• Selected historical consolidated financial and other data as of December 31, 2004, for KMG America. The historical consolidated financial data as of December 31, 2004, 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.
• the businesses of our predecessor are intended to be only a portion of our business in the future and are not entirely representative of the principal business strategy we plan to pursue;
• our acquisition of Kanawha was subject to GAAP purchase accounting, which caused us to adjust the recorded amounts of our predecessor’s assets and liabilities to fair value following the acquisition; and
Worksite insurance business. Our worksite insurance business is a provider of voluntary life and health insurance products to employers and their employees in the southeastern United States. The primary insurance products that we underwrite include: life insurance; short-term disability insurance; dental insurance; indemnity health insurance; and critical illness insurance. For the year ended December 31, 2004, our predecessor’s worksite insurance business produced premiums, commissions and fees, excluding intercompany payments, of $56.3 million, which accounted for 48.4% of our predecessor’s premiums, commissions and fees, excluding intercompany payments in that period. Our business strategy is to operate our existing worksite insurance business efficiently
Senior market insurance business. Our senior market insurance business is 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 offers include long-term care insurance that we underwrite and Medicare supplement insurance underwritten by another carrier. For the year ended December 31, 2004, our predecessor’s senior market insurance business produced premiums, commissions and fees, excluding intercompany payments, of $42.1 million, which accounted for 36.2% of our predecessor’s premiums, commissions and fees, excluding intercompany payments, in that period. While growing this business is not a primary component of our business strategy, we intend to operate this business efficiently and may consider expanding its geographic target market.
Third-party administration business. Our third-party administration business provides a wide range of insurance product administration, claims handling, eligibility administration, call center and support services. This business primarily administers the insurance plans offered by our worksite insurance business and senior market insurance business. Our third-party administration business also provides administrative and managed care services to third parties, such as employers with self-funded health care plans, other insurance carriers, reinsurers and managed care plans. For the year ended December 31, 2004, our predecessor’s third-party administration business produced commissions and fees, excluding intercompany payments, of $13.3 million, which accounted for 11.4% of our predecessor’s premiums, commissions and fees, excluding intercompany payments, in that period. Our primary business strategy for this business is to grow this business as it administers the increasing volume of policies and products that we anticipate will be sold by the worksite insurance business as we attempt to grow that business. In addition, as our national worksite marketing business develops, we intend to opportunistically market our third-party administration services to self-insured plans, stop loss insurers, pharmacy benefit organizations, managed care service providers, other insurance carriers and reinsurers nationwide. It is expected that any incremental costs associated with this expanded marketing will be modest and will be funded out of the operations of our third-party administration business.
• We also believe we will be able to take advantage of the anticipated increases in demand for morbidity products.
• We believe recently enacted Medicare legislation and Medical Savings Accounts proposals should benefit life and health insurers in the worksite business. Medical Savings Accounts (“MSAs”) were created by the United States Congress as a trial program in 1996 and allow self-employed individuals, as well as employees of employers with 50 or fewer employees, to set aside funds on a tax-free basis to pay eligible medical expenses, so long as such persons are covered under a high-deductible health insurance policy. MSA health insurance policies became an important and growing product line for our predecessor. The MSA legislation expired on December 31, 2004. However, on December 8, 2003, the Medicare Prescription & Modernization Act was signed into law. This act includes a provision providing for Health Savings Accounts, or HSAs, which are similar to MSAs but may be utilized by a much larger class of individuals.
• As an increasing percentage of the United States population reaches retirement age, we believe we will benefit from increased demand for “in-retirement” products rather than “to-retirement” products, as aging baby boomers will require immediate annuities, critical illness and long-term care products to meet their needs.
the remaining DAC asset of $0.1 million resulted in no gain or loss being reflected on our predecessor’s GAAP financial statements as a result of the transaction. Total premium considerations of $0, $2.6 million, and $1.3 million generated by our predecessor’s fixed annuity business were recognized in the years ended December 31, 2004, 2003 and 2002, respectively.
We recorded the Kanawha acquisition in a manner consistent with Financial Accounting Standard No. 141, Business Combinations (“FAS 141”). FAS 141 requires that all business combinations be accounted for under the purchase method of accounting, requiring that assets and liabilities be recorded at fair value, and establishes specific criteria for the recognition of intangible assets separately from goodwill. We have conducted analyses of how the purchase price will be allocated among our predecessor’s assets and liabilities, including amounts attributable to VOBA, goodwill and other intangibles, policy benefit reserves and reinsurance recoverables. The result of these analyses are reflected in the pro forma consolidated statements of operations included in Note 4 to the consolidated financial statements for the years ended December 31, 2004, 2003, and 2002.
• emerging medical perceptions regarding physiological or psychological causes of disability;
• emerging health issues and new methods of treatment or accommodation;
Reserve interest assumptions (i.e., discount rates) used by us in establishing our current policy benefit reserves were modified upon the completion of the Kanawha acquisition. The valuation interest rate is determined by taking into consideration actual and expected earned rates on our asset portfolio. These liabilities are, for some plans, graded to equal statutory values or cash values at or prior to maturity. Benefit reserves for individual life insurance policies include certain deferred profits on limited payment policies that are being recognized in income over the policy term. Policy benefit claims are charged to expense in the period that the claims are incurred.
are purchased is below or above the investment yield of the existing investment portfolio, it is likely that the discount rate on new claims will be established below or above, respectively, the discount rate on existing claims.
