of the experience account at that time, and to then invest theassets in a manner that we request in order to minimize short term volatility.

 

Aspart of our reinsurance agreement, effective December 31, 2001, thereinsurer was granted four tranches of warrants to purchase shares ofnon-voting convertible preferred stock. The first three tranches of warrantsare exercisable through December 31, 2007 at common stock equivalentprices ranging from $4.00 to $12.00 per share. If exercised and converted, theconvertible preferred stock would represent approximately 15% of the thenoutstanding shares of our common stock on a fully diluted basis. If theagreement is not commuted on December 31, 2007, the reinsurer may exercisethe fourth tranche of convertible preferred stock purchase warrants at a commonstock equivalent price of $2.00 per share, which if converted would representan additional 20% of the then outstanding common stock on a fully dilutedbasis.  We are recognizing the additionalconsideration of entering into the agreement, represented by the fair value ofthe warrants granted to the reinsurer, over the period of time to the expectedcommutation date.

 

As a result of the Company’s intention to commute, it considered onlythe expense and risk charges anticipated prior to the commutation date in itsunamortized deferred acquisition costs (“DAC”) recoverability analyses and hasnot recorded the potential of future escalating charges.  In the event we determine that commutation of the reinsurance agreementis unlikely on December 31, 2007, but likely at some future date, we willinclude additional annual expense and risk charge credits against our notionalexperience account in our DAC recoverability analysis. As a result, we couldimpair the value of our DAC asset and record the impairment in our financialstatements. However, we currently believe that we will have sufficientstatutory capital and surplus to commute the reinsurance agreement onDecember 31, 2007 or that sufficient alternatives, such as additional capitalissuance or new reinsurance opportunities, are available to enable us tocommute the agreement as planned.

 

Thereinsurance agreement also granted the reinsurer an option to participate inreinsuring new business sales on a quota share basis. In August 2002, thereinsurer exercised its option to reinsure up to 50% of future sales, subjectto a limitation on the reinsurer’s risk. The reinsurer may continue this levelof participation on the next $100,000 in new policy premium issued afterJanuary 1, 2002. The final agreement, which was entered into inDecember 2002, further provides the reinsurer with an option to reinsure aportion of the next $1,000,000 in newly issued long-term care annual insurancepremium, subject to maximum quota share amounts of up to 40% as additionalpolicies are written.

 

Thisagreement does not qualify for reinsurance treatment in accordance with GAAPbecause the agreement does not result in the reasonable possibility that thereinsurer may realize a significant loss. This is due to an aggregate limit ofliability that reduces the likelihood of the

 

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reinsurerrealizing a significant loss on the agreement. However, this agreement meetsthe requirements to qualify for reinsurance treatment under statutoryaccounting rules.

 

InFebruary 2003, the reinsurer notified us that it may, for reasonsunrelated to us, discontinue its quota share reinsurance of new long-term careinsurance policies issued on or after September 1, 2003. Our separateagreement with the reinsurer to reinsure existing policies issued prior toDecember 31, 2001 will be unaffected by any determination made by thereinsurer regarding newly issued policies. To date, the reinsurer has not provided us with official notificationthat it intends to discontinue the agreement, which if received would beeffective for policies issued 120 days after notification.

 

Inaddition to the requirement to enter into the 2001 Centre Agreement, the Plan,among other things:

 

a)                                      Limitsnew investments to those rated by the National Association of InsuranceCommissioners (“NAIC”) as 1 or 2.

b)                                     Limitsand requires Department approval for affiliated transactions.

c)                                      Requires a $125,000 increase in statutoryreserves over a three-year period, of which a $28,000 increase remains to bemade before the end of 2004.

 

EffectiveSeptember 10, 2001, we determined to discontinue the sale nationally ofall new long-term care insurance policies until the Plan was approved by theDepartment. The decision resulted from our concern about further depletion ofstatutory surplus from new sales prior to the completion and approval of thePlan and from increasing concern regarding our status by many states in whichwe are licensed to conduct business. The form of our cessation varied by state,ranging from no action to certificate suspensions.

