All per share data has been restated to show the effect of the Company's one for three reverse split (see Note 2).
Premiums increased to $60.2 million in the year ended December 31, 2004 from $37.8 million in the year ended 2003.
Average percentage of Medical Stop-Loss business ceded from IHC to Independence American increased to 19.3% during 2004 from 13.1% during 2003.
92% of invested assets in bonds and short-term investments, 98% of the bonds have the highest NAIC rating designation (NAIC ratings of 1 and 2 designation).
Acquired IndependenceCare Underwriting Services - MidAtlantic LLC, a Medical Stop-Loss MGU.
In a separate transaction on July 30, 2002, IHC acquired Pacific Century Cyberworks Limited's ("PCCW") entire interest in the Company consisting of 1,666,666 shares of common stock at $9.00 per share for a total value of $15,000,000. As a result of this transaction, PCCW's two appointees resigned from the Company's Board of Directors, and Edward Netter, Chairman of IHC, and Roy T.K. Thung, President and Chief Executive Officer of IHC, were appointed to the Company's Board of Directors. On April 22, 2003, a wholly-owned subsidiary of IHC completed its tender for one million shares of the common stock of the Company at $9.00 per share for a total value of $9 million. On December 22, 2003, IHC purchased an aggregate of 613,401 shares in the market and private transactions. During 2004, IHC purchased an additional 1% interest in the Company. At December 31, 2004, IHC owned a 40% interest in AMIC.
On February 10, 2003, but effective as of January 1, 2003, the Company acquired 80% of the business of an employer Medical Stop-Loss MGU and an affiliated entity (the "Acquired MGUs"). The acquisition was accomplished by the formation of Voorhees Risk Management LLC d.b.a. Marlton Risk Group ("Marlton") into which the Acquired MGUs contributed all of their assets, and the Company contributed $16,000,000 cash for an 80% ownership interest. The Company's cash contribution was then distributed to the Acquired MGUs together with the remaining 20% interest in Marlton, and Marlton assumed all of the liabilities of the Acquired MGUs. Under certain circumstances set forth in the Limited Liability Company Agreement of Marlton, the Company has the right and/or obligation to purchase some or all of the minority interests in Marlton.
On April 16, 2004, the Company expanded its business through the acquisition of substantially all of the assets of an employer Medical Stop-Loss managing general underwriter, which had a block of approximately $13 million of annualized premium, for a purchase price of $600,000. The assets were acquired by IndependenceCare Underwriting Services-MidAtlantic LLC ("ICH-MidAtlantic"), which is a subsidiary of IndependenceCare Holdings. ICH-MidAtlantic, which is based in Baltimore, Maryland, retained the key marketing personnel of the former MGU. This acquisition resulted in goodwill in the amount of $486,000 and intangible assets in the amount of $114,000.
Effective July 1, 2004, a wholly-owned subsidiary of the Company acquired a 23% interest in Majestic Underwriters LLC ("Majestic"), a Medical Stop-Loss managing general underwriter which had a block of approximately $41 million of annualized premium, for a purchase price of $1,610,000. Concurrently, wholly-owned subsidiaries of IHC acquired a 52% interest in Majestic. The senior management of Majestic owns the remaining 25% interest. The Company accounts for this investment using the equity method of accounting. This acquisition resulted in a $522,000 reduction of valuation allowance related to the deferred tax assets, with the effect being an increase to deferred tax asset and a corresponding decrease in other investments. Under certain circumstances set forth in the Limited Liability Agreement of Majestic, the Company and/or IHC have the right and/or obligation to purchase some or all of the minority interest in Majestic.
As of December 31, 2004, the Company had substantially completed the wind down of all of its Internet services related subsidiaries, ISP Channel, Intellicom, and Aerzone, as well as its other subsidiaries, MTC and KCI.
Results of Operations for the Fiscal Year Ended December 31, 2004, Compared to the Fiscal Year Ended December 31, 2003
. Premiums earned increased $22,386,000 to $60,203,000 for the fiscal 2004, compared to $37,817,000 for fiscal 2003, an increase of 59.2%. This is primarily due to a combination of a higher percentage of Medical Stop-Loss business assumed from, as well as increased volume of business written by, Independence Holding Company in 2004. The average percentage of Medical Stop-Loss business ceded from IHC to Independence American for fiscal years 2004 and 2003 was 19.3% and 13.1%, respectively. Beginning in the 2004 third quarter, IHC also ceded 20% of its DBL premiums to Independence American.
Insurance Benefits, Claims and Reserves. Insurance benefits, claims and reserves amounted to $39,173,000 for fiscal 2004 as compared to $23,312,000 for fiscal 2003, an increase of $15,861,000, or 68%. The increase is mainly due to additional claims relating to increased earned premium volume from Independence American in 2004. Additionally, 2004 was negatively impacted by higher than expected claims from certain of Independence American's 2003 Medical Stop-Loss programs. Insurance benefits, claims and reserves for 2004 includes a charge of $1,730,000 to reflect loss development from prior treaty years and a corresponding increase in reserves for the current treaty year. While management sets reserves based on its best estimate of ultimate claim settlement cost, the Company adjusts reserves as claims mature, approach settlement or are otherwise resolved.
