In 2001, we received net proceeds of $46.5 million from a public offering of 16.1 million shares of our common stock, at $3.20 per share.
This discussion should be read in conjunction with the audited consolidated financial statements, notes, and tables included elsewhere in this report. Management’s discussion and analysis contains forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. However, future performance involves risks and uncertainties, which may cause actual results to differ materially from those expressed in the forward-looking statements. See “Forward-Looking Statements.”
Our insurance subsidiaries include Central Reserve Life Insurance Company, Provident American Life & Health Insurance Company, United Benefit Life Insurance Company and Continental General Insurance Company. Central Reserve markets and sells both major medical health insurance to individuals, families, associations, and small employer groups and senior products to Americans age 55 and over. Continental General markets and sells both major medical and senior health and life products to individuals, families, associations and Americans age 55 and over. Provident American Life discontinued new medical sales activities and currently has approximately 200 active major medical certificate holders and 300 life policyholders. In June 2005, Provident American Life began marketing and selling a new portfolio of senior products. United Benefit Life has no active policyholders.
Management has identified the following items that represent our most sensitive and subjective accounting estimates that have or could have a material impact on our financial statements. These estimates required management to make assumptions about matters that were highly uncertain at the time the estimates were made. Changes to these estimates occur from period to period and may have a material impact on our consolidated financial statements in the period in which they are made. Management has discussed the development, selection and disclosure of these estimates with our Audit Committee.
For the more recent incurred months, the percentage of claims paid to claims incurred in those months is generally low. As a result, the completion factor methodology is less reliable for such months. For that reason, incurred claims for recent months are not projected solely from historical completion and payment patterns. Instead, they are projected by estimating the claim expense for those months based upon recent claim expense levels and claim trend levels, or “trend factors.” As these months mature over time, the two estimates (completion factor and trend) are blended with completion factors being used exclusively for older months.
Long-Term Care Disabled Life Reserves. With respect to long-term care disabled life reserves, the tabular method is used for all open claims where the eligibility for benefits has been established. The ability to accurately perform a disabled life reserve calculation is dependent upon the appropriateness of the continuance tables used. The long-term care continuance tables are based on a third party actuarial firm’s long-term care guidelines. The continuance factors are adjusted based on emerging actual-to-expected claim cost data by benefit type and cause of impairment. A hypothetical 1% annual increase in the assumed termination rate in the continuance tables would result in an approximately 2% increase in the case reserve, or $700,000 at December 31, 2005.
The claim liability model develops estimates of 1) claims in the course of settlement, 2) case reserves, and 3) IBNR. The calculation methodologies for the three specific reserves are as follows:
For each open claim, a claim in the course of settlement amount is calculated, representing the amount of payments expected to be owed on existing claims for services received prior to the valuation date but for which benefits have not yet been paid. This amount is calculated by multiplying the number of days between the valuation date and the last service date for which benefits have been paid by the daily benefit of the policy, where the daily benefit is adjusted by the expected salvage factor. This salvage factor represents the average portion of the full daily benefit expected to be paid.
An IBNR reserve is calculated to represent the liability for claims incurred but not yet reported as of the valuation date. This would include a case reserve portion for ongoing claims as well as nonrecurring claims for both known and unknown cases. Historical information is used to establish the amount of IBNR that develops after various points in time. This information is used to calculate an average IBNR per policy in-force. Adjustments are made to account for changes in durational mix and trend. These factors are then applied to the current in-force.
Adequacy of Liability for Other Policy Claims and Benefits Payable. Claims liabilities are recorded at amounts we estimate to be appropriate. Adjustments of prior year estimates may result from higher-than-expected medical costs or, as we have experienced during the last two years, a reduction in projected medical costs in the period an adjustment was made. Our reserve models in the aggregate have developed favorably in recent years, suggesting that the accrued liabilities calculated from the models were more than adequate to cover our ultimate liability for unpaid claims.
The following is a breakdown of the estimated redundancy (deficiency) by segment:
As discussed above, liability estimates are developed using actuarial principles and assumptions that consider a variety of issues. Changes in the completion and trend factors can have a significant effect on these liability
estimates. For example, in the Medical Segment, a $10.1 million redundancy in the 2002 reserves emerged in 2003 due to the moderation of the higher than expected claim trend (including severity and frequency) experienced in 2002 related to December 31, 2001 reserves. This ultimate claim trend with the benefit of hindsight and payment of the underlying claims was significantly lower than the historical claim trends that were used to establish the reserves. The $14.2 million redundancy in the 2003 reserves (which emerged in 2004) reflects the successful cancellation of unprofitable business in 2002 and the subsequent improvement in actual claims experience, as well as the improving claim trend. The $3.1 million redundancy in the 2004 reserves (which emerged in 2005) reflects the lower level of severity on fourth quarter 2004 incurreds.
