Immediately prior to the closing of the Pyramid Life sale, Continental General acquired Pyramid Life’s building in Kansas. See Note D. Discontinued Operations for further information.
The selected audited consolidated financial data presented below as of and for each of the five years ended December 31, 2004, 2003, 2002, 2001 and 2000 have been derived from our audited consolidated financial statements. However, financial data for 2001 and 2000 was reclassified to reflect the sale of Pyramid Life. For further information, see Note D. Discontinued Operations to our audited consolidated financial statements. The financial information for the years ended December 31, 2004, 2003, 2002, 2001 and 2000 includes the operations of all our subsidiaries for the entire year except for Pyramid Life. Pyramid Life, which is presented separately as discontinued operations, was acquired on July 26, 2000 and sold on March 31, 2003. The data for 2004, 2003 and 2002 should be read in conjunction with the more detailed information contained in the audited consolidated financial statements and accompanying notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this filing.
In 2001, we received net proceeds of $46.5 million from a public offering of 16.1 million shares of our common stock, at $3.20 per share. In 2000, we received net proceeds of $27.5 million from the private placement of 3.3 million shares of our common stock at $6.00 per share and 75,000 shares of preferred stock at $100.00 per share.
Liabilities for Other Policy Claims and Benefits Payable. The most significant accounting estimate in our audited consolidated financial statements is our liability for other policy claims and benefits payable.
Liabilities for unpaid claims are based on an estimation process that is complex and uses information obtained from both company specific and industry data, as well as general economic information. These estimates are developed using actuarial methods based upon historical data for payment patterns, medical inflation, product mix, seasonality, utilization of health care services, and other relevant factors. The amount recorded for unpaid claims liabilities is sensitive to judgments and assumptions made in the estimation process. The most significant assumptions used in the estimation process include determining utilization and
Management considered the volatile claims experience in recent periods when it established its liabilities for unpaid claims at December 31, 2004. Management believes that the recorded liabilities for unpaid claims at December 31, 2004 is within a reasonable range of outcomes. Management closely monitors and evaluates developments and emerging trends in claims costs to determine the reasonableness of judgments made. A retrospective test is performed on prior period claims liabilities and, as adjustments to the liabilities become necessary, the adjustments are reflected in current operations. Management believes that the amount of medical and other benefits payable is adequate to cover our liabilities for unpaid claims as of December 31, 2004.
During 2002, we wrote-off $4.2 million of deferred acquisition costs associated with certain of our major medical business due to the continuing unprofitability of terminated blocks of business.
Management believes the amount of deferred acquisition costs as of December 31, 2004 is recoverable.
with a related contract asset or liability. At December 31, 2004, our other intangible assets consisted of $3.4 million in licenses, or 0.4% of our total assets.
Effective January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets issued by the Financial Accounting Standards Board (FASB), which provides that goodwill and intangibles with indefinite useful lives should not be amortized but instead be tested for impairment annually at the reporting unit level. In accordance with SFAS No. 142, we completed a transitional goodwill impairment test, which indicated that an impairment loss against our goodwill and other intangible assets was not required. Goodwill and intangibles with indefinite useful lives are tested for impairment on an annual basis and more often if indications of impairment exist. The estimated fair value of goodwill of a reporting unit is determined by applying the appropriate discount rates to estimated future cash flows for the reporting unit. The estimated fair value of licenses was determined by independent appraisals. The results of our analysis indicated that no reduction of goodwill or licenses was required in 2004. A slight reduction of $0.1 million was made to the carrying value of licenses in 2003 due to the cancellation of business in certain unprofitable states.
Long-lived Assets. Property and intangible assets are reviewed for possible impairment when events indicate that the carrying amount of an asset may not be recoverable. Assumptions and estimates used in the evaluation of impairment may affect the carrying value of long-lived assets, which could result in impairment charges in future periods. Depreciation and amortization policies reflect judgments on the estimated useful lives of assets.
Lapsation and persistency. Other factors that affect our results of operations are lapsation and persistency, both of which relate to the renewal of insurance policies and certificates in force. Lapsation is the termination of a policy for nonrenewal and, pursuant to our practice, is automatic if and when premiums become more than 31 days overdue. However, policies may be reinstated, if approved, within 90 days after the
policy lapses. Persistency represents the percentage of total certificates in force at the end of a period less any newly-issued certificates divided by the total certificates in force at the beginning of the period.
Policies renew or lapse for a variety of reasons, due both to internal and external causes. We believe that our efforts to address any concerns or questions of our insureds in an expedient fashion help to ensure ongoing policy renewal. We work closely with our licensed agents, who play an integral role in obtaining policy renewals and communicating with our insureds. However, in 2004, we experienced higher than expected lapse rates on our major medical business as we believe that necessary rate increases implemented in excess of claims trends on certain blocks caused higher lapsation rates.
