approximately 331,000 square feet of office space that we occupy. Management considers its office facilities suitable and adequate for the current level of operations. In addition to the above, Pennsylvania Life is the named lessee on approximately 52 properties occupied by career agents for use as field offices. Rent for these field offices is reimbursed by the agents. Additional information regarding our lease obligations is included in Note 15-Commitments and Contingencies in our consolidated financial statements included in this Annual Report on Form 10-K.
The table below provides selected financial data and other operating information as of and for the five fiscal years ended December 31, 2006. We derived the selected financial data presented below for the five fiscal years ended December 31, 2006 from our audited financial statements, which were audited by Ernst & Young LLP, our independent auditors. We have prepared the following data, other than statutory data, in conformity with generally accepted accounting principles. You should read this selected financial data together with our financial statements and the notes to those financial statements as well as the discussion under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
The following analysis of our consolidated results of operations and financial condition should be read in conjunction with the consolidated financial statements and related consolidated footnotes included in this Annual Report on Form 10-K.
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The preparation of our financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts of assets and liabilities and disclosures of assets and liabilities reported by us at the date of the financial statements and the revenues and expenses reported during the reporting period. As additional information becomes available or actual amounts become determinable, the recorded estimates may be revised and reflected in operating results. Actual results could differ from those estimates. Accounts that, in our judgment, are most critical to the preparation of our financial statements include future policy benefits and claim liabilities, deferred policy acquisition costs, goodwill, present value of future profits and other intangible assets, the valuation of certain investments and deferred income taxes. There have been no changes in our critical accounting policies during the current quarter.
We calculate and maintain reserves for the estimated future payment of claims to our policyholders using the same actuarial assumptions that we use in the pricing of our products. For our accident and health insurance business, we establish an active life reserve for expected future policy benefits, plus a liability for due and unpaid claims and incurred but not reported claims. Our net income depends upon the extent to which our actual claims experience is consistent with the assumptions we used in setting our reserves and pricing our policies. If our assumptions with respect to future claims are incorrect, and our reserves are insufficient to cover our actual losses and expenses, we would be required to increase our liabilities resulting in reduced net income and shareholders’ equity.
For our fixed benefit accident and sickness and our long term care products, we establish a reserve for future policy benefits at the time each policy is issued based on the present value of future benefit payments less the present value of future premiums. (It should be noted that we no longer issue new long term care policies, however our current policies are renewably annually at the discretion of the policyholder, as evidenced by the policyholder continuing to make premium payments.) In establishing these reserves, we must evaluate assumptions about mortality, morbidity, lapse rates and the rate at which new claims are submitted to us. We estimate the future policy benefits reserve for these products using the
above assumptions and actuarial principles. For long-duration insurance contracts, these original assumptions are used throughout the life of the policy and generally are not subsequently modified.
months, the incurred claims are estimated primarily from a trend analysis based upon per member per month (“PMPM”) claims trends developed from our historical experience in the preceding months, adjusted for known changes in estimates of recent hospital and drug utilization data, provider contracting changes, changes in benefit levels, product mix, and seasonality.
$2.4 million more than originally estimated, representing 0.6% of the incurred claims recorded in 2004. This unfavorable development related primarily to higher than anticipated claims for the Medicare supplement business in the Senior Market Health Insurance Segment. During 2004, the claim reserve balances at December 31, 2003 ultimately settled during 2004 for $0.2 million less than originally estimated, representing less than 0.1% of the incurred claims recorded in 2003.
During the fourth quarter of 2005, we recorded a pre-tax adjustment that increased incurred claims by $9.9 million. Two factors caused this action. First, incurred claims increased by $4.4 million as a result of a change in the estimate of our Medicare supplement claim reserves of $6.8 million, offset by an increase in amounts recoverable from reinsurers of $2.4 million. Second, we determined that, over a four year period, we had overstated the amounts recoverable from reinsurers for ceded Medicare supplement claim reserves. During the fourth quarter of 2005, we decreased our recoverable from reinsurers for ceded Medicare supplement claim reserves by $5.5 million. Approximately $1.1 million of the decrease was determined to relate to the first three quarters of 2005 and $3.1 million of the decrease was determined to relate to the years 2002 through 2004.
Upon the identification of the overstatement, we took the following steps to reduce the likelihood of such overstatements from occurring in the future by: (i) adding additional analytical procedures to ensure the accuracy of claim reserves estimation methods; (ii) retaining independent consulting actuaries to review the estimation of claim reserves on a regular basis; and (iii) strengthening the management review of claim reserves trends and methods used to estimate Medicare supplement claim reserves and amounts recoverable from reinsurers.