In the Senior segment, we adjusted the continuance tables in 2002 to reflect the higher level of cognitive claims in our long-term care block. The redundancy, which emerged in 2003 and 2004, reflected the improvement in actual claim experience and the reduction in expected length of stay. The $2.6 million deficiency, which emerged in 2005, reflects an extension in the length of stay on our long-term care block coupled with an increase of policies on claim with inflation rider benefit protection.
Future Policy Benefits, Losses and Claims. Liabilities for future policy reserves for accident and health and traditional life business are based on the net level premium basis and estimates of future claims, investment yield, lapses using our experience and actuarial judgment with an allowance for possible future adverse deviations from expected experience. Interest rates used range from 4.5% to 6.125%. Original assumptions will continue to be used in subsequent accounting periods to determine changes in the liability for future policy benefits (often referred to as the “lock-in” concept) unless a premium deficiency exists. We review actual experience with respect to investment yields, mortality, morbidity, and lapses to help insure that existing liabilities, together with the present value of future premiums, will be sufficient to cover the present value of future benefits and maintenance costs and to recover unamortized acquisition costs.
Effective January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets issued by the Financial Accounting Standards Board (FASB), which provides that goodwill and intangibles with indefinite useful lives should not be amortized but instead be tested for impairment annually at the reporting unit level. In accordance with SFAS No. 142, we completed a transitional goodwill impairment test, which indicated that an impairment loss against our goodwill and other intangible assets was not required. Goodwill and intangibles with indefinite useful lives are tested for impairment on an annual basis and more often if indications of impairment exist. The estimated fair value of goodwill of a reporting unit is determined by applying the appropriate discount rates to estimated future cash flows for the reporting unit. The estimated fair value of licenses was determined by independent appraisals. The results of our analysis indicated that no reduction of goodwill or licenses was required in 2005 or 2004. A slight reduction of $0.1 million was made to the carrying value of licenses in 2003 due to the cancellation of business in certain unprofitable states.
Premium revenue recognition. Life insurance premiums are recognized as revenue when they become due. Health premiums are recognized as revenue over the terms of the policies. Revenue from interest sensitive contracts, principally universal life and annuity products, consist of mortality charges for the cost of insurance, contract administration charges, and surrender charges assessed against policyholder account balances during the period. Amounts received from interest sensitive contacts are not reflected in premium revenue; rather, such amounts are accounted for as deposits with the related liabilities included in future policy benefits, losses and claims.
Policies renew or lapse for a variety of reasons, due both to internal and external causes. We believe that our efforts to address any concerns or questions of our insureds in an expedient fashion help to ensure ongoing policy renewal. We work closely with our licensed agents, who play an integral role in obtaining policy renewals and communicating with our insureds. In 2005, we continued to experience high lapse rates on our renewal major medical business.
Insurance. We use a combination of insurance and self-insurance for a number of our risks including property, general liability, directors’ and officers’ liability, workers’ compensation, vehicle liability, and employee-related healthcare benefits. Liabilities associated with the risks that are retained are estimated by considering various historical trends and forward-looking assumptions. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends. Over the past couple of years, increases in the cost and availability of commercial insurance as a result of significant changes in the insurance market have impacted our insurance coverages. We have renewed most of our insurance policies for
2006. Other policies are up for renewal in mid-2006. We may not be successful in obtaining coverage on terms favorable to us or at all.
Corporate and Other - includes primarily interest income, interest expense, and corporate expenses of the holding company.
The financial information for the years ended December 31, 2005, 2004 and 2003, includes the operations of all our subsidiaries for the entire period with the exception of Pyramid Life.
Discontinued Operations. On March 31, 2003, we sold our indirect subsidiary, Pyramid Life Insurance Company, to the Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash before transaction costs of $2.2 million. Consistent with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, Pyramid Life was classified as held for sale as of December 31, 2002, and was measured at its fair value less costs to sell. A total loss from the sale of $13.8 million was recorded in 2002 and 2003 ($11.6 million in 2002 and $2.2 million in 2003.) The financial information for the year ended December 31, 2003 excludes the operations of Pyramid Life and the $2.2 million loss from the sale, net of taxes except where specifically noted. The results of operations and cash flows of Pyramid Life have been reported separately as discontinued operations of a subsidiary in our audited consolidated financial statements for 2003. See Note D. Discontinued Operations to our audited consolidated financial statements for further information.
Overview and Outlook for 2006. Net income for 2005 was $15.0 million or $0.44 per diluted share, compared to net income for 2004 of $19.1 million or $0.55 per diluted share.
For the year ended December 31, 2005, total net premiums decreased 0.6% to $427.9 million, compared to $430.2 million for 2004.
