Carolina, where a processing center of our third-party administration business is located. We lease facilities in 16 other locations throughout the United States that house regional and field offices of our sales organization.
Selected historical consolidated financial and other data as of December 31, 2001, 2002 and 2003, and for each of the four years ended December 31, 2004, for our predecessor. The historical consolidated financial data as of December 31, 2003, and for each of the three years ended December 31, 2003 have been derived from, and should be read together with, our predecessor’s audited consolidated financial statements and the related notes;
Selected historical financial and other data for the period from January 21, 2004 (KMG America’s date of inception), to December 31, 2004, for KMG America. For such period, KMG America had insignificant operations and cash flows. See KMG America’s audited financial statements and the related notes included in this report; and
Selected historical consolidated financial and other data as of and for the year ended December 31, 2005, for KMG America. The historical consolidated financial data as of December 31, 2005, for KMG America have been derived from, and should be read together with, KMG America’s audited consolidated balance sheet and the related notes included in this report.
For GAAP accounting purposes, Kanawha is treated as our predecessor entity and is referred to in this table as our “predecessor.” For financial reporting purposes, we have treated the Kanawha acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material. Accordingly, selected historical consolidated financial and other data as of any date prior to, or for any period ending on or prior to, December 31, 2004, are reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition. Selected historical financial data and other data as of any date on or after, or for any period ending after, December 31, 2004, reflect GAAP purchase accounting adjustments made as of December 31, 2004, reflecting the acquisition.
KMG America is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004. We commenced our operations shortly before we completed our initial public offering of common stock on December 21, 2004, and our shares trade on the New York Stock Exchange under the symbol “KMA.” Concurrently with the completion of our initial public offering, we completed our acquisition of Kanawha and its subsidiaries, which are our primary operating subsidiaries and which underwrite and sell life and health insurance products which have been historically marketed primarily in the southeastern United States, but are now actively marketed nationwide.
which accounted for 49.8% of our premiums, commissions and fees, excluding intercompany payments in that period. Our business strategy is to operate our existing worksite insurance business efficiently while developing a new worksite marketing and distribution organization that targets larger employer groups nationwide with an expanded variety of life and health insurance products which will add a new set of employer-paid life insurance, disability and health products to our existing voluntary products. In December 2004, we opened sales offices hosting regional sales managers in Boston, Massachusetts and Irvine, California, a Los Angeles suburb. During 2005, we opened regional sales offices in Tampa, Florida; Chicago, Illinois; New York, New York; Atlanta, Georgia; Dallas, Texas; Kansas City, Missouri; Cleveland, Ohio; Philadelphia, Pennsylvania; New Orleans, Louisiana; San Diego and San Francisco, California; and Minneapolis, Minnesota. We expect to continue to add and train additional sales and sales support staff and marketing personnel at these facilities and at offices we open in other markets throughout the United States , and will recognize the costs associated with the these additions before we recognize revenues resulting from new sales activity. Consequently, we expect negative cash flow and operating losses in the short term.
Senior market insurance business. Our senior market insurance business has been a provider in the southeastern United States of individual insurance products tailored to the needs of older individuals. The primary insurance products that this business offered include long-term care insurance that we underwrote and Medicare supplement insurance underwritten by another carrier. For the year ended December 31, 2005, our senior market insurance business produced premiums, commissions and fees, excluding intercompany payments, of $42.2 million, which accounted for 34.8 % of our premiums, commissions and fees, excluding intercompany payments, in that period.
The trend to shift health care costs to employees and rising healthcare costs in general are causing individuals to purchase a wider array of life and health insurance products. We believe these trends will result in greater demand for our voluntary worksite insurance products.
The volatility in the equity markets over the past few years has posed a number of problems for some participants in the life and health insurance industry. Even though the capital markets have recovered, not all companies have participated evenly in the recovery. We and our predecessor have historically had minimal equity exposure (less than 1% of total invested assets as of December 31, 2005) and we plan to continue to manage equity asset allocations conservatively in the future.
Some life and health insurance companies have recently suffered significant reductions in capital and will have to improve their capital adequacy ratios to support their business or divest a portion of their business. We expect these trends to have a positive impact on our competitive position in the industry as carriers become more disciplined with product pricing and/or exit markets or product lines in which we will compete.
Recently announced governmental investigations and litigation alleging the illegal use of bid-rigging schemes and contingent commissions by insurance companies and brokers may adversely affect our industry and us (1) by negatively impacting the level and volatility of stock prices of companies operating in the insurance industry, (2) if we become the subject of investigations or related litigation of this type, or (3) if industry regulation, practices and customs change in ways that are detrimental to the success of our business strategy.
In accordance with GAAP purchase accounting requirements, our predecessor’s policy and contract reserves were recorded at fair value upon the closing of the Kanawha acquisition. The policy and contract reserves were calculated as the present value of future benefits and expenses less the present value of future net premiums. These values were actuarially determined and were based upon assumed future interest rates, administrative expenses, mortality, morbidity and policy lapse rates as appropriate for the particular benefit on the purchase date. For long-term care insurance, assumptions for the present value of net premiums in the fair value calculation are consistent with current and anticipated premium increases, including those approved in the last twelve to eighteen months in certain jurisdictions for policies currently in force. These assumptions now serve as the original assumptions described in the first paragraph above.
Reserve interest assumptions (i.e., discount rates) used by us in establishing our current policy benefit reserves were modified on the purchase date. The valuation interest rate is determined by taking into consideration actual and expected earned rates on our asset portfolio. Benefit reserves for limited payment policies take into
For most insurance products, amortization of DAC and VOBA is recognized in proportion to the ratio of annual premium revenue to the total anticipated premium revenue, which gives effect to expected terminations. DAC is amortized over the premium-paying period of the related policies. Anticipated premium revenue is determined using assumptions consistent with those utilized in the determination of liabilities for insurance reserves.
Under our assumptions as of December 31, 2005, we estimate that the amortization of VOBA, for the next five years will be as follows:
We regularly monitor our investment portfolio to ensure that investments that may be other than temporarily impaired are identified in a timely fashion and properly valued and that any impairment is charged against earnings in the proper period. Our investment portfolio is managed by an external asset management firm, with the exception of certain invested assets that are managed internally. Our methodology used to identify potential impairments requires judgment by us in conjunction with our investment managers.
