The selected consolidated financial data presented below as of and for each of the five years ended December 31, 2001, 2000, 1999, 1998, and 1997 have been derived from our audited consolidated financial statements. The acquisitions of Provident American Life, Continental General and Pyramid Life occurred on December 31, 1998, February 17, 1999 and July 26, 2000, respectively. These acquisitions had no impact on our results of operations in 1998. 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 for Provident American Life and United Benefit Life (through reinsurance) for the entire period, and the financial information for the year ended December 31, 2000 includes the operations of Pyramid Life since July 26, 2000. The financial information for the year ended December 31, 2001 includes the operations of all our subsidiaries for the entire year. This data should be read in conjunction with the more detailed information contained in the consolidated financial statements and accompanying notes, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other financial information included elsewhere in this filing.
(1) Loss per share amounts for 1997 and 1996 have been restated to comply with Statement of Financial Accounting Standard No. 128 "Earnings Per Share."
(3) "Accumulated other comprehensive income (loss)" relates primarily to the net unrealized gain (loss) on available-for-sale securities.
(4) We received proceeds from our December 2001 public offering and private placement offerings in 2000, 1999 and 1998. For more information, see Note B, Equity Transactions, to our consolidated financial statements.
- entered into a quota share reinsurance agreement with Hannover, effective January 1, 1997, under which Hannover reinsured 50% of certain group health policies in force at Central Reserve and written during 1997;
- entered into an agreement with United Benefit Life Insurance Company as of August 1, 1998 to reinsure 100% of the major medical policies of United Benefit Life and entered into a reinsurance agreement with Hannover in which we ceded 80% of the risk for United Benefit Life policies in force before August 1, 1998 and 50% of the risk for United Benefit Life policies in force after August 1, 1998;
- acquired Continental General Insurance Company from The Western & Southern Life Insurance Company of Cincinnati, Ohio, on February 17, 1999 for $84.5 million including $40.0 million from a credit facility with Chase, $15.0 million from a private placement of 2,000,000 shares of our common stock, $22.5 million from a special pre-closing dividend to Western & Southern from Continental General, and the balance in cash;
- acquired a block of individual and small group health insurance written by American Chambers Life Insurance Company effective May 1, 2000;
- acquired Pyramid Life Insurance Company from United Insurance Company of America, a subsidiary of Unitrin, Inc., on July 26, 2000 for $67.5 million including $25.0 million from a special pre-closing dividend from Pyramid Life to Unitrin, $20.0 million from a private placement offering of 3,333,334 shares of our common stock, $15.0 million from cash at Continental General and financing provided by Chase, and $7.5 million from the sale of our convertible voting preferred stock to United Insurance Company;
In addition to the reserves discussed above, we also maintain reserves for policies that are not currently in claims based upon actuarial expectations that a policy may become a claim in the future. These reserves are calculated based on factors that include estimates for mortality, morbidity, interest rates and persistency. Factor components generally include assumptions that are consistent with both our experience and industry practices.
premiums are earned over the life of the contract. Deferred acquisition costs associated with interest-sensitive life and annuity products are charged to expense over the estimated duration of the policies in relation to the present value of the estimated gross profits from surrender charges and investments, mortality, and expense margins. Amortized deferred acquisition costs are affected by unanticipated termination of policies because, upon such unanticipated termination, we expense fully the unamortized deferred acquisition costs associated with the terminated policy.
Value of business acquired. A portion of the purchase price paid for Pyramid Life and 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 unamoritized 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.
Policies renew or lapse for a variety of reasons, due both to internal and external causes. We believe that our efforts to address any concerns or questions of our insureds in an expedient fashion help to ensure ongoing policy renewal. We also believe that we enjoy a favorable reputation with our insureds for providing desirable policy benefits and efficient claims processing. We work closely with our licensed agents, who play an integral role in obtaining policy renewals and communicating with our insureds.
External factors also contribute to policy renewal or lapsation. Economic cycles can influence an insured's ability to continue the payment of insurance premiums when due. New government initiatives have raised public awareness of the escalating costs of healthcare, which we believe boosts new sales and promotes renewal payments.
Lapsation and persistency may positively or adversely impact future earnings. Higher persistency generally results in higher renewal premium. However, higher persistency may lead to increased claims in future periods. Additionally, increased lapsation can result in reduced premium collection, accelerated deferred acquisition cost amortization and anti-selection of higher-risk insureds.
Reinsurance. Consistent with the general practice of the insurance industry, we reinsure portions of the coverage provided by our insurance products to unaffiliated insurance companies under reinsurance agreements. Reinsurance provides a greater diversification of underwriting risk, minimizes our aggregate exposure
Fee and other income increased to $36.2 million for 2001 compared to $32.7 million for 2000, an increase of 10.5%. This net increase was attributable to new administrative fees introduced at Continental General in May 2000, fees received on a larger volume of business in force and partially offset by the United Benefit Life and Provident American Life termination or replacement program and the cancellation of other medical business in certain states.
Medical benefits, claims, losses and settlement expenses were $333.7 million for 2001 compared to $288.3 million for 2000, an increase of 15.8%. The increase was a result of higher than anticipated benefit utilization in 2001 versus 2000 in the medical segment related to increased costs of services, greater utilization of medical services and greatly increased expenditures on prescription drugs, a larger volume of business in force at Continental General, and $3.1 million attributable to a full year of Pyramid Life. Additionally, for these same reasons, a $12.4 million deficiency in 2000 reserves emerged in 2001. The medical loss ratio was 81.8% for 2001 compared to 76.7% for 2000. The medical loss ratio without United Benefit Life and Provident American Life was 79.1% compared to 76.6% for 2001 and 2000, respectively. The increase was due to the above mentioned items.
Selling, general and administrative expenses increased to $223.9 million in 2001 compared to $186.4 million in 2000, an increase of 20.1%. The increase in selling, general and administrative expenses represented a $3.0 million increase in commissions, a $14.3 million increase in other operating and reinsurance expenses attributable to our increased business base, and reduced reinsurance allowances of $20.2 million resulting from a lower volume of ceded premiums. The inclusion of Pyramid Life for a full year accounted for $17.0 million of the $37.5 million increase. As a percentage of revenues, selling, general and administrative expenses have decreased to 31.4% in 2001 compared to 32.3% in 2000.
The net (deferral) amortization and change in acquisition costs and value of business acquired resulted in a net deferral of $29.2 million for 2001 compared to a net deferral of $30.5 million for 2000. Pyramid Life accounted for $4.9 million of the net deferral. The decrease was primarily attributable to the write-off of Central Reserve's deferred acquisition costs (DAC) asset of approximately $6.7 million in six states due to the continuing unprofitability of the business in those states.
The amortization of deferred reinsurance gain of $6.1 million for 2000 represented the recognition and amortization of the ceding commission allowances received on our reinsurance agreements. The unamortized amount of $18.8 million at December 31, 2000 was accounted for as a deferred reinsurance gain on our consolidated balance sheet.
Senior and other benefits, claims, losses and settlement expenses were $101.6 million for 2000 compared to $56.6 million for 1999, an increase of 79.5%. The increase was a result of $17.4 million attributable to Pyramid Life for five months, claims and benefits paid on a larger volume of business and the inclusion of Continental General's results for twelve months in 2000 compared to eleven months in 1999. The senior loss ratio was 74.8% for 2000 compared to 74.6% for 1999.
Selling, general and administrative expenses increased $48.5 million to $186.4 million in 2000 compared to $137.9 million in 1999, an increase of 35.1%. The increase in selling, general and administrative expenses resulted from a $42.6 million increase in commissions and a $13.8 million increase in other operating expenses and a $5.4 million increase in premium taxes, licenses and fees attributable to our increased business base. This increase was partially offset by a net change in reinsurance expenses and allowances of $13.3 million. The addition of Pyramid Life accounted for $10.0 million of the $48.5 million increase. As a percentage of
consolidated revenues, selling, general and administrative expenses decreased to 32.3% in 2000 compared to 37.1% in 1999.
The net amortization and change in deferral of acquisition costs and value of business acquired resulted in a net deferral of $30.5 million for 2000 compared to a net deferral of $21.9 million for 1999. Pyramid Life accounted for $2.5 million of the net deferral in 2000. The remaining increase in the deferral was a result of capitalized acquisition expenses on new business, including Continental General's new business for twelve months in 2000 versus eleven months in 1999.
Interest expense and financing costs increased to $5.6 million in 2000 compared to $4.1 million in 1999 as a result of the interest expense incurred under our credit agreement for twelve months in 2000 compared to interest expense for 1999 which did not begin to accrue until February 17, 1999, the closing date of the purchase of Continental General, and a higher outstanding balance. Interest rates charged under the credit agreement in 2000 were also higher than those charged in 1999.
For the year ended December 31, 2000, the provision for federal income taxes was $8.4 million, or 33.8% of income before federal income taxes of $24.8 million. The 1999 effective rate was 35.0%.
Royalton Investors, LLC and Big T Investments, LLC for $16.0 million and concurrently we leased it back for a term of 15 years with four optional five-year extensions. Monthly rent payments began in August 2001 and annually total $1.7 million through July 2003, $1.8 million through July 2006, $2.0 million through July 2011, and $2.1 million through July 2016. The net proceeds were used to:
- prepay in full the outstanding $7.9 million mortgage note on the building on August 3, 2001;
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, Ceres borrowed $40.0 million under a tranche A term loan and secured a $10.0 million revolver.
On December 27, 2001, our credit agreement again was amended in connection with the stock offering. The credit agreement, as amended, contains financial and other covenants that among other things:
- an interest coverage ratio (consolidated earnings before interest, income taxes, depreciation, and amortization to consolidated interest expense) of 3.00 to 1.00;
- repay a portion of our tranche A term loan with $10.0 million of the proceeds from the December 2001 equity offering;
- allowed repurchase of all of our convertible voting preferred stock with $5.0 million of the proceeds from the equity offering; and
The following schedule summarizes current and future contractual obligations as of December 31, 2001:
At December 31, 2001, we had a tax net operating loss, or NOL, carryforward of approximately $26.6 million for federal income tax purposes, which expires through 2015. 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. The December 2001 public offering resulted in an "ownership change" of our company, 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 $26.6 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.
In addition, insurance companies are subject to extensive federal and state regulation and compliance with these regulations could increase the insurance companies' operating costs. In some circumstances, failure to comply with certain insurance regulations could subject an insurance company to regulatory actions by such insurance company's state of domicile. For example, states have statutory risk-based capital, or RBC, requirements for health and other insurance companies based on the RBC Model Act. These RBC requirements are intended to assess the capital adequacy of life and health insurers, taking into account the risk characteristics of an issuer's investments and products. In general, under these laws, an insurance company must submit a report of its RBC level to the insurance department of its state of domicile as of the end of the previous calendar year. These laws provide for four different levels of regulatory attention depending on the ratio of an insurance company's total adjusted capital (defined as the total of its statutory capital, surplus and asset valuation reserve) to its risk-based capital. As of December 31, 2001, our risk-based capital levels for each of our insurance subsidiaries exceeded the levels required by regulatory authorities.
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
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, as evidenced by the year ended December 31, 2001, 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.
- the failure to successfully manage our expanding operations and integrate future acquisitions, if any, including the failure to achieve cost savings;
- the performance of others on whom we rely for administrative and operations services;
- restrictions on our insurance subsidiaries' ability to pay dividends to Ceres;
- the failure to comply with financial and other covenants in our loan agreements;
- our ability to obtain additional debt or equity financing on terms favorable to us to facilitate our long-term growth.
This Statement required that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and by broadening the presentation of discontinued operations to include more disposal transactions. The provisions of this Statement generally are to be applied prospectively. The adoption of SFAS No. 144 on January 1, 2002 is not expected to have a significant effect on our results of operations, financial position or liquidity.
In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets, which replaces APB Opinion No. 17, Intangible Assets. This Statement addressed how intangible assets that are acquired
In general, application of the new provisions for goodwill and other indefinite-lived intangible assets may result in more income statement volatility due to the potential for periodic recognition of impairment losses, which could vary in amount and regularity versus reducing those assets through systematic amortization over a finite period of time.
In September 2000, the FASB issued SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which replaces SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This Statement revised the methods for accounting for securitizations and other transfers of financial assets and collateral as outlined in SFAS No. 125, and required certain additional disclosures. The adoption of this Statement did not have a material effect on our results of operations, financial position or liquidity.
CERES GROUP, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
DECEMBER 31, 2001 AND 2000 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
The Company provides through its wholly-owned subsidiaries a wide array of health and life insurance products to over 535,000 insureds. While the Company through its subsidiaries is licensed in 49 states, the District of Columbia and the U.S. Virgin Islands, approximately 60.0% of premium volume is generated from ten states: Ohio, Texas, Florida, Indiana, Pennsylvania, Tennessee, Georgia, Missouri, Illinois and Nebraska.
The accompanying financial statements have been prepared in accordance with generally accepted accounting principles, which differ from accounting practices prescribed or permitted by the various state departments of insurance in which the insurance subsidiaries are domiciled. See Note P, Statutory Financial Information for further information.
Certain excess first year costs associated with issuing an insurance policy, including commissions and underwriting, all of which vary with and are primarily related to the production of new business, have been deferred and reported as deferred acquisition costs. Deferred acquisition costs associated with traditional life and accident and health contracts are charged to expense over the premium-paying period or as premiums are earned over the life of the contract. Deferred acquisition costs associated with interest-sensitive life and annuity products are charged to expense over the estimated duration of the policies in relation to the present value of the estimated gross profits from surrender charges and investments, mortality, and expense margins.
The Company evaluates the recoverability of deferred acquisition costs on a quarterly basis and determined that these amounts are recoverable.
Goodwill represents the excess of cost over the fair value of net assets acquired. Goodwill is being amortized on a straight-line basis over periods of 25 years or less. On a periodic basis, management reviews goodwill to determine if events or changes in circumstances indicate the carrying value of such assets is not recoverable, in which case an impairment charge would be recorded in current operations. Management believes that no impairment of goodwill exists at December 31, 2001. See New Accounting Pronouncements for further information.
Liabilities for future policy reserves for accident and health and ordinary life business are based on the net level premium basis and estimates of future claims, investment yield, lapses using the Company's experience and actuarial judgment with an allowance for possible future adverse deviations from expected experience. Interest rates used range from 4.5% to 6.0%. Liabilities for interest sensitive products such as deferred
annuities and universal life are based on the retrospective deposit method. This is the policyholder fund balance before adjusting for any surrender charges. Guaranteed minimum rates for universal life contracts are 4.0% to 4.5%. At December 31, 2001, credited rates ranged from 4.0% to 6.0%. Guaranteed base minimum rates for deferred annuities range from 3.0% to 5.0% depending on the duration of the contract. Current rates credited range from 4.0% to 7.0%.
Comprehensive income in 2001, 2000 and 1999 includes a change in unrealized gains or losses on available-for-sale securities, in addition to reported net income. See Note Q, Comprehensive Income (Loss) for further information.
Fee and other income consist of association, collection, management, and administrative fees, and are recognized when earned.
Pursuant to an administrative services agreement with Antares Management Solutions, we outsource all information and telephone systems at our Cleveland headquarters, as well as claims processing and network access for our Central Reserve Ohio insureds. Antares is a division of Medical Mutual Services, which is a subsidiary of Medical Mutual of Ohio, a 2.0% stockholder of the Company on a diluted basis and a party to the Company's voting agreement. Under the administrative services agreement, we have paid $18.4 million in 2001, $21.4 million in 2000 and $18.8 million in 1999.
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and certain Hedging Activities and SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133. We adopted the new statement effective January 1, 2001. If in the future we have derivative instruments, this Statement will require us to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If a derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will either be offset against the change in fair value of the hedged asset, liability, or firm commitment through earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value will be immediately recognized in earnings. The adoption of SFAS No. 133 did not have a significant effect on our results of operations, financial position or liquidity.
- repay $10.0 million of our tranche A term loan (See Note L, Debt, for further information);
- $14.0 million was used by the Company to invest in the statutory surplus of Central Reserve, and was evidenced by a surplus note in favor of the Company from Central Reserve; and
The Bridge Loan was repaid in full by the Company in July 1998 from the proceeds received in accordance with the New Stock Purchase Agreement.
On July 26, 2000, the Company, through Continental General Corporation, completed the purchase of Pyramid Life from United Insurance. Pyramid Life, based in Mission, Kansas, provides health and life insurance primarily for the senior market, including Medicare supplement, long-term care, home health care, and senior life insurance products. At June 30, 2000 (prior to payment of the $25.0 million pre-closing dividend), Pyramid Life had assets of $140.9 million and total revenues of $37.0 million for the first six months of 2000. Pyramid Life markets senior insurance products through approximately 2,500 independent agents in 40 states.
- $20.0 million from the sale of 3,333,334 newly-issued shares of common stock at $6.00 per share, in a private placement offering;
- $7.5 million from the sale to United of 75,000 newly-issued shares of convertible voting preferred stock, which shares (1) are entitled to vote on all matters presented to stockholders as if conversion has occurred, (2) are convertible into common stock by dividing the $100.00 per share purchase price, plus any accrued and unpaid dividends, by the initial conversion price of $6.145 (the average market price of our common stock at the time of issuance), (3) receive cumulative stock dividends of 10% per annum in additional shares of convertible voting preferred stock, (4) prohibit the payment of dividends on shares of common stock unless all previous dividends on the convertible voting preferred stock have been paid, and (5) as of December 31, 2000, $0.3 million in dividends were accrued or $4.36 per convertible voting preferred share;
- $25.0 million from a special pre-closing dividend paid by Pyramid Life to United in connection with the acquisition; and
On December 31, 1998, Central Reserve acquired 100% of the outstanding common stock of Provident American Life from Provident American Corporation for $5.5 million. Provident American Life is a life and accident and health insurer, domiciled in Ohio, licensed in 40 states and the District of Columbia, that markets managed care health insurance products to individuals and small businesses, and critical illness coverage. Funds for the acquisition were provided from Central Reserve's working capital. This transaction was accounted for in the accompanying consolidated financial statements in accordance with the purchase method and accordingly, the purchase price was allocated to assets and liabilities acquired based upon estimates of their fair values. There was no impact on the accompanying consolidated statement of operations for 1998 as a result of this transaction.
Effective January 1, 1999, Hannover assumed from Provident Indemnity 100% of its accident and health block of business. As of January 1, 1999, Central Reserve entered into a separate reinsurance agreement with Hannover, wherein Central Reserve assumed from Hannover 10% of the block acquired by Hannover from
Provident Indemnity. Also, at January 1, 1999, Provident American Life ceded 50% of all business written after December 31, 1998 to Hannover.
The amortized cost and estimated fair value of invested assets as of December 31, 2001 were as follows:
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, 2001 and 2000.
At December 31, 2001, the Company held no unrated bonds and 5.2% of fixed maturity investments were in less-than-investment grade securities. Corporate bonds representing approximately 1.1% of fixed maturities were downgraded by rating agencies. Approximately 4.1% of the portfolio was invested in BB rated subordinated non-agency residential and commercial mortgage-backed securities. These securities include jumbo residential mortgages and commercial mortgages with strong prepayment protection. The Company has, however, taken a $0.8 million write-down for other than temporary impairment on securities backed by leasehold interests in the World Trade Center complex--most of which was destroyed by terrorists on September 11, 2001. No default has occurred on contractual payments for these securities, which represent less than 0.1% of total invested assets. The Company performs periodic evaluations of the relative credit standings of the issuers of the bonds held in the Company's portfolio. The Company considers these evaluations in its overall investment strategy.
Other property and equipment consists principally of software, leasehold improvements and office equipment. Depreciation expense for the years ended December 31, 2001, 2000 and 1999 was $1.9 million, $1.5 million, and $1.1 million, respectively.
A portion of the purchase price paid by the Company for Pyramid Life and 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 unamoritized asset balance. If such current estimate is less than the existing asset balance, the difference would be charged to expense.
For accident and health and ordinary life business, the value of business acquired is amortized over the estimated life of the in force business using assumptions consistent with those in computing reserves. Interest of 6.0% and 7.0% is credited to the unamortized balance for Continental General Corporation and Pyramid Life, respectively. For interest sensitive products such as universal life and deferred annuities, the value of business acquired is amortized over the expected profit stream of the in force business. The expected profit stream is based upon actuarial assumptions as to mortality, lapses and expenses. Earned interest was assumed to be 6.0% for Continental General Corporation and 7.0% for Pyramid Life which was the market rate at the time of acquisition.
The federal income tax returns for the Company and its subsidiaries have been examined by the Internal Revenue Service through 1997.
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2001 and 2000 are presented below:
At December 31, 2001, the Company had a tax net operating loss carryforward, or NOL, of approximately $26.6 million for federal income tax purposes, which expires through 2015. 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. The December 2001 public offering resulted in an "ownership change" of our company, 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 $26.6 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 Company determines a valuation allowance based on an analysis of amounts recoverable in the statutory carryback period and available tax planning strategies. In assessing the valuation allowance established at December 31, 2001 and 2000, estimates were made as to the potential financial impact on the Company of recent NOLs and our financial condition.
In accordance with federal tax law, a portion of insurance companies' net income, prior to 1984, is not subject to federal income taxes (within certain limitations) until it is distributed to policyholders, at which time it is taxed at regular corporate rates. For federal income tax purposes this untaxed income is accumulated in a memorandum account designated "policyholders' surplus." At December 31, 2001, the accumulated untaxed policyholders' surplus for the Company, all of which relates to Central Reserve, is $2.9 million.
The foregoing indicates that a $12.4 million deficiency in the 2000 reserves emerged in 2001 as a result of higher than expected benefit utilization in the medical segment related to increased costs of services, greater utilization of medical services and greatly increased expenditures on prescription drugs. In 2000, a $5.4 million deficiency in the 1999 reserves emerged as a result of higher utilization in all segments, and in 1999, a $1.5 million redundancy in the 1998 reserves emerged.
In February 1999, Continental General entered into a reinsurance agreement with Hannover, under which Hannover reinsured 50% of all insurance business in force at Continental General for a ceding allowance of $13.0 million. The ceding allowance is being accounted for as a deferred reinsurance gain in the accompanying consolidated financial statements and will be amortized into income over the duration of the underlying block of business. Various assets, primarily comprised of fixed income securities with a market value of $188.4 million, were transferred from Continental General to Hannover for the policy liabilities assumed by Hannover.
Effective August 1, 1998, Central Reserve entered into a reinsurance treaty with United Benefit Life, a life and accident and health insurer in Texas. Under the terms of the treaty, Central Reserve agreed to assume 100% of United Benefit Life's block of business, until such time as profits earned by Central Reserve on the assumed block reach a contractual threshold, which approximates $20.0 million of pre-tax income. Central Reserve paid to United Benefit Life a $20.0 million ceding allowance in connection with this transaction. In addition, Central Reserve entered into an agency arrangement with respect to the marketing of United Benefit Life policies with Insurance Advisors of America, Inc., or IAA, a subsidiary of United Benefit Managed Care Corporation and an affiliate of United Benefit Life, in exchange for a $7.0 million note receivable. Central Reserve recorded a full valuation allowance against such note receivable at December 31, 1998.
On March 18, 1999, Central Reserve announced the execution of an agreement with United Benefit Managed Care Corporation, to purchase all of the outstanding shares of its subsidiary, United Benefit Life. On June 14, 1999, Central Reserve terminated this agreement due to a reserve shortfall at United Benefit Life in excess of amounts projected. Pursuant to the "true up" provision in the agreements between United Benefit Life, IAA and Central Reserve, the reserve shortfall on the business assumed from United Benefit Life by Central Reserve at December 31, 1999, was approximately $19.4 million. On July 21, 1999, following receipt of approval from the Department of Insurance of the State of Indiana, Central Reserve foreclosed on the stock of United Benefit Life and the renewal commissions due IAA in partial payment of the $19.4 million reserve shortfall accounted for under purchase accounting rules.
Interest on the outstanding balance of the term loan and revolver are determined based on our selection each quarter of either a Base Rate Loan or a Eurodollar Loan. Under the Base Rate Loan, the interest rate will be 2.5% per annum plus the higher of (a) the rate which is 0.50% of 1.0% in excess of a federal funds rate or (b) Chase's prime rate as in effect from time to time. Under the Eurodollar Loan, the interest rate will be 3.5% per annum plus a Eurodollar rate, which is the arithmetic average of the offered quotation to first-class banks in the interbank Eurodollar market by Chase, adjusted for certain reserve requirements.
On March 30, 2001, our credit agreement again was amended to enter into a new $10.0 million term loan with CIT 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 under the credit agreement. The terms of the amendment provide for CIT Group to participate equally with the syndicate of
banks and Chase under the credit agreement. At December 31, 2001, the interest rate on our tranche A term loan balance of $18.5 million was 6.0% per annum and our $10.0 million CIT tranche B term loan was 6.5% per annum. The first principal payment on the CIT tranche B term loan of $0.3 million will be due on June 17, 2002. Quarterly principal payments will be due thereafter as follows: $0.3 million through March 17, 2004; $0.6 million thereafter through March 17, 2005; and $1.2 million thereafter through March 17, 2006.
- prohibit the payment of cash dividends on our shares of common stock;
- a leverage ratio (consolidated debt to consolidated total capital) of 0.35 to 1.00 through December 31, 2001, and 0.30 to 1.00 thereafter;
- a risk-based capital (RBC) ratio for any of our regulated insurance company subsidiaries of not less than 125.0% of the RBC Company Action Level;
- consolidated net worth of $110.0 million through December 31, 2001, and beginning in 2002, consolidated net worth, excluding goodwill, of no less than the sum of (i) $85.0 million plus (ii) 80% of the net proceeds from the equity offering excluding the $5.0 million repurchase of our convertible voting preferred stock plus (iii) 50% of our aggregate consolidated net income calculated quarterly; and
- allowed capital contributions to our insurance subsidiaries with proceeds from the equity offering after the repayments to the banks and repurchase of our convertible voting preferred stock.
In addition, the common stock of Central Reserve, Continental General, and most of our non-regulated subsidiaries are pledged as security for the credit agreement. At December 31, 2001, we were in compliance with our credit agreement, as amended.
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. Due to the equity offering and the amendment to our credit agreement, we believe that funds should be sufficient to meet all our debt obligations over the next 12 months. Funds to meet our debt obligations are generated from fee income from our non-regulated subsidiaries and from dividends of our insurance subsidiaries, if available. 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. Dividends from the regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. As of December 31, 2001, none of the direct insurance subsidiaries (Central Reserve Life and Continental General) could pay a dividend to Ceres Group, the parent company, without prior approval of their respective state regulators as a result of their respective statutory levels of unassigned surplus.
In 1999, 373 employees each received 1,000 common stock options under the 1998 Employee Stock Option Plan. A second grant was made for new employees hired from January 1, 1999 through September 30, 1999, and still employed as of December 31, 1999. Under this second grant in 2000, 75 employees received 1,000 common stock options. Each grant vests after three years and expires ten years from the date of the grant, with accelerated vesting upon an event of a change in control. The Company terminated this plan in December 2000. At December 31, 2001, there were options outstanding under the plan to purchase 325,000 shares.
In 1998 and 1999, pursuant to various individual employment agreements, the Company granted non-qualified options to purchase 815,000 shares of our common stock to certain key employees. Such grants generally vest over three years. At December 31, 2001 there were options outstanding under the plan to purchase 815,000 shares.
Also, pursuant to employment contracts, the Company provided an award of shares of common stock to Peter Nauert. The number of shares awarded is contingent upon the weighted average fair value of the common shares over specified periods, but is based on a stock award equal to $1.0 million per year through July 1, 2001 and $0.5 million per year through July 1, 2003. Management currently estimates that 269,881 shares (including 28,403 shares issued in 2001, 139,852 shares issued in 2002 and 101,626 shares issued in 2003) will be issued pursuant to the employment contract, based upon the fair value of the Company's shares at December 31, 2001.
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 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
The Company has authorized 1,900,000 Non-Voting Preferred Shares, $.001 par value. The Company has never issued any Non-Voting Preferred Shares; however, the Board of Directors is authorized at any time to provide for the issuance of, such shares in one or more series, and to determine the designations, preferences, limitations and other rights of the shares issued, including but not limited to the dividend rate, liquidation preference, redemption rights and price, sinking fund requirements, conversion rights and restrictions on the issuance of such shares. Holders of non-voting preferred shares shall have no voting rights except as required by law.
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 and Note C, Business Combinations.
State insurance laws and regulations prescribe accounting practices for determining statutory net income and equity for insurance companies. In addition, state regulators may permit statutory accounting practices that differ from prescribed practices. The use of such permitted practices by Ceres and its insurance subsidiaries did not have a material effect on their statutory equity at December 31, 2001 and 2000.
(1) Statutory capital and surplus for Central Reserve includes Provident American Life and United Benefit Life.
Generally, the capital and surplus of Ceres' insurance subsidiaries available for transfer to the parent company are limited to the amounts that the insurance subsidiaries' capital and surplus, as determined in accordance with statutory accounting practices, exceed minimum statutory capital requirements; however, payments of the amounts as dividends may be subject to approval by regulatory authorities. In 2002, Central Reserve, United Benefit Life and Provident American Life cannot pay any dividends without the prior approval of the Ohio Insurance Commissioner as a result of their respective statutory levels of unassigned surplus at December 31, 2001. As of December 31, 2001, Continental General cannot pay any dividends in 2002, without the prior approval of the Nebraska Insurance Commissioner. By agreement with the Kansas Department of Insurance, Pyramid Life can pay dividends to its parent Continental General Insurance only from net underwriting profits of Pyramid Life, and, therefore, as of December 31, 2001, Pyramid Life could pay approximately $1.0 million in dividends in 2002, without the prior approval of the Kansas Insurance Commissioner.
(1) Net of reclassification adjustments for net gains (losses) included in net income.
Based on provisions of the Plan, participants can elect to make pre-tax contributions from 1% to 15% of their compensation and can elect to make after-tax contributions up to 15% of their compensation. 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.
The corporate and other segment encompasses all other activities of the Company, including interest income, interest expense, or corporate expenses of the parent company. Revenues from each segment are primarily generated from premiums charged to external policyholders and interest earned on cash and investments and are summarized in the following tables:
Fair values of financial instruments are based upon quoted market prices, where available, or on values obtained from independent pricing services. In cases where quoted market prices are not available, fair value is based on estimates using the present value of future cash flows or other valuation techniques. These techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Although fair value estimates are calculated using assumptions that management believes are appropriate, differences between estimated and actual outcomes or changes in the underlying assumptions could cause these values to vary materially. Consequently, calculated fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized by the immediate settlement of the instruments.
CERES GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CERES GROUP, INC. (PARENT ONLY) BALANCE SHEETS DECEMBER 31, 2001 AND 2000 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
CERES GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CERES GROUP, INC. (PARENT ONLY) STATEMENT OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
CERES GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CERES GROUP, INC. (PARENT ONLY) STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------