The following selected consolidated statement of operations data and balance sheet data as of and for the years ended December 31, 2003, 2002, 2001, 2000 and 1999 have been derived from our Consolidated GAAP Financial Statements.
cumulative effect of accounting change (16,444 ) (38,313 ) (64,869 ) 34,470
(Benefit) provision for federal income taxes (3,091 ) (13,026 ) (16,280 ) 11,720
Net (loss) income $ (13,353 ) $ (30,438 ) $ (48,589 ) $ 22,750
(8) $ (13,353 ) $ (25,287 ) $ (47,736 ) $ 23,603
of accounting change (7) $ (0.64 ) $ (1.31 ) $ (3.41 ) $ 3.13
change (8) $ (0.64 ) $ (1.31 ) $ (3.35 ) $ 2.70
Expense ratio 38.7 % 37.1 % 59.0 % 32.0 % 31.3 %
Total (11) 115.6 % 148.6 % 127.3 % 100.2 % 99.8 %
Return on average equity (12) (8.7 )% (17.5 )% (25.5 )% 13.1 % 13.5 %
Effective December 31, 2001, we entered into a reinsurance agreement for substantially all of our long-term care insurance policies, which we are accounting for as deposit accounting. The reinsurer maintains a notional experience account for our benefit in the event of commutation. The notional experience account receives an investment credit, derived from the separate components of the notional experience account. This gain represents the income from the embedded derivative portion of our notional experience account, similar to that of an unrealized gain or loss on a bond.
During the third quarter of 2002, we determined to refine certain of our processes and assumptions in the establishment of our reserves for current claims. As a result of this change, we increased our reserves for current claims by approximately $83,000 for claims incurred prior to the third quarter of 2002.
Our reinsurance agreement requires us to accrue an annual expense and risk charge to the reinsurer. Primarily as a result of these anticipated charges, we impaired the value of our net unamortized policy acquisition costs by $61,800 in 2001. In the third quarter of 2002, we impaired the value of our deferred acquisition cost asset by approximately $1,100 as a result of the change in our assumptions regarding the future profitability of our existing business in force.
As a result of our December 31, 2001 reinsurance agreement with a foreign reinsurer, we must pay federal excise tax of 1% on all ceded premium. The 2001 expense represents excise taxes due for premiums transferred at the inception of the contract. Beginning in 2002, we also accrue an annual expense and risk charge payable to the reinsurer in the event of future commutation of the agreement.
During 1999, we discontinued the implementation of a new computer system, for which we had previously capitalized $2,799 of licensing, consulting and software costs. When we decided not to use this system, its value became fully impaired. In 2003, having completed a significant portion of our needs assessment and rules development for our current SRP, and a portion of the programming necessary, we reevaluated the time and expense required to fully implement the SRP. We believe, based upon a review of certain vendor solutions recently introduced or more fully tested, that we will be able to modify our plans for an internally developed program and utilize a new vendor solution while maximizing the use of our efforts and capitalized costs to date. We are currently evaluating proposals from vendors and anticipate making a determination during the second quarter of 2004. As a result of our intention to select one of these additional vendors, we determined to impair $522 of our capitalized charges for development of software at December 31, 2003.
On May 25, 2001, we issued approximately 11,547 new shares of our common stock, for net proceeds of $25,726, through a rights offering. We also issued approximately 570 new shares in 2002 through a direct equity placement. In 2003, approximately $2,000 of convertible debt due 2003 was exchanged for new convertible debt due 2008. In addition, we issued approximately $33,000 in new convertible debt due 2008 and used a portion of the proceeds to retire approximately $9,000 in convertible debt due 2003. During 2003, holders of approximately $8,000 of the convertible debt due 2008 converted their debt for approximately 5,000 shares of our common stock.
We measure our combined ratio as the total of all expenses, including benefits to policyholders, related to policies in-force divided by premium revenue. This ratio provides an indication of the portion of premium revenue that is devoted to the coverage of policyholder related expenses. We depend on our investment returns to offset the amounts by which our combined ratio is greater than 100%. In 2001, reduced premium revenue, the impairment of our DAC asset in the fourth quarter (see note 4) and the payment of excise taxes on the initial premium for our new reinsurance agreement (see note 5) increased our combined ratio above what it otherwise would have been. For 2002, see note 2.
Under statutory accounting principles, ceded reserves are accounted for as offsetting negative benefits and negative premium. Our 2003, 2002, 2001 and 2000 premium is reduced by approximately $309,000, $326,000, $408,000 and $226,000, respectively from reinsurance transactions.
GAAP expense ratio (excluding interest) 35.1 % 41.4 % 39.1 % 26.0 %
o It requires assumptions to be made that were uncertain at the time the estimate was made; and
Our policies are accounted for as long duration policies. As a result there are two components to the liabilities associated with our policies. The first is a liability for future policyholder benefits, represented by the present value of future benefits less future premium collections. In calculating these reserves we utilize assumptions, including estimates for persistency (policies that do not lapse), morbidity (claims expectations), mortality, interest rates, and premium rate increases. These assumptions are estimated in the year a policy is issued. Once the assumptions are established, we continue to utilize those assumptions unless our assessment of deferred acquisition costs (“DAC”) indicates that the current unamortized DAC asset is not recoverable in future periods. Any variance from the assumptions established in the year a policy is issued could have a material impact on our results of operations and financial condition.
For policies issued in 2002 and 2003, we use a 4.5% interest rate to discount future experience. For policies issued prior to 2002, we use a 5.7% interest discount rate.
o We also include an estimate of premium rate increases based on what we have currently filed or specifically plan to file and/or have partially implemented.
Long-term care insurance has fixed annual premiums that can be adjusted only upon approval of the insurance departments of the states where the premiums were written. The process for filing for premium rate increases requires the company to demonstrate to the insurance department that expected claims experience is anticipated to exceed original assumptions. The approval of premium rate increases is at the discretion of the insurance department.
The second component is a reserve we establish is for incurred, either reported or not yet reported, claims. This amount represents the benefits to be paid in the future for our current claims. The significant assumptions utilized in establishing claim reserves are expectations about the duration and incidence of claims and the interest rate utilized to discount the claim reserves. These assumptions are based on our past experience, industry experience and current trends. We establish our claim reserves in each period based upon our most currently available information and assumptions.
The DAC recoverability analysis includes our most recent assumptions for persistency, morbidity, interest rates, and premium rate increases, all or any of which may be different than the assumptions utilized in establishing our benefit reserves.
Investment of future cash flows in instruments and at durations similar to our current investment mix, using current market interest rates for new investments (new investments are assumed to average 5.34%).
We are also involved in a dispute with one of our reinsurers over an alleged breach of contract by the Company as a result of the Company entering into the 2001 Centre reinsurance agreement without obtaining prior written approval of the reinsurer. We have contested this assertion of breach and are continuing discussions with reinsurer to reach an equitable resolution, including, but not limited to, arbitration, the recapture of the coverage and reserves, premium rate increases, or additional reinsurance business in the future. Reinsurance recoverables related to this treaty were $10,600 and $10,200 at December 31, 2003 and 2002, respectively. We have additional reinsurance agreements with the same reinsurer, for which it has also claimed the same breach. However, none of the reinsured policies were ceded to Centre Solutions (Bermuda), Inc. and we believe any claim of breach is baseless.
We have established the accounting model for this reinsurance agreement assuming that we will commute the contract on December 31, 2007, the first available commutation date. We intend, but are not required, to commute the agreement on December 31, 2007. We have significant incentive to commute the agreement on December 31, 2007 as the expense and risk charges applied to the notional experience account for the benefit of the reinsurer begin to escalate after December 31, 2007 and the reinsurer may exercise warrants at a common stock equivalent price of $2.00 per share, representing approximately 20% of the then outstanding common stock on a fully diluted basis.