In many cases, differences in discount rates and recovery rates can have a significant effect on reserve liabilities. For example, if the discount rate used in the policy reserve calculation was adjusted by 50 basis points, the resulting reserve amount calculated would change by about 16%. Similarly, if the discount rate used in the claim reserve calculation varied by 50 basis points, the resulting claim reserve calculated would vary by about one percent. If rates of recovery on claim reserves for long term care insurance claims varied by ten percent from those actually assumed, the resulting claim reserve calculation would change by about nine percent.
We reestablished the valuation interest rate assumptions (generally to make them lower) for all of our products as a part of the application of GAAP purchase accounting requirements effective December 31, 2004. Liabilities were recorded at fair value as of December 31, 2004, using updated interest rate assumptions and other factors.
Claim reserves relating to short duration contracts generally are recorded when insured events occur. The liability is based on the expected ultimate cost of settling the claims. The claims and benefits payable reserves include: (1) case base reserves for known but unpaid claims as of the balance sheet date; (2) incurred but not reported (“IBNR”) reserves for claims where the insured event has occurred but has not been reported as of the balance sheet date; and (3) loss adjustment expense reserves for the expected handling costs of settling the claims. Case base reserves and the IBNR reserves are recorded at an amount equal to the net present value of the expected future claims payments. Factors considered when setting IBNR reserves include patterns in elapsed time from claim incidence to claim reporting, and elapsed time from claim reporting to claim payment. Claim reserves generally equal our estimate, at the end of the current reporting period, of the present value of the liability for future benefits and expenses to be paid on claims incurred as of that date. A claim reserve for a specific claim is based on assumptions derived from our actual historical experience as to claim duration, as well as the specific characteristics of the claimant such as benefits available under the policy, the benefit period, and the age and occupation of the claimant.
VOBA is the value assigned to the insurance in force of acquired insurance companies or blocks of business at the date of acquisition. The amortization of VOBA is recognized using amortization schedules established at the time of the acquisitions based upon expected patterns of premiums, mortality, policy lapses, and morbidity as adjusted to take into account variances between expected and actual costs. VOBA is amortized over the expected life of the underlying business reinsured (or acquired).
Our predecessor has historically accounted for VOBA in a manner similar to DAC. The interest rate used to amortize VOBA in 2003 and 2004 was approximately 7%. Periodically, our predecessor performed tests to determine if VOBA remained recoverable from future premiums on the acquired business. Our predecessor did not incur any write-offs in 2004, 2003 or 2002 from impairments as a result of these recoverability tests.
We eliminated all of our predecessor’s historical VOBA upon the closing of the Kanawha acquisition as part of our application of GAAP purchase accounting requirements. We simultaneously re-established VOBA for the value of our predecessor’s in force business. VOBA interest rate assumptions to amortize the VOBA were also reset upon the closing of the Kanawha acquisition and the rate was approximately 6% at December 31, 2004.
If actual lapse and mortality experience is higher or lower than assumed for the table above, then actual amortization will be faster or slower than indicated in the table.
Effective December 31, 2004, under GAAP purchase accounting rules, we recorded our predecessor’s investments at fair value and thereby eliminated all unrealized gains and losses in our predecessor’s portfolio.
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, 2004, 2003 and 2002, there was no allowance for doubtful accounts.
• Historical consolidated financial information for each of the three years ended December 31, 2004, for our predecessor.
(1) Net investment income for the year ended December 31, 2004, was negatively impacted by a $1.6 million incentive payment to one of our predecessor’s outside investment managers at the conclusion of the contract period. There are no other incentive arrangements of this type in effect, and this contract was terminated upon the closing of KMG America’s acquisition of Kanawha.
(2) The benefits to premiums ratio is equal to policyholder benefits divided by insurance premiums.
• Premiums: Premiums are categorized as direct, assumed, ceded, and net. Each of these categories are further categorized as new or renewal.
• Net premiums: Net premiums represent the sum of direct premiums and assumed premiums, less ceded premiums.
• New premiums: New premiums represent premiums collected within the first twelve months following the initial policy date.
• Other income: Other income is comprised primarily of commission and expense allowances from reinsurance companies relating to insurance ceded from us to the reinsurance companies.
• General insurance expenses: General insurance expenses include primarily selling, general and administrative expenses incurred by corporate headquarters personnel in conducting operations including marketing, policy set-up, administration, adjudication and customer service.
• Amortization of DAC and VOBA: DAC relating to most insurance products is amortized over the premium-paying period of related policies in a manner consistent with the establishment of benefit reserves. The amortization of VOBA is comparable to the amortization of DAC and is recognized using amortization schedules established at the time of acquisition based upon expected patterns of premiums, mortality, policy lapses and morbidity, and adjustments are made to take into account certain variances between expected and actual costs.
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 and critical illness. The earnings reported in any period for our worksite insurance business generally depends on growth in underwritten business, business mix, persistency of business in force, benefit payouts and administrative expenses incurred. Revenues are generated primarily from new and renewal premiums. The worksite insurance business also includes business sold through our career agency distribution channel, which is a group of agents and managers that are our employees that sell life and health insurance products directly to individuals and small businesses.