External factors also contribute to policy renewal or lapsation. Economic cycles can influence an insured’s ability to continue to pay insurance premiums when due.
Reinsurance. Consistent with the general practice of the insurance industry, we reinsure portions of the coverage by our insurance products to unaffiliated insurance companies under reinsurance agreements. Reinsurance provides a greater diversification of underwriting risk, minimizes our aggregate exposure on major risks and limits our potential losses on reinsured business. Reinsurance involves one or more insurance companies participating in the liabilities or risks of another insurance company in exchange for a portion of the premiums. Although the effect of reinsurance is to lessen our risks, it may lower net income. We have entered into a variety of reinsurance arrangements under which we cede business to other insurance companies to mitigate risk. A significant portion of our risks are reinsured with a single reinsurance company, Hannover Life Reassurance Company of America. For more information on Hannover, see “Business-Reinsurance-Existing Arrangements.” We also have assumed risk on a “quota share” basis from other insurance companies. Our results of operations are presented net of reinsurance.
employee-related healthcare benefits. Liabilities associated with the risks that are retained are estimated by considering various historical trends and forward-looking assumptions. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends. Over the past couple of years, increases in the cost and availability of commercial insurance as a result of significant changes in the insurance market have impacted our insurance coverages. We have renewed most of our insurance policies for 2005. Other policies are up for renewal in mid-2005. We may not be successful in obtaining coverage on terms favorable to us or at all.
Overview and Outlook for 2005. Net income for 2004 was $19.1 million or $0.55 per diluted share, compared to net income for 2003 of $22.9 million or $0.67 per diluted share, which included $3.6 million or $0.11 per share from Pyramid Life.
For the year ended December 31, 2004, total net premiums decreased 10.1% to $430.2 million, compared to $478.3 million for 2003.
Medical premiums for 2004 were $247.0 million, compared to $305.4 million for 2003, a decrease of 19.1%. The decrease in medical premiums was primarily the result of a 20.7% decrease in major medical certificates in force from 84,167 at December 31, 2003 to 66,724 at December 31, 2004 due to higher lapsation rates. We believe that necessary rate increases implemented in excess of claim trends on certain blocks caused higher lapsation rates in 2003 and 2004. In addition, in 2004, we experienced higher than anticipated lapse rates on new business.
Net investment income was $26.2 million for 2004, compared to $25.1 million for 2003, an increase of 4.5%. This increase was the result of an increase in average invested assets due to the investment of most of the proceeds from the sale of Pyramid Life on March 31, 2003 and the assumption of a related block of life business with approximately $12.1 million in invested assets. In addition, net investment income included $0.8 million of unrealized gains on our fixed maturity and equity securities trading portfolios in 2004. The book yield of our available-for-sale investment portfolio at December 31, 2004 was 5.34% compared to a book yield of 5.39% at December 31, 2003.
Medical benefits, claims, losses and settlement expenses were $176.1 million for 2004, compared to $226.2 million for 2003, a decrease of 22.1%. The decrease was primarily the result of a smaller volume of business in force due to the reduction in medical business as a result of higher than anticipated lapse rates. In addition, the medical loss ratio was 71.3% for 2004, compared to 74.1% for 2003. The improvement in the loss ratio was due primarily to favorable run-off of prior year claim reserves.
A federal income tax expense of $2.8 million was recorded for 2004, which included a $5.0 million reduction to the deferred tax valuation allowance. As a result of our continued profitability, a projection of continued taxable income in future periods, and the corresponding utilization of a portion of the net operating
Income from continuing operations was $19.1 million, or $0.55 per share, for 2004, compared to $19.4 million, or $0.56 per share for 2003. Income from the discontinued operations of Pyramid Life for 2003 was $3.6 million, or $0.11 per share (which included $3.9 million of net realized investment gains, $1.8 million of operating income and an additional loss on the sale of $2.1 million). For 2004, net income was $19.1 million, or $0.55 per share, compared to $22.9 million, or $0.67 per share, for 2003, which included $3.6 million, or $0.11 per share, from Pyramid Life.
Medical premiums for 2003 were $305.4 million compared to $370.0 million for 2002, a decrease of 17.5%. The change in medical premiums was primarily the result of the following:
a 34.0% decrease in major medical certificates in force from 127,463 at December 31, 2002 to 84,167 at December 31, 2003 due to exiting certain unprofitable states and higher lapsation rates. Rate increases implemented in excess of claim trend on certain unprofitable blocks caused higher lapsation rates in 2003.
a decline in the percentage of business ceded from 15.3% in 2002 to 13.5% in 2003.
Fee and other income decreased to $28.9 million for 2003 compared to $33.5 million for 2002, a decrease of 13.9%. This decrease was primarily attributable to the decline in major medical policies and the associated policy fee income and was partially offset by $5.7 million of third party administrator fees in the Senior and Other segment related to the transition processing of senior business for Pyramid Life. This transition agreement terminated on December 31, 2003. Due to the decline in our medical business and the termination of this transition agreement, we expected total policy fee income to decline approximately 35% in 2004.