We analyzed the impact of the overstatement to determine whether it was material to the current or prior periods. We considered both qualitative and quantitative factors in assessing materiality in order to evaluate misstatements in financial statements, including the evaluation of whether the misstatement: a) arose from an item that could be precisely measured or is an estimate, b) resulted in a change of earnings trends or other trends, c) resulted in a failure to meet analysts’ consensus expectations, d) changed income to a loss or loss into income, e) had an impact on segment information and related trends, f) affected compliance with regulatory requirements, g) affected compliance with loan covenants or other contractual requirements, h) had the effect of increasing management’s compensation, or i) concealed an unlawful act.
In 2004, we acquired Heritage. The balances acquired represent the accident and health claim liabilities acquired in this transaction.
The following table illustrates the sensitivity of our accident and health IBNR payable at December 31, 2006 to certain reasonably possible changes to the estimated weighted average completion factors and health care cost trend rates. However, it is possible that the actual completion factors and health care cost trend rates will develop differently from our historical patterns and therefore could be outside of the ranges illustrated below.
For other life and health products, these costs are amortized in proportion to premium revenue using the same assumptions used in estimating the liabilities for future policy benefits in accordance with FAS No. 60, “Accounting and Reporting by Insurance Enterprises.”
The Company utilizes a prospective unlocking approach to account for DAC for its Medicare supplement business. Assumptions for future rate increases, persistency and benefit-design are used in the
At January 1, 2005, prospective unlocking was triggered due to the actual trend in premium rates of 11.6% exceeding the assumed trend of 10%. The balance of DAC for Medicare supplement business as of January 1, 2005 was approximately $81 million. The prospective unlocking had the effect of slowing the future amortization of DAC, as compared to the anticipated amortization had the prospective unlocking not been triggered. Prospective unlocking also had the effect of slowing the future increase in benefit reserves, as compared to the anticipated increase had the unlocking not been triggered.
Deferred policy acquisition costs are written off to the extent that it is determined that present value of future policy premiums and investment income or the net present value of expected gross profits would not be adequate to recover the unamortized costs.
We regularly evaluate the amortized cost of our investments compared to the fair value of those investments. Impairments of securities generally are recognized when a decline in fair value below the amortized cost basis is considered to be other-than-temporary. The evaluation is based on the intent and ability to hold the security to recovery, and is considered on an individual security basis, not on a portfolio basis. Generally, we consider a decline in fair value to be other-than-temporary when the fair value of an individual security is below amortized cost for an extended period and we do not believe that recovery in fair value is probable. Impairment losses for certain mortgage-backed and asset-backed securities are recognized when an adverse change in the amount or timing of estimated cash flows occurs, unless the adverse change is solely a result of changes in estimated market interest rates and we intend to hold the
We establish valuation allowances on our deferred tax assets for amounts that we determine will not be recoverable based upon our analysis of projected taxable income and our ability to implement prudent and feasible tax planning strategies. Increases in these valuation allowances are recognized as deferred tax expense. Subsequent determinations that portions of the valuation allowances are no longer necessary are reflected as deferred tax benefits. To the extent that valuation allowances were established in conjunction with acquisitions, changes in those allowances are first applied to increasing or decreasing the goodwill (but not below zero) or other intangibles related to the acquisition and then applied as an increase or decrease in income tax expense.
During the year ended December 31, 2006, we released approximately $1.9 million of valuation allowances on tax capital loss carryforwards as a result of investments gains taken during that period. As of December 31, 2006 we have $0.2 million of valuation allowances on tax capital loss carryforwards remaining.
On December 1, 2006, we completed the sale of our Canadian operations for approximately $131 million cash. The sale resulted in an after-tax realized gain of approximately $48 million and generated approximately $96 million of after tax proceeds. As a result, our Canadian Subsidiary has been reported as discontinued operations. See ”Note 21-Discontinued Operations” in our consolidated financial statements included in this Annual Report on Form 10-K for a more detailed description of the sale.
For 2007, we have expanded into new markets for our Medicare HMO and PFFS plans. We will be offering our Medicare Advantage coordinated care plans in 3 new markets; Florida, north Texas and Wisconsin. Through our insurance subsidiaries American Progressive and Pyramid Life, we will offer our PFFS products in 35 states in 2007, up from 15 states in 2006. We incurred approximately $25 million of additional costs in order to execute these expansion initiatives during the third and fourth quarters of 2006. As of March 1, 2007 our enrollment in PFFS plans has increased to approximately 140,000, representing approximately $1.1 billion of annualized premium.
