The Company owns its home office building, located at 17800 Royalton Road, Strongsville, Ohio. The building, which consists of 121,625 square feet of gross floor area, was occupied in late 1990 by the Company and all its subsidiaries. At December 31, 1997, the outstanding principal balance of the mortgage note on the building was $8,399,028, see Note 9 to the consolidated financial statements. Central, the principal operating subsidiary, entered into a 15 year triple net lease agreement with the Company for 100% of the space. All operations are conducted in this building.
(2) No incremental shares related to options/warrants are included due to the loss for the year.
claim payments to insureds, managed care expenses, operating expenses such as salaries, employee benefits, commissions, taxes, etc., and shareholder dividends payable to the Company. The Company has, in the past, relied on the dividend from Central to enable it to pay dividends to shareholders. Central and the Company discontinued paying dividends at the end of 1996 and no dividends were paid in 1997. By statute, the state regulatory authorities set minimum liquidity standards to protect both policyholders and shareholders and limit the dividends payable by Central to the Company. See Item 5.
The majority of the Company's assets are in investments which were $81,927,130, after a net unrealized holding gain (before taxes of $314,894) of $926,158 (see below), or 60% of the total assets at December 31, 1997. Fixed maturities are the primary investment of the Company and were $79,860,513 or 97% of total investments at December 31, 1997. Other investments consist of short-term securities and policy loans. The Company is carrying fixed maturities of $11,898,627 at amortized cost (held to maturity) and fixed maturities of $67,961,886 at estimated fair value (available for sale) at December 31, 1997. The Company does not hold any so-called "junk" bonds or what are generally considered high-yield type securities, and 97.9% of the bonds are of investment grade quality. In accordance with Statement of Financial Accounting Standards (Statement) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," the Company recorded an increase in investments of $926,158 to reflect the reporting of investments classified as available for sale at fair value (estimated market value) which was higher than amortized cost. The amount is reflected in shareholders' equity as a "net unrealized holding gain, net of $314,894 for taxes". In addition to the fixed maturities, the Company also had $5.7 million in unrestricted cash and $1.9 million in short-term investments at December 31, 1997.
During 1997, total assets increased about $16 million, however this was offset by an increase in total liabilities of about $36 million after debt. The major reasons for the increase in assets was due to the reinsurance treaty with Hannover and the $20 million note payable. The Company suffered a large negative cash flow in 1997 from the operations of Central. (See consolidated cash flow financial statements.) The negative cash flow was primarily generated from claim payments, much of what was due to a run off of claims due to lapses. Although the majority of the lapsed policies had high loss ratios, new business did not offset the lapses enough to produce a positive cash flow. The Company anticipates that with the changes made during 1997 and into 1998, that future operating cash flow needs, including surrenders of annuity policies, can be provided from premiums and the current investment portfolio.
If Shareholder approval of the equity financing transaction (the "Equity Financing") is not obtained, the $20,000,000 note evidencing the Bridge Financing (the "Bridge Note") and 800,000 of the 1,000,000 Guarantee Warrants, which have already been issued in connection with the Bridge Financing, will remain outstanding and enforceable against the Company. The Bridge Note matures on June 30, 1998, at which time the Company will be required to repay the loan evidenced by the Bridge Note. Because of regulatory restrictions, it is highly unlikely the Company could receive the funds to repay the Bridge Note from Central. Thus, if Shareholder approval of the Equity Financing is not obtained, it is likely that the Company will not have the ability to repay its obligations under the Bridge Note and will be required immediately to locate an alternate source of financing to meet its obligations under the Bridge Note and to fund its operations. There can be no assurance that the Company would be able to obtain such a refinancing at all or on terms that are favorable to the Company or its Shareholders, particularly in light of Central's current financial position and its recent efforts to obtain financing. The Company's failure to obtain sufficient financing within the requisite time may entitle Strategic Partners to exercise its rights as a secured creditor, including by foreclosing upon all of the common shares of Central which were pledged to Strategic Partners as collateral for the Bridge Financing. As the Company is a holding company with no operations and limited assets, such foreclosure upon the Company's principal asset could result in the Common Shares having little or no value, make it impossible for the Company to continue operations, and/or force the Company to seek protection under federal bankruptcy law.