The following section discusses significant factors that impact our revenues and insurance underwriting results segregated into the following five business segments:
Worksite insurance business. The worksite insurance business provides life and health insurance products to employers and their employees. This business segment includes worksite business as well as individual insurance business sold directly to the end consumer and not considered part of the senior market business. The primary insurance products sold by this business include life, short-term disability, dental, indemnity health, employer excess
Acquired business. Our predecessor obtained over time through assumption and indemnity reinsurance transactions, a number of blocks of life and health insurance business in which it has since elected to discontinue accepting new business. Revenue from this business reflects renewal premiums and other considerations on business in force that will continue to decline over time as policies lapse. The earnings generated by acquired blocks of business in any period will be affected by, among other things, historical pricing levels together with approved premium rate increases if any, diversification of the underlying insurance policies, persistency and loss frequency and severity.
Corporate and other. The corporate and other segment includes investment income earned on the investment portfolio related to capital and surplus not allocated to the insurance segments. This segment also includes marketing allowances, commissions and related expenses pertaining to product sales for other insurance carriers, which are currently not material. In addition, this segment includes certain unallocated expenses, primarily deferred compensation and incentive compensation costs, and other unallocated immaterial items. The results of this business segment are reflected in the following discussions of net investment income, realized investment gains and losses, and general insurance expenses.
Assumed Premiums: Assumed premiums represent premiums written and issued by other insurance companies and subsequently reinsured by us.
Commission and fee income: Commission and fee income consists of the commissions received by our insurance marketing business for the sale by us of insurance products underwritten by other insurance companies and fees generated by our third-party administration business. In addition, both of these businesses provide services to us. The commission and fee income for services that these businesses provide to us is eliminated from the financial statement amounts referenced in this report.
Policyholder benefits: Policyholder benefits consist of the policy benefit claims paid to policyholders and the increase or decrease in benefit reserves. The primary factors affecting policyholder benefits are
Premiums: Premiums are categorized as direct, assumed, ceded, and net. Each of these categories are further categorized as new or renewal.
Revenues: Revenues consist primarily of premiums, net investment income, commission and fee income, realized investment gains and losses and other income.
We were incorporated on January 21, 2004, and completed our initial public offering of common stock on December 21, 2004.
Net income for the year ended December 31, 2005, decreased $1.5 million, or 24.2%, to $4.7 million from net income of $6.2 million in 2004. The decrease in net income was primarily due to decreases in revenues as the result of decreases in net realized gains offset by increases in premiums. In addition there were increases in expenses offset by decreases in policyholder benefits, all of which are described in greater detail below.
Total revenues for the year ended December 31, 2005, decreased $0.7 million, or 0.5%, to $153.4 million from total revenues of $154.1 million in 2004. The primary factors causing the fluctuations are explained below under the captions “Premiums,” “Net Investment Income” “Commission and Fee Income” “Realized Investment Gains and Losses” and “Other Income”.
Worksite net new premiums increased $3.8 million, or 29.9%, to $16.5 million for the year ended December 31, 2005, from $12.7 million for the year ended December 31, 2004, due to increased sales volumes. New sales increased $1.7 million, or 12.8%, to $15.0 million in the year ended December 31, 2005, from $13.3 million in the year ended December 31, 2004, due to increased emphasis on this core business segment. Net renewal premiums increased $0.4 million, or 0.9%, due to the increased amount of insurance in force created by prior year sales.
Senior market net new premiums decreased $0.8 million, or 50.0%, to $0.8 million for the year ended December 31, 2005, from $1.6 million for the year ended December 31, 2004, due to a decrease in new sales. New sales decreased $1.7 million, or 53.1%, to $1.5 million in the year ended December 31, 2005, from $3.2 million in the year ended December 31, 2004. A sales decline that began in mid-2003, resulting from the discontinuance of an older product and the introduction of a new product with significantly higher premiums, continued into 2005. In addition, decisions were made to no longer actively underwrite long term care insurance policies after December 31, 2005 and to close our primary long term care distribution office in October, 2005. We intend to retain and actively manage the existing in force block of long term care. Net renewal premiums increased $0.9 million, or 2.2%, due to the increased amount of insurance in force created by prior year sales. This increase is reflected in both the direct renewal premiums and the ceded renewal premiums.
Acquired business premiums decreased $0.5 million, or 10.9%, to $4.1 million for the year ended December 31, 2005, from $4.6 million for the year ended December 31, 2004. Neither we nor our predecessor has acquired any blocks of business since 1999 and the decline is a result of policy lapses.
Net investment income increased $2.5 million, or 9.9%, to $27.7 million in the year ended December 31, 2005, from $25.2 million in the year ended December 31, 2004. Net investment income for 2004 was negatively impacted by a non-recurring $1.6 million incentive payment to one of Kanawha’s outside investment managers at the conclusion of the contract period. Excluding this item, net investment income increased $0.9 million in the year ended December 31, 2005. Net investment income is primarily affected by changes in levels of invested assets and interest rates. The increase in investment income in 2005 occurred as a result of an increase in total cash and investments of approximately $58.0 million that occurred in conjunction with the completion of our initial public offering on December 21, 2004. These proceeds were held in short term investments or cash equivalents for the majority of 2005, which produced lower effective yields for that portion of the portfolio. Invested assets increased by $82.2 million or 17.8%, to $543.3 million as of December 31, 2005, from $461.1 million as of December 31, 2004, reflecting the investment of cash generated by 2004 asset sales and our initial public offering. Generally, increases in cash and invested assets are due to retention of premiums to establish policy reserves for the payment of future policyholder benefits.
The average yield on cash and invested assets on an amortized cost basis was 4.78% for the year ended December 31, 2005, compared to an average yield of 5.14% for the year ended December 31, 2004, excluding the effects of the non-recurring $1.6 million incentive payment to one of Kanawha’s outside investment managers. This decline resulted from lower interest rates combined with the significantly larger amount of assets held in cash for a significant period of time during the year ended December 31, 2005. The incentive payment made in 2004 was charged directly to the corporate and other segment, while all other net investment income is allocated to our various business segments on a pro rata basis based on the invested assets attributed to the business segment.
