We own six office buildings in Lancaster, South Carolina, where most of our operations are located. We also own an office building in Fort Mill, South Carolina. Our owned properties had an aggregate book value of approximately $7.1 million as of December 31, 2006. We also lease our principal executive offices in Minnetonka, Minnesota, a suburb of Minneapolis, where some members of our executive management team, some holding company and underwriting operations and a regional sales office are located. We lease offices in Greenville, South Carolina, where a processing center of our third-party administration business is located. We lease facilities in 16 other locations throughout the United States that house regional and field offices of our sales organization.
Selected historical consolidated financial and other data as of and for the year ended December 31, 2005 and 2006 for KMG America. The historical consolidated financial data as of December 31, 2005 and 2006, for KMG America have been derived from, and should be read together with, KMG America’s audited consolidated balance sheet and the related notes included in this report.
the businesses of our predecessor are intended to be only a portion of our business in the future and are not entirely representative of the principal business strategy we plan to pursue; and
our acquisition of Kanawha was subject to GAAP purchase accounting, which caused us to adjust the recorded amounts of our predecessor’s assets and liabilities to fair value following the acquisition; and
The financial data set forth below should be read in conjunction with, and is qualified in its entirety by reference to “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and our predecessor’s and our audited financial statements and the related notes included in this report.
Income per share before cumulative effects of changes in accounting principle
For GAAP accounting purposes, Kanawha is treated as KMG America’s predecessor entity and is referred to herein as our “predecessor.” For financial reporting purposes, we have treated the acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material. Accordingly, in the following discussion any financial information as of any date prior to, or for any period ending on or prior to, December 31, 2004, is reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition, and any financial information as of any date on or after, or for any period ending after, December 31, 2004, reflects GAAP purchase accounting adjustments made as of December 31, 2004, reflecting the acquisition.
In addition, we have retained our predecessor’s closed block of life and health insurance business reported in the acquired business segment and the investment and marketing activities reported in the corporate and other segment. While acquisitions of books of business from other insurance carriers is not one of our principal growth strategies, we will consider making acquisitions on an opportunistic basis if we can complete the acquisitions on favorable financial terms that we expect to be generally accretive to earnings per share and return on equity while maintaining our financial strength ratings.
The volatility in the equity markets over the past few years has posed a number of problems for some participants in the life and health insurance industry. Even though the capital markets have recovered, not all companies have participated evenly in the recovery. We and our predecessor have historically had minimal equity exposure (less than 1% of total invested assets as of December 31, 2006) and we plan to continue to manage equity asset allocations conservatively in the future.
Many of the events and trends affecting the life and health insurance industry have had an equal (or greater) impact on the life and health reinsurance industry. These events led to a decline in the availability of reinsurance. While we currently cede a limited amount of our primary insurance business to reinsurers, and we plan to continue this practice, diminishing reinsurance capacity has negatively impacted our predecessor in the past and may further negatively impact our operations in the future. If we cannot obtain affordable reinsurance coverage, either our net exposures will increase or we will have to reduce our underwriting commitments.
There is a trend of consolidation of insurance carriers, product lines and services in the insurance marketplace, which increases the likelihood that insureds or their employers will elect not to renew existing policies with their existing carrier and will purchase new policies with another carrier. This trend benefits new entrants to the insurance markets, such as KMG America, by increasing the opportunities to place new policies. Consolidation in the insurance market also reduces the number of products and service choices, which creates opportunities for insurance companies to grow by creating new and specialized insurance products to fill niches.
Revenues. We derive our revenues primarily from the sale of our insurance policies and, to a lesser extent, fee income from administrative services and commissions on the placement of third-party insurance products. Sales of insurance policies are recognized in revenue when earned as insurance premiums, while sales of administrative services and commission income are recognized as fee income on our consolidated statements of operations when earned.
Our premium, fee and commission income is supplemented by income earned from our investment portfolio. We recognize revenue from interest payments, dividends and sales of investments when earned. Our investment portfolio is currently primarily invested in fixed maturity securities. Both investment income and realized capital gains on these investments can be significantly impacted by changes in interest rates.
The fair market value of the fixed maturity securities in our portfolio and the investment income from these securities fluctuate depending on general economic and market conditions. The fair market value generally increases or decreases in an inverse relationship with fluctuations in interest rates, while net investment income realized by us from future investments in fixed maturity securities will generally increase or decrease with interest rates. In addition, actual net investment income and/or cash flows from investments that carry prepayment risk, such as mortgage-backed and other asset-backed securities, may differ from those anticipated at the time of investment as a result of interest rate fluctuations. In periods of declining interest rates, mortgage prepayments generally increase and mortgage-backed securities, mortgage loan obligations and bonds in our investment portfolio are more likely to be prepaid or redeemed as borrowers seek to borrow at lower interest rates, and we may be required to reinvest funds in lower interest-bearing investments.
Reserves. Policy benefit reserves and other claim reserves are established according to generally accepted actuarial principles and are based on a number of factors. These factors include historical claim payments experience
inherent claims volatility in a new book of business, such as our employer excess risk insurance; and
Many of these items are not directly quantifiable, particularly on a prospective basis. Reserve estimates are refined as experience develops. Adjustments to reserves, both positive and negative, are reflected in the consolidated statements of operations of the period in which such estimates are updated. Because establishment of reserves is an inherently uncertain process involving estimates of future losses, there can be no certainty that ultimate losses will not exceed existing reserves. Future loss development could require reserves to be increased, which could have a material adverse effect on earnings in the periods in which such increases are made.
Reserving Methodology. Policy benefit reserves for life insurance, long-term care insurance, individual and group accident and health insurance, disability insurance and group life and health insurance are recorded at the present value of future benefits to be paid to policyholders less the present value of the future net premiums (this method is called the “net level premium method”). These amounts are estimated and include assumptions made when the policy is issued as to the expected investment yield, inflation, mortality, morbidity, claim termination rates, awards for social security and withdrawal rates, as well as other assumptions that are based on our experience. These assumptions reflect anticipated trends and include provisions for possible unfavorable deviations. Throughout the life of the policy, reserves are based on these original assumptions and cannot be modified pursuant to GAAP unless policy reserves prove inadequate. We also record an unearned premium reserve which represents the portion of premiums collected or due and unpaid which is intended to pay for insurance coverage in a period after the current accounting period.
Reserve interest assumptions (i.e., discount rates) used by us in establishing our current policy benefit reserves were modified on the purchase date. The valuation interest rate is determined by taking into consideration actual and expected earned rates on our asset portfolio. Benefit reserves for limited payment policies take into account, where necessary, any deferred profits to be recognized in income over the policy term. Policy benefit claims are charged to expense in the period that the claims are incurred.
