We lease 10,000 square feet of space located at 2525 North Shadeland, Indianapolis, Indiana for warehouse purposes. This lease expires on September 30, 2004.
The following discussion highlights the principal factors affecting the results of our operations and the significant changes in our balance sheet items on a consolidated basis for the periods listed, as well as liquidity and capital resources. This discussion should be read in conjunction with the accompanying Consolidated Financial Statements, related Notes and “Selected Historical Financial Data”.
Mortality, morbidity and other factors which may affect the profitability of our insurance products.
We specialize in the sale of individual annuities. Under accounting principles generally accepted in the United States, or GAAP, premium collections for deferred annuities are reported as insurance policy liabilities instead of as revenues. Sources of revenues for products accounted for as insurance policy liabilities are net investment income, surrender charges deducted from the account balances of policyholders in connection with withdrawals, realized gains and losses on investments and call option income. Components of expenses for products accounted for as insurance policy liabilities are interest credited to account balances, amortization of deferred policy acquisition costs, and other operating costs and expenses.
Variances Between Actual and Expected Profits. Actual experience on purchased and produced insurance may vary from projections due to differences in renewal premiums collected, investment spreads, mortality costs, persistency, administrative costs and other factors. Variances from original projections, whether positive or negative, are included in net income as they occur. To the extent that these variances indicate that future experience will differ from the estimated profits reflected in the capitalization and amortization of the PVFP and DAC assets, current and future amortization rates may be adjusted.
Present Value of Future Profits. In accordance with industry practice, when we purchase a block of existing insurance business, we assign a portion of the purchase price, PVFP, as the pre-tax value of the business acquired. The asset is the discounted value of future cash flows arising from the existing block of business. The discount rate used is based upon many elements, such as yields generated on similar business, our cost of capital and the interest rate environment as of the purchase date. Discount rates used in determining our PVFP assets range from 8% to 18%.
Deferred Policy Acquisition Costs. Insurance policies issued after the purchase date of a company will generate significant costs that vary directly with and relate to the acquisition of the new business. Under GAAP, these acquisition costs on new policies are to be capitalized and recorded as DAC. For universal and interest sensitive life and annuity products, the DAC asset is amortized in proportion to estimated gross profits over the life of the contract. For immediate annuities, DAC is amortized so as to produce a constant yield on the net policyholder liability. Virtually all of our DAC is a result of writing annuity products.
Accounting for Deferred Annuities and Universal and Interest-Sensitive Life Products. We primarily account for our deferred annuity, universal and interest-sensitive life policy deposits in accordance with Statement of Financial Accounting Standards No. 97 (“SFAS No. 97”), “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses on the Sale of Investments”. Under SFAS No. 97, a benefit reserve is established at the time of policy issuance in an amount equal to the deposits received. Thereafter, the benefit reserve is adjusted for any additional deposits, interest credited and partial or complete withdrawals. Revenues for annuities and universal and interest-sensitive life policies, other than certain non-interest sensitive annuities, consist of policy charges for surrenders and partial withdrawals, mortality and administration, and investment income earned. These revenues do not include the annuity, universal and interest-sensitive life policy deposits. Expenses related to these products include interest credited to policyowner account balances, operating costs for policy administration, amortization of DAC and mortality costs in excess of account balances.
Accounting for Equity Indexed Annuities. Revenues and expenses for equity-indexed annuities are recognized in accordance with the SFAS No. 97 model, described above. Policy liabilities for equity-indexed annuities are computed in accordance with SFAS No. 133, which requires that an equity-indexed annuity liability be bifurcated into a “host contract” and a “derivative contract”. The host contract liability is a book value liability providing for the equity-indexed annuity policy’s guaranteed benefits. The derivative contract liability is a market value liability providing for the equity-linked benefits available in the policy. The derivative liability includes a liability for equity-linked benefits accruing during the current contract year, as well as liability amounts for future equity benefits which have not yet been granted.
