(1) Immediately prior to the closing of the Pyramid Life sale, Continental General acquired Pyramid Life's building in Kansas. See Note E. Discontinued Operations for further information.
(1) Effective March 31, 2003, Continental General sold its subsidiary, Pyramid Life Insurance Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. See Note E. Discontinued Operations to our audited consolidated financial statements for further information.
(2) The exercise of options and warrants is not assumed when a loss from operations is reported and the result would be antidilutive.
This discussion should be read in conjunction with the audited consolidated financial statements, notes, and tables included elsewhere in this report. Management's discussion and analysis contains forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. However, future performance involves risks and uncertainties, which may cause actual results to differ materially from those expressed in the forward-looking statements. See "Forward-Looking Statements."
changes in the timing of claims submission patterns from providers, changes in our speed of processing claims, and expected costs to settle unpaid claims.
Actual conditions could differ from those assumed in the estimation process. Due to the uncertainties associated with the factors used in these assumptions, materially different amounts could be reported in our statement of operations for a particular period under different conditions or using different assumptions. As is common in the health insurance industry, we believe that actual results may vary within a reasonable range of possible outcomes. Management believes that our reasonable range of actual outcomes may vary up to 10% to 15% of the total liabilities for other policy claims and benefits payable recorded at the end of a period.
Management believes the amount of deferred acquisition costs as of December 31, 2003 is recoverable.
GOODWILL AND OTHER INTANGIBLE ASSETS. Goodwill represents the excess of purchase price over the fair value of tangible and identifiable intangible net assets acquired. At December 31, 2003, goodwill was $10.7 million and represented approximately 1.4% of our total assets. Additionally, other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract asset or liability. At December 31, 2003, our other intangible assets consisted of $3.4 million in licenses, or 0.4% of our total assets.
Effective January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets issued by the Financial Accounting Standards Board (FASB), which provides that goodwill and intangibles with indefinite useful lives should not be amortized but instead be tested for impairment annually at the reporting unit level. In accordance with SFAS No. 142, we completed a transitional goodwill impairment test, which indicated that an impairment loss against our goodwill and other intangible assets was not required. Goodwill and intangibles with indefinite useful lives are tested for impairment on an annual basis and more often if indications of impairment exist. The estimated fair value of goodwill of a reporting unit is determined by applying the appropriate discount rates to estimated future cash flows for the reporting unit. The estimated fair value of licenses was determined by independent appraisals. The results of our analysis indicated that no reduction of goodwill was required. A slight reduction of $0.1 million was made to the carrying value of licenses in 2003 due to the cancellation of business in certain unprofitable states.
VALUE OF BUSINESS ACQUIRED. A portion of the purchase price paid for Continental General Corporation was allocated to the value of business acquired based on the actuarially determined present value of the expected pre-tax future profits from the business assuming a discount rate of 15.0%. Interest is accrued on the balance annually at a rate consistent with the rate credited on the acquired policies on the acquisition date, which ranges from 4.0% to 8.75%. Recoverability of the value of business acquired is evaluated periodically by comparing the current estimate of the present value of expected pre-tax future profits to the unamortized asset balance. If the current estimate is less than the existing asset balance, the difference would be charged to expense, and if the current estimate is higher than the existing asset balance, the difference will emerge into profits as earned.
THE NUMBER OF YEARS A POLICY HAS BEEN IN EFFECT. Claims costs tend to be higher on policies that have been in force for a longer period of time. As the policy ages, it is more likely that the insured will need services covered by the policy. However, generally, the longer the policy is in effect, the more premium we will receive for major medical and Medicare supplement policies. For other health, life and annuity policies/contracts, reserve liabilities are established for policy benefits expected to be paid for in future years.
LAPSATION AND PERSISTENCY. Other factors that affect our results of operations are lapsation and persistency, both of which relate to the renewal of insurance policies and certificates in force. Lapsation is the termination of a policy for nonrenewal and, pursuant to our practice, is automatic if and when premiums become more than 31 days overdue. However, policies may be reinstated, if approved, within six months after the policy lapses. Persistency represents the percentage of total certificates in force at the end of a period less any newly-issued certificates divided by the total certificates in force at the beginning of the period.