Medical benefits, claims, losses and settlement expenses were $226.2 million for 2003 compared to $291.8 million for 2002, a decrease of 22.5%. The decrease was primarily the result of a smaller volume of business in force due to the cancellation of medical business in certain unprofitable states. In addition, the medical loss ratio decreased to 74.1% for 2003 compared to 78.9% for 2002. The medical loss ratio primarily decreased due to the following:
the implementation of rate increases in excess of claim trend on certain unprofitable blocks;
the cancellation of Central Reserve’s major medical business in Texas effective September 30, 2002; and
Senior and other benefits, claims, losses and settlement expenses were $127.5 million for 2003 compared to $129.2 million for 2002, a decrease of 1.3%. The senior and other loss ratio decreased to 73.7% for 2003 compared to 76.0% for 2002. The lower loss ratio in the current year was primarily due to the improvement in Medicare supplement loss ratios from 69.8% in 2002 to 67.1% in 2003.
The net (deferral) amortization and change in acquisition costs (DAC) and value of business acquired (VOBA) resulted in net amortization of $6.0 million for 2003 compared to a net deferral of $3.8 million for 2002. The decrease in the net deferral was primarily attributable to lower capitalization of DAC due to decreases in new business sales.
Income from continuing operations before federal income taxes was $26.0 million for 2003 compared to $3.5 million for 2002.
Liquidity is our ability to generate adequate amounts of cash to meet our financial commitments. Our major needs for cash are to enable our insurance subsidiaries to pay claims and expenses as they come due and for Ceres to pay interest on, and to repay principal of, its indebtedness. The primary sources of cash are premiums, investment income, fee income, equity and debt financings, and reimbursements from reinsurers. Payments consist of current claim payments to insureds, medical cost management expenses, and operating expenses such as salaries, employee benefits, commissions, taxes, and interest on debts. Net cash used in operating activities in 2004 was $15.4 million compared to net cash provided by operating activities of $43.0 million in 2003. The decrease was primarily attributable to the following:
the current year includes an $23.5 million increase in fixed maturity and equity securities classified as trading due to our purchase of convertible bonds and convertible preferred stock in the fourth quarter of 2004;
the prior year reflected a larger reduction in our reinsurance receivable due to the final settlement of our London Life reinsurance receivable in 2004 and a larger decline in our reinsurance receivable and reserves ceded balances; and
Assets decreased 1.0% to $766.0 million at December 31, 2004 from $773.9 million at December 31, 2003. Assets of $495.0 million, or 64.6% of the total assets, were in investments at December 31, 2004. Fixed maturities, our primary investment, were $474.6 million, or 95.9% of total investments, at December 31, 2004. Other investments consist of equity securities, an investment in a limited partnership, policy loans, and mortgage loans. We have classified $456.1 million of our fixed maturities as available-for-sale and $18.5 million as trading and accordingly have reported them at their estimated fair values at December 31, 2004.
Approximately 97.0% of our fixed maturities available-for-sale were of investment grade quality at December 31, 2004. In addition to the fixed maturities, we also had $22.6 million in cash and cash equivalents of which $7.0 million was restricted at December 31, 2004.
Our current credit facility consists of a $4.0 million term loan A with National City Bank with quarterly principal payments of $250,000 through December 2005, $375,000 through December 2006, and a payment of $500,000 on March 1, 2007. The $9.0 million term loan B with CIT Group has quarterly principal payments of $312,500 through December 2004, $375,000 through December 2006, $562,500 through December 2007, and $1,250,000 through June 2008.
Both term loans bear interest at floating rates, based on either Prime or LIBOR, plus applicable spreads. Under Prime rate borrowings, the interest rate for term loan A and term loan B will be the Prime interest rate plus 0.50% and 1.25%, respectively. Under Eurodollar borrowings, the interest rate for term loan A and term loan B will be LIBOR plus 3.25% and 4.00%, respectively. At December 31, 2004, the interest rate on our term loan A balance of $3.0 million was 5.65% per annum and our $7.8 million term loan B was 6.40% per annum.
Our obligations under the credit agreement are guaranteed by four of our non-regulated subsidiaries and are secured by pledges of the capital stock of Central Reserve, Continental General, and our non-regulated subsidiaries, as well as security interests in certain equipment and other tangible property of Ceres and the non-regulated subsidiaries.
The credit agreement contains various covenants including financial covenants relating to leverage, fixed charge coverage, risk-based capital of the regulated insurance subsidiaries, and tangible net worth. It also has a number of affirmative and negative covenants, including limitations relating to indebtedness, liens, mergers, purchases and sales of assets, investments, dividends, and stock repurchases. At December 31, 2004, we were in compliance with these covenants.
The following table presents the revenues, expenses, and profit (loss) from continuing operations before federal income taxes, for the last three years attributable to our industry segments. We do not separately allocate investments or other identifiable assets by industry segment, nor are income tax expenses (benefits) allocated by industry segment.
debt downgrades or other events that adversely affects an investee’s access to, or cost of, financing;
All of our fixed maturity investments are reported at fair market value at December 31, 2004. The amortized cost and estimated fair value of fixed maturities on our investment surveillance list at December 31, 2004 were $0.1 million and $0.2 million, respectively. For more information, see Note B. Cash and Investments to our audited consolidated financial statements.
Interest Rate Risk is the risk that interest rates will change and cause a decrease in the value of an insurer’s investments. This change in rates may cause certain interest-sensitive products to become uncompetitive or may cause disintermediation if we attempt to mitigate this risk by charging fees for non-conformance with certain policy provisions and/or by attempting to match the maturity schedule of our assets with the expected payouts of its liabilities. To the extent that liabilities come due more quickly than assets mature, we would have to sell assets prior to maturity and recognize a gain or loss. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical decline in fair value of stockholders’ equity is estimated to be $12.7 million after-tax at December 31, 2004. This amount represents approximately 6.2% of our stockholders’ equity at such date.
Seasonality is the risk of fluctuations of revenues and operating results. Historically, our revenues and operating results have varied from quarter to quarter and are expected to continue to fluctuate in the future. These fluctuations have been due to a number of factors, including higher benefit utilization by our insureds during the winter months and the use of deductibles. More specifically, our Senior segment’s seasonality is the opposite of our Medical segment’s, meaning that earnings in the Senior segment are generally lower in the first quarter and higher throughout the remainder of the year. This is mainly a factor of certain of our standardized Medicare supplement plans that pay the Medicare Part B deductible for our insureds generally during the early months of the year. The earnings in our Medical segment are generally lower in the fourth quarter as policyholders meet their annual required co-payments and deductibles. In 2004, we experienced a higher level of seasonality in the fourth quarter as policyholders shifted to products with higher average deductible levels.
Inflation rates impact our financial condition and operating results in several areas. Changes in inflation rates impact the market value of the investment portfolio and yields on new investments.
these efforts by us will fully offset the impact of inflation or that premiums will equal or exceed increasing healthcare costs.
unforeseen losses with respect to loss and settlement expense reserves for unreported and reported claims or adverse changes in persistency or profitability of insurance contracts that would accelerate the amortization of our deferred acquisition costs;
our ability to implement increases in premium rates and to develop, market, distribute and administer competitive products and services in a timely, cost-effective manner;
the risk of material adverse outcomes in litigation and related matters;
our ability to continue to meet the terms of our debt obligations under our credit agreement which contains a number of significant financial and other covenants;
the performance of others on whom we rely for insurance and reinsurance, particularly Hannover Life Reassurance Company of America upon whom we have relied for substantially all of our reinsurance;
the performance of others on whom we rely for administrative and operations services;
disclosure requirements of EITF 03-01 were effective December 31, 2003. The recognition and measurement guidance of EITF 03-01 was effective on July 1, 2004. In September 2004, the FASB issued FASB Staff Position EITF 03-01-1, which delayed the original effective date of the recognition and measurement guidance of EITF 03-01 until the FASB deliberates certain issues related to the implementation of EITF 03-01.
Notes to Consolidated Financial Statements for the years ended December 31, 2004, 2003 and 2002
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on criteria established in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 18, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting contained in Item 9A, “Controls and Procedures” of Ceres Group, Inc.’s (the “Company”) 2004 Annual Report on Form 10-K, that the Company maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
In our opinion, management’s assessment that Ceres Group, Inc. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also, in our opinion, Ceres Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Ceres Group, Inc. as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the years then ended, and our report dated March 18, 2005 expressed an unqualified opinion on those consolidated financial statements.
We have audited the accompanying consolidated statement of operations, stockholders’ equity, and cash flows for the year ended December 31, 2002. We have also audited the information related to 2002 presented in the financial statement schedules listed in the Index at Item 15(a). These financial statements and financial statement schedules are the responsibility of Ceres Group’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audit.
Ceres Group, Inc. (formerly known as Central Reserve Life Corporation) operated in 1998 and prior periods primarily through its wholly-owned subsidiary, Central Reserve Life Insurance Company. As of December 31, 2004, 2003 and 2002, the Company’s consolidated statements also include the continuing operations of Provident American Life & Health Insurance Company acquired on December 31, 1998, Continental General Corporation and its wholly-owned subsidiary, Continental General Insurance Company, acquired on February 17, 1999, United Benefit Life Insurance Company under a reinsurance arrangement effective August 1, 1998 and acquired on July 21, 1999 (through foreclosure), and the discontinued operations of Pyramid Life Insurance Company acquired on July 26, 2000. Effective March 31, 2003, Ceres sold its subsidiary, Pyramid Life Insurance Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. See Note D. Discontinued Operations for further information.