On March 1, 2007, the Company acquired Harmony Health, Inc. (“Harmony”), a provider-owned company that operates GlobalHealth, Inc. (“GlobalHealth”), a Medicare Advantage HMO plan and
Medicare supplement insurance reimburses the policyholder for certain expenses that are not covered by standard Medicare coverage such as deductibles and co-pays. This coverage is designed for people who want the freedom to choose providers who participate in the standard Medicare program, as opposed to the more restrictive networks that exist in Medicare Advantage products. In the past ten years, we have become a successful provider of Medicare supplement coverage as well as other products designed for the senior market. We believe that the market for Medicare supplement products will continue to be attractive, especially because many seniors may lose similar coverage that had previously been offered to them as a retiree benefit by their former employers.
Recently, there has been increased competition from other Medicare supplement carriers, as well as from Medicare Advantage plans, which has affected our production and persistency of Medicare supplement business. As a result, we continue to experience higher than expected lapsation in our Medicare supplement business. This excess lapsation has accelerated the amortization of the deferred acquisition cost and present value of future profits assets associated with the business that lapsed. We cannot give assurances that lapsation of our Medicare supplement business will decline, requiring faster amortization of the deferred costs.
During the third quarter of 2005, we began to provide an insured drug benefit for the employees of the State of Connecticut. This coverage is renewable annually by the State of Connecticut. The risk is reinsured to PharmaCare Re on a 100% first dollar quota share basis. We receive an underwriting fee of two percent of premium.
The following table reflects income from each of our segments(1) and contains a reconciliation to reported net income:
(2) Prior periods adjusted to reflect the operations of our Canadian subsidiary as discontinued operations.
Income from discontinued operations, after taxes, was $10.1 million or $0.17 per diluted share, for 2005, compared to $12.1 million, or $0.22 per diluted share, for 2004.
Our Senior Market Health Insurance segment generated segment income of $10.2 million during 2005, a 71% decline compared to segment income of $35.4 million in 2004. Segment income for 2005 was affected by higher claim costs and reserve adjustments in our Medicare Supplement lines and increased lapsation of our Medicare Supplement in force business, which resulted in an acceleration of the amortization of deferred acquisition costs and present value of future profits. Additionally, segment income for 2005 was reduced by expenses of $4.8 million relating to the implementation of our Part D program.
(1) Includes results for the seven months since acquisition or inception.
Segment Components. The components of the revenues and results within the segment are as follows:
During 2006, the health plans had revenues of $335.8 million and reported a medical loss ratio of 81.2% as compared to revenues of $217.3 million and medical loss ratio of 82.3% in 2005.
During 2006, the IPA’s earned $11.2 million on $142.8 million in revenues received from our health plans as compared to earnings of $12.0 million on $118.2 million in revenues for 2005.
For 2006, these MSO’s had a loss of $5.6 million on $47.3 million of fees collected as compared to earnings of $3.8 million on $36.0 million of fees collected.
As of December 31, 2006, we had 18,183 members enrolled in our PFFS plans. During 2006, we collected $112.3 million of premium from CMS and the members, and reported a medical loss ratio of 78.9% as compared to revenues of $22.2 million and a medical loss ratio of 67.2% in 2005.
During 2005, the health plans had revenues of $217.3 million and reported a medical loss ratio of 82.3%. For the seven months since the acquisition of Heritage in 2004, the health plans had revenues of $90.5 million and reported a medical loss ratio of 83.3%.
For 2005, these MSO’s earned $3.8 million of income on $36.0 million of fees collected. For the seven months since the acquisition of Heritage in 2004, these MSO’s earned $1.1 million of income on $15.8 million of fees collected.
Our Senior Market Health Insurance segment historically has included our Medicare supplement business and other health insurance products designed for the senior market. On January 1, 2006, we began covering prescription drug benefits in accordance with Medicare Part D as a stand-alone benefit to Medicare eligible beneficiaries under PDPs. We reinsure 50% of the business of our PDPs to PharmaCare Re. The total results for the segment are presented above. Results for our Medicare Supplement business are separately presented below on a comparative basis. Additionally, we have also separately presented the results for our Part D business.