As part of our reinsurance agreement, effective December 31, 2001, the reinsurer was granted four tranches of warrants to purchase shares of non-voting convertible preferred stock. The first three tranches of warrants are exercisable through December 31, 2007 at common stock equivalent prices ranging from $4.00 to $12.00 per share. If exercised and converted, the convertible preferred stock would represent approximately 15% of the then outstanding shares of our common stock on a fully diluted basis. If the agreement is not commuted on December 31, 2007, the reinsurer may exercise the fourth tranche of convertible preferred stock purchase warrants at a common stock equivalent price of $2.00 per share, which if converted would represent an additional 20% of the then outstanding common stock on a fully diluted basis. We are recognizing the additional consideration of entering into the agreement, represented by the fair value of the warrants granted to the reinsurer, over the period of time to the expected commutation date.
a). The fixed debt host yields a fixed return based upon the yield to maturity of the underlying benchmark indices. The return on the fixed debt host is reported as investment income in the Statements of Income and Comprehensive Income.
At December 31, 2003, the balance of our goodwill was $20,360. The goodwill relates to our agency operations.
The agency valuation is sensitive to future growth in sales of insurance policies, the persistency of the renewal commission stream and expense saving initiatives that we have implemented. We utilized a 15% discount rate in the goodwill analysis. We assume that our agencies are capable of future growth from both the sale of our products and from the sale of other carriers’ products.
As of December 31, 2003 the fair value of the embedded derivative was $3,018. In determining the fair value of the embedded derivative, we make certain assumptions, including the future volatility and liquidity of the Company’s common stock. We believe the liquidity of the stock significantly impacts the assumed value of the embedded derivative due to the optionality of the ability for a converting holder to liquidate the shares and recognize its intended value. We also take into consideration recent trends in the number of holders converting. If we assumed that all holders converted on December 31, 2003, without giving any consideration to the relationship of the current share price to the conversion price or to the impact of this level of conversions on the stock price, the value of the embedded derivative would be $9,073.
We have net operating loss carryforwards of $30,295 or $10,603 on a tax effected basis, which have been generated by taxable losses at the parent company, and if unused will expire between 2012 and 2022. We have net operating loss carryforwards of $29,931 or $10,476 on a tax effected basis, which have been generated by taxable losses at our insurance subsidiaries, and if unused, will expire in 2016. In 2003, we recorded a valuation allowance of approximately $2,500 against our operating loss carryforwards.
Economic cycles can influence a policyholder’s ability to continue the payment of insurance premiums when due. We believe that publicity regarding Federal and state tax legislation allowing medical deductions for certain long-term care insurance premiums has raised public awareness of the escalating costs of long-term care and the value provided to the consumer by long-term care insurance. The ratings assigned to our insurance subsidiaries by independent rating agencies also influence consumer decisions.
Net investment income. Net investment income earned for the 2003 period increased 7.9% to $43,273, from $40,107 for the 2002 period.
Our average yield on invested assets at cost, including cash and cash equivalents, was 5.19% and 5.91%, respectively, in the 2003 and 2002 periods. The investment income component of our notional experience account investment credit generated $41,426 and $38,375 in the 2003 and 2002 periods, respectively. The notional experience account yields a fixed return based upon the yield to maturity of the underlying benchmark indices, which are comprised of U.S. Treasury strips, government agencies and investment grade corporate bonds with weightings of approximately 25%, 15% and 60%, respectively, and have duration of approximately 11 years. The average yield on the notional experience account was 5.63% and 6.51% for the 2003 and 2002 periods, respectively.
Market gain (loss) on notional experience account. We recorded a loss on our notional experience account of $9,494 in the 2003 period compared to a market gain of $56,555 in the 2002 period.
Change in preferred interest on early conversion. Holders of our convertible subordinated notes are entitled to convert their notes into shares of our common stock before October 2005 and receive a discounted amount of interest that they would have otherwise received until that date. We may elect to pay this interest in cash or in newly issued shares of common stock. We have determined that this feature is an embedded derivative as defined in Statement of Financial Accounting Standards No. 133 “Accounting for Derivative Instruments and Hedging Activities.” As discussed in “Critical Accounting Policies,” we have separately valued and bifurcated the embedded derivative from the 2008 Notes. At each balance sheet date, the embedded derivative must be recorded at fair value, with any change in fair value recognized in current operations.
Benefits to policyholders. Total benefits to policyholders in the 2003 period decreased 33.4% to $247,730 compared to $371,998 in the 2002 period. Our loss ratio, or policyholder benefits to premiums, was 77.0% in the 2003 period, compared to 111.5% in the 2002 period. Excluding the impact of a refinement of our assumptions and processes and a change in interest discounting, our loss ratio in the 2002 period was approximately 86.6% compared to the 2003 period loss ratio of 77.0%. We believe the improvement in the 2003 loss ratio is primarily due to the impact of premium rate increases and better than anticipated development of our claim reserves for prior year incurrals.
We evaluate our prior year assumptions by reviewing the development of reserves for the prior period. This favorable amount of $3,095 and unfavorable amount of $80,948, in 2003 and 2002, respectively, from prior year-end reserve balances plus adjustments to reflect actual versus estimated claims experience. These adjustments (particularly when calculated as a percentage of the prior year-end reserve balance) provide a relative measure of deviation in actual performance as compared to our initial assumptions.
The adjustments to reserves for claims incurred in prior periods are primarily attributable to claims incurred from our long-term care insurance policies, which represent approximately 96% of our premium in-force. The development of our prior year assumptions were in line with our expectations and included the reduction of our claim reserves of approximately $5,200 in the quarter ended June 30, 2003. The reduction related to new claims adjudication procedures for family member and private caregiver services, following an internal review of historic home health care claims and external consultant guidance. The new protocols include increased in-home assessments and additional plan of care structure.
Further we employed a lower discount rate of 5.7% in the 2002 period, which increased our claims reserves by approximately $5,000. We believe that, as a result of lower market interest rates, the lower discount rate more closely matched our anticipated return from the investment of assets supporting these reserves. We continue to use the 5.7% discount rate in the 2003 period.
When we experience deviation from our estimates, we typically seek premium rate increases that are sufficient to offset future deviation. We have filed and implemented premium rate increases on most of our in force policies as a result of experience studies performed prior to 2002. Based upon our most recent experience and assumptions relating to future claims experience, we have and are continuing to file and implement additional premium rate increases on the majority of our products based upon our claims studies completed in 2002. We have been generally successful in the past in obtaining state insurance department approvals for increases. If we are unsuccessful in obtaining future rate increases when deemed necessary, or if we do not pursue rate increases when actual claims experience exceeds our expectations, we would suffer a financial loss. We may also be susceptible to adverse selection in our claims experience resulting from the lapse of healthier policyholders that do not elect to renew their policies at the higher premium rates.
First year commissions on accident and health business in the 2003 period increased 19.7% to $4,288, compared to $3,582 in the 2002 period, due to the increase in first year accident and health premiums. The ratio of first year accident and health commissions to first year accident and health premiums was 54.0% in the 2003 period and 55.7% in the 2002 period. The first year commission ratio for both the 2003 and 2002 periods is lower than the first year commission ratio prior to the cessation of sales in 2001, due to the increased sale of our Secured Risk, Medicare Supplement and franchise group policies as a percentage of total new sales. All of these policies pay a lower commission as a percentage of premium revenue to agents than our individual long-term care policies. We believe that sales of these policies as a percentage of new sales are likely to remain at this level as we recommence sales in many states. We believe that the sale of long-term care policies has declined as a percentage of sales as a result of our lower financial ratings with A.M. Best and Standard and Poor’s rating services and continued consumer and agent concerns regarding our financial strength.
Renewal commissions on accident and health business in the 2003 period decreased 12.1% to $38,802, compared to $44,127 in the 2002 period due to the decrease in renewal accident and health premiums. The ratio of renewal accident and health commissions to renewal accident and health premiums was 12.5% in the 2003 period and 13.6% in the 2002 period. We have implemented premium rate increases on a majority of policies written prior to December 31, 2001. We do not pay commissions on the additional premium collected as a result of a rate increase, which reduces the ratio of renewal commissions to renewal premium revenue. We anticipate that this ratio will continue to decline until the premium rate increases are fully implemented, which we anticipate will occur prior to the end of 2004.