We provide, through our insurance subsidiaries, a wide array of health and life insurance products. While our insurance subsidiaries are licensed in 48 states, the District of Columbia, and the U.S. Virgin Islands, approximately 60.2% of our total premium volume is generated from ten states: Ohio, Florida, Pennsylvania, Texas, Indiana, Georgia, Kansas, Nebraska, Illinois and Virginia.
The accompanying audited consolidated financial statements include the continuing operations of Ceres and its wholly-owned subsidiaries, except for Pyramid Life, which is included in discontinued operations. All intercompany transactions have been eliminated in consolidation.
On January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets. Under the provisions of SFAS 142, goodwill is no longer ratably amortized into the income statement over an estimated life, but rather is tested at least annually for impairment. Intangible assets which have finite lives continue to be amortized over their estimated useful lives and also continue to be subject to impairment testing. Prior to the adoption of SFAS 142, goodwill was amortized on a straight-line basis over periods of 25 years or less. See Note H. Goodwill and Other Intangible Assets for a summary of our goodwill and other intangible assets, as well as further detail related to the impact of the adoption of SFAS 142 in 2002.
The preparation of the audited consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
The investment in the limited partnership is carried on the equity method of accounting. Investments in policy notes and mortgage loans are reported at cost, which approximates fair value.
Realized gains and losses on the sale of investments are determined using the specific-identification method, and are credited or charged to income. Also charged to income are unrealized losses on investment securities for which a decline in fair market value is deemed to be other-than-temporary, and unrealized holding gains and losses on trading securities.
We evaluate the recoverability of deferred acquisition costs on a quarterly basis and determine whether these amounts are recoverable.
For accident and health and ordinary life business, the value of business acquired is amortized over the estimated life of the in force business using assumptions consistent with those in computing reserves. Interest of 6.5% is credited to the unamortized balance for Continental General Corporation. For interest sensitive products such as universal life and deferred annuities, the value of business acquired is amortized over the
As certain fixed maturities available-for-sale related to our interest-sensitive life insurance products are carried at fair value, an adjustment is made to deferred acquisition costs and the value of business acquired equal to the change in amortization that would have occurred if such securities had been sold at their stated fair value and the proceeds reinvested at current yields. The change in this adjustment is included with the change in fair value of fixed maturity securities available-for-sale, net of tax, that is credited or charged directly to stockholders’ equity and is a component of other comprehensive income. At December 31, 2004 and 2003, deferred acquisition costs were decreased by $1.0 million and $0.8 million, respectively; the value of business acquired was decreased by $1.0 million and $1.1 million, respectively.
Effective January 1, 2002, we adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144). This Statement superseded SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, and the accounting and reporting provisions of Accounting Principles Board Opinion (APB Opinion) No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business. This Statement also amended Accounting Research Bulletin No. 51, Consolidated Financial Statements.
Liabilities for unpaid life and accident and health claims, which include a provision for estimated costs to investigate and settle claims, are estimated based upon past experience for pending, incurred but not reported, and reopened claims. Accident and health claims incurred but not reported are computed using actuarially-determined factors based on a combination of claim completion and projected claim cost methods, utilizing durational experience, seasonal cycle, changes in health care practice, changes in inflation rates, and any claims backlog.
Life premiums are recognized as revenue when they become due. Accident and health premiums are recognized as revenue over the terms of the policies. Revenues from interest sensitive contracts, principally universal life and annuity products, consist of mortality charges for the cost of insurance, contract administration charges, and surrender charges assessed against policyholder account balances during the period. Amounts received from interest sensitive contracts are not reflected in premium revenue; rather, such amounts are accounted for as deposits with the related liabilities included in future policy benefits, losses, and claims.
Federal income taxes are accounted for using the liability method in accordance with SFAS No. 109, Accounting for Income Taxes issued by the FASB. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. See Note I. Federal Income Taxes for further information.
The following table illustrates the effect on net income (loss) and earnings (loss) per share if we had applied the fair value recognition provisions of SFAS 123.
For the year ended December 31, 2003, there was a positive pro forma impact on net income and basic and diluted earnings per share due to the forfeiture of options resulting from employee terminations.