Minority Interest. The Company recorded $678,000 for fiscal 2004 and $645,000 for fiscal 2003 of expense related to the 20% minority interest in Marlton.
Income Taxes. The income tax expense was $3,569,000 for fiscal 2004 as compared to a tax benefit of $2,993,000 for fiscal 2003, an increase of $6,562,000. In 2003, the Company further reduced the valuation allowance relating to the deferred tax asset, which caused a corresponding increase in such deferred tax asset. The valuation allowance relates to the possibility that AMIC might not be able to fully utilize its prior tax year federal net operating loss carryforwards ("NOLs"). AMIC reviews the valuation allowance quarterly to determine the reasonableness of the amount, and previously reduced it in connection with the Company's acquisitions in 2002, 2003 and 2004. Based upon AMIC's profitability in 2003 and projected continuing profitable results, it was management's view that it was appropriate to further reduce the valuation allowance in the fourth quarter of 2003 which resulted in an increase in net income and income from continuing operations. There was no such adjustment in 2004.
Net Income. The Company had net income of $5,904,000, or $.69 diluted per share, for fiscal 2004, compared to net income of $12,671,000, or $1.50 per share diluted, for fiscal year 2003.
. The Company earned $37,817,000 of premiums on insurance business of Independence American for fiscal 2003.
Net Investment Income. Net investment income increased $237,000 to $1,967,000 for fiscal 2003, compared to $1,730,000 for fiscal 2002, mainly due to a higher yield from investments in fixed maturities in 2003. Investment income in 2002, although based on greater assets, was at a lower yield due to the shorter duration of the investments.
Net Realized Gains. The Company realized net gains of $330,000 from sales of its investments for fiscal 2003. Decisions to sell securities are based on cash flow needs, investment opportunities, and economic and market conditions, thus creating fluctuations in gains or losses from period to period.
Selling, General and Administrative. Selling, general, and administrative expenses increased $12,406,000 to $19,724,000 for fiscal 2003, compared to $7,318,000 for fiscal 2002. The increase is primarily due to commission expense recorded by Independence American and operating expenses from the MGUs. Selling, general, and administrative expenses for the 3 MGUs were $7,882,000 and commission expense for Independence American was $10,660,000 for fiscal 2003.
Minority Interest. The Company's share of minority interest expense for fiscal 2003 was $645,000 for its share of its investment in Voorhees.
Provision for Impaired Assets. The Company recognized a charge of $352,000 for the year ended September 30, 2002, as a result of writing off its accounting software. In light of its reduced operations, the Company changed to an off-the-shelf accounting software.
Gain (Loss) Attributed to Discontinued Operations. The Company recognized a $110,000 gain on discontinued operations for fiscal 2003, compared to a $5,926,000 loss attributed to discontinued operations for fiscal 2002. For the year ended September 30, 2002, the loss attributed to discontinued operations consisted of a $3,120,000 loss on disposition of Interlace, a $1,829,000 loss from operations of Intellicom, a $1,127,000 loss on disposition of Micrographic Technology Corporation ("MTC"), as a result of a preliminary arbitration decision related to a dispute with Applications Informatiques Multimedia and a dispute related to the sale of MTC to Global Information Distribution GmbH, a $900,000 gain on disposition of ISP Channel, resulting from the lower than anticipated costs of closing ISP Channel, and a $750,000 loss on disposition of Aerzone, resulting from a court decision related to a breach of contract and other legal matters. The gain of $110,000 in 2003 is primarily attributable to lower than expected interest and expenses with regard to an arbitration award, substantially offset by additional reserves on Intellicom related to the lease obligations of the Livermore facility due to difficulty in subletting the facility as compared to original expectations.
Net Income/Loss. The Company had net income of $12,671,000 or $1.50 per share, diluted, for fiscal 2003, compared to a net loss of $14,756,000 or a net loss per share of $1.76, diluted, for the year ended September 30, 2002.
Due to the acquisition of the insurance operations of IAHC, certain line items do not appear in the quarter ended December 31, 2001 Consolidated Statement of Operations.
Net Investment Income. Interest income decreased $324,000 to $292,000 for the quarter ended December 31, 2002, compared to $616,000 for the three months ended December 31, 2001, as a result of lower interest rates, and a decrease in cash, cash equivalents, and investments, available-for-sale due to the funding of losses from the Internet operations and the purchase of IAHC.