Commission and fee income increased $1.1 million, or 8.1%, to $14.6 million for the year ended December 31, 2005, from $13.5 million for the year ended December 31, 2004. Most of the commission and fee income was from administrative fees relating to third-party administration. The increase was due to an increase in business in force resulting from increased sales of our administrative services.
Realized investment gains and losses occur as a result of the sale or impairment of investments. The net realized investment gain in the year ended December 31, 2005 decreased by $9.0 million to $0.4 million from $9.4 million in the year ended December 31, 2004. The net gain realized on fixed maturity securities in the year ended December 31, 2005, totaled $0.1million compared to a net gain realized on fixed maturity securities of $7.1 million in the year ended December 31, 2004. In 2004, our predecessor’s investment committee elected to take advantage of favorable market conditions for fixed maturity securities by selling certain fixed maturity securities to recognize gains. Realized gains on fixed maturity securities in 2005 and 2004 were negatively impacted by impairment charges of $0.2 million and $0.5 million, respectively. The net gain realized on equity securities in the year ended December 31, 2005, totaled $0.0 million compared to a net gain realized on equity securities of $2.4 million for the
year ended December 31, 2004. The 2004 gains on equity securities were due to our predecessor’s investment committee’s election to take advantage of favorable market conditions by selling certain common stocks to recognize gains on these sales. Realized gains on equity securities in 2005 and 2004 were negatively impacted by impairment charges of $0.0million and $0.2, respectively. The net gain realized on other investments in the year ended December 31, 2005, totaled $0.2 million compared to a net gain realized on other investments of $0.4 million for the year ended December 31, 2004. Other investments represent the assets purchased to support the deferred compensation liability of the company, and realized gains and or losses are directly offset with increases and or decreases in compensation expenses. Realized investment gains and losses are allocated entirely to the corporate and other business segment.
Other income increased $0.8 million, or 25.8%, to $3.9 million in the year ended December 31, 2005, from $3.1million in the year ended December 31, 2004. In 2005, other income includes $0.3 million of proceeds from litigation settlements, resulting from our participation in various class action litigations. The remaining increases reflect increased commission and expense allowances from reinsurance companies generated from an increase in renewal ceded premiums.
Worksite marketing policyholder benefits decreased $0.7 million, or 1.6 %, to $43.6 million for the year ended December 31, 2005, from $44.3 million for the year ended December 31, 2004. This produced benefits to premium ratios of 72.0 % for the year ended December 31, 2005, compared to 78.7% for the year ended December 31, 2004. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the near future. The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves.
Acquired business policyholder benefits decreased $4.7 million, or 46.5%, to $5.4 million for the year ended December 31, 2005, from $10.1 million for the year ended December 31, 2004. This produced benefits to premium ratios of 130.5% for the year ended December 31, 2005, compared to 225.1% for the year ended December 31, 2004. These benefits to premium ratios are affected by large portions of the acquired business that are no longer premium paying with substantial reserves and investment income on reserves. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the near future.
The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves.
General insurance expenses increased $14.1million, or 50.7%, to $41.9 million in the year ended December 31, 2005, from $27.8 million in the year ended December 31, 2004. General insurance expenses for 2005 include approximately $13.3 million of incremental costs associated with our continuing expansion to a national insurance company, including the addition of management and marketing personnel, occupancy costs, infrastructure development, back-office expenses, director and officer and related types of insurance coverage, and costs associated with being a public company. Overhead expenses that are not directly associated with a particular business segment are allocated to the various business segments on a pro rata basis based on different factors, such as headcount, policy count, number of policies issued, premiums and other relevant factors. During 2005, we incurred $0.7 million in defense costs related to the ReliaStar litigation and shut down costs of $0.3 million associated with the sale of our Ft. Myers based senior market insurance agency office. We also incurred deferred compensation expenses of $0.2 million associated with the increase in market value of the deferred compensation plan assets. The deferred compensation expenses are directly offset with realized investment gains of the same amount
Insurance taxes, licenses and fees were unchanged at $4.7 million in the years ended December 31, 2005 and 2004. Premium income, which drives premium taxes, was relatively flat between 2005 and 2004.
Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% due to tax-advantaged investments and net operating loss carry forwards available. The effective income tax rates for the years ended December 31, 2005, and 2004 were 32.2% and 36.5% respectively. The variations in these rates is due to the fact that a portion of our consolidated income for the year ended December 31, 2005 resulted from a subsidiary that has net operating loss carry forwards available. Due to the uncertainty of using these net operating losses, a valuation allowance had been established offsetting the deferred tax asset; therefore, the tax on the net income from this subsidiary has been offset by the release of the associated valuation allowance, which reduces the effective tax rate for the consolidated company.
Worksite net new premiums decreased $2.4 million, or 15.9%, due to decreased sales volumes. New sales decreased $1.4 million in total, or 9.5%, to $13.3 million in the year ended December 31, 2004, from $14.7 million in the year ended December 31, 2003. Our predecessor stopped issuing annuities and Medicare supplement policies in 2003, but both of these products were offered for the majority of 2003. Sales of our predecessor’s products through its career agency distribution channel declined as a result. New product sales distributed exclusively through worksite marketing increased $2.3 million, or 27.4%, to $10.7 million in the year ended December 31, 2004, from $8.4 million in the year ended 2003. Net renewal premiums increased $0.3 million, or 0.7%, due to the increased amount of insurance in force created by prior year sales.
Senior market net new premiums decreased $4.2 million, or 72.4%, due to the combination of a decrease in direct new premiums and an increase in ceded new premiums. Direct new premiums decreased $5.2 million, or 54.2%, due to a decline in new sales. New sales decreased $5.1 million, or 61.4%, to $3.2 million in the year ended December 31, 2004, from $8.3 million in the year ended December 31, 2003. A sales decline that began in mid-2003, resulting from the discontinuance of an older product and the introduction of a new product with significantly higher premiums, continued into 2004. Net new premiums also declined because the new product is reinsured to a greater degree than the discontinued product, resulting in an increase to ceded premiums. The risk retained by Kanawha was 85% on the discontinued product compared to 40% on the new product. Net renewal premiums increased $4.8 million, or 13.4%, due to the increased amount of insurance in force created by prior year sales. This increase is reflected in both the direct renewal premiums and the ceded renewal premiums.