We eliminated all of our predecessor’s historical VOBA upon the closing of the Kanawha acquisition as part of our application of GAAP purchase accounting requirements. We simultaneously re-established VOBA for the value of our predecessor’s in force business. VOBA interest rate assumptions to amortize the VOBA were also reset upon the closing of the Kanawha acquisition and the rate was approximately 6.0% on both December 31, 2005 and December 31, 2006.
Investments. We regularly monitor our investment portfolio to ensure that investments that may be other than temporarily impaired are identified in a timely fashion and properly valued and that any impairment is charged against earnings in the proper period. Our investment portfolio is managed by an external asset management firm, with the exception of certain invested assets that are managed internally. Our methodology used to identify potential impairments requires judgment by us in conjunction with our investment managers.
Reinsurance. As part of our overall risk and capacity management strategy, we purchase reinsurance for loss protection to manage individual and aggregate risk exposure and concentration, to free up capital to allow us to write additional business and, in some cases, effect business dispositions. We utilize ceded reinsurance for those product lines where there is exposure on a per risk basis or in the aggregate which exceeds our internal risk retention and concentration management guidelines.
Under indemnity reinsurance transactions in which we are the ceding insurer, we remain liable for policy claims if the assuming company fails to meet its obligations. In the event one or more assuming companies were to default on its obligations, it could have an adverse effect on our business, results of operations and financial condition. To limit this risk, we have implemented procedures to evaluate the financial condition of reinsurers and to monitor the concentration of credit risk to minimize this exposure. In some cases, the reinsurers have placed amounts in trust that would be the equivalent of the recoverable amount and for which we are the beneficiary. The selection of reinsurance companies is based on criteria related to solvency and reliability and, to a lesser degree, diversification. An estimated allowance for doubtful accounts is recorded on the basis of periodic evaluations of balances due from reinsurers, reinsurer solvency, management experience and current economic conditions. As of December 31, 2006, 2005 and 2004, there were no allowances for doubtful accounts.
Historical consolidated financial information for the year ended December 31, 2004 for our predecessor.
Historical consolidated financial information for the period from January 21, 2004 (KMG America’s date of inception), to December 31, 2004 and for the years ended December 31, 2005 and 2006, for KMG America.
For financial reporting purposes, we have treated the Kanawha acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material. Accordingly, in the following discussion any financial information as of any date prior to, or for any period ending on or prior to, December 31, 2004, is reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition, and any financial information as of any date on or after, or for any period ending after, December 31, 2004, reflects GAAP purchase accounting adjustments made as of December 31, 2004, reflecting the acquisition.
The benefits to premiums ratio is equal to policyholder benefits divided by insurance premiums.
Worksite insurance business. The worksite insurance business provides life and health insurance products to employers and their employees. This business segment includes worksite business as well as individual insurance business sold directly to the end consumer and not considered part of the senior market business. The primary insurance products sold by this business include life, short-term disability, long-term disability, dental, indemnity health, employer excess risk and critical illness. The earnings reported in any period for our worksite insurance business generally depends on growth in underwritten business, business mix, persistency of business in force, benefit payouts and administrative expenses incurred. Revenues are generated primarily from new and renewal premiums. The worksite insurance business also includes business sold through our career agency distribution channel, which is a group of agents and managers that are our employees that sell life and health insurance products directly to individuals and small businesses.
Senior market insurance business. Throughout the reporting period, the senior market insurance business provided individual insurance products, primarily long-term care insurance, tailored to the needs of older
Third-party administration business. The third-party administration business provides administrative services to both the worksite insurance business and the senior insurance market business, as well as to third parties such as employers with self-funded insured health plans, other insurance carriers who do not administer the plans they offer, reinsurers and managed care plans. Fees paid by our insurance operations to our third-party administrative services subsidiary are eliminated in our consolidated financial statements. Fees received from third parties for these services are recorded as commissions and fee income in our consolidated statements of operations. Costs associated with the operation of this business primarily reflect general overhead expenses and related information technology costs that are reflected in our consolidated statements of operations as general insurance expenses.
The following list includes definitions of insurance terms used in the discussion of our consolidated results of operations. Terms are listed in alphabetical order.
Benefits and expenses: Benefits and expenses consist primarily of policyholder benefits, insurance commissions, general insurance expenses, insurance taxes, licenses and fees, depreciation and amortization and the amortization of DAC and VOBA.
Benefits to premiums ratio: Benefits to premiums ratio equals policyholder benefits divided by net premiums. In general, an increase in the ratio indicates a decrease in underwriting margins of the relevant business segment. Conversely, a decrease in the ratio generally indicates an increase in underwriting margins for the relevant business segment. Our management believes that this ratio is more meaningful in evaluating the changes in underwriting margins on our products from period to period than comparing absolute dollar changes in premiums and reserves because growth in net premiums produces corresponding increases in reserves.
General insurance expenses: General insurance expenses include primarily selling, general and administrative expenses incurred by corporate headquarters personnel in conducting operations including marketing, policy set-up, administration, adjudication and customer service.
Insurance commissions: Insurance commissions represent renewal commissions on products after the first anniversary date as well as first year commissions that are not deferred.
The following discussion reflects our and our predecessor’s results for the years ended December 31, 2006, 2005, and 2004.
Concurrently with the completion of our initial public offering, we completed the acquisition of Kanawha and its subsidiaries. For financial reporting purposes, we have treated the acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material.
During the quarter ended June 30, 2006, the Company implemented the use of seriatim PGAAP reserve factors. While the implementation of seriatim PGAAP factors did not change total reserves of the Company, it did result in a reallocation of reserves among the worksite insurance, senior market insurance and acquired business segments. This reallocation has been reflected in the current results of the affected segments.
(2)Aggregate total assets for our predecessor as of December 31, 2004, is not reported because our predecessor had been acquired by KMG America at that date and our predecessor’s assets had been consolidated into the KMG America balance sheet at that date.
Financial Results Overview. Net income for the year ended December 31, 2006, increased $ 2.5 million, or 53.2%, to $ 7.2 million from net income of $ 4.7 million in 2005.The increase in net income was primarily due to increases in premiums, net investment income, and net realized gains, offset by increases in policyholder benefits and general expenses, all of which are described in greater detail below.
Worksite net new premiums increased $22.1 million, or 133.9%, to $38.6 million for the year ended December 31, 2006, from $16.5 million for the year ended December 31, 2005, due to increased sales volumes generated by the new KMG America sales force. There were direct new premiums of $44.7 million, offset by $8.8 million of ceded new premiums. In addition, there was $2.7 million of new reinsurance assumed premium for the block acquisition of voluntary term life insurance and universal life insurance policies from Columbian Life Insurance Company and Columbian Mutual Life Insurance Company.