Non-Cash Compensation Expense (Benefit) Related to Stock Options. The Company recognized a non-cash compensation expense related to stock options of $632,000 for the quarter ended December 31, 2002. This expense is broken up into two components: an expense of $570,000 relating to the fair value of options issued for the three months ended December 31, 2002 accounted for under SFAS No. 123. (SFAS No. 123 was adopted as of October 1, 2002); and an expense of $62,000 for options issued prior to October 1, 2002 accounted for under the intrinsic value method of Accounting Principles Board #25 ("APB 25"). The expense for the three months ended December 31, 2001 of $405,000 relates to options accounted for under APB 25.
Loss from Discontinued Operations. As a result of the decision by the Board of Directors to discontinue the operations of Intellicom on March 29, 2002, the loss on operations for the quarter ended December 31, 2001 of $928,000 has been reclassified as loss from discontinued operations.
Net Loss. The Company had a net loss of $7,052,000 or a net loss per share of $0.84, for the quarter ended December 31, 2002, compared to a net loss of $2,780,000 or a net loss per share of $0.33, for the three months ended December 31, 2001. There was no gain or loss from discontinued operations for the quarter ended December 31, 2001.
Net cash provided by operating activities of continuing operations for the fiscal year ended December 31, 2004 was $8,447,000. Net cash flows benefited from premium volume and fees from MGUs, partially offset by higher than expected claims and losses.
Net cash used by investing activities of continuing operations for fiscal year ended December 31, 2004 was $7,577,000. This use of cash results from purchases of fixed maturities, equity securities, and short-term investments, net of sales of all such securities. The Company also acquired ICH-MidAtlantic and a 23% equity interest in Majestic.
Net cash provided by financing activities for the fiscal year ended December 31, 2004 was $198,000, resulting from the exercise of common stock options.
The Company believes it has sufficient cash to meet its presently anticipated business requirements over the next twelve months including the funding of discontinued operations, working capital requirements, and capital investments.
The composition of the Company's fixed maturities at December 31, 2004, utilizing Standard and Poor's rating categories, was as follows:
The Company reviews its investments regularly and monitors its investments continually for impairments. For the years ended December 31, 2004 and 2003, the Company recorded a realized loss for other than temporary impairments of $134,000 and $0 respectively. The Company's gross unrealized losses on fixed maturities totaled $500,000 at December 31, 2004. Substantially all of these securities were investment grade. The unrealized losses have been evaluated in accordance with the Company's policy and were determined to be temporary in nature at December 31, 2004. The Company holds all fixed maturities as available-for-sale and accordingly marks all of its securities to market through accumulated other comprehensive income (loss).
The following summarizes the estimated pre-tax change in fair value (based upon hypothetical parallel shifts in the U.S. Treasury yield curve) of the fixed income portfolio assuming immediate changes in interest rates at specified levels at December 31, 2004:
The Company monitors its investment portfolio on a continuous basis and believes that the liquidity of the Company will not be adversely affected by its current investments.
The Company had receivables from reinsurers of $13,496,000 at December 31, 2004. Substantially all of the business ceded to such reinsurers is of short duration. All of such receivables are either due from highly rated companies or are adequately secured. No allowance for doubtful accounts was deemed necessary at December 31, 2004.
The Company enters into a variety of contractual obligations with third-parties in the ordinary course of its operations. These obligations, as of December 31, 2004, are set forth in the table below. Insurance reserves all represent short-tail business. However, we do not believe that our cash flow requirements can be fully assessed based upon an analysis of these obligations. Future cash outflows, whether they are contractual obligations or not, also will vary based upon our future needs. Although some outflows are fixed, others depend on future events. The Company has expected contractual obligations relating to non-cancelable leases and insurance reserves of the following at December 31, 2004 (in thousands):
Under certain circumstances set forth in the Limited Liability Company Agreements of Marlton and Majestic, the Company has the right and/or obligation to purchase some or all of the minority interests in Marlton and Majestic.
Independence American, which is domiciled in Delaware, is licensed to write property and/or casualty insurance in 33 states and the District of Columbia, and has a B+ (Very Good) rating from A.M. Best Company, Inc. ("A.M. Best"). An A.M. Best rating is assigned after an extensive quantitative and qualitative evaluation of a company's financial condition and operating performance, and is also based upon factors relevant to policyholders, agents, and intermediaries, and is not directed towards protection of investors. A.M. Best ratings are not recommendations to buy, sell or hold securities of the Company.
Independence American is primarily a reinsurer, and currently derives most of its business from long-term reinsurance treaties with IHC's carriers. In addition to Medical Stop-Loss, Independence American also began to reinsure in 2004 a short-term statutory disability benefit product ("DBL") in New York, and will reinsure several additional IHC products in 2005, including 5% of a $50,000,000 block of employer-sponsored group major medical business. This block was recently 100% reinsured by Standard Security Life Insurance Company of New York from another carrier. In addition, in 2005, Independence American will reinsure up to 10% of IHC's employer-sponsored group major medical, short-term medical, dental and vision business. The short-term medical will be administered by Health Plan Administrators, Inc. ("HPA"), a market leader in this product, which is now affiliated with IHC. The employer-sponsored group major medical will be marketed and administered by Insurers Administrative Corporation, a market leader in consumer-driven medical plans for small and medium size employer groups.