Accounting for Traditional Life Products. Traditional life insurance products are accounted as long-duration insurance contracts in accordance with Statement of Financial Accounting Standards No. 60 (“SFAS No. 60”), “Accounting and Reporting by Insurance Enterprises”. Under SFAS No. 60, benefit reserves are actuarially calculated using the net level reserve method. Revenues consist of policy premiums and investment income on assets supporting policy liabilities. Expenses consist of policy benefits incurred, increases in policy liabilities, and operating costs for policy administration, and amortization of DAC.
The carrying value of our investment portfolio was $1.7 billion in Financial Services at December 31, 2003. The accounting risks associated with these assets relate to the recognition of income, our determination of other-than-temporary impairments and our estimation of fair values.
When we sell a security, we report the difference between the sales proceeds and amortized cost (determined based on specific identification) as an investment gain or loss.
We periodically evaluate whether the declines in fair value of our investments are other-than-temporary. Our evaluation consists of a review of qualitative and quantitative factors. We also consider additional factors to determine whether the declines in fair value are other-than-temporary, such as downgrades of the security by a rating agency, deterioration in the financial condition of the issuer, and other publicly available issuer-specific news or general market conditions. For investments in companies with no quoted market price, we consider similar qualitative and quantitative
factors and also take into account the cost of the investment, the type of investment, subsequent purchases of the same or similar investments, the current financial position and operating results of the company invested in, and such other factors as may be relevant. Declines in fair values of securities deemed to be other-than-temporary are recognized as a reduction of net income.
Equity indexed call options are derivative instruments linked to the major stock indices (S&P 500 Index and DJIA Index) which are used to hedge the equity benefits of our equity indexed annuity products. We purchase call options whose payoff characteristics mirror the equity benefits of our products. These securities are carried at fair value and the change in fair value is included in net investment income.
The balance of our goodwill and intangible assets was $11.0 million at December 31, 2003. The recovery of this asset is dependent on the fair value of the business to which it relates. Effective in 2002, pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), goodwill is no longer amortized but is subject to annual impairment tests based on the estimated fair value of the business units. There are numerous assumptions and estimates underlying the determination of the estimated fair value of these businesses. Different valuation methods and assumptions can produce significantly different results that could affect the amount of any potential impairment charge that might be required to be recognized. A charge of $1.2 million resulting from the impairment of goodwill from the adoption of SFAS No. 142 was recorded in 2002 in the Financial Services segment.
The total balance of our liabilities for insurance products was $1.84 billion at December 31, 2003. These liabilities are often payable over an extended period of time and the profitability of the related products is dependent on the pricing of the products and other factors. Differences between pricing assumptions and actual experience will impact future financial results.
Financial Services: Net loss for 2003 was $.2 million, compared to a $5.3 million net loss for 2002. The 2003 net loss included net realized investment gains of $7.9 million, charges of accelerated amortization of DAC of $5.2 million on fixed annuity products, reduced spread income of $2.6 million due to the decline in net investment income yield, which has declined faster than we were able to reduce credited rates on our in-force business, and $.8 million associated with lower expense capitalization due to reduced new business writings. The loss for 2002 included net realized investment losses of $5.9 million, accelerated amortization of DAC of $5.1 million, reserve strengthening of $1.5 million, the write-off of an agency receivable balance of $.8 million, and tax benefits of $2.5 million.
Health Services: Net loss for 2003 was $7.2 million, compared to a loss of $1.2 million for 2002. The 2003 loss included expenses associated with the continued development of U. S. Health Service’s operating platform and infrastructure, as well as ongoing concentrated marketing initiatives. Also, 2003 results were reduced by $3.0 million as a result of recording a valuation allowance on the tax benefits on this segment’s operating loss.