Net policy acquisition costs amortized (deferred). The net deferred policy acquisition costs in the 2003 period increased to a net amortization of costs of $10,617, compared to $8,695 in the 2002 period.
General and administrative expenses. General and administrative expenses in the 2003 period increased 27.2% to $59,110, compared to $46,472 in the 2002 period. The ratio of total general and administrative expenses to premium revenues was 18.4% in the 2003 period, compared to 13.9% in the 2002 period. The primary contributors to our expense growth in the 2003 period were as follows:
We have added two actuarial officers and three finance officers during the 2002 and 2003 period. These positions were added in order to enhance our abilities to analyze our business through the use of customized actuarial models, to ensure compliance with Sarbanes-Oxley regulations, and to improve our financial analysis capabilities. We also anticipate that we will reduce the reliance on outside consultants that we have used in the past to fulfill these roles. The salaries and benefits associated with these new positions were $497 in the 2003 period as compared to $86 in the 2002 period.
We maintain our own computer system for most aspects of our operations, including policy issuance, billing, claims processing, commissions, premiums and general ledger. We believe that our overall systems are an integral component in delivering that service. Accordingly, we have started development of aSystem Replacement Project (“SRP”). In 2002, we determined, based upon our assessment of currently available long-term care processing systems that we would be better served to build our own program, which would incorporate the specific requirements deemed necessary to support our unique current and planned business processes. We recorded an expense of $995 in the 2003 period, compared to $513 in the 2002 period related to the SRP. Having completed a significant portion of our needs assessment and rules development, and a portion of the programming necessary, we reevaluated the time and expense required to fully implement the SRP. We currently believe, based upon a review of certain vendor solutions recently introduced or more fully tested, that we will be able to modify our plans for an internally developed program and utilize a new vendor solution while maximizing the use of our efforts and capitalized costs to date. In relation to this decision to leverage the assistance gained with a new vendor solution, we have recorded an impairment expense of $522 in the 2003 period. We are currently evaluating proposals from vendors and anticipate making a determination on a new vendor during the second quarter of 2004.
We believe that we currently have substantial capacity for premium growth at our current staff levels, print inventories and other expense categories. We also believe that our current expense levels represent the minimum requirements necessary to reengage agents in additional sales territories, design competitive product lines and properly underwrite new policy applications. However, we believe that if we remain unable to write new business in certain states where we have ceased new production, or if we are unable to use our existing staff and infrastructure capacity to generate additional premium revenue, we will need to decrease production expenses, which could result in decisions to reduce our staff or other operating functions further.
Expense and risk charges on reinsurance and excise tax expense. Our reinsurance agreement provides the reinsurer with annual expense and risk charges, which are credited against our notional experience account in the event of future commutation of the agreement. The annual charge consists of a fixed cost and a variable component based upon reserve and capital levels needed to support the reinsured business. In the 2003 and 2002 period, we incurred charges of $11,073 and $14,308, respectively for this item. In addition, we are subject to an excise tax for premium payments made to a foreign reinsurer equal to one percent of the premium revenue ceded to the foreign reinsurer. We recorded $3,065 and $2,919 for excise tax expenses in the 2003 and 2002 periods, respectively.
Interest expense. Interest expense in the 2003 period increased 41.5% to $8,112, compared to $5,733 in the 2002 period. The interest expense in the 2002 period is primarily related to our convertible subordinated notes, which pay interest at an annual percentage rate of 6.25% and had an outstanding aggregate principal balance of $74,750 throughout the 2002 period. During the 2003 period, we issued $32,421 of additional convertible subordinated notes and paid our entire obligation of $8,957 related to convertible subordinated notes that matured in 2003. Our average outstanding convertible subordinated debt for 2003 was $97,099.
Holders of our convertible subordinated notes are entitled to convert their notes into shares of our common stock before October 2005 and receive a discounted amount of interest that they would have otherwise received through October 2005 had they not converted the notes. As a result of additional issuances of notes, interest expense in the 2003 period increased $1,283. In addition, we incurred $1,069 of interest expense from the early conversion of $8,122 in convertible subordinated notes during the 2003 period.
Cumulative effect of accounting change. We recognized an impairment loss of $5,151 in the 2002 period as a result of our transitional impairment test of goodwill.
Premiums. Total premium revenue earned in the 2002 period, including long-term care, disability, life and Medicare supplement, decreased 4.8% to $333,643, compared to $350,391 in the same period in 2001 (the “2001 period”).
Total first year premiums earned in the 2002 period decreased 85.5% to $6,436, compared to $44,539 in the 2001 period. First year long-term care premiums earned in the 2002 period decreased 86.9% to $5,501, compared to $42,135 in the 2001 period. We experienced significant reductions in new premium sales due to the cessation of new business generation in all states in 2001 and due to continued market concerns regarding our insurance subsidiaries’ statutory surplus. Under our Plan, which was approved by the Department in the first quarter 2002, we recommenced sales in certain states, but intend to limit new business growth to levels that will allow us to maintain sufficient statutory surplus. See “Liquidity and Capital Resources.”
Net investment income. Net investment income earned for the 2002 period increased 31.0% to $40,107, from $30,613 for the 2001 period.
As a result of our 2001 Centre Agreement, substantially all of our investable assets from business written prior to December 31, 2001, were transferred to the reinsurer in February 2002. The reinsurer maintains a notional experience account on our behalf in the event that the reinsurance agreement is later commuted. As discussed above in “Overview,” the notional experience account is credited with an investment credit equal to the most recent yield to maturity of a series of benchmark indices and derivative hedges, which are designed to closely match the duration of our liabilities. See “Liquidity and Capital Resources.”
Our average yield on invested assets at cost, including cash and cash equivalents, was 5.91% and 5.62%, respectively, in the 2002 and 2001 periods. Although market rates have declined, the higher yield in the 2002 period resulted from a significant change in our portfolio. In 2001, we held a portfolio of bonds with a duration of approximately 5 years and common stocks. The investment income component of our notional experience account investment credit generated $38,375 in the 2002 period, with an average yield of 6.51%. The notional experience account yields a fixed return based upon the yield to maturity of the underlying benchmark indices, which are comprised of U.S. Treasury strips, agencies and investment grade corporate bonds, with weightings of approximately 25%, 15% and 60%, respectively, and have a duration of approximately 11 years.
During the 2001 period, we classified our convertible bond portfolio as trading account investments. Changes in trading account investment market values were recorded in our Statements of Income and Comprehensive Income during the period in which the change occurred, rather than as an unrealized gain or loss recorded directly through equity. As a result, we recorded a trading account loss in the 2001 period of $3,428, which reflected the unrealized and realized loss of our convertible portfolio that arose during that period. No investments were classified as trading during the 2002 period.
We evaluate our prior year assumptions by reviewing the development of reserves for the prior period. This amount of $80,948 and $8,845, in 2002 and 2001, respectively, from prior year-end reserve balances plus adjustments to reflect actual versus estimated claims experience. These adjustments (particularly when calculated as a percentage of the prior year-end reserve balance) provide a relative measure of deviation in actual performance as compared to our initial assumptions.
Over the past 10 years, our percentage of policies-in-force offering benefits for both nursing facility and in-home health care coverage has increased. We have recorded claims that begin in one type of care and later move to another type of care as two separate claims. Defining claims in this manner has projected a greater number of expected claims from certain types of policies, as well as a shorter expected length of individual claims. We have now determined to define this as one claim, using the earliest date of service as the incurral date. This redefinition of claims results in fewer expected future claims, but anticipates that each claim will last longer.
By redefining these ‘multiple’ claims as a single claim and by employing new assumptions and processes for predicting the continuance of claims, we are confident that we can predict future claims development with a much higher degree of precision. By identifying trends earlier, we would have seen substantially less adverse deviation from expected results in the development of claims reserves. We believe that the new assumptions will serve to reduce future reserve volatility by more closely predicting future claims development.