Acquired business premiums decreased $2.0 million, or 30.3%, for the year ended December 31, 2004. We and our predecessor have not acquired any blocks of business since 1999 and the decline is a result of policy lapses and premium refunds that our predecessor was required to pay to ceding companies under some of its reinsurance agreements because its claims experience was better than contemplated in the agreements. These premium refunds are offset by reductions in policyholder benefits.
Other income increased $0.8 million, or 34.8%, to $3.1 million in the year ended December 31, 2004, from $2.3 million in the year ended December 31, 2003, reflecting the increased commission and expense allowances from reinsurance companies generated from the increase in ceded premiums described in “-Premiums” above.
Policyholder benefits increased $0.9 million, or 1.0%, to $90.2 million in the year ended December 31, 2004, from $89.3 million in the year ended December 31, 2003. This, in combination with the aforementioned decline in premiums, produced a benefits to premium ratio of 87.7% in 2004 compared to 83.9% in 2003.
Acquired business policyholder benefits decreased $0.9 million, or 8.2%, to $10.1 million for the year ended December 31, 2004, from $11.0 million for the year ended December 31, 2003. This produced benefits to premium ratios of 225.1% for the year ended December 31, 2004, compared to 170.7% for the year ended December 31, 2003. These benefits to premium ratios are affected by large portions of the acquired business that are no longer premium paying, substantial reserves and investment income on reserves that is a primary component of this line of business. The decline in policyholder benefits results from the fact that claims experience was better than contemplated under some of the related reinsurance agreements. These better than contemplated policyholder benefits were offset by premium refunds that our predecessor was required to pay to the ceding companies because claims experience was favorable. The primary reason for the increased benefits to premium ratio was an increase of $0.9 million in policyholder benefits combined with a decrease of $0.5 million in premiums on a block of insurance policies acquired from Metropolitan Life Insurance Company. The increase in policyholder benefits on the Metropolitan Life Insurance Company business was due in part to several larger claims, but primarily reflects increased claims volume due to the aging of the business. Other than these benefit fluctuations, there were no significant changes in acquired business policyholder benefits from 2003 to 2004.
Our predecessor deferred first year commissions and general insurance expenses associated with the acquisition of new business. The total deferrals of policy acquisition costs were $13.1 million and $14.5 million in 2004 and 2003, respectively. The decrease in deferrals was primarily due to the decrease in net new long-term care premiums in the senior market.
Net unrealized (losses) on fixed maturity securities were $7.7 million as of December 31, 2005.
Loss Impairment. All fixed maturity securities are classified as available-for-sale and marked to market through other comprehensive income. All securities with gross unrealized losses at the consolidated balance sheet date are subjected to our process for identifying other-than-temporary impairments. Securities deemed to be
other-than-temporarily impaired are written down to fair value in the period the securities are deemed to be so impaired. The assessment of whether such impairment has occurred is based on management’s case-by-case evaluation of the underlying reasons for the decline in fair value. Management considers a wide range of factors, as described below, about the issuer of the security and uses its best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing its prospects for near term recovery. Inherent in management’s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential.
catastrophic loss suffered by the issuer or the industry in which the issuer operates; and
Policyholder dividends are recognized over the term of the related policies. Participating business represents approximately 30% and 30%, respectively, of the Company’s total ordinary life insurance in force at December 31, 2004, and 2005. Dividends paid to policyholders in 2005, 2004 and 2003 were approximately $2.1 million, $2.2 million and $2.0 million, respectively. Participating premiums as a percentage of direct life premiums were 46% in 2005, 51% in 2004 and 52% in 2003.
The following table sets forth reinsurance recoverables by category as of the dates indicated:
Reinsurance recoverables increased by $6.9 million, or 9.7%, to $78.3 million as of December 31, 2005, from $71.4 million as of December 31, 2004. The increase in the recoverable balance is attributable to underlying business growth, specifically the growth in long-term care business reinsured.
Under indemnity reinsurance transactions in which we are the ceding insurer, we remain liable for policy claims if the assuming company fails to meet its obligations. In the event one or more assuming companies were to default on its obligations, it could have an adverse effect on our business, results of operations and financial condition. To limit this risk, we have implemented procedures to evaluate the financial condition of reinsurers and to monitor the concentration of credit risk to minimize this exposure. In some cases, the reinsurers have placed amounts in trust that would be the equivalent of the recoverable amount and for which we are the beneficiary. The selection of reinsurance companies is based on criteria related to solvency and reliability and, to a lesser degree, diversification. An estimated allowance for doubtful accounts is recorded on the basis of periodic evaluations of balances due from reinsurers, reinsurer solvency, management experience and current economic conditions. As of December 31, 2005 and 2004, there was no allowance for doubtful accounts.
The following table sets forth our individual reinsurance recoverables exposure to specific reinsurers and their corresponding A.M. Best financial strength rating as of December 31, 2005:
For 2006, the maximum amount of dividends that Kanawha can pay to KMG America under applicable laws and regulations without prior regulatory approval is $8.5 million. If KMG America is able to successfully execute its business plan and accelerate Kanawha’s earnings growth in its insurance operations, KMG America expects that the maximum allowable dividend from Kanawha to the holding company will increase at an accelerated rate year-over-year. If the ability of Kanawha to pay dividends or make other payments to KMG America is materially restricted by regulatory requirements, it could adversely affect KMG America’s ability to pay any dividends on its common stock and/or service its debt and pay its other corporate expenses.
KMG America has outstanding debt of approximately $15.8 million because a portion of the purchase price for the Kanawha acquisition was paid in the form of a $15.0 million subordinated promissory note with a five-year term beginning on the closing date of the acquisition. Interest on the promissory note is accruing at 5% per annum and is added to the principal balance on December 31 of each year and is payable on the maturity date. No cash payments are required under the promissory note until maturity, at which time approximately $19.1 million of principal and accrued interest will be due and payable. The terms of the promissory note limit KMG America’s and Kanawha’s ability to incur additional debt. KMG America maintains a $2.0 million line of credit available to meet short-term cash flow needs. We are seeking to expand our available credit facilities in order to maximize financial flexibility and are considering adding leverage to our capital structure.