Senior market insurance business. The senior market insurance business provides individual insurance products, primarily long-term care insurance, tailored to the needs of older individuals. The level of operating earnings reported in any period for our senior market insurance business generally depends on growth in underwritten business, business mix, risk concentration, the ability to adjust premium rates, persistency of business in force, benefit payouts and administrative expenses incurred. Revenues are generated primarily from new and renewal premiums.
Third-party administration business. The third-party administration business provides administrative services to both the worksite insurance business and the senior insurance market business, as well as to third parties such as employers with self-funded insured health plans, other insurance carriers who do not administer the plans they offer, reinsurers and managed care plans. Fees paid by our insurance operations to our third-party administrative services subsidiary are eliminated in our consolidated financial statements; fees received from third parties for these services are recorded as commissions and fee income in our consolidated statements of operations. Costs associated with the operation of this business primarily reflect general overhead expenses and related information technology costs that are reflected in our consolidated statements of operations as general insurance expenses.
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.
(2) Aggregate total assets for our predecessor as of December 31, 2004, is not reported because our predecessor had been acquired by KMG America at that date and our predecessor’s assets had been consolidated into the KMG America balance sheet at that date.
Net income for the year ended December 31, 2004, decreased $1.6 million, or 20.1%, to $6.2 million from net income of $7.8 million in 2003. The decrease in net income was primarily due to decreases in premiums and net investment income and an increase in policyholder benefits, partially offset by a decrease in general expenses, all of which are described in greater detail below.
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.
Net investment income declined $1.9 million, or 7.0%, to $25.2 million in the year ended December 31, 2004, from $27.1 million in the year ended December 31, 2003. The decline in 2004 was largely the result of an incentive payment of $1.6 million to one of our predecessor’s outside investment managers at the conclusion of the contract period as well as a decline in the yield on, and the dollar amount of, invested assets. There are no other incentive arrangements of this type in effect, and this contract was terminated upon the closing of the Kanawha acquisition. Net investment income is primarily affected by changes in levels of invested assets and interest rates. The decline in investment income in the year ended December 31, 2004, occurred despite an increase in total cash and investments of $34.7 million, or 7.2%, to $519.1 million as of December 31, 2004, from $484.4 million as of December 31, 2003, excluding the effects of the Kanawha acquisition. Invested assets declined to $461.1 million as of December 31, 2004, from $477.2 million as of December 31, 2003, because assets were sold in the last several months of 2004 and the proceeds of the sale of those assets were not reinvested as of December 31, 2004. This generated a corresponding increase in cash. The increase in cash and invested assets is due to retention of premiums to establish policy reserves for the payment of future policyholder benefits.
Commission and fee income increased $0.5 million, or 3.8%, to $13.5 million for the year ended December 31, 2004, from $13.0 million for the year ended December 31, 2003. 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 increases in sales of our predecessors administrative services.
impacted by impairment charges of $0.5 million and $0.7 million, respectively. The net gain realized on equity securities in the year ended December 31, 2004, totaled $2.4 million compared to a net gain realized on equity securities of $1.4 million for the year ended December 31, 2003. These net 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 2004 and 2003 were negatively impacted by impairment charges of $0.2 million and $0, respectively. Realized investment gains and losses are allocated entirely to the corporate and other business segment.
Commission expenses increased $0.6 million, or 6.6%, to $9.7 million in the year ended December 31, 2004, from $9.1 million in the year ended December 31, 2003. This increase is consistent with the 6.5% increase in net renewal premiums for the non-acquired business.
Our predecessor also assigned a value to the insurance in force of acquired companies or blocks of insurance business at the date of acquisition. No companies or blocks of business were acquired in 2004 or 2003.
Year Ended December 31, 2003, Compared to Year Ended December 31, 2002
Net income for 2003 increased $4.7 million, or 151.6%, to $7.8 million from net income of $3.1 million in 2002. The increase in net income was due to an increase in realized investment gains partially offset by an increase in policyholder benefits, all of which are described in greater detail below.
The following table presents the distribution of premiums by type and business segment.
New sales increased $3.2 million in total, or 27.8% to $14.7 million in 2003 from $11.5 million in 2002. New product sales distributed exclusively through worksite marketing increased $2.0 million, or 31.2%, to $8.4 million in 2003 from $6.4 million in 2002. In late 2001, our predecessor hired a new team of marketing executives to grow this business and expended considerable effort and resources to achieve this objective. As a result, our predecessor’s product sales distributed exclusively through worksite marketing increased in both 2002 and 2003. Net renewal premiums increased $2.1 million, or 5.1%, due to the increased amount of insurance in force created by prior year sales.
Senior market net new premiums decreased $6.0 million, or 50.8%, due to the combination of a decrease in direct new premiums and an increase in ceded new premiums. Direct new premiums decreased $4.2 million, or 30.4%, due to a decline in new sales. New sales decreased $5.1 million, or 38.1%, to $8.3 million in 2003 from $13.4 million in 2002. Sales declined as a result of the discontinuance of an older long-term care product and the introduction of a new long-term care product with significantly higher premiums. Ceded new premiums increased $1.8 million, or 90.0%, as a result of the fact that the new product is reinsured to a greater degree than the discontinued product. Net renewal premiums increased $9.6 million, or 36.8%, 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 $1.0 million, or 13.3%, in 2003. Our predecessor and we have not acquired any blocks of business since 1999 and the decline is a result of policy lapses.