EXTERNAL FACTORS ALSO CONTRIBUTE TO POLICY RENEWAL OR LAPSATION. Economic cycles can influence an insured's ability to continue to pay insurance premiums when due.
REINSURANCE. Consistent with the general practice of the insurance industry, we reinsure portions of the coverage by our insurance products to unaffiliated insurance companies under reinsurance agreements. Reinsurance provides a greater diversification of underwriting risk, minimizes our aggregate exposure on major risks and limits our potential losses on reinsured business. Reinsurance involves one or more insurance companies participating in the liabilities or risks of another insurance company in exchange for a portion of the premiums. Although the effect of reinsurance is to lessen our risks, it may lower net income. We have entered into a variety of reinsurance arrangements under which we cede business to other insurance companies to mitigate risk. A significant portion of our risks are reinsured with a single reinsurance company, Hannover Life Reassurance Company of America. For more information on Hannover, see "Business -- Reinsurance -- Existing Arrangements." We also have assumed risk on a "quota share" basis from other insurance companies. Our results of operations are presented net of reinsurance.
INSURANCE. We use a combination of insurance and self-insurance for a number of our risks including property, general liability, directors' and officers' liability, workers' compensation, vehicle liability, and employee-related healthcare benefits. Liabilities associated with the risks that are retained are estimated by considering various historical trends and forward-looking assumptions. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends. Over the past couple of years, increases in the cost and availability of commercial insurance
- Senior and Other -- includes Medicare supplement, long-term care, dental, life insurance and annuities; and
- Corporate and Other -- includes primarily interest income, interest expense, and corporate expenses of the holding company.
All of our acquisitions were accounted for using the purchase method of accounting. Results for United Benefit Life are included from August 1, 1998 to July 20, 1999 under a reinsurance agreement and thereafter as an acquired entity. The financial information for the year ended December 31, 1999 includes the operations of Continental General since February 1, 1999 and of Provident American Life for the entire year. The financial information for the years ended December 31, 2003, 2002 and 2001, includes the operations of all our subsidiaries for the entire period with the exception of Pyramid Life.
For the year ended December 31, 2003, total net premiums were $478.3 million, a decrease of 11.4%, from $540.1 million for 2002.
- a decline in the percentage of business ceded from 15.3% in 2002 to 13.5% in 2003.
Our 2004 marketing strategy will continue to focus on a reduced number of geographic locations which have historically produced favorable underwriting results. We expect increased production levels in 2004 and the decline in major medical premium to moderate to 10-15%.
Net realized gains were $1.9 million for 2003 compared to $2.3 million for 2002. The prior year reflected a partial redistribution of our investment portfolio, that resulted in the realization of capital gains, offset by the write-down for other-than-temporary impairment on bonds held in WorldCom of $0.9 million.
Total benefits, claims, losses and settlement expenses decreased to $353.7 million for 2003 compared to $421.0 million for 2002, a decrease of 16.0%.
- the implementation of rate increases in excess of claim trend on certain unprofitable blocks;
- the cancellation of Central Reserve's major medical business in Texas effective September 30, 2002; and
Selling, general and administrative expenses decreased to $146.8 million in 2003 compared to $175.2 million in 2002, a decrease of 16.2%. Commissions decreased $25.2 million and other operating expenses decreased $8.7 million as a direct result of our cancelled business offset by reduced reinsurance allowances of $5.5 million resulting from a lower volume of ceded premiums. As a percentage of revenues, selling, general and administrative expenses decreased to 27.5% in 2003 compared to 29.2% in 2002 due to the decrease in the overall commissions rate as a result of lower new sales, and a reduced workforce.
The special charge for 2002 represented a pre-tax non-recurring charge of $2.7 million ($2.4 million in continuing operations and $0.3 million in discontinued operations) related to the retirement of Peter W. Nauert, our former CEO. See Note O. Special Charges to our audited consolidated financial statements for further information.
Senior and other premiums were $170.1 million for 2002 compared to $153.3 million for 2001, an increase of 11.0%. The increase in senior and other premiums were primarily the result of premium rate increases averaging 10% to 12% on business in force.