Further, by employing a lower discount rate of 5.7% in the 2002 period, rather than the 6.5% that had been used in prior periods, we increased our claims reserves by approximately $5,000. We believe that, as a result of lower market interest rates, the lower discount rate more closely matches our currently anticipated return from the investment of assets supporting these reserves.
First year commissions on accident and health business in the 2002 period decreased 87.8% to $3,582, compared to $29,371 in the 2001 period, due to the decrease in first year accident and health premiums. The ratio of first year accident and health commissions to first year accident and health premiums was 55.7% in the 2002 period and 67.4% in the 2001 period. We believe that the decrease in the first year commission ratio is primarily attributable to the increased sale of our Secured Risk, Medicare Supplement and franchise group policy as a percentage of total sales. All of these policies pay a lower commission as a percentage of premium revenue than our individual long-term care policies. Our Secured Risk policy provides limited benefits to higher risk policyholders at a substantially increased premium rate. We believe that sales of these policies as a percentage of new sales are likely to remain at this level when we recommence sales in many states as a result of our lower financial ratings with A.M. Best and Standard and Poor’s rating services.
Renewal commissions on accident and health business in the 2002 period decreased 10.9% to $44,127, compared to $49,540 in the 2001 period. The ratio of renewal accident and health commissions to renewal accident and health premiums was 13.6% in the 2002 period and 16.6% in the 2001 period. We began the implementation of premium rate increases at the end of the 2001 period. We do not pay commissions on the portion of collected premiums related to premium rate increases. As a result, commission ratios are reduced. In addition, during 2001, we experienced the sale of a greater portion of higher-risk policies that generally have a higher premium and reduced or no renewal commission structure. The reduced commission ratio in the 2002 period is, in part, due to the impact of these policies being renewed.
The net amortization of deferred policy acquisition costs is affected by new business generation, imputed interest on prior reserves and policy persistency. The amortization of deferred costs is generally offset largely by the deferral of costs associated with new premium generation. However, lower new premium sales during the 2002 period produced significantly less expense deferral to offset amortized costs.
During the 2002 period, we determined to recognize a DAC impairment charge of $1,100 primarily as a result of the incorporation of certain assumptions related to the future profitability of our current business in force. These assumptions included the use of a lower discount rate, which reflects the current interest rate environment, higher anticipated claims costs due to newly estimated claim duration and reasonable expected future premium rate increases on policies for which we have already filed or anticipate filing. In the event that premium rate increases cannot be obtained as needed, or our actual experience differs from our assumptions, our DAC could be further impaired and we would incur an expense in the amount of the impairment.
Expense and risk charges on reinsurance and excise tax expense. Our reinsurance agreement provides the reinsurer with annual expense and risk charges, which are credited against our experience account in the event of future commutation of the agreement. The annual charge consists of a fixed cost and a variable component based upon reserve and capital levels needed to support the reinsured business. In the 2002 period, we incurred a charge of $14,308 for this charge. In addition, we are subject to an excise tax for premium payments made to a foreign reinsurer. We recorded $2,919 for excise tax expenses in the 2002 period and recorded $5,635 in the 2001 period in connection with the effective date of the agreement. The excise tax is equal to one percent of premiums ceded to the foreign reinsurer.
Provision for federal income taxes. As a result of current losses, our provision for Federal income taxes for the 2002 period decreased 20.0% to an income tax benefit of $13,026, compared to an income tax benefit of $16,280 for the 2001 period. The effective tax rate of 34% in the 2002 and 2001 periods is below the normal Federal corporate income tax rate as a result of the tax-exempt nature of income from our investments in corporate owned life insurance.
In the 2002 period, our cash flows were attributable to cash provided by operations, cash used in investing and cash used in financing. Our cash decreased $85,394 in the 2002 period primarily due to payments made to our reinsurer of $623,027 and the purchase of $27,641 in bonds and equity securities. Cash was provided primarily from the maturity and sale of $488,855 in bonds and equity securities. These sources of funds were supplemented by $79,542 from operations. The major source of cash from operations was premium and investment income received.
2) In March 2002, we completed a private placement of 510 shares of common stock for net proceeds of $2,352. The common stock was sold to several current and new institutional investors at $4.65 per share. The offering price was a 10 percent discount to the 30-day average price of our common stock prior to the issuance of the new shares. We filed a registration statement with the Securities and Exchange Commission on June 5, 2002 to register these shares for resale.
3) In June 2002, we completed a private placement of 60 shares of common stock as compensation to our financial advisor. We filed a registration statement for 30 of these additional shares with the Securities and Exchange Commission on June 5, 2002. In November 2002 and January 2003, we completed an additional private placement of 20 and 20 shares of common stock, respectively, to the same financial advisor.
In conjunction with the new issuance, we modified the terms of all of our 2008 Notes to provide holders of the 2008 Notes incentive to convert their 2008 Notes into shares of our common stock prior to October 2005 by offering to pay interest that would have otherwise been received from the date of conversion until October 2005. The interest amount, which is discounted from October 2005 to the date of early conversion, is payable at our discretion in cash or in shares of our common stock, discounted by 10% from the prevailing market rate of our shares.
7) Subsequent to December 31, 2003, we issued an additional $16,000 in 2008 Notes. We intend to use the proceeds to supplement parent liquidity, for general working capital purposes and to further supplement our subsidiaries’ statutory surplus. Since December 31, 2003, holders of $15,295 of our 2008 Notes elected to convert their 2008 Notes for 8,740 shares of our common stock. In addition to the issuance of shares upon conversion of the 2008 Notes, we issued these holders 1,442 shares of common stock as payment of discounted interest between the date of conversion and October 2005.
The maturities of our principal contractual cash obligations, excluding insurance liabilities, at December 31, 2003, are as follows:
(3) Contractual payments owed to vendor relating to the outsourcing arrangement for the daily operations of our information technology department.
Our insurance subsidiaries are regulated by various state insurance departments. The National Association of Insurance Commissioners (“NAIC”) has Risk-Based Capital (“RBC”) requirements for insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks, such as asset quality, mortality and morbidity, asset and liability matching, benefit and loss reserve adequacy, and other business factors. The RBC formula is used by state insurance regulators as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized. In addition, the formula defines minimum capital standards that an insurer must maintain. Regulatory compliance is determined by a ratio of the enterprise’s regulatory Total Adjusted Capital, to its Authorized Control Level RBC, as defined by the NAIC. Companies below specific trigger points or ratios are classified within certain levels, each of which may require specific corrective action depending upon the insurer’s state of domicile.
Our insurance subsidiaries, PTNA, ANIC, and AINIC (representing approximately 91%, 8% and 1% of our direct in-force premium, respectively) are required to hold statutory surplus that is above a certain required level. At December 31, 2000, PTNA had Total Adjusted Capital at the Regulatory Action level, which required it to file a Plan with the Department. ANIC is also subject to the Plan because it is 100% owned by PTNA.
As part of this agreement, annual risk charges in excess of $10,000 are assessed against our experience account by the reinsurer. The annual amount increases if we do not commute before January 1, 2008. This agreement meets the requirements to qualify for reinsurance treatment under statutory accounting rules. However, this agreement does not qualify for reinsurance treatment in accordance with GAAP because, the agreement does not result in the reasonable possibility that the reinsurer may realize a significant loss. This is due to a number of factors related to the agreement, including experience refund provisions, the expense and risk charges credited to the experience account by the reinsurer and the aggregate limit of liability.
The initial premium of the treaties was approximately $619,000, comprised of $563,000 of cash and qualified securities transferred in February 2002, and $56,000 as funds held due to the reinsurer. The initial premium and future cash flows from the reinsured policies, less claims payments, ceding commissions and risk charges, is credited to a notional experience account, which is held for our benefit in the event of commutation and recapture on or after December 31, 2007. The notional experience account balance receives an investment credit based upon the total return from a series of benchmark indices and derivative hedges that are intended to match the duration of our reserve liability.