Net investment income declined $0.1 million, or 0.4%, to $27.1 million in 2003 from $27.2 million in 2002. Net investment income is primarily affected by changes in levels of invested assets and interest rates. The decline in investment income in 2003 occurred despite an increase in total investments of $13.3 million, or 2.9%, to $477.2 million as of December 31, 2003, from $463.9 million as of December 31, 2002. The total investments on an amortized cost basis as of December 31, 2003, totaled $455.9 million compared to $443.5 million as of December 31, 2002. The increase in invested assets on an amortized cost basis is due to retention of premiums to establish policy reserves for the payment of future policyholder benefits. The average yield on invested assets on an amortized cost basis was 6.02% in 2003 compared to an average yield of 6.21% in 2002. The continuing decline in prevailing interest rates and our predecessor’s sale of some higher yield investments when it restructured its portfolio in 2002 contributed to the decline in net investment income in 2003 from 2002. Net investment income is allocated to the various business segments on a pro rata basis based on the invested assets attributed to the business segment.
Total assets attributed to the worksite insurance business have not experienced any significant fluctuations. Total assets attributed to the senior market insurance business have increased significantly due to the accumulation of long-term care insurance premiums retained to establish policy reserves for the payment of future policyholder benefits. Assets attributed to the third-party administration business consist primarily of operating cash and receivables with respect to administrative claims payments awaiting settlement. These assets are subject to significant variations due to timing of payments made, and there is no investment income attributed to them. Assets attributed to the acquired business have declined since 1999 as a result of policy lapses and the fact that our predecessor has not acquired any blocks of business since 1999. Assets attributed to the corporate and other segment are subject to significant fluctuations because the changes in unrealized gains are all allocated to the corporate and other segment.
Realized investment gains and losses occurred as a result of the sale or impairment of our predecessor’s investments. The net realized investment gain increased by a total of $10.6 million to $7.6 million in 2003 from a net realized investment loss of $3.0 million in 2002. The net gain on the sale of fixed maturity securities in 2003 totaled $6.3 million compared to a net loss on the sale of fixed maturity securities of $3.0 million in 2002. The $6.3 million net gain in 2003 was primarily due to our predecessor’s investment committee’s election to take advantage of favorable market conditions for fixed maturity securities by selling fixed maturity securities to recognize gains on these sales. The $3.0 million net loss in 2002 was primarily due to losses on distressed bonds from companies including WorldCom, Inc. and ATT Canada, Inc. The net gain on the sale of common stock in 2003 totaled $1.4 million due to our predecessor’s investment committee’s election to take advantage of favorable market conditions by selling certain common stock to recognize gains on these sales. The sale of common stock in 2002 was at a price that approximated the value of the stock on our predecessor’s balance sheet; therefore, the realized gain was de minimis. Realized investment gains and losses are allocated entirely to the corporate and other business segment.
Total benefits and expenses increased $11.8 million, or 8.8%, to $145.2 million in 2003, from $133.4 million in 2002. The primary factors causing this increase are explained below in the benefits and expenses related discussion below.
Policyholder benefits increased $8.0 million, or 9.8%, to $89.3 million in 2003 from $81.3 million in 2002. The policyholder benefits for 2003 include a charge of approximately $0.9 million reflecting a reserve deficiency for accident and health insurance that emerged during the year. Conversely, policyholder benefits for 2002 include a reserve redundancy for accident and health insurance of approximately $5.3 million that was released into earnings.
Senior market policyholder benefits increased $4.3 million, or 14.9%, to $33.1 million for 2003 from $28.8 million for 2002. This produced benefits to premium ratios of 79.8% for 2003 compared to 75.8% for 2002. The primary reason for the ratio increase is the increase in actual claims, due to an increase in the number of policies in force and the aging of our predecessor’s insureds, and the associated claims reserves established.
Acquired business policyholder benefits increased $0.6 million, or 5.8%, to $11.0 million for 2003 from $10.4 million for 2002. This produced benefits to premium ratios of 170.7% for 2003 compared to 139.1% for 2002. These benefits to premium ratios reflect the facts that a large portion of the acquired business is no longer premium paying, this business has substantial reserves and the investment income on the reserves is a primary component of this line of business. The change in the benefits-to-premium ratio from 2002 to 2003 was the result of several factors including a $0.2 million leukemia claim in the group accident and health line, an arbitration settlement with John Hancock Financial Services, Inc. for $0.3 million more than the amount reserved and increases of $0.8 million in individual claims on a block of insurance policies acquired from Metropolitan Life Insurance Company over 2002. The increase in claims on the Metropolitan Life Insurance Company block of insurance policies was due in part to several larger claims, but primarily reflects increased claims volume due to the aging of the business.
Commission expenses increased $1.7 million, or 23.0%, to $9.1 million in 2003 from $7.4 million in 2002. Net renewal premiums increased by 14.2%, which generated $1.2 million in increased commissions. In addition, our predecessor paid $0.6 million of first year non-deferred commissions that were related to sales of group cancelable products that were introduced during 2003.
Insurance taxes, licenses and fees increased $0.8 million, or 20.5%, to $4.7 million in 2003 from $3.9 million in 2002. The increase exceeded the growth rate in the insurance premiums for the same period due primarily to the additional fees of $0.3 million resulting from an examination performed by the South Carolina Department of Insurance.
Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% because our predecessor qualified for the small life insurance company deduction and due to our predecessor’s tax-advantaged investments. Our predecessor’s effective tax rates for 2003 and 2002 were 31.1% and 27.3%, respectively. The effective tax rate increased because, as income increased, the benefit of the small life insurance company deduction decreased.
Of the fixed maturity securities shown above, 77.8% and 80.9% (based on total carrying value) were invested in securities rated “A” or better as of December 31, 2003, and 2004, respectively.
Net unrealized gains on fixed maturity securities were $18.8 million as of December 31, 2003.
Net unrealized gains on equity securities were $2.5 million as of December 31, 2003.
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.
• conditions of the industry sector or subsector in which the issuer operates;
• catastrophic loss suffered by the issuer or the industry in which the issuer operates; and
categories have generally been adversely impacted by the downturn in the financial markets, overall economic conditions and certain industry trends. The first category generally includes securities that have declined in value as a result of fluctuations in interest rates, rather than due to difficulties experienced by the issuer of the securities. While all of these securities are monitored for potential impairment, our and our predecessor’s experience indicates that securities in the first two categories do not present as great a risk of impairment, and securities in these categories often recover their fair value over time as the factors that caused the declines improve.
Writedowns are recorded as investment losses and the cost bases of the securities are adjusted accordingly. The revised cost basis is not changed for subsequent recoveries in value. Writedowns of fixed maturity securities were $0.5 million for the year ended December 31, 2004. This write-down reflected other than temporary impairments on Delta Airlines and Triton Aviation fixed income securities. Both of these securities have been impacted by the negative conditions affecting the airline industry generally. Delta’s credit rating was downgraded twice during 2004 and the value of the Triton securities continued a decline for which an impairment of $0.7 million was recognized in 2003. Writedowns of equity securities were $0.2 million for the year ended December 31, 2004, reflecting poor operating results and a market value decline in excess of 75 percent on Verso Technologies, Inc.
Effective December 31, 2004, we recorded all of our predecessor’s assets at fair market value, thereby eliminating all unrealized gains and losses for the year ended December 31, 2004, as part of the application of GAAP purchase accounting requirements.
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, 2004, 2003 and 2002, there was no allowance for doubtful accounts.
KMG America has outstanding debt of approximately $15.0 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
We are not currently planning to make any other significant capital expenditures or acquisitions in 2005 or subsequent years. However, we plan to significantly expand outlays relating to marketing and sales activities over the next several years including outlays required to build a national sales organization, which is a key component of our strategy. These outlays will include expenses such as salaries and cash incentive compensation, employee benefits, occupancy and information technology expenses of additional sales personnel, advertising and marketing costs, consulting and recruiting. The execution of our business plan will require additional outlays associated with the development of a national insurance company including home office expenses for executive management and additional financial, actuarial and underwriting personnel, infrastructure development and back-office expenses, as well as costs associated with our being a public company.
We monitor cash flows at both the consolidated and subsidiary levels. Cash flow forecasts at the consolidated and subsidiary levels are provided on a monthly basis, and we use trend and variance analyses to project future cash needs, making adjustments to the forecasts when needed.
Cash Flows for the Years Ended December 31, 2002, 2003 and 2004. Key factors resulting in the net cash inflow of $6.6 million for the year ended December 31, 2002, were higher cash flows from operations, specifically premium income that was placed in reserves, partially offset by $18.9 million in net purchases of investments. The key factor resulting in net cash outflow of $15.5 million for the year ended December 31, 2003, was the increase in reinsurance balances recoverable that was generated when our predecessor ceded its annuity block of business to Madison National Life Insurance Company. The transfer of assets related to that transaction was $15.0 million. There were also additional purchases of long-term investments with excess cash and cash equivalents. The key factors resulting in net cash inflow of $52.1 million for the year ended December 31, 2004, were cash flows from
Reinsurance recoverables increased in 2002 as a result of increased reinsurance, primarily from long term care insurance. Reinsurance recoverables increased significantly by $20.2 million in 2003. The key 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. The remaining increase in reinsurance recoverables in 2003 resulted from increased reinsurance on the long term care insurance business. In 2004, reinsurance recoverables increased by $6.7 million, primarily due to increased reinsurance on the long term care insurance business.
The increases in policy and contract liabilities result from premiums that are retained to establish policy reserves.
Accounts payable and accrued expenses increased in 2002 as the result of payment for a bond trade for $6.1 million that did not settle until 2003. The payment of this liability largely accounts for the decrease in accounts payable and accrued expenses in 2003. In 2004, accounts payable and accrued expenses increased by $4.5 million, 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.
The liability for benefits for employees and agents decreased by $2.3 million in 2003 as the result of payments for accrued pension plan contributions of $4.4 million. The remaining increase is attributable to additional pension plan liability accruals of $1.3 million established to fund future payments under the pension plan. The liability for benefits for employees and agents decreased by $2.1 million in 2004 as the result of payments for accrued pension plan contributions of $3.1 million. The remaining increase is attributable to additional pension plan liability accruals of $1.2 million established to fund future payments under the pension plan.
As a function of our third party administration business, insurance funds for clients are managed by us. These funds are held in suspense pending appropriate disposition, and the balances in these funds will vary on a day-to-day basis. The variations in funds held in suspense from year to year are a refection of this activity.