Medical premiums for 2005 were $221.0 million, compared to $247.0 million for 2004, a decrease of 10.5%. The decrease in medical premiums was primarily the result of a 10.0% decrease in major medical certificates in force from 66,724 at December 31, 2004 to 60,080 at December 31, 2005 due to continued high lapsation rates on both first year and renewal business.
Medical premiums increased 1.6% from the third quarter to the fourth quarter of 2005 primarily due to new business production. In mid-2005, we introduced our new Advantage Series of major medical products designed to offer customers a choice of benefit levels and prices. We now expect medical premiums to increase by approximately 5% on an annualized basis in 2006, the first annual increase in premiums since 2001.
In addition, we have begun marketing Medicare Part D prescription drug plans through our relationship with Coventry Health Care, Inc. and its affiliates. At January 31, 2006, we had approximately 10,000 insureds enrolled in these plans. We will participate in 25% of the risk on all Part D policies sold by our agents. Part D policies are effective January 1, 2006 and after.
Net investment income was $26.9 million for 2005, compared to $25.4 million for 2004, an increase of 5.9%. The increase was attributable to an increase in the overall book yield of our investment portfolio caused by the increased interest rate environment and the shift out of our convertible bond trading portfolios in 2005. The book yield of our available-for-sale investment portfolio at December 31, 2005 was 5.50% compared to a book yield of 5.34% at December 31, 2004.
Net realized gains decreased to $0.7 million for 2005, compared to $1.2 million for 2004. The $0.5 million decrease was primarily attributable to $0.7 million in realized losses on our trading portfolios in 2005 compared to $0.8 million in realized gains in 2004 partially offset by a $1.0 million increase in realized gains on our available-for-sale portfolios. The trading portfolios were liquidated in 2005.
Fee and other income decreased to $17.1 million for 2005, compared to $19.5 million for 2004, a decrease of 12.3%. This decrease was attributable to the decline in major medical policies and the associated policy fee income.
a decrease in salaries and benefits of approximately $1.0 million due to a reduced workforce;
a decrease in consulting expenses of approximately $1.0 million related to bringing our Cleveland data processing and programming back in-house from a third party vendor in the first half of 2004;
a decrease in actuarial consulting fees due to the appointment of a chief actuary in 2005; and
Interest expense and financing costs were $0.7 million in 2005, which was comparable to 2004. The higher effective interest rate in 2005 was offset by the reduction in debt outstanding.
A federal income tax expense of $5.4 million was recorded for 2005, which included a $1.8 million ($0.05 per share) federal income tax benefit related to the reduction of federal income tax reserves associated with the elimination of our untaxed policyholder surplus account exposure and recently closed tax years. In 2004, a federal income tax expense of $2.8 million was recorded, which included a $5.0 million reduction in the deferred tax valuation allowance. As a result of our continued profitability, a projection of continued taxable income in future periods, and the corresponding utilization of the net operating loss (NOL) carryforwards against 2004 taxable income, the deferred tax valuation allowance was reduced by $5.0 million, or $0.14 per share, in 2004. The effective tax rate, including the $1.8 million reduction of federal income tax reserves, was 26.2% of the income before federal income taxes for 2005. The effective tax rate for 2004, including the $5.0 million reduction to the deferred tax valuation allowance, was 12.6% of the income before federal income taxes. See Note I. Federal Income Taxes for a detailed reconciliation of our effective tax rate. We expect our effective tax rate will be 35% in 2006.
Medical premiums for 2004 were $247.0 million, compared to $305.4 million for 2003, a decrease of 19.1%. The decrease in medical premiums was primarily the result of a 20.7% decrease in major medical certificates in force from 84,167 at December 31, 2003 to 66,724 at December 31, 2004 due to higher lapsation rates. We believed that necessary rate increases implemented in excess of claim trends on certain blocks caused higher lapsation rates in 2003 and 2004. In addition, in 2004, we experienced higher than anticipated lapse rates on new business.
Fee and other income decreased to $19.5 million for 2004, compared to $28.9 million for 2003, a decrease of 32.6%. This decrease was attributable to the decline in major medical policies and the associated policy fee income as well as $5.7 million of fees in 2003 related to the transition processing of senior business for Pyramid Life. This transition agreement terminated on December 31, 2003.
Total benefits, claims, losses and settlement expenses decreased to $314.6 million for 2004, compared to $353.7 million for 2003, a decrease of 11.1%.
