Standard Security Life leases 13,000 square feet of office space in New York, New York as its corporate headquarters, 3,000 square feet of office space in Farmington, New York for its DBL claims processing center and 800 square feet of office space in Heathrow, Florida for a marketing office.
Majestic leases 5,495 square feet of office space in Troy, Michigan as its corporate headquarters and 984 square feet in Hinsdale, Illinois.
While management considers a wide range of factors in its strategic planning and decision-making, underwriting profit is consistently emphasized as the primary goal in all decisions as to whether or not to increase our retention in a core line, expand into new products, acquire an entity or a block of business, or otherwise change our business model. Management's assessment of trends in healthcare and morbidity, with respect to medical stop-loss, major medical, STM, dental, vision, disability and DBL; mortality rates with respect to life insurance; and changes in market conditions in general play a significant role in determining the rates charged, deductibles and attachment points quoted, and the percentage of business retained. Management has always focused on managing costs of operations, and the Company believes that the acquisition of IAC in January 2006 should afford it an opportunity to affect further cost efficiencies.
The following is a summary of key performance information and events:
2005 net income was negatively impacted by higher net loss ratios from certain Medical Stop-Loss programs. The Net Loss Ratios (defined as insurance benefits, claims and reserves divided by (premiums earned less underwriting expenses)) for the Medical Stop-Loss line of business for the years ended December 31, 2005, 2004 and 2003 were 93.2%, 86.6% and 84.1%, respectively;
Gross premiums in the Medical Stop-Loss line of business decreased 7.5% due, in part, to the continuing generally "soft" market;
Appointed three new MGUs expected to generate significant Medical Stop-Loss premium in 2006, (revenues for the Company will depend on retention percentages and other factors);
Effective June 2005, acquired a $120 million block of life and annuity policies; and, effective December 2005, acquired a $36 million block of life and annuity business, which together have helped increase assets to over $1.1 billion;
In 2005, acquired a 45% interest in CAIS, which markets major medical and other products for IHC; and in February 2006, acquired the remaining 55% interest;
In 2005, acquired HPA, a marketing and administrative organization specializing in short-term medical insurance products and GroupLink, a marketing and administrative organization specializing in dental benefits;
As of January 31, 2006, acquired IAC, a leading producer and administrator of group and individual major medical insurance (including Consumer Driven Health Plans (CDHPs)) and other life and health policies;
The Company maintains loss reserves to cover its estimated liability for unpaid losses and loss adjustment expenses (including legal, other fees, and costs not associated with specific claims but related to the claims payment function) for reported and unreported claims incurred as of the end of each accounting period. These loss reserves are based on actuarial assumptions and are maintained at levels that are in accordance with GAAP. Many factors could affect these reserves, including economic and social conditions, frequency and severity of claims, medical trend resulting from the influences of underlying cost inflation, changes in utilization and demand for medical services, and changes in doctrines of legal liability and damage awards in litigation. Therefore, the Company’s reserves are necessarily based on estimates, assumptions and analysis of historical experience. The Company’s results depend upon the variation between actual claims experience and the assumptions used in determining reserves and pricing products. Reserve assumptions and estimates require significant judgment and, therefore, are inherently uncertain. The Company cannot determine with precision the ultimate amounts that will be paid for actual claims or the timing of those payments. The Company’s estimate of loss reserves represents management’s best estimate of the Company’s liability at the balance sheet date.
The Company believes that its recorded insurance reserves are reasonable and adequate to satisfy its ultimate liability. The Company primarily uses its own loss development experience, but will also supplement that with data from its outside actuaries, reinsurers and industry loss experience as warranted. To illustrate the impact that projected Net Loss Ratios have on the Company’s loss reserves and related expenses, each hypothetical 1% change in the Net Loss Ratio for the health business (i.e., the ratio of benefits, claims and settlement expenses to earned health premiums) for the year ended December 31, 2005, would increase reserves (in the case of a higher ratio) or decrease reserves (in the case of a lower ratio) by approximately $1.9 million with a corresponding increase or decrease in the pre-tax expense for insurance benefits, claims and reserves in the Consolidated Statement of Operations. Depending on the circumstances surrounding a change in the Net Loss Ratio, other pre-tax amounts reported in the Consolidated Statement of Operations could also be affected, such as amortization of deferred acquisition costs and commission expense.