(1) The information technology and document management outsourcing contract is a ten-year contract that began in November 2003. This contract is subject to cancellation by us at any time starting in November 2006, with the payment of a termination penalty that is based on the number of months remaining in the contract.
(2) The development of these anticipated payments by period entailed the use of actuarial projections of expected future benefits and expected future net premiums from current in force business.
The final consensus on EITF 03-1 included additional disclosure requirements incremental to those adopted by our predecessor effective December 31, 2003, that are effective for fiscal years ending after June 15, 2004.
• The potential recognition of unrealized losses in situations where we anticipate a full recovery of certain unrealized losses but do 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
• Changes in the timing of the recognition of the difference between carrying value and expected settlement value of debt securities for which an other-than-temporary impairment is taken.
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 our predecessor’s consolidated financial position and results of operations.
The pro forma disclosures previously permitted under FAS 123 no longer will be an alternative to financial statement recognition. Although we have not yet determined whether the adoption of FAS 123 (revised 2004) will result in amounts that are similar to the current pro forma disclosures under FAS 123, we are evaluating the requirements under FAS 123 (revised 2004) and expect the adoption to have an impact on our consolidated statements of operations and net income per share that is substantially similar to the current pro forma disclosure under FAS 123.
Consolidated Balance Sheets for KMG America Corporation as of December 31, 2004, and for Kanawha Insurance Company (the “Predecessor”), as of December 31, 2003
Consolidated Statements of Operations for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the Predecessor for the years ended December 31, 2002, 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 Predecessor for the years ended December 31, 2002, 2003 and 2004
KMG America Corporation (“KMG America” or the “Company”) was incorporated on January 21, 2004, as a Virginia corporation. KMG America was formed to acquire Kanawha Insurance Company (“Kanawha” or the “Predecessor”), a life and health insurance company.
KMG America commenced its operations shortly before it completed its initial public offering of 21,735,000 shares of common stock on December 21, 2004. The net proceeds from the initial public offering of common stock, after deducting the underwriting discount and offering expenses payable by KMG America, were approximately $188.0 million. KMG America used $130.0 million of the net proceeds to fund the cash portion of the purchase price to acquire all of the outstanding common stock of the Predecessor on December 21, 2004.
The remaining net proceeds, approximately $58.0 million, have or are expected to be used as working capital for general corporate purposes, including:
• to pay KMG America’s fees and expenses incurred in connection with the acquisition of the Predecessor, approximately $0.8 million;
• to fund negative cash flow of approximately $5.0 million to $6.0 million associated with initial start-up costs and other expenditures that have been incurred and that KMG America anticipates will be incurred in 2005, including expenditures to open, improve and relocate KMG America’s principal offices within the Minneapolis, Minnesota metropolitan area, as well as to open new facilities in New England, southern California and other selected markets, and to hire and train additional sales and support staff and marketing personnel at these new facilities; and
• to maintain the required capital of Kanawha at the level necessary to achieve its desired rating agency financial strength ratings and to comply with applicable regulatory requirements, which, based on a preliminary estimate, is expected to be between $32.2 million and $33.2 million.
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 are 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 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 life, annuity, supplemental health and short-term disability, as well as products specifically directed at the senior market including Medicare supplement, final expense life insurance and long-term care products. The Company’s
third-party administration and medical management businesses include a wide array of services with the primary emphasis in the offering of administrative service-only products.
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 notes. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein.
The accompanying consolidated financial statements for the Predecessor reflect historical consolidated financial statements of the Predecessor prior to its acquisition by the Company and have been prepared in conformity with GAAP. The accompanying consolidated financial statements include the accounts of the Company and the Predecessor after elimination of all significant intercompany balances and transactions. The Company also submits financial statements to insurance industry regulatory authorities. Those financial statements are prepared on the basis of statutory accounting practices (“SAP”) and are significantly different from financial statements prepared in accordance with GAAP (see Note 11).
Effective December 31, 2004, under GAAP purchase accounting rules, the Company recorded the Predecessor’s investments at fair value.
Mortgage loans on real estate are stated at unpaid balances, net of allowances for unrecoverable amounts. Valuation allowances for mortgage loans are established when the Company determines it is probable that it will be unable to collect all amounts (both principal and interest) due according to the contractual terms of the loan
agreement. Such allowances are based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, if foreclosure is probable, on the estimated fair value of the underlying real estate.
Amortization of premiums and accrual of discounts on investments in fixed maturity securities are reflected in earnings over the contractual terms of the investments in a manner that produces a constant effective yield. Realized gains and losses on dispositions of securities are determined by the specific-identification method.
• Length of time the fair value was below amortized cost;
• Past due interest or principal payments or other violation of covenants; and
• Deterioration of the overall financial condition of the specific issuer.
In analyzing its potentially distressed securities list for other-than-temporary impairments, the Company pays special attention to securities that have been on the list for a period greater than six months. The Company assumes that, absent reliable contradictory evidence, a security that is potentially distressed for a continuous period greater than twelve months has incurred an other-than-temporary impairment. Reliable contradictory evidence might include, among other factors, a liquidation analysis performed by the Company’s investment advisors or outside consultants, improving financial performance of the issuer, or valuation of underlying assets specifically pledged to support the credit.
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, 2002, 2003 and 2004, total depreciation expense was approximately $2.9 million, $3.0 million and $2.5 million, respectively.
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 and subsequent renewal commissions.
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 discount 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.