Our current modeling and actuarial projections suggest that we are likely to be able to commute the agreement, as planned, on December 31, 2007. In order to commute the agreement, our statutory capital following commutation must be sufficient to support the reacquired business in compliance with all statutory requirements. Upon commutation, we would receive cash or other liquid assets equaling the market value of our experience account from the reinsurer. We would also record the necessary reserves for the business in our statutory financial statements. Our ability to commute the agreement is highly dependent upon the market value of the notional experience account exceeding the level of required reserves to be established. In addition to the performance of the reinsured policies from now until 2007, the notional experience account value is susceptible to market interest rate changes. A market interest rate increase of 100 basis points could reduce the market value of the current notional experience account by approximately $77,000 and jeopardize our ability to commute as planned. As we approach the intended commutation date, the sensitivity of our notional experience account to market interest rate movement will decline as the duration of the benchmark indices becomes shorter, however the amount of assets susceptible to such interest sensitivity will continue to grow as additional net cash flows are added to the notional experience account balance prior to commutation. We intend to give notice to the reinsurer of our intention to commute on December 31, 2007 at such time as we are highly confident of our ability to support the reacquired policies. The reinsurer has agreed to fix the market value of the notional experience account at that time, and to then invest the assets in a manner that we request in order to minimize short term volatility.
As part of our reinsurance agreement, effective December 31, 2001, the reinsurer was granted four tranches of warrants to purchase shares of non-voting convertible preferred stock. The first three tranches of warrants are exercisable through and expire on December 31, 2007 at common stock equivalent prices ranging from approximately $4.00 to $12.00 per share. If exercised, the convertible preferred stock would represent, if converted, approximately 15% of the then outstanding shares of our common stock on a fully diluted basis. If the agreement is not commuted on December 31, 2007, the reinsurer may exercise the fourth tranche of convertible preferred stock purchase warrants at a common stock equivalent price of $2.00 per share. If the fourth tranche of warrants was exercised, the convertible preferred stock, if converted, would represent an additional 20% of the then outstanding common stock on a fully diluted basis. No assurance can be given that the reinsurer will exercise any or all of the warrants granted or that it will pay cash in connection with their exercise.
Upon the Department’s approval of the Plan in February 2002, we recommenced new policy sales in 23 states, including Pennsylvania. We have now recommenced new policy sales in 16 additional states, including Florida (subject to a voluntary corrective order). Florida and Pennsylvania accounted for approximately 17% and 14%, respectively of our direct premium revenue for the year ended December 31, 2003. We have recently agreed upon terms for the recommencement of sales in California, subject to certain continuing conditions and approval of our filed product forms and rates. California renewal premiums represented approximately 14% of our direct premium revenue for the year ended December 31, 2003. We are actively working with the remaining states to recommence new policy sales in all jurisdictions.
An agreement to increase statutory reserves by an additional $125,000 throughout 2002-2004, of which $23,000 remained at December 31, 2003. The reinsurance agreement has provided the capacity to accommodate this increase.
Effective September 10, 2001, we determined to discontinue the sale nationally of all new long-term care insurance policies until the Plan was approved by the Department. The decision resulted from our concern about further depletion of statutory surplus from new sales prior to the completion and approval of the Plan and from increasing concern regarding our status by many states in which we are licensed to conduct business. The form of our cessation varied by state, ranging from no action to certificate suspensions.
Under the insurance laws of Pennsylvania and New York, where our insurance subsidiaries are domiciled, insurance companies can pay ordinary dividends only out of earned surplus. In addition, under Pennsylvania law, our Pennsylvania insurance subsidiaries (including our primary insurance subsidiary) must give the Department at least 30 days’ advance notice of any proposed “extraordinary dividend” and cannot pay such a dividend if the Department disapproves the payment during that 30-day period. For purposes of that provision, an extraordinary dividend is a dividend that, together with all other dividends paid during the preceding twelve months, exceeds the greater of 10% of the insurance company’s surplus as shown on the company’s last annual statement filed with Department or its statutory net income as shown on that annual statement. Statutory earnings are generally lower than earnings reported in accordance with generally accepted accounting principles due to the immediate or accelerated recognition of all costs associated with premium growth and benefit reserves. Additionally, the Plan requires the Department to approve all dividend requests made by Penn Treaty Network America, regardless of normal statutory requirements for allowable dividends. We believe that the Department is unlikely to consider any dividend request in the foreseeable future, as a result of Penn Treaty Network America’s current statutory surplus position. Although not stipulated in the Plan, this requirement is likely to continue until such time as Penn Treaty meets normal statutory allowances, including reported net income and positive cumulative earned surplus. We do not expect that this will occur in the foreseeable future.
Penn Treaty Network America Insurance Company and American Network Insurance Company have not paid any dividends to Penn Treaty for the past three years and are unlikely in the foreseeable future to be able to make dividend payments due to insufficient statutory surplus and anticipated earnings. However, our New York subsidiary is not subject to the Plan and was permitted by New York statute to make a dividend payment following December 31, 2001. Consequently, in 2002, Penn Treaty received a dividend from our New York subsidiary of $651.
SFAS No. 142, “Goodwill and Other Intangible Assets,” primarily addresses the accounting for goodwill and intangible assets subsequent to their acquisition. We adopted SFAS No. 142 on January 1, 2002 and ceased amortizing goodwill at that time. During the second quarter 2002, we completed an impairment analysis of goodwill, in accordance with FASB No. 142. Our goodwill was recorded as a result of the purchase of our agencies and our insurance subsidiaries. As part of our evaluation, we completed numerous steps in determining the recoverability of our goodwill. The first required step was the measurement of total enterprise fair value versus book value. Because our fair market value, as measured by our stock price, was below book value at January 1, 2002, goodwill was next evaluated at a reporting unit level, which comprised our insurance agencies and insurance subsidiaries.
In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, which addresses the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees. This interpretation also clarifies the requirements related to the recognition of a liability by a guarantor at the inception of a guarantee for the obligations the guarantor has undertaken in issuing that guarantee. The provisions related to the disclosure requirements to be made by a guarantor are effective for financial statements of interim and annual reporting periods ending after December 15, 2002. The provisions related to the recognition of a liability and initial measurement shall be applied prospectively to guarantees issued or modified after December 31, 2002, irrespective of the guarantor s fiscal year-end. The adoption of this interpretation did not have a material impact on our financial statements.
In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51” ( “FIN No. 46” ). FIN No. 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. FIN No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. FIN No. 46 applies to public enterprises as of the beginning of the applicable interim or annual period. FIN No. 46 may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated. The implementation of FIN No. 46 did not have a material impact on our financial statements.
Cash and investments of $27,045 and $22,022 , respectively are restricted as to use.
Investment credit on corporate owned life insurance (2,036 ) (3,295 ) (2,850 )
Realized investment gains and losses, including provisions for market declines considered to be other than temporary, are included in income. Gains and losses on sales of investment securities are computed on the specific identification method. Debt and equity securities are regularly evaluated to determine if market values below amortized cost are as a result of credit quality, performance or general market decline. If market value declines are determined to be other than temporary, the amortized cost is adjusted to the market value of the security, with the loss recognized in the current period. Any future increases to the market value of a security that is considered to be an other than temporary impairment is recorded as an unrealized gain. Purchases and sales of securities are recorded on the trade-date basis. Interest income is recorded on the accrual basis. Dividends are recorded on the ex-dividend date.