Other Services: Net loss for 2003 was $2.8 million, compared to a net loss of $1.4 million for 2002. The results for 2003 were negatively impacted by a higher effective tax rate and the reduced net commission income due to the sale of a small marketing service subsidiary which period over period impact the results by $1.8 million, and $1.2 million, respectively. Also impacting 2003, was deferred debt write-offs associated with recent refinancing activities of $.3 million. The results for 2002 were negatively impacted from net realized investment losses of $1.0 million.
Premium deposits consist of deposits from our flexible premium deferred annuities, equity-indexed annuities, single premium immediate annuities and other financial products that do not incorporate significant mortality features. Under GAAP, these premium deposits are not shown as premium income in the income statement. A change in premium deposits in a single period does not directly cause our operating income to change, although continued increases or decreases in premiums may affect the growth rate of assets on which investment spreads are earned.
Premium deposits decreased in 2003 due to management actions to preserve spread income in response to market conditions. These actions included reducing crediting rates, lowering agent commissions, and temporarily suspending sales of selected products.
Premium income consists of premiums earned from 1) traditional life products and 2) annuity products that incorporate significant mortality features.
Premium income for 2003 decreased $.2 million or 3%, to $8.9 million.
Premium income decreased during 2003 and 2002 as a result of policy lapses and surrenders.
Policy income represents 1) mortality income and administrative fees earned on universal life products and 2) surrender income earned as a result of terminated universal life and annuity policies.
Policy income increased during 2003 and 2002 as a result of an increase in policy surrender charges.
The increase in call option income for the 2003 period resulted from changes in the market value of our call options due to changes in the S&P 500 Index and the DJIA Index.
Fee and other income consist of fee income related to servicing unaffiliated blocks of business and commission income.
Benefits and claims in 2003 increased by $3.0 million or 30%, to $13.0 million. Benefits and claims were higher in 2003 primarily due to increased death claims and other benefits for our in-force life policies and increased benefit payments for our supplemental contracts including life contingencies.
Interest credited to interest sensitive annuities and other financial products represents interest credited to insurance liabilities of deferred annuities, equity-indexed annuities, single premium immediate annuities and other financial products. This expense fluctuates with changes in 1) the average interest-sensitive insurance liabilities, 2) the average credited rate on those liabilities and 3) the market value fluctuations of call options.
In 2002, interest credited increased $12.4 million or 41%, to $42.6 million due to a 48% increase in average interest sensitive liabilities of $384.0 million compared to 2001, partially offset by a reduction in credited rates. In addition, interest credited decreased $1.8 million as a result of market value changes of call options supporting our equity-indexed products. Reserve strengthening actions increased interest credited by $2.4 million.
The weighted average credited rate on interest sensitive liabilities, including equity-indexed annuities, for 2003 and 2002 were 4.62% and 3.63%, respectively. The increase in average credited rate was due to the impact of improved equity market performance on equity indexed annuity crediting rates. When offset by gains on call option assets used to hedge equity-indexed annuity liabilities, the “effective” crediting rates for 2003 and 2002 were 3.84% and 4.50%, respectively, a reduction of .66% from the prior period.
Amortization in 2003 increased by $3.8 million or 19%, to $24.3 million. This increase relates primarily to higher annuity sales volume, offset by lower gross profits. We recorded a charge of $7.9 million and $7.8 million for 2003 and 2002, respectively, related to the acceleration of DAC amortization due to DAC unlocking.
Acquisition costs for deferred annuity contracts and equity-indexed annuity contracts are required to be amortized over the lives of the contracts in relation to the incidence of estimated gross profits. Estimated gross profits on fixed and equity-indexed annuity contracts include investment spread, surrender income, expense margins, and realized investment gains and losses. Gross profit estimates are evaluated regularly, with historical gross profit estimates adjusted to actual results and projected gross profit estimates updated to reflect current expectations. DAC amortization is adjusted both retrospectively and prospectively (unlocked) in accordance with the revised profit stream, and retrospective adjustments are reported in the current reporting period.
Operating expenses consist of general operating expenses, including salaries, net of deferrable amounts.