The Senior Market Health Insurance segment income increased by $46.5 million to $56.7 million for 2006. Segment income for our Part D business increased by $54.0 million, to $49.2 million, for 2006, compared to a loss of $4.8 million for 2005. This was offset, in part, by the results for our Medicare supplement business, which declined by $7.5 million, compared to 2005, as a result of the continued effect of higher than expected lapsation of our Medicare supplement in force business, which resulted in an acceleration of the amortization of deferred acquisition costs and present value of future profits.
lapsation of our Medicare supplement in force business, which resulted in an acceleration of the amortization of deferred acquisition costs and present value of future profits. Additionally, segment income for 2005 was reduced by expenses of $4.8 million relating to the implementation of our Part D program.
Revenues. Net premiums for our Medicare supplement business declined by $22.1 million, compared to 2005, due to the continued effect of higher lapsation of our Medicare supplement in force business, offset in part by increased retention of our Medicare supplement business, rate increases and new sales.
The amortization of intangibles relates primarily to intangibles recorded from the acquisition of Pyramid Life, and decreased by $0.1 million compared to 2005.
Benefits, Claims and Expenses. Policyholder benefits incurred increased by $45.7 million, or 19%, compared to 2004. Overall loss ratios for the segment increased 550 basis points to 74.7% for 2005 compared to 69.2% for 2004. During the fourth quarter of 2005, the Company recorded a pre-tax adjustment that increased incurred claims by $9.9 million. Two factors caused this action. First, incurred claims increased by $4.4 million as a result of a change in the estimate of the Company’s Medicare supplement claim reserves of $6.8 million, offset by an increase in amounts recoverable from reinsurers of $2.4 million. Second, the Company determined that, over a four year period, it had overstated the amounts recoverable from reinsurers for ceded Medicare supplement claim reserves. During the fourth quarter of 2005, the Company decreased its recoverable from reinsurers for ceded Medicare supplement claim reserves by $5.5 million. Approximately $1.1 million of the decrease was determined to relate to the first three quarters of 2005 and $3.1 million of the decrease was determined to relate to the years 2002 through 2004. When the effect of the reserve adjustments relating to prior periods is eliminated, the estimated pro-forma Medicare supplement loss ratio for the full year 2005 was 73.4%. The increase in our Medicare supplement loss ratio was primarily as a result of higher-than-anticipated outpatient doctor (Part B) and skilled nursing facility utilization. Approximately $10.0 million of the increase related to the increase in the loss ratio, exclusive of the reserve adjustment noted above. Additionally, higher net premiums added approximately $25.8 million to policyholder benefits.
The increase in deferred acquisition costs was $1.8 million less for 2005, than the increase for 2004. We experienced higher than expected lapsation in our Medicare supplement business beginning in the third quarter of 2005. We believe that there are a number of factors contributing to the lapsation, including competitive pressure from other Medicare supplement companies and Medicare Advantage products, as well as the departure of certain of our sales managers. This excess lapsation required us to accelerate the
amortization of the deferred acquisition cost and present value of future profits assets associated with the business that lapsed. The excess lapsation of our Medicare supplement in force resulted in the acceleration of approximately $4.6 million in the amortization of deferred acquisition costs. Excluding the effect of the excess lapsation, the increase in deferred acquisition costs was $2.7 million more for 2005, than for 2004, primarily as a result of higher retained premium and the effect of prospective unlocking resulting from higher than anticipated rate increases and better than anticipated persistency (excluding the lapses incurred from the departure of the sales managers discussed above). As a percentage of premium, the increase in deferred acquisition costs, excluding the effect of the excess lapsation, was 9.1% for 2005 compared to 9.3% for 2004.
The amortization of intangibles relates primarily to intangibles recorded from the acquisition of Pyramid Life, and increased by $1.9 million compared to 2004, due to the excess lapsation of in force business noted above.
Commissions and general expenses increased by $7.0 million, or 6%, compared to 2004. The following table details the components of commission and other operating expenses:
The ratio of commissions to gross premiums decreased to 14.3% for 2005, from 15.0% for 2004, as a result of lower overall commission rates associated with the continued growth of our in force renewal premium. Other operating costs as a percentage of gross premiums were 12.7% for 2005, compared to 12.7% for 2004. Commission and expense allowances received from reinsurers as a percentage of the premiums ceded decreased to 20.6% for 2005 from 22.4% for 2004, primarily due to the reduction in new business ceded and the effects of normal lower commission allowances on our aging base of ceded renewal business.
compared to 2005 as a result of declines of $3.5 million in our U.S. fixed benefit accident and sickness line and $1.9 million in our long term care line.