The Company regularly assesses the recoverability of deferred acquisition costs through actuarial analysis. To determine recoverability, the present value of future premiums less future costs and claims are added to current reserve balances. If this amount is greater than current unamortized deferred acquisition costs, the unamortized amount is deemed recoverable. In the event recoverability is not demonstrated, the Company reassesses the calculation using justifiable premium rate increases. If rate increases are not received or are deemed unjustified, the Company will expense, as impaired, the attributed portion of the deferred acquisition cost asset in the current period. If the Company concludes that the deferred acquisition costs are impaired, the Company will record an impairment loss and a reduction in the deferred acquisition cost asset. In the event of an impairment, the Company will also evaluate its historical assumptions utilized in establishing the policy reserves and deferred acquisition costs and may update those assumptions to reflect current experience (referred to as “unlocking”). The primary assumptions include persistency, morbidity (claims expectations), investment yields and premium rate increases. Recoverability of deferred acquisition costs is highly dependent upon the Company’s ability to obtain future premium rate increases. While the Company has been successful in obtaining premium rate increases on existing policies in the past, the ability to obtain these increases is subject to regulatory approval, and is not guaranteed.
The following table lists the range of lives, cost and accumulated depreciation for various asset classes:
At the time of purchase, the acquired ANIC premium in-force was deemed to have a remaining average life of approximately ten years. Although amortization of future profits will normally occur in accordance with actuarial assumptions over the life of the policies, the Company determined to amortize this on a straight-line basis over ten years and regularly monitors the emerging profitability of the acquired business. The Company believes that this approach is not materially different than if an actuarial methodology had been employed. The remaining unamortized carrying amount of future profits at December 31, 2003 and 2002, was $399 and $791, respectively.
Income taxes consist of amounts currently due plus deferred tax expense or benefits. Income taxes have been provided in accordance with the provisions of FAS No. 109, Accounting for Income Taxes. Deferred tax assets and liabilities result from temporary differences between the amounts recorded in the consolidated financial statements and the tax bases of the Company's assets and liabilities. Such temporary differences are primarily due to the difference in allowable deductions for deferred
acquisition costs, the deposit accounting for our 2001 Centre Agreement, the warrants issued as compensation for the 2001 Centre Agreement and tax benefits of net operating loss carryforwards. 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. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all, or some portion, of the benefits related to deferred tax assets will not be realized.
The Company pays excise taxes related to reinsurance agreements with a foreign reinsurer. The amount recorded each year is equal to one percent of the premiums ceded to the reinsurer. The Company recorded an expense of $3,065, $2,919 and $5,635 for the years ended December 31, 2003, 2002 and 2001, respectively.
There are two components to the Company’s policyholder liabilities. The first is a policy reserve for future policy benefits and the second is a claim reserve for incurred claims, either reported or unreported.
o an estimate, based upon prior experience, for accident and health claims reported, and incurred but unreported claims;
accounting change $ (13,353 ) $ (25,287 ) $ (48,589 )
Net loss $ (13,353 ) $ (30,438 ) $ (48,589 )
Basic earnings per share from net loss $ (0.64 ) $ (1.58 ) $ (3.41 )
cumulative effect of accounting change $ (0.64 ) $ (1.31 ) $ (3.41 )
Diluted earnings per share $ (0.64 ) $ (1.58 ) $ (3.41 )
Pro forma net (loss) income $ (13,543 ) $ (30,982 ) $ (49,133 )
Basic - as reported $ (0.64 ) $ (1.58 ) $ (3.41 )
Diluted - as reported $ (0.64 ) $ (1.58 ) $ (3.41 )
Diluted - pro forma $ (0.65 ) $ (1.61 ) $ (3.45 )
SFAS No. 142, “Goodwill and Other Intangible Assets,” primarily addresses the accounting for goodwill and intangible assets subsequent to their acquisition. The Company adopted SFAS No. 142 on January 1, 2002 and ceased amortizing goodwill at that time. During the second quarter 2002, the Company completed an impairment analysis of goodwill, in accordance with SFAS No. 142. The Company’s goodwill was recorded as a result of the purchase of its agencies and its insurance subsidiaries. As part of its evaluation, the Company completed numerous steps in determining the recoverability of its goodwill. The first required step was the measurement of total enterprise fair value versus book value. Because the Company’s fair market value, as measured by its stock price, was below book value at January 1, 2002, goodwill was next evaluated at a reporting unit level which comprised its insurance agencies and insurance subsidiaries.
Upon completion of its evaluation, the Company determined that the goodwill associated with the agency purchases was fully recoverable. The deficiency of current market value to book value was attributed to the insurance subsidiary values. As a result, the Company determined that the goodwill associated with its insurance subsidiaries was impaired and recognized an impairment loss of $5,151 from its transitional impairment test of goodwill, which it recorded as a cumulative effect of change in accounting principle. The impairment has been recorded effective January 1, 2002. Management has completed an assessment of other intangible assets and has determined to continue to amortize these assets so as to closely match the future profit emergence from these assets.
effect of change in accounting principles $ (0.64 ) $ (1.31 ) $ (3.41 )
Adjusted basic earnings per share $ (0.64 ) $ (1.31 ) $ (3.35 )
Reported diluted earnings per share $ (0.64 ) $ (1.31 ) $ (3.41 )
The amortized cost and estimated market values of debt securities at December 31, 2003 are shown below.
At December 31, 2001, the Company entered a reinsurance agreement for which substantially all of its investment portfolio was later ceded as the initial premium for this agreement. As a result of this intended transfer or sale of assets, the Company determined that all gross unrealized losses on its debt and equity securities likely would not be recovered and were therefore deemed to be other than temporary impairments. The Company recognized a loss of $3,867 from this determination. The Company recognized other debt securities impairment charges in 2001 of approximately $1,900 due to other than temporary declines. Also, in 2001, the Company reduced its cost basis of equity securities by $5,767 as a result of differences deemed other than temporary. The Company reduced its cost basis on bonds in 2002 by $12 due to differences deemed other than temporary. There were no differences deemed to be other than temporary during 2003. The following table describes the Company’s debt securities at December 31, 2003, which had a market value below cost:
The Company maintains assets in a trust account under a reinsurance agreement with an unaffiliated insurer. The Company is required to hold assets equal to 102% of the reserves, for the policies assumed under this agreement. At December 31, 2003 and 2002, the market value of the assets in the trust was $14,460 and $11,174, respectively.
The reinsurance agreement with Centre Solutions (Bermuda) Limited (“Centre”) includes a provision for the maintenance of a notional experience account for the Company’s benefit in the event of future commutation of the agreement.
The fixed debt host yields a fixed return based on the yield to maturity of the underlying benchmark indices. The return on the fixed debt host is reported as investment income in the Consolidated Statement of Income and Comprehensive Income.
The change in fair value of the embedded derivative represents the percentage change in the underlying indices applied to the notional experience account, similar to that of an unrealized gain/loss on a bond. The change in the fair value of the embedded derivative is reported as market (loss) gain on notional experience account in the Consolidated Statement of Income and Comprehensive Income.
During 2003 and 2002, the notional experience account activity was as follows:
experience. Morbidity represents the claim costs we expect to incur in the
withdrawals represent the lapsation of policies due to either death or
The Company evaluates its prior year assumptions by reviewing the development of reserves for the prior period (i.e. incurred from prior years). This amount includes imputed interest from prior year-end reserve balances plus adjustments to reflect actual versus estimated claims experience. These adjustments (particularly when calculated as a percentage of the prior year-end reserve balance) provide a relative measure of deviation in actual performance as compared to its initial assumptions.
Once a claim occurs, the Company develops claim reserves by using continuance tables, which measure the likelihood of a claim continuing in the future. Historically, the Company has applied every claim to a set of uniform continuance tables. The Company’s actuarial modeling suggests that this uniform continuance assumption no longer reflects the increasing number of claims from policies with longer benefit periods or increased benefit amounts. The Company has developed an improved methodology by creating separate continuance tables for facility, home health and comprehensive care, as well as for tax qualified and non-qualified plans. In addition, the Company has established separate continuance tables for claims caused by cognitive impairment. The Company’s 2002 analysis indicated that the duration of its existing claims has been increasing in recent years and will be longer than was previously expected. The Company revised its continuance assumption to reflect this trend.