No goodwill was recorded as a result of the Company’s acquisition of the Predecessor, because the purchase price paid by the Company was less than the fair value of the net assets acquired by the Company. The difference was recorded as a reduction in the value of certain tangible assets on the acquisition date.
Insurance reserves for individual life insurance, individual accident and health insurance, group life insurance and group accident and health insurance are associated with earned premiums so as to recognize profits over the premium-paying period. This association is accomplished by recognizing the liabilities for insurance reserves on a net level premium method based on assumptions deemed appropriate at the date of issue as to future investment yield, mortality, morbidity, withdrawals and maintenance expenses, and including margins for adverse deviations. Interest assumptions are based on the Predecessor’s experience. Mortality, morbidity and withdrawal assumptions are based on recognized actuarial tables or the Predecessor’s experience, as appropriate. Life reserves are calculated using mean reserve factors. Accident and health reserves are calculated using mid-terminal reserve factors. Benefit reserves for investment products are computed under a retrospective deposit method and represent policy account balances before applicable surrender charges. Policy benefits and claims that are charged to expense include benefit claims incurred in the period in excess of related policy account balances.
Realized capital gains and losses are reported in the income statement on a pretax basis in the period that the asset giving rise to the gain or loss is sold. Impairment writedowns are recorded when there has been a decline in value deemed other than temporary, in which case the write down for such impairments is charged to income.
The Company has adopted the provisions of SFAS No. 87, Employers’ Accounting for Pensions, which requires accrual for pension costs for employees’ pension benefits over the employees’ approximate service period.
Accordingly, the Company and the Predecessor recognized no compensation expense for stock option awards to employees or directors when the option price was not less than the market value of the stock at the date of award.
insurance in force at December 31, 2003, and 2004. Dividends paid to policyholders in 2002, 2003 and 2004 were approximately $2.2 million, $2.0 million and $2.2 million, respectively. Participating premiums as a percentage of direct life premiums were 53% in 2002, 52% in 2003 and 51% in 2004.
In December 2003, the FASB issued Statement No. 132 (revised 2003), Employers’ Disclosures about Pensions and Other Postretirement Benefits (“Statement 132 (revised 2003)”). Statement 132 (revised 2003) revises employers’ disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition provisions of FASB Statements No. 87, Employers’ Accounting for Pensions, No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, and No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions. Statement 132 (revised 2003) retains the disclosure requirements contained in FASB Statement No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits (“Statement 132”), which it replaces. It requires additional disclosures about the assets, obligations, cash flows and net periodic benefit cost of defined benefit pension plans and other postretirement benefit plans. The required information is provided separately for pension plans and for other postretirement benefit plans.
The provisions of Statement 132 remain in effect until the provisions of Statement 132 (revised 2003) are adopted. Disclosure of the benefits expected to be paid in each of the next five fiscal years, and in the aggregate for the five fiscal years thereafter is effective for fiscal years ending after June 15, 2004. The additional disclosure provisions were adopted by the Predecessor in 2003.
In March 2004, the Emerging Issues Task Force (“EITF”) reached a final consensus on EITF 03-1, which is effective for fiscal periods beginning after June 15, 2004. EITF 03-1 requires that when the fair value of an investment security is less than its carrying value, an impairment exists for which a determination must be made as to whether the impairment is other-than-temporary. An impairment loss should be recognized equal to the difference between the investment’s carrying value and its fair value when an impairment is other-than-temporary. Subsequent to an other-than-temporary impairment loss, a debt security should be accounted for in accordance with Statement of Position No. 03-3, “Accounting for Loans and Certain Debt Securities Acquired in a Transfer,” which allows the accretion of the discount between the carrying value and expected value of a security if the amount and timing of the recognition of that difference in cash is reasonably estimable. EITF 03-1 also indicates that, although not presumptive, a pattern of selling investments prior to the forecasted recovery may call into question an investor’s intent to hold the security until it recovers its value.
The pro forma disclosures previously permitted under FAS 123 no longer will be an alternative to financial statement recognition. Although the Company has not yet determined whether the adoption of FAS 123 (revised 2004) will result in amounts that are similar to the current pro forma disclosures under FAS 123, the Company is evaluating the requirements under FAS 123 (revised 2004) 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.
Proceeds from the sale of investments in common stocks during the years ended December 31, 2002, 2003 and 2004, were $0.3 million, $13.1 million and $2.7 million, respectively. Gross gains of approximately $0 and gross losses of $0 were realized in 2002 on these sales. Gross gains of $1.4 million and gross losses of approximately $0 were realized in 2003 on those sales. Gross gains of $2.6 million and gross losses of $0 were realized in 2004 on those sales.
Major categories of the Predecessor’s net investment income for the years ended December 31, 2002, 2003 and 2004, are summarized as follows:
The minimum and maximum lending rates for mortgage loans originated in 2004 were 7.25% and 7.25%, respectively. At the issuance of a loan, the percentage of loan to value on any one loan does not exceed 75%. All properties covered by mortgage loans have fire insurance equal to at least the loan excess over the maximum loan that would be allowed on the land without the building.
The Company’s mortgage loan portfolio is comprised of conventional real estate mortgages collateralized primarily by commercial and retail (2.7%), office (2.7%), apartment (3.1%) and residential (91.5%) properties. Mortgage loan underwriting standards emphasize the credit status of a prospective borrower, quality of the underlying collateral and conservative loan-to-value ratios. Approximately 96.5% of the loans are on properties located in the South Atlantic region. No other geographic region includes mortgaged property representing 1.8% of the aggregate principal amount of the Company’s mortgage loans as of December 31, 2004.