Effective September 1, 2006, KMG America’s subsidiaries Kanawha and Kanawha HealthCare Solutions entered into a reinsurance and administrative arrangement with Columbian Life Insurance Company (“CLIC”) and Columbian Mutual Life Insurance Company (“CMLIC”). CLIC and CMLIC are affiliates of each other. Under the arrangement, Kanawha reinsures 100% of the risk of a block of voluntary term life insurance policies and universal life insurance policies from CLIC and CMLIC. Kanawha HealthCare Solutions, Inc. will assume responsibility for the administration of these policies. As part of the transaction, CLIC and CMLIC also assigned key trademarks to Kanawha for these insurance policies and their marketing brand, “UNIQ Benefit Solutions”.
The average yield on cash and invested assets on an amortized cost basis was 5.06 % for the year ended December 31, 2006, compared to an average yield of 4.78 % for the year ended December 31, 2005. This increase resulted from higher interest rates combined with the significantly lesser amount of assets held in cash during 2006.
Net investment income is allocated to our various business segments on a pro rata basis based on the invested assets attributed to the business segment. Assets attributed to the senior market insurance segment continue to increase as a result of policy reserve increases in this segment, while assets attributed to the acquired segment continue to decline as this business lapses. In addition, the reallocation of reserves has a corresponding reallocation of attributed assets between business segments. This balance sheet impact is further discussed in Note 16 Business Segments,” of the “Notes to Consolidated Financial Statements” included in this report, which is incorporated herein by reference.
Realized Investment Gains and Losses. Realized investment gains and losses occur as a result of the sale or impairment of investments. The net realized investment gain in the year ended December 31, 2006 increased by $0.8 million to $1.2 million from $0.4 million in the year ended December 31, 2005. The net loss realized on fixed maturity securities in the year ended December 31, 2006, totaled $0.6 million compared to a net gain realized on fixed maturity securities of $0.1 million in the year ended December 31, 2005. The capital losses recognized in 2006 resulted from the sale of assets as is necessary from time to time in order to keep the portfolio properly structured. Offsetting these capital losses in 2006 were capital gains of $0.6 million which were recognized due to marking to market investments held in the Company’s trading account. These investments represent the assets purchased to support the deferred compensation liability of the Company, and realized gains and/ or losses are directly offset with increases and /or decreases in compensation expenses. Also, there was recognition of $1.3 million of additional capital gains in 2006 as the result of the sale of our investment in a limited liability company owned by a subsidiary of Kanawha Insurance Company. Realized investment gains and losses are allocated entirely to the corporate and other business segment.
Other Income. Other income increased $0.6 million, or 15.4%, to $4.5 million in the year ended December 31, 2006, from $3.9 million in the year ended December 31, 2005, reflecting increased commission and expense allowances from reinsurance companies generated from an increase in renewal ceded premiums. Also, there was $0.2 million of other income from the new reinsurance assumed universal life policies’ premium loads and fees for the block acquisition from Columbian Life Insurance Company and Columbian Mutual Life Insurance Company.
Policyholder Benefits. Policyholder benefits increased $15.5 million, or 18.4 %, to $99.8 million in the year ended December 31, 2006, from $84.3 million in the year ended December 31, 2005. This produced a benefits to premium ratio of 78.0 % in 2006 compared to 78.9 % in 2005. The primary drivers behind the benefits to premium ratio change by segment is discussed in the next three paragraphs.
Senior market policyholder benefits increased $33.3 million, or 94.1%, to $68.7 million for the year ended December 31, 2006, from $35.4 million for the year ended December 31, 2005. This produced a benefits to premium ratios of 165.7% for the year ended December 31, 2006, compared to 83.7% for the year ended December 31, 2005. The 2006 ratio is impacted by the $37.5 million conversion adjustment to PGAAP seriatim reserve factors from the aggregate method which was completed as of June 30, 2006, and resulted in increased benefits. The 2006 benefits to premium ratio excluding the reserve conversion impact would be 75.3%.
Insurance Commissions. Commission expenses increased $3.1 million, or 32.3%, to $12.7 million in the year ended December 31, 2006, from $9.6 million in the year ended December 31, 2005. The increase consists of normal increases related to increased renewal premiums, in addition to an increase in first year commissions that were not deferred, a large portion of which relates to the increased sales of excess risk products.
Provision for Income Taxes. Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% due to tax-advantaged investments and net operating loss carry forwards available. The effective income tax rates for the years ended December 31, 2006, and 2005 were 34.8 % and 32.2 % respectively. The variations in these rates are due to the fact that a portion of our consolidated income for the years ended December 31, 2006 and December 31, 2005 resulted from a subsidiary that has net operating loss carry forwards available. Due to the uncertainty of using these net operating losses, a valuation allowance had been established offsetting the deferred tax asset; therefore, the tax on the net income from this subsidiary has been offset by the release of the associated valuation allowance, which reduces the effective tax rate for the consolidated company. The variation in the overall consolidated rate between periods is driven by the level of the subsidiary’s contribution to total income.
Year Ended December 31, 2005, Compared to Year Ended December 31, 2004
Financial Results Overview. Net income for the year ended December 31, 2005, decreased $1.5 million, or 24.2%, to $4.7 million from net income of $6.2 million in 2004. The decrease in net income was primarily due to decreases in revenues as the result of decreases in net realized gains offset by increases in premiums. In addition there were increases in expenses offset by decreases in policyholder benefits, all of which are described in greater detail below.
Revenues. Total revenues for the year ended December 31, 2005, decreased $0.7 million, or 0.5%, to $153.4 million from total revenues of $154.1 million in 2004. The primary factors causing the fluctuations are explained below under the captions “Premiums,” “Net Investment Income” “Commission and Fee Income” “Realized Investment Gains and Losses” and “Other Income”.
Senior market net new premiums decreased $0.8 million, or 50.0%, to $0.8 million for the year ended December 31, 2005, from $1.6 million for the year ended December 31, 2004, due to a decrease in new sales. New
selling certain fixed maturity securities to recognize gains. Realized gains on fixed maturity securities in 2005 and 2004 were negatively impacted by impairment charges of $0.2 million and $0.5 million, respectively. The net gain realized on equity securities in the year ended December 31, 2005, totaled $0.0 million compared to a net gain realized on equity securities of $2.4 million for the year ended December 31, 2004. The 2004 gains on equity securities were due to our predecessor’s investment committee’s election to take advantage of favorable market conditions by selling certain common stocks to recognize gains on these sales. Realized gains on equity securities in 2005 and 2004 were negatively impacted by impairment charges of $0.0 million and $0.2 million, respectively. The net gain realized on other investments in the year ended December 31, 2005, totaled $0.2 million compared to a net gain realized on other investments of $0.4 million for the year ended December 31, 2004. Other investments represent the assets purchased to support the deferred compensation liability of the company, and realized gains and or losses are directly offset with increases and or decreases in compensation expenses. Realized investment gains and losses are allocated entirely to the corporate and other business segment.
Other Income. Other income increased $0.8 million, or 25.8%, to $3.9 million in the year ended December 31, 2005, from $3.1million in the year ended December 31, 2004. In 2005, other income includes $0.3 million of proceeds from litigation settlements, resulting from our participation in various class action litigation matters. The remaining increases reflect increased commission and expense allowances from reinsurance companies generated from an increase in renewal ceded premiums.