Independence American is also positioning itself to be an issuing carrier of Medical Stop-Loss and short-term medical. Currently, it has approved employer Medical Stop-Loss policies in 24 states and approved provider excess loss policies in 13 states. It is also in the process of filing a short-term medical product in 30 states for the continUcare program and otherwise. Independence American is actively seeking more licenses and product approvals.
Madison National and Independence American entered into a reinsurance agreement to protect Independence American against losses (excluding terrorism and extra-contractual obligations) occurring during the period from January 1, 2005 to December 31, 2005. In the event that Independence American's claims, loss adjustment expenses, and incurred but not reported reserves ("Net Losses") exceeds 95% of the net premiums earned by Independence American, then Madison National will pay Independence American an amount equal to the excess over the Net Losses. In no event shall Madison National pay Independence American more than $5,000,000. Independence American will pay Madison National, quarterly, a premium of .175% of net retained premium subject to a minimum premium of $50,000 and a maximum premium of $100,000.
In December 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004) ("SFAS No. 123R"), "Share-Based Payment" which revised SFAS No. 123, "Accounting for Stock-Based Compensation. This statement supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." The revised statement addresses the accounting for share-based payment transactions with employees and other third parties, eliminates the ability to account for share-based compensation transactions using APB 25 and requires that the compensation costs relating to such transactions be recognized in the consolidated statement of operations. The revised statement is effective as of the first interim period beginning after June 15, 2005. The Company already applies the fair value based method of accounting for all stock based compensation issued after October 1, 2002. At December 31, 2004 all such share accounted for under APB 25 were fully vested or expired.
On September 30, 2004, the Financial Accounting Standards Board ("FASB") Issued Staff Position No. EITF Issue 03-1-1, "Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," which delays the effective date for the measurement and recognition guidance contained in Emerging Issues Task Force ("EITF") Issue No. 03-1. EITF Issue No. 03-1 provides guidance for evaluating whether an investment is other-than-temporarily impaired and was originally to be effective for other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004 (July 1, 2004 for the Company). The delay in the effective date for the measurement and recognition guidance contained in EITF Issue No. 03-1 does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. Subsequent to the issuance of Staff Position No. EITF Issue 03-1-1, the FASB announced plans for a full reconsideration of existing authoritative literature concerning other-than-temporary impairment of securities. The outcome of this reconsideration and the impact, if any, on the Company's impairment recognition cannot be predicted at this time.
IHC Will Exercise Significant Influence Over the Company's Business and Affairs, Which May Result in Potential Conflicts of Interest Between IHC and the Company; Reliance on IHC's Expertise
The Company's operations are being directed by IHC management and employees, which may result in potential conflicts of interest between IHC and the Company. For example, a conflict may arise if IHC were to engage in activities or pursue corporation opportunities that overlap with the Company's business. Because IHC's management will also constitute the Company's management, these individuals will have fiduciary duties to both companies, which could result in conflicts of interest, including the Company foregoing opportunities or taking actions that disproportionately benefit IHC. IHC will also have at least two representatives on the Company's Board of Directors who will have similar conflicts of interest. In addition, the Company is relying upon the management and expertise of officers of IHC who also serve as officers of the Company.
Although the stock transfer restrictions contained in the Certificate of Incorporation are intended to reduce the likelihood of an ownership change, it will not prevent all transfers that might result in an "ownership change." Furthermore, certain changes in relationships and other events not addressed by the stock transfer restrictions could cause AMIC to undergo an "ownership change." Section 382 of the Code is an extremely complex provision with respect to which there are many uncertainties. In addition, AMIC has not requested a ruling from the IRS regarding the effectiveness of the stock transfer restrictions and, therefore, AMIC cannot be certain that the IRS will agree that the stock transfer restrictions are effective for purposes of Section 382 of the Code. Further, AMIC cannot assure that the stock transfer restrictions or portions thereof will be enforceable in Delaware courts or that the IRS would agree that all of AMIC's tax net operating loss carryforwards are allowable. In addition, AMIC's board of directors may determine, in its sole discretion, to permit a restricted transfer that results in an "ownership change" if it determines that such transfer is in the best interests of AMIC. Therefore, the stock transfer restrictions were to reduce, but not necessary eliminate, the risk that Section 382 of the Code will cause limitations on the use of tax attributes of AMIC.
The overall level of economic activity and the competitive environment in the industry.