 

Uponthe Department’s approval of the Plan in February 2002, we recommenced newpolicy sales in 23 states, including Pennsylvania. We have now recommenced newpolicy sales in 13 additional states. These 36 states represented approximately 71% of our premium revenue inthe 2003 period. We are actively working with the remaining states torecommence new policy sales in all jurisdictions. We have recently agreed uponterms for the recommencement of sales in California, which representedapproximately 14% of our premium revenue during the 2003 period.  Recommencement of sales is pending subjectto the completion of certain conditions, which we remain hopeful can besatisfied during the fourth quarter of 2003. We believe new sales in California are likely to recommence in the firstquarter of 2004.

 

InAugust 2002, we recommenced new policy sales in Florida subject to a consentorder which contained, among other factors, a requirement to meet a grosspremium to surplus ratio as required by Florida statute.  In September of 2003 the Florida Departmentof Insurance notified us that, based upon our most recent statutory filings,that we were in marginal violation of the ratio and of the consent order.  However, we have challenged the accuracy ofthe calculation of this ratio and have requested clarification from the FloridaDepartment of Insurance regarding our interpretation.  If our interpretation of the calculation is correct, we are notin violation of the Florida statute or the consent order.  If we are incorrect in our interpretation,we have several alternatives, including the use of currently availableresources at our subsidiary to immediately satisfy the requirement and cure theviolation.  As a result, we do notanticipate any interruption in our ability to sell new policies in Florida.

 

Themajority of our insurance subsidiaries’ cash flow results from our existinglong-term care policies, which have been ceded to the reinsurer under thisagreement. Our subsidiaries’ ability to meet additional liquidity needs andcover fixed expenses in the future is highly dependent upon our ability toissue new policies and to control expense growth. Our future growth and newpolicy issuance is dependent upon our ability to continue to expand ourhistorical markets, retain and expand our network of agents and effectivelymarket our products and fund our marketing and expansion while maintainingminimum statutory levels of capital and surplus required to support suchgrowth.

 

Underthe insurance laws of Pennsylvania and New York, where our insurancesubsidiaries are domiciled, insurance companies can pay ordinary dividends onlyout of earned surplus. In addition, under Pennsylvania and New York law,insurance subsidiaries must give the Department and the New York InsuranceDepartment at least 30 days’ advance notice of any proposed “extraordinarydividend” and cannot pay such a dividend if the Department disapproves thepayment during that 30-day period. For purposes of Pennsylvania law, anextraordinary dividend is a dividend that, together with all other dividendspaid during the preceding twelve months, exceeds the greater of 10% of theinsurance company’s surplus as shown on the company’s last annual statementfiled with Department or its statutory net income as shown on that annualstatement. Statutory earnings are generally lower than earnings reported inaccordance

 

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withgenerally accepted accounting principles due to the immediate or acceleratedrecognition of all costs associated with premium growth and benefit reserves.For purposes of New York law, approval must be obtained for any dividend that,together with all other dividends paid during the preceding twelve months,exceeds the lesser of 10% of the insurance company’s surplus as of thepreceding December 31 or its adjusted net investment income for the yearended the preceding December 31. Additionally, the Plan requires the Department to approve all dividendsmade by PTNA, regardless of normal statutory requirements for allowabledividends. We believe that the Department is unlikely to approve any dividendin the foreseeable future as a result of PTNA’s current statutory surplus position.Although not stipulated in the Plan, this requirement is likely to continueuntil such time as PTNA meets normal statutory allowances, including reportednet income and positive cumulative earned surplus. We do not expect that thiswill occur in the foreseeable future.

 

PTNAand ANIC have not paid any dividends to the parent company for the past threeyears and are unlikely in the foreseeable future to be able to make dividendpayments due to insufficient statutory surplus and anticipated earnings.  However, American Independent is not subjectto the Plan and was permitted by New York statute to make a dividend payment tothe parent company of $651 in 2002.

 

Oursubsidiaries’ debt currently consists primarily of a mortgage note in theamount of $1,416 that was issued by a former subsidiary and assumed by us whenthat subsidiary was sold.** **Wepaid the outstanding balance of the note in October 2003 with availablecash at our subsidiary.

 

***New Accounting Principles***

 

InMay 2003, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards No. 150, “Accounting for Certain FinancialInstruments with Characteristics of Both Liabilities and Equity” (“SFAS No.150”).  SFAS No. 150 specifies thatinstruments within its scope embody obligations of the issuer and that,therefore, the issuer must classify them as liabilities.  SFAS No. 150 represents phase one of theFASB’s broader project on (1) distinguishing between liability and equity instrumentsand (2) accounting for instruments that have characteristics of both types ofinstruments.  SFAS No. 150 covers alimited number of instruments that are to be classified as liabilities and iseffective at the beginning of the first interim period beginning afterJune 15, 2003.  The implementationof certain provisions related to mandatorily redeemable financial instrumentshas been deferred.  The adoption of SFASNo. 150 will not have any impact on our consolidated financial statements.

 

***Forward Looking Statements***

 

Certain statements made byus in this report may be considered forward looking within the meaning of thePrivate Securities Litigation Reform Act of 1995. Although we believe that ourexpectations are based upon reasonable assumptions within the bounds of ourknowledge of our business and operations, there can be no assurance that actualresults of our operations will not differ materially from ourexpectations.  An investment in PTAsecurities includes certain risks, which may be specific to us or to thelong-term care insurance industry. Factors which could cause actual results todiffer from expectations include, among others, our ability to comply with theCorrective Action Plan, the Florida Consent Order, the orders or directives ofother states in which we do business or any special provisions imposed bystates in connection with the resumption of writing new business, our abilityto commute our reinsurance agreement and to recapture our reinsured policiesand accumulated notional experience account balance, whether our CorrectiveAction Plan will be accepted and approved by all states, our ability to meetour

 

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futurerisk-based capital goals, the adverse financial impact of suspending newbusiness sales, our ability to raise adequate capital to meet regulatoryrequirements and to support anticipated growth, our ability to refinance,convert or repay our convertible subordinated notes, the cost associated withrecommencing new business sales, liquidity needs and debt obligations, theadequacy of our loss reserves and the recoverability of our DAC asset, ourability to sell insurance products in certain states, including California, ourability to resume generating new business in all states, our ability to complywith government regulations and the requirements which may be imposed by stateregulators as a result of our capital and surplus levels, the ability of seniorcitizens to purchase our products in light of the increasing costs of healthcare, our ability to defend ourselves against adverse litigation, and ourability to recapture, expand and retain our network of productive independentagents, especially in light of the suspension of new business.

 

**Item 3.**Quantitative and Qualitative DisclosuresAbout Market Risk****(amounts in thousands)

 

Weinvest in securities and other investments authorized by applicable state lawsand regulations and follow an investment policy designed to maximize yield tothe extent consistent with liquidity requirements and preservation of assets. Asignificant portion of assets and liabilities are financial instruments, whichare subject to the market risk of potential losses from adverse changes inmarket rates and prices. Our primary market risk exposures relate to interestrate risk on our notional experience account and fixed rate domesticmedium-term instruments and, to a lesser extent, domestic short-term andlong-term instruments. We have established strategies, asset quality standards,asset allocations and other relevant criteria for our portfolio to manage ourexposure to market risk.  We currentlyhave an interest rate swap on our mortgage, which is used as a hedge to convertthe mortgage to a fixed interest rate. We believe that, since the notional amountof the swap is amortized at the same rate as the underlying mortgage and bothfinancial instruments are with the same bank, no credit risk is carried withthe swap.  The mortgage was paid in fullin October, 2003.

 

Ourfinancial instruments are held for purposes other than trading. Our portfoliodoes not contain any significant concentrations in single issuers (other thanU.S. treasury and agency obligations), industry segments or geographic regions.However, our notional experience account balance, which representssubstantially all of our investable assets at September 30, 2003, is withone reinsurer. Although sufficient assets to support our statutory reserveliabilities are secured by trust accounts and irrevocable letters of creditwith major United States financial institutions, the accumulated profits of ourreinsured business are susceptible to significant credit risk of the reinsurer.

 

Weurge caution in evaluating overall market risk from the information below.Actual results could differ materially because the information was developedusing estimates and assumptions as described below, and because insuranceliabilities and reinsurance receivables are excluded in the hypotheticaleffects (insurance liabilities represent 85.75% of total liabilities).Long-term debt, although not carried at fair value, is included in thehypothetical effect calculation.

 

Thehypothetical effects of changes in market rates or prices on the fair values ofour financial instruments (including our notional experience account balance,as discussed below) as of September 30, 2003, excluding insuranceliabilities and reinsurance receivables on unpaid losses because such insurancerelated assets and liabilities are not carried at fair value, would have beenas follows:

 

Ifinterest rates had increased by 100 basis points at September 30, 2003,there would have been a decrease of approximately $74,500 in the net fair valueof our investment portfolio less our long-term debt and the related swapagreement. A 200 basis point increase in market

 

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rates at September 30,2003 would have resulted in a decrease of approximately $140,900 in the netfair value. If interest rates had decreased by 100 and 200 basis points, therewould have been a net increase of approximately $83,600 and $177,400,respectively, in the net fair value of our total investments and debt.

 

EffectiveDecember 31, 2001, we entered a reinsurance agreement to reinsure, on aquota share basis, substantially all of our long-term care insurance policiesin-force. The transaction resulted in the transfer of approximately $563,000 indebt and equity securities to the reinsurer. The agreement provides us with theopportunity to commute and recapture after December 31, 2007. To that end,the reinsurer will maintain a notional experience account for our benefit onlyin the event of commutation and recapture, which reflects the initial premiumpaid, future premiums collected net of claims, expenses and accumulatedinvestment earnings. The notional experience account balance will receive aninvestment credit based upon the total return of a series of benchmark indicesand hedges that are designed to closely match the duration of reserveliabilities.  The notionalexperience account value is susceptible to market interest rate changes. Amarket interest rate increase of 100 basis points could reduce the market valueof the current notional experience account by approximately $77,000.

 

We hold certain mortgageand asset backed securities as part of our investment portfolio. The fair valueof these instruments may react in a convex or non-linear fashion when subjectedto interest rate increases or decreases. The anticipated cash flows of these instruments may differ from expectationsin changing interest rate environments, resulting in duration drift or avarying nature of predicted time-weighted present values of cash flows. Theresult of unpredicted cash flows from these investments could cause the abovehypothetical estimates to change. However, we believe that the minimal amountwe have invested in these instruments and their broadly defined paymentparameters sufficiently outweigh the cost of computer models necessary toaccurately predict the possible impact on our investment income of hypotheticaleffects of changes in market rates or prices on the fair values of financialinstruments as of September 30, 2003.

 

**Item 4. **Controls andProcedures

 

The Company carried out an evaluation of the effectiveness of itsdisclosure controls and procedures within 90 days prior to the filing date ofthis report. This evaluation was carried out under the supervision and with theparticipation of the Company’s management, including the Company’s Presidentand Chief Executive Officer and the Company’s Executive Vice President and ChiefFinancial Officer. Based upon that evaluation, the Company’s President andChief Executive Officer and the Company’s Executive Vice President and ChiefFinancial Officer concluded that the Company’s disclosure controls andprocedures are effective. There have not been any significant changes in theCompany’s internal controls, or in other factors which could significantlyaffect internal controls subsequent to the date the Company carried out itsevaluation, or any corrective actions with regard to significant deficienciesand material weaknesses.

 

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**PARTII     OTHER INFORMATION**

** **

**Item 1.**LegalProceedings****(amounts in thousands)

 

Our Company and certain of our key executiveofficers are defendants in consolidated actions that were instituted onApril 17, 2001 in the United States District Court for the EasternDistrict of Pennsylvania by our shareholders, on their own behalf and on behalfof a putative class of similarly situated shareholders who purchased shares ofour common stock from July 23, 2000 through and including March 29,2001. The consolidated amended class action complaint seeks damages in anunspecified amount for losses allegedly incurred as a result of misstatementsand omissions allegedly contained in our periodic reports filed with the SEC,certain press releases issued by us, and in other statements made by ourofficials. The alleged misstatements and omissions relate, among other matters,to the statutory capital and surplus position of our largest subsidiary, PennTreaty Network America Insurance Company. On July 1, 2002, the defendantsfiled an answer to the complaint, denying all liability.  Plaintiffs filed a motion for classcertification on August 15, 2002, which is currently pending. OnFebruary 26, 2003, the parties reached an agreement in principle to settlethe litigation for $2,300, to be paid entirely by our directors and officers’liability insurance carrier. The settlement remains subject to documentationand court approval.

 

Our Company and itssubsidiary, PTNA, are defendants in an action in the Fifth Judicial Circuit ofthe State of Florida in and for Marion County, Civil Division.  Plaintiffsfiled this matter on January 10, 2003 in Florida State Court, on behalf ofthemselves and a class of similarly situated Florida long-term carepolicyholders. We removed this case from the Florida State Court to UnitedStates District Court, Middle District of Florida, Ocala Division.  Plaintiffs’ motion to remand the case toFlorida State Court was granted on June 25, 2003. Plaintiffs claimwrongdoing in connection with the sale of long-term care insurance policies tothe Plaintiffs and the class. Plaintiffs allege claims for reformation, breachof fiduciary duty, breach of the implied duty of good faith and fair dealing,negligent misrepresentation, fraudulent misrepresentation, and restitution. Wehave filed motions to dismiss for failure to state a claim, lack of personaljurisdiction against the Company, and to strike certain allegations of thecomplaint as irrelevant and improper.  A hearing on these motions had beenoriginally scheduled for October 9, 2003, and is in the process of beingrescheduled.  While we cannot predictthe outcome of this case, it could have a material adverse impact upon ourfinancial condition and results of operations. However, we believe that thecomplaint is without merit and intend to continue to defend the mattervigorously.

 

Our Company and two ofour subsidiaries, Penn Treaty Network America Insurance Company and SeniorFinancial Consultants Company, are defendants in an action instituted onJune 5, 2002 in the United States District Court for the Eastern Districtof Pennsylvania by National Healthcare Services, Inc. The complaint seekscompensatory damages in excess of $150 and punitive damages in excess of $5,000for an alleged breach of contract and misappropriation.  The claims arise out of a joint venturerelated to the AllRisk Healthcare program, which was marketed first by PennTreaty Network America Insurance Company and then later by Senior FinancialConsultants Company. The parties completed the depositions of fact witnesses onOctober 30, 2003 and we intend to file a motion for summaryjudgment.  The court has set forth a schedule for the filing ofsummary judgment briefs, and has scheduled oral argument on the motions forFebruary 26, 2004.  The defendants have denied theallegations of the complaint and will continue to defend the matter vigorously.

 

Our subsidiaries are parties to various other lawsuits generallyarising in the normal course of their business. We do not believe that theeventual outcome of any of the other suits to which we are a party will have amaterial adverse effect on our financial condition or results of operations. However,the outcome of any single event could have a material impact upon the

 

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quarterly or annual financial results of the period in which it occurs.

 

**Item 2.  **Changes inSecurities

 

Not Applicable

 

**Item 3.  **Defaults UponSenior Securities

** **

Not Applicable

 

**Item 4.  **Submission ofMatters to a Vote of Security Holders

 

Not Applicable

 

**Item 5.  **Other Information

** **

Not Applicable

 

**Item 6.**Exhibitsand Reports on Form 8-K****

** **
| (a)    |                                                                                                                                              | Exhibits |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------|----------|
|   |                                                                                                                                              |     |
| 31.1   | Certification of Chief Executive Officer pursuant to 18 U.S.C.  Section  1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act. |
|   |                                                                                                                                              |     |
| 31.2   | Certification of Chief Financial Officer pursuant to 18 U.S.C.  Section  1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act. |
|   |                                                                                                                                              |     |
| 32.1   | Certification of Chief Executive Officer pursuant to 18 U.S.C.  Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act. |
|   |                                                                                                                                              |     |
| 32.2   | Certification of Chief Financial Officer pursuant to 18 U.S.C.  Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act. |

 

(b)                                 Reportson Form 8-K.

 
| **Date**             |   | **Item No.** |   | **Financial  Statements** |
|----------------------|--------|--------------|--------|---------------------------|
|                 |   |         |   |                      |
| August 11, 2003 |   | 7,  12       |   | No                        |

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|   | PENN TREATY AMERICAN CORPORATION |   |
|--------|----------------------------------|--------|
|   | Registrant                       |   |
|   |                             |
|   |                             |
| Date:  | November 11, 2003           |   | /s/ William W. Hunt |   |
|   | William W. Hunt                  |
|   | President and                    |
|   | Chief Executive Officer          |
|   |                             |
| Date:  | November 11, 2003           |   | /s/ Cameron B. Waite |   |
|   | Cameron B. Waite                 |
|   | Executive Vice President and     |
|   | Chief Financial Officer          |
|        |                                  |        |  |  |  |  |

 

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