Operating expenses - affiliated consist of general operating expenses, including rent and management fees paid to Standard Management and recorded in the Other Services segment.
In 2002, affiliated operating expenses increased $0.2 million or 3%, to $4.9 million.
In 2003, affiliated interest expense and financing costs decreased by $.1 million or 7%, to $1.7 million. The decline in interest expense resulted from the decline in the prime rate.
The weighted average interest rate for 2003, 2002, and 2001 was 6.20%, 6.67%, and 9.13%, respectively.
We maintain a high quality investment portfolio with 99% and 97% of our fixed maturity securities classified as investment grade securities as of December 31, 2003 and 2002, respectively.
Net loss in for 2003 was $7.2 million as compared to $1.2 million for 2002. The 2003 loss included expenses associated with the continued development of U. S. Health Service’s operating platform and infrastructure, as well as ongoing concentrated marketing initiatives. Also, the 2003 results were reduced by $3.0 million as a result of recording a valuation allowance on the tax benefits on this segments operating loss.
General: Our Other Services segment consists of revenues and expenses primarily related to corporate operations and financing costs. During the third quarter of 2003, we sold the assets of our marketing services company, Savers Marketing Corporation, for a $200,000 note receivable. The sale led to a reduction in commission income and commission expenses.
Interest income - affiliated consists of interest income from the Financial Services segment related to the surplus debentures issued by Standard Management.
Commission income consists of fee income related to servicing unaffiliated blocks of business.
During 2003, commission income decreased $1.8 million or 73%, to $.7 million due to the sale of the assets of Savers Marketing.
Commission expenses represents commission expenses related to servicing unaffiliated blocks of business.
During 2002, commission expenses decreased $2.7 million or 78%, to $.8 million due to a decrease in sales by Savers Marketing.
Net investment expenses - affiliated represents interest expense paid to Financial Services.
During 2003, interest expense and financing costs increased $.1 million or 2%, to $4.4 million.
During 2003, federal income tax benefit decreased $1.9 million or 82%, to $.4 million. Federal income benefit decreased due to a valuation allowance related to the operating losses recorded in 2003. Also, in 2002, there was a utilization of a net operating loss carryforward of $1.0 million.
During 2002, federal income tax benefit increased $2.7 million to $2.3 million. Federal income benefit increased due to the utilization a of a net operating loss carryforward of $1.0 million.
Income from discontinued operations consist of general operating expenses, including salaries, net of deferrable amounts.
Gain (loss) on sale of discontinued operations, net of related costs results from the sale of our International Operations in 2002.
We anticipate that available cash from our existing working capital, surplus debenture interest, dividends, management fees, rental income and tax sharing payments will be adequate to meet our anticipated parent company cash requirements for 2004. The following describes our potential sources of cash in 2004.
The following are characteristics of our mortgage payable agreement at December 31, 2003:
The following are characteristics of our promissory notes at December 31, 2003:
The following are characteristics of our senior secured credit agreement at December 31, 2003:
principal payments: $1.5 million to be paid in 2004, $2.0 million to be paid in 2005, $2.1 million to be paid in 2006, and $2.2 million to be paid in 2007. The remaining principal payment of $12.2 million is due in 2008
may be redeemed on or after August 9, 2006 at $10 per security plus accumulated and unpaid distributions;
General. On a consolidated basis we reported net cash provided by operations of $26.8 million and $18.4 million for 2003 and 2002, respectively. Although deposits received on our interest-sensitive annuities and other financial products are not included in cash flow from operations under GAAP, these funds are available. Cash provided by operations plus net deposits received, less net account balances returned to policyholders on interest sensitive annuities and other financial products, resulted in positive cash flow of $230.5 million and $479.0 million for 2003 and 2002, respectively. The decrease is primarily due to a decline in annuity premium deposits. Cash generated on a consolidated basis is available only to the extent that it is generated at the holding company level or is available through interest, dividends, management fees or other payments from our subsidiaries.
At December 31, 2003, we had “parent company only” cash and short-term investments of $.3 million. These funds are available for general corporate purposes. Our “parent company only” operating expenses, not including interest expense, were $5.5 million and $5.5 million for 2003 and 2002, respectively.
The principal liquidity requirements of Standard Life are its 1) contractual obligations to policyholders, 2) surplus debenture interest, dividends, management fees and rental fees to Standard Management and 3) operating expenses. The primary source of funding for these obligations has been cash flow from premium income, net investment income, investment sales and maturities and sales of annuity products. These sources of liquidity for Standard Life significantly exceed scheduled uses. Liquidity is also affected by unscheduled benefit payments including death benefits, policy withdrawals and surrenders. The amount of withdrawals and surrenders is affected by a variety of factors such as renewal interest crediting rates, interest rates for competing products, general economic conditions, Standard Life’s A.M. Best rating and events in the industry that affect policyholders’ confidence. In October 2003, A.M. Best confirmed Standard Life’s rating of (“B+”), or “very good”.
We believe that the operational cash flow of our Health Services segment will not be sufficient to meet our anticipated operational needs for 2004. Therefore, this segment is expected to continue to fund its cash needs through external borrowings and capital contributions from Standard Management.
We are currently considering a transaction that would significantly alter the nature of our business.
We are subject to a number of factors affecting its business, including intense competition in the industry and the ability to attract and retain agents, suppliers, clients and employees. If we are unable to respond appropriately to any of these factors, business and financial results could suffer.
Our operating results are affected by many factors, including competition, lapse rates, interest rates, maintenance of insurance ratings, changes in the regulatory environment with respect to pharmacy service providers, relationships with suppliers of inventory held in its health services division, relationships with large institutional clients, general governmental regulation and general business conditions, many of which are outside our control.
Our financial services division operates in a highly competitive environment and is in direct competition with a large number of insurance companies, many of which offer a greater number of products through a greater number of agents and have greater resources. In addition, we may be subject, from time to time, to new competition resulting from additional insurance carriers introducing products similar to those offered by us. Moreover, as a result of recent federal legislation, commercial banks, insurance companies, and investment banks may now combine, provided certain requirements are satisfied, and we can expect to encounter increased competition from these providers of financial services. This competitive environment could result in lower premiums, loss of sales and reduced profitability.
Since a notable portion of our future institutional pharmacy business will be made available to Medicare-qualified patients who may qualify for this new benefit, it may have a substantial and lasting effect on the profitability of our business depending on how it and similar initiatives are administered by the government agencies charged with implementation. Since important elements of the new act relating to issues as formulary development, drug pricing and drug discount cards have yet to be finalized, it is impossible to predict the impact of the act on our profitability.
that, in their opinion, have achieved very good overall performance when compared to the standards established by A.M. Best, and have a good ability to meet their obligations to policyholders over a long period of time. A rating of (“B”) is assigned by A.M. Best to companies that, in their opinion, have achieved good overall performance when compared to the standards established by A.M. Best. According to A.M. Best, these companies generally have an adequate ability to meet their obligations to policyholders, but their financial strength is vulnerable to unfavorable changes in underwriting or economic conditions. In evaluating a company’s financial and operating performance, A.M. Best reviews the company’s profitability, leverage and liquidity as well as the company’s book of business, the adequacy and soundness of its reinsurance, the quality and estimated market value of its assets, the adequacy of its reserves, and the experience and competence of its management. A.M. Best reviews its ratings of insurance companies from time to time. If the A.M. Best ratings were downgraded, sales of annuity products could be significantly impacted and the financial condition and results of operations could be materially adversely affected.
The NAIC, and state insurance regulators continually reexamine existing laws and regulations and their application to insurance companies. Changes in the NAIC or state regulations, including, for example, changes in the risk-based capital requirements, which are determined by the NAIC and state regulators, could affect the ability of our subsidiaries to pay dividends to us which could affect our ability to make payments upon our contractual obligations.
Our health subsidiary is also subject to substantial regulation at both the state and Federal levels. Our ability to continue operating as a retail, mail order and institutional pharmacy is contingent upon our ability to maintain appropriate licenses in all the states in which they currently conduct business. We are also required to comply with a comprehensive set of regulations under the Federal Health Insurance Portability and Accountability Act (“HIPAA”) with respect to the privacy and security of patient health information and the method in which this information is electronically transmitted to payors and governmental agencies such as the agencies responsible for implementing the Medicare and Medicaid programs. Regulations implementing HIPAA are still being disseminated, revised and actively reviewed as of the time of this writing. It is possible that substantial changes in these regulations, or in the strictness of interpretation of these regulations, may adversely affect our relationships with our clients and materially affect our future operations by increasing the costs of regulatory compliance. As with the insurance laws, we cannot predict the impact of future state or Federal laws or regulations on its health services business.
Significant changes in interest rates expose insurance companies to the risk of not earning anticipated spreads between the interest rate earned on
investments and the credited interest rates paid on outstanding policies. Both rising and declining interest rates can negatively affect spread income. Although we develop and maintain asset/liability management programs and procedures designed to preserve spread income in rising or falling interest rate environments, changes in interest rates could adversely affect these spreads.
Our financial results could be materially adversely affected if our assumptions regarding the value of intangible assets proven to be incorrect.
A large portion of the present and future growth of our institutional pharmacy business is contingent upon our ability to acquire and retain long-term contracts at favorable terms with institutional care facilities. Currently we have thirteen contractual relationships with large institutional clients and forty three relationships with smaller facilities. We are presently attempting to grow and diversify the number, type and terms of these contracts, but a number of factors - including the ability to favorably compete with respect to pricing, our relationships with drug and supplement manufacturers and suppliers, and the economic solvency and profitability of our institutional clients - can impact our profitability and opportunities for future growth. In addition, although we believe our current relationship with our institutional clients is strong, the loss of key institutional clients would materially affect the operation of our health services segment.
Because our health services business model is relatively new and unproven, its limited operating history in this segment is not indicative of future performance, and this part of its business is difficult to evaluate.
Because we have only recently entered the Health Services segment, it does not have an operating history upon which an investor can evaluate our prospects. In attempting to implement our business model, we may need to significantly change our business operations, sales and implementation practices, customer service and support operations and management focus. We are also facing new risks and challenges, including a lack of meaningful historical financial data upon which to plan future budgets, the need to develop strategic relationships and other risks described below
Continuing efforts to contain healthcare costs may reduce our future health services revenue.
The sales and profitability of the health services segment are affected by the efforts of healthcare payors to contain or reduce the cost of healthcare by lowering reimbursement rates, limiting the scope of covered services, and negotiating reduced or capitated pricing arrangements. Any changes which lower reimbursement levels under Medicaid, Medicare or private pay programs, including managed care contracts, could reduce our future revenue. Furthermore, other changes in these reimbursement programs or in related regulations could reduce its future revenue. These changes may include modifications in the timing or processing of payments and other changes intended to limit or decrease the growth of Medicaid, Medicare or third party expenditures.
As of December 31, 2003, approximately 25% of our health services’ pharmacy billings were directly reimbursed by government sponsored programs. Government sponsored programs include Medicaid and, to a lesser extent, Medicare. Our remaining billings are currently paid or reimbursed by individual residents, long-term care facilities and other third-party payors, including private insurers. A portion of these revenues are indirectly dependent on government programs. We anticipate that as the institutional pharmacy portion of our Health Services segment grows, direct reimbursement from government sponsored programs will become a material portion of our pharmacy billings.
Even though an acquired business may have experienced positive financial performance as an independent company prior to an acquisition, we cannot be sure that the business will continue to perform positively after an acquisition.