If the Company is Unsuccessful in Competing Against Larger or More Well-Established Competitors, Its Results of Operations and Financial Condition Will Be Adversely Affected
Regulatory authorities may deny or revoke licenses for various reasons, including the violation or regulations. In some instances, the Company follows practices based on its interpretations of regulations, or those that it believes to be generally followed by the industry, which may be different from the requirements or interpretations of regulatory authorities. If the Company does not have the requisite licenses and approvals and does not comply with applicable regulatory requirements, the insurance regulatory authorities could preclude or temporarily suspend it from carrying on some or all of its activities or otherwise penalize it. That type of action could have a material adverse effect on its business. Also, changes in the level of regulation of the insurance industry (whether federal, state or foreign), or changes in laws or regulations themselves or interpretations by regulatory authorities, could have a material adverse effect on the Company's business.
Individuals who obtain health coverage through self-insured plans cannot currently sue their employer in state court for punitive or compensatory damages, but can seek legal recourse in federal court where an employer can be ordered to cover a wrongfully-denied benefit. In the continuing debate over health care reform, certain federal and state legislation has been proposed which could have the effect of making plan sponsors, administrators, or certain other parties liable for punitive damages in state court. While the Company cannot predict whether any of these proposals will be adopted or what, if any, impact enactment of any of these would have on its reinsurance of Medical Stop-Loss, the number of employers offering health benefits or choosing self-insured plans could be reduced, plans could increase the portion paid by employees (thereby reducing participation), pricing and coverage options could be affected, and the Company could be faced with greater liability exposure.
One of the Company's principal assets through its ownership of IAHC, is the shares of capital stock of Independence American. The Company may rely on dividends from Independence American to meet its obligations for paying principal and interest on outstanding debt obligations, dividends to stockholders and corporate expenses. The payment of dividends by Independence American is subject to regulatory restrictions and will depend on the surplus and future earnings of Independence American, as well as the regulatory restrictions. As a result, should the Company's other sources of funds prove to be inadequate. The Company may not be able to receive dividends from Independence American at times and in amounts necessary to meet its obligations.
The Company is a Delaware corporation. The Delaware General Corporation Law contains certain provisions that may discourage or delay a change in control of the Company, make a change in control the Company more difficult or prevent the removal of incumbent directors. In addition, the Company's Certificate of Incorporation and Bylaws contain certain provisions that have the same or a similar effect. These provisions may have a negative impact on the price of the Company's common stock and may discourage third-party bidders from making a bid for the Company or may reduce any premiums paid to stockholders for their common stock.
and 2003 and September 30, 2002, and for the three months ended December 31, 2002
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. 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.
AMIC acquired IndependenceCare Underwriting Services - MidAtlantic LLC ("MidAtlantic") during 2004. Management excluded from its assessment of the effectiveness of AMIC's internal control over financial reporting as of December 31, 2004, MidAtlantic's internal control over financial reporting associated with total assets of $2,341,000 and total revenues of $516,000 as of and for the year ended December 31, 2004.
Management assessed the effectiveness of AMIC's internal control over financial reporting as of December 31, 2004. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control -Integrated Framework. Based on our assessment we concluded that, as of December 31, 2004, AMIC's internal control over financial reporting is effective.
KPMG LLP, the independent registered public accounting firm that audited the financial statements in this Annual Report, has issued an attestation report on management's assessment of, and the effective operation of, AMIC's internal control over financial reporting as of December 31, 2004, which is included herein on page 33.
In our opinion, management's assessment that American Independence Corp. and subsidiaries 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 (COSO). Also, in our opinion, American Independence Corp. and subsidiaries 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 (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of American Independence Corp. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders' equity and cash flows for the years ended December 31, 2004 and 2003, the three-months ended December 31, 2002 and for the year ended September 30, 2002, and our report dated March 15, 2005 expressed an unqualified opinion on those consolidated financial statements. As discussed in Notes 2 and 13 to the consolidated financial statements, the Company adopted certain provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," in the three months ended December 31, 2002.
We have audited the accompanying consolidated balance sheets of American Independence Corp. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders' equity and cash flows for the years ended December 31, 2004 and 2003, the three months ended December 31, 2002 and for the year ended September 30, 2002. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of American Independence Corp. and subsidiaries' 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 15, 2005, expressed an unqualified opinion on management's assessment of, and the effective operation of, internal control over financial reporting.
Prior to November 14, 2002, the Company (then known as SoftNet Systems, Inc.) was a holding company principally engaged in providing Internet services. As of September 30, 2002, the Company had discontinued the businesses of ISP Channel, Inc. ("ISP Channel"), Intelligent Communications, Inc. ("Intellicom") and Aerzone Corporation ("Aerzone"), and reduced its corporate headquarters staff. Four previously reported business segments, business center services, satellite-based Internet services, cable-based Internet services and document management, have ceased operations or have been sold, and accordingly are reported as discontinued operations (see Note 9).