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123R (Revised 2004), Share-Based Payment (SFAS 123R), which amends SFAS 123 and will be effective for public companies for interim or annual periods beginning after June 15, 2005. SFAS 123R eliminates the intrinsic value method under APB Opinion 25 as an alternative method of accounting for stock-based compensation. SFAS 123R also revises the fair value-based method of accounting for share-based payment liabilities, forfeitures and modifications of stock-based awards and clarifies SFAS 123’s guidance in several areas, including measuring fair value, classifying an award as equity or as a liability and attributing compensation cost to reporting periods. In addition, SFAS 123R amends SFAS No. 95, Statement of Cash Flows, to require that excess tax benefits be reported as a financing cash flow rather than as a reduction to taxes paid, which is included within operating cash flows. We currently use the intrinsic value method of APB Opinion 25 to value stock options, and accordingly, do not recognize compensation expense in our Consolidated Statements of Operations. On a quarterly and annual basis, we
In March 2004, the FASB’s Emerging Issues Task Force concluded its discussion of Issue No. 03-01, The Meaning of Other-Than-Temporary Impairments and Its Application to Certain Investments (EITF 03-01). EITF 03-01 provides accounting guidance regarding the determination of when an impairment (i.e., fair value is less than carrying value) of debt and marketable equity securities and investments accounted for under the cost method should be considered other-than-temporary and recognized in earnings. EITF 03-01 also requires annual disclosures of certain quantitative and qualitative factors of debt and marketable equity securities classified as available-for-sale or held-to-maturity that are in an unrealized loss position at the balance sheet date, but for which an other-than-temporary impairment has not been recognized. The disclosure requirements of EITF 03-01 were effective December 31, 2003. The recognition and measurement guidance of EITF 03-01 was effective on July 1, 2004. In September 2004, the FASB issued FASB Staff Position EITF 03-01-1, which delayed the original effective date of the recognition and measurement guidance of EITF 03-01 until the FASB deliberates certain issues related to the implementation of EITF 03-01.
In July 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (SOP 03-1). SOP 03-1 addresses a number of topics, the most significant of which is the accounting for contracts with guaranteed minimum death benefits. SOP 03-1 requires companies to evaluate the significance of guaranteed minimum death benefits to determine whether the contract should be accounted for as an investment or insurance contract. If the contract is determined to be an insurance contract, companies are required to establish a reserve to recognize a portion of the assessment (revenue) that compensates the insurance company for benefits to be provided in future periods. SOP 03-1 also provides guidance on separate account presentation, interest in separate accounts, gains and losses on the transfer of assets from the general account to a separate account, liability valuation, return based on a contractually referenced pool of assets or index, annuitization options and sales inducements to contract holders. The effective date of SOP 03-1 is for fiscal years beginning after December 15, 2003, with earlier adoption encouraged. We adopted SOP 03-1 on January 1, 2004. The adoption of SOP 03-1 did not have a significant impact on our consolidated results of operations, cash flows or financial position.
The amortized cost and estimated fair value of available-for-sale securities as of December 31, 2004 were as follows:
Except for bonds and notes of the U.S. Government or of a non-government agency or authority, no investment of the Company exceeds 10% of total stockholders’ equity at December 31, 2004 and 2003.
The amortized cost and estimated fair value of available-for-sale securities as of December 31, 2004 by contractual maturity were as follows:
At December 31, 2004 and 2003, $6.5 million of cash was held for fully insured employer shared risk plans, which is restricted to use. We are entitled to investment income from these funds.
The following is a summary of available-for-sale securities that have been in a continuous unrealized loss position as of December 31, 2004:
On March 31, 2003, Continental General sold the stock of its subsidiary, Pyramid Life, which was primarily included in our Senior and Other segment, to the Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. Net proceeds from the sale were used to strengthen Continental General’s statutory capital and repay $10.0 million of our bank debt. Additionally, we continued to process Pyramid Life’s business through an administrative services agreement, which terminated on December 31, 2003. The total loss from the sale (net of taxes and expenses incurred) was $13.8 million. Accordingly, we adjusted the carrying value of Pyramid Life’s assets held for sale to fair market value at December 31, 2002, which resulted in a charge of $11.6 million. In addition, we recorded a $2.2 million loss on the sale in 2003. As a result of the sale, Pyramid Life’s operations were classified as discontinued operations for 2003 and 2002.
On May 25, 2001, we entered into an agreement with Royalton Investors, LLC and Big T Investments, LLC, an unaffiliated third party, to sell our Cleveland headquarters. The transaction was effective July 31, 2001. The building was sold to Royalton Investors, LLC and Big T Investments, LLC for $16.0 million and concurrently we leased it back for a term of 15 years with four optional five-year extensions. A deferred gain of $7.2 million was recorded at the time of the sale. On October 19, 2004, Royalton Investors, LLC and Big T Investments, LLC sold the building and assigned its interest as lessor under the lease agreement dated July 31, 2001, to Strongsville Corporate Center Acquisitions, LLC, an unaffiliated third party. At December 31, 2004 and 2003, the unamortized deferred gain related to the sale of the building was $5.8 million and $6.2 million, respectively, and was included with other liabilities in our Consolidated Balance Sheets. The amortization of the deferred gain was included in net realized gains in our Consolidated Statements of Operations and was $0.4 million for each of the years ended December 31, 2004, 2003, and 2002.