Generally, during the first twelve months of an underwriting year, reserves for Medical Stop-Loss are first set at the Projected Net Loss Ratio, which is set using pricing assumptions developed using completed prior experience trended forward. The Projected Net Loss Ratio is the Company’s best estimate of future performance until such time as developing losses provide a better indication of ultimate results.
While the Company establishes a best estimate of the Projected Net Loss Ratio, actual experience may deviate from this estimate. While the Company believes that larger variations are possible (as is the case with the 2004 underwriting year which deviated by ten Net Loss Ratio points), based on a review of historical Net Loss Ratios experienced by the Company, the reasonably likely deviation from the expected Net Loss Ratio was between three and five Net Loss Ratio points. Therefore, based on its experience to date, it was reasonably likely that the actual experience will fall within a range up to five Net Loss Ratio points above or below the expected pricing Net Loss Ratio. The impact of these reasonably likely changes at December 31, 2005, would be an increase in net reserves (in the case of a higher ratio) or a decrease in net reserves (in the case of a lower ratio) of up to approximately $2.7 million with a corresponding
Due to the short-term nature of Medical Stop-Loss, redundancies or deficiencies will typically emerge during the course of the following year rather than over a number of years. For Employer Stop-Loss, as noted above, the Company maintains its reserves based on underlying pricing assumptions until it determines that an adjustment is appropriate based on emerging experience from all of its MGUs for prior underwriting years. Reserves for HMO Reinsurance and Provider Excess are adjusted on a policy by policy basis. Because of the small number of HMO Reinsurance and Provider Excess policies it writes, the Company is able to evaluate each policy individually for potential liability by reviewing open claims with each HMO or provider group and applying completion factors using historical data.
based on actuarial estimates of the amount of loss inherent in that period’s claims, including losses incurred for which claims have not been reported. The Company establishes reserves for benefit claims that (i) have been reported, but not paid; and (ii) have been incurred, but not reported.
This segment is a combination of closed lines of business as well as certain small existing lines. While the assumptions used in setting reserves vary between these different lines of business, the assumptions would generally relate to the following: (i) the rate of disability; (ii) the morbidity rates on specific diseases; and (iii) accident rates. The reported reserves are based on management’s best estimate for each line within this segment. General uncertainties that surround all insurance reserving methodologies would apply. However, since the Company has such few policies of this type, volatility may occur due to a small number of claims.
For long duration type contracts accounted for under SFAS No. 97, such as annuities and universal life business, amortization of DAC is charged to expense over the life of the book of such contracts based on the present value of the estimated gross profits ("EGPs") expected to be realized over the life of the book of contracts. EGPs consist of margins based on expected mortality rates, persistency rates, interest rate spreads, and other revenues and expenses. The Company regularly evaluates its EGP's to determine if actual experience or other evidence suggests that earlier estimates should be revised. If the Company determines that the current assumptions underlying the EGPs are no longer the best estimate for the future due to changes in actual versus expected mortality rates, persistency rates, interest rate spreads, or other revenues and expenses, the future EGPs are updated using the new assumptions and prospective unlocking occurs. These updated EGPs are locked into for future amortization calculations. The total amortization recorded to date is adjusted through a current charge or credit to the Consolidated Statement of Operations.
For credit health insurance policies accounted for under SFAS No. 60, amortization of DAC is charged to expense in proportion to premium revenue recognized.