As a result of its redefinition of claims and employment of new continuance tables for separate types of claims with longer claim durations, the Company strengthened its claim reserves by approximately $78,000 in 2002 for claims incurred prior to January 1, 2002. In addition, the Company reduced its assumed discount rate from 6.5% to 5.7% based upon recent investment yields. This change resulted in an increase to reserves of approximately $5,000.
In 2001, the Company added $8,845 to its claim reserves for 2000 and prior claim incurrals. Two factors affected the reserves the Company held for claims incurred in prior years. (1) In 2001, the Company engaged a new consulting actuary that provided the Company with additional industry data to incorporate in its continuance expectations (the probability that a claim in one duration will continue to another). The Company’s analysis of this supplemental data suggested that it would recognize higher future payments on currently incurred claims than was previously anticipated. As a result, the Company lengthened its continuance tables for claim durations beyond the third year, and increased its reserves held for claims incurred to record this liability. This resulted in an increase of reserves incurred in prior years of $7,262; and (2) in 2001, the Company reduced the discount rate used in the establishment of reserves to appropriately reflect the current investment rate earned on assets supporting this liability. As a result, reserves for claims incurred in prior years were increased $1,583.
Convertible, subordinated debt issued in 2002 and 2003, semi-annual coupon of at 6.25%
Mortgage loan with interest rate fixed for five years at 6.85% effective September
1998, which was repriced from 7.3% in 1997. Although carrying a variable rate of
swap with the same institution. Current monthly payment of $16 based on a fifteen
collateralized by property with depreciated cost of $2,673 and $2,361 as of December
At December 31, 2003, the Company’s total debt and financing obligations through 2008 were as follows:
During 2002 the Company commenced an offer to exchange its then outstanding $74,750, 6.25% convertible subordinated notes due 2003 (the “2003 Notes”). The $90,092, 6.25% convertible subordinated notes due 2008 (the “2008 Notes”) carry terms similar to the 2003 Notes with the exception of a reduced conversion price of $1.75 per share and an extended maturity date of October 2008. Approximately $65,793 of the 2003 Notes were exchanged for the 2008 Notes. During 2003, the Company retired the remaining outstanding 2003 Notes of approximately $8,957. The 2008 Notes are mandatorily convertible if, at any time after October 2005, the 15-day average closing price of the Company's common stock exceeds 110% of the conversion price. The 2008 Notes also contain a provision that, upon conversion prior to October 2005, the Company will pay the holder additional interest (referred to as “preferred interest on early conversion”) equal to the amount that would otherwise have been paid from the date of conversion until October 2005. The interest amount, which is discounted from October 2005 to the date of early conversion, is payable at the Company's discretion in cash or in shares of common stock equal to 90% of the current market prices of the Company's common stock.
In October 2003, the Company retired the outstanding $1,416 balance of its headquarters building mortgage obligation.
Holders of the 2008 Notes are entitled to convert their notes into shares of common stock before October 2005 and receive a discounted amount of interest that they would have otherwise received until that date. This feature is an embedded derivative as defined in Statement of Financial Accounting Standards No. 133 “Accounting for Derivative Instruments and Hedging Activities.” This embedded derivative is not clearly and closely related to the host contract, the convertible subordinated notes, because it could at least double the investor’s initial rate of return on the host contract and could also result in a rate of return that is at least twice what otherwise would be the market return for a contract that has the same terms as the host contract and that involves a debtor with a similar credit quality.
The Company has valued and bifurcated the embedded derivative from the host contract. At each balance sheet date, the embedded derivative is recorded at fair value, with any change in fair value recognized in current operations.
As of December 31, 2003 the fair value of the embedded derivative was $3,018. In determining the fair value of the embedded derivative, the Company makes certain assumptions, including the future volatility and liquidity of the Company’s common stock, as well as recent trends in the number of holders converting.
The total benefit for federal income taxes for the years ended December 31 consisted of:
The Company has net operating loss carryforwards of $30,295 or $10,603 on a tax effected basis, which have been generated by taxable losses at the parent company, and if unused will expire between 2012 and 2022.
The life subsidiaries’ and parent’s valuation allowances recorded in 2003 were as a result of potential future limitations on their use due to Internal Revenue Code Section 382. The Internal Revenue Service has established rules that potentially limit a company’s use of prior period net operating loss carryforwards in the event that a majority of the company’s common stock ownership changes within any consecutive three year period. Due to the issuance of additional shares of the Company’s common stock since May 2001 and conversions of the Company’s subordinated convertible notes during 2003 and the first quarter of 2004, the Company believes it has become subject to these limitations and has established the valuation allowance at December 31, 2003 accordingly.
provision at statutory rate $ (5,755 ) $ (15,212 ) $ (22,704 )
At December 31, 2003, the accumulated earnings of the Company for Federal income tax purposes included $1,451 of “Policyholders’ Surplus”, a special memorandum tax account. This memorandum account balance has not been currently taxed, but income taxes computed at then-current rates will become payable if surplus is distributed. Provisions of the Deficit Reduction Act of 1984 do not permit further additions to the “Policyholders’ Surplus” account.
Total reserves, including claim reserves, reported to regulatory authorities were approximately $824,232 and $761,042 less than those recorded for GAAP as of December 31, 2003 and 2002, respectively. This difference is primarily attributable to reinsurance agreements in force as of December 31, 2003 and 2002.
The 2001 Centre Agreement is accounted for as reinsurance for statutory accounting purposes, but does not qualify as reinsurance under GAAP. As the agreement is treated as reinsurance for statutory accounting purposes, it results in the ceding (or removal) of substantially all of PTNA’s and ANIC’s policy reserve and claim reserve liabilities for statutory accounting purposes. Furthermore, subject to certain limitations, any adverse development of the 2001 and prior policy and claim reserves, including the $125,000 of reserve increases mentioned above, is ceded to the reinsurer and is not reflected on PTNA’s or ANIC’s statutory financial statements.
The Company has a 401(k) retirement plan, covering substantially all employees with at least one year of service. Under the plan, participating employees may contribute up to 15% of their annual salary on a pre-tax basis. The Company, under the plan, equally matches 100% of employee contributions up to the first 3% of the employee’s salary. The Company and employee portion of the plan is vested immediately. The Company’s expense related to this 401(k) plan was $240, $239 and $167 for the years ended December 31, 2003, 2002 and 2001, respectively. The Company may elect to make a discretionary contribution to the plan, which will be contributed proportionately to each eligible employee. The Company did not make a discretionary contribution in 2003, 2002 or 2001.
a) The Company’s Founder will assume the new position of Founding Chairman.
b) The Company will pay the Founding Chairman or his spouse, until the later of his death or the death of his spouse, a retirement benefit of $100 per year and health and welfare benefits comparable to those the Company offers to its executives from time to time.
The plans are unfunded. The following table provides the components of the benefit obligation at December 31, 2003:
The expense components of the net periodic pension and post retirement benefit cost for the year ended December 31, 2003 consisted of only interest expense and were $83 and $16 for Pension and Other Benefits, respectively.
The above measurement of the Net Periodic Pension and Postretirement Benefit Cost is based upon the following assumptions:
An increase in the medical trend rate of 1% for each year would increase the 2004 Service and Interest Cost Medical Components of the Net Periodic Pension and Postretirement Benefit Cost by $1. A decrease in the medical trend rate of 1% for each year would decrease the 2004 Service and Interest Cost Medical Components of the Net Periodic Pension and Postretirement Benefit Cost by $1.
At December 31, 2003, the Company had three stock-based compensation plans, which are described below. For 2000, and for certain options granted in 2001 and 2002, the Company applies APB Opinion No. 25 in accounting for its plans. The Company issues options at the current market value and does not record a charge to earnings upon the issuance of options. While the Company continues to maintain its accounting for stock-based compensation in accordance with APB Opinion No. 25, it has adopted the disclosure provisions of SFAS No. 148.