The Company changed its fiscal year end from September 30 to December 31 in 2002. As a result, the Company filed a Form 10-QT for the quarter ended December 31, 2002 representing the transitional reporting period. This report on Form 10-K for the twelve months ended December 31, 2004 and 2003 represents the new fiscal year end, which is December 31. The Company's tax year remains unchanged at September 30.
The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of the revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash and cash equivalents consist of cash and highly liquid securities with maturities of three months or less from date of purchase. Restricted cash primarily consists of funds held by the MGUs for the benefit of their insurers and reinsurers. These funds are restricted and are to be used to facilitate expeditious payment of approved claims. The funds are replenished by the insurers and reinsurers as claims are paid by the MGUs.
Investments with original maturities of 91-days to 1 year are considered short-term investments and are carried at cost which approximates fair value.
(ii) Financial instruments sold, but not yet purchased, represent obligations to replace borrowed securities that have been sold. Such transactions occur in anticipation of declines in the fair value of the securities. The Company's risk is an increase in the fair value of the securities sold in excess of the consideration received, but that risk is mitigated as a result of relationships to certain securities owned. Unrealized gains or losses on open transactions are credited or charged, as appropriate, to the Consolidated Statements of Operations. While the transaction is open, the Company will also incur an expense for any accrued dividends or interest payable to the lender of the securities. When the transaction is closed, the Company realizes a gain or loss in an amount equal to the difference between the price at which the securities were sold and the cost of replacing the borrowed securities.
(iv) The Company enters into derivative financial instruments, such as put and call option contracts and options on interest rate futures contracts, to minimize losses on portions of the Company's fixed income portfolio in a rapidly changing interest rate environment. Equity index options are entered into to offset price fluctuations in the equity markets. These derivative financial instruments are all readily marketable and are carried on the Consolidated Balance Sheets at their current fair value with changes in unrealized gains or losses, credited or charged, as appropriate, directly to the Consolidated Statements of Operations. All realized gains and losses are reflected currently in the Consolidated Statements of Operations. There were no such derivatives outstanding at December 31, 2004 and 2003. Gains and losses on these instruments were insignificant during 2004, 2003 and 2002.
(vi)The Company reviews its investment securities regularly and determines whether other than temporary impairments have occurred. If a decline in fair value is judged by management to be other than temporary, a loss is recognized by a charge to the Consolidated Statements of Operations, establishing a new cost basis for the security. The factors considered by management in its regular review include, but are not limited to: the length of time and extent to which the fair value has been less than cost; the financial condition and near-term prospects of the issuer; adverse changes in ratings announced by one or more rating agencies; whether the issuer of a debt security has remained current on principal and interest payments; whether the decline in fair value appears to be issuer specific or, alternatively, a reflection of general market or industry conditions; and the Company's intent and ability to hold the security for a period of time sufficient to allow for a recovery in fair value. For securities within the scope of Emerging Issues Task Force Issue 99-20, such as purchased interest-only securities, an impairment loss is recognized when there has been a decrease in expected cash flows combined with a decline in the security's fair value below cost.
Fixed assets are stated at cost net of accumulated depreciation. Improvements are capitalized while repair and maintenance costs are charged to operations as incurred. Depreciation of property and equipment has been provided on the straight-line method over the estimated useful lives of the respective assets (3 years for computer equipment and 10 years for furniture and fixtures). Amortization of leasehold improvements has been provided on the straight-line method over the shorter of the lease term or the estimated useful life of the asset.
The Company accounts for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial carrying amounts of existing assets and liabilities and their respective tax basis, and operating loss and tax credit carry forwards. 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. Valuation allowances are established when necessary to reduce deferred tax assets where it is more likely than not that the deferred tax asset will not be realized (see Note 16).
Basic income (loss) per common share is computed using the weighted average number of common stock shares outstanding during the period. Diluted income (loss) per common share is computed using the weighted average number of common stock shares and common stock equivalent shares outstanding during the period. Common stock equivalents consist of stock options (using the "treasury stock" method). Common Stock equivalent shares are excluded from the computation if the effect is anti-dilutive. As a result of the anti-dilutive effect, common stock equivalent shares have been excluded from the computation of diluted earnings per share for periods presented with a net loss. Included in the diluted earnings per share calculation for fiscal years 2004 and 2003, are 101,000 and 54,000 shares, respectively, from the assumed exercise of options using the treasury stock method. Net income does not change as a result of the assumed dilution of options.
In December 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004) ("SFAS No. 123R"), "Share-Based Payment" which revised SFAS No. 123, "Accounting for Stock-Based Compensation. This statement supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." The revised statement addresses the accounting for share-based payment transactions with employees and other third parties, eliminates the ability to account for share-based compensation transactions using APB 25 and requires that the compensation costs relating to such transactions be recognized in the consolidated statement of operations. The revised statement is effective as of the first interim period beginning after June 15, 2005. The Company already applies the fair value based method of accounting for all stock based compensation issued after October 1, 2002. At December 31, 2004 all such share accounted for under APB 25 were fully vested or expired.