Declines in value judged to be other-than-temporary are determined based on the specific identification method and are reported in the Consolidated Statements of Operations as net realized losses. The factors considered by management in determining when a decline is other than temporary include but are not limited to: the length of time and extent to which the fair value has been less than cost; the financial condition and near-term prospects of the issuer; adverse changes in ratings announced by one or more rating agencies; whether the issuer of a debt security has remained current on principal and interest payments; whether the decline in fair value appears to be issuer specific or, alternatively, a reflection of general market or industry conditions; and the Company's intent and ability to hold the security for a period of time sufficient to allow for a recovery in fair value. For securities within the scope of Emerging Issues Task Force Issue 99-20, such as purchased interest-only securities, an impairment loss is recognized when there has been a decrease in expected cash flows combined with a decline in the security's fair value below cost.
The Company had net realized and unrealized gains of $2.1 million in 2005 compared to $2.4 million in 2004, for a decrease in realized and unrealized gains of $.3 million. Decisions to sell securities are based on cash flow needs, investment opportunities and economic and market conditions, thus creating fluctuations in gains and losses from period to period.
Agreement related to the expired portion of the 2004 treaty year business; and (iii) $1.2 million primarily generated from the Medical Stop-Loss business.
Amortization of deferred acquisition costs increased $1.5 million due to amortization of expenses related to the new Fully-Insured Health segment (formerly Strategic Health) and acquisitions of policy blocks.
Interest expense increased $1.2 million primarily due to the issuance of $15.5 million of fixed rate subordinated debt during the fourth quarter of 2004. The Company has $38.2 million of fixed rate debt (including $25.7 million of junior subordinated debt) and $12.4 million of floating rate junior subordinated debt. The floating rate debt carried a weighted average interest rate of 7.3% in 2005 versus 5.5% in 2004.
Selling, general and administrative expenses increased $28.1 million primarily due to (i) an $8.5 million increase in the Medical Stop-Loss segment caused by a $2.9 million increase in commissions due to greater retention rates, higher profit commissions and higher levels of assumed premiums, which charge higher commission rates, and a $5.6 million increase in other general expenses corresponding with the increase in premiums; (ii) a $13.3 million increase in the Fully-Insured Health segment (formerly Strategic Health) due to the formation of SHA and the business of HPA and GroupLink, which has no comparable amount in 2004; (iii) a $3.7 million increase in the Group segment primarily due to a $1.8 million increase in commissions, $.5 million in expenses on new business in the group A&H line, a $1.1 million increase in commissions on annuities, and $.5 million of increased expenses in the GTL line, partially offset by a $.2 million decrease in other expenses; (iv) a $1.8 million increase in the Individual and Other segment due to $1.0 million in increased commissions on annuities, a $.5 million increase in expenses on the blanket line, and a $.3 million increase in other expenses; (v) a $.4 million increase in the Credit segment due to increased commissions and expenses
commensurate with higher premiums; and (vi) a $.4 million increase in Corporate segment expenses primarily due to higher audit fees and Sarbanes-Oxley compliance costs.
Total premiums earned grew $24.7 million to $174.1 million in 2004 from $149.4 million in 2003. The increase is due to: (i) the Medical Stop-Loss segment which increased $21.0 million primarily due to $10.7 million of employer stop-loss due to increased retentions and $10.3 million in premiums earned on new business; (ii) the Individual and Other segment which increased $3.2 million comprised of a $.5 million increase in retention in blanket accident and sickness policies, a $1.0 million increase due to the acquisition of a block of supplemental annuity contracts, and a $1.9 million increase in the ordinary life line due to the assumption of a block of runoff business in November 2003, partially offset by a $.2 million decrease in the remaining other individual and other lines experiencing ordinary runoff; (iii) the Credit segment which increased $.3 million; and (iv) a $.2 million increase in the Group and DBL segment due to a $.7 million increase in group LTD, a $.3 million increase in group life, partially offset by a $.8 million decrease in DBL due to the 20% reinsurance agreement with Independence American as of July 1, 2004.
Equity income from AMIC increased $.1 million due to a decrease in earnings of AMIC, more than offset by an increase in IHC's ownership to approximately 40% at December 31, 2004 from 39% at December 31, 2003.
Fee income increased $2.5 million, primarily in the Medical Stop-Loss segment due to the acquisition of Majestic in July 2004.
