Our executive offices are located in Rye Brook, New York. Marketing and professional staff for our U.S. insurance subsidiaries occupy space in Lake Mary, Florida. Our Canadian operations are located in Mississauga, Ontario, Canada. Our Administrative Services operations occupy office space in Pensacola and Weston, Florida. Our Medicare Advantage operations occupy office space in Houston and Beaumont, Texas. We lease all of the approximately 295,000 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 or Penncorp Life (Canada) is the named lessee on approximately 69 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 16-Commitments and Contingencies in our consolidated financial statements included in this 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, 2005. We derived the selected financial data presented below for the five fiscal years ended December 31, 2005 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 discussion and analysis presents a review of the Company as of December 31, 2005 and its results of operations for the fiscal years ended December 31, 2005, 2004 and 2003.
Inter-segment revenues and expenses are reported on a gross basis in each of the operating segments but eliminated in the consolidated results. These inter-segment revenues and expenses affect the amounts reported on the individual financial statement line items, but are eliminated in consolidation and do not change income before taxes. The significant items eliminated include inter-segment revenue and expense relating to services performed by the Senior Administrative Services segment for our other segments and interest on notes payable or receivable between the Corporate segment and the other operating segments.
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, claims in the course of settlement and incurred but not reported claims. Many factors can affect these reserves and liabilities, such as economic and social conditions, inflation, hospital and pharmaceutical costs, changes in doctrines of legal liability, premium rate increases and extra contractual damage awards. Therefore, the reserves and liabilities we establish are based on extensive estimates, assumptions and prior years’ statistics. When we acquire other insurance companies or blocks of insurance, our assessment of the adequacy of acquired policy liabilities is subject to similar estimates and assumptions. Establishing reserves involves inherent uncertainties, and it is possible that actual claims
could materially exceed our reserves and have a material adverse effect on our results of operations and financial condition. Our net income depends significantly 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.
The cost of acquiring new business, principally non-level commissions, agency production, policy underwriting, policy issuance, and associated costs, all of which vary with, and are primarily related to the production of new and renewal business, are deferred. For interest-sensitive life and annuity products, these costs are amortized in relation to the present value of expected gross profits on the policies arising principally from investment, mortality and expense margins in accordance with FAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments”. 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.” Amortization of deferred acquisition costs for Medicare Supplement policies is periodically adjusted for significant changes in benefit structures and differences in assumed premium rates on a prospective basis, consistent with assumptions used in the related reserves for future policy benefits. During 2005, the Company determined that the historical actual approved rate increases and persistency were higher than assumed levels. The prospective unlocking of these assumptions resulted in a slower amortization of Medicare Supplement deferred acquisition costs.
The determination of expected gross profits for interest-sensitive products is an inherently uncertain process that relies on assumptions including projected interest rates, the persistency of the policies issued as well as anticipated benefits, commissions and expenses. It is possible that the actual profits from the business may vary materially from the assumptions used in the determination and amortization of deferred acquisition costs. Deferred policy acquisition costs are written off to the extent that it is determined that future policy premiums and investment income or expected gross profits would not be adequate to recover the unamortized costs.
During the year ended December 31, 2005, we released approximately $1.6 million of valuation allowances on tax capital loss carryforwards as a result of investments gains taken during that period. As of December 31, 2005 we have $2.1 million of valuation allowances on tax capital loss carryforwards remaining.
We believe that attractive growth opportunities exist in providing a range of products, particularly health insurance, to the growing senior market. At present, more than 44 million Americans are eligible for Medicare, the Federal program that offers basic hospital and medical insurance to people over 65 years old plus certain disabled people under the age of 65. The standard Medicare coverage does not cover prescription drugs except as required in the course of a covered hospital stay. According to the U.S. Census Bureau, more than 2 million Americans turn 65 in the United States each year, and this number is expected to grow as the so-called baby boomers begin to turn 65. In addition, many large employers who traditionally provided medical and prescription drug coverage to their retirees have begun to curtail these benefits. Finally, the passage of the Medicare Modernization Act of 2003 (the “MMA”) demonstrated the Federal government’s commitment to expand the healthcare options available to Medicare beneficiaries through the expansion of Medicare managed care plans (“Medicare Advantage”) and the authorization of a subsidized prescription drug insurance benefit pursuant to Part D (“Part D”). Taken together, these conditions present significant opportunities for us to increase the sale of our products.
During the third and fourth quarters of 2005, we experienced Medicare Supplement claim costs that were higher than the comparable quarters of the prior year, and higher than we had anticipated. During the fourth quarter of 2005, the Company recorded a pre-tax adjustment that increased incurred claims by $9.9 million, or $0.11 per diluted share after tax. 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.
On June 22, 2005, we issued 2.0 million shares of our common stock at a price of $23.61 per share, in a public offering pursuant to a 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 under the same shelf registration by Capital Z Financial Services Fund II, L.P. and its affiliates (“Capital Z”), our largest shareholder. 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. See “Shelf Registration and Equity Offering” in the Liquidity section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Effective April 1, 2003, we entered into agreements to recapture approximately $48 million of Medicare Supplement business that had previously been reinsured to Transamerica Occidental Life Insurance Company, Reinsurance Division under two quota share contracts. No ceding allowance was paid in the recapture and we currently retain 100% of the risks on the $48 million of Medicare Supplement business. There was no gain or loss reported on these recapture agreements.
Net income for 2005 declined 16% to $53.9 million, or $0.91 per diluted share, compared to $63.9 million, or $1.13 per diluted share in 2004. Net income for 2005 was affected by higher claim costs and reserve adjustments in our Medicare Supplement business, which reduced net income by $6.3 million, or $0.11 per diluted share, 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 which reduced net income by $1.7 million, or $0.03 per diluted share. Additionally, net income for 2005 was reduced by after-tax expenses of $8.1 million, or $0.14 per diluted share, relating to the implementation of our Part D program and Medicare Advantage growth initiatives. These items are offset, in part, by the growth in our Senior Managed Care business, which added $11.5 million, or $0.21 per diluted share, in 2005.
Net income for 2005 includes realized investment gains, net of tax, of $5.4 million, or $0.09 per diluted share, which reflects the benefit from a $1.6 million release of a tax valuation allowance relating to capital loss carryforwards. The realized investment gains during 2005 were generated as we took advantage of the tightening of the yield curve and sold longer duration investments. Net income for 2004 includes realized investment gains, net of tax, of $6.9 million, or $0.12 per diluted share.
Our overall effective tax rate was 34.3% for 2005, reflecting the release of the valuation allowance noted above, and 33.8% for 2004.
Our Specialty Health Insurance segment income of $26.9 million for 2005 improved by 2% compared to $26.3 million for 2004, primarily as a result of the underwriting fees earned on the new reinsurance arrangement with PharmaCare Re and the strengthening of the Canadian dollar, partially offset by higher claim costs.
Net income for 2004 increased 48% to $63.9 million, or $1.13 per share, compared to $43.1 million, or $0.78 per share in 2003. During 2004, we recognized realized gains, net of tax, of $6.9 million, or $0.12 per share, compared to realized gains, net of tax, of $1.3 million, or $0.02 per share in 2003. The realized gains in 2004 were generated at Penncorp Life (Canada) as a result of the sale of investments to fund the dividend of approximately $19.9 million paid to the parent company during the first quarter of 2004 and the tax payments made during the first quarter of 2004 relating to 2003 taxable income. See “Liquidity and Capital Resources-Obligations of the Parent Company to Affiliates” for additional information regarding the dividend. Additionally, during the third quarter of 2004, we took the opportunity to realize investment gains as interest rates dropped during the year to make efficient use of our tax capital loss carryforwards. We believe that further opportunity for generating realized investment gains is limited. Our overall effective tax rate was 33.8% for 2004 and 35.2% for 2003.
Our Senior Managed Care-Medicare Advantage segment includes the results of Heritage and our other initiatives in Medicare managed care, including our Medicare Advantage private fee for service plans, for the seven months since acquisition or inception.
Our Specialty Health Insurance segment results improved by $1.9 million, or 8%, to $26.3 million in 2004 compared to 2003, primarily as a result of improvement in loss ratios, as well as the strengthening of the Canadian dollar, relative to the U.S. dollar.
(1) In addition to segment income, we also evaluate the results of our Medicare Advantage segment based on earnings before interest, taxes, depreciation and amortization (“EBITDA”). EBITDA is a common alternative measure of performance used by investors, financial analysts and rating agencies. It is also a measure that is included in the fixed charge ratio required by the covenants for our outstanding bank debt. Accordingly, these groups use EBITDA, along with other measures, to estimate the value of a company and evaluate the Company’s ability to meet its debt service requirements. While we consider EBITDA to be an important measure of comparative operating performance, it should not be construed as an alternative to segment income or cash flows from operating activities (as determined in accordance with generally accepted accounting principles).
(2) Includes results for the seven months since acquisition or inception.
In August 2005, SelectCare of Oklahoma (“SCOK”), a wholly owned subsidiary of Heritage, began enrolling members in a Medicare Advantage special needs program that provides health care management services to Medicare eligible seniors in nursing home facilities in ten counties in Oklahoma.
Heritage participates in the profits from the two affiliated IPA’s that receive capitated payments from SCOT. As of December 31, 2005, the affiliated IPA’s managed the care for approximately 15,795 SCOT members. During 2005, the IPA’s earned $12.0 million on $118.2 million in revenues received from SCOT. For the seven months since the acquisition of Heritage in 2004, the IPA’s earned $5.6 million on $58.5 million in revenues received from SCOT.
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.
Commissions and general expenses increased by $11.8 million, or 11%, compared to 2004. The following table details the components of commission and other operating expenses:
The change in deferred acquisition costs was $11.0 million more in 2004, compared to the amount in 2003. $3.7 million of this change is due to the Pyramid Life business being included for a full year in 2004 compared to nine months in 2003. The balance of $7.3 million is a result of growth and the increased retention of the Medicare Supplement business.
The ratio of commissions to gross premiums decreased to 15.0% during 2004, from 15.3% in 2003, as a result of the growth in the in force renewal premium from better persistency and rate increases. Other operating costs as a percentage of gross premiums increased to 12.7% during 2004 from 12.0% in 2003. Commission and expense allowances received from reinsurers as a percentage of the premiums ceded also decreased to 22.4% during 2004 from 24.6% in 2003, primarily due to the reduction in new business ceded and the affects of normal lower commission allowances on an aging base of renewal ceded business.
Our Specialty Health Insurance segment income improved by 2%, to $26.9 million for 2005, compared to $26.3 million for 2004, primarily as a result of the underwriting fees earned on the new reinsurance arrangement with PharmaCare Re and the strengthening of the Canadian dollar, partially offset by higher claim costs. The operations of Penncorp Life (Canada), which are included in our Specialty Health segment results, are transacted using the Canadian dollar as the functional currency. The Canadian dollar strengthened relative to the U.S. dollar in 2005. The average conversion rate increased 7%, to C$0.8256 per U.S.$1.00 for 2005, from C$0.7689 per U.S.$1.00 for 2004. This strengthening added approximately $1.0 million of pre-tax income to the Specialty Health segment results compared to 2004. See discussion below under the heading “Quantitative and Qualitative Disclosures about Market Risk” for additional information.
Net investment income increased by approximately $0.8 million, or 3%, compared to 2004. The increase is due primarily to investing cash that we had been accumulating in anticipation of rising interest rates.
The increase in deferred acquisition costs was $0.5 million more in 2005 than the increase in 2004, primarily as a result of the increase in commissions and acquisition costs for our Canadian business.
Our Specialty Health Insurance segment results improved by $1.9 million, or 8%, to $26.3 million in 2004 compared to 2003, primarily as a result of improvement in loss ratios, as well as the strengthening of the Canadian dollar. The operations of Penncorp Life (Canada), which are included in our Specialty Health segment results, are transacted using the Canadian dollar as the functional currency. The Canadian dollar strengthened relative to the U.S. dollar in 2004. The average conversion rate increased 8%, to C$0.7689 per U.S.$1.00 for 2004, from C$0.7141 per U.S.$1.00 for 2003. This strengthening added approximately $1.0 million of pre-tax income to the Specialty Health segment results for 2004, compared to 2003. See discussion below under the heading “Quantitative and Qualitative Disclosures about Market Risk” for additional information.
Revenues. Net premiums for the Specialty Health Insurance segment increased by $2.9 million, or 2%, compared to 2003. Approximately, $1.9 million of the increase relates to additional long term care and major medical premiums from the inclusion of the results of operations of Pyramid Life business for a full year in 2004 compared to only nine months in 2003. The balance of the increase is due to rate increases, offset by a reduction in long term care premium as a result of our decision to discontinue marketing that product, beginning in late 2003. Canadian business accounted for approximately 40% of the net premiums of this segment in 2004 and 38% of the net premiums in 2003, the increase attributed to the stronger Canadian dollar.