The Company completed its annual impairment testing of goodwill and an impairment charge was not required.
The changes in the carrying amount of goodwill are as follows (in thousands):
On April 16, 2004, the Company expanded its business through the acquisition of substantially all of the assets of an employer Medical Stop-Loss managing general underwriter, which had a block of approximately $13 million of annualized premium, for a purchase price of $600,000. The assets were acquired by IndependenceCare Underwriting Services-MidAtlantic LLC ("ICH-MidAtlantic"), which is based in Baltimore, Maryland and which retained the key marketing personnel of the former MGU. This acquisition resulted in goodwill in the amount of $486,000 and intangible assets in the amount of $114,000.
Government-sponsored enterprise mortgage-backed securities consist of Federal Home Loan Mortgage Corporation and Federal National Mortgage Association securities.
Gross gains of $12,000 and no gross losses were realized on sales of available-for-sale securities for the quarter ended December 31, 2002.
There were no gross gains or gross losses for the year ended September 30, 2002.
Major categories of net investment income for fiscal years 2004, 2003 and 2002 and the quarter ended December 31, 2002 are summarized as follows:
Net realized gains on investments for fiscal years 2004, 2003 and the quarter ended December 31, 2002 are as follows:
In the transition period ending December 31, 2002, the Company wrote off its investment in 337,496 series B preferred stock shares of Dotcast.com for $1,000,000 as an other-than-temporary decline. Dotcast.com is a privately held company developing a national high-speed digital network for the distribution of digital entertainment, interactive services and multimedia communications.
Prior to becoming an insurance holding company as a result of the acquisition of IAHC on November 14, 2002, the Company was a holding company principally engaged in providing Internet services through the following discontinued operations, Intelligent Communications, Inc. ("Intellicom"), Aerzone, ISP Channel, KCI, and MTC. The operating results of these discontinued operations have been segregated from continuing operations and are reported as a gain or loss from discontinued operations on the consolidated statements of operations. Although it is difficult to predict the final results, the gain or loss on disposition from discontinued operations includes management's estimates of costs to wind down the business and costs to settle its outstanding liabilities. The actual results could differ from these estimates. The net liabilities associated with discontinued operations are reflected in net liabilities associated with discontinued operations in the accompanying consolidated balance sheets.
On January 24, 2000, the Company founded Aerzone (formerly SoftNet Zone, Inc.) to provide high-speed Internet access to global business travelers. As part of the Aerzone business, the Company acquired Laptop Lane, on April 21, 2000. On December 19, 2000, the Company decided to discontinue the Aerzone business in light of significant long-term capital needs and the difficulty of securing the necessary financing because of the current state of the financial markets. The Company has a remaining reserve for discontinued operations of Aerzone of $27,000 at December 31, 2004.
On December 7, 2000, the Company's Board of Directors approved a plan to discontinue providing cable-based Internet services through its ISP Channel subsidiary by December 31, 2000, because consolidation in the cable television industry made it difficult for ISP Channel to achieve the economies of scale necessary to provide such services profitably, and the Company was no longer able to bear the costs of maintaining the ISP Channel. The Company does not have a reserve for ISP Channel at December 31, 2004.
Gain from disposition of discontinued operations results from re-estimation of certain expected expenses.
Net liabilities associated with discontinued operations at December 31, 2004 and 2003 are as follows (in thousands):
On December 28, 2000, the Company's Board of Directors approved a plan to reduce its corporate headquarters staff. At December 31, 2004, the Company had a remaining reserve of $300,000 relating to the restructuring. This reserve primarily relates to the leasehold obligations of the former corporate headquarters in San Francisco, California; the Company maintains an $800,000 security deposit with respect to this liability which is included in restricted cash and will become unrestricted as of August 1, 2005.
On July 30, 2002, the Company's Board of Directors approved a shareholder rights plan (the "Plan"). Pursuant to the Plan's approval, the Company's Board of Directors declared a dividend distribution of one Preferred Share Purchase Right (the "Rights") on each outstanding common stock share. The dividend distribution of the Rights would have been be payable to common stock stockholders of record on August 14, 2002. The Rights distribution is not taxable to stockholders. Subject to limited exceptions, the Rights would have been exercisable if a person or group acquires or announces a tender offer for 4.99% or more of the Company's common stock. Under certain circumstances, each Right would have been entitled shareholders to buy one one-hundredth of a share of newly created Series A Junior Participating Preferred Stock of the Company at an exercise price of $9.00. The Company's Board of Directors would have been entitled to redeem the rights at $0.01 per right at any time before a person acquired 4.99% or more of the outstanding common stock. The Plan expired pursuant to its terms upon the Company's filing of its Amended and Restated Certificate of Incorporation with the Secretary of State of the State of Delaware on November 14, 2002. This Amended and Restated Certificate of Incorporation provided for limitations on the acquisition of the Company's common stock in excess of certain percentage amounts (see note 16).