Acquired business policyholder benefits decreased $4.7 million, or 46.5%, to $5.4 million for the year ended December 31, 2005, from $10.1 million for the year ended December 31, 2004. This produced benefits to premium ratios of 130.5% for the year ended December 31, 2005, compared to 225.1% for the year ended December 31, 2004. These benefits to premium ratios are affected by large portions of the acquired business that are no longer premium paying with substantial reserves and investment income on reserves. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the near future. The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves.
Insurance Commissions. Commission expenses decreased $0.1 million, or 1.0 %, to $9.6 million in the year ended December 31, 2005, from $9.7 million in the year ended December 31, 2004. This change resulted from normal fluctuations related to renewal premiums.
General Insurance Expenses. General insurance expenses increased $14.1million, or 50.7%, to $41.9 million in the year ended December 31, 2005, from $27.8 million in the year ended December 31, 2004. General insurance expenses for 2005 include approximately $13.3 million of incremental costs associated with our continuing expansion to a national insurance company, including the addition of management and marketing personnel, occupancy costs, infrastructure development, back-office expenses, director and officer and related types of insurance coverage, and costs associated with being a public company. Overhead expenses that are not directly associated with a particular business segment are allocated to the various business segments on a pro rata basis based on different factors, such as headcount, policy count, number of policies issued, premiums and other relevant factors. During 2005, we incurred $0.7 million in defense costs related to the ReliaStar litigation and shut down costs of $0.3 million associated with the sale of our Ft. Myers based senior market insurance agency office. We also incurred deferred compensation expenses of $0.2 million associated with the increase in market value of the deferred compensation plan assets. The deferred compensation expenses are directly offset with realized investment gains of the same amount.
Insurance Taxes, Licenses and Fees. Insurance taxes, licenses and fees were unchanged at $4.7 million in the years ended December 31, 2005 and 2004. Premium income, which drives premium taxes, was relatively flat between 2005 and 2004.
Our predecessor assigned a value to the insurance in force of acquired companies or blocks of insurance business at the date of acquisition. No companies or blocks of business were acquired in 2005 or 2004.
The following table provides the cumulative net unrealized gains (pre-tax) on the Company’s fixed maturity securities and equity securities as of the dates indicated.
Net unrealized losses on fixed maturity securities were $10.9 million as of December 31, 2006 and $7.7 million as of December 31, 2005.
Effective December 31, 2004, our investments were recorded at fair value, thereby eliminating all unrealized gains and losses, as part of the application of GAAP purchase accounting requirements. As a result, the mark to market adjustments to the investment portfolio occurred at a time when very low market interest rates prevailed. Therefore, as interest rates rise, we would expect substantial unrealized investment losses. Due to the long range nature of our liabilities, the majority of these interest related unrealized losses are not expected to materialize into realized losses, and therefore should not have an adverse effect on our operations.
Loss Impairment. All fixed maturity securities are classified as available-for-sale and marked to market through other comprehensive income. All securities with gross unrealized losses at the consolidated balance sheet date are subjected to our process for identifying other-than-temporary impairments. Securities deemed to be other-than-temporarily impaired are written down to fair value in the period the securities are deemed to be so impaired. The assessment of whether such impairment has occurred is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value. Management considers a wide range of factors, as described below, about the issuer of the security and uses its best judgment in evaluating the cause of the decline in
the estimated fair value of the security and in assessing its prospects for near term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential.
Considerations used by management in the impairment evaluation process include, but are not limited to, the following:
other subjective factors, including information obtained from regulators and rating agencies.
The review of fixed maturity securities for impairments includes an analysis of the total gross unrealized losses for three categories of securities: (1) securities where the estimated fair value had declined and remained below amortized cost by less than 20%; (2) securities where the estimated fair value had declined and remained below amortized cost by 20% or more for less than six months; and (3) securities where the estimated value had declined and remained below amortized cost by 20% or more for six months or greater. Securities in the first two categories have generally been adversely impacted by the downturn in the financial markets, overall economic conditions and certain industry trends. The first category generally includes securities that have declined in value as a result of fluctuations in interest rates, rather than due to difficulties experienced by the issuer of the securities. While all of these securities are monitored for potential impairment, our experience indicates that securities in the first two categories do not present as great a risk of impairment and securities in these categories often recover their fair value over time as the factors that caused the declines improve. In addition, the Company has the intent and ability to hold these securities until they recover in value.
Writedowns are recorded as investment losses and the cost bases of the securities are adjusted accordingly. The revised cost basis is not changed for subsequent recoveries in value. Writedowns of fixed maturities were $0.0 million and $0.2 million for the years ended December 31, 2006 and 2005, respectively. The writedowns in 2005 reflected other than temporary impairments on Delta Airlines and Triton Aviation fixed income securities. Both of these securities were impacted by the negative conditions affecting the airline industry generally.
The following table presents insurance policy benefit and contract-related liabilities information as of the dates indicated, by reserve type:
Life and annuity reserves decreased by $46.8 million, or 15.6%, to $252.7 million as of December 31, 2006, from $299.5 million as of December 31, 2005. A large portion of the life and annuity reserves relates to acquired blocks of business that are lapsing at a steady pace because no new blocks of business have been acquired since 1999, and therefore represents a significant portion of the decrease in reserves for the year ended December 31, 2006 as well as the conversion to PGAAP seriatim reserves ( Refer to Note 16 - Business Segments, of the Notes to Consolidated Financial Statements included in this report, which is incorporated herein by reference for further explanation). Accident and health reserves increased by $66.9 million or 29.4%, to $294.6 million as of December 31, 2006, from $227.7 million as of December 31, 2005. These reserve increases are consistent with
Policy and contract claims, which represent liabilities for actual claims reported and payable, increased by $4.5 million, or 45.2%, to $14.5 million as of December 31, 2006, from $10.0 million as of December 31, 2005. The majority of the increase represents claim reserves established for the new excess risk business sold in 2005 and early 2006. Although there are always fluctuations in policy and contract claim reserves from period to period, we are not aware of other significant events or trends for the periods discussed in this paragraph that would produce any material changes in our claim reserves.
Reinsurance recoverables represent the portion of the policy and contract liabilities that are covered by reinsurance. These liabilities include reserves for life, annuity, accident and health, policy and contract claims and other policyholder liabilities as shown in the consolidated balance sheets. The cost of reinsurance is accounted for over the terms of the underlying reinsured policies using assumptions consistent with those used to account for the policies reinsured. Amounts recoverable from reinsurers are estimated in a manner consistent with the methods used to determine the underlying liabilities reported in the consolidated balance sheets.
monitor the concentration of credit risk to minimize this exposure. In some cases, the reinsurers have placed amounts in trust that would be the equivalent of the recoverable amount and for which we are the beneficiary. The selection of reinsurance companies is based on criteria related to solvency and reliability and, to a lesser degree, diversification. An estimated allowance for doubtful accounts is recorded on the basis of periodic evaluations of balances due from reinsurers, reinsurer solvency, management experience and current economic conditions. As of December 31, 2006 and 2005, there was no allowance for doubtful accounts.
