(1) For a discussion of policy acquisition costs, see "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Our unaudited quarterly data for each quarter of 1998 and 1999 have been derived from unaudited financial statements and include all adjustments, consisting only of normal recurring accruals, which we consider necessary for a fair presentation for the results of operations for these periods. Such quarterly operating results are not necessarily indicative of our future results of operations.
The following table presents unaudited quarterly data for each quarter of 1998 and 1999.
GAAP loss ratio 66.2% 69.8% 69.4% 70.3% GAAP expense ratio 31.4% 27.4% 28.2% 28.1% ----- ----- ----- ----- Total 97.6% 97.1% 97.6% 98.4%
GAAP loss ratio 67.7% 68.3% 68.8% 69.0% GAAP expense ratio 32.2% 35.3% 31.7% 30.1% ------ ------ ------ ------ Total 99.9% 103.7% 100.5% 99.1%
The following table sets forth the components of our condensed statements of operations for the years ended December 31, 1997, 1998 and 1999, expressed as a percentage of total revenues.
Year Ended December 31, ----------------------- 1997 1998 1999 ---- ---- ---- Statement of Operations Data: Revenues: Accident and health: First year premiums 29.7% 32.5% 29.9% Renewal premiums 58.3% 54.1% 58.6% Life: First year premiums 0.6% 0.3% 0.2% Renewal premiums 1.3% 1.1% 0.8% ----- ----- ----- Total premiums 89.9% 88.0% 89.5%
Investment income, net 9.1% 8.1% 6.9% Net realized gains (losses) 0.8% 3.6% 1.7% Other income 0.2% 0.3% 1.9% ------ ------ ------ Total revenues 100.0% 100.0% 100.0%
Income before federal income taxes 5.5% 14.0% 9.8% Provision for federal income taxes 1.4% 4.5% 3.3% ---- ---- ----
We develop and market insurance products primarily designed for the care of individuals age 65 and over. Our principal products are individual fixed, defined benefit accident and health insurance policies that consist of nursing home care, home health care, Medicare supplement and long-term disability insurance. Our underwriting practices rely upon the base of experience, which we have developed over 28 years of providing nursing home care insurance, as well as upon available industry and actuarial information. As the home health care market has developed, we have encouraged the purchase of both nursing home care and home health care coverage, and have introduced new life insurance products as well, thus providing policyholders with enhanced protection while broadening our policy base. In late 1996, we introduced our Personal Freedom Plan and Assisted Living Plan. Both plans are designed to provide comprehensive nursing home and home health care coverage. During 1998, we developed our Secured Risk Nursing Facility and Post Acute Recovery Plans, which provide limited benefits to higher risk applicants. Long-term nursing home care and home health care policies accounted for approximately 95% of our total annualized premiums in-force as of December 31, 1999 and approximately 85% of our consolidated revenues for 1999.
Our results of operations are affected significantly by the following factors:
The number of years a policy has been in effect. Claims costs tend to be higher on policies that have been in-force for a longer period of time. As the policy ages, it is more likely that the insured will need services covered by the policy. However, the longer the policy is in effect, the more premium we will receive.
Policies renew or lapse for a variety of reasons, due both to internal and external causes. We believe that our efforts to address any policyholder concerns or questions in an expedient fashion help to ensure ongoing policy renewal. We also believe that we enjoy a favorable policyholder reputation for providing desirable policy benefits, minimal premium rate increases and efficient claims processing. We work closely with our licensed agents, who play an integral role in policy conservation and policyholder communication.
External factors also contribute to policy renewal or lapsation. Economic cycles can influence a policyholder's ability to continue the payment of insurance premiums when due. New government/ legislative initiatives have raised public awareness of the escalating costs of long-term care, which we believe boosts new sales and promotes renewal payments. Recent initiatives also include tax relief for certain long-term care insurance coverage, which promotes new and renewal payments.
Lapsation and persistency can positively and adversely impact future earnings. Improved persistency generally results in higher renewal premium and reduced amortization of deferred acquisition costs than anticipated. However, higher persistency may lead to increased claims in future periods. Additionally, increased lapsation can result in reduced premium collection, accelerated deferred acquisition cost amortization and anti-selection of higher-risk, remaining policyholders.
Twelve Months Ended December 31, 1999 and 1998 (amounts in thousands, except per share data)
Premiums. Total premium revenue earned in the twelve month period ended December 31, 1999, including long-term care, disability, life and Medicare supplement, increased 30.8% to $292,516, compared to $223,692 in the same period in 1998. During 1999, we entered a reinsurance and administration transaction with an unaffiliated insurer (the "Reinsurance Transaction"). Under the terms of the Reinsurance Transaction, we assumed $2,251 of first year and renewal long term care insurance in-force under a 100% quota share agreement.
When actuarially warranted, we have been generally successful in obtaining premium rate increases.
Excluding the impact of the Reinsurance Transaction, renewal premiums earned in 1999 increased 38.6% to $194,243, compared to $140,170 in 1998. Renewal long-term care premiums earned in 1999 increased 41.1% to $181,010, compared to $128,259 in 1998. This increase reflects renewals of a larger base of in-force policies. We also attribute this renewal growth to an increase in persistency from 85.5% in 1998 to 86.7% in 1999 (renewals as a percentage of total prior year business).
Other Income. We recorded $6,297 in other income during 1999, up from $885 in 1998. The increase is attributable to the inclusion of commissions earned by United Insurance Group on sales of insurance products underwritten by unaffiliated insurers.
Policyholder benefits include additions to reserves and claims payments for policyholders' incurring claims in the current and prior years. In 1999, we paid $25,145 related to current year incurrals and $69,887 related to claims incurred in 1998 and prior years. In 1998, we paid $22,744 for current year claims and $52,402 related to prior year incurrals. Paid claims as a percentage of premiums were 32.5% in 1999, compared to 33.6% in 1998. We anticipate that as policies age, and new premium as a percentage of total premium decreases, this paid ratio will increase.
In the year in which a claim is first incurred, we establish reserves that are actuarially determined to be the present value of all future payments required for that claim. We assume that our current reserve amount and interest income earned on invested reserves will be sufficient to make all future payments. We measure the validity of our prior year assumptions by reviewing the development of reserves for the prior period (i.e., incurred from prior years). This amount, $10,064 and $9,016 in 1999 and 1998, respectively, includes imputed interest from prior year-end reserve balances of $5,085 and $3,913, respectively, plus adjustments to reflect actual versus estimated claims experience. These adjustments, particularly as a percentage of the prior year-end reserve balance, yield a relative measure of deviation in actual performance to our initial assumptions. In 1999, we added approximately $4,100 or 3.9% of prior year-end reserves to our claim reserves for 1998 and prior claim incurrals. In 1998, we added approximately $5,100 or 6.4% of prior year-end reserves to our claim reserves for 1997 and prior claim incurrals.
Excluding the impact of the Reinsurance Transaction and from the inclusion of United Insurance Group, which serves to reduce commissions by $2,474 from policies that we underwrite, first year commissions on accident and health business in 1999 increased 15.8% to $65,538, compared to $56,594 in 1998, corresponding to the increase in first year accident and health premiums and to the issuance of younger age policies, which typically pay a higher first year commission rate. The ratio of first year accident and health commissions to first year accident and health premiums was 69.4% in 1999 and 69.2% in 1998.
Net Policy Acquisition Costs Deferred. The net deferred policy acquisition costs in 1999 increased 9.0% to $51,134, compared to $46,915 in 1998.
Provision for Federal Income Taxes. Our provision for federal income taxes for 1999 decreased 6.4% to $10,837, compared to $11,578 for 1998. The effective tax rates of 33.7% and 32.5% in 1999 and 1998, respectively, are below the normal federal corporate rate as a result of credits from the small life insurance company deduction, as well as our investments in tax-exempt bonds and from dividends received that are partially exempt from taxation, which are partially offset by non-deductible goodwill amortization.
Renewal long-term care premiums in 1998 increased 27.4% to $128,258, compared to $100,674 in 1997. This increase reflects higher persistency and growth of in-force premiums. Persistency in 1998 was 85.5%, compared to 83.1% in 1997.
Benefits to Policyholders. Benefits to policyholders in 1998 increased 24.6% to $154,300, compared to $123,865 in 1997. Accident and health benefits to policyholders in 1998 increased 24.4% to $151,247, compared to $121,608 in 1997. The 1998 loss ratio for accident and health business was 68.7%, compared to 74.1% in 1997. In 1997 we added approximately $12,000 to our reservs as a result of our reassessment of assumptions utilized in the actuarial determination of reserves for current reserves. This resulted in a higher loss ratio for 1997. The remaining growth in benefits is attributable to new premium growth. Management expects the loss ratio to increase with time due to the impact of a maturing portfolio. Also, due to our policy of discounting reserves, reserve releases will typically be less than actual claims payments. Management believes that interest earnings from invested assets will be sufficient to offset the difference between claims payments and reserve releases.
Commissions. Commissions to agents increased 45.3% to $80,273 in 1998 compared to $55,240 in 1997. Commissions expense includes American Network commissions on long-term disability policies, which generated $1,084 of expenses in 1998.
First year commissions on total accident and health business in 1998 increased 56.2% to $56,594, compared to $36,240 in 1997, corresponding to the increase in first year accident and health premiums. The ratio of first year accident and health commissions to first year accident and health premiums was 69.2% in 1998 and 66.9% in 1997. The commission ratio increased in 1998 as a result of the increased sale of policies to younger individuals. We pay higher first year commissions on younger policies due to our expectation that these policies will generate revenues for more years than at older issue ages. First year commissions on life business in 1998 decreased 17.4% to $726, compared to $879 in 1997, directly reflecting our reduction in first year life premiums. The ratio of first year life commissions to first year life premiums was 86.8% in 1998 compared to 83.2% in 1997 due to an increase in single premium policies sold.
General and Administrative Expenses. General and administrative expenses in 1998 increased 26.5% to $26,069, compared to $20,614 in 1997. General and administrative expenses, excluding goodwill and convertible debt cost amortization, as a percentage of premiums were 11.3% in 1998, compared to 11.9% in 1997.
Net Income. Net income of $24,048 for 1998 was $16,449 or 216.5% above 1997 income of $7,599. Net income includes income tax provisions of $11,578 and $2,695 for the 1998 and 1997 periods, respectively. Income before federal income taxes increased in 1998 by $25,332 or 246.1% to $35,626. This increase was primarily attributable to premium growth and capital gains realized from bond and equity sales. We made a 1998 provision for federal income taxes of $11,578, reflecting an effective rate of 32.5%, as compared to an effective 1997 tax rate of 26.2%.
Comprehensive Income. During 1998, our investment portfolio generated increases in unrealized gains of $10,032, compared to 1997 gains of $9,867. After accounting for deferred taxes from these gains, shareholders' equity increased by $24,591 from comprehensive income during 1998, compared to $13,176 in 1997, or an increase of $11,415 or 86.6%.
Statement of Position 98-1 "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" (SOP 98-1) was issued by the American Institute of Certified Public Accountants in March 1998 and provides guidance on accounting for the costs of computer software developed or obtained for internal use. The statement is effective for 1999 financial statements. The adoption of SOP 98-1 has not had a material impact on our financial condition or results of operations.
As many computer systems and other equipment with embedded chips or processors use only two digits to represent the year, they may be unable to accurately process certain data before, during or after the year 2000. As a result, business and governmental entities may be at risk for possible miscalculations or systems failures causing disruptions in their business operations. This is commonly known as the Year 2000 ("Y2K") issue. The Y2K issue can arise at any point in our supply, billing, processing, sales or financial chains.
We implemented a Y2K readiness program with the objective of having all of our significant operations functioning properly with respect to Y2K before January 1, 2000. We believe that our preparation for Y2K was successful, and have subsequently identified no material problems as a result.
Since January 1999, we have been operating our system using Y2K dates and have not experienced any difficulties or problems. Any policy written with an annual collection of premium has been successfully processed since January 1999, with no interruption of services. No material issues have been experienced since January 1, 2000.
We have spent approximately $400 to date related to modifying existing systems to become Y2K compliant, and estimate that this amount represented approximately 15% of our total information technology budget in 1999. We expect the impact of Y2K to have no material impact upon our financial condition and results of operations.
In 1999, our cash flows were attributable to cash provided by operations, cash used in investing and cash used in financing. Our cash decreased $21,055 in 1999 primarily due to the purchase of $192,990 in bonds and equity securities, $4,999 used for the purchase of our Common Stock, which is held as Treasury Stock, as well as cash of $9,194 used to purchase United Insurance Group. Cash was provided primarily from the maturity and sale of $140,892 in bonds and equity securities. These sources of funds were supplemented with $50,533 from operations. The major provider of cash from operations was premium revenue used to fund reserve additions of $104,610.
Our cash increased $27,161 in 1998 primarily due to the sale of $95,860 in bonds and equity securities and the maturity of $31,640 of bonds. These sources of funds coupled with $52,126 from operations more than offset $154,544 used to acquire bonds and equity securities. The major provider of cash from operations was premium revenue used to fund reserve increases of $78,915.
Our cash decreased by $40,373 in 1997 primarily due to the purchase of $134,199 in bonds, which more than offset cash provided by operations and $44,080 in proceeds from the sale of bonds. The major provider of cash from operations was additions to reserves of $59,038 in 1997.
As of December 31, 1999, shareholders' equity was decreased by $7,064 due to unrealized losses of $10,703 in the investment portfolio. As of December 31, 1998, shareholders' equity was increased by $8,381 due to unrealized gains of $12,699 in the investment portfolio. As of December 31, 1997, shareholders' equity was increased by $7,838 due to unrealized gains of $11,875 in the investment portfolio.
Our debt currently consists primarily of a mortgage note in the approximate amount of $1,700 and $74,750 in convertible subordinated debt. The convertible debt, issued in November 1996, is convertible into common stock at $28.44 per share until November 2003. The debt carries a fixed interest coupon of 6.25%, payable semi-annually. The mortgage note is currently amortized over 15 years, and has a balloon payment due on the remaining outstanding balance in December 2003. Although the note carries a variable interest rate, we have entered into an amortizing swap agreement with the same bank, with a notional amount equal to the outstanding debt, which has the effect of converting the note to a fixed rate of interest of 6.85%.
In March 1998, we contributed approximately $6,000 of the proceeds from the proceeds of the convertible subordinated debt to American Independent Network to initially capitalize this subsidiary. In December 1999, we contributed $1,000 to initially capitalize Penn Treaty (Bermuda). Penn Treaty (Bermuda) concurrently lent us $750 in exchange for a note receivable. The note is expected to pay interest at a rate of six percent, with principal repaid upon demand.
On December 31, 1997, Penn Treaty Life dividended us its common stock ownership of Penn Treaty Network. At that time, Penn Treaty Network assumed substantially all of the assets, liabilities and premium in-force of Penn Treaty Life through a purchase and assumption reinsurance agreement. On December 30, 1998, we sold our common stock interest in Penn Treaty Life to an unaffiliated insurer. All remaining policies in-force were assumed by Penn Treaty Network through a 100% quota share agreement.
On November 26, 1998, we entered a purchase agreement to acquire all of the common stock of United Insurance Group, a Michigan based consortium of long-term care insurance agencies. The acquisition was effective January 1, 1999, for the amount of $18,192. As part of the purchase, we issued a note payable for $8,078, which was in the form of a three-year zero-coupon installment note. The installment note, after discounting for imputed interest, was recorded as a note payable of $7,167, with a current outstanding balance of $6,372 at December 31, 1999. The remainder of the purchase was for cash. United Insurance Group paid us a dividend of $750 in 1999.
The Parent currently has the obligation of making semi-annual interest payments attributable to its convertible debt. In that the dividend ability of the subsidiaries is restricted, the Parent must rely on its own liquidity and
We believe that our insurance subsidiaries' capital and surplus presently meet or exceed the requirements in all jurisdictions in which they are licensed. Our continued growth is dependent upon our ability to (1) continue marketing efforts to expand our historical markets, (2) continue to expand our network of agents and effectively market our products in states where our insurance subsidiaries are currently licensed and (3) fund such marketing and expansion while at the same time maintaining minimum statutory levels of capital and surplus required to support such growth. Management believes that the funds necessary to accomplish the foregoing, including funds required to maintain adequate levels of statutory surplus in our insurance subsidiaries, can be met through 2000 by funds generated from non-insurance subsidiary dividends, current and future financial reinsurance transactions, off-shore reinsurance through Penn Treaty (Bermuda) and the availability of our line of credit facility. We expect future capital market activities will be necessary to support our ongoing growth, but continue to seek alternative measures. If alternative measures to support our growth are unsuccessful, we believe that additional capital would be required as early as 2001.
In the event (1) we fail to maintain minimum loss ratios calculated in accordance with statutory guidelines, (2) we fail to meet other requirements mandated and enforced by regulatory authorities, (3) we have adverse claims experience in the future, (4) we are unable to obtain additional financing to support future growth or (5) the economy continues to affect the buying powers of senior citizens, our results of operations, liquidity and capital resources could be adversely affected.
Certain information presented in this filing constitutes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Although we believe that our expectations are based upon reasonable assumptions within the bounds of our knowledge of our business and operations, there can be no assurance that actual results of our operations will not differ materially from our expectations. Factors which could cause actual results to differ from expectations include, among others, the adequacy of our loss reserves and our ability to meet statutory surplus requirements (especially in light of our recent growth), our ability to comply with government regulations, the ability of senior citizens to purchase our products given the increasing costs of health care, the modality of premium revenue and our ability to expand our network of productive independent agents. For additional information, please refer to our reports filed with the Securities and Exchange Commission.