We anticipate that these costs will be offset over time by increased sales production resulting from hiring additional sales personnel and increased cross-selling, as well as efficiencies resulting from greater scale.
The table below shows the Company’s and our predecessor’s recent net cash flows:
Cash Flows for the Years Ended December 31, 2005, 2004 and 2003. In the table shown above, increases in net cash provided by operating activities generally result from collected premiums while decreases in net cash flow provided by investing activities generally are a result of the investment of collected premiums. Policy and contract liabilities increase when premiums collected are retained to establish policy reserves. The portions of these liabilities that are reinsured by reinsurance companies are reflected in reinsurance balances recoverable.
As a function of our third party administration business, we manage insurance funds for our clients. These funds are held in suspense accounts pending appropriate disposition, and the balances held in suspense vary on a day-to-day basis as insurance funds are received and applied by us.
Accounts payable and accrued expenses increased by $4.5 million in 2004, primarily due to an increase in reinsurance payables of $6.8 million relating to acquired business, and a decrease in accrued compensation expense of $1.8 million relating to payments of accrued compensation that were made in 2004.
Other assets decreased by $2.2 million in 2004, primarily due to the timing of payments and receipts from our reinsurers.
In 2004, our predecessor had realized gains of $9.4 million primarily due to its decision to sell its convertible bond portfolio and the majority of its equity securities. These realized gains were higher than the gains in 2003, although the activity levels for sales and purchases was significantly lower than in 2003.
Reinsurance recoverables increased significantly by $20.2 million in 2003. The key, non-routine component of the increase was the result of ceding $15.0 million of reserves associated with the annuity block of business to Madison National Life Insurance Company.
Other assets increased by $3.2 million in 2003 as the result of a reclassification of assets pertaining to an employee deferred compensation plan from “available-for-sale” to “trading,” offset by a decrease in common stock.
Report of Management of the Consolidated Financial Statements and Management’s Assessment of Internal Control Over Financial Reporting
Report of Independent Registered Public Accounting Firm on Internal Controls over Financial Reporting
Consolidated Statements of Operations for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the year ended December 31, 2005, and for Kanawha Insurance Company (the “Predecessor”) for the years ended December 31, 2003 and 2004
Consolidated Statements of Shareholders’ Equity for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the year ended December 31, 2005, and for the Predecessor for the two years ended December 31, 2003 and 2004
*All other required financial statement schedules are omitted because the information required is either not applicable or is included in the financial statements or the related notes included in this report.
The management of KMG America Corporation (“KMG”) is responsible for the preparation, integrity and fair presentation of Consolidated Financial Statements of KMG and for establishing and maintaining adequate internal control over financial reporting. The accompanying Consolidated Financial Statements, including Notes to Financial Statements, have been prepared by management in accordance with U.S. generally accepted accounting principles (GAAP), and reflect management’s estimates and judgments, the use of which are inherent in the preparation of financial statements. In the opinion of management, the accompanying Consolidated Financial Statements present fairly KMG’s financial position and results of operations, giving due consideration to materiality.
KMG management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2005. In making this assessment, it 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 believe that, as of December 31, 2005, the company’s internal control over financial reporting is effective based on those criteria.
KMG’s Consolidated Financial Statements and assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005 have been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their reports which appear on pages 75 and page 76, respectively.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of KMG America Corporation as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity and cash flow for the year ended December 31, 2005, and for the period January 21, 2004 (inception) through December 31, 2004, and our report dated March 9, 2006, expressed an unqualified opinion thereon.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of KMG America Corporation at December 31, 2005 and 2004, and the consolidated results of KMG America Corporation’s operations and cash flow for the year ended December 31, 2005, and for the period January 21, 2004 (inception) through December 31, 2004, and the Predecessor’s consolidated results of operations and cash flow for each of the two years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in related to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of KMG America Corporation’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 9, 2006, expressed an unqualified opinion thereon.
Kanawha, the primary operating subsidiary of KMG America, is licensed to issue life and accident and health insurance. Kanawha is domiciled in South Carolina. Kanawha has one wholly owned subsidiary, Kanawha HealthCare Solutions, Inc., a third-party administrator with operations in Lancaster and Greenville, South Carolina, and one wholly owned indirect subsidiary, Kanawha Marketing Group, Inc.
The Company’s primary businesses are life and health insurance risk assumption, third-party administration and medical management services. Included in risk assumption are the Company’s product lines of individual and group life, annuity, supplemental health, excess risk and short-term disability. The Company sold its agency office in Ft. Myers, Florida that distributes senior market insurance products on October 5, 2005, and it expects to cease actively underwriting new long-term care insurance policies after December 31, 2005. The Company intends to retain and actively manage its existing block of in force long-term care policies. The Company’s third-party administration and medical management businesses include a wide array of services with the primary emphasis on the offering of administrative service-only products.
For accounting purposes, Kanawha is treated as KMG America’s predecessor entity and is referred to in these Notes as the “Predecessor.” For financial reporting purposes, management has treated the acquisition of the Predecessor as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material to the Predecessor’s consolidated statements of operations, cash flows, and changes in shareholders’ equity for the year ended December 31, 2004. Accordingly, financial information in the following discussion that relates to the Predecessor’s consolidated results of operations, cash flows and changes in shareholders’ equity for the year ended December 31, 2004 is reported on a historical basis without GAAP (generally accepted accounting principles in the United States) purchase accounting adjustments reflecting the acquisition of the Predecessor. Financial information relating to the Company’s financial position as of December 31, 2004, has been adjusted for GAAP purchase accounting adjustments reflecting the Predecessor’s acquisition.
The presentation of the accompanying consolidated financial statements requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and accompanying
The Company includes with cash and cash equivalents its holdings of highly liquid investments with maturities of three months or less of the date of acquisition.
Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Fixed Maturity and Equity Securities, requires that all fixed maturity and equity securities be classified into one of three categories-held to maturity, available-for-sale, or trading. The Company has no securities classified as held to maturity. Management determines the appropriate classification of fixed maturities at the time of purchase.