The Company believes that if the Equity Financing is approved and consummated, its effect, together with the financial transactions described above and below, recent expense reductions, and internally generated funds, should enable the Company to finance the planned growth for the foreseeable future. If additional funds are required for long-term growth, the Company believes that these funds could be obtained through equity or debt offerings as market conditions permit or dictate.
The Company has conducted a comprehensive review of its computer systems to identify the systems that could be affected by the "Year 2000" issue. The Year 2000 problem is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a major system failure or miscalculations. The Company entered into an Administrative Services Agreement in March 1998 to outsource its computer operations with an independent vendor. The vendor is already in compliance with the Year 2000 issue, so there should be no material additional costs incurred by the Company for the Year 2000 issue.
Benefits and claims incurred expenses increased 23% in 1996 to $203,677,232 from $165,472,603 in 1995. The incurred loss ratio was 78.9% for 1996 compared to 71% for 1995. The major reasons for the increase in the claims loss ratio and the level of claims were (a) the underpricing, as a result of inaccurate actuarial and managerial projections and conclusions, of a new product (PMO) introduced in late 1994 and sold heavily in 1995, accounting for 63% of certificates issued, (b) greater utilization than anticipated and (c) new state mandates such as guaranteed issue (not subject to medical underwriting) and preventive benefits, which are medical services that are not for the care, treatment or diagnosis of an illness. By far the biggest cause was the underpriced PMO product which contributed to an estimated 80% of the loss before net investment income. The losses on the new product were recognized in the year the claims were reported and through actuarial estimates of incurred but not reported claims. Higher premiums and aggressive rate renewal actions started April 1, 1996. Because the business is primarily sold on a monthly basis the full renewal action took 12 months ending March 31, 1997.
difficulties. The RBC Financial Plan identified the following conditions: (a) the PMO product, which was found to be underpriced, was introduced in late 1994 and sold heavily in 1995, (b) the harsh winter of 1995/96, causing numerous accidents and related heart conditions, (c) greater utilization causing an increase in claims processed, (d) state mandates requiring guaranteed issue, (e) state mandated benefits, and (f) the medical trend was higher than expected.
Other operating expenses increased 8% to $37,687,498 or 14.6% of premiums in 1996, compared to $34,978,063 or 15% of premiums in 1995. Salaries, benefits and premium taxes remained the largest portions of the other operating expenses.
standards for all stock-based compensation plans, including employee stock options, restricted stock and stock appreciation rights. Statement 123 allows for either the adoption of the "fair value" method of accounting for stock-based compensation or the continued use of APB No. 25, "Accounting for Stock Issued to Employees." The Company has elected to continue to comply with APB No. 25. The Company has not granted any new stock options subsequent to January 1, 1995, therefore, the pro forma disclosures required by Statement 123 are not applicable.
In 1997, FASB issued Statement No. 130, "Reporting Comprehensive Income." Statement 130 establishes new rules for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. It does not apply to not-for-profit entities. Disclosure of total comprehensive income is required in interim period financial statements. The new rules require that all items that are recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. The rules require companies to (a) display items of other comprehensive income either below the total for net income, in a separate statement of comprehensive income, or in a statement of changes in equity, the alternative we believe many companies will follow, and (b) disclose the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of the balance sheet. Statement 130 does not specify a format for the financial statement that portrays the components of comprehensive income but requires that a company display an amount representing total comprehensive income for the periods reported in that financial statement. The final Statement eliminated the proposed requirement to display comprehensive income per share because of the overwhelming negative response the FASB received related to this matter. Application of Statement 130 will not impact amounts previously reported for net income or affect the comparability of previously issued financial statements. The statement is effective for fiscal years beginning after December 15, 1997 and is not considered to have a material effect on the consolidated financial statements.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Central Reserve Life Corporation and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
The accompanying consolidated financial statements and financial statement schedules have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has suffered substantial losses from operations in 1997 and 1996 that resulted in a significantly reduced net capital position. The Company has entered into an Amended and Restated Stock Purchase Agreement to issue and sell 7,300,000 Common Shares and warrants to purchase an additional 3,650,000 Common Shares at an exercise price of $5.50 per share for an aggregate purchase price of $40,150,000. The closing of the Amended and Restated Stock Purchase Agreement is subject to shareholder approval and regulatory approvals. In December 1997, the Company obtained an interim loan of $20 million and that loan is due June 30, 1998. Should the Amended and Restated Stock Purchase Agreement not be completed before June 30, 1998, and due to regulatory limitations on the Company's ability to receive dividends from its insurance subsidiary, the Company, absent some alternative capital resource, will not have the ability to repay the interim loan. These matters raise substantial doubt about the ability of the Company to continue as a going concern. Management's plans in regard to these matters are also described in Note 1 to the consolidated financial statements. The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
The significant accounting policies followed by the Company that materially affect financial reporting are summarized below. The accompanying financial statements have been prepared in accordance with generally accepted accounting principles (GAAP) which differ from statutory accounting practices prescribed or permitted by regulatory authorities (see Note 4).