The following table sets forth our individual reinsurance recoverables exposure to specific reinsurers and their corresponding A.M. Best financial strength rating as of December 31, 2006:
KMG America is a holding company and had minimal operations of its own prior to the completion of its initial public offering and the Kanawha acquisition. KMG America’s assets consist primarily of the capital stock of Kanawha and its non-insurance subsidiary. Accordingly, KMG America’s cash flows depend upon the availability of dividends and other statutorily permissible payments, such as payments under tax allocation agreements and under management agreements, from Kanawha. Kanawha’s ability to pay dividends and to make other payments is limited primarily by applicable laws and regulations of South Carolina, the state in which Kanawha is domiciled, which subjects insurance operations to significant regulatory restrictions. These laws and regulations require, among other things, that Kanawha, KMG America’s insurance subsidiary, maintain minimum solvency requirements and limit the amount of dividends it can pay to the holding company. Solvency regulations, capital requirements, types of insurance offered and rating agency status are some of the factors used in determining the amount of capital available for dividends. In general, South Carolina will permit annual dividends from insurance operations equal to the greater of (1) the most recent calendar year’s statutory net income or (2) 10% of total capital and surplus of the insurance operations at the end of the previous calendar year, provided that the dividend payment does not exceed earned surplus, in which case further limitations apply.
For 2007, the maximum amount of dividends that Kanawha can pay to KMG America under applicable laws and regulations without prior regulatory approval is $7.2 million. If KMG America is able to successfully execute its business plan and accelerate Kanawha’s earnings growth in its insurance operations, KMG America expects that the maximum allowable dividend from Kanawha to the holding company will increase at an accelerated rate year-over-year. If the ability of Kanawha to pay dividends or make other payments to KMG America is materially restricted by regulatory requirements, it could adversely affect KMG America’s ability to pay any dividends on its common stock and/or service its debt and pay its other corporate expenses.
On February 18, 2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company and ReliaStar Life Insurance Company of New York ("ReliaStar"), both indirect wholly-owned subsidiaries of ING America U.S., in the Fourth Judicial District Court in Hennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and Thomas J. Gibb. Messrs. Kuk, Kraemer, Moore and Gibb are officers of KMG America and former employees of the plaintiffs. We believe the plaintiffs' allegations are without merit and intend to defend the action vigorously. While the outcome of legal actions cannot be predicted with certainty, management believes the outcome of this matter will not have a material adverse effect on our consolidated financial position or results of operations. We have been advised by the insurance carrier for its primary directors and officers insurance policy that the insurance carrier will, subject to the terms, conditions and limitations of the insurance policy, reimburse us for a significant portion of future defense costs and potential damages, losses and liabilities resulting from this litigation. We also have received partial reimbursement under the insurance policy for defense costs incurred to date. As a result, we expect that the ongoing defense cost reimbursements and reimbursements of any damages, losses or liabilities under the directors and officers insurance policy should reduce the risk that future defense costs and any damages, losses or liabilities may have a material adverse effect on the Company’s future consolidated financial position or results of operations. For a discussion of the litigation involving ReliaStar, see the fourth paragraph of "Note 13 Commitments and Contingencies" of the "Notes to Consolidated Financial Statements" included in this report, which is incorporated hereby by reference.
Notes payable including interest decreased $1.7 million as the Company entered into a credit agreement with Wachovia on December 21, 2006 which provides a $15.0 million unsecured revolving credit facility from which we borrowed $14.0 million to repay the previous five year subordinated promissory note at a discount. (See “Note 13 - Commitments and Contingencies” of Item 8 of this report, which is incorporated herein by reference).
Federal income tax recoverable remained constant from the December 31, 2005 balance. There was a federal income tax accrued liability established for $0.5 million at the year ended December 31, 2006. The deferred tax asset increased by $0.6 million and the deferred tax liability increased by $1.6 million. The combination of these items resulted in a net increase in tax liabilities of $1.5 million, inclusive of a decrease of $3.8 million related to the decrease in fair market value of the invested assets and a decrease of $1.1 million related to the pension liability established for SFAS 158.
Share based compensation expense of $1.4 million was also recognized for the year ended December 31, 2006 as we adopted SFAS 123(R).
2005: We held approximately $117.4 million in cash at December 31, 2004, primarily consisting of cash proceeds from sales and maturities of our invested assets and from our initial public offering of common stock. We invested a significant portion of this cash in fixed maturity securities in 2005, resulting in the net cash outflow from investing activities of $96.0 million. This produced a corresponding increase in invested assets.
The liability for benefits for employers and agents increased by $1.5 million in 2005, primarily resulting from additional pension plan liability accruals of $1.0 million established to fund future payments under the pension plan as well as additional deferred compensation balances of $0.3 million.
2004: Accounts payable and accrued expenses increased by $4.5 million in 2004, primarily due to an increase in reinsurance payables of $6.8 million relating to acquired business, and a decrease in accrued compensation expense of $1.8 million relating to payments of accrued compensation that were made in 2004.
In connection with our acquisition of Kanawha in 2004, outstanding Kanawha stock options were exercised, resulting in cash receipts of $6.1 million and a tax benefit of $3.3 million. The exercise of these outstanding stock options produced the majority of the $3.8 million increase in federal income tax recoverable.
Report of Management on the Consolidated Financial Statements and Management’s Assessment of Internal Control Over Financial Reporting
Consolidated Balance Sheets for KMG America Corporation as of December 31, 2006, and 2005
Consolidated Statements of Operations for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for Kanawha Insurance Company (the “Predecessor”) for the year ended December 31, 2004
Consolidated Statements of Cash Flow for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for the Predecessor for the year ended December 31, 2004
KMG’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. KMG's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of KMG's assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that KMG's receipts and expenditures are being made only in accordance with authorization of KMG's management and directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of KMG's assets that could have a material effect on the financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
KMG’s Consolidated Financial Statements and assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 have been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their reports which appear on pages 75 and page 76, respectively.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of KMG America Corporation as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity and cash flow for the years ended December 31, 2006 and 2005, and for the period January 21, 2004 (inception) through December 31, 2004, and our report dated March 8, 2007, expressed an unqualified opinion thereon.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of KMG America Corporation at December 31, 2006 and 2005, and the consolidated results of KMG America Corporation’s operations and cash flow for the years ended December 31, 2006 and 2005, and for the period January 21, 2004 (inception) through December 31, 2004, and the Predecessor’s consolidated results of operations and cash flow for the year ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of KMG America Corporation’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 8, 2007 expressed an unqualified opinion thereon.
Fixed maturity securities available for sale, at fair value (amortized cost of $531,477,537 and $505,848,751 for 2006 and 2005, respectively)
Real estate and equipment (net of accumulated depreciation of $3,652,073 and $1,748,519 for 2006 and 2005, respectively)
and KMG America Corporation from January 21, 2004, through December 31, 2006
Amortization of deferred policy acquisition costs and value of business acquired
Unless the context requires otherwise, references to “we”, “us,” “our,” KMG America” or the “Company” are intended to mean KMG America Corporation and its consolidated subsidiaries, including, without limitation, Kanawha Insurance Company (“Kanawha”). References to our “predecessor” mean Kanawha prior to it being acquired by KMG America.
The Company's sales historically have been primarily in the southeastern United States, predominantly in Florida, South Carolina and North Carolina, but are now expanding nationwide. Sales are made through an internal sales force, full-time agents, general agents and brokers. Under the Company’s current business strategy, the Company expects group lines of business to account for an increasing percentage of the Company's premium revenues.
Effective September 1, 2006, KMG America’s subsidiaries Kanawha and Kanawha HealthCare Solutions, Inc. entered into a reinsurance and administrative arrangement with Columbian Life Insurance Company (“CLIC”) and Columbian Mutual Life Insurance Company (“CMLIC”). CLIC and CMLIC are affiliates of each other. Under the arrangement, Kanawha reinsures 100% of the risk of a block of voluntary term life insurance policies and universal life insurance policies from CLIC and CMLIC. Kanawha HealthCare Solutions, Inc. will assume responsibility for the administration of these policies. As part of the transaction, CLIC and CMLIC also assigned key trademarks to Kanawha for these insurance policies and their marketing brand, “UNIQ Benefit Solutions”.
For accounting purposes, Kanawha is treated as KMG America’s predecessor entity and is referred to in these Notes as the “Predecessor.” For financial reporting purposes, management has treated the acquisition of the Predecessor as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material to the Predecessor’s consolidated statements of operations, cash flows, and changes in shareholders’ equity for the year ended December 31, 2004. Accordingly, financial information in the following discussion that relates to the Predecessor’s consolidated results of operations, cash flows and changes in shareholders’ equity for the year ended December 31, 2004 is reported on a historical basis without GAAP (generally accepted accounting principles in the United States) purchase accounting adjustments reflecting the acquisition of the Predecessor. Financial information
Assets supporting the deferred compensation plan are classified as trading and are included in other investments. Trading account assets are held for resale in anticipation of short-term market movements. Trading account assets, consisting of mutual funds, are stated at fair value. Gains and losses, both realized and unrealized, are included in realized gains and losses.
industry factors or conditions related to a geographic area negatively affecting the security;
Expenditures for improvements are capitalized, and expenditures for maintenance and repairs are charged to operations as incurred. Upon sale or retirement, the cost and related accumulated depreciation and amortization are removed from the accounts and the resulting gain or loss, if any, is reflected in operations. For the years ending December 31, 2006, 2005 and 2004, total depreciation expense was approximately $1.9 million, $1.8 million and $2.5 million, respectively.
For most insurance products, the amortization of deferred acquisition costs is recognized in proportion to the ratio of annual premium revenue to the total anticipated premium revenue, which gives effect to expected terminations. Deferred acquisition costs are amortized over the premium-paying period of the related policies. Anticipated premium revenue is determined using assumptions consistent with those utilized in the determination of liabilities for insurance reserves.
Long-lived assets include property and equipment, other intangible assets, systems development and other deferred costs and other assets. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”), the Company regularly evaluates whether events and circumstances have occurred which indicate that the carrying amount of long-lived assets may warrant revision or may not be recoverable. When factors indicate that long-lived assets should be evaluated for possible impairment, the Company uses an estimate of the future undiscounted net cash flows of the related business over the remaining life of the asset in measuring whether the carrying amount of the related asset is recoverable. To the extent these projections indicate that future undiscounted net cash flows are not sufficient to recover the carrying amounts of the related assets, the underlying assets are written down by charges to expense so that the carrying amount is equal to fair value, primarily determined based on future discounted cash flows. In the opinion of management, the Company’s long-lived assets are appropriately valued at December 31, 2006 and 2005.
Benefit reserves as reported are shown on a GAAP purchase accounting basis (“PGAAP”). Prior to the quarter ending June 30, 2006, this conversion was based on an adjustment to benefit reserves developed on a historical GAAP basis. Effective June 30, 2006, a refinement in methodology was implemented whereby the benefit reserves are now being developed directly on a purchase GAAP basis. This seriatim factor approach was not implemented in prior quarters because of the significant amount of time it has taken to develop the complete set of reserve factors that was needed. The refinement of the methodology to use seriatim developed reserves had no material impact on income but does have an impact on the balance sheet on a segment by segment basis. This balance sheet impact is further discussed in Note 16 (Business Segments).
Premiums on life insurance products are reported as revenue when due unless received in advance of the due date. Premiums on accident and health insurance are reported as earned over the contract period. A reserve is provided for the portion of premiums written which relate to unexpired coverage terms.
Revenue from annuity and interest sensitive products including universal life products includes charges for the cost of insurance, for initiation and administration of the policy and for surrender of the policy. Revenue from these products is recognized in the year assessed to the policyholder, except that any portion of an assessment, which relates to services to be provided in future years, is deferred and recognized over the period during which services are provided.
The Company has adopted the provisions of SFAS 158, “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans - An Amendment of FASB Statements No. 87, 88, 106, and 132R. SFAS 158 required the Company to recognize a pension liability of $3,032,877 and a prepaid pension asset of $3,127,725 as of December 31, 2006. The reported net asset of $94,848 represented the overfunded status of the defined benefit pension plan. Also, as the pension liability was established the recognized change was reported in accumulated other comprehensive income which after tax effects was $1,971,370.
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including stock options and restricted common stock based on estimated fair values. SFAS 123(R) supersedes the Company’s previous accounting for periods beginning in 2006.
In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).
On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 123(R)-3 “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” The Company has elected to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance.
Income taxes are computed using the liability method required by SFAS No. 109, Accounting for Income Taxes. Under this Statement, deferred tax assets and liabilities are determined based on the differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Recorded amounts are adjusted to reflect changes in income tax rates and other tax law provisions as they become enacted.
Policyholder dividends are recognized over the term of the related policies. Participating business represents approximately 30% and 30%, respectively, of the Company’s total ordinary life insurance in force at December 31, 2006 and 2005. Dividends paid to policyholders in 2006, 2005 and 2004 were approximately $1.5 million, $2.1 million and $2.2 million, respectively. Participating premiums as a percentage of direct life premiums were 39% in 2006, 46% in 2005 and 51% in 2004.
In September 2006, the FASB issued SFAS No. 158, “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans - An Amendment of FASB Statements No. 87, 88, 106, and 132R” (“SFAS No. 158”). SFAS No. 158 requires companies to (1) recognize as an asset or liability, the overfunded or underfunded status of defined pension and other postretirement benefit plans; (2) recognize changes in the funded status through other comprehensive income in the year in which the changes occur; (3) measure the funded status of defined pension and other postretirement benefit plans as of the date of the company’s fiscal year-end; and (4) provide enhanced disclosures. The provisions of SFAS No. 158 are effective for the Company’s year-ending December 31, 2006. The Company adopted SFAS 158 at December 31, 2006.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AcSEC) issued Statement of Position 05 -1 (SOP 05 -1), Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts. SOP 05 -1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in Statement of Financial Accounting Standards (SFAS) No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from Sale of Investments. SOP 05 -1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occur by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. SOP 05 -1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006 with earlier adoption encouraged. Retrospective application of SOP 05 -1 to previously issued financial statements is not permitted. The Company is currently assessing the impact of SOP 05-1 on its financial statements.
The amortized cost and fair value of fixed maturity securities at December 31, 2006, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
Net gains of $0.6 million, $0.2 million, and $0.4 million were realized on the trading portfolio in 2006, 2005, and 2004, respectively.
Changes during the years ended December 31, 2006, 2005 and 2004, in amounts affecting the net unrealized gains and losses, reduced by deferred income taxes, included in shareholders’ equity as accumulated other comprehensive income are as follows:
Fixed Maturity Securities which have been in an unrealized loss position for:
Management has reviewed these securities which either have been in an unrealized loss position for more than twelve months or have significant unrealized losses relative to cost and have concluded that these securities have not experienced an other-than-temporary impairment. Factors considered in making this evaluation included issue-specific drivers of the decrease in price, near-term prospects of the issuer, the length of time the value has been depressed, and the financial condition of the industry. Based on this review, no unrealized losses were considered to be other than temporary during 2006. Unrealized losses of $0.2 million and $0.7 million were considered to be other-than-temporary for this review and were recognized as realized losses during 2005 and 2004, respectively.
Major categories of the Company’s and Predecessor’s net investment income for the years ended December 31, 2006, 2005 and 2004, are summarized as follows:
There were no new mortgage loans originated in 2006. At the issuance of a loan, the percentage of loan to value on any one loan does not exceed 75%. All properties covered by mortgage loans have fire insurance equal to at least the loan excess over the maximum loan that would be allowed on the land without the building.
The Company’s mortgage loan portfolio is comprised of conventional real estate mortgages collateralized primarily by office (3.6%), apartments (4.6%) and residential (91.8%) properties. Mortgage loan underwriting standards emphasize the credit status of a prospective borrower, quality of the underlying collateral and conservative loan-to-value ratios. Approximately 97.3% of the loans are on properties located in the South Atlantic region. Other geographic regions include mortgaged property representing 2.7% of the aggregate principal amount of the Company’s mortgage loans as of December 31, 2006.
Interest is recognized as revenue when earned according to the terms of the loans and when, in the opinion of management, it is collectible. The accrual of interest on the loans is discontinued at the time the loan is 90 days past due or when, in management’s opinion, collection of such interest is doubtful. Past due status is based on the contractual terms of the loan. Loans are placed on non-accrual or charged off at an earlier date if collection of principal or interest is considered doubtful. The Company maintains an allowance for potentially uncollectible loans. Additions to the allowance are based on assessments of certain factors, including but not limited to historical loan loss experience of similar types of loans, the Company’s loan loss experience, the amount of past due and non-performing loans and current and anticipated economic and interest rate conditions. Evaluation of these factors involves subjective estimates and judgments that may change. Additions to the allowance are provided through a charge to earnings. There was no balance in the allowance account at December 31, 2004. There were no additions to the allowance for the years ended December 31, 2006 and 2005.
value, accumulated amortization and net carrying value of other intangible assets, which are included in other assets in the consolidated balance sheet, as of December 31, 2006, and 2005, were as follows:
Amortization expense relating to intangible assets was $0.57 million in 2006, $0.57 million in 2005, and $0.0 million in 2004. Estimated future amortization expense relating to intangible assets for the years ending December 31 are as follows:
Real estate and equipment consist of the following at December 31:
Certain premiums and benefits are assumed from and ceded to other insurance companies under various reinsurance agreements. The assumption agreements provide the Company with increased economies of scale and the ceded agreements provide the Company with increased capacity to write larger risks and maintain its exposure to loss within its capital resources and, in some cases, effect business dispositions. However, if the assuming reinsurer is unable to meet its obligations, the Company remains contingently liable. The Company evaluates the financial condition of reinsurers and monitors concentration of credit risk to minimize this exposure. All reinsurers for which we hold an amount recoverable have a financial strength rating from A.M. Best of at least an A- (excellent) (with the exception of Scottish Re, which is rated B, but to which we have limited exposure as the current amount recoverable as of December 31, 2006 is $125,619) and the majority of our reinsurers have a rating of A+ (superior). In some cases, reinsurers have placed amounts in trusts equivalent to the amount recoverable from the reinsurer. The following represent reinsurance amounts included in the accompanying financial statements:
Income taxes as reported in the consolidated statements of operations for the years ended December 31, 2006, 2005 and 2004, are summarized as follows:
The provision for federal income taxes incurred is different from that which would be obtained by applying the statutory Federal income tax rate to income before income taxes. The significant items causing this difference are:
State insurance laws and regulations prescribe accounting practices for determining statutory net income and equity for insurance companies. In addition, state regulators may permit statutory accounting practices that differ from prescribed practices. The Company does not have any permitted accounting practices that differ from prescribed practices.
Under South Carolina insurance regulations, Kanawha is required to maintain minimum capital of $1.2 million and minimum surplus of $1.2 million. Additionally, Kanawha is restricted as to amounts that can be transferred in the form of dividends, loans, or advances without the approval of the South Carolina Insurance Commissioner. Under these restrictions, during 2007, dividends, loans or advances by Kanawha in excess of $7.2 million will require the approval of the South Carolina Insurance Commissioner.
investments, insurance risk, interest rate risk and general business risk. As of December 31, 2006, the Company’s adjusted SAP capital and surplus exceeded its authorized control level RBC.
The foregoing reconciliation reflects a redundancy in the December 31, 2005 and 2004, reserves of $0.6 million, and a deficiency in the December 31, 2004 reserves of $0.2 million that emerged in 2006 and 2005, respectively. The changes in those reserves were primarily the result in changes in estimates as more information became available.
Beneficiaries may elect to receive benefits in the form of lump-sum distribution, subject to certain dollar limitations, or through one of several annuity options. Based on the plan’s current funding status and ERISA guidelines, no required contributions to the plan are anticipated for 2007.
The defined benefit plan’s change in benefit obligation, change in plan assets, funded status and amounts recognized in the Company’s consolidated balance sheets are as follows:
The initial amount recognized in accumulated other comprehensive income of $1,971,370 after tax is the result of adopting SFAS No. 158 as of December 31, 2006. An additional pension liability of $3,032,877 was established as the result of the requirement to recognize the funding status of the defined benefit pension plan on the balance sheet as of December 31, 2006. Previously, under SFAS No. 87 and 132R the Company only needed to recognize its pension obligation to the extent of the minimum liability represented by the accumulated benefit obligation. The Company had historically funded the plan to the extent of the minimum liability, thus to avoid the adjustment to other comprehensive income prior to 2006 year end which would have been required under SFAS 132R if the Company was under funded. The newly adopted accounting pronouncement required the recognition of the full projected benefit obligation when measuring the funded status as of December 31, 2006. The net position of the prepaid pension asset and the pension liability results in the amount recognized in the statement of financial position of $94,848 representing the Company’s over funded status of the defined benefit pension plan.
The estimated net loss and prior service cost for the defined benefit pension plan that will be amortized from accumulated other comprehensive income into periodic benefit cost over the next fiscal year are $172,000 and $0, respectively.
The key assumptions used in the calculation of the benefit obligations above for years ended December 31 are as follows:
The Company’s investment strategy for pension plan assets is for approximately one-half of the equity investments to be invested in a large capitalization diversified equity portfolio. During the fourth quarter of 2005, the Company terminated Morgan Stanley as investment manager of the equity portfolio and redeemed the portfolio’s investment in an absolute return hedge fund, the Mangan & McColl Offshore Arbitrage Fund.
The Company offers a 401(k) qualified savings plan for which substantially all employees and agents are eligible. Plan participants may contribute up to 15% of pretax annual compensation, which includes overtime, bonuses and commissions. Participants may also contribute amounts representing distributions from other qualified defined benefit or defined contribution plans. Until October 1, 2006, the Company contributed 25% of the first 6% of base compensation that a participant contributed to the Plan. The Company also could make an additional contribution up to 25% at its discretion.
Effective as of October 1, 2006, the Company matches 100% of the first 3% of salary deferral contributions that a participant contributes to the plan and 50% of the next 2% of salary deferral contributions a participant contributes to the plan. Effective January 1, 2007, participants will be 100% vested in all matching contributions made by the Company to the plan on and after that date.
The Company has a non-qualified deferred compensation plan for senior management that allows the deferment of a portion of their compensation until their services with the Company have terminated. The plan includes deferred contributions, which were not elected by employees to be transferred to the 401(k) plan upon adoption of the 401(k) plan. The plan’s investments include mutual funds and are recorded in investments as held for trading. The corresponding deferred obligations to participants are recorded in other liabilities.
Approximately $5.3 million of compensation expense was recorded as unearned upon the issuance of these options.
In connection with the closing of the acquisition of the Predecessor, on December 21, 2004, all 371.8 options became 100% vested and were exercised and the Predecessor stock option plan was terminated. No additional stock options can be granted under the Predecessor’s plan.
SFAS 123 required the presentation of pro forma information as if the Company had accounted for its employee and director stock options granted after December 31, 1994, under the fair value method of that Statement.
The Company also followed APB 25 for 2005 and 2004 and related interpretations in accounting for its stock options issued to senior management.
During 2005, the Company issued options to purchase a total 229,250 shares of Company common stock, at a weighted average exercise price of $9.35 per share, which is equal to 100% of the estimated fair market value of the common stock on the date of the grant. These options generally vest with respect to one fourth of the shares subject to the option on each of the first, second, third and fourth anniversaries of the date of grant. During 2005, 61,500 shares were forfeited. During 2005, the Company also issued 54,357 shares of restricted common stock at a weighted average of $8.86, which is equal to 100% of the estimated fair market value of the common stock on the date of grant. These shares of restricted stock generally vest with respect to one fourth of the shares granted on each of the first, second, third and fourth anniversaries of grant. On December 15, 2004, the Company issued options to purchase a total of 1,246,000 shares of Company common stock at an exercise price of $9.50 per share, which is equal to 100% of the estimated fair market value of the common stock on the date of grant. These options generally vest with respect to one fourth of the shares subject to the option on each of the first, second, third and fourth anniversaries of the date of grant. Options to purchase 310,000 shares, however, generally vest one third on each of the first, second and third anniversaries of the date of grant.
The activity related to the common stock grants is set forth below:
Weighted Average Grant Date Fair Value Per Share of Common Stock Grants Outstanding
(1) Represents the tax benefit, recognized in additional paid-in-capital for stock options exercised.
On January 1, 2000, the Predecessor established its Performance Share Plan and authorized the issuance of up to 80,000 stock units to attract and retain quality employees and to allow such employees to participate in the growth of the Predecessor. Awards could be made to participants in the form of stock units. The Performance Share Plan provided for vesting over the 10 years subsequent to date of grant (10% per year). Compensation expense was recorded based on the vesting and the change in the book value of the Predecessor’s common stock from the date of grant to the date of exercise, adjusted for dividends, stock redemption proceeds and capital contributions subsequent to the date of grant. Eligible participants under the Performance Share Plan included executives or key employees of the Predecessor. During 2004, 7,354 units were forfeited or redeemed resulting in 65,864 outstanding units at December 20, 2004. The plan continued in effect through the closing of the Company’s acquisition of the Predecessor on December 21, 2004, when it terminated and all outstanding stock units were redeemed. No additional stock units may be awarded under the plan. The Company does not intend to implement a stand-alone successor performance share plan, but the Company’s 2004 Equity Incentive Plan permits the Company to award performance shares.
The Company had no commitments to fund mortgage loans at December 31, 2006.
The Company leases office equipment under noncancellable leases. Total rental expense amounted to $0.1 million in 2004 and $0.2 million in 2005 and $0.2 million in 2006. As of December 31, 2006, future minimum lease payments under noncancellable operating leases with initial or remaining terms in excess of one year are as follows:
Investment Contracts: The fair values of the Company’s liabilities under investment-type insurance contracts are estimated using discounted cash flow calculations, based on interest rates currently being offered for similar contracts with maturities consistent with those remaining for the contracts being valued.
The carrying amounts and fair values of the Company’s liabilities for investment-type insurance contracts at December 31 are summarized in the following table.
The worksite insurance business provides life and health insurance products to employers and employees. The primary insurance products that the Company underwrites include: group and individual life insurance; group long term disability; group and individual short term disability; group and individual dental insurance; group and individual indemnity health insurance; group critical illness insurance and employer group excess risk insurance. This segment also includes business sold through the career agency distribution channel, which is a group of agents and managers that are employees of the Company or its subsidiaries.
This reallocation of reserves between the business segments does impact the comparability of the current reported policyholder benefits and the resulting reported benefit ratios by segment.
Net investment income, realized gains and brokerage income, and gain on extinguishment of debt