The Company regularly reviews its investment portfolio to identify securities that may have suffered impairments in value that will not be recovered, termed potentially distressed securities. In identifying potentially distressed securities, the Company first screens for all securities that have a fair value to cost or amortized cost ratio of less than 80%. Additionally, as part of this identification process, the Company utilizes the following information:
Expenditures for improvements are capitalized, and expenditures for maintenance and repairs are charged to operations as incurred. Upon sale or retirement, the cost and related accumulated depreciation and amortization are removed from the accounts and the resulting gain or loss, if any, is reflected in operations. For the years ending December 31, 2005, 2004 and 2003, total depreciation expense was approximately $1.8 million, $2.5 million and $3.0 million, respectively.
For most insurance products, the amortization of deferred acquisition costs is recognized in proportion to the ratio of annual premium revenue to the total anticipated premium revenue, which gives effect to expected terminations. Deferred acquisition costs are amortized over the premium-paying period of the related policies. Anticipated premium revenue is determined using assumptions consistent with those utilized in the determination of liabilities for insurance reserves. For interest-sensitive life insurance and investment products such as deferred annuities (no longer sold by the Company) to the extent recoverable from future gross profits, deferred policy acquisition costs are amortized generally in proportion to the present value of expected gross profits from surrender charges and investment, mortality and expense margins.
Value of business acquired is the value assigned to the insurance in force of acquired insurance companies or blocks of insurance business at the date of acquisition.
The Predecessor’s historical value of business acquired was eliminated upon the closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements. Value of business acquired was simultaneously re-established, by the Company, for the value of the Predecessor’s in force business. Interest rate assumptions used to amortize the value of business acquired were reset upon the closing of the Kanawha acquisition. The interest rate was approximately 6% at December 31, 2004.
Goodwill reflected in the Predecessor’s consolidated balance sheet resulted from the acquisition of Kanawha HealthCare Solutions, Inc. (formally Kanawha Benefit Solutions, Inc.) in 1990. Accumulated amortization totaled $3.7 million at December 31, 2002 and 2001. Effective January 1, 2002, the Predecessor adopted SFAS No. 141, Business Combinations (“SFAS No. 141”) and SFAS No. 142 Goodwill and Other Intangible Assets (“SFAS No. 142”). Under SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized but are reviewed annually for impairment, or more frequently if impairment indicators arise, with consideration given to financial performance and other relevant factors. In addition, certain events including a significant adverse change in legal factors or the business climate, an adverse action or assessment by a regulator, or unanticipated competition, would cause the Company and the Predecessor to review amounts of goodwill for impairment. When considered impaired, the carrying amounts are written down using a combination of fair value and discounted cash flows. Separate intangible assets that are not deemed to have an indefinite life continue to be amortized over their useful lives. For the years ended December 31, 2003, and 2004, the Predecessor and the Company completed impairment analyses and determined that goodwill was not impaired. The Predecessor’s goodwill was eliminated upon the Company’s closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements.
Long-lived assets include property and equipment, other intangible assets, systems development and other deferred costs and other assets. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”), the Company regularly evaluates whether events and circumstances have occurred which indicate that the carrying amount of long-lived assets may warrant revision or may not be recoverable. When factors indicate that long-lived assets should be evaluated for possible impairment, the Company uses an estimate of the future undiscounted net cash flows of the related business over the remaining life of the asset in measuring whether the carrying amount of the related asset is recoverable. To the extent these projections indicate that future undiscounted net cash flows are not sufficient to recover the carrying amounts of the related assets, the underlying assets are written down by charges to expense so that the carrying amount is equal to fair value, primarily determined based on future discounted cash flows. In the opinion of management, the Company’s long-lived assets are appropriately valued at December 31, 2005 and 2004.
Benefits related to traditional life and accident and health insurance products are recognized when incurred in a manner designed to match them with related premiums and spread income recognition over expected policy lives. For annuity products, benefits include interest credited to policyholders’ accounts, which is recognized as it accrues.
SFAS 123 requires the presentation of pro forma information as if the Company and the Predecessor had accounted for their employee and director stock options granted after December 31, 1994, under the fair value method of that Statement.
In March 2004, the Emerging Issues Task ( “EITF”), reached a final consensus on EITF 03 -16, Accounting for Investments in Limited Liability Companies, which is effective for reporting periods beginning after June 15, 2004. Opinion 18 prescribes the accounting for investments in common stock of corporations that are not consolidated. Opinion 18 specifies that investments that allow the investor to exercise significant influence over the operating and financial policies of an investee should be accounted for using the equity method. Opinion 18 established a presumption of significant influence for investments that represent 20 percent or more of the investee’s outstanding voting stock. SOP 78 -9 requires non controlling investments in limited partnerships (LPs) to be accounted for using the equity method as described in Opinion 18. Also, in Topic No. D -46, “Accounting for Limited Partnership Investments”, the SEC clarified that limited partnership investments of more than 3 to 5 percent are considered to be more than minor and should be accounted for using the equity method as well. Limited liability companies (LLCs) have characteristics of both corporations and partnerships but are dissimilar from both in some respects. In this issue the Task Force reached consensus that an investment in an LLC that maintains a “specific ownership account” for each investor should be viewed as similar to an investment in a limited partnership for purposes of determining whether a noncontrolling investment in an LLC should be accounted for using the cost method or equity method. The Company after further review determined that an affiliate’s investments in limited liability companies should be accounted for using the equity method and as a result the effect of adopting the consensus from the EITF 03 -16 was reported as the cumulative effect of change in accounting principle pursuant to the guidance in Statement 3 and Opinion 20.
The final consensus on EITF 03-1 included additional disclosure requirements incremental to those adopted by the Predecessor effective December 31, 2003, that were effective for fiscal years ending after June 15, 2004.
In October 2004, the Financial Accounting Standards Board (FASB) delayed the implementation of the accounting requirements included in EITF 03-1 until further study could be completed regarding the impact of this guidance, particularly with respect to “available-for-sale” portfolios. The disclosure requirements included in EITF 03-1 remain in effect.