Senior and other benefits, claims, losses and settlement expenses were $129.2 million for 2002 compared to $115.0 million for 2001, an increase of 12.3%. The increase was a result of additional claims and benefits paid on a larger volume of business in force and reserve strengthening of $2.5 million on a block of long-term care business. The senior and other loss ratio increased to 76.0% for 2002 compared to 75.0% for 2001, primarily due to higher than anticipated long-term care benefits.
Selling, general and administrative expenses decreased to $175.2 million in 2002 compared to $197.0 million in 2001, a decrease of 11.1%. Commissions decreased $19.9 million and other operating expenses decreased $19.4 million as a direct result of our cancelled or replaced business offset by reduced reinsurance allowances of $17.5 million resulting from a lower volume of ceded premiums. As a percentage of revenues, selling, general and administrative expenses decreased to 29.2% in 2002 compared to 31.6% in 2001 due to a reduced workforce at our Cleveland facility, economies of scale achieved from the conversion of the senior business to our Kansas City facility, and a decrease in the overall commission rate.
Liquidity is our ability to generate adequate amounts of cash to meet our financial commitments. Our major needs for cash are to enable our insurance subsidiaries to pay claims and expenses as they come due and for Ceres to pay interest on, and to repay principal of, its indebtedness. The primary sources of cash are premiums, investment income, fee income, equity and debt financings, and reimbursements from reinsurers.
Payments consist of current claim payments to insureds, medical cost management expenses, and operating expenses such as salaries, employee benefits, commissions, taxes, and interest on debts. Net cash provided by operating activities in 2003 was $43.0 million compared to net cash used in operating activities of $17.6 million in 2002. The increase was primarily attributable to the following:
- improved operating results in both our Senior and Medical segments;
Assets decreased 12.8% to $773.9 million at December 31, 2003 from $887.5 million at December 31, 2002. Assets of $484.3 million, or 62.6% of the total assets, were in investments at December 31, 2003. Fixed maturities, our primary investment, were $479.1 million, or 98.9% of total investments, at December 31, 2003. Other investments consist of surplus notes, policy loans, and mortgage loans. We have classified all of our fixed maturities as "available-for-sale" and accordingly have reported them at their estimated fair values at December 31, 2003.
The total policy liabilities and benefits accrued were 85.7% of the total liabilities at December 31, 2003 compared to 71.1% at December 31, 2002.
OFF-BALANCE SHEET ARRANGEMENTS. We do not have transactions or relationships with variable interest entities, and we do not have any off balance sheet financing other than normal operating leases.
We believe that cash flow from operating activities will be sufficient to meet the currently anticipated operating and capital expenditure requirements of our subsidiaries over the next 12 months. Funds to meet our debt obligations are generated from fee income from our non-regulated subsidiaries. Our ability to make scheduled payments of the principal and interest on our indebtedness depends on our future performance and the future performance of our non-regulated subsidiaries, which are subject to economic, financial, competitive and other factors beyond our control. Fee income is derived from fees charged primarily on our major medical business. As that business continues to decline, fee income will decline.
At December 31, 2003, we had a tax net operating loss, or NOL, carryforward of approximately $14.1 million for federal income tax purposes, which expires through 2021. Changes in ownership, as defined by Sections 382 and 383 of the Internal Revenue Code, could limit the amount of NOL carryforwards used in any one year. Our December 2001 public offering resulted in an "ownership change" as defined in Section 382 of the Code and the regulations issued thereunder. Pursuant to Section 382, our ability to use our NOLs originating prior to the offering, accounting for approximately $14.1 million, is subject to certain restrictions, including an annual limitation of approximately $5.4 million. Losses incurred subsequent to this offering are available without annual limitation to offset future income.
- adverse changes in the regulatory environment specific to the issuer's industry;
- corporate bond prices that move more than 10% over the past week, 20% over the past month, or 30% over the past three months.
All of our fixed maturity investments are reported at fair market value at December 31, 2003. The amortized cost and estimated fair value of fixed maturities on our investment surveillance list at December 31, 2003 were $4.9 million and $4.7 million, respectively. For more information, see Note C. Cash and Investments to our audited consolidated financial statements.
Interest Rate Risk is the risk that interest rates will change and cause a decrease in the value of an insurer's investments. This change in rates may cause certain interest-sensitive products to become uncompetitive or may cause disintermediation if we attempt to mitigate this risk by charging fees for non-conformance with certain policy provisions and/or by attempting to match the maturity schedule of our assets with the expected payouts of its liabilities. To the extent that liabilities come due more quickly than assets mature, we would have to sell assets prior to maturity and recognize a gain or loss. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical decline in fair value of stockholders' equity is estimated to be $13.5 million after-tax at December 31, 2003. This amount represents approximately 7.3% of our stockholders' equity at such date.
Seasonality is the risk of fluctuations of revenues and operating results. Historically, our revenues and operating results have varied from quarter to quarter and are expected to continue to fluctuate in the future. These fluctuations have been due to a number of factors, including higher benefit utilization by our insureds during the winter months and the use of deductibles. More specifically, our Senior segment's seasonality is the opposite of our Medical segment's, meaning that earnings in the Senior segment are generally lower in the first quarter and higher later in the year. This is mainly a factor of our Medicare supplement products that pay the Medicare deductible for our insureds generally during the early months of the year.
Inflation has had an impact on claim costs and overall operating costs and although it has been lower in the last few years, hospital and medical costs have still increased at a higher rate than general inflation, especially prescription drug costs. New, more expensive and wider use of pharmaceuticals is inflating health care costs. We will continue to establish premium rates in accordance with trends in hospital and medical costs along with concentrating on various cost containment programs. However, there can be no assurance that these efforts by us will fully offset the impact of inflation or that premiums will equal or exceed increasing healthcare costs.
This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are necessarily based on estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, us.
- our ability to continue to meet the terms of our debt obligations under our credit agreement which contains a number of significant financial and other covenants;
- our financial and claims paying ratings, including any potential downgrades;
In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 (FIN 46). FIN 46 addresses consolidation by business enterprises of variable interest entities which have certain characteristics by requiring that if a business enterprise has a controlling interest in a variable interest entity (as defined by FIN 46), the assets, liabilities, and results of activities of the variable interest entity be included in the consolidated financial statements with those of the business enterprise. FIN 46 applies to variable interest entities created after January 31, 2003 and to variable interest entities in which an enterprise obtains an interest after that date. For variable interests acquired before February 1, 2003, FIN 46 applies in the first fiscal year or interim period beginning after June 15, 2003. We have, and will continue to, adopt the various provisions of FIN 46 as indicated above, but presently do not have any variable interest entities that would be required to be included in our consolidated results of operations, cash flows or financial position.
In June 2002, the FASB, issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (SFAS 146), which supercedes Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)(EITF Issue 94-3). The provisions of this Statement are effective for exit or disposal activities initiated after December 31, 2002. SFAS 146 requires recognition of a liability for costs associated with an exit or disposal activity when the liability is incurred, rather than when the entity commits to an exit plan under EITF Issue 94-3. This Statement applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a disposal activity covered by SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Additionally, this Statement does not apply to costs associated with the retirement of a long-lived asset covered by SFAS No. 143, Accounting for Asset Retirement Obligations. The adoption of this Standard did not have a material effect on our consolidated results of operations, cash flows or financial position.
We have audited the accompanying consolidated balance sheet of Ceres Group, Inc. (the "Company") as of December 31, 2003 and the related consolidated statements of operations, stockholders' equity, and cash flows for the year then ended. In connection with our audit of the consolidated financial statements, we have also audited the financial statement schedules as listed in the accompanying index. These audited consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these audited consolidated financial statements and financial statement schedules based on our audit.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Ceres Group, Inc. and subsidiaries at December 31, 2002, and the consolidated results of their operations and their cash flows for each of the two years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States. Also in our opinion, the related financial statement schedules when considered in relation to the basic 2002 and 2001 consolidated financial statements taken as a whole, present fairly, in all material respects, the 2002 and 2001 information set forth therein.
Ceres Group, Inc. (formerly known as Central Reserve Life Corporation) operated in 1998 and prior periods primarily through its wholly-owned subsidiary, Central Reserve Life Insurance Company. As of December 31, 2003, 2002 and 2001, the Company's consolidated statements also include the continuing operations of Provident American Life & Health Insurance Company acquired on December 31, 1998, Continental General Corporation and its wholly-owned subsidiary, Continental General Insurance Company, acquired on February 17, 1999, United Benefit Life Insurance Company under a reinsurance arrangement effective August 1, 1998 and acquired on July 21, 1999 (through foreclosure), and the discontinued operations of Pyramid Life Insurance Company acquired on July 26, 2000. Effective March 31, 2003, Ceres sold its subsidiary, Pyramid Life Insurance Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. See Note E. Discontinued Operations for further information. As a result of the sale of Pyramid Life, our previously reported consolidated financial statements for 2001 have been reclassified to present the discontinued operations of Pyramid Life separate from continuing operations to conform to the current year's presentation.
The FASB staff also issued Emerging Issues Task Force, or EITF D-100: Clarification of Paragraph 61(b) of FASB Statement No. 141 and Paragraph 49(b) of FASB No. 142, which further clarified what the FASB staff believed was the Board's intent for reclassifying an intangible asset out of goodwill of a previously acquired intangible asset.
Cash and cash equivalents include cash and all liquid securities with maturities of 90 days or less when purchased. See Note C. Cash and Investments for further information.
Premiums and discounts arising from the purchase of mortgage-backed securities are amortized using the interest method over the estimated remaining term of the securities, adjusted for anticipated prepayments. Premiums and discounts on other debt instruments are amortized using the effective interest method over the remaining term of the security.
Realized gains and losses on the sale of investments are determined using the specific-identification method, and are credited or charged to income. Also charged to income are unrealized losses on investment securities for which a decline in fair market value is deemed to be other-than-temporary.
- the duration and extent to which the fair value has been less than cost; and
Property and equipment are carried at cost less allowances for depreciation and amortization. Office buildings are depreciated on the straight-line method over 35 years, except for certain components, which are depreciated over 15 years. Depreciation for other property and equipment is computed on the straight-line basis over the estimated useful lives of the equipment, principally three to seven years. Property held for sale is stated at estimated fair value less cost to sell. No depreciation or amortization is provided for property held for sale.
Claim liabilities with a long pay out period, such as disability income and long-term care claims, are discounted at interest rates of 4.5% and 6.5%, respectively. Although considerable variability is inherent in such computations, management believes that the liabilities for unpaid life and accident and health claims are adequate. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known with such adjustments included in current operations.
Statement of Position No. 97-3, Accounting by Insurance and Other Enterprises for Insurance-Related Assessments, provides guidance for determining when an insurance or other enterprise should recognize a liability for guaranty-fund and other insurance-related assessments and guidance for measuring the liability.
For the year ended December 31, 2003, there was a positive pro forma impact on net income, net income attributable to common stockholders, and basic and diluted earnings per share due to the forfeiture of options resulting from employee terminations.
Basic earnings per share is computed by dividing the income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if common stock equivalents were exercised and shared in the earnings of the Company. Only those potential common shares, which are dilutive, are included in the computation of diluted earnings per share. See Note T. Computation of Net Income Per Common Share for further information.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (SFAS 150). SFAS 150 establishes standards for how an issuer classifies and measures three classes of freestanding financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. For mandatorily redeemable financial instruments of a nonpublic entity, this Statement is effective for fiscal years beginning after December 15, 2003. We have not entered into any financial instruments within the scope of SFAS 150 since May 31, 2003, nor do we currently hold any significant financial instruments as defined within the scope of this pronouncement.
In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (SFAS 149). SFAS 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133). SFAS 149 is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of SFAS 149 on July 1, 2003 did not have a material impact on our consolidated results of operations, cash flows or financial position.
Except for bonds and notes of the U.S. Government or of a U.S. Government agency or authority, no investment of the Company exceeds 10% of total stockholders' equity at December 31, 2003 and 2002.
The amortized cost and estimated fair value of invested assets as of December 31, 2003 by contractual maturity were as follows:
The following is a summary of net investment income by category of investment:
At December 31, 2003 and 2002, the Company's insurance subsidiaries had certificates of deposit and fixed maturity securities with a carrying value of $26.4 million and $33.1 million, respectively, on deposit with various state insurance departments to satisfy regulatory requirements.
In December 2003, Continental General committed to invest $5.0 million in a limited partnership, NYLIM-GCR Fund I-2002, L.P. Investments by this Fund are expected to consist primarily of a diversified pool of subordinated real estate mezzanine debt and sub-tranche loans with an expected concentration in office assets located in major metropolitan areas. At December 31, 2003, the Fund had not made a capital call on Continental General's limited partner commitment.
The following is a summary of investments that have been in a continuous unrealized loss position as of December 31, 2003:
The Company evaluates its investment policies consistent with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and has determined that all of its investments are to be classified as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported in accumulated other comprehensive income. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are identified as net realized gains (losses). Management continually evaluated whether changes in the value of any investment should be considered other-than-temporary. In June 2003, the Company wrote down its holdings in American Airlines and Coastal Corp. to their then fair market value, recording a total realized pre-tax loss of $0.3 million. None of the fixed investments above are delinquent or in default and there are no conditions present that indicate a high probability that all amounts will not be collected. Based on evaluation by both internal management along with external investment managers, including our ability to sell or hold the investments and the length of time and magnitude of the unrealized loss, management has determined that at December 31, 2003, none of the above fixed investment values represent an other-than-temporary impairment.
Other property and equipment consists principally of software, leasehold improvements, and office equipment. Depreciation expense for the years ended December 31, 2003, 2002 and 2001 was $1.5 million, $1.2 million, and $1.6 million, respectively.
On March 31, 2003, Continental General sold the stock of its subsidiary, Pyramid Life, which was primarily included in our Senior and Other segment, to the Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. Net proceeds from the sale were used to strengthen Continental General's statutory capital and repay $10.0 million of our bank debt. Additionally, we continued to process Pyramid Life's business through an administrative services agreement, which terminated on December 31, 2003. The total loss from the sale (net of taxes and expenses incurred) was $13.8 million. Accordingly, we adjusted the carrying value of Pyramid Life's assets held for sale to fair market value at December 31, 2002, which resulted in a charge of $11.6 million. In addition, we recorded a $2.2 million loss on the sale in 2003. As a result of the sale, Pyramid Life's operations were classified as discontinued operations and prior years' financial information has been reclassified.
Rent expense for the Cleveland headquarters was approximately $1.8 million in 2003, $1.7 million in 2002, and $0.7 million in 2001. Future rent payments for the Cleveland headquarters and all other operating leases are as follows:
In 2001, goodwill and licenses amortization was $0.7 million ($0.4 million on an after-tax basis, or $0.02 per diluted shared).
The following table reflects the consolidated results adjusted as though the adoption of SFAS 142 occurred as of the beginning of fiscal 2001:
At December 31, 2003, the Company had a tax net operating loss carryforward, or NOL, of approximately $14.1 million for federal income tax purposes, which expires through 2021. Future changes in
ownership, as defined by Sections 382 and 383 of the Internal Revenue Code, could limit the amount of NOL carryforwards used in any one year. Our December 2001 public offering resulted in an "ownership change" as defined in Section 382 of the Code and the regulations issued thereunder. Pursuant to Section 382, our ability to use our NOLs originating prior to the offering, accounting for approximately $14.1 million, is subject to certain restrictions, including an annual limitation of approximately $5.4 million. Losses incurred subsequent to this offering are available without annual limitation to offset future income.
The foregoing indicates that a $13.0 million redundancy in the 2002 reserves emerged in 2003 as a result of an improvement of medical claim trends primarily on fourth quarter 2002 incurred versus our original projected levels. In 2002, a $8.4 million deficiency in the 2001 reserves emerged as a result of higher than anticipated claims cost associated with a reduction in pending claims inventory in the Medical segment. In 2001, a $17.0 million deficiency in the 2000 reserves emerged as a result of higher utilization in the Medical segment related to increased costs of services, a greater utilization of medical services and greatly increased expenditures on prescription drugs.
In December 1999, Central Reserve entered into a reinsurance transaction with Hannover for certain health insurance policies issued during the period from July 1, 1998 through June 30, 1999. As part of the coinsurance funds withheld transaction, Hannover paid Central Reserve on a quarterly basis, an experience refund, the amount of which was based upon the earnings derived from the business reinsured. Concurrent with this transaction, Hannover reinsured to Continental General on a stop loss basis 100% of any losses incurred for the business reinsured in excess of a pre-determined aggregate annualized loss ratio of 76.0% in 2000, 78.0% in 2001, and 80.0% in 2002. In exchange for coverage under the stop loss reinsurance, Hannover paid Continental General a stop loss premium on the business reinsured. The effects of the transaction, except the net risk charge to Hannover, was eliminated in consolidation. This reinsurance agreement was terminated effective December 31, 2002 by mutual consent of the parties.
Central Reserve received 100 basis points of reinsurance premium in 2002 from London. On June 2, 2002, these reinsurance agreements were terminated. The Company determined that this contract did not transfer risk in accordance with generally accepted accounting principles, and reflected this agreement as a deposit in 2002 and 2001.
Effective March 31, 2003, Continental General entered into a reinsurance agreement with Pyramid Life under which Continental General reinsured on a 100% coinsurance basis and, to the extent policyholders consent or are deemed to consent thereto, on an assumption reinsurance basis, certain interest sensitive whole-life policies. Cash of $12.1 million was transferred from Pyramid Life to Continental General for the policy liabilities assumed by Continental General.
Effective January 1, 1999, Provident American Life entered into a reinsurance agreement with Provident Indemnity, whereby Provident American Life reinsured 100% of Provident Indemnity's business written after December 31, 1998. In a separate reinsurance agreement, Provident American Life ceded to Hannover 50% of its direct business written after December 31, 1998 and 50% of the business reinsured from Provident Indemnity.
In connection with the United Benefit Life reinsurance treaty, Central Reserve ceded 80% of the business in force on August 1, 1998 to Hannover, thereby retaining a net risk of 20%. Additionally, Central Reserve ceded 50% of the policies written by United Benefit Life subsequent to August 1, 1998 and reinsured by Central Reserve to Hannover. This treaty provided Central Reserve an initial ceding allowance of $20.0 million, which was being accounted for as a deferred reinsurance gain in the accompanying audited
business. The above table does not include the amortization of initial ceding allowances received from reinsurers. Amortization of deferred reinsurance gain for the years ended December 31, 2003, 2002 and 2001 was $1.7 million, $2.8 million, and $5.0 million, respectively.
We are involved in various legal and regulatory actions occurring in the normal course of business. Based on current information, including consultation with outside counsel, we believe any ultimate liability that may arise from these actions would not materially affect our consolidated financial position, results of operations or cash flows. However, we cannot predict with certainty the outcome of lawsuits against the Company or the potential costs involved. Our evaluation of the likely impact of these actions could change in the future and an unfavorable outcome could have a material adverse effect on our consolidated financial position, results of operations or cash flows of a future period.
To provide funds for the acquisition of Continental General, on February 17, 1999, we entered into a credit agreement among Ceres, various lending institutions, and JPMorgan Chase (formerly the Chase Manhattan Bank), as Administrative Agent. Under the agreement, we borrowed $40.0 million under a tranche A term loan and secured a $10.0 million revolver. The credit agreement was amended on July 25, 2000 to increase the revolver from $10.0 million to $15.0 million in connection with the acquisition of Pyramid Life. On March 30, 2001, the credit agreement was amended to enter into a $10.0 million term loan with The CIT Group/Equipment Financing, Inc. The proceeds of this term loan, the tranche B term loan, were used to permanently pay down $10.0 million of our then fully-drawn $15.0 million revolver agreement. On February 17, 2002, the balance of the revolver was permanently repaid from the proceeds of our December 2001 public offering. On March 31, 2003, the credit agreement was amended in connection with the sale of Pyramid Life and required sale proceeds of $10.0 million to be used to partially pay down bank debt. After this payment and along with normally scheduled principal payments, the balance of the term loans at December 23, 2003 was $11.4 million.
Both term loans bear interest at floating rates, based on either Prime or LIBOR, plus applicable spreads. Under Prime rate borrowings, the interest rate for term loan A and term loan B will be the Prime interest rate plus 0.50% and 1.25%, respectively. Under Eurodollar borrowings, the interest rate for term loan A and term loan B will be LIBOR plus 3.25% and 4.00%, respectively. At December 31, 2003, the interest rate on our term loan A balance of $4.0 million was 4.41% per annum and our $9.0 million term loan B was 5.16% per annum.
On April 15, 2002, Peter W. Nauert announced his retirement from his position as our Chief Executive Officer effective June 1, 2002. He remained as Chairman of the Board of Directors until May 2003. In the first quarter of 2002, we reported a pre-tax non-recurring special charge to operations of approximately $2.7 million ($2.4 million in continuing operations and $0.3 million in discontinued operations) related to the early termination of his employment agreement and the payment of certain benefits through June 2003.
We reported special charges of $7.1 million in the first quarter of 2001 related to:
- the elimination of $5.9 million deferred acquisition cost (DAC) asset on all products of United Benefit Life and Provident American Life; and
In 1999, pursuant to the 1999 Special Agents' Stock Option Plan, the Company granted 78,706 common stock options to certain Regional Sales Directors and Managing General Agents. Each grant vested immediately and expires ten years from the date of grant. The Company terminated this plan at the end of 2000. At December 31, 2003, there were options outstanding under the plan to purchase 78,706 shares.
Our 2000 Employee Stock Purchase Plan was adopted by our stockholders on June 27, 2000. Under the plan, employees may purchase shares of our common stock at a 15% discount from fair value. All of our full time employees, including officers, are eligible to participate in the employee stock purchase plan, subject to limited exceptions. Eligible employees participate voluntarily, and may withdraw from an offering at any time before the stock is purchased. Participation terminates automatically upon termination of employment other
than for death, disability or retirement. Six-month offerings are made available beginning May 1 and November 1 of each year. The purchase price per share in an offering will not be less than 85% of the lesser of the stock's fair value at the beginning of the offering period or on the applicable exercise date and may be paid through payroll deductions. As of December 31, 2003 and 2002, 35,183 and 63,954 shares, respectively, had been issued under the employee plan.
The Company has authorized 100,000 Convertible Voting Preferred Shares, $.001 par value, of which none are outstanding at December 31, 2003. On December 27, 2001, the Company repurchased its convertible voting preferred stock for $5.0 million from the proceeds of the public offering. The carrying value of the convertible voting preferred stock was $8.2 million and the related dividends distributable was $0.4 million. The resulting gain from repurchase of the convertible voting preferred stock was $3.6 million. The gain was recorded in retained earnings and was reflected as a component of net income attributable to common stockholders. For more information regarding our convertible voting preferred stock, see Note B. Equity Transactions.
(2) Statutory capital and surplus for Continental General includes Pyramid Life for the years ended December 31, 2002 and 2001, and an additional $21.0 million from the sale of Pyramid Life in 2003. Continental General's statutory net gain for the year ended December 31, 2003 includes $31.0 million from the sale of Pyramid Life.
Basic and diluted earnings per share are calculated in accordance with SFAS No. 128, Earnings per Share. Basic earnings per common share is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of shares outstanding during the period. Diluted earnings per common share is computed by dividing net income (loss) by the weighted average number of shares outstanding during the period including the effect of the assumed exercise of dilutive stock options under the treasury stock method.
Effective June 1, 2002, the Plan was amended so that participants can elect to make pre-tax contributions from 1% to 25% of their compensation and after-tax contributions were no longer permitted. In addition to the Company Match Contribution, Ceres will match 100% of each participant's contributions (Stock Match Contribution) to the Ceres Group, Inc. Stock Fund, up to a maximum of $1,000 per year provided the participant agrees that the pre-tax contributions will not be transferred out of the fund for a minimum of one year.
allocate investments or other identifiable assets by industry segment, nor are income tax expenses (benefits) allocated by industry segment.
CASH, CASH EQUIVALENTS, ACCRUED INVESTMENT INCOME, PREMIUMS RECEIVABLE, SURPLUS NOTES, MORTGAGE LOANS AND POLICY NOTES -- The carrying amounts reported in the consolidated balance sheets for these instruments approximate their fair value.
The following is a summary of quarterly results of operations for the years ended December 31, 2003 and 2002. All prior quarters have been reclassified to reflect the sale of Pyramid Life:
CERES GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CERES GROUP, INC. (PARENT ONLY) BALANCE SHEETS DECEMBER 31, 2003 AND 2002 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
CERES GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CERES GROUP, INC. (PARENT ONLY) STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
CERES GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CERES GROUP, INC. (PARENT ONLY) STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
CERES GROUP, INC. AND SUBSIDIARIES SUPPLEMENTAL INSURANCE INFORMATION (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------