The Company’s 1987 Employee Incentive Stock Option Plan provided for the granting of options to purchase up to 1,200 shares of common stock. This plan expired in 1997 and was subsequently replaced by the 1998 Employee Non-Qualified Incentive Stock Option Plan (“1998 Plan”). The 1998 Plan allows for the grant of options to purchase up to 600 shares of common stock. No new options may be granted under the 1987 Plan. The term of each option granted in 2003, 2001 and 2000 is ten years and each is vested one year following the date of original grant.
Effective May 1995, the Company adopted a Participating Agent Stock Option Plan which provides for the granting of options to purchase up to 300 shares of common stock. The exercise price of all options granted under the plan may not be less than the fair market value of the shares on the date of grant. The term of each option is ten years, and the options become exercisable in four equal, annual installments commencing one year from the option grant date. SFAS No. 123 requires that the fair value of options granted to non-employees (agents) be recognized as compensation expense over the estimated life of the option. Options were granted to agents in 1997, 1996 and 1995. No agent options have been granted since 1997. The Company recognized $0, $0 and $51 of compensation expense in 2003, 2002 and 2001, respectively as a result of these grants.
During 2001, the Company granted 566 replacement options to its employees for all existing options granted under its existing fixed option plans. As a result, these options are now subject to the variable accounting provisions of APB Opinion No. 25 until exercised, forfeited or cancelled. The Company recorded a compensation expense of $430 in 2001 and recorded compensation income of $430 in 2002, related to these variable options, representing the intrinsic value of the stock options at the reporting date. In addition, 30 options were granted to a new senior executive in 2001, 4 were granted to another new executive in 2002, and 23 were granted to new executives in 2003.
The total net rental expenses under all leases amounted to approximately $928, $1,059 and $1,003 for the years ended December 31, 2003, 2002 and 2001 respectively.
At December 31, 2003, 2002 and 2001, the Company received letters of credit of $169,463, $149,339 and $29,000, respectively, which allowed its subsidiaries to receive statutory reserve credit and statutory surplus credit for its 2001 quota share reinsurance agreement with Centre.
The Company’s subsidiaries are parties to various lawsuits generally arising in the normal course of their business. The Company does not believe that the eventual outcome of any of the suits to which it is party will have a material adverse effect on its financial condition or results of operations. However, the outcome of any single event could have a material impact upon the quarterly or annual financial results of the period in which it occurs.
The Company and its subsidiary, PTNA, are defendants in an action in the Fifth Judicial Circuit of the State of Florida in and for Marion County, Civil Division. Plaintiffs filed this matter on January 10, 2003 in Florida State Court, on behalf of themselves and a class of similarly situated Florida long-term care policyholders. The Company removed this case from the Florida State Court to United States District Court, Middle District of Florida, Ocala Division. Plaintiffs’ motion to remand the case to Florida State Court was granted on June 25, 2003. The Company removed this case to United States District Court, Middle District of Florida, Ocala Division for a second time in November, 2003. A hearing on this motion was held on February 18, 2004. Plaintiffs claim wrongdoing in connection with the sale of long-term care insurance policies to the Plaintiffs and the class. Plaintiffs allege claims for reformation, breach of fiduciary duty, breach of the implied duty of good faith and fair dealing, negligent misrepresentation, fraudulent misrepresentation, and restitution. The Company has filed motions to dismiss for failure to state a claim, lack of personal jurisdiction against the Company, and to strike certain allegations of the complaint as irrelevant and improper. While the Company cannot predict the outcome of this case, it could have a material adverse impact upon its financial condition and results of operations in the event of an unfavorable outcome. The Company believes that the complaint is without merit and intends to continue to defend the matter vigorously.
The Company’s current modeling and actuarial projections suggest that it is likely to be able to commute the agreement, as planned, on December 31, 2007. In order to commute the agreement, PTNA’s and ANIC’s statutory surplus following commutation must be sufficient to support the reacquired business in compliance with all statutory requirements. Upon commutation, the Company will receive cash or other liquid assets equaling the value of its notional experience account from the reinsurer. The Company would also record the necessary reserves for the business in its statutory financial statements. Accordingly, the Company’s ability to commute the agreement is highly dependent upon the value of the notional experience account exceeding the level of required statutory reserves to be established. As of December 31, 2003, the statutory basis reserve liabilities of $970,055 exceeded the combination of the notional experience account value and funds held due to the reinsurer of $832,519. Management expects that the growth in the notional experience account will exceed the growth in the reserve liabilities such that the notional experience account value will exceed the reserve liabilities at December 31, 2007. In addition to the performance of the reinsured policies from now through 2007, the notional experience account value is susceptible to market interest rate changes. A market interest rate increase of 100 basis points could reduce the value of the current notional experience account by approximately $77,000 and jeopardize the Company’s ability to commute as planned. As the intended commutation date approaches, the sensitivity of the notional experience account to market interest rate movement will decline as the duration of the benchmark indices becomes shorter, however the amount of assets susceptible to such interest sensitivity will continue to grow as additional net cash flows are added to the notional experience account balance prior to commutation.
Effective January 1994, PTNA entered into a reinsurance agreement to cede 100% of certain life, accident and health and Medicare supplement insurance to a third party insurer. Total reinsurance recoverables taken related to this agreement as of December 31, 2003, 2002 and were approximately $405 and $401, respectively.
PTNA is party to a reinsurance agreement to cede 100% of certain whole life and deferred annuity policies issued by PTNA to a third party insurer. These policies are intended for the funeral arrangement or “pre-need” market. Total reinsurance recoverables taken related to this agreement as of December 31, 2003 and 2002 were approximately $2,923 and $3,099, respectively. The third party reinsurer is required to maintain securities at least equal to the statutory reserve credit in escrow with a bank. Effective January 1, 1996, this agreement was modified, and as a result, no new business is reinsured under this facility. Effective December 31, 2002, the Company entered into an assumption agreement with another insurer that desired to acquire this business. Upon approval of certain required state insurance departments and policyholders, the acquiring company will assume all future liability for the business reinsured.
Irv Levit Insurance Management Corporation, an insurance agency which is owned by our former Chairman and Chief Executive Officer, now director and Founding Chairman, currently produced approximately $13, $11 and $10 of renewal premiums for some of our subsidiaries for the years ended December 31, 2003, 2002 and 2001, respectively, for which it received commissions of approximately $3, $2 and $2, respectively. Irv Levit Insurance Management Corporation also received commission overrides on business written for some of our subsidiaries by certain agents, principally general agents who were its agents prior to January 1979 and any of their sub-agents hired prior and subsequent to January 1979. These commission overrides totaled approximately $433, $510 and $544 for the years ended December 31, 2003, 2002 and 2001, respectively.
As of December 31, 2001, Palisade Capital Management owned less than 1% of our common stock. Until January, 2002, Palisade Capital Management also managed a portion of our investment portfolio for which it received fees of $224 for the year ended December 31, 2001. There were no fees in 2003 or 2002.
A member of the Company’s board of directors and the chairman of its audit committee is a senior executive with Advest, Inc., an investment banking firm, which has provided investment banking services in the past and that the Company has engaged as a financial advisor in the offering of its 2008 Subordinated Convertible Notes. This firm received $581, $2 and $475 in fees during 2003, 2002 and 2001, respectively.
A member of the Company’s board of directors has in the past been a principal and has an ownership interest in U.S. Care, Inc., a marketing organization to which the Company paid commissions of $165, $128 and $159 in 2003, 2002 and 2001, respectively. The Company also made a loan of $100, with interest applied at 9%, to U.S. Care, Inc. in 2001, which is guaranteed by renewal commissions payable to the Company in future periods.
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and investments. The Company places its cash and cash equivalents and investments with high quality financial institutions, and attempts to limit the amount of credit exposure to any one institution. However, at December 31, 2003, and at other times during the year, amounts in any one institution exceeded the Federal Deposit Insurance Corporation limits. The Company is also party to certain reinsurance transactions whereby the Company remains ultimately liable for claims exposure under ceded policies in the event the assuming reinsurer is unable to meet its commitments due to default or insolvency.