The potential recognition of unrealized losses in situations where the Company anticipates a full recovery of certain unrealized losses but does not want to indicate a permanent intent to hold the affected securities, regardless of internal and external facts and circumstances, until such time as they fully recover or mature; and
In November 2005, the Financial Accounting Standards Board (FASB), issued FSP (FASB Staff Position) FAS 115 -1 and 124 -1 - The Meaning of Other - Than- Temporary Impairment and its Application to Certain Investments. The FSP addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. The FSP also addresses accounting considerations subsequent to the recognition of an other - than - temporary impairment and requires certain disclosures about unrealized losses. FSP FAS 115 -1 replaces the impairment evaluation guidance of EITF 03 -1. EITF 03 -1 ‘s disclosure requirements stay in effect. The guidance is effective for reporting periods beginning after December 15, 2005. At December 31, 2005 the Company followed the current guidance in place (EITF 03 -1) when assessing its portfolio for Other - Than - Temporary Impairments. The Company and its Investment Committee will recognize the changes as a result of FSP FAS 115 -1 and ensure adherence to the guidelines effective in the first quarter 2006. The adoption of FSP FAS 115-1 is not expected to have a material impact on the Company’s operations or financial position.
In July 2003, the Accounting Standards Executive Committee (“AcSEC”) of the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position 03-01, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (the “SOP”). AcSEC developed the SOP to address the evolution of product designs since the issuance of SFAS No. 60, Accounting and Reporting by Insurance Enterprises, and SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. The SOP provides guidance related to the reporting and disclosure of certain insurance contracts and separate accounts, including guidance for computing reserves for products with guaranteed benefits, such as guaranteed minimum death benefits, and for products with annuitization benefits such as guaranteed minimum income benefits. In addition, the SOP addresses certain issues related to the presentation and reporting of separate accounts, as well as rules concerning the capitalization and amortization of sales inducements. The SOP was effective for financial statements on January 1, 2004. The adoption of the SOP did not have a material impact on the Predecessor’s consolidated financial position and results of operations.
In December 2004, the Financial Accounting Standards Board (FASB) enacted SFAS No. 123 (revised 2004) (“FAS 123 (revised 2004)”), Share-Based Payment, which replaces SFAS No. 123 (“FAS 123”), Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25 (“APB 25”), Accounting for Stock Issued to Employees. FAS 123 (revised 2004) requires the measurement of all employee share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in the Company’s consolidated statements of operations. The accounting provisions of FAS 123 (revised 2004) are effective for reporting periods beginning December 31, 2005 The Company is required to adopt FAS 123 (revised 2004) in the first quarter of 2006.
cut approach when a company transitions to Statement 123R. An entity that adopts the FAS 123(R) using either the modified retrospective method or modified prospective method may make a one time election to adopt the transition method described in FSP 123(R). The entity must follow the guidance for calculating the pool of excess tax benefits and the guidance related to reporting the cash flows. An entity is free to choose either approach to the calculation of excess tax benefits without having to justify the preferability of the election. The Company is evaluating the requirements under FAS 123(R) in tandem with FSP FAS 123(R) and expects the adoption to have an impact on its consolidated statements of operations and net income per share that is substantially similar to the current pro forma disclosure under FAS 123.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AcSEC) issued Statement of Position 05 -1 ( SOP 05 -1), “ Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts”. SOP 05 -1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in Statement of Financial Accounting Standards (SFAS) No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long - Duration Contracts and for Realized Gains and Losses from Sale of Investments. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. SOP 05 -1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006 with earlier adoption encouraged. Retrospective application of SOP 05 -1 to previously issued financial statements is not permitted. The Company will be evaluating the impact of the adoption of this pronouncement on the Company’s consolidated financial condition and results of operations in 2006.
Proceeds from the sale of investments in common stocks during the years ended December 31, 2005, 2004 and 2003, were $0 million, $2.7 million and $13.1 million, respectively. Gross gains of $2.6 million and gross losses of $0 were realized in 2004 on those sales. Gross gains of $1.4 million and gross losses of $0 were realized in 2003 on those sales.
Changes during the years ended December 31, 2003, 2004 and 2005, in amounts affecting the net unrealized gains and losses, reduced by deferred income taxes, included in shareholders’ equity as accumulated other comprehensive income are as follows:
Management has reviewed these securities which either have been in an unrealized loss position for more than twelve months or have significant unrealized losses relative to cost and have concluded that these securities have not experienced an other-than-temporary impairment. Factors considered in making this evaluation included issue-specific drivers of the decrease in price, near-term prospects of the issuer, the length of time the value has been depressed, and the financial condition of the industry. Unrealized losses of $0.2 were considered to be other-than-temporary for this review and have been recognized as realized losses during 2005.
At December 31, 2005, the Company held $0.4 million in residential mortgage loans with interest overdue more than 90 days.
The interest rate used in 2003 and 2004 to amortize value of business acquired was approximately 7.0%. Periodically, the Company performs tests to determine whether the value of business acquired remains recoverable from future premiums on the acquired business. No write-offs were incurred in 2003, 2004 or 2005 from impairments as a result of such recoverability tests. The interest rate assumption used to amortize the value of business acquired was reset upon the closing of the Kanawha acquisition and the rate was approximately 6.0% at December 31, 2004. Under the Company’s assumptions as of December 31, 2005, the Company estimated that the amortization of value of business acquired for the next five years will be as follows:
Insurance reserves for individual life insurance, individual accident and health insurance, group life insurance and group accident and health insurance are computed using the net level premium method, including assumptions based on our experience, modified as necessary to reflect anticipated trends and to include provisions for possible unfavorable deviations. Reserve interest assumptions are graded and range from 3.0% to 8.5% for
Income taxes as reported in the consolidated statements of operations for the years ended December 31, 2005, 2004 and 2003, are summarized as follows:
The tax effects of temporary differences that result in significant deferred income tax assets and deferred income tax liabilities at December 31 are as follows:
Prior to 1984, a portion of the Predecessor’s income was not taxed, but was set aside in a special tax account designated as “Policyholders’ Surplus.” Kanawha, the Company’s insurance subsidiary, has approximately $4.3 million of untaxed “Policyholders’ Surplus” on which no payment of federal income taxes will be required unless it is distributed as a dividend, or under other specified conditions. The Company does not believe that any significant portion of the account will be taxed in the foreseeable future and no related deferred tax liability has been recognized. If the entire balance of the account became taxable under the current federal rate, the tax would approximate $1.5 million.