In November 1997, the Company entered into a Stock Purchase Agreement (the "Original Stock Purchase Agreement") with Strategic Acquisition Partners, LLC (Strategic Partners), in which the Company agreed to issue and sell 5,000,000 Common Shares and warrants to purchase an additional 2,500,000 Common Shares at an exercise price of $6.50 per share for an aggregate purchase price of $27,500,000. On March 30, 1998, the Company revised its agreement with Strategic Partners and entered into an amended and restated Stock Purchase Agreement (the "New Stock Purchase Agreement") with Strategic Partners and two additional investors, Insurance Partners, L.P. and Insurance Partners Offshore (Bermuda), L.P. (collectively, "Insurance Partners"). Pursuant to the New Stock Purchase Agreement, the Company will issue and sell 7,300,000 Common Shares at $5.50 per share and warrants to purchase an additional 3,650,000 Common Shares at an exercise price of $5.50 per share for an aggregate purchase price of $40,150,000. The transaction is subject to shareholder and regulatory approvals.
Concurrent with the signing of the Original Stock Purchase Agreement, Strategic Partners arranged for an interim loan (the "Bridge Loan") of $20 million to the Company (see Note 7). In consideration of the
arrangement, the Company issued warrants to purchase 800,000 Common Shares at $6.00 per share. The proceeds of the Bridge Loan were used as follows: (i) $5.2 million was utilized to repay outstanding bank debt; (ii) $14 million was used by the Company to invest in the statutory surplus of Central and was evidenced by a surplus note in favor of the Company from Central; and (iii) $800,000 was used to establish an interest reserve at the Company and to pay transaction expenses. The Bridge Loan, as amended, is due June 30, 1998. As collateral for the Bridge Loan, the Company pledged to Strategic Partners all of the common shares of Central and the surplus note executed by Central in favor of the Company. The Company executed a promissory note in favor of Strategic Partners to evidence the Bridge Loan and the Company and Strategic Partners executed a Credit Agreement to govern the transaction.
Management believes that the New Stock Purchase Agreement will be approved and completed in the second quarter of 1998 and intends to utilized the proceeds from that transaction to, among others things, repay the Bridge Loan. Should the New Stock Purchase Agreement not be completed before June 30, 1998, and due to regulatory limitations on the Company's ability to receive dividends from its insurance subsidiary, the Company, absent some alternative capital resource, will not have the ability to repay the interim loan (see Notes 4 and 7). The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
The estimates susceptible to significant change are those used in determining the liability for future policy benefits, losses and claims. Although some variability is inherent in these estimates, management believes the amounts provided are adequate.
Effective January 1, 1994, the Company adopted the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (Statement) No. 115, "Accounting for Certain Investments in Debt and Equity Securities". Statement 115 requires that investments in all debt securities and those equity securities with readily determinable market values be classified into one of three categories: held to maturity, trading or available for sale. Classification of investments is based upon management's current intent. Debt securities which management has a positive intent and ability to hold until maturity are classified as securities held to maturity and are carried at amortized cost. Unrealized holding gains and losses on securities held to maturity are not reflected in the consolidated financial statements. Debt and equity securities that are purchased for short-term resale are classified as trading securities. Trading securities are carried at estimated fair value, with unrealized holding gains and losses included in earnings. All other debt and equity securities not included in the above two categories are classified as securities available for sale. Securities available for sale are carried at estimated fair value, with unrealized holding gains and losses reported as a separate component of shareholders' equity, net of tax. At December 31, 1997, the Company did not have any investments classified as trading securities.
Certain costs, principally commissions, which vary with and are directly related to the production of ordinary life business, have been deferred. The deferred costs are being amortized through the use of factors over the benefit period of the related policies. These factors were developed using assumptions which are consistent with those used in setting rates. Due to the nature of the business and its persistency experience, the Company does not defer policy acquisition costs for Central's group business. Deferred policy acquisition costs at December 31, 1997 and 1996 were $325,572 and $321,567, respectively. The net amounts amortized to income were $4,005 in 1997, $111,807 in 1996 and $59,834 in 1995. The decrease in 1997 was due to the decrease in sales of Central's 10-year term policies.
(2) Estimates of future mortality and withdrawals are based on experience and established industry tables.
The liabilities for unpaid accident and health and death claims are estimated principally based upon past experience for pending, incurred but not reported, and reopened claims. The liability includes a provision for the estimated cost of investigating and settling the claim liability. The estimate of accident and health claim reserves incurred, but not yet due, are computed using actuarially determined factors based on a combination of claim completion and loss ratio methods, utilizing durational experience, seasonal cycle, changes in health care practice, changes in inflation rates and the claims backlog. The liability is particularly sensitive to recent claims frequency and severity experience of Central. Management believes the liabilities for unpaid claims are adequate, but no assurance can be made that the ultimate payments will not exceed the liability recorded at December 31, 1997.
The amortized cost and estimated fair value of securities held to maturity and available for sale as of December 31, 1997, are as follows. The estimated fair value is based on quoted market prices, where available, or on values obtained from independent pricing services.
The amortized cost and estimated fair value of fixed maturities at December 31, 1997, by contractual maturity, are as follows. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalties.
The Company does not engage in trading market risk sensitive instruments. Neither does the Company purchase as investments, hedges or for purposes "other than trading" instruments that are likely to expose the Company to market risk, whether interest rate, foreign currency exchange, commodity price or equity price risk. The Company has issued no debt instruments, has entered into no forward or futures contracts, has purchased no options and has entered no swaps. Following is a table reflecting the quality of Central's portfolio:
At December 31, 1997 cash includes approximately $3.9 million held for self-funded accident and health accounts, which is restricted as to its use. Central is entitled to investment income from these restricted funds. A corresponding amount is included in liabilities in the accompanying consolidated financial statements.
At December 31, 1997 Central had certificates of deposit and fixed maturities on deposit with various state insurance departments, carried at $4,194,490, for the protection of policyholders.
Central, the Company's main operating subsidiary, is subject to certain restrictions which are contained in the Insurance Holding Company statute (Ohio Revised Code 3901.34) which prevent Central from paying the Company, without the approval of the Ohio Superintendent of Insurance, any dividend from other than earned surplus (as defined in the statute). At December 31, 1997, Central had $24,650,804 of statutory capital and surplus, however it had negative earned surplus of $7,511,306 due to losses in 1996 and 1997. Because of the negative earned surplus, Central is not permitted to pay any dividends without approval of the Ohio Superintendent of Insurance. There can be no assurance that Central would be able to obtain such approval before returning to profitability and establishing an adequate positive earned surplus.
The Ohio Department of Insurance imposes risk-based capital (RBC) requirements on insurance enterprises, including Central. The RBC Model serves as a benchmark for the regulation of life insurance companies by state insurance regulators and provides for targeted surplus levels based on formulas which specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk, and are set forth in the RBC requirements. Such formulas focus on four general types
of risk: (a) the risk with respect to the company's assets (asset or default risk); (b) the risk of adverse insurance experience with respect to the company's liabilities and obligations (insurance or underwriting risk); (c) the interest rate risk with respect to the company's business (asset/liability matching); and, (d) all other business risks (management, regulatory action, and contingencies). The amount determined under such formulas is called the Authorized Control Level RBC (ACL).
In December 1997, the Company contributed, in the form of a surplus note, $14 million to Central, from the proceeds of the $20 million loan. Central also entered into a reinsurance treaty in December 1997, that provided an initial ceding allowance of $10 million, which increased Central's statutory surplus. The treaty also provided for a 50/50 quota-share formula relieving Central of approximately 50% of its insurance risk at December 31, 1997. At December 31, 1997 Central's TAC was $24,927,585 or 3.1 times its ACL and accordingly, Central was above the Company Action Level.
The Company files a consolidated Federal income tax return with its subsidiaries. The provision for Federal income tax does not bear the customary relationship to pretax accounting income because of special tax provisions available to life insurance companies. Central receives a benefit provided for "small" life insurance companies.
The Federal income tax returns for the Company and its subsidiaries have been examined by the Internal Revenue Service (IRS) for 1991 and 1992. During the third quarter of 1994, the IRS issued a proposal for adjustments to the Company's returns for 1991 and 1992. The proposed deficiencies were approximately $2.4 million of which $215,303 was paid in 1994 and $590,000 paid in 1997. The balance primarily deals with whether or not the Company's subsidiary, Central, qualified as a life company, for tax purposes. The Company intends to vigorously protest the proposed deficiency and based on discussions with counsel management believes existing law supports the Company's position. Therefore, the Company has not recorded a liability for the difference. The tax case is currently on the May 18, 1998, trial calendar of the United States Tax Court at Cleveland, Ohio, but it is expected that the case will be submitted as a legal issue, i.e., without the need for a trial.
If the IRS were to prevail in its position that Central no longer qualifies as a life company for tax purposes, approximately $2.6 million of tax and interest would be payable and Federal income taxes would increase in the future. Presently, as a small life company, Central is permitted, among other things, a deduction from the first $3 million of income of 60% or $1.8 million. As Central's income increases above $3 million, the special deduction is reduced proportionately. Besides relying on favorable existing case law, Central may have, under certain circumstances, the ability to change and market policies that could insure its qualifications as a life company for tax purposes in the future, if the need arises.
On December 16, 1997, Central issued to the Company a $14 million surplus note with interest on the unpaid balance payable quarterly at a fixed rate of 8 1/2%. The issuance of the surplus note was approved by the Ohio Department of Insurance and any payment of interest or principal on the note may be made only with the prior approval of the Director of Insurance of the State of Ohio. Central reports the $14 million as surplus rather than a liability under statutory accounting. The amount is eliminated in the consolidated financial statements. No interest was paid or accrued at December 31, 1997.
In computing diluted earnings per share, only potential common shares that are dilutive, those that reduce earnings per share, are included. The exercise of options and warrants is not assumed if the result would be antidilutive, such as when a loss from continuing operations is reported. The Company reported such a loss in both 1997 and 1996, therefore the basic and diluted (loss) per share are the same. The weighted average number of shares used in the calculation was 4,182,672 for 1997 and 4,052,314 for 1996. For 1995, 4,037,391 was used for basic and 4,221,636 for diluted earnings per share (EPS) calculation.
The Company is involved in litigation and may become involved in potential litigation arising in the ordinary course of business. In the opinion of management, the effects, if any, of such litigation are not expected to be material to the Company's consolidated financial condition or results of operations.
Under the terms of the retroactive reinsurance treaty with Hannover, effective January 1, 1997, Central transferred $24,550,000 of reserve liabilities and received a ceding allowance of $10,000,000, resulting in a net cash transfer of $14,550,000 to Hannover as of December 31, 1997. Under statutory accounting, Central reduced its reserve by $24,550,000 and increased its surplus $10,000,000. For GAAP accounting, the Company did not decrease the reserves and recorded the $24,550,000 as a receivable and the $10,000,000 as a deferred reinsurance gain on the balance sheet. For GAAP purposes the deferred gain will be amortized into earnings over approximately five years, the estimated settlement period of the reinsured business.
Outstanding stock options consist of options granted by the Company at prices equal to or above market price on the date of grant. On March 15, 1983, an Incentive Stock Option Plan was adopted. The plan, which expired in May 1993, provided that key full-time employees of the Company and its subsidiaries were eligible for participation in the Plan. As of December 31, 1997, 1996 and 1995, all options were fully vested, subject to employment. The following table summarizes data regarding all stock options:
The exercise price of options outstanding at December 31, 1997, was $6.75 per share and they expire February 25, 1998. Also, on December 17, 1997, in connection with the arrangement of the $20 million interim loan to the Company, warrants to purchase 800,000 common shares at $6.00 per share, were issued with a five year term.
The following table presents the revenues and income (loss), on a GAAP basis, attributable to the Company's consolidated industry segments. The Company does not allocate investment assets or identifiable assets by industry segments.
Statement of Financial Accounting Standards No. 107 (Statement 107) "Disclosures about Fair Value of Financial Instruments" requires disclosure of fair value information about existing on and off-balance sheet financial instruments. In cases where quoted market prices are not available, fair value is based on estimates using present value or other valuation techniques.
The following is a summary of quarterly results of operations for the years ended December 31, 1997 and 1996.
(1) No incremental shares related to options and warrants are included due to losses for the quarters.