Rent expense for our Cleveland headquarters was approximately $1.8 million in 2004, $1.8 million in 2003, and $1.7 million in 2002. Future rent payments for the Cleveland headquarters and all other operating leases are as follows:
Management is currently evaluating any actions that may enable the company to provide current distributions, thus reducing or eliminating the PSA balance. At the close of the suspension period, the previous ordering rules will be reinstated. Accordingly, we consider the likelihood of additional distributions from the PSA account after the suspension period to be remote and, therefore, no specific federal income tax has been provided for such distributions in the financial statements.
In December 2000, Central Reserve entered into a reinsurance transaction with Lincoln National Reassurance Company, or Lincoln, for a ceding allowance of $4,000,000. The policies reinsured, on a combined coinsurance and modified coinsurance basis, were 80% of all group term life insurance and 35% of all individual deferred annuities in force on and after December 31, 2000. The ceding allowance is being
Effective January 1, 1999, Provident American Life entered into a reinsurance agreement with Provident Indemnity, whereby Provident American Life reinsured 100% of Provident Indemnity’s business written after December 31, 1998. In a separate reinsurance agreement, Provident American Life ceded to Hannover 50% of its direct business written after December 31, 1998 and 50% of the business reinsured from Provident Indemnity.
The following table summarizes the net impact of reinsurance arrangements on premiums and benefits, claims, losses and settlement expenses, and selling, general and administrative expenses:
The nature of our business subjects us to a variety of legal actions and claims relating to such things as denial of healthcare benefits, premium rate increases, termination of coverage, claims administration and alleged violations of state and federal statutes.
As previously disclosed, a California lawsuit was filed against United Benefit Life, Central Reserve, Ceres, the American Association for Consumer Benefits (AACB), and Does 1 through 100 inclusive in the Superior Court for San Luis Obispo County, California (Case No.: CV 020275, filed April 2002) by Annelie and Joseph Purdy, on behalf of themselves and all others similarly situated, seeking class action certification on behalf of individuals in California who purchased group health insurance from United Benefit Life through the AACB. Plaintiffs alleged causes of action for breach of contract, bad faith, violations of California’s Unfair Competition Law and fraud in the inception. Plaintiffs sought unspecified damages, including the return of premium rate increases during the relevant period of time. Plaintiffs’ motion for statewide class certification was granted in November 2003 and the case was scheduled to go to trial in January 2005. The plaintiffs also filed an action against Provident American Life containing somewhat similar allegations. On September 15, 2004, we announced that we had agreed to settle these lawsuits. The settlements contemplated payments to class members and others, as well as certain attorneys’ fees and costs. In 2004, we recorded (in selling, general and administrative expenses) a pre-tax charge of $3.1 million ($2.0 million after-tax). Although the final amount of the settlement payout may vary, we believe that the ultimate payout will not materially exceed that amount. These California litigation settlements do not involve any admission of wrongdoing by the Company or any subsidiary.
In addition, we are involved in various other legal and regulatory actions occurring in the normal course of business that could result in significant liabilities and costs. Based on current information, including consultation with outside counsel, we believe that any ultimate liability that may arise from any of these other actions would not materially affect our audited consolidated financial position or results of operations. However, we cannot predict with certainty the outcome of any of these actions against us or the potential costs involved. Our evaluation of the likely impact of any of these actions could change in the future and an unfavorable outcome in any case could have a material adverse effect on our consolidated financial position, results of operations or cash flows of a future period.
Our credit facility consists of a $4.0 million term loan A with National City Bank with quarterly principal payments of $250,000 through December 2005, $375,000 through December 2006, and a payment of $500,000 on March 1, 2007. The $9.0 million term loan B with CIT Group has quarterly principal payments of $312,500
In 1999, 373 employees each received 1,000 common stock options under the 1998 Employee Stock Option Plan. A second grant was made for new employees hired from January 1, 1999 through September 30, 1999, and still employed as of December 31, 1999. Under this second grant in 2000, 75 employees received 1,000 common stock options. Each grant vests after three years and expires ten years from the date of the grant, with accelerated vesting upon an event of a change in control. We terminated this plan in December 2000. At December 31, 2004, there were options outstanding under the plan to purchase 198,000 shares.