* Included in liability for benefits for employees and agents in the accompanying consolidated balance sheets.
The Company’s investment strategy for pension plan assets is for approximately one-half of the equity investments to be invested in a large capitalization diversified equity portfolio. During the fourth quarter of 2005, the Company terminated Morgan Stanley as investment manager of the equity portfolio and redeemed the portfolio’s investment in an absolute return hedge fund, the Mangan & McColl Offshore Arbitrage Fund. The portfolio is currently held in cash and cash equivalents pending investment in equities in accordance with the Plan.
The Company offers a 401(k) qualified savings plan for which substantially all employees and agents are eligible. Presently, each year, plan participants may contribute up to 15% of pretax annual compensation, which includes overtime, bonuses and commissions. Participants may also contribute amounts representing distributions from other qualified defined benefit or defined contribution plans. The Company contributes 25% of the first 6% of
base compensation that a participant contributes to the Plan. The Company may contribute amounts greater than 25% at its discretion. Amounts contributed to the plan by the Company are not significant.
On January 31, 2006, the Company approved amendments to the defined contribution plan increasing the Company’s match of salary deferral contributions. Effective as of October 1, 2006, the Company will match 100% of the first 3% of salary deferral contributions that a participant contributes to the plan and 50% of the next 2% of salary deferral contributions a participant contributes to the plan. Effective January 1, 2007, participants will be 100% vested in all matching contributions made by the Company to the plan on and after that date.
These options generally vested 30% in 1998 and 10% annually thereafter. Amortization of deferred stock option compensation expense of approximately $0.2 million was recognized in 2003 and 2004, respectively.
Pro forma information regarding net income and net income per share, as presented in Note 1, is required by SFAS 123, as amended by SFAS 148, and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS 123 as of its effective date. The fair value for these options was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:
On January 1, 2000, the Predecessor established its Performance Share Plan and authorized the issuance of up to 80,000 stock units to attract and retain quality employees and to allow such employees to participate in the growth of the Predecessor. Awards could be made to participants in the form of stock units. The Performance Share Plan provides for vesting over the 10 years subsequent to date of grant (10% per year). Compensation expense was recorded based on the vesting and the change in the book value of the Predecessor’s common stock from the date of grant to the date of exercise, adjusted for dividends, stock redemption proceeds and capital contributions subsequent to the date of grant. Eligible participants under the Performance Share Plan included executives or key employees of the Predecessor. During 2003 and 2004, the Predecessor granted 12,000 units and 0 units, respectively, and recognized compensation expense of approximately $0.7 million and $0.0 million, respectively, related to these units. During 2003 and 2004, 2,918 units and 7,354 units, respectively, were forfeited or redeemed resulting in 65,864 outstanding units at December 20, 2004. The plan continued in effect through the closing of the Company’s acquisition of the Predecessor on December 21, 2004, when it terminated and all outstanding stock units were redeemed. No additional stock units may be awarded under the plan. The Company does not intend to implement a stand-alone successor performance share plan, but the Company’s 2004 Equity Incentive Plan permits the Company to award performance shares.
On February 18, 2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company and ReliaStar Life Insurance Company of New York, both indirect wholly-owned subsidiaries of ING America U.S., in the Fourth Judicial District Court in Hennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and Thomas J. Gibb. Messrs. Kuk, Kraemer and Moore are officers of KMG America and former employees of the plaintiffs. Mr. Gibb is an employee of KMG America and a former employee of the Plaintiffs. The complaint alleges misappropriation of trade secrets, conversion, tortious interference with business and employment relationships, breach of fiduciary duties and breach of contract by KMG America, Kanawha and Messrs. Kuk, Kraemer, and Moore. The complaint seeks injunctive relief and unspecified monetary damages. On August 24, 2005, the plaintiffs amended their complaint to add Scott H. DeLong III and Thomas D. Sass as defendants. Messrs. DeLong and Sass are officers of KMG America and former employees of the plaintiffs. The plaintiffs’ amended complaint adds claims alleging unfair competition, interference with contractual relationships, civil conspiracy, fraudulent misrepresentations and civil theft. On August 9, 2005, a hearing was held before the court to consider plaintiffs’ motion for a temporary injunction and on August 26, 2005, the court issued a ruling denying plaintiffs’ motion. Since that date, plaintiffs have filed a notice of appeal of the court’s ruling with the Minnesota Court of Appeals. The Company believes the allegations are without merit and intends to defend the action vigorously. While the outcome of legal actions cannot be predicted with certainty, management believes the outcome of this matter will not have a material adverse effect on the Company’s consolidated financial position or results of operations; however, defense costs may have a material adverse effect on our consolidated financial position or results of operations.
The Company had no commitments to fund mortgage loans at December 31, 2005.
The Company leases office equipment under noncancellable leases. Total rental expense incurred during 2003 was not significant and amounted to $0.1 million in 2004 and $0.2 million in 2005. As of December 31, 2005, future minimum lease payments under noncancellable operating leases with initial or remaining terms in excess of one year are as follows:
During November 2003, the Predecessor entered into a contract for IT and document management. Expenses incurred during 2003, 2004, and 2005 were $0.5 million, $5.0 million, and $6.8 million respectively. This ten-year contract is subject to cancellation by the Company at any time after 42 months, with the payment of a termination penalty that is subject to the number of months remaining in the contract. The document management portion of the agreement is variable by transaction volume. Future payments under this contract are as follows:
The following methods and assumptions were used by the Company in estimating the “fair value” disclosures for financial instruments in the accompanying financial statements and notes thereto:
Cash and Cash Equivalents: The carrying amounts reported in the accompanying balance sheets for these financial instruments approximate their fair values.
The worksite insurance business provides life and health insurance products to employers and their employees. The primary insurance products include life, short-term disability, dental, indemnity health, employer excess risk and critical illness. This segment includes business sold through the career agency distribution channel, which is a group of agents and managers that are employees of the Company or its subsidiaries.
insurance policies. The Company also markets Medicare supplement insurance issued by another carrier, which generates commission income for the Company.
The following is a summary of the unaudited quarterly results of operations for the years ended December 31, 2004, and 2005: