In accordance with the 2001 Centre reinsurance agreement which was commuted on May 24, 2005, the reinsurer maintained a notional experience account for our benefit in the event of commutation. The notional experience account received an investment credit, derived from the separate components of the notional experience account. This gain represented the income from the embedded derivative portion of our notional experience account, similar to that of an unrealized gain or loss on a bond.
During the fourth quarter of 2005, we revised our assumption related to the length of time a policyholder will stay on claim once they have been on claim in excess of three years. Primarily as a result of increasing our assumption for the duration of these claims we increased our claim reserves by approximately $42,000. During the third quarter of 2002, we determined to refine certain of our processes and assumptions in the establishment of our reserves for current claims. As a result of this change, we increased our claim reserves by approximately $83,000.
deferred acquisition cost asset by approximately $1,100 as a result of the change in our assumptions regarding the future profitability of our existing business in force.
We accrued additional expenses related to accounting, actuarial and consulting fees in 2005. These fees were incurred due to work related to our increase in claim reserves in the fourth quarter of 2005, our written submission to the SEC related to prospective unlocking and the delay in filing our 2005 Form 10-K.
As a result of our December 31, 2001 reinsurance agreement with Centre Solutions (Bermuda) Limited, we paid federal excise tax of 1% on all ceded premium. The 2001 expense represents excise taxes due for premiums transferred at the inception of the contract. Beginning in 2002 through 2004, we also accrued an annual expense and risk charge payable to the reinsurer in the event of future commutation of the agreement. This agreement was commuted on May 24, 2005. Subsequently, we entered into a reinsurance agreement with Imagine International Reinsurance Limited effective June 30, 2005 for all long-term care policies issued prior to December 31, 2001. Under this new agreement, we accrued an annual expense and risk charge similar to the agreement with Centre Solutions (Bermuda) Limited. No excise tax is owed in connection with the reinsurance agreement with Imagine International Reinsurance Limited.
Excludes $5,151 impairment charge of goodwill from the adoption of SFAS Nos. 141 and 142, which was recorded as a cumulative effect of change in accounting principle. In 2002, in accordance with SFAS No. 142, we determined that the goodwill associated with our insurance subsidiaries was
SAB No. 108 permits companies to initially apply its provision either by (1) restating prior financial statements or (2) recording the cumulative effect of initially applying the methodology for quantifying errors described in SAB No. 108 as adjustments to the carrying values of assets and liabilities as of January 1, 2005 with an offsetting adjustment recorded to the opening balance of retained earnings. We have elected to record the effects of applying SAB No. 108 using the cumulative effect transition method. The following table summarizes the effects of applying the guidance in SAB No. 108:
Diluted shares outstanding include shares issuable upon the conversion of our convertible debt and exercise of options outstanding in 2004. They are excluded for 2005, 2003, 2002 and 2001 since inclusion of such shares would be anti-dilutive. The inclusion of converted shares from the issuance of our Convertible Subordinated Notes due 2008 was expected to produce significant dilution in earnings per share in future periods. As stated previously, the convertible debt mandatorily converted on November 4, 2005.
We measure our combined ratio as the total of all expenses, including benefits to policyholders, related to policies in-force divided by premium revenue. This ratio provides an indication of the portion of premium revenue that is devoted to the coverage of policyholder related expenses. We depend on our investment returns to offset the amounts by which our combined ratio is greater than 100%. In 2001, reduced premium revenue, the impairment of our DAC asset in the fourth quarter (see note 5) and the payment of excise taxes on the initial premium for our reinsurance agreement (see note 8) increased our combined ratio above what it otherwise would have been. For 2002, see note 3. In 2004, goodwill impairment and litigation expense are not included in the expense ratio. In 2005, litigation expense, commutation expense and reinsurance warrant expense are not included in the expense ratio. Also for 2005, see note 3.
As a result of our reinsurance agreement with Centre Solutions (Bermuda) Limited, effective December 31, 2001, we transferred substantially all of our investable assets to the reinsurer. We received back our investable assets upon commutation of the reinsurance agreement in May, 2005.
Under statutory accounting principles, ceded reserves are accounted for as offsetting negative benefits and negative premium. The premium amounts are significantly reduced each year due to the ceding of all of our long-term care premiums for business written prior to December 31, 2001.
Our unaudited quarterly data for each quarter of 2005 and 2004 have been derived from unaudited financial statements and include all adjustments, consisting only of normal recurring accruals, which we consider necessary for a fair presentation of the results of operations for these periods. Such quarterly operating results are not necessarily indicative of our future results of operations. The following is our 2005 quarterly data:
In accordance with the 2001 Centre reinsurance agreement which was commuted on May 24, 2005, the reinsurer maintained a notional experience account for our benefit in the event of commutation. The notional experience account received an investment credit, derived from the separate components of the notional experience account. This gain represented the income from the embedded derivative portion of our notional experience account, similar to that of an unrealized gain or loss on a bond. The gain or loss on the notional experience account created variance in our net realized capital gains and losses and other income included above.
The 2001 Centre Agreement was commuted effective May 24, 2005. We recorded a termination fee of $18,300 in the second quarter of 2005 related to the early commutation of this agreement. As part of the 2001 Centre Agreement, the reinsurer was granted four tranches of warrants to purchase shares of non-voting convertible preferred stock. The warrants were forfeited as part of the early commutation of the agreement. The remaining value of $7,267 was recorded as an expense in the second quarter of 2005.
GAAP expense ratio excludes interest expense, goodwill impairment, litigation accrual, reinsurance warrant expense, commutation expense and the loss due to impairment of property and equipment.
We test for impairment of goodwill on an annual basis unless an event occurs or circumstances change that would more likely than not indicate that an impairment has occurred. We tested our goodwill quarterly during 2004 due to decreasing sales levels at our agency subsidiaries. During our impairment test related to the fourth quarter of 2004, we determined that the goodwill related to the agency reporting unit was impaired. This impairment was a result of declining sales, particularly in the fourth quarter of 2004, which led to lower than planned net income at the reporting unit level. During the impairment test, we lowered the assumptions related to future sales growth and as a result recognized an impairment of $13,376 in 2004.
As of January 1, 2005, we discovered errors related to prior period financial statements for the years 1999-2004 that on a cumulative basis total $2,318 on a pre-tax basis and $1,507 net of federal income
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts and related disclosures. Such estimates and assumptions significantly affect various reported amounts of assets and liabilities. Management discusses the development, selection and disclosure of these estimates and assumptions with the audit committee. Management has made estimates in the past that we believed to be appropriate but which were subsequently revised to reflect actual experience. If our future experience differs materially from these estimates and assumptions, our financial condition and results of operations could be affected. Management considers an accounting estimate to be critical if:
It requires assumptions to be made that were uncertain at the time the estimate was made; and
Our policies are accounted for as long duration policies. As a result there are two components of the liabilities associated with our policies. The first is a liability for future policyholder benefits, represented by the present value of future benefits less the present value of future premium collections. In calculating these reserves we utilize assumptions, including estimates for persistency (policies that do not terminate), morbidity (claims expectations), interest rates, expenses and premium rate increases. These assumptions are estimated in the year a policy is issued. Once the assumptions are established, we continue to utilize those assumptions unless our assessment of deferred acquisition costs (“DAC”) indicates that the current unamortized DAC asset is not recoverable in future periods. Any variance from the assumptions established in the year a policy is issued could have a material adverse impact on our financial condition and results of operations.
The DAC recoverability analysis includes our most recent assumptions for persistency, morbidity, interest rates, expenses and premium rate increases, all or any of which may be different than the assumptions utilized in establishing our benefit reserves.
The significant assumptions utilized in the DAC recoverability analysis that differs from our current assumptions for policy reserves and DAC include:
Recognition of actual premium rate increases achieved as well as an estimate related to premium rate increases that we began filing in November of 2006. Our assumption is that most of these premium rate increases will be implemented beginning in the second half of 2007 through the end of 2008, although we also assume that some of the premium rate increases will be implemented in 2009 and 2010. There is also an assumption related to an increased number of people lapsing due to the premium rate increases and therefore an assumption related to anti-selection as a result of the premium rate increases. Anti-selection is the lapsation of policies held by healthier policyholders, leading to a higher expected ratio of claims to premiums in future periods.
Mortality assumptions based on a study completed in September 2005 which measured our actual mortality experience, considering underwriting class as well as age and gender.
Long-term care insurance has fixed annual premiums that can be adjusted only upon approval of the insurance departments of the states where the premiums were written. The process for filing for premium rate increases requires us to demonstrate to the insurance department that expected claims experience is anticipated to exceed original assumptions. The approval of premium rate increases is at the discretion of the insurance department.
A significant majority of our claims do not go beyond three years in duration. Due to the relatively large amount of data we have on claims in these early durations, the assumption about the length of claims in these durations is primarily based on our own past experience. The expected duration of claims is derived through continuance studies. Continuance studies determine our assumption about the probability of a claim continuing once it has reached a certain point. The continuance studies are done by segments of similar claims which include categories such as policy type (nursing home, home health care, or comprehensive), medical condition causing the claims (which is categorized as short-term, intermediate, long-term or cognitive impairment), the age of the claimant at time of claim and gender. There is no guarantee that past performance is an indicator of future performance. If our assumptions about continuance are incorrect and individuals stay on claim longer than expected, it could have a material adverse affect on our financial condition and results of operations
There are also assumptions related to claims that are closed but are expected to reopen. These are typically claims where we have requested information that has not been received and therefore close the claim and receive the requested information subsequent to closing the claim. The assumption related to these claims is also based on our historical experience.
We also make an assumption related to improvements in our claims adjudication processes that we believe will result in lower benefits expense than our historical experience would indicate. These improvements, some of which have been fully implemented and some of which are in the process of being implemented, include, but are not limited to:
The use of our in-house nursing staff to establish and manage plans of care for a larger number of claims than in the past,
As noted above, the Imagine Agreement contains commutation provisions and allows the Company to recapture the reinsured policies as of January 1, 2008, or on January 1 of any year thereafter. If the agreement is commuted on January 1, 2008, the Company will be obligated to pay an early termination fee equal to two quarters of expense and risk charges. The Company intends, but is not required, to commute the agreement on January 1, 2009. In the event the Company does not commute the 2001 Imagine Agreement on or before January 1, 2009, the expense and risk charge paid to the reinsurer will increase by 50 percent. In the event the Company does not commute the agreement on or before January 1, 2011, but does commute at a later date, the experience refund will not exceed the statutory reserves as of the date of commutation, resulting in the Company’s forfeiture of any accumulated statutory profits.
In the event the Company determines that commutation of the 2001 Imagine Agreement is unlikely on or before January 1, 2009, but likely at some future date, it will include additional annual expense and risk charges in its unamortized deferred acquisition cost (“DAC”) recoverability analysis. As a result, it could impair the value of its DAC asset and record the impairment in its financial statements at that time. However, the Company currently believes that PTNA and ANIC will have sufficient statutory capital and surplus to commute the agreement on January 1, 2009.
Our agreement requires us to file premium rate increases within 30 days of our determination of need for these increases. Failure to file such rate increases within the prescribed time is defined in the agreement as a Material Breach Event, which, if uncorrected would ultimately lead to a reduction in the reinsurer’s liability to reimburse claims made in the future under the agreement. Although we filed our premium rate increases more than 30 days after our determination of need in 2006, thereby creating a Material Breach Event, the Reinsurer considers our ultimate filings to be sufficient to cover our obligations under the agreement and has not reduced the aggregate limit of liability.
Our future growth assumptions ranged from 15% in the first years and stabilized at 5% in the later years of our analysis. The growth rates in the early years are dependent upon the ability of our agencies to execute on recently signed agreements with unaffiliated insurance companies and to sell policies underwritten by our insurance subsidiaries. The renewal commission stream is based on the contracts that the agencies have with various insurance carriers and historical patterns of persistency.
We have net operating loss carryforwards of $34,188 or $11,966 on a tax affected basis, which have been generated by taxable losses at the parent company, and if unused will expire between 2012 and 2025. We have net operating loss carryforwards of $25,016 or $8,755 on a tax effected basis, which have been generated by taxable losses at our insurance subsidiaries, and if unused, will expire in 2016. The parent company’s net operating loss carryforwards can be utilized by our insurance subsidiaries, subject to a limitation equal to the lesser of 35% of the insurance subsidiary taxable income or 35% of the current aggregate carryforward amount.
We have recorded a valuation allowance of $8,275 against our net operating loss carryforwards on a tax affected basis. We recorded the valuation allowance due to a change in ownership as defined in the Internal Revenue Code. As a result of the change in ownership, we are now subject to a limitation on the amount of prior period net operating loss carryforwards we can utilize. If we do not generate enough taxable income in the future we may need to record an additional valuation allowance, which could have a material impact on our financial condition and results of operations.
Our average yield on invested assets at cost, including cash and cash equivalents, was 5.02% and 5.17% in 2005 and 2004, respectively. Our net investment income included an investment income component from our 2001 Centre agreement notional experience account prior to May 24, 2005 and for all of 2004. The investment income component of our notional experience account investment credit generated $18,859 and $46,172 in 2005 and 2004, respectively. The notional experience account yielded a fixed return based upon the yield to maturity of the underlying benchmark indices, which were comprised of U.S. Treasury strips, government agencies and investment grade corporate bonds with weightings of approximately 25%, 15% and 60%, respectively, and had a duration of approximately 14 years. The average yield on the notional experience account was 5.26% and 5.65% in 2005 and 2004, respectively. We commuted the 2001 Centre agreement in May of 2005 and received investments of approximately $950 million as a result of the commutation. We have gradually reduced the duration
of this portfolio to approximately 11 years at December 31, 2005 by selling long duration U.S. Treasury strips and purchasing medium duration mortgage backed securities.
During the period of January 2005 through May 2005 the interest rates on the underlying investments in the benchmark indices supporting our notional experience account declined resulting in a market gain. During 2004 the interest rates on the underlying investments in the benchmark indices supporting our notional experience account were lower at the end of the year compared to the beginning of the year, resulting in a market gain.
The total return of the Lehman Brothers US Aggregate Bond Index was 2.4% and 4.3% in 2005 and 2004, respectively. The total return on our notional experience account, which generated the majority of our net investment income through May 2005 and throughout 2004, was 7.35% and 10.51% for the five months of 2005 and all of 2004, respectively. We attribute the favorable return achieved from the notional experience account in 2005 and 2004 to the impact of declining market interest rates upon the long duration of the underlying benchmark indices.
Change in preferred interest on early conversion. We recorded a gain of $1,403 on the change in preferred interest on early conversion or our convertible debt in 2005 as compared to a gain of $2,237 in 2004. The fair value of the embedded derivative decreased to zero in October 2005, the date the offer ended for the additional shares of our common stock. As a result, a gain of $1,403 was recorded for 2005. The gain in 2004 was a result of $29,499 of conversions and the decrease in the value of the interest we would pay upon the conversion due to the shortening of the time period between the date of conversion and October 2005. All of our outstanding convertible debt was converted to our common stock in November 2005.
Other income. We recorded $8,847 in other income in 2005, as compared to $5,864 in 2004. The increase is attributable to a number of items, including the recognition of a deferred gain from the 2001 sale of our disability business. The sale was done as a 100% quota share agreement, in contemplation of a subsequent assumption of the business, where actual ownership of the policies would change. For 2005, the process to complete the remaining policyholder assumptions was completed and we recorded $1,714 as other income. We recorded a gain of $815 as a result of the commutation of the 2002 Centre Agreement. The commission income related to our agency subsidiaries increased to $5,359 in 2005 compared to $4,979 in 2004. The increase in commission income was related to the sale of Medicare Private Fee for Service and Part D Medicare products by our agency subsidiaries.
Refinements to the model we utilized to calculate claim reserves, including the addition of diagnosis code data, payment frequency data, and further delineation of policy forms for purposes of evaluation of existing continuance tables. As a result claims reserves were reduced by approximately $6,000.
The remaining variance between 2004 and 2005 is attributable to the change in our future policyholder benefits. This is due to variances between our original assumptions for lapses, morbidity and mortality compared to our actual experience. In addition, although we achieved 95% of our projected aggregate premium rate increases (as of December 31, 2005) from our 2002 locked in assumptions, premium rate increases on individual forms were either above or below the average, which resulted in additional increases to our reserve for future policyholder benefits. We achieved 100% of the assumed premium rate increases by June 2006 and therefore do not anticipate any additional variances caused by this assumption.
First year commissions on accident and health business in 2005 increased 18.0% to $7,703 compared to $6,530 in 2004, primarily due to the increase in first year accident and health premiums. The ratio of first year accident and health commissions to first year accident and health premiums was 63.7% in 2005 and 58.4% in 2004. This increase was due to the first year commission paid to one FMO that is paid a higher first year commission and lower renewal commissions than our traditional structure. We collected $1,032 of premium for this FMO and paid first year commissions of $1,217. This arrangement was not material in 2004. The ratio of first year accident and health commission to first year accident and health premiums would have been 58.6% in 2005 without this arrangement.
The increase in 2005 was primarily related to additional costs related to accounting, actuarial and consulting fees. These fees increased due to work related to our increase in claim reserves in the fourth quarter of 2005, our written submission to the SEC related to prospective unlocking and the delay in filing our 2005 Form 10-K. In addition the general and administrative expenses at our agency subsidiaries increased in 2006, corresponding with their increase in other income.
Interest expense. Interest expense in 2005 decreased 37.1% to $6,567, compared to $10,443 in 2004. The interest
Premium revenue. Total premium revenue earned in the twelve months ended December 31, 2004, decreased 0.6% to $319,885, compared to $321,946 in the same period in 2003.
Total first year premium revenue earned in 2004 increased 40.9% to $11,186, compared to $7,942 in 2003. First year long-term care premiums earned in 2004 increased 47% to $10,358, compared to $7,040 in 2003. We believe that the increase in first year premiums is due to (1) the recommencement of sales in additional states, (2) the engagement of additional independent agents that had not previously sold our policies, and (3) the introduction of our new products, which have higher annual premiums than our previously sold products.
Our average yield on invested assets at cost, including cash and cash equivalents, was 5.17% and 5.19%, respectively, in 2004 and 2003. The investment income component of our notional experience account investment credit generated $46,172 and $41,426 in 2004 and 2003, respectively. The notional experience account yields a fixed return based upon the yield to maturity of the underlying benchmark indices, which are comprised of U.S. Treasury strips, government agencies and investment grade corporate bonds with weightings of approximately 25%, 15% and 60%, respectively. The notional experience account has a duration of approximately 14 years and the average yield on the notional experience account was 5.65% and 5.63% for 2004 and 2003, respectively.
Market gain (loss) on notional experience account. We recorded a market gain on our notional experience account of $39,749 in 2004 compared to a market loss of $9,494 in 2003.
Benefits to policyholders. Total benefits to policyholders in 2004 decreased 6.1% to $232,698 compared to $247,822 in 2003. Our loss ratio, or policyholder benefits to premiums, was 72.7% in 2004, compared to 77.0% in 2003. We believe the improvement in the 2004 loss ratio is primarily due to the impact of premium rate increases, changes in certain assumptions used in the calculation of our claim reserves and improved claims adjudication procedures implemented during 2003 and 2004.
The adjustments to reserves for claims incurred in prior periods are primarily attributable to claims incurred from our long-term care insurance policies, which represent approximately 96% of our premiums in-force. The favorable development in 2004 is attributable to:
The development of our prior year assumptions were in line with our expectations for 2003.
Commissions. Commissions to agents decreased 4.13% to $39,115 in 2004, compared to $40,800 in 2003.
Net policy acquisition costs amortized. The net deferred policy acquisition costs amortized in 2004 increased to $11,578, compared to $10,243 in 2003.
The net amortization of deferred policy acquisition costs is affected by new business generation, imputed interest on prior reserves and policy persistency. The amortization of deferred costs is generally offset largely by the deferral of costs associated with new premium generation. However, the level of new premium sales during the 2004 and 2003 periods produced less expense deferral than needed to offset amortized costs.
The $10,000 of convertible subordinated notes issued in November of 2004, were issued when the price of our common stock was $7.48 per share. Because this price exceeded the conversion price of $7.00 per share, we recorded additional interest expense of $686 in 2004.
(Provision) benefit for federal income taxes. In 2004, we recorded a provision for Federal income taxes of $15,676 compared to a benefit from Federal income taxes of $2,992 in 2003. The effective tax rate was 43.3% in 2004 compared to 18.5% in 2003.
Our cash increased $2,488 in 2004 primarily due to $26,000 in additional funds generated from the issuance of convertible subordinated debt. This was supplemented by $30,076 from operations and the sale of $34,177 of bonds. The major source of cash from operations was premium received. Cash decreased in 2004 primarily due to payments made to our reinsurer of $43,354 and the purchase of $51,469 in bonds.
The maturities of our principal contractual cash obligations at December 31, 2005, are as follows (amounts in thousands):
Insurance liabilities consist of future policy benefits and unpaid claims and claim expenses relating to the Company’s insurance products. Substantially all of the amounts contained in this table with respect to such liabilities consist of estimates by the Company’s management based on various actuarial and other assumptions relating to morbidity, mortality and persistency. In accordance with GAAP, a substantial portion of such liabilities are carried on a discounted basis on the consolidated balance sheet, however, the amounts contained in the table are presented on an undiscounted basis. The actual payments relating to these liabilities will differ, both in amount and timing, from indicated in the table.
We have historically engaged in financing activities, including issuance of debt securities to fund our liquidity and subsidiary capital needs. We did not engage in financing activities in 2005 or 2006. In the first and third quarters of 2004, we issued an additional $16,000 and $10,000, respectively in Notes. We used the proceeds to supplement parent liquidity, for general working capital purposes and to further supplement our subsidiaries’ statutory surplus. All notes have been converted to common shares as of December 31, 2005.
Our cash needs for 2007 at the Parent Company are approximately $1,200, which are needed for operating expenses. We have approximately $1,300 of cash and investments at the Parent Company and approximately $3,100 of cash and investments at our agency subsidiaries to fund these expenses. In addition we believe that we will have available approximately $2,000 of additional funds available based on projections of net income at our agency subsidiaries.
States also restrict the dividends our insurance subsidiaries are permitted to pay. Dividend payments will depend on profits arising from the business of our insurance company subsidiaries, computed according to statutory formulae. Under the insurance laws of Pennsylvania, New York and Florida, where our insurance subsidiaries are domiciled, insurance companies can pay ordinary dividends only out of earned surplus. In addition, under Pennsylvania law, our Pennsylvania insurance subsidiaries (including our primary insurance subsidiary) must give the Department at least 30 days’ advance notice of any proposed “extraordinary dividend” and cannot pay such a dividend if the Department disapproves the payment during that 30-day period. For purposes of that provision, an extraordinary dividend is a dividend that, together with all other dividends paid during the preceding twelve months, exceeds the greater of 10% of the insurance company’s surplus as shown on the company’s last annual statement filed with Department or its statutory net income as shown on that annual statement. Statutory earnings are generally lower than earnings reported in accordance with generally accepted accounting principles due to the immediate or accelerated recognition of all costs associated with premium growth and benefit reserves.
Under Florida law, our Florida insurance subsidiary (Southern Security Life Insurance Company), the purchase of which remains subject to regulatory approval, must give the Florida Department of Insurance Regulation 30 days’ advance notice of any proposed “extraordinary dividend” or any other “extraordinary distribution” to our shareholders and cannot pay such a dividend or distribution if the regulator disapproves the payment during that 30-day period. For purposes of that provision, an extraordinary dividend or extraordinary distribution is any dividend or distribution that exceeds the greater of (i) the lesser of 10% of the insurance company’s surplus or net gain from operations, not including realized capital gains; (ii) 10% of surplus, with dividends payable constrained to unassigned funds minus 25% of unrealized capital gains; or (iii) the lesser of 10% of surplus or net investment income (net gain before capital gains) plus a 2 year carryforward with dividends payable constrained to unassigned funds minus 25% of unrealized capital gains; but shall not include prorata distributions of any class of our Florida insurance subsidiary’s own securities.
In February 2007, FASB issued SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities”. This statement provides an option to report selected financial assets and liabilities, including insurance contracts, at fair value. SFAS No. 159 can be adopted January 1, 2007 so long as the decision to adopt is made within 120 days of the beginning of the fiscal year of adoption. We would need to make this decision by April 30, 2007. We are in the process of evaluating this decision and do not yet know the impact of adopting SFAS No. 159.
In September 2006, the staff of the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” The interpretations in this SAB express the staff’s views regarding the process of quantifying financial statement misstatements. Specifically, the SEC staff believes that registrants must quantify the impact on current period financial statements of correcting all misstatements, including both those occurring in the current period and the effect of reversing those that have accumulated from prior periods. This SAB should be applied beginning with the first fiscal year ending after November 15, 2006, with early adoption encouraged. We have elected to adopt SAB No. 108 early, and it is therefore effective for our financial statements for the year ended December 31, 2005.
Certain statements made by us in this report may be considered forward looking within the meaning of the Private Securities Litigation Reform Act of 1995. Although we believe that our expectations are based upon reasonable assumptions within the bounds of our knowledge of our business and operations, there can be no assurance that actual results of our operations will not differ materially from our expectations. An investment in our securities includes certain risks, which may
be specific to us or to the long-term care insurance industry. Factors which could cause actual results to differ from expectations include, among others, our ability to comply with the Corrective Action Plan, the Florida Consent Order, the orders or directives of other states in which we do business or any special provisions imposed by states in connection with the resumption of writing new business, our ability to commute our reinsurance agreement and to recapture our reinsured policies, whether our Corrective Action Plan will be accepted and approved by all states, our ability to secure premium rate increases, our ability to meet our future risk-based capital goals, the adverse financial impact of suspending new business sales, our ability to raise adequate capital to meet regulatory requirements and to support anticipated growth, the cost associated with recommencing new business sales, liquidity needs and debt obligations, the adequacy of our loss reserves and the recoverability of our DAC asset, our ability to sell insurance products in certain states, our ability to resume generating new business in all states, our ability to comply with government regulations and the requirements which may be imposed by state regulators as a result of our capital and surplus levels, the ability of senior citizens to purchase our products in light of the increasing costs of health care, our ability to defend ourselves against adverse litigation, the results of the SEC review of our request related to prospective unlocking of future policyholder benefits and our ability to recapture, expand and retain our network of productive independent agents, especially in light of the suspension of new business.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Penn Treaty American Corporation's 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) and our report dated March 23, 2007 expressed an adverse opinion thereon.
In our opinion, the accompanying consolidated balance sheet as of December 31, 2004 and the related consolidated statements of income and comprehensive income, of shareholders' equity and of cash flows for each of the two years in the period ended December 31, 2004 present fairly, in all material respects, the financial position of Penn Treaty American Corporation and its subsidiaries at December 31, 2004, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
(1) Cash and investments of $955,543 and $31,497, are restricted as to use as of December 31, 2005 and 2004, respectively (See Note 4).
(1) 2004 and 2003 adjusted to reflect impact of reverse stock split (See Note 2).
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities and the reported amounts of revenues and expenses. Actual results could differ from those estimates. The Company’s principal estimates include:
A one-for-four reverse stock split for current holders of the Company’s common stock became effective July 11, 2005. The financial statements and notes related to the years ended December 31, 2004 and 2003 have been restated to reflect the impact of the reverse stock split.
Realized investment gains and losses, including provisions for market declines considered to be other than temporary, are included in income. Gains and losses on sales of investment securities are computed on the specific identification method. Purchases and sales of securities are recorded on the trade-date basis. Interest income is recorded on the accrual basis. Dividends are recorded on the ex-dividend date.
Debt and equity securities are regularly evaluated to determine if market values below amortized cost are as a result of credit quality, performance or general market decline. If market value declines are determined to be other than temporary, the amortized cost is adjusted to the market value of the security, with the loss recognized in the current period. Any future increases to the market value of a security that has been written down due to an other than temporary impairment is recorded as an unrealized gain in other comprehensive income.
The Company is subject to interest rate and credit risk to the extent that its investment portfolio cash flows are not matched to its insurance liabilities. The Company does not match the duration of assets and liabilities, which could subject it to interest rate risk from the investment of new cash flows that are inadequate to meet our future claims payments. In addition, the Company is limited by the Corrective Action Plan with the Pennsylvania Insurance Department as to the types of new investments that it may purchase. The Company is also limited by its statutory surplus in terms of the level of realized loss it can incur in order to sell existing assets and purchase new investments. This could, and has, limited its ability to realign the duration of its investment portfolio and to maximize its investment yield.
Cash and cash equivalents include highly liquid debt instruments with an original maturity of three months or less.
The costs primarily related to and varying with the acquisition of new business, principally commissions, underwriting and policy issue expenses, have been deferred. These deferred costs are amortized over the related
premium-paying periods utilizing the same projected premium assumptions, related to persistency, used in computing reserves for future policy benefits.
The significant assumptions utilized in the DAC recoverability analysis that differ from the current assumptions for policy reserves and DAC include:
An investment income rate of 5.01% initially, grading to the 5.45% for newly investable funds by 2027.
An estimate that claims expense will improve beyond the assumptions utilized in the locked-in estimates due to the expected results from recently implemented and future planned improvements to claims adjudication procedures.
The premium rate increases the Company is filing vary by the policy type, benefit period, underwriting class and the age of the policyholder. The aggregate average increase is approximately 34%, although the policy forms for which the Company has filed premium rate increase requests have an average increase ranging from 3.2% to 99.1%. The timing of state approvals for premium rate increases varies. Some states will approve the amount we filed within 3 to 4 months of the receipt of the filing while other states will take up to a year and may only approve a portion of the amount the Company filed. In those situations, the Company will file for additional premium rate increases as soon as practicable in order to obtain the remaining portion of the premium rate increase, so long as it is still actuarially justified. Therefore, to implement 100% of the premium rate increases may take as long as 3 or 4 years. The Company has received approval from one state for one of its policy forms in that state as of the date of the filing of these financial statements.
Long-term care insurance has fixed annual premiums that can be adjusted only upon approval of the insurance departments of the states where the premiums were written. The process for filing for premium rate increases
requires us to demonstrate to the insurance department that expected claims experience is anticipated to exceed original assumptions. The approval of premium rate increases is at the discretion of the insurance department.
Receivables from agents represent balances accumulated by agents due to either commission amounts that are advanced, or premiums that are submitted net of commission amounts due prior to the policy being issued, which may be declined and therefore the balance is due to the Company. These amounts are typically collected by reducing future commission payments to the agents. The Company regularly reviews these balances to determine if amounts are collectible and records an allowance for any amounts the Company believes are not collectible.
Effective October 1, 2005, the Company entered into an agreement to reinsure, on a 75% quota share basis, its long-term care insurance policies issued between October 1, 2005 and September 30, 2006 with Imagine International Reinsurance Limited (the “2005 Imagine Agreement”). This agreement has been extended through September 30, 2007. This agreement does not qualify for reinsurance treatment in accordance with GAAP because it does not result in the reasonable probability that the reinsurer may realize a significant loss. This is due to a number of factors related to the agreement, including an experience refund provision, expense and risk charges due to the reinsurer that escalate over the life of the agreement and an aggregate limit of liability. Therefore, the agreement is being accounted for in accordance with deposit accounting for reinsurance contracts. However, the agreement meets the requirements to qualify for reinsurance treatment under statutory accounting rules, which requires a reinsurance agreement to transfer risk to the reinsurer, but does not require the reasonable probability of a significant loss required under GAAP.
The Company purchased corporate owned life insurance (“COLI”) to fund the future payment of employee benefit expenses. The Company has purchased $50,000 of COLI. No additional purchases were made in 2005 or 2004. The COLI, which is invested in investment grade corporate bonds and equity indexes, is recorded at cash surrender value. Increases in the cash surrender value are recorded as other income. When a covered employee dies, the Company receives cash equal to the death benefit. No income or expense is recorded as a result.
The notional experience account represented a hybrid instrument, containing both a fixed debt host contract and an embedded derivative. The economic characteristics and risks of the embedded derivative instrument were not clearly and closely related to the economic characteristics and risks of the fixed debt host contract. In accordance with SFAS No. 133, the Company accounted for the investment credit received on the notional experience account as follows:
The fixed debt host yielded a fixed return based on the yield to maturity of the underlying benchmark indices. The return on the fixed debt host was reported as investment income in the Consolidated Statement of Income and Comprehensive Income.
Other assets consist primarily of deferred reinsurance premiums, premiums due but not yet collected, deferred offering costs, prepaid assets, receivables due to our agency subsidiaries from other insurance companies, and a deposit account related to a reinsurance agreement.
The deferred reinsurance premium for 2005 represents the initial expense and risk charge paid to Imagine International Reinsurance Limited, which is being amortized over 42 months, the estimated life of the agreement. For the year ended December 31, 2004, the deferred reinsurance premiums represented the warrants granted as part of entering into the reinsurance agreement with Centre. The warrants were part of the consideration for the reinsurance contract and were recognized as reinsurance premiums over the anticipated life of the contract, which was six years. Because the reinsurance agreement was commuted May 24, 2005, the warrants were fully expensed as part of the commutation and there in no balance related to the warrants at December 31, 2005.
Deferred offering costs were amortized on a straight-line basis over the maturity period of the related convertible debt, which was due to mature in 2008. A pro-rata portion was expensed at the time of any early conversions. There in no deferred offering cost balance remaining at December 31, 2005 as they were fully expensed due to the conversion of the convertible debt in November, 2005.
The deposit account related to a 50% quota share reinsurance agreement for policies issued between January 1, 2002 and July 31, 2004, with Centre. The net cash flows relating to premiums paid to the reinsurer, claim payments collected from the reinsurer, investment income earned on the cash flows, less a finance charge were recoded to the deposit account. This agreement was commuted in January 2005 and the assets in the deposit account were transferred back to the Company, therefore there is no amount recorded on the Company’s balance sheet related to the deposit account at December 31, 2005.
The liability for claim reserves represents the amount needed to provide for the estimated ultimate cost of settling claims relating to insured events that have occurred on or before the end of the respective reporting period. The estimated liability includes requirements for future payments of (a) claims that have been reported
to the insurer, (b) claims related to insured events that have occurred but that have not been reported to the insurer as of the date the liability is estimated, and (c) claim adjustment expenses. Claim adjustment expenses include costs incurred in the claim settlement process such as legal fees and costs to record, process, and adjust claims. The Company discounts all claims, which involve fixed periodic payments extending beyond one year. See Note 8 for a description of the significant assumptions utilized in establishing the claim reserves.
Long-term debt was carried at face value less the remaining related unamortized discount. The discount on long-term debt was equal to the fair value of the preferred interest on early conversion at the time of issuance. The discount was recorded as interest expense over the maturity of the long-term debt, which was 2008, using the effective interest method. A pro-rata portion of the discount was charged immediately to interest expense at the time of any early conversion.
Income taxes consist of amounts currently due plus deferred tax expense or benefits. Deferred tax assets and liabilities result from temporary differences between the amounts recorded in the consolidated financial statements and the tax bases of the Company’s assets and liabilities. Such temporary differences are primarily due to the difference in allowable deductions for deferred acquisition costs, the deposit accounting for the Company’s 2001 Centre Agreement and Imagine Agreements, the warrants issued as compensation for the 2001 Centre Agreement and tax benefits of net operating loss carryforwards. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all, or some portion, of the benefits related to deferred tax assets will not be realized.
Commission revenue that the Company’s agencies receive from unaffiliated insurers is included in other income when the commission from the underlying policy premium is due, net of an allowance for unissued or cancelled policies.
The Company paid excise taxes related to its previous reinsurance agreements with Centre. The amount recorded each year was equal to one percent of the premiums ceded to the reinsurer. The Company does not pay any excise taxes related to its reinsurance agreement with Imagine.
(1) Amounts not included in 2005 or 2003 because they are anti-dilutive
(2) 2004 and 2003 are restated to reflect impact of reserve stock split - See Note 2
The following table reflects net income, basic and diluted earnings per share as reported and pro-forma as if the Company had adopted the fair value based method of accounting for its stock-based employee compensation awards:
(1) 2004 and 2003 are restated to reflect impact of reserve stock split - See Note 2
In June of 2006, the Emerging Issues Task Force (“EITF”) of the Financial Accounting Standards Board (“FASB”) reached a consensus on EITF Issue No, 06-5 “Accounting for Purchases of Life Insurance - Determining the Amount that Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4” (“EITF 06-5”). EITF 06-5 relates to accounting for corporate-owned life insurance (“COLI”). The Company owns a COLI policy, which is utilized to fund the future payment of employee benefit expenses. The EITF reached a consensus that a policyholder should consider any additional amounts included in the contractual terms of the policy in determining the amount that could be realized under the insurance contract. The EITF also reached a consensus that a policyholder should determine the amount that could be realized under the life insurance contract assuming the surrender of an individual-life by individual-life policy (or certificate by certificate in a group policy). EITF 06-5 is effective for fiscal years beginning after December 15, 2006. The Company has not yet determined if the adoption of EITF 06-5 will have an impact on our financial statements or results of operations.
In February 2007, FASB issued SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities.” This statement provides an option to report selected financial assets and liabilities, including insurance contracts, at fair value. SFAS No. 159 can be adopted January 1, 2007 as long as the decision to adopt is made within 120 days of the beginning of the fiscal year of adoption. The Company will need to make this decision by April 30, 2007. The Company is in the process of evaluating this decision and does not yet know the impact of adopting SFAS No. 159.
As of January 1, 2005, the Company discovered errors related to prior period financial statements for the years 1999-2004 that on a cumulative basis total $2,318 on a pre-tax basis and $1,507 net of federal income taxes. The entire amount relates to return of premium benefits that should have been paid to policyholders in prior years but due to an error in the Company’s process of identifying which policyholders should be paid, not all of the policyholders were properly identified. This process has been corrected for 2005. Although these individual errors are immaterial to the prior periods, the cumulative amount is material to the 2005 financial statements because of the adoption of SAB No. 108 as mentioned above.
The amortized cost and estimated market values of debt securities at December 31, 2005 and 2004 are shown below.
The amortized cost and estimated market values of debt securities at December 31, 2005, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The above table includes 250 fixed income securities with $24,616 of unrealized losses that have been in an unrealized loss situation for less than twelve months. There are no fixed income securities that have been in an unrealized loss situation for greater than 12 months. All of the fixed income securities are investment grade, which is defined as a security having a rating from the NAIC of 1 or 2; a Moody’s equivalent rating of Aaa, Aa, A, or Baa; a Standard & Poor’s equivalent rating of AAA, AA, A, or BBB; or a comparable internal rating. Unrealized losses on investment grade securities are principally related to changes in interest rates or changes in issuer or sector related credit spreads since the securities were acquired.
Effective October 1, 2005, the Company entered into a 75% quota share reinsurance agreement with the same reinsurer for policies issued on and after October 1, 2005, on a funds withheld basis. As a condition precedent to withholding the funds due to the reinsurer, the Company has agreed to hold assets in trust for the benefit of the reinsurer. The amount required to be held in trust at December 31, 2005 was $129.
Pursuant to certain statutory licensing requirements, as of December 31, 2005 and 2004, the Company had on deposit bonds with an estimated market value aggregating $12,121 and $12,264, respectively, in Insurance Department special deposit accounts. The Company is not permitted to remove the bonds from these accounts without approval of the regulatory authority.
The Company maintains assets in a trust account under a reinsurance agreement with an unaffiliated insurer. The Company is required to hold assets equal to at least 102% of the reserves for the policies assumed under this agreement. At December 31, 2005 and 2004, the Company was required to hold $23,781 and $18,869, respectively.
The Company maintains assets in a certificate of deposit for the benefit of the lessor under its sale leaseback agreement entered into in 2005. As of December 31, 2005 the amount of the certificate of deposit was $3,500.
The Company amortized $1,100, $849 and $631 of its cost related to software in 2005, 2004 and 2003, respectively. Depreciation expense on other property and equipment was $743, $792 and $1,079 for the years ended December 31, 2005, 2004 and 2003, respectively.
During the Company’s quarterly impairment testing, as of December 31, 2004, it determined that the goodwill related to its agency reporting unit consisting of UIG and NISHD was impaired. The test was done on a quarterly basis during 2004 due to declining sales. This impairment was a result of declining sales which led to lower than planned net income at the reporting unit level. The fair value of the reporting unit is determined utilizing the present value of cash flows, which includes assumptions for future growth in sales. The Company lowered the assumption related to future sales growth and as a result has recognized an impairment of $13,376 in 2004. There was no impairment in 2005.
The Company utilizes the 1975-80 SOA Mortality Table (Age Last Birthday) for the life insurance policy
The significant assumptions utilized in establishing claim reserves are expectations about the duration, cost of care being reimbursed, the interest rate utilized to discount the claim reserves, claims that have been incurred but not yet reported, claims that have been closed but are expected to reopen and assumptions about which claims that are currently in their eligibility review stage will eventually become claims that have payments associated with them. The Company establishes its claim reserves in each period based upon its most currently available information and assumptions.
A significant majority of claims do not go beyond three years in duration. Due to the relatively large amount of data that the Company has on claims in these early durations, the assumption about the length of claims in these durations is primarily based on the Company’s past experience. The expected duration of claims is derived through continuance studies. Continuance studies determine the assumption about the probability of a claim continuing once it has reached a certain point. The continuance studies are done by segments of similar claims which include categories such as policy type (nursing home, home health care, or comprehensive), medical condition causing the claims (which is categorized as short-term, intermediate, long-term or cognitive impairment), the age of the claimant at time of claim and gender. There is no guarantee that past performance is an indicator of future performance.
The Company’s experience with claims that last longer than three years is much more limited due to the relatively small number of claims that go past the third year. Therefore, the Company relies on a combination of its experience and studies performed by the Society of Actuaries or other sources for claims in the later durations. Due to the limited amount of data, there is a higher likelihood of variance related to this assumption and any variance could have a material affect on the Company’s financial condition and results of operations. In the fourth quarter of 2005, the Company changed its assumption related to claims that lasted longer than three years, resulting in a revised assumption that once a claim lasted longer than three years, it would last longer than the Company previously assumed. As a result of this change in assumptions, the Company increased claim reserves approximately $42,000 in the fourth quarter of 2005. As part of continuance assumptions, the Company also tries to reflect anticipated changes in mortality of disabled lives and recovery rates of people on claim. Reviewing past experience is a partial guide, but changes in the future may not follow past patterns.
The development of the Company’s claim reserves and paid claims is summarized as follows for claims incurred (the date of original claim) in 2005 and prior.
In 2005, prior year incurred claims developed unfavorably by $28,783 compared to prior period expectations. The unfavorable development in 2005 is primarily attributable to the change in the assumption related to the mortality of policyholders that are on claim in excess of three years. The Company changed its mortality assumptions related to these claims in the fourth quarter of 2005 based on actuarial studies that indicated these claimants were staying on claim longer than previously anticipated.
Refinements to the model utilized to calculate claim reserves, including the addition of diagnosis code data, payment frequency data, and further delineation of policy forms for
At December 31, 2005 there was no long-term debt outstanding due to the conversion in November, 2005. At December 31, 2004 our long-term debt consisted entirely of convertible subordinated debt issued in 2002, 2003 and 2004, all of which was to mature in 2008 (the “Notes”).
The Notes paid a semi-annual coupon at a 6.25% annual percentage rate. The Notes were callable after October 15, 2005, at the Company’s option, at a price equal to 100% of the principal amount of the Notes plus accrued and unpaid interest.
The Notes also contained a provision that, upon conversion prior to October 15, 2005, the Company would pay the holder additional interest (referred to as “preferred interest on early conversion”) equal to the amount that would otherwise have been paid from the date of conversion until October 15, 2005. The interest amount, which was discounted from October 15, 2005 to the date of early conversion, was payable at the Company’s discretion in cash or in shares of common stock equal to 90% of the average closing prices of the Company’s common stock for the five trading days immediately preceding the conversion date. The preferred interest on early conversion was accounted for as an embedded derivative with changes in its fair value recorded on the Consolidated Statements of Income and Comprehensive Income.
As of December 31, 2005 and 2004, the fair value of the embedded derivative was $0 and $1,403, respectively. In determining the fair value of the embedded derivative, the Company made certain assumptions, including the future volatility and liquidity of the Company’s common stock, as well as recent trends in the number of holders converting.
During 2005 and 2004, the activity in the preferred interest on early conversion was as follows:
During November 2004, the Company issued $10,000 of additional Notes. At the time of issuance the market price of the Company’s common stock was $7.48. As a result of the market price of the common stock exceeding the conversion price, the Company recorded additional interest expense of $686 related to this issuance.
The total benefit (provision) for federal income taxes for the years ended December 31 consisted of:
The valuation allowance was recorded as a result of future limitations on the use of the Company’s net operating loss carryforwards. Section 382 of the Internal Revenue Code limits a company’s use of net operating loss carryforwards in the event that a majority of the company’s common stock ownership changes within any consecutive three year period. Due to the issuance of additional shares of the Company’s common stock since May 2001 and conversions of the Company’s subordinated convertible notes during 2003, 2004, and 2005, the Company became subject to these limitations and has established the valuation allowance at December 31, 2003 accordingly. There was no change to the valuation allowance in 2004 or 2005.
The differences in statutory net income (loss) compared to GAAP net income (loss) are primarily due to the immediate expensing of acquisition costs, as well as differing reserving methodologies and treatment of reinsurance and deferred income taxes. Due to the differences in expensing of acquisition costs and reserving methodologies, under statutory accounting there is generally a net loss and a corresponding decrease in surplus, referred to as surplus strain, when new policies are issued.
The Company’s Pennsylvania insurance subsidiaries are required to hold statutory surplus that is, at a minimum, above a calculated authorized control level at which the Pennsylvania Insurance Department (the “Department”) may place them under regulatory control, leading to rehabilitation or liquidation. At December 31, 2000, the Company’s primary insurance subsidiary, Penn Treaty Network America Insurance Company (“PTNA”), which represented 90% of the Company’s direct premium revenue, had statutory surplus which, while above the authorized control level, was at an amount that required PTNA to file a Corrective Action Plan (the “Plan”) with the insurance commissioner. In addition, American Network Insurance Company (“ANIC”), which is owned 100% by PTNA, is also subject to the provisions of the Plan.
Failure to comply with the Plan could result in the Department taking control of the Company’s insurance subsidiaries.
The Florida Department of Insurance Regulation (“Florida OIR”) issued a Consent Order dated July 30, 2002, as amended, reinstating PTNA’s Certificate of Authority in Florida as a foreign insurer. The Consent Order sets forth the following obligations which PTNA must satisfy to maintain its Certificate of Authority in Florida:
Maintain compliance with Florida laws which establish minimum surplus required for health and life insurers;
PTNA will seek prior approval of the Florida OIR before commencing or terminating any new reinsurance agreements.
PTNA will maintain a risk-based capital ratio in excess of 250%. PTNA’s reported ratio as of December 31, 2006 and 2005 was approximately 730% and 714%, respectively.
States restrict the dividends the Company’s insurance subsidiaries are permitted to pay. Dividend payments will depend on profits arising from the business of its insurance company subsidiaries, computed according to statutory formulae. Under the insurance laws of Pennsylvania and New York, where the Company’s insurance subsidiaries are domiciled, insurance companies can pay ordinary dividends only out of earned surplus. In addition, under Pennsylvania law, PTNA and ANIC must give the Department at least 30 days’ advance notice of any proposed “extraordinary dividend” and cannot pay such a dividend if the Department disapproves the payment during that 30-day period. For purposes of that provision, an extraordinary dividend is a dividend that, together with all other dividends paid during the preceding twelve months, exceeds the greater of 10% of the insurance company’s surplus as shown on the company’s last annual statement filed with the Department or its statutory net income as shown on that annual statement. Statutory earnings are generally lower than earnings reported in accordance with generally accepted accounting principles due to the immediate or accelerated recognition of all costs associated with premium growth and benefit reserves. Additionally, the Plan requires the Department to approve all dividend requests made by the parent, regardless of normal statutory requirements for allowable dividends. The Company believes that the Department is unlikely to consider any dividend request in the foreseeable future, as a result of PTNA’s statutory surplus position. Although not stipulated in the Plan, this requirement is likely to continue until such time as PTNA meets normal statutory requirements, including reported net income and positive cumulative earned surplus.
Under New York law, AIN must give the New York Insurance Department 30 days advance notice of any proposed dividend and cannot pay any dividend if the regulator disapproves the payment during that 30-day period. In addition, AIN must obtain the prior approval of the New York Insurance Department before paying any dividend that, together with all other dividends paid during the preceding twelve months, exceeds the lesser of 10% of the insurance company’s surplus as of the preceding December 31 or its adjusted net investment income for the year ended the preceding December 31.
PTNA and ANIC have not paid any dividends to the parent company for the past three years and are unlikely in the foreseeable future to be able to make dividend payments due to insufficient statutory surplus and anticipated earnings. However, AIN is not subject to the Plan, but has not made any dividend payments in 2003, 2004 or 2005.
Assumed health care cost trend rates have an effect on the amounts reported for the health care plans. A one-percentage point change in assumed health care cost trend rates would have the following effects:
The following benefits are expected to be paid in the future:
The Company’s 2002 Incentive Stock Option Plan, which was adopted in March 2003, allows for the grant of options to purchase up to 500 shares of the Company’s common stock. The exercise price of all options granted under the plan may not be less than the fair market value of the shares on the date of grant. The term of each option granted under the 2002 Incentive Stock Option Plan in 2005, 2004 and 2003 is ten years and each is vested one year following the date of original grant. Under the 2002 Plan, new option grants of 199, 130, and 99, were made to officers, employees and directors of the Company in 2005, 2004, and 2003, respectively.
Effective May 1995, the Company adopted a Participating Agent Stock Option Plan that provides for the granting of options to purchase up to 75 shares of common stock. The exercise price of all options granted under the plan may not be less than the fair market value of the shares on the date of grant. The term of each option is ten years, and the options become exercisable in four equal, annual installments commencing one year from the option grant date. SFAS No. 123 requires that the fair value of options granted to non-employees (agents) be recognized as compensation expense over the estimated life of the option. Options were granted to agents in 1997, 1996 and 1995. No agent options have been granted since 1997. The Company did not have any compensation expense related to this Plan in 2005, 2004 or 2003.
Had compensation cost for the Company’s employee stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans consistent with the method of SFAS No. 123, the Company’s net loss and earnings per share would have been reduced to the pro-forma amounts indicated in Note 3.
Pro-forma compensation cost is estimated using an option-pricing model with the following assumptions for new options granted to employees in 2005, 2004 and 2003. In 2005, options were valued with an expected life of 5.3 years, volatility of 50% and a risk free interest rate of 3.9%. The weighted average fair value of options granted in 2005 was $4.21. In 2004, options were valued with an expected life of 5.3 years, volatility of 67.7% and a risk free interest rate of 3.9%. The weighted average fair value of options granted in 2004 was $4.44. In 2003 options were valued with an expected life of 5.3 years, volatility of 70.9% and a risk free rate of 3.5%. The weighted average fair value of options granted in 2003 was $3.92.
The total net rental expenses under all leases amounted to approximately $1,071, $1,173 and $928 for the years ended December 31, 2005, 2004 and 2003 respectively.
The Company’s required payments due under non-cancelable leases in each of the next five years are as follows:
The Company and its subsidiaries are parties to various legal actions generally arising in the normal course of their business. While the outcome of any single lawsuit could have a material impact upon the Company's financial results for the period in which it occurs, the Company does not believe that the eventual outcome of the majority of these lawsuits is likely to have a material adverse effect on its overall financial condition or results of operations. However, the matters specifically described below, while settled, were viewed by management as potentially material and, in the event of an unfavorable outcome; any one of these matters could have a material adverse effect on the Company's financial condition and results of operations.
The Company and its subsidiary, PTNA, were defendants in an action in the Fifth Judicial Circuit of the State of Florida in and for Marion County, Civil Division. Plaintiffs filed this matter on January 10, 2003 in Florida State Court, on behalf of themselves and a class of similarly situated Florida long-term care policyholders. Plaintiffs claimed wrongdoing in connection with the sale of long-term care insurance policies to the plaintiffs and the class. In December 2005, the court issued final approval of a settlement negotiated between the parties and certified, for settlement purposes only, a proposed national class. With no appeal having been taken, the settlement agreement is now final and the matter has been discontinued.
The Company and PTNA were defendants in an action in the Orange County Superior Court in the state of California. Plaintiffs filed this matter in November 2003 on behalf of themselves, all other persons similarly situated and the general public. Plaintiffs alleged wrongdoing in violation of the California Business & Professions Code in connection with the sale of long term care insurance policies. In December 2005, the court in the Florida matter above issued final approval of a settlement negotiated between the parties and certified, for settlement purposes only, a proposed national class. With no appeal having been taken, the settlement agreement is now final and the matter has been discontinued.
Effective June 30, 2005, the Company entered into an agreement to reinsure, on a 100% quota share basis, substantially all of its long-term care insurance policies in-force as of December 31, 2001 with Imagine International Reinsurance Limited (the “Imagine Agreement”). This agreement does not qualify for reinsurance treatment in accordance with GAAP because it does not result in the reasonable probability that the reinsurer may realize a significant loss. This is due to a number of factors related to the agreement, including an experience refund provision, expense and risk charges due to the reinsurer that escalate over the life of the agreement and an aggregate limit of liability. Therefore, the agreement is being accounted for in accordance with deposit accounting for reinsurance contracts. However, the agreement meets the
The funds withheld liability and the corresponding experience refund are comprised of (1) an initial premium of approximately $1.039 billion equal to the statutory reserves for the reinsured policies at the effective date, plus (2) future investment income, plus (3) future premiums, less (4) future losses paid, less (5) an initial ceding commission of $60 million, less (6) future expense allowances less (7) future expense and risk charges.
The quarterly expense and risk charge is equal to the sum of (1) 0.25% of total ceded statutory reserves at the end of a quarter; and (2) 0.50% of the value of the combination of any letters of credit or funds deposited in trust by the reinsurer as of the beginning of the quarter. In addition, the Company paid the reinsurer an initial expense and risk charge of $2.92 million, which is being amortized to expense over 42 months, the estimated life of the agreement. The Company recorded an expense and risk charge of approximately $5,910 for the year ended December 31, 2005.
not commute the agreement on or before January 1, 2011, but commutes at a later date, the experience refund will not exceed the statutory reserves as of the date of commutation, resulting in our forfeiture of any accumulated statutory profits for which the Company otherwise may have been entitled.
The 2005 Imagine Agreement allows the Company to withhold all funds due to the reinsurer as a funds withheld liability, which is only recorded for statutory purposes. In addition, the agreement allows the Company to recapture the reinsured policies on any September 30, commencing on September 30, 2008. In order to recapture any policies reinsured under the 2005 Imagine Agreement, the Company is required to
first or concurrently recapture policies reinsured under the Imagine Agreement for polices issued December 31, 2001 or prior.
The reinsurance agreement also granted the reinsurer an option to participate in reinsuring new business sales on a quota share basis. In August 2002, the reinsurer exercised its option to reinsure up to 50% of future sales, subject to a limitation of the reinsurer’s risk (the “2002 Centre Agreement”). On March 29, 2004, the reinsurer notified the Company of its decision to cease reinsuring newly issued policies on or after August 1, 2004. The 2002 Centre Agreement was commuted effective February 1, 2005 and all policies previously reinsured under the agreement were recaptured. The Company recorded a gain of $815,000 as a result of the recapture and does not currently have reinsurance for long-term care insurance policies issued between August 1, 2004 and September 30, 2005.
The Company has a reinsurance agreement with General Re Life Corporation with respect to home health care policies with benefit periods exceeding 36 months. No new policies have been reinsured under this agreement since 1998. Reinsurance recoveries related to this contract were the subject of arbitration that was resolved in 2006. See Note 14 “Commitments and Contingencies” for a description of current legal proceedings. The reinsurance recoverables related to this agreement were $21,250 and $11,236 at December 31, 2005 and 2004, respectively.
The Company also has a reinsurance agreement with General Re Life Corporation with respect to certain home health and nursing home claims. The claims ceded are either in excess of 60 months, $250,000 or $350,000 depending on the policy type. There have been no new policies reinsured under this agreement since 2001. The reinsurance recoverable related to this agreement was $201 and $70 at December 31, 2005 and 2004, respectively.
The reinsurance recoverable related to this agreement was $2,623 and $2,861 at December 31, 2005 and 2004, respectively.
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and investments. The Company places its cash and cash equivalents and investments with high quality financial institutions, and attempts to limit the amount of credit exposure to any one institution. However, at December 31, 2005, and at other times during the year, amounts in any one institution exceeded the Federal Deposit Insurance Corporation limits. The Company is also a party to certain reinsurance transactions whereby the Company remains ultimately liable for claims exposure under ceded policies in the event the assuming reinsurer is unable to meet its commitments due to default or insolvency.
In 2005, 2004 and 2003, the Company completed private placements of 16, 25 and 25 shares, respectively, as compensation to its financial advisor. In 2005 the Company completed private placements of 11 shares as compensation to one of its independent agents. There was no compensation to agents in the form of shares in 2004 or 2003. In 2005 the Company issued 12 shares as a result of the exercise of options. There were no exercises of options in 2004 or 2003.
During 2005, the Company entered into a sale leaseback agreement under which it sold property and equipment, consisting entirely of software, with a value of $4,558 to a third party and agreed to lease back the same equipment. Since the Company retains all the risk and reward of ownership of the leased property and there is $3,500 of collateral related to this agreement, the sale leaseback feature of the lease agreement does not meet the requirements of sale accounting. As such, the transaction is accounted for as a financing arrangement with no gain or loss recognized on the sale of the assets. Although the term of the lease is two years a portion of the lease payments did not begin until 2006 and therefore there are payments that extend until 2008.
Minimum annual rentals for the term of the lease are as follows:
Present value of the net minimum lease payments under capital lease
The Company had letters of credit totaling $52,200 at December 31, 2005, which allowed its subsidiaries to receive statutory reserve credit and statutory surplus credit for its Imagine reinsurance agreements.
In December 2006 the Company entered into a purchase agreement to acquire Southern Security Life Insurance Company (“Southern Security”), a Florida-domiciled shell insurance company. The purchase agreement is conditioned upon the approvals of the Florida and Pennsylvania Insurance Departments, which are still pending. The purchase price for Southern Security Life Insurance Company consisted of $400,000 plus the capital and surplus of Southern Security as of December 31, 2006, which was $3,861,363, plus all investment income and interest on the capital and surplus accruing between December 31, 2006 and the date of final distributions from escrow, which has not yet been determined.
In January 2006 the Company ceded all of our remaining life policies to an unaffiliated insurer on a 100% quota share assumption basis. Upon approval from state insurance departments in which the policies were issued, or policyholder approval as may be prescribed by state regulation, we will no longer record these policies in our financial statements. The Company transferred cash equal to the statutory reserves to the reinsurer and eliminated its carried deferred acquisition costs for these policies, which results in the recording of a loss of $2,323 in 2006.
The following lists the condensed financial information for the parent company as of December 31, 2005 and 2004 and for the years ended December 31, 2005, 2004 and 2003.