Included in unaffiliated revenue are fees received to administer certain business of our insurance subsidiaries that is 100% reinsured to an unaffiliated reinsurer, which amounted to $4.1 million in the year ended December 31, 2005, $5.3 million for 2004 and $7.4 million for 2003. These fees, together with the affiliated revenue, were eliminated in consolidation.
Our contractual obligations as of December 31, 2005, are shown below.
(1) These obligations include contractual interest and the table reflects scheduled maturities for contractual obligations existing as of December 31, 2005 and does not include any obligations arising as a result of our shelf registration.
(2) Trust preferred securities all have scheduled maturities of 30 years from the dates of issue; however they are all callable by us five years from the date of issuance. For the purpose of this schedule, we have assumed that the securities will be redeemed at their scheduled maturities, not the call date. Accordingly, the obligation for repayment of principal relating to these is included in the more than 5 Years column. The trust preferred securities all have floating rate coupons, except for $15 million which has a fixed rate through its no call period and then converts to a floating rate. Additionally, we have entered into separate swap agreements whereby we pay fixed rates on $35 million of the trust preferred securities through the no call period. We did not project future changes in the base interest rates. For the purpose of this schedule, we applied the base rate in effect at December 31, 2005 to all future periods. Additionally, we assumed that, upon the expiration of the swap agreements and the fixed rate, the rate for the respective trust preferred securities adjusted to a variable rate using the current base rate.
(3) Includes scheduled amortization through final maturity in 2009. The loan payable is floating rate debt. We did not project future changes in the base interest rates. For the purpose of this schedule, we applied the rate in effect at December 31, 2005 to all future periods.
(4) Includes minimum obligations on our data center outsourcing contract, as well as our outsourced administrative service contracts for certain portions of our Part D business and our HMO product (See Outsourcing Arrangements above). Our actual monthly payments are affected by the amount of service provided under the contract and the levels of business administered and currently the actual payments exceed the minimums stated in the contracts. Therefore our actual payments will exceed the amounts presented in the above schedule based upon future usage and premium amounts.
Our capital is used primarily to support the retained risks and growth of our insurance company subsidiaries and health plan 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 availability of our $15.0 million revolving credit facility, the expected cash flows of our administrative service company and management service organizations (acquired in the acquisition of Heritage) and the surplus note interest and principal payments from American Exchange (as explained below) can support our parent company obligations for the foreseeable
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. During the fourth quarter of 2005, the Company was in default with a covenant regarding limitations on treasury stock repurchases. 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.
The Company made regularly scheduled principal payments of $5.3 million during the year ended December 31, 2005, $5.7 million during 2004 and $8.7 million during 2003 in connection with its credit facilities. The Company paid interest of $5.5 million during 2005, $3.1 million during 2004 and $2.7 million during 2003 in connection with its credit facilities. Due to the variable interest rate for this Credit Agreement, the Company would be subject to higher interest costs if short-term interest rates rise.
On March 31, 2003, the Credit Facility issued in 1999 was repaid from the proceeds of the Credit Agreement obtained in connection with the acquisition of Pyramid Life. The early extinguishment of this debt resulted in the immediate amortization of the related capitalized loan origination fees, resulting in a pre-tax expense of approximately $1.8 million.
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 FIN 46R, we have deconsolidated the trusts.
(3) Effective April 29, 2004, we entered into a swap agreement whereby it will pay a fixed rate of 6.98% in exchange for a floating rate of LIBOR plus 395 basis points. The swap contract expires in October 2008.
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 date of issuance, and payable quarterly in arrears at a floating rate equal to the three-month LIBOR plus a spread. The floating rate resets quarterly and is limited to a maximum of 12.5% during the first sixty months. Due to the variable interest rate for these securities, we may be subject to higher interest costs if short-term interest rates rise. The Capital Securities are subject to mandatory redemption upon repayment of the Junior Subordinated Debt at maturity or upon earlier redemption. The Junior Subordinated Debt is unsecured and ranks junior and subordinate in right of payment to all present and future senior debt of our parent holding company and is effectively subordinated to all existing and future obligations of the Company’s subsidiaries. Our parent holding company has the right to redeem the Junior Subordinated Debt after five years from the date of issuance.
In January 2002, our parent company issued an $18.5 million, 8.5% debenture to Pennsylvania Life in connection with the transfer of the business of Pennsylvania Life’s Canadian Branch to Penncorp Life (Canada). The debenture has been repaid in full as of December 31, 2005. Our parent company repaid principal of $4.5 million in 2002, $7.1 million in 2003, $3.5 million in 2004 and $3.4 million in 2005. Our parent holding company paid $0.3 million in interest on these debentures during 2005, $0.5 million in 2004 and $1.0 million in 2003. The interest on these debentures is eliminated in consolidation. Dividends from Penncorp Life (Canada) funded all the interest and principal paid on the debenture.
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.
The issues affecting the profitability of the Company during the third and fourth quarters of 2005, as discussed in the Managements’ Discussion and Analysis, do not materially affect the sources of liquidity to the Parent Company as discussed below. The increase in the Medicare Supplement loss ratios is confined to insurance companies that we do not look to for significant cash flow. The increased amortization of deferred acquisition cost and present value of future profits is a non-cash item.
Senior Managed Care Company. Liquidity for our managed care company is measured by its ability to pay operating expenses and pay dividends to our parent company. The primary source of liquidity is management fees for administration of SCOT and services provided to the IPA’s. Dividend payments by SCOT to Heritage are subject to the approval of the insurance regulatory authorities of the state of Texas, SCOT’s state of domicile. SCOT is not able to pay dividends during 2006 without prior approval. However, we believe that the sources of cash to our managed care holding company exceed scheduled uses of cash which will result in funds available to dividend to our parent holding company. We measure the ability of the senior managed care holding company to pay dividends based on its EBITDA. EBITDA for our senior managed care holding company was $30.8 for the year ended December 31, 2005 and $12.3 million for the seven months since its acquisition on May 28, 2004 through December 31, 2004.
Penncorp Life (Canada) Dividends. Penncorp Life (Canada) is a Canadian insurance company. Canadian law provides that a life insurer may pay a dividend after such dividend declaration has been approved by its board of directors and upon at least 10 days prior notification to the Superintendent of Financial Institutions. Such a dividend is limited to retained net income (based on Canadian GAAP) for the preceding two years, plus net income earned for the current year. In considering approval of a dividend, the board of directors must consider whether the payment of such dividend would be in contravention of the Insurance Companies Act of Canada. During 2005, Penncorp Life (Canada) paid dividends of C$6.4 million (approximately US$5.4 million) to Universal American. During 2005, Penncorp Life (Canada) became subject to a 5% withholding tax on dividends paid to Universal American. The withholding tax paid on the dividends from Penncorp Life (Canada) in 2005 was C$0.2 million (approximately US$0.2 million). During the first quarter of 2004, Penncorp Life (Canada) paid dividends of C$26.7 million (approximately US$20.0 million) to Universal American, relating to 2003 net income. The amount of the dividend was larger than normal due to a benefit received by Penncorp Life (Canada) from an actuarial experience study that allowed Penncorp Life (Canada) to reduce its policy benefit reserves at December 31, 2003 on a Canadian GAAP basis. The actuarial experience study did not have an impact on Penncorp Life (Canada)’s policy benefit reserves on a U.S. GAAP basis. During the remainder of 2004, Penncorp Life (Canada) paid dividends totaling C$7.2 million (US$5.6 million) relating to net income for 2004. Penncorp Life (Canada) paid dividends to Universal American totaling C$11.2 million (US $8.1 million) during 2003. Due to limitations resulting from the timing of prior dividend payments by PennCorp (Canada), we do not anticipate that Penncorp (Canada) will be able to pay dividends in 2006, without prior approval.
Our parent holding company made capital contributions to American Exchange amounting to $17.8 million during 2004. In March 2004, Pennsylvania Life declared and paid a dividend in the amount of $10.6 million to American Exchange. American Exchange made capital contributions of $12.0 million to Union Bankers, $8.2 million to American Pioneer and $7.0 million to American Progressive during the year ended December 31, 2004.
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 and Canada, 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.
Some of our life insurance and annuity policies are interest-sensitive in nature. The amount of surrenders and withdrawals is affected by a variety of factors such as credited interest rates for similar products, general economic conditions and events in the industry that affect policyholders’ confidence. Although the contractual terms of substantially all of our in force life insurance policies and annuities give the holders the right to surrender the policies and annuities, we impose penalties for early surrenders. As of December 31, 2005 we held reserves that exceeded the underlying cash surrender values of our net retained in force life insurance and annuities by $33.8 million. Our insurance subsidiaries, in our view, have not experienced any material changes in surrender and withdrawal activity in recent years.
As of December 31, 2005, our insurance company subsidiaries held cash and cash equivalents totaling $124.9 million, as well as fixed maturity securities that could readily be converted to cash with carrying values (and fair values) of $1.3 billion.
Our health plan affiliates are also required to maintain minimum amounts of capital and surplus, as required by regulatory authorities and is also subject to RBC requirements. At December 31, 2005, the
Penncorp Life (Canada) reports to Canadian regulatory authorities based upon Canadian statutory accounting principles that vary in some respects from U.S. statutory accounting principles. Penncorp Life (Canada)’s net assets based upon Canadian statutory accounting principles were C$62.3 million (US$53.6 million) as of December 31, 2005 and were C$57.4 million (US$47.8 million) as of December 31, 2004. Net income based on Canadian generally accepted accounting principles was C$11.3 million (US$9.3 million) for the year ended December 31, 2005, C$8.4 million (US$6.5 million) for 2004 and C$34.4 million (US$24.6 million) for 2003. Penncorp Life (Canada) maintained a Minimum Continuing Capital and Surplus Requirement Ratio (“MCCSR”) in excess of the minimum requirement at December 31, 2005.
At December 31, 2005, the Company (exclusive of American Exchange and its subsidiaries and PennCorp Life) had net operating loss carryforwards of approximately $3.8 million (including $2.8 million from Heritage) that expire in 2015 and 2024 and capital loss carryforwards of $0.8 million that expire in 2007. At December 31, 2005, the Company also had an Alternative Minimum Tax (AMT) credit carryforward for Federal income tax purposes of approximately $0.3 million that can be carried forward indefinitely. At December 31, 2005, American Exchange and its subsidiaries had net operating loss carryforwards, most of which relate to the companies acquired in 1999 (and were incurred prior to their acquisition), of approximately $0.5 million that expire in 2017. At December 31, 2005, American Exchange and its subsidiaries also had capital loss carryforwards of $5.2 million that expire in 2007 and an AMT credit carryforward for Federal income tax purposes of approximately $0.9 million that can be carried forward indefinitely. As a result of changes in ownership of the Company in July 1999, the use of most of the loss carryforwards of the Company are subject to annual limitations.
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 $2.9 million at December 31, 2005 and $3.8 million at December 31, 2004. At December 31, 2003, the valuation allowance on certain of the life tax loss carryforwards no longer was considered necessary and the Company released the valuation allowance of $4.5 million which was reported as a deferred income tax benefit. As a result of uncertainty regarding the ability to generate taxable capital gains to utilize capital loss carryforwards, the Company established a valuation allowance in the amount of $3.2 million during 2004 that was reported as a deferred income tax expense. Approximately $1.6 million of the valuation allowance related to the capital loss carryforward was released during 2005, and reported as a deferred income tax benefit, as capital gains were generated and the Company was able to realize the benefit from the capital loss carryforwards. 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 approximately $0.8 million was established because the Company lacks sufficient foreign source income to realize the benefit for the foreign tax credit. In 2003, the Company established a reserve for pre-acquisition tax years of certain life insurance subsidiaries that were being examined by the Internal Revenue Service in the amount of $4.4 million. During 2004, the Company released $3.8 million relating to a portion of reserve amounts established for pre-acquisition tax years of certain life insurance subsidiaries that were being examined by the Internal Revenue Service. Management believes it is more likely than not that the Company will realize the recorded value of its net deferred tax assets.
Our U.S. insurance company subsidiaries, other than Peninsular Life Insurance Company, 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, 2005 due to the existence of our insurance company subsidiaries’ net operating loss carryforwards.
The Jobs Creation Tax Act of 2004 contains a provision that places a two year moratorium on the imposition of tax on distributions from Policyholder Surplus Accounts (“PSA”). Additionally, the ordering rules were changed to allow for the first dollar of any distribution to reduce the PSA. Any distribution
There was no material impact on our consolidated financial condition or results of operations as a result of our adoption of the recently issued accounting pronouncements. We do not anticipate any material impact from the future adoption of the pending accounting pronouncements, other than the adoption of Statement of Financial Accounting Standards No. 123-Revised, “Share-Based Payment” (“FAS 123-R”). FAS 123-R requires all companies to recognize compensation costs for share-based payments to employees based on the grant-date fair value of the award for financial statements for annual reporting periods beginning after June 15, 2005. Refer to Consolidated Financial Statements Note 2-Recent and Pending Accounting Pronouncements.
The financial statements and supplementary schedules are listed in the accompanying Index to Consolidated Financial Statements and Financial Statement Schedules on Page F - 1.