Senior and other benefits, claims, losses and settlement expenses were $138.5 million for 2004, compared to $127.5 million for 2003. The senior and other loss ratio was 75.6% for 2004, compared to 73.7% for 2003. The Medicare supplement loss ratio was higher than expected in 2004. The Medicare supplement loss ratio for 2004 was 71.9%, compared to 67.1% in 2003. The increase in the Medicare supplement loss ratio was caused by an increase in claim frequency on Medicare Part B physician claims. For 2004, rate increases on this block were approximately 5% based on the Company’s estimate of claims trends when the 2004 rate increases were filed. However, the 2004 claims trend was approximately 10%, resulting in the higher than expected loss ratio for the full year.
Income from continuing operations before federal income taxes, including the $3.1 million pre-tax charge from the California litigation settlements, was $21.9 million for 2004, compared to $26.0 million for 2003.
2004 included a significant reduction in our major medical claim reserves due to our declining block of major medical business in force and the decline in our claim inventory; and
an increase in 2005 operating cash flows of approximately $22.8 million due to the liquidation of the trading investment portfolios in September 2005. The trading portfolios were purchased in the fourth quarter of 2004 which resulted in a decrease in 2004 operating cash flows of approximately $22.7 million.
The increases previously mentioned were partially offset by the payment of the California litigation settlements in the first quarter of 2005.
Approximately 95.2% of our fixed maturities available-for-sale were of investment grade quality at December 31, 2005. In addition to the fixed maturities, we also had $26.8 million in cash and cash equivalents of which $6.1 million was restricted at December 31, 2005.
The total policy liabilities and benefits accrued were 89.5% of the total liabilities at December 31, 2005 compared to 87.3% at December 31, 2004.
Credit Agreement. At December 31, 2004, our credit facility consisted of a $4.0 million term loan A with National City Bank and a $9.0 million term loan B with CIT Group. The term loan A had quarterly principal payments of $250,000 through December 2005, $375,000 through December 2006, and a payment of $500,000 on March 1, 2007. The term loan B had quarterly principal payments of $312,500 through December 2004, $375,000 through December 2006, $562,500 through December 2007, and $1,250,000 through June 2008.
Changed the term loan B maturity date to March 1, 2008 from June 1, 2008;
Modified the “Minimum Consolidated Fixed Charge Coverage Ratio” to 1.50 to 1.00 from 1.15 to 1.00; and
The credit agreement contains various covenants including financial covenants relating to leverage, fixed charge coverage, risk-based capital of the regulated insurance subsidiaries, and tangible net worth. It also has a number of affirmative and negative covenants, including limitations relating to indebtedness, liens, mergers, purchases and sales of assets, investments, dividends, and stock repurchases. At December 31, 2005, we were in compliance with these covenants.
Off-Balance Sheet Arrangements. We do not have transactions or relationships with variable interest entities, and we do not have any off-balance sheet financing other than normal operating leases.
Represents estimated timing for fulfilling unfunded and callable capital commitments for investments in a limited partnership and two commercial mortgage loan trusts. Outstanding commitments are included in payments due in less than one year since the timing of funding these commitments cannot be reasonably estimated.
Estimated payments required under interest sensitive life and annuity contracts. The actual payments could vary based on changes in assumed crediting rates, persistency, and mortality levels.
Includes claims and benefits payable on our major medical, Medicare supplement, long-term care and other health care products.
In 2005, we committed to invest $10.0 million in a limited partnership, NYLIM Real Estate Mezzanine Fund II, L.P. Like the first fund, investments by this partnership are expected to consist primarily of a diversified pool of subordinated real estate mezzanine debt and sub-tranche loans with an expected concentration in office assets located in major metropolitan areas. The capital commitments can be called by the partnership at any time during the commitment period to fund working capital needs or to purchase new investments. Once the commitment period expires, we are under no obligation to fund the remaining unfunded commitment, but may elect to do so. The partnership has not made any capital calls on our $10.0 million commitment. Therefore, at December 31, 2005, we had outstanding unfunded and callable capital commitments totaling $10.0 million related to this limited partnership.
At December 31, 2005, we had a tax net operating loss, or NOL, carryforward of approximately $1.6 million for federal income tax purposes, which expires through 2021.
We determine whether a valuation allowance for our deferred tax asset is necessary based on an analysis of amounts recoverable in the statutory carryback period and available tax planning strategies. At December 31, 2005, we had a deferred tax asset of approximately $0.6 million established relating to the remaining NOL carryforwards of $1.6 million. We have determined that no valuation allowance is required due to our continued profitability and the projection of a continued pattern of taxable income sufficient to utilize these NOLs. During 2004, we evaluated and reduced our valuation allowance for deferred taxes by $5.0 million, or $0.14 per share, as a result of our continued profitability and the projection of a continued pattern of taxable income in future periods sufficient to utilize these net operating losses.
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2005, 2004 and 2003
Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003
We have audited the accompanying consolidated balance sheets of Ceres Group, Inc. (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three year period ended December 31, 2005. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting contained in Item 9A, “Controls and Procedures” of Ceres Group, Inc.’s (the “Company”) 2005 Annual Report on Form 10-K, that the Company maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
In our opinion, management’s assessment that Ceres Group, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also, in our opinion, Ceres Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission.
On January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets. Under the provisions of SFAS 142, goodwill is no longer ratably amortized into the income statement over an estimated life, but rather is tested at least annually for impairment. Intangible assets which have finite lives continue to be amortized over their estimated useful lives and also continue to be subject to impairment testing. Prior to the adoption of SFAS 142, goodwill was amortized on a straight-line basis over periods of 25 years or less. See Note H. Goodwill and Other Intangible Assets for a summary of our goodwill and other intangible assets.
Premiums and discounts arising from the purchase of mortgage-backed securities are amortized using the interest method over the estimated remaining term of the securities, adjusted for anticipated prepayments. The majority of our mortgage-backed securities are of high credit quality and therefore, the retrospective method is used to adjust the effective yield. Premiums and discounts on other debt instruments are amortized using the effective interest method over the remaining term of the security.
We regularly review our investment portfolio for factors that may indicate that a decline in fair value of an investment is other-than-temporary. Some factors considered in evaluating whether or not a decline in fair value is other-than-temporary include:
the duration and extent to which the fair value has been less than cost; and
A portion of the purchase price paid for Continental General Corporation was allocated to the value of business acquired for all long duration insurance contracts, including guaranteed renewable Medicare supplement and long-term care, based on the actuarially-determined present value of the expected pre-tax future profits from the business assuming a discount rate of 15.0%. In addition to the initial value of business acquired assigned to Continental General’s health business, certain of the Medicare supplement plans contained higher commission rates in the first six policy years as compared to the ultimate renewal commission rate. The initial deferral of these higher commission costs subsequent to the purchase date resulted in net additions to the original value of business acquired
Liabilities for unpaid life and accident and health claims (except long-term care disabled life reserves) consist of actual claims reported but not paid and estimates of claims incurred but not reported (IBNR). Liability estimates are developed using actuarial principles and assumptions that consider, among other things, historical claim payment patterns, claim inventory levels, network reimbursement changes, historical utilization trends, current levels of authorized inpatient days, other medical cost inflation factors, in-force levels, benefit design changes, seasonality, demographic mix change and expected costs to settle unpaid claims.
Although considerable variability is inherent in the computation of claim liabilities, management believes that the liabilities for unpaid life and accident and health claims are adequate. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known with such adjustments included in current operations.
Other policyholders’ funds consist of supplementary contracts without life contingencies, premiums and annuity considerations received in advance and remittance and items not allocated.
Statement of Position No. 97-3, Accounting by Insurance and Other Enterprises for Insurance-Related Assessments, provides guidance for determining when an insurance or other enterprise should recognize a liability for guaranty-fund and other insurance-related assessments and guidance for measuring the liability. At December 31, 2005 and 2004, the liability for guaranty-fund and other insurance-related assessments was $0.8 million and $1.0 million, respectively, and was included in other liabilities in our Consolidated Balance Sheets.
We account for our stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB Opinion No. 25), as amended. Accordingly, no compensation expense has been recognized for our stock option plans in our Consolidated Statements of Operations.
expect the adoption of this staff position to have a significant impact on our consolidated results of operations, cash flows or financial position.
Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted net income per share reflects the potential dilution that could occur if common stock equivalents were exercised and shared in the earnings of the Company. Only those potential common shares, which are dilutive, are included in the computation of diluted net income per share. See Note S. Computation of Net Income Per Common Share for further information.
The amortized cost and estimated fair value of available-for-sale securities as of December 31, 2005 by contractual maturity were as follows:
At December 31, 2005 and 2004, $5.6 million and $6.5 million, respectively, of cash was held for fully insured employer shared risk plans, which is restricted to use. We are entitled to investment income from these funds.
In 2003, we committed to invest $5.0 million in a limited partnership, NYLIM-GCR Fund I-2002, L.P. Investments by this partnership consisted primarily of a diversified pool of subordinated real estate mezzanine debt and sub-tranche loans with a concentration in office assets located in major metropolitan areas. These capital commitments could be called by the partnership at any time during the commitment period to fund working capital needs or to purchase new investments. During 2005, the partnership made capital calls on our limited partnership commitment of $1.6 million and made returns of capital totaling $1.3 million from the proceeds received from partial debt repayments. At December 31, 2005, we had outstanding unfunded capital commitments totaling $0.4 million related to this limited partnership. The commitment period on this limited partnership expired on December 31, 2005. Accordingly, we are under no obligation to fund the remaining unfunded commitment.
In 2005, we committed to invest $10.0 million in a limited partnership, NYLIM Real Estate Mezzanine Fund II, L.P. Like the first fund, investments by this partnership are expected to consist primarily of a diversified pool of subordinated real estate mezzanine debt and sub-tranche loans with an expected concentration in office assets located in major metropolitan areas. The capital commitments can be called by the partnership at any time
In addition, we committed to invest $5.0 million in the aggregate, in two commercial mortgage loan trusts in 2005. These investments are classified as mortgage loans as they represent investments where return is based solely on the mortgage loans and there are no other assets of the trusts. At December 31, 2005, we had outstanding unfunded commitments totaling $2.0 million related to these commercial mortgage loan trusts.
At December 31, 2005, we held no unrated bonds and approximately 4.8% of fixed maturity investments classified as available-for-sale were in less-than-investment grade securities. Approximately 4.2% of the fixed maturities available-for-sale were invested in BB rated subordinated non-agency residential and commercial mortgage-backed securities. These securities include jumbo residential mortgages and commercial mortgages with strong prepayment protection. We perform periodic evaluations of the relative credit standings of the issuers of the bonds held in our portfolio. We consider these evaluations in our overall investment strategy.
The following is a summary of available-for-sale securities that have been in a continuous unrealized loss position as of December 31, 2005:
We evaluate our investment policies consistent with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Trading securities are carried at fair value with unrealized gains and losses reported in our Consolidated Statements of Operations as part of net realized gains. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported in accumulated other comprehensive income, net of deferred federal income taxes. Investments in fixed and equity securities are designated at purchase as held-to-maturity, available-for-sale, or trading. The investment in the limited partnership is accounted for under the equity method of accounting and accordingly, the partnership earnings are included in net investment income. Investments in policy notes and mortgage loans are reported at cost which approximates fair value.
If management believes a decline in the value of a particular investment is temporary, the decline is reported as an unrealized capital loss, net of deferred federal income taxes, in Stockholders’ Equity. If the decline is expected to be other-than-temporary, the carrying value of the investment is written down and a realized capital loss is reported in our Consolidated Statements of Operations. In June 2003, we wrote down our holdings in American Airlines and Coastal Corp. to their then fair market value, recording a total realized pre-tax loss of $0.3 million. None of the investments above are delinquent or in default and there are no conditions present that indicate a high probability that all amounts will not be collected. Based on evaluation by both internal management along with external investment managers, including our ability to sell or hold the investments and the length of time and magnitude of the unrealized loss, management has determined that at December 31, 2005, none of the above investment values represent an other-than-temporary impairment.
On May 25, 2001, we entered into an agreement with Royalton Investors, LLC and Big T Investments, LLC, unaffiliated third parties, to sell our Cleveland headquarters. The transaction was effective July 31, 2001. The building was sold to Royalton Investors, LLC and Big T Investments, LLC for $16.0 million and concurrently we leased it back for a term of 15 years with four optional five-year extensions. A deferred gain of $7.2 million was recorded at the time of the sale. On October 19, 2004, Royalton Investors, LLC and Big T Investments, LLC sold the building and assigned its interest as lessor under the lease agreement dated July 31, 2001, to Strongsville Corporate Center Acquisitions, LLC, an unaffiliated third party. At December 31, 2005 and 2004, the unamortized deferred gain related to the sale of the building was $5.3 million and $5.8 million, respectively, and was included with other liabilities in our Consolidated Balance Sheets. The amortization of the deferred gain was included in net realized
gains in our Consolidated Statements of Operations and was $0.5 million for the year ended December 31, 2005 and $0.4 million for each of the years ended December 31, 2004 and 2003.
Rent expense for our Cleveland headquarters was approximately $1.8 million for each of the years ended December 31, 2005, 2004 and 2003. Future rent payments for the Cleveland headquarters and all other operating leases are as follows:
Goodwill and intangibles with indefinite useful lives are tested for impairment on an annual basis as of September 30 and more often if indications of impairment exist. The estimated fair value of goodwill of a reporting unit is determined by applying the appropriate discount rates to estimated future cash flows for the reporting unit. The estimated fair value of licenses was determined by independent appraisals. The results of our analysis indicated that no reduction of goodwill or licenses was required in 2005 or 2004. A slight reduction of $0.1 million was made to the carrying value of licenses in 2003 due to the cancellation of business in certain unprofitable states.
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2005 and 2004 are presented below:
At December 31, 2005 and 2004, we had a federal income tax receivable, which is included in other assets on our Consolidated Balance Sheets, of $1.0 million and $3.7 million, respectively.
At December 31, 2004, management was evaluating any actions that would enable us to provide current distributions, thus reducing or eliminating the PSA balance. At the close of the suspension period, the previous ordering rules will be reinstated. We previously established a general tax contingency reserve for the untaxed PSA balance exposure because distribution prior to the end of the suspension period was not certain.
On February 24, 2005, Central Reserve received approval from the Ohio Department of Insurance to pay an extraordinary dividend to Ceres Group. Accordingly, we made a $2.9 million tax free distribution from the PSA and reduced the corresponding tax contingency reserve by $1.0 million in 2005.
The above table indicates a net redundancy in reserves (“Incurred claims and claims adjustment expenses, net of reinsurance for prior years” divided by “Adjusted net beginning balance”) of 0.5% in 2004, 19.0% in 2003 and 10.9% in 2002.
emerging profit stream of the in force business. This reinsurance agreement was terminated effective June 30, 2005 by mutual consent of the parties.
In February 1999, Continental General entered into a reinsurance agreement with Hannover, under which Hannover reinsured 50% of all insurance business in force at Continental General for a ceding allowance of $13.0 million. The ceding allowance is being accounted for as a deferred reinsurance gain in the accompanying audited consolidated financial statements and is being amortized into income over the duration of the underlying block of business. Various assets, primarily comprised of fixed income securities with a market value of $188.4 million, were transferred from Continental General to Hannover for the policy liabilities assumed by Hannover.
Effective August 1, 1998, Central Reserve entered into a reinsurance treaty with United Benefit Life, a life and accident and health insurer in Texas. Under the terms of the treaty, Central Reserve agreed to assume 100% of United Benefit Life’s block of business, until such time as profits earned by Central Reserve on the assumed block reached a contractual threshold, which approximated $20.0 million of pre-tax income. Central Reserve paid to United Benefit Life a $20.0 million ceding allowance in connection with this transaction.
In connection with the United Benefit Life reinsurance treaty, Central Reserve ceded 80% of the business in force on August 1, 1998 to Hannover, thereby retaining a net risk of 20%. Additionally, Central Reserve ceded 50% of the policies written by United Benefit Life subsequent to August 1, 1998 and reinsured by Central Reserve to Hannover. This treaty provided Central Reserve an initial ceding allowance of $20.0 million, which was being accounted for as a deferred reinsurance gain in the accompanying audited consolidated financial statements, and was amortized into income over the duration of the underlying block of business. In 1999, Central Reserve acquired through foreclosure the stock of United Benefit Life.
On December 31, 2002, United Benefit Life and Hannover entered into an agreement, which amended these reinsurance arrangements. For claims incurred June 30, 2002 and prior, Hannover continues to be responsible for its quota share percentage. For claims incurred July 1, 2002 and subsequent, Central Reserve retains 100% of the risk.
In the ordinary course of business, the Company maintains other reinsurance arrangements with other insurers. These arrangements are designed to limit the maximum amount of exposure that the Company retains on a given policy. At December 31, 2005, for ordinary and group life claims, Continental General’s maximum retention is $125,000 and Central Reserve’s maximum retention is $50,000 with no retention maintained over age 70. For accident and health claims, maximum retention on individual claims is $500,000.
The nature of our business subjects us to a variety of legal actions (including class actions) and claims relating to such things as denial of healthcare benefits, premium rate increases, termination of coverage, claims administration, our relationship with the associations that market our products, and alleged violations of state and federal statutes.
We are involved in various other legal and regulatory actions occurring in the normal course of business that could result in significant liabilities and costs. Based on current information, including consultation with outside counsel, we believe that any ultimate liability that may arise from any of these other actions would not materially affect our audited consolidated financial position or results of operations. However, we cannot predict with certainty
the outcome of any of these actions against us or the potential costs involved. Our evaluation of the likely impact of any of these actions could change in the future and an unfavorable outcome in any case could have a material adverse effect on our consolidated financial position, results of operations or cash flows of a future period.
Effective May 2, 2005, we entered into an amendment to the credit facility in order to permit the stock repurchase program and to allow National City to assume the term loan B. The amendment:
Revised the amortization of term loan B so that term loan B has quarterly payments of $687,500 (previously $375,000) from June 2005 through March 2006, $375,000 from June 2006 through December 2006, $562,500 from March 2007 through December 2007, and $1,250,000 in March 2008;
Permitted the $10 million stock repurchase program (announced on May 4, 2005).
The credit agreement contains various covenants including financial covenants relating to leverage, fixed charge coverage, risk-based capital of regulated insurance subsidiaries and tangible net worth. It also has a number of affirmative and negative covenants, including limitations relating to indebtedness, liens, mergers, purchases and sales of assets, investments, dividends and stock repurchases. At December 31, 2005, we were in compliance with these covenants.