Total other income increased $1.4 million related primarily to a $1.3 million increase in the Individual and Other segment due to the surrender of a large number of ordinary life policies.
Interest expense increased $1.4 million primarily due to the issuance of $12.4 million of floating rate junior subordinated debt in the first quarter of 2004 which carried a weighted average interest rate of 5.5% in 2004, and a full year of interest on the $12.5 million debt under a line of credit obtained in the third quarter of 2003.
Income tax expense increased $.6 million to $10.7 million for the year ended December 31, 2004 from $10.1 million for 2003. This resulted in an effective rate of 31.8% for the year ended December 31, 2004, and 35.3% for the year ended December 31, 2003, primarily reflecting the reversal of $1.1 million of prior tax expenses under the American Jobs Creation Act of 2004.
Total Corporate liquidity (cash, cash equivalents, resale agreements, short-term investments, fixed maturities, equity securities, partnership interests and certain other current assets, net of current liabilities) amounted to $30.6 million at December 31, 2005. Corporate liquidity excludes the repayment of $12.5 million of debt due September 2006, as such debt is in the process of renewal. During 2005, IHC repurchased 310,200 shares of its common stock for $5.6 million under its common stock repurchase program.
The Company had net receivables from reinsurers of $97.4 million at December 31, 2005. Substantially all of the business ceded to such reinsurers is of short duration. All of such receivables are either due from the Company's affiliate, Independence American, highly rated companies or are adequately secured. No allowance for doubtful accounts was necessary at December 31, 2005. As of December 31, 2005, the balance due from Independence American is $15.5 million.
approximately 86.8% was invested in investment grade fixed maturities, resale agreements, policy loans and cash and cash equivalents at December 31, 2005. Also at such date, approximately 94.1% of the Insurance Group's fixed maturities were investment grade. These investments carry less risk and, therefore, lower interest rates than other types of fixed maturity investments. At December 31, 2005, approximately 5.9% of the carrying value of fixed maturities was invested in diversified non-investment grade fixed maturities (investments in such securities have different risks than investment grade securities, including greater risk of loss upon default, and thinner trading markets). The Company does not have any mortgage loans or non-performing fixed maturities at December 31, 2005.
The Company reviews its investments regularly and monitors its investments continually for impairments. For the year ended December 31, 2005, the Company recorded an insignificant realized loss for other-temporary impairments. For the year ended December 31, 2004, the Company recorded a realized loss for other-than-temporary impairments of $.6 million of which $.4 million related to certain interest only securities ("IO Securities") resulting from unexpected prepayments of the mortgage obligations underlying the IO Securities due to falling interest rates. At December 31, 2005, the Company had no investments in IO Securities.
The Company experienced net unfavorable development of $2.0 million in the Medical Stop-Loss segment. The net unfavorable development is based on $4.7 million negative development in the 2004 reserves, partially offset by positive development of $2.7 million related to prior years. While the Company establishes a best estimate of the Projected Net Loss Ratio, it is reasonably likely that the actual experience will fall within a range up to five Net Loss Ratio points above or below this ratio. The Company sets its pricing and underwriting guidelines at the beginning of each treaty year based on its evaluation of its own experience and current market conditions. Changes in market conditions through the treaty year have unexpected effects on the underwriting and rating decisions of its MGUs and produce results which vary from the expectations implicit in its pricing. With respect to the 2004 reserves, the deviation above the Company’s estimated Projected Net Loss Ratio was ten Net Loss Ratio points. The higher deviation for 2004 was largely a result of: (i) the “soft” Medical Stop-Loss market continuing longer than anticipated; (ii) deviations from underwriting guidelines and disclosure protocols by certain of its MGUs and producers as a result of the soft market, which were detected by the Company in its 2005 underwriting audits; and (iii) an unanticipated continuation of historically high inpatient hospital cost trends. This larger than expected deviation was magnified for 2004 reserves because of an overall increase in the Company’s risk retention in that year. With respect to the 2003 and prior reserves, the positive deviation resulted from loss development being much lower than anticipated based on the Company's historical loss development patterns. This resulted from actual loss development from more recently appointed MGU's during this period and therefore their development patterns were not included in historical Company loss development statistics.
There were no changes in the Company’s experience factor or the IBNR factor for Group Disability. The reserving process used by management was consistent from 2004 to 2005.
The Individual A&H and Other segment had a favorable development of $.5 million for 2005. The favorable development was not due to a change in assumptions, but rather the volatility of having a relatively small block of business. The reserving process used by management was consistent from 2004 to 2005.
Due to its strong capital ratios, broad licensing and excellent asset quality and credit-worthiness, the Insurance Group remains well positioned to increase or diversify its current activities. It is anticipated that future acquisitions or other expansion of operations will be funded internally from existing capital and surplus and parent company liquidity. In the event additional funds are required, it is expected that they would be borrowed or raised in the public or private capital markets to the extent determined to be necessary or desirable. In November 2004, December 2003 and March 2003, the Company borrowed $15 million, $12 million and $10 million, respectively, through pooled trust preferred issuances by subsidiary trusts. In September 2003, the Company entered into a $12.5 million line of credit, all of which was drawn down. The cash proceeds of the line of credit and the trust preferred securities issued in 2003 were used to repay existing debt and for general corporate purposes. See Note 11 of the Notes to Consolidated Financial Statements in Item 8.
IHC enters into a variety of contractual obligations with third-parties in the ordinary course of its operations. These obligations, as of December 31, 2005, are set forth in the table below. However, we do not believe that our cash flow requirements can be fully assessed based upon an analysis of these obligations. Future cash outflows, whether they are contractual obligations or not, also will vary based upon our future needs. Although some outflows are fixed, others depend on future events. The Company had the following expected contractual obligations relating to debt, trust preferred securities (junior subordinated debt), non-cancelable leases, insurance reserves and funds on deposit at December 31, 2005:
IHC has historically been a life and health insurance holding company for two insurance companies, Standard Security Life Insurance Company of New York ("Standard Security Life") and Madison National Life Insurance Company, Inc. ("Madison National Life"), which relied on independent general agents, managing general underwriters (MGUs) and administrators to perform the majority of all marketing, underwriting, claims and administrative functions for its two primary product segments ( M edical S top- L oss and G roup disability, life, annuities and DBL). For 2006, IHC’s business plan is to: (i) improve the profitability of its core lines of business, in particular Medical Stop-Loss, while expanding distribution, (ii) diversify its product mix by accelerating its expansion into the Fully-Insured health insurance sector, and thereby reduce the volatility of its portfolio and reduce its exposure to market cycles , and (iii) continue to acquire blocks of life and annuity business , and blocks of fully-insured health and dental . The following summarizes what IHC has accomplish ed and the outlook for 2006 and beyond by segment.
With respect to distribution, Standard Security Life writes Medical Stop-Loss in all 50 states through 15 MGUs. Madison National Life, which began writing medical stop-loss in 2002 after it was upgraded to A- (Excellent) by A.M. Best, writes this line in 46 states through five MGUs. Of these MGUs , the Company has a significant ownership interest in nine MGUs (including those owned by AMIC), which produced $156.2 million (71.4%) of IHC’s Medical Stop-Loss premium in 2005. As a result of these changes and competitors' willingness to write business at profit margins lower than those acceptable to IHC, the Company's gross premiums from Medical Stop-Loss were reduced by approximately $22 million in 2005. In late 2005, the Company appointed three new independent MGUs that are expected to add substantial premiums in 2006.
Through the acquisitions of HPA and GroupLink, which is 75% owned by IHC, in 2005 and IAC in 2006, IHC has expanded into multiple new Fully-Insured Health first- dollar health product s, including short-term medical (“ST M ”), group major medical (including Consumer Driven Health Plans (“CDHPs”)), dental and vision (the “ Fully-Insured Health Products”). These products are now approved in the majority of states, although the Company does not anticipate writing CDHPs in the Northeastern and certain other states. IHC will further expand its F ully- I nsured H ealth P roducts in 2006 to include major medical for individuals and families including CDHPs ) and limited medical . Collectively, IHC will administer, manage and distribute its Fully-Insured Health Products to 50,000 general agents, agents and brokers (“Producers”) in the majority of states. IHC believes this will be one of the largest networks of Producers focusing on the sale of Fully-Insured Health Products in the country. In addition, in the first quarter of 2006, the Company acquired 100% of CAIS, which will market major medical for groups, individuals and families (including CDHPs ) , STM and dental products on behalf of IHC . CAIS has announced that it has signed a definitive agreement subject to certain closing conditions to acquire a block of approximately $50 million of small group major medical business (including CDHPs) and key personnel of a marketing and administrative company. It is anticipated that most of this $50 million block of small group medical business will be trans ition ed to Madison National Life as of August 1, 2006.
The Company believes that in the next several years, its Fully-Insured Health premiums may exceed its Medical Stop-Loss premiums. The F ully- I nsured H ealth market is a much larger market than the excess market, estimated at $500 billion compared to a Medical Stop-Loss market of approximately $4 billion. As a result of its multiple product filings, distribution sources, and the sheer size of the market, the Company is optimistic that its F ully- I nsured Health business will grow rapidly while yielding profitable results, which will help balance the more volatile and cyclical M edical S top- L oss business.
In summary, the Company anticipates improved operating performance in 2006 as a result of (i) increased premiums and fee income from multiple fully-insured health products distributed through greatly expanded distribution channels as a result of the acquisitions during 2005 and the first quarter of 2006 of IAC, HPA, GroupLink, and CAIS; (ii) improved profitability of its Medical Stop-Loss business through corrective actions instituted for the business incepting in 2005 and increases in production due to the appointment of additional MGUs; (iii) reduced susceptibility to market cycles due to a better balance between excess and fully-insured health business; and (iv) continued acquisitions of blocks of business.
In May 2005, the Financial Accounting Standards Board (the "FASB") issued SFAS No. 154, "Accounting Changes and Error Corrections," which replaces APB Opinion No. 20, "Accounting Changes," and SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements," and changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle and to changes required by an accounting pronouncement when the pronouncement does not include specific transition provisions. SFAS No. 154 requires retrospective application of changes in accounting principle to prior periods' financial statements unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. APB Opinion No. 20 previously required that most voluntary changes in accounting principle be recognized by including the cumulative effect of the change in net income for the period of the change in accounting principle. SFAS No. 154 carries forward without change the guidance contained in APB Opinion No. 20 for reporting the correction of an error in previously issued financial statements and a change in accounting estimate. SFAS No. 154 also carries forward the guidance in APB Opinion No. 20 requiring justification of a change in accounting principle on the basis of preferability. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, with early adoption permitted.
In December 2004, the FASB issued SFAS No. 123 (revised 2004) ("SFAS 123(R)"), "Share-Based Payment", which supersedes SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123") and APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123(R) addresses the accounting for share-based payment transactions with employees and other third parties; eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25; and requires that the compensation costs relating to such transactions be recognized in the statement of operations. A rule issued by the SEC in April 2005 changed the compliance date for SFAS 123(R) to the beginning of the first fiscal year beginning after June 15, 2005 and, therefore, the Company adopted SFAS 123(R) on January 1, 2006. SFAS No. 123(R) applies to all awards granted after the adoption date and to awards modified, repurchased, or cancelled after that date. Additionally, beginning on the adoption date, compensation expense is recognized for the portion of outstanding awards for which the requisite service (vesting) has not yet been rendered, based on the grant-date fair value of those awards that had been calculated under SFAS No. 123 for pro forma disclosures. The impact of adoption of SFAS No. 123(R) on the Company's 2006 net income is expected to approximate the impact that SFAS No. 123 had on 2005 net income as shown in the pro forma disclosure included in Note 1(R) of the Notes to Consolidated Financial Statements in Item 8.