Effective October 1, 1998, the Company implemented the 1998 Plan, which the Company's stockholders approved on April 13, 1999. The 1998 Plan provides for the grants of non-statutory and incentive stock options, stock appreciation rights, restricted stock awards, performance shares, and other awards to officers, employee and other individuals. Under the terms of the 1998 Plan, stock options have a maximum term of ten years from the date of grant, and have various vesting criteria depending on the grant with most grants vesting 25% on the first year anniversary date of the grant and ratably over the next 36 months. In addition, the number of common stock shares reserved for issuance under the 1998 Plan will automatically increase on the first trading day of each calendar year, beginning in calendar year 2000, by an amount equal to four percent of the total number of common stock shares outstanding on the last trading day of the preceding calendar year, but in no event will any such annual increase exceed 666,666 shares, subject to adjustment for subsequent stock splits, stock dividends and similar transactions. At December 31, 2004, a total of 2,831,251 stock shares are reserved for issuance under the 1998 Plan. At December 31, 2004, stock options for 447,552 common stock shares were outstanding, stock options for 325,872 common stock shares were vested, and 2,383,699 common stock shares remained available for future stock options grants and other awards.
The following table summarizes the outstanding options and warrants to purchase common stock shares for fiscal years 2004, 2003 and 2002:
The following table summarizes information regarding stock options outstanding at December 31, 2004:
On November 14, 2002, the Company adopted certain provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). SFAS 123 established a fair-value-based method of accounting for stock-based compensation plans. Pursuant to the transition provisions of SFAS 123, the Company will apply the fair value method of accounting to all option grants issued on or after October 1, 2002. The fair value method will not be applied to stock option awards granted prior to October 1, 2002. Such awards will continue to be accounted for under the intrinsic value method pursuant to APB 25, except to the extent those prior years' awards are modified subsequent to October 1, 2002. At December 31, 2004 all such shares accounted for under APB 25 were fully vested or expired. The Company recorded an expense of approximately $456,000, $123,000 and $570,000 for the years ended December 31, 2004 and 2003 and the three months ended December 31, 2002, respectively, related to options issued under the fair value based method. For the year ended December 31, 2003 and the three months ended December 31, 2002, the remaining $18,000 and $62,000, respectively, of non-cash compensation expense relates to options issued under the intrinsic value method pursuant to APB 25.
From October 1, 1998 to April 12, 1999, the Company, pursuant to the 1998 Plan, granted 539,516 incentive and non-qualified common stock options with a weighted average exercise price of $38.22 per share to certain employees. As a result of the adoption of the 1998 Plan, and in accordance with APB 25, the Company recorded a non-cash deferred stock compensation charge of $77,361,000 related to the issuance of these stock options. Deferred stock compensation was amortized on a straight-line basis over the remaining vesting period of such stock options to compensation related to stock options. For the year ended December 31, 2003, the three months ended December 31, 2002, and the year ended September 30, 2002 the Company recognized compensation expense related to these stock options of $17,000 $62,000 and $1,501,000, respectively, which includes $35,000 allocated to the discontinued operations of Intellicom.
The Company and its subsidiaries file a consolidated Federal income tax return on a September 30 fiscal tax year. The provision (benefit) for income taxes for the periods ended December 31, 2004, 2003 and 2002 and September 30, 2002 are as follows:
The Federal income tax provision (benefit) for the periods ending December 31, 2004 and 2003 include income tax provisions of $3,155,000 and $969,000, respectively, for the utilization of the Company's Federal net operating loss carryforwards (NOLs).
The difference between the Company's actual tax expense (benefit) recorded and the amounts computed by applying the U.S. Federal income tax rate of 35% to pre-tax loss for the three months ended December 31, 2002 and the fiscal year ended September 30, 2002 are due primarily to the valuation allowance on the Company's net operating losses.
At December 31, 2004, the Company had Federal net operating loss carryforwards of approximately $280,340,000 which expire as follows (in thousands).
At December 31, 2004, the Company also had net operating loss carryforwards of approximately $25,814,000 for state income tax purposes, primarily in the State of California. Management believes that it is more likely than not that the state tax benefit of these net operating loss carryforwards will not be realized.
The liability for insurance reserves as of the acquisition date of IAHC on November 14, 2002 was $3,025,000, net of reinsurance recoverables of $3,484,000.
As a result of the Company's Board of Directors decision to discontinue the last of its former business segments in April 2002, segment information for all periods prior to the acquisition of IAHC has been restated. Management has reclassified its segment information to show Independence American separately from its MGU operations, which is how management currently views its operations. Segment information is as follows: