• The Company has continued to restructure its investment portfolio to consist of a greater percentage of investment grade fixed maturity securities and less investment in equities. This action reduces the risks inherent in the equities market, improves investment income yields and is looked upon favorably by regulators and rating agencies.
• The Company earned a profit for the third straight year despite experiencing reduced premiums and reduced net realized investment gains.
• The Company reached a final settlement of a long-standing class action lawsuit involving United Liberty, one of its insurance subsidiaries.
• The Company completed the installation of a new group administration system to create a platform for Group Dental growth.
using a portion of profits to fund higher sales growth in 2006 and beyond without straining capital and surplus
for Home Service: improving 13-month persistency, strengthening controls over field premium collection, recruiting satisfactory agents and controlling expenses
The Company manages its operations in five business segments, Home Service Life, Broker Life, Preneed Life, Dental, and Other Health. Products in all five segments are sold through independent agency operations. Home Service Life consists primarily of traditional life insurance coverage sold in amounts of $10,000 and under to middle and lower income individuals. This distribution channel is characterized by a significant amount of agent contact with customers throughout the year. Broker Life product sales consist primarily of simplified issue and graded-benefit policies in amounts of $10,000 and under. Other products in the Broker Life segment that comprise a significant portion of existing business include group life, universal life, annuities and participating life policies. Preneed Life products are sold to individuals in connection with prearrangement of their funeral and include single and multi-pay policies, generally in amounts of $10,000 and less. These policies are generally sold to middle aged and elderly individuals. Dental products are term policies generally sold to small and intermediate size employer groups. Other Health products include various accident and health policies sold to individuals and employer groups. Profit or loss for each segment is reported on a pretax basis, without an allocation of realized investment gains or interest expense.
The Company’s 2005 segment loss was $(76,000) compared to losses of $(2,307,000) in 2004 and $(973,000) in 2003. The segment loss in 2004, excluding nonrecurring items described below, was $(481,000).
The decrease of $2,231,000 in segment loss from $(2,307,000) in 2004 to $(76,000) in 2005 results primarily from: (a) a decrease in premiums and other considerations of $2,317,000 (Preneed decreased $1,937,000, Dental decreased $545,000, Home Service decreased $135,000, Other Health decreased $150,000, while Broker Life increased $450,000 (including new final expense premiums of $324,000)); (b) an increase in investment and other income of $577,000; (c) a decrease in policyholder benefits and commissions of $2,934,000; (d) a decrease in general expenses and depreciation of $864,000; and (e) a decrease in amortization of deferred policy acquisition costs and value of insurance acquired of $236,000, offset by a decrease in amortization of acquisition costs deferred of $63,000.
The Company’s discussion and analysis of its financial condition and results of operations are based on its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to investments, agent receivables, intangible assets, policy liabilities, income taxes, regulatory requirements and contingencies. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The Company believes the following accounting policies, judgments and estimates, which have been discussed with the Audit Committee of the Board of Directors, critically impact preparation of its consolidated financial statements.
Deferred Acquisition Costs (“DAC”). The Company is required to defer certain policy acquisition costs and amortize them over future periods. These costs include commissions and certain other expenses that vary with and are primarily associated with acquiring new business. The deferred costs are recorded as an asset commonly referred to as deferred policy acquisition costs (“DAC”). The DAC asset balance is subsequently charged to income over the lives of the underlying contracts in relation to the anticipated emergence of revenue or profits. Actual revenue or profits can vary from Company estimates, resulting in an increase or decrease in the rate of amortization. The Company regularly evaluates its DAC balances to determine if actual experience or other evidence suggests that earlier estimates should be revised. Assumptions considered significant include surrender and lapse rates, mortality, expense levels, investment performance, and estimated interest spread. Should actual experience dictate that the Company change its assumptions regarding the emergence of future revenues or profits (commonly referred to as “unlocking”), the Company would record a charge or credit to bring its DAC balance to the level it would have been if using the new assumptions from the inception date of each policy.
Goodwill and Intangible Impairment. The balance of the Company’s goodwill and value of insurance acquired (VIF) was $3 million at December 31, 2005. The recovery of these assets is dependent on the fair value of the business to which they relate. Pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets”, goodwill is subject to annual impairment tests based on the estimated fair value of the respective assets. There are numerous assumptions and estimates underlying the determination of the estimated fair value of these assets. Different valuation methods and assumptions can produce significantly different results that could affect the amount of any potential impairment charge that might be required to be recognized. During both 2005 and 2004, the Company concluded that no impairment adjustment was necessary for its goodwill or VIF.
Assets. At December 31, 2005, the Company's available-for-sale fixed maturities had a fair value of $112,924,772 and amortized cost of $112,087,958. The Company’s fixed maturities portfolio increased approximately 1% during 2005 and 6% during 2004, on an amortized cost basis. Shown below is a distribution by rating category of the Company's fixed maturities portfolio as of December 31, 2005.
The Company believes it has a well-diversified portfolio and has no plans to adjust its non-investment grade portfolio significantly, unless necessary to satisfy requirements of state regulators or rating agencies. The Company purchases non-investment grade bonds to obtain higher yields or convertible features and attempts to reduce credit risk by portfolio diversification. Non-investment grade securities comprised 3.8% and 5.7% of the fixed maturities portfolio, on an amortized cost basis, at December 31, 2005 and 2004, respectively. During 2005, the Company did not recognize any impairment losses on fixed maturities. The Company reviews its fixed maturity portfolio quarterly for impairment losses which might be other than temporary losses and recognizes all such losses in the quarter they are deemed other than temporary.
During 2005, the Company's investment in equity securities increased $1,001,000 on a cost basis, and decreased $363,000 on a fair value basis, after decreasing $771,000 and $2,394,000 on a cost and fair value basis, respectively, during 2004. As of December 31, 2005, 2004 and 2003, there were $288,000, $1,652,000 and $3,275,000 respectively, of unrealized gains on equity securities.
The Company reviews its marketable investments each quarter to determine if there have been declines in their value that in management’s opinion are other-than-temporary. These reviews can involve qualitative and quantitative information relating to an individual company or industry and general factors impacting the economy. However, due to wide market fluctuations occurring during the past two years, determining whether declines are temporary has become much more complex and judgmental. These reviews resulted in the recognition of impairment losses on equity securities totaling $473,000 during 2004 ($101,000, $319,000 and $53,000 for the first, third and fourth quarters, respectively). In addition, $334,000 of impairment losses were recognized on fixed maturities during 2004, all in the third quarter. During 2005, equity securities were sold which contained impairment write-downs of $358,000 and no fixed maturities were sold which contained impairment write downs.
Liabilities. A comparison of total policy liabilities as of December 31, 2005, 2004 and 2003 is shown below. Approximately 89% of the 2005 total consist of insurance policy benefit reserves while policyholder deposit liabilities represent 11% of the total.
Home Service Life sales have decreased only moderately in recent years (Home Service Life revenue, including net investment and other income, increased by 1.5% in 2005 from 2004) with net growth in policy liabilities of 2.2% and 3.0% in 2005 and 2004, respectively, through a combination of attracting new producers and continuing to focus on meeting the needs of existing customers and agents. Broker Life sales increased 12.8% in 2005 (9.2% from sales of the new final expense product). Only a modest change was experienced in 2004. Preneed Life premiums are lower, due in part to the Company’s decision to emphasize the lower annual premium “multi-pay” policies rather than “single-pay” policies and some loss of volume attributable to reducing commission levels and the rate of annual growth credited to policies. The Company is not currently focusing any marketing effort to this segment because of the adverse effects of the low interest rate environment of recent years. During 2005, Dental premiums were unfavorably impacted by the non-renewal of a large group with unsatisfactory claims experience and more aggressive renewal underwriting for all groups. The Other Health segment products are not being actively marketed.
Premiums and Other Considerations. The following table details premiums and other considerations received during the past three years.
Home Service Life premium decreased modestly in both 2005 and 2004. New sales began to decline in the fourth quarter of 2005 and have continued to decline in 2006 as a result of producer response to the Company’s introduction of a variable first year commission program designed to improve persistency in this segment. The Company also lost our regional representative for the Florida and Georgia region, as well as several producers in that region early in 2005. The Company continues its efforts to attract successful, experienced Home Service agents. In the fourth quarter of 2004, the Company began to geographically expand the Home Service market, hiring two new regional representatives to recruit new agents in Ohio and Pennsylvania. Company management considers it a challenge to increase new sales even modestly, while providing incentive to keep business in force for longer periods than we have historically experienced (i.e. improve our persistency rate) in this segment.
The Company has not been actively marketing Other Health policies for several years. However, in response to agent requests, certain cancer and disability protection products have been updated and promoted. Pricing, underwriting, and claims experience on these products are closely monitored. Due to unsatisfactory financial results in this product line, the Company discontinued selling new disability policies in October 2004, and received approval to increase premium rates by 35% effective February 1, 2006 in the state of New Jersey, where the majority of such policies have been issued.
focus. The Company’s equity securities comprised 7.1% and 7.2% of its total investment portfolios at December 31, 2005 and 2004, respectively. The Company’s investment income yields were 5.1%, 4.7%, and 4.5% for 2005, 2004, and 2003, respectively. The 2005 yield increase resulted primarily from increasing interest rates on new investments, as well as improved short-term yields during the year. Although the Company’s total return on investments has historically been favorable, returns in recent years have been severely impacted by declines in the airline, automobile, telecommunications and technology sectors, declines in the fixed maturities market (due to increasing rates), a general economic recession and the effect of terrorist events on the securities markets.
investment income, net realized investment gains or losses and net change in the excess or deficit of market values
over book values of the investment portfolios or unrealized gains (losses)) yields for the five years ended December
Segment Earnings. Pretax profit is shown below for the Company’s five business segments, along with total net realized investment gains and interest expense.
In 2005 the Home Service Life segment benefited by $272,000 of higher investment and other income and by $382,000 of decreased expenses (including net deferral of policy acquisition costs), associated primarily with one-time consulting costs, severance and legal costs, resulting in a decrease in the segment loss of $604,000.
The $932,000 decrease in the loss in the Broker Life segment is primarily the result of an increase in premium of $450,000 (primarily from our new final expense product), a decrease of $205,000 in policyholder benefits and an increase in investment and other income of $275,000.
The $740,000 change from a loss of $275,000 in 2004 to a profit of $464,000 in 2005 in the Preneed life segment is primarily the result of a decrease of $643,000 in expenses (including net deferral of policy acquisition costs), associated primarily with one-time consulting costs, severance and legal costs a decrease in commissions of $344,000 and a decrease of $1,674,000 in policyholder benefits offsetting the decrease of $1,936,000 in premiums resulting from the reduced level of business. During 2002, the Company accepted a significant amount of single-premium business, which generally has higher than average mortality rates. At that time, significant management and marketing resources were devoted to this business. To improve profitability, annual benefit growth rates were reduced in early 2003 and again in September 2004. Also, twice during 2002, certain commission rates were reduced and agent contracts revised to encourage production of the more profitable multi-pay products.
Income Taxes. Historically, the Company has experienced a relatively low effective current income tax rate, due primarily to the small life insurance company deduction, along with operating loss carryforwards and capital loss carryforwards. The effective expense (benefit) rate is approximately 0.0% and (23)% in 2005 and 2004, respectively.
During December 2002, Citizens Financial strengthened the statutory capital position of Citizens Security by acquiring $2,000,000 of Citizens Security redeemable preferred stock. During January 2001, Citizens Financial contributed 100% of the capital stock of Citizens Insurance to Citizens Security. The statutory value of this contribution was $3,540,555. Citizens Security has reported its investments in United Liberty and Citizens Insurance on the equity method of accounting, since their acquisitions in 1998 and 2001, respectively. However, beginning in 2001, new rules changed the statutory equity method of accounting to preclude a parent insurer from recording as income, its share of undistributed subsidiary earnings. For 2005, 2004, and 2003, Citizens Security reported as income the $250,000, $1,174,090 and $116,400 respectively, of dividend distributions that it received from United Liberty and Citizens Insurance. At December 31, 2005, Citizens Security reported its investments in United Liberty and Citizens Insurance at their statutory equity values of $2,096,243 and $2,431,907 respectively. To provide a more detailed understanding of Citizens Security's operations, shown below are SAP basis net income (loss), pretax net operating income (loss), statutory capital and surplus, asset valuation reserves, and capital ratios for Citizens Security for the five years ended December 31, 2005.
2 Represents Statutory Capital and Surplus plus Asset Valuation Reserves divided by invested assets plus cash.
In addition to the statutory totals shown above, Citizens Insurance generated statutory net income of approximately $63,000, $76,000, and $93,000 during, 2002, 2001, and 2000, respectively without remitting any dividends to its parent. Citizens Insurance generated statutory net income of $22,000 and $56,000 and paid dividends of $250,000 and $1,174,000 to Citizens Security in 2005 and 2004, respectively. United Liberty generated statutory net income (loss) of approximately $117,000, ($692,000), $536,000, ($328,000), and ($48,000), during 2005, 2004, 2003, 2002 and 2001, respectively and remitted dividends to its parent of $54,000 and $214,000 in 2003 and 2002, respectively.
A summary of all known commitments of the Company as of December 31, 2005, including the aforementioned borrowings, and an estimate (based on reasonable assumptions and anticipated trends) of payments to be made for future policy benefits and contract claims, is as follows:
The Company generated approximately $138,000, $913,000 and $6,069,000 of cash flow from operations during 2005, 2004 and 2003, respectively. The fluctuations are principally attributable to growth of Preneed Life premiums in 2003 and a decrease in Preneed Life premiums in 2004 and 2005.
Cash provided by (used in) investment activities of $316,000, $(2,464,000), and $(2,618,000) during 2005, 2004, and 2003 respectively, relates primarily to investing additional Preneed Life premiums in fixed maturity securities in 2004 and 2003. The net cash provided by investments in 2005 results primarily from the sale of short-term investments for $612,000, less approximately $300,000 used to acquire new equipment.
Cash used in financing activities during 2005 of $1,592,000 includes $1,416,000 of debt repayments and $1,176,000 of net withdrawals of policyholder deposits, offset by additional borrowings of $1,000,000 from the Company’s Chairman. The $2,346,000 of cash used by financing activities during 2004 includes $1,342,000 of debt repayments and $902,000 of net withdrawals of policyholder deposits, and $102,000 used to repurchase the Company’s common stock.
The Company is subject to various market risks. However, the most significant such risks relate to fluctuations in prices of equity securities and interest rates. Historically, total returns on the Company’s equity portfolio have been favorable and the Company has successfully managed the risk of equity security price fluctuations over many years. The Company devotes significant attention to the equity markets and repositions the Company’s portfolio upon detection of adverse risk trends associated with individual securities or overall markets. The Company also manages market risks associated with investments in option securities, as described in Note 2 of the Notes to Consolidated Financial Statements. The fair value of the Company’s equity portfolio was approximately $8,580,000 and $8,943,000 at December 31, 2005 and 2004, respectively. Accordingly, a 10% decline in equity prices would have reduced the fair value of the Company’s equity portfolio by $858,000 and $894,000 at December 31, 2005 and 2004, respectively. The average cost value of the Company’s equity portfolio was $7,559,000 and $11,133,000 during 2005 and 2004, respectively.
Interest expense on the Company’s debt varies quarterly and is therefore also subject to interest rate risk. For its commercial bank debt, the Company elects the lower of the prime lending rate or the one-month LIBOR rate plus 2.75%. For its related party debt, the interest rate is the higher of 6% or the commercial bank prime lending rate plus 1%. At December 31, 2005, the weighted average rate on the Company’s $5,375,003 of borrowings was 8.09%. The Company believes its current liquidity position and profitability levels are adequate to guard against this interest rate risk.
The Life Insurance Subsidiaries’ most recent cash flow testing, which was completed in February 2006, involved a review of two basic measures. The first was the value of free market surplus, which is defined as the difference between the projected market value of assets and liabilities at the end of the analysis period (typically 10-30 years). Deficits could indicate the need for corrective action depending upon the severity and the number of scenarios in which a deficit appeared. A second measure involved distributable earnings. Negative earnings for extended durations might impair the ability of the Life Insurance Subsidiaries to continue without exhausting surplus. Again, depending upon severity and frequency, corrective measures might be needed. Based on results of the testing, no corrective measures were indicated at the current time. However, such testing is ongoing and dynamic in nature and future events in the interest and equity markets or a significant change in the composition of Life Insurance Subsidiaries’ business could negatively impact testing results and require the initiation of corrective measures.
All statements, trend analyses and other information contained in this report relative to markets for the Company’s products and trends in the Company’s operations or financial results, as well as other statements including words such as “anticipate”, “believe”, “plan”, “estimate”, “expect”, “intend”, and other similar expressions, constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to known and unknown risks, uncertainties and other factors that may cause actual results to be materially different from those contemplated by the forward-looking statements. Such factors include, among other things:
the market value of the Company’s investments, including stock market performance and prevailing interest rate levels (see the Cash Flow and Liquidity section of this Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations);
mortality, morbidity, lapse rates, and other factors which may affect the profitability of the Company’s insurance products;