In 1998, pursuant to the 1998 Key Employee Share Incentive Plan, we granted common stock options to certain key employees. In 1999 through 2004, we granted additional common stock options to certain employees under the 1998 Key Employee Share Incentive Plan. In general, such grants vest over three years and expire ten years from the date of the grant. In the event of a change in control, all options granted immediately vest and become exercisable in full. On May 19, 2004, our shareholders adopted an amendment to the plan, to increase the total number of shares of our common stock reserved for issuance under the plan by an additional 1,000,000 shares to a total of 3,000,000 shares of our common stock. The adopted amendments to the plan also allowed for the grant of stock and restricted stock awards in addition to stock options and stock appreciation rights to officers, non-employee directors, consultants and advisors. At
Exercise prices for options outstanding at December 31, 2004 ranged from $1.95 to $9.50. While some options have no expiration date, management estimates the remaining average contractual life of options awarded is 5 years. A summary of the options by range of exercise price is as follows:
Our 2000 Employee Stock Purchase Plan was adopted by our stockholders on June 27, 2000. Under the plan, employees may purchase shares of our common stock at a 15% discount from fair value. All of our full time employees, including officers, are eligible to participate in the employee stock purchase plan, subject to limited exceptions. Eligible employees participate voluntarily, and may withdraw from an offering at any time before the stock is purchased. Participation terminates automatically upon termination of employment other than for death, disability or retirement. Six-month offerings are made available beginning May 1 and November 1 of each year. The purchase price per share in an offering will not be less than 85% of the lesser of the stock’s fair value at the beginning of the offering period or on the applicable exercise date and may be paid through payroll deductions. As of December 31, 2004 and 2003, 9,027 and 35,183 shares, respectively, had been issued under the employee plan.
We also have a 2000 Agent Stock Purchase Plan similar to the employee plan under which certain of our agents may purchase shares of our common stock at the same discount from fair value. The agent stock purchase plan does not qualify as an employee stock purchase plan within the meaning of Section 423 of the Code. As of December 31, 2004 and 2003, 22,265 and 75,828 shares, respectively, had been issued under the agent plan. There are 1,000,000 shares of common stock reserved for issuance in the aggregate under both plans. Both of the plans will terminate when all of the shares reserved for issuance under the plans have been purchased unless sooner terminated by our Board.
Also, pursuant to employment contracts, we provided an award of common shares to Peter W. Nauert. The number of shares awarded was contingent upon the weighted average fair value of the common shares over specified periods, but was based on a stock award equal to $1.0 million per year through July 1, 2001 and $0.5 million per year through May 31, 2002, which was revised from July 1, 2003 due to his retirement. For the year ended December 31, 2002, 88,661 shares were awarded. We recognized stock compensation expense related to these awards of $0.2 million in 2002.
Based on the methodology and assumptions delineated above, the weighted average fair value of options was $1.47, $1.48, and $1.39 per share for 2004, 2003 and 2002, respectively. There was no pro forma impact on net income and net income per share of stock-based compensation under the fair value method for the year ended December 31, 2004. The pro forma impact for the year ended December 31, 2003 would be to increase net income by $0.9 million or $0.02 per share due to the forfeiture of options resulting from employee terminations. The pro forma impact for the year ended December 31, 2002 would be to increase the net loss by $0.4 million or $0.01 per share.
such shares in one or more series, and to determine the designations, preferences, limitations and other rights of the shares issued, including but not limited to the dividend rate, liquidation preference, redemption rights and price, sinking fund requirements, conversion rights and restrictions on the issuance of such shares. However, our credit agreement prohibits the payment of dividends on preferred stock. Holders of non-voting preferred shares shall have no voting rights except as required by law.
We also have authorized 100,000 Convertible Voting Preferred Shares, $.001 par value, of which none were outstanding at December 31, 2004.
Statutory accounting practices prescribed or permitted by regulatory authorities for our insurance subsidiaries differ from generally accepted accounting principles. Shareholders’ equity and net income, as determined in accordance with statutory accounting practices (as filed with respective state insurance departments), for Ceres and its subsidiaries are summarized as follows:
Generally, the capital and surplus of our insurance subsidiaries available for transfer to the parent company are limited to the amounts that the insurance subsidiaries’ capital and surplus, as determined in accordance with statutory accounting practices, exceed minimum statutory capital requirements. However, payments of the amounts as dividends may be subject to approval by regulatory authorities. In 2005, Continental General could pay a dividend to Ceres, the parent company, of up to $10.3 million without prior
approval of the state regulator. In 2005, Central Reserve would be prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus. However, on February 24, 2005, Central Reserve received approval from the Ohio Department of Insurance to pay an extraordinary dividend of $12.0 million to Ceres.
Basic and diluted earnings per share are calculated in accordance with SFAS No. 128, Earnings per Share. Basic earnings per common share is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of shares outstanding during the period. Diluted earnings per common share is computed by dividing net income (loss) by the weighted average number of shares outstanding during the period including the effect of the assumed exercise of dilutive stock options under the treasury stock method. In 2002, the diluted earnings per share calculation was adjusted for a one time net gain
Cash and cash equivalents, accrued investment income, premiums receivable, surplus notes, mortgage loans and policy notes - The carrying amounts reported in the consolidated balance sheets for these instruments approximate their fair value.
Carrying amounts and estimated fair values of financial instruments at December 31, 2004 and 2003 are summarized as follows:
We maintain cash and cash equivalent investments with various financial institutions, and perform periodic evaluations of the relative credit standings of those financial institutions.