On May 4, 2005, our Board of Directors authorized the repurchase of up to $10 million of our outstanding common stock in the open market or in private transactions utilizing a $10 million extraordinary dividend from our Central Reserve subsidiary.
In 1999, 372 employees each received 1,000 common stock options under the 1998 Employee Stock Option Plan. A second grant was made for new employees hired from January 1, 1999 through September 30, 1999, and still employed as of December 31, 1999. Under this second grant in 2000, 75 employees each received 1,000 common stock options. Each grant vests after three years and expires ten years from the date of the grant, with accelerated vesting upon an event of a change in control. We terminated this plan in December 2000. At December 31, 2005, there were options outstanding under the plan to purchase 285,000 shares.
In 1998, pursuant to the 1998 Key Employee Share Incentive Plan, we granted common stock options to certain key employees. In 1999 through 2004, we granted additional common stock options to certain employees under the 1998 Key Employee Share Incentive Plan. In general, such grants vest over three years and expire ten years from the date of the grant. In the event of a change in control, all options granted immediately vest and become exercisable in full. On May 19, 2004, our shareholders adopted an amendment to the plan, to increase the total number of shares of our common stock reserved for issuance under the plan by an additional 1,000,000 shares to a total of 3,000,000 shares of our common stock. The adopted amendments to the plan also allowed for the grant of stock and restricted stock awards in addition to stock options and stock appreciation rights to officers, non-employee directors, consultants and advisors. At December 31, 2005, there were options outstanding under the plan to purchase 1,204,267 shares.
Exercise prices for options outstanding at December 31, 2005 ranged from $1.95 to $9.50. A summary of the options by range of exercise price is as follows:
In 2005 and 2004, we issued 285,166 and 61,931 shares of our common stock, respectively, to various investors upon the cashless exercise of certain warrants that were issued in July 1998. These warrants, which expired in 2005, were fully exercisable for 3,335,575 and 287,960 shares of our common stock in 2005 and 2004, respectively. On December 23, 2003, we issued a warrant to purchase 25,000 shares of our common stock at an exercise price of $5.27 per share to a current marketing agency of the Company which exchanged its QQLink stock for cash and the warrant. All of these warrants, which expire in 2008, were outstanding at December 31, 2005.
We also have a 2000 Agent Stock Purchase Plan similar to the employee plan under which certain of our agents may purchase shares of our common stock at the same discount from fair value. The agent stock purchase plan does not qualify as an employee stock purchase plan within the meaning of Section 423 of the Code. In 2005 and 2004, 20,850 and 22,265 shares, respectively, had been issued under the agent plan. There are 1,000,000 shares of common stock reserved for issuance in the aggregate under both plans. Both of the plans will terminate when all of the shares reserved for issuance under the plans have been purchased unless sooner terminated by our Board.
Based on the methodology and assumptions delineated above, the weighted average fair value of options was $1.51, $1.50, and $1.51 per share for 2005, 2004 and 2003, respectively. There was no significant pro forma impact on net income and net income per share of stock-based compensation under the fair value method for the years ended December 31, 2005 and 2004. The pro forma impact for the year ended December 31, 2003 would be to increase net income by $0.8 million or $0.02 per share due to the forfeiture of options resulting from employee terminations.
The NAIC also has risk-based capital (RBC) requirements for life and health insurers to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks associated with asset quality, mortality and morbidity, asset and liability matching and other business factors. The RBC formula is used by state insurance regulators to monitor trends in statutory capital and surplus for the purpose of initiating regulatory action. We calculated the risk-based capital for its insurance subsidiaries as of December 31, 2005 using the applicable RBC formula. Based on these calculations, the RBC levels of each of our insurance subsidiaries at December 31, 2005 exceeded the levels required by regulatory authorities.
Basic and diluted weighted average shares of common stock are as follows:
We sponsor the Ceres Group, Inc. 401(k) Plan, a defined contribution 401(k) savings plan (the Plan). Effective January 1, 2001, the Plan was amended to increase the employer match (Company Match Contribution) to 50% of the participant’s contributions subject to a maximum of 6% of the participant’s salary.
A participant’s interest in the Company Match Contribution, Stock Match Contribution and Profit Sharing Contribution allocated to the participant’s account becomes vested over a five-year graded vesting schedule with 100% vesting over five years. Our total matching contributions were approximately $520,000 for 2005, $506,000 for 2004, and $504,000 for 2003.
Investment securities - Fair value for fixed maturity and equity securities is based on quoted market prices, where available. For fixed maturity securities not actively traded, fair value is estimated using values obtained from independent pricing services.
The following is a summary of quarterly results of operations for the years ended December 31, 2005 and 2004.
Includes the parent company’s equity of regulated and non-regulated subsidiaries, which is eliminated in consolidation.