Net investment income increased by approximately $1.4 million, or 8%, compared to 2005. The increase is due primarily to investing cash that we had been accumulating in anticipation of rising interest rates.
Benefits, Claims and Expenses. Policyholder benefits incurred increased by $1.7 million, or 3%, compared to 2005. Overall loss ratios for the segment increased to 85.2% for 2006 compared to 77.8% for 2005, primarily as a result of higher loss ratios for our long term care line. Long term care loss ratios increased to 139.7% for 2006 from 112.2% for 2005.
Benefits, Claims and Expenses. Policyholder benefits incurred increased by $0.4 million, or 1%, compared to 2004. Overall loss ratios for the segment increased to 77.8% for 2005 compared to 73.2% for 2004, primarily as a result of higher loss ratios for our long term care and our U.S. fixed benefit accident and sickness lines. Loss ratios for our long-term care lines increased to 112.2% for 2005 from 106.9% for 2004 and for our U.S. fixed benefit accident and sickness lines increased to 58.8% for 2005 from 54.1% for 2004 .
The increase in deferred acquisition costs was $2.1 million less during 2005, as compared to the increase during 2004. This was primarily due to lower production of new fixed benefit accident and sickness business during 2005, resulting in a lower level of acquisition costs to capitalize.
Segment income from our Life Insurance and Annuity segment increased by $2.4 million, compared to 2005, primarily as a result of a $1.5 million gain on the sale of our group life insurance business and increased investment income.
Our agents sold $21.5 million of fixed annuities during 2006 and $44.8 million during 2005. Annuity deposits are not considered premiums for reporting in accordance with generally accepted accounting principles. Since September 30, 2006, we are no longer issuing annuity product. The reduction in annuity sales was the result of lower interest crediting rates offered and our reduced emphasis on this business as we continue our focus more on providing health insurance alternatives to the growing senior market.
Net investment income increased by approximately $3.4 million, or 9%, compared to 2005, primarily as a result of the increase in portfolio yields.
Benefits, Claims and Expenses. Policyholder benefits incurred increased by $2.1 million, or 6%, compared to 2005. The increase in business added approximately $1.2 million to policyholder benefits and claim costs were higher by approximately $0.9 million as a result of increased mortality in 2006, as compared to 2005. The increase in deferred acquisition costs was $10.7 million less during 2006, as compared to the increase during 2005. This was primarily due to lower production of new life insurance and annuity business during 2006, resulting in a lower level of acquisition costs to capitalize, as well as increased levels of amortization (primarily in the first quarter of 2006) as compared to 2005 as a result of higher lapsation and aging of the block of business. Commissions and general expenses, net of allowances decreased by $9.1 million, or 22%, compared to 2005,including the $1.5 million allowance on the sale of the group life insurance business. The remaining $7.6 million decrease is primarily due to the lower production levels of new life insurance an annuity business, as noted above.
Results for our Life Insurance and Annuity segment improved by $2.4 million, or 18%, to $15.7 million compared to 2004, primarily as a result of an increase in renewal business and lower claim costs.
Our agents sold $44.8 million of fixed annuities during 2005 and $72.0 million during 2004. Annuity deposits are not considered premiums for reporting in accordance with generally accepted accounting principles. The reduction in annuity sales was the result of lower interest crediting rates offered and our reduced emphasis on this business as we continue our focus more on providing health insurance alternatives to the growing senior market.
The loss from our Corporate segment increased by $8.5 million, or 61%, for the year ended December 31, 2006 compared to 2005. The increase was due primarily to the increase in stock-based compensation expense as a result of the adoption of FAS 123-R, costs of due diligence and higher interest cost. During 2006, we recognized $2.6 million of stock-based compensation expense relating to options vesting during the period. We also incurred $0.7 million of costs associated with due diligence for a potential acquisition that we determined we will not pursue at this time and we incurred $0.6 million of costs associated with our board of directors’ review of the proposed buyout offer. Additionally, certain of the companies acquired in July 1999 had post-retirement benefit plans in place prior to their acquisition and Universal American maintained the liability for the expected cost of such plans. In October 2000, participants were notified of the termination of the plans in accordance with their terms. The liability has been reduced as, and to the extent that, it becomes certain that we will incur no liabilities for the plans as a result of the termination. During the fourth quarter of 2006, $0.6 million of the liability was released, compared to a release of $1.8 million in 2005.
Our combined outstanding debt was $165.6 million at December 31, 2006 compared to $170.8 million at December 31, 2005. The weighted average interest rate on our loan payable increased to 7.3% for 2006 from 5.5% for 2005. The weighted average interest rate on our other long term debt increased to 7.8% for 2006 from 7.2% for 2005. See “Liquidity and Capital Resources” for additional information regarding our loan payable and other long term debt.
Our combined outstanding debt was $170.8 million at December 31, 2005 compared to $176.1 million at December 31, 2004. The weighted average interest rate on our loan payable increased to 5.5% for 2005 from 4.1% for 2004. The weighted average interest rate on our other long term debt increased to 7.2% for 2005 from 6.3% for 2004. The increase in interest cost was offset partially by interest income earned on the proceeds from our equity offering in June 2005.
Our contractual obligations as of December 31, 2006, are shown below.
Our capital is used primarily to support the retained risks and growth of our insurance company subsidiaries and health plans and to support our parent company as an insurance holding company. In addition, we use capital to fund our growth through acquisitions of other companies, blocks of insurance or administrative service business.
We believe that our current cash position, the expected cash flows of our administrative service company and our senior managed care company, and the surplus note interest and principal payments from American Exchange can support our current parent company obligations. However, there can be no assurance as to our actual future cash flows or to the continued availability of dividends from our insurance company subsidiaries.
was drawn as of December 31, 2006. Under the Amended Credit Agreement, the spread over LIBOR was reduced to 225 basis points from 275 basis points. Effective January 1, 2007, the interest rate on the term loan was 7.6%. Principal repayments are scheduled at $5.3 million per year over a five-year period with a final payment of $80.1 million due upon maturity on March 31, 2009.
The Amended Credit Facility requires the Company and its subsidiaries to meet certain financial tests, including a minimum fixed charge coverage ratio, a minimum risk based capital test and a minimum consolidated net worth test. The Amended Credit Facility also contains covenants, which among other things, limit the incurrence of additional indebtedness, dividends, capital expenditures, transactions with affiliates, asset sales, acquisitions, mergers, prepayments of other indebtedness, liens and encumbrances and other matters customarily restricted in such agreements. The Amended Credit Facility contains customary events of default, including, among other things, payment defaults, breach of representations and warranties, covenant defaults, cross-acceleration, cross-defaults to certain other indebtedness, certain events of bankruptcy and insolvency and judgment defaults. The Company requested and received, from the administrative agent for the bank group, a waiver of the event of default and an amendment to the Amended Credit Facility to increase the limitation for treasury stock purchases to $30.0 million in the aggregate after January 1, 2006.
In November, 2006, the Company requested and received, from the administrative agent for the bank group a waiver and amendment to the Amended Credit Facility. The waivers included the retention of proceeds from the Sale of PennCorp Life and the notification of the then pending acquisition of Harmony Health. The amendments included an additional short-term revolving credit facility of $50.0 million and an increase in the capital expenditure limits. On March 13, 2007, the Company drew down all $50.0 million of the new short-term revolving credit facility. This new short-term revolving credit facility has a maturity date of September 30, 2007 and bears interest at a spread of 75 basis points over the three month LIBOR rate. The initial rate is 6.1%.
We formed statutory business trusts, which exist for the exclusive purpose of issuing trust preferred securities representing undivided beneficial interests in the assets of the trust, investing the gross proceeds of the trust preferred securities in junior subordinated deferrable interest debentures of our parent holding company (the “Junior Subordinated Debt”) and engaging in only those activities necessary or incidental thereto. In accordance with the adoption of FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities,” the Company does not consolidate the trusts.
Separate subsidiary trusts of our parent holding company (the “Trusts”) have issued a combined $75.0 million in thirty year trust preferred securities (the “Capital Securities”) as detailed in the following table:
(2) The rate on this issue is fixed at 7.4% for the first five years. On May 15, 2008 it will be converted to a floating rate equal to LIBOR plus 410 basis points.
The Capital Securities represent an undivided beneficial interest in the Trusts’ assets, which consist solely of the Junior Subordinated Debt. Holders of the Capital Securities have no voting rights. Our parent holding company owns all of the common securities of the Trusts. Holders of both the Capital Securities and the Junior Subordinated Debt are entitled to receive cumulative cash distributions accruing from the
We paid $5.8 million in interest in connection with the Junior Subordinated Debt during the year ended December 31, 2006, $5.3 million during 2005 and $4.7 million during 2004.
We are obligated under certain lease arrangements for our executive and administrative offices in New York, Florida, Indiana, Texas, Wisconsin, Oklahoma and Ontario, Canada. Rent expense was $4.4 million for the year ended December 31, 2006, $3.9 million for 2005 and $3.1 million for 2004. Annual minimum rental commitments, subject to escalation, under non-cancelable operating leases (in thousands) are as follows:
In addition to the above, Pennsylvania Life is the named lessees on 52 properties occupied by career agents for use as field offices. The career agents reimburse Pennsylvania Life the actual rent for these field offices. The total annual rent paid by the Company and reimbursed by the career agents for these field offices during 2006 was approximately $1.8 million.
On November 3, 2004, we filed a universal shelf registration statement on Form S-3 with the U.S. Securities and Exchange Commission (“SEC”), pursuant to which we may issue common stock, warrants and debt securities from time to time, up to an aggregate offering of $140 million. The registration statement also covers five million shares of common stock that may be offered for sale by Capital Z Financial Services Fund II, L.P. (“Capital Z”), our largest shareholder. The shelf registration statement was declared effective in December, 2004.
On June 22, 2005, we issued 2.0 million shares of our common stock at a price of $23.61 per share, in connection with a public offering pursuant to the shelf registration. The issuance of these shares generated proceeds to us of $44.2 million, net of underwriters discount and other issuance costs. Additionally, 5.0 million shares were sold by Capital Z Financial Services Fund II, L.P. and its affiliates (“Capital Z”), our largest shareholder, under the same shelf registration. On July 20, 2005, the underwriters exercised their over-allotment option and we issued an additional 660,000 shares of our common stock at $23.61 per share, generating additional net proceeds of $14.8 million. Following the offering, Capital Z owned 20.2 million shares, or 34.5% of our outstanding common stock.
Subsequent to the offering noted above, the aggregate amount that remains available for offering under the shelf registration statement is $77.2 million.
· the expected cash flows of our senior managed care company; and
In addition, we have access to $15.0 million under the revolving portion of our credit facility. Finally, we have the ability, from time to time, to access the capital markets for additional capital. In March of 2007, we drew down all $50 million of the new short-term revolving portion of the credit facility. Additionally, we signed a letter of intent to issue up to additional $100 million of trust preferred securities through a separate subsidiary trust. The trust preferred securities will not be and have not been registrered under the Securities Act of 1933, as amended, and may not be offered or sold in the United States absent registration on an applicable exemption from registration requirements. This reference to the trust preferred securities shall not constitute an offer of any sale of the security. The closing of the issuance of $50 million of the trust preferred securities is expected to occur in late March 2007. There can be no assurance as to our actual future cash flows, from the continued availability of dividends from our insurance company subsidiaries or from access to the capital markets to support our growth and expansion ititiatives.
Insurance Subsidiaries-Surplus Note, Dividends and Capital Contributions. Cash generated by our insurance company subsidiaries will be made available to our holding company, principally through periodic payments of principal and interest on the surplus note owed to our holding company by our subsidiary, American Exchange Life. As of December 31, 2006, the principal amount of the surplus note was $27.6 million. The note bears interest to our parent holding company at LIBOR plus 250 basis points. We anticipate that the surplus note will be primarily serviced by dividends from Pennsylvania Life, a wholly owned subsidiary of American Exchange, by distributions from PDMS, and by tax-sharing payments among the insurance companies that are wholly owned by American Exchange and file a consolidated Federal income tax return. American Exchange made principal payments totaling $12.5 million during the year ended December 31, 2006, $8.4 million during 2005 and $11.6 million during 2004. American Exchange paid interest on the surplus note of $2.5 million during the year ended December 31, 2006, $2.6 million in 2005, and $2.4 million in 2004.
Dividend payments by our U.S. insurance companies to our holding company or to intermediate subsidiaries are limited by, or subject to the approval of the insurance regulatory authorities of each insurance company’s state of domicile. Such dividend requirements and approval processes vary
Our accident and health insurance policies generally provide for fixed-benefit amounts and, in the case of Medicare supplement policies, for supplemental payments to Medicare provider rates. Some of these benefits are subject to medical-cost inflation and we have the capability to file for premium rate increases to mitigate rising medical costs. Our health insurance business is widely dispersed in the United States, which mitigates the risk of unexpected increases in claim payments due to epidemics and events of a catastrophic nature. These accident and health polices are not interest-sensitive and therefore are not subject to unexpected policyholder redemptions due to investment yield changes.
Changes in interest rates may affect the incidence of policy surrenders and withdrawals. In addition to the potential impact on liquidity, unanticipated surrenders and withdrawals in a changed interest rate environment could adversely affect earnings if we were required to sell investments at reduced values in order to meet liquidity demands. We manage our asset and liability portfolios in order to minimize the adverse earnings impact of changing market rates. We have segregated a portion of our investment portfolio in order to match liabilities that are sensitive to interest rate movements with fixed income securities containing similar characteristics to the related liabilities, most notably the expected duration and required interest spread. We believe that this asset/liability management process adequately covers the expected payment of benefits related to these liabilities.
At December 31, 2006, our insurance company subsidiaries held cash and cash equivalents totaling $251.8 million and fixed maturity securities that could readily be converted to cash with carrying values (and fair values) of $1.1 billion at December 31, 2006. In addition, our insurance company subsidiaries have cash totaling approximately $207.6 million for the operation of our PDPs that cannot be used for other lines of business or general corporate purposes.
The net yields on our cash and invested assets decreased to 5.1% for the year ended December 31, 2006, from 5.0% for 2005 and 4.9% for 2004. A portion of these securities are held to support the liabilities for policyholder account balances, which liabilities are subject to periodic adjustments to their credited interest rates. The credited interest rates of the interest-sensitive policyholder account balances are
As of December 31, 2006, approximately 99% of our fixed maturity investments had investment grade ratings from Standard & Poor’s Corporation or Moody’s Investor Service. There were no non-income producing fixed maturities as of December 31, 2006. During the years ended December 31, 2006, 2005 and 2004, we did not write down the value of any fixed maturity securities. A write-down of the value of a fixed maturity security would represent our estimate of an other than temporary decline in value and would be included in net realized gains and losses on investments in our consolidated statements of operations.
At December 31, 2006, the Company (exclusive of American Exchange and its subsidiaries) had net operating loss carryforwards of approximately $0.5 million that expire in 2015. At December 31, 2006, American Exchange and its subsidiaries foreign tax credit carryforward for Federal income tax purposes of approximately $1.5 million that expires in 2016.
The Company establishes valuation allowances based upon an analysis of projected taxable income and its ability to implement prudent and feasible tax planning strategies. The Company carried valuation allowances on its deferred tax assets of $0.2 million at December 31, 2006 and $2.9 million at December 31, 2005.
During 2005, the Company incurred creditable foreign taxes related to dividends from Penncorp Life, its Canadian subsidiary, generating a foreign tax credit carryforward, for which a deferred tax asset of approximately $0.8 million was established. A valuation allowance for the entire amount was established because the Company lacked sufficient foreign source income to realize the benefit for the foreign tax credit. As foreign source income was generated in 2006, the valuation allowance related to the foreign tax credit carryforward was released.
Our U.S. insurance company subsidiaries are taxed as life insurance companies as provided in the Internal Revenue Code. The Omnibus Budget Reconciliation Act of 1990 amended the Internal Revenue Code to require a portion of the expenses incurred in selling insurance products to be capitalized and amortized over a period of years, as opposed to an immediate deduction in the year incurred. Instead of measuring actual selling expenses, the amount capitalized for tax purposes is based on a percentage of premiums. In general, the capitalized amounts are subject to amortization over a ten-year period. Since this change only affects the timing of the deductions, it does not, assuming stability of rates, affect the provisions for taxes reflected in our financial statements prepared in accordance with GAAP. However, by deferring deductions, the change has the effect of increasing our current tax expense and reducing statutory surplus. There was no material increase in our current income tax provision for any of the three years in the period ended December 31, 2006 due to the existence of our insurance company subsidiaries’ net operating loss carryforwards.
The Jobs Creation Tax Act of 2004 (the “Jobs Act”) contains a provision that places a two year moratorium on the imposition of tax on distributions from Policyholder Surplus Accounts (“PSA”), the Phase III tax. Additionally, the ordering rules were changed to allow for the first dollar of any distribution to reduce the PSA. At December 31, 2006, we have $7.1 million in deferred tax liabilities for potential Phase III tax. In accordance with the Jobs Act, distributions during 2005 and 2006 from an insurance company that has a PSA will be treated as a distribution from its PSA account, however, the distribution will not be subject to Federal income tax. We received the approval of the Insurance Departments of the respective companies for the transactions that could trigger the elimination of the potential tax and made such distributions during 2006. Upon the confirmation of the elimination of the potential Phase III tax on the PSAs, the deferred tax liability will be released. Approximately $3.8 million will reduce goodwill related to the acquisition of Pyramid. The remaining $3.3 million will reduce deferred tax expense.