At December 31, 2004, the Company did not hold any residential mortgage loans with interest overdue more than 90 days.
The Predecessor’s other-than-temporary impairment losses on available-for-sale securities totaled approximately $0.7 million and $0.7 million for the years ended December 31, 2003, and 2004, respectively.
The unaudited pro forma financial information presented below assumes that the Kanawha acquisition had occurred as of the beginning of each respective period. Accordingly, as part of the application of purchase accounting requirements, all of the Predecessor’s assets and liabilities were recorded at fair value as of the beginning of each respective period. The unaudited pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results of operations that would have occurred had the Kanawha acquisition been consummated at the beginning of the respective periods.
The Company eliminated all of the Predecessor’s deferred acquisition costs upon the closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements. The Company will record deferred acquisition costs prospectively on January 1, 2005.
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 the Predecessor’s experience, modified as necessary to reflect anticipated trends and to include provisions for possible unfavorable deviations. Reserve interest assumptions are graded and range from
Certain premiums and benefits are assumed from and ceded to other insurance companies under various reinsurance agreements. The assumption agreements provide the Company with increased economies of scale and the ceded agreements provide the Company with increased capacity to write larger risks and maintain its exposure to loss within its capital resources and, in some cases, effect business dispositions. However, if the assuming reinsurer is unable to meet its obligations, the Company remains contingently liable. The Company evaluates the financial condition of reinsurers and monitors concentration of credit risk to minimize this exposure. In some cases, reinsurers have placed amounts in trusts equivalent to the amount recoverable from the reinsurer.
The following represent reinsurance amounts included in the accompanying financial statements:
Income taxes as reported in the consolidated statements of operations for the years ended December 31, 2002, 2003 and 2004, are summarized as follows:
The Predecessor’s provision for federal income taxes incurred is different from that which would be obtained by applying the statutory Federal income tax rate to income before income taxes. The significant items causing this difference are:
The Predecessor’s federal income tax returns for all years through 2000 are closed. In the opinion of management, recorded income tax liabilities adequately provide for all remaining open years.
The foregoing reconciliation reflects a deficiency in the December 31, 2002, reserves of $0.9 million, and a redundancy in the December 31, 2003 reserves of $0.7 million emerged in 2003 and 2004, respectively. The changes in those reserves were primarily the result in changes in estimates as more information became available.
The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for the retirement plans with accumulated benefit obligations in excess of plan assets were as follows:
The actuarial present value of accumulated plan benefits does not reflect the actual benefits that will be paid on retirement, but rather the liability that would exist if the Plan were terminated as of the valuation date.
The pension plan asset allocation at December 31, 2003, and 2004 by asset category is as follows:
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. The portfolio is currently managed by Morgan Stanley. The investment objective is to meet or exceed the S&P 500 index. At December 31, 2003, and 2004, the Predecessor’s year-end contribution to the Plan was held in cash pending investment in accordance with the Plan.
The Company has a non-qualified deferred compensation plan for senior management that allows the deferment of a portion of their compensation until their services with the Company have terminated. The plan includes deferred contributions, which were not elected by employees to be transferred to the 401K plan upon adoption of the 401K plan. The plan’s investments include money market funds and are recorded in investments as held for trading. The corresponding deferred obligations to participants is recorded in other liabilities.
No options were issued, exercised or canceled by the Predecessor under its stock option plan during 2002 and 2003. In connection with the closing of the acquisition of the Predecessor, on December 21, 2004, all 371.8 options became 100% vested and were exercised and the Predecessor stock option plan was terminated. No additional stock options can be granted under the Predecessor’s plan.
The Company also follows APB 25 and related interpretations in accounting for its stock options issued to senior management.
As of December 31, 2004, no options to purchase shares of the Company’s common stock were exercisable. All options granted under the plan in 2004 vest in annual increments and are exercisable through December 15, 2014, subject to earlier termination of the option holders’ rights to exercise such options under the terms of the plan and the option agreements relating to such options.
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 US, in the Fourth Judicial District Court in Hennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and another individual. Messrs. Kuk, Kraemer and Moore are officers of KMG America and former employees 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. KMG America believes the allegations are without merit, intends to defend the action and believes that the outcome of this matter will not have a material adverse effect on its consolidated financial position or results of operations.
On December 21, 2004, the Company entered into a $15.0 million five-year subordinated promissory note to fund a portion of the purchase price for the Kanawha acquisition. Interest on the promissory note accrues 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 the Company’s and Kanawha’s ability to incur additional debt.
During February 2005, the Company entered into a lease agreement, pursuant to which it has agreed to pay an aggregate of $551,250 to lease its principal executive offices located in Minnetonka, Minnesota for the period from April 1, 2005, through June 30, 2010. This lease is not cancelable by the Company except in connection with specified events that are generally beyond the Company’s control.
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 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.
The corporate and other segment includes investment income earned on the investment portfolio allocated to capital and surplus, as well as all realized capital gains and losses, which are not allocated by line of business. 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 non-allocated immaterial items.
The following is a summary of the unaudited quarterly results of operations for the years ended December 31, 2003, and 2004: