Return on average equity (15) .0% (9 .0)% (18 .9)% (26 .8)% .9%
(1) The adjustment as of December 31, 2001 represents an opening retained earnings adjustment on January 1, 2002.
During our quarterly impairment test as of December 31, 2004, we determined that the goodwill related to the agency reporting unit was impaired. This impairment was a result of declining sales, particularly in the fourth quarter of 2004, which led to lower than planned net income at the reporting unit level. The decline in sales is attributable to a decline in sales across the long-term care industry during 2004 as a result of higher priced policies and the negative impact of premium rate increases that have been implemented on previously issued policies. The fair value of the reporting unit is determined utilizing the present value of cash flows, which includes assumptions for future growth in sales. During the most recent impairment test, we lowered the assumptions related to future sales growth and as a result recognized an impairment of $13,376 in 2004.
We have net operating loss carryforwards of $39,876 or $13,957 on a tax effected basis, which have been generated by taxable losses at the parent company, and if unused will expire between 2012 and 2024. We have net operating loss carryforwards of $27,102 or $9,486 on a tax effected basis, which have been generated by taxable losses at our insurance subsidiaries, and if unused, will expire in 2016. The parent company’s net operating loss carryforwards can be utilized by our insurance subsidiaries, subject to a limitation equal to the lesser of 35% of the insurance subsidiary taxable income or 35% of the current aggregate carryforward amount.
(Certain amounts related to 2003 have been restated to reflect the impact of previously unreserved policy riders)
Other income. We recorded $5,864 in other income in 2004, as compared to $9,082 in 2003. The income generated from our ownership of corporate owned life insurance policies decreased to $322 in 2004, as compared to $2,036 in 2003. The cash value of these policies is invested in investment grade corporate bonds and equity indexes. We receive a crediting rate net of insurance costs and fees for maintaining a stable value of the assets, which was reduced significantly during 2004 due to deterioration in the underlying bond and equity investments of the funds supporting the COLI. In addition, the average balance decreased from approximately $59,000 in 2003 to approximately $53,300 in 2004 due to death benefit payments. The average yield on the income generated from the corporate owned life insurance was 0.22% in 2004, compared to 3.10% in 2003. The commission income related to our agency subsidiaries decreased to $4,979 in 2004 compared to $6,947 in 2003. This decrease was a result of lower sales in 2004, primarily related to the sale of long-term care insurance. The long-term care industry experienced a 25% decrease in new policy sales in 2004 compared to 2003.
Commissions to agents decreased 4.13% to $39,115 in 2004, compared to $40,800 in 2003.
During our quarterly impairment test as of December 31, 2004, we determined that the goodwill related to the agency reporting unit was impaired. This impairment was a result of declining sales, particularly in the fourth quarter of 2004, which led to lower than planned net income at the reporting unit level. The decline in sales is attributable to a decline in sales across the long-term care industry during 2004 as a result of higher priced policies and the negative impact of premium rate increases that have been implemented on previously issued policies. The fair value of the reporting unit is determined utilizing the present value of cash flows, which includes assumptions for future growth in sales. During the most recent impairment test, we lowered the assumptions related to future sales growth and as a result recognized an impairment of $13,376 in 2004. There was no impairment recognized in 2003.
Net realized capital gains and trading account activity. During 2003, our capital gains were $237, compared to capital gains of $15,663 in 2002. We accounted for the transfer of the securities portion of the initial premium payment for our 2001 Centre Agreement during 2002 as a sale of these assets. Substantially all of the recognized capital gains in 2002 resulted from the transfer of the initial premium of approximately $563,000 to the reinsurer. The results in 2003 were recorded due to normal investment management activity.
Commissions. Commissions to agents decreased 10.8% to $40,800 in 2003, compared to $45,741 in 2002.
(3) Primarily represents the pay down of funds held due to a reinsurer.
Certain statements made by us in this report may be considered forward looking within the meaning of the Private Securities Litigation Reform Act of 1995. Although we believe that our expectations are based upon reasonable assumptions within the bounds of our knowledge of our business and operations, there can be no assurance that actual results of our operations will not differ materially from our expectations. An investment in our securities includes certain risks, which may be specific to us or to the long-term care insurance industry. Factors which could cause actual results to differ from expectations include, among others, our ability to comply with the Corrective Action Plan, the Florida Consent Order, the orders or directives of other states in which we do business or any special provisions imposed by states in connection with the resumption of writing new business, our ability to commute our reinsurance agreement and to recapture our reinsured policies and accumulated notional experience account balance, whether our Corrective Action Plan will be accepted and approved by all states, our ability to meet our future risk-based capital goals, the adverse financial impact of suspending new business sales, our ability to raise adequate capital to meet regulatory requirements and to support anticipated growth, our ability to refinance, convert or repay our convertible subordinated notes, the cost associated with recommencing new business sales, liquidity needs and debt obligations, the adequacy of our loss reserves and the recoverability of our DAC asset, our ability to sell insurance products in certain states, our ability to enter into a reinsurance agreement for policies sold after July 31, 2004, our ability to resume generating new business in all states, our ability to comply with government regulations and the requirements which may be imposed by state regulators as a result of our capital and surplus levels, the ability of senior citizens to purchase our products in light of the increasing costs of health care, our ability to defend ourselves against adverse litigation, and our ability to recapture, expand and retain our network of productive independent agents, especially in light of the suspension of new business.
Reclassification of gains included in net income (167 ) (237 ) (15,663 )
Deposits to notional experience account due from reinsurer (43,354 ) (58,110 ) (623,027 )
Cash (paid) received during the year for federal income taxes (1,055 )
Policy reserves (accident and health) (508,344 ) (10,256 ) (518,600 ) (464,318 ) (10,163 ) (474,481 )
At December 31, 2003, the Company concluded that its system replacement project would be more expensive and take longer to implement than it had originally intended. As a result of this conclusion and the availability of alternative vendor solutions that had become available since the start of its project, the Company determined to evaluate additional vendors for a portion of its system replacement project, which if selected would not utilize certain components of the programming completed and capitalized in prior periods. As a result of its decision to select another vendor and discontinue the use of a portion of its current software, the Company impaired the capitalized value of the unused software by $522 at December 31, 2003. No impairment losses were recorded in 2004 or 2002.
The Company evaluates its prior year assumptions by reviewing the development of reserves for the prior period (i.e. incurred from prior years). This amount includes imputed interest from prior year-end reserve balances plus adjustments to reflect actual versus estimated claims experience. These adjustments (particularly when calculated as a percentage of the prior year-end reserve balance) provide a relative measure of deviation in actual performance as compared to its initial assumptions. The adjustments to reserves for claims incurred in prior periods are primarily attributable to claims incurred from our long-term care insurance policies, which represent approximately 95% of our premium in-force.
At December 31, 2004 and 2003 our long-term debt consists entirely of convertible subordinated debt issued in 2002, 2003 and 2004, all of which matures in 2008 (the “Notes”).
During 2004 and 2003 the activity in long-term debt was as follows:
The valuation allowances were recorded as a result of potential future limitations on their use due to Internal Revenue Code Section 382. The Internal Revenue Service has established rules that potentially limit a company’s use of prior period net operating loss carryforwards in the event that a majority of the company’s common stock ownership changes within any consecutive three year period. Due to the issuance of additional shares of the Company’s common stock since May 2001 and conversions of the Company’s subordinated convertible notes during 2003 and the first quarter of 2004, the Company became subject to these limitations and has established the valuation allowance at December 31, 2003 accordingly. There was no change to the valuation allowance in 2004.
A 6.0% weighted average discount rate was assumed in determining both the benefit obligation at December 31, 2004 and 2003 and to determine the net periodic benefit cost for the years ended December 31, 2004 and 2003.
As a result of the Company’s intention to commute, it considered only the expense and risk charges anticipated prior to the commutation date in its most recent DAC recoverability analyses and has not recorded the potential of future escalating charges in its current DAC recoverability analysis. In addition, the Company is recognizing the additional consideration of entering into the agreement, represented by the fair value of the warrants granted to the reinsurer, over the period of time to the expected commutation date.