(1) Immediately prior to the closing of the Pyramid Life sale, Continental General acquired Pyramid Life's building in Kansas. See Note F. Discontinued Operations and Subsequent Event for further information.
Ceres Group, through its insurance subsidiaries, provides a wide array of health and life insurance products to approximately 358,000 insureds through two primary business segments. The senior segment includes senior health, life and annuity products for Americans age 55 and over. The major medical segment includes major medical health insurance for individuals, families, associations and small businesses.
Ceres' insurance subsidiaries include Central Reserve Life Insurance Company, Provident American Life & Health Insurance Company, United Benefit Life Insurance Company and Continental General Insurance Company. Central Reserve markets and sells major medical health insurance to individuals, families, associations and small employer groups. Continental General markets and sells both major medical and senior health and life products to individuals, families, associations and Americans age 55 and over. United Benefit Life discontinued new sales activities in July 2000 and terminated all of its existing business at the end of 2001. United Benefit Life has no active policyholders and its business was substantially wound down at December 31, 2002. Provident American Life also has discontinued new sales activities and currently has approximately 3,000 active policyholders.
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, subject to further adjustment based on Pyramid Life's statutory capital and surplus at March 31, 2003. For more information on the Pyramid Life sale, see "Recent Events."
LIABILITIES FOR OTHER POLICY CLAIMS AND BENEFITS PAYABLE. The most significant accounting estimate in our consolidated financial statements is our liability for other policy claims and benefits payable.
We recognize claim costs in the period the service was provided to our insureds. However, claim costs incurred in a particular period are not known with certainty until after we receive, process and pay the claim. The receipt and payment date of claims may lag significantly from the date the service was provided. Consequently, we must estimate our liabilities for claims that are incurred but not yet paid.
Liabilities for unpaid claims are based on an estimation process that is complex and uses information obtained from both company specific and industry data, as well as general economic information. These estimates are developed using actuarial methods based upon historical data for payment patterns, medical inflation, product mix, seasonality, utilization of health care services and other relevant factors. The amount recorded for unpaid claims liabilities is sensitive to judgments and assumptions made in the estimation process. The most significant assumptions used in the estimation process include determining utilization and inflation trends, the expected consistency in the frequency and severity of claims incurred but not yet reported,
Note L. Liabilities for Other Policy Claims and Benefits Payable to our audited consolidated financial statements for the years ended December 31, 2002, 2001 and 2000 provides historical information regarding the accrual and payment of our unpaid claims liability. Components of the total incurred claims for each year include amounts accrued for current year estimated claims expense, as well as adjustments to prior year estimated accruals.
During 2002 and 2001, we wrote off $4.2 million and $6.7 million, respectively, of deferred acquisition costs associated with major medical business in certain states due to the continuing unprofitability of the business in that state or in which we terminated the in force policies due to continued operating losses.
Management and our independent outside consultants believe the amount of deferred acquisition costs as of December 31, 2002 is recoverable.
with a related contract asset or liability. At December 31, 2002, our other intangible assets consisted of $3.6 million in licenses, or 0.4% of our total assets.
LONG-LIVED ASSETS. Property and intangible assets are reviewed for possible impairment when events indicate that the carrying amount of an asset may not be recoverable. Assumptions and estimates used in the evaluation of impairment may affect the carrying value of long-lived assets, which could result in impairment charges in future periods. Depreciation and amortization policies reflect judgments on the estimated useful lives of assets.
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 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.
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.
Policies renew or lapse for a variety of reasons, due both to internal and external causes. We believe that our efforts to address any concerns or questions of our insureds in an expedient fashion help to ensure ongoing policy renewal. We work closely with our licensed agents, who play an integral role in obtaining policy renewals and communicating with our insureds.
LIABILITIES FOR LITIGATION. We are involved in various litigation and regulatory actions. Such actions typically involve disputes over policy coverage and benefits, but may also relate to premium rates, agent and employment related issues, regulatory compliance and market conduct, contractual relationships and other matters. These disputes are resolved by settlement, dismissal or upon a decision rendered by a judge, jury or regulatory official.
Inherent uncertainties surround legal proceedings and actual results could differ materially from those assumed in estimating the liabilities. The possibility exists that a decision could be rendered against us, and, in some circumstances, include punitive or other damage awards in excess of amounts reserved, that may have a material impact on our financial condition, results of operations or cash flow of a future period.
INSURANCE. We use a combination of insurance and self-insurance for a number of 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
Effective March 31, 2003, we sold our subsidiary, Pyramid Life Insurance Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash, subject to further adjustment based on Pyramid Life's statutory capital and surplus as of March 31, 2003. Net proceeds of the sale were used as follows: (1) $10.0 million to repay a portion of our bank debt, and (2) the remainder to strengthen the statutory capital of Continental General.
After the transaction, Continental General has approximately $55.0 million in statutory capital and surplus with a risk based capital ratio in excess of 350%, an increase of approximately $21.0 million from December 31, 2002. In addition, after the transaction, we have $13.7 million in outstanding bank debt compared to $25.0 million at year end.
Medical premiums for 2002 were $370.0 million compared to $402.2 million for 2001, a decrease of 8.0%. The decrease in medical premiums was primarily the result of a 28% decrease in major medical certificates in force due to our decision in July 2001 to terminate or replace the policies at United Benefit Life and Provident American Life, to cancel other medical business in certain states and to target market in more profitable states, offset by the increase in new and renewal premiums averaging 20% to 30%.
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 was primarily the result of premium rate increases averaging 10% to 12% on business in force.
Net realized gains were $2.3 million for 2002 and 2001. Realized gains were primarily a result of the sale of corporate bonds, which reduced the corporate bond sector. Cash was reinvested in agency backed planned amortization class mortgage securities, thirty year pass-throughs, and U.S. Government Agency bonds. Gains in 2002 were partially offset by the write-down for other-than-temporary impairment of $0.9 million on bonds held in WorldCom. Additionally, Pyramid Life had a $0.8 million write-down for other-than-temporary impairment on bonds held in WorldCom, which is reflected in discontinued operations.
Medical benefits, claims, losses and settlement expenses were $291.8 million for 2002 compared to $328.8 million for 2001, a decrease of 11.3%. The decrease was primarily the result of a smaller volume of business in force due to the termination or replacement program, cancellation of other medical business as previously mentioned. The medical loss ratio was 78.9% for 2002 compared to 81.7% for 2001. The medical loss ratio decreased due to the termination or replacement program and the cancellation of business in poor performing markets, as well as, pricing increases and benefit changes to keep pace with medical inflation. However, the decrease was partially offset by a higher severity of claims than anticipated in the December 31, 2001 claim inventory.
The net (deferral) amortization and change in acquisition costs (DAC) and value of business acquired (VOBA) resulted in a net deferral of $3.8 million for 2002 compared to a net deferral of $21.7 million for 2001. The decrease in the net deferral was primarily attributable to lower capitalization of DAC due to decreases in new business sales and a $1.3 million increase in the amortization of VOBA. The Company also wrote-off $4.2 million in DAC in 2002 compared to $6.7 million in 2001 due to the unprofitability of the major medical business in certain states.
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 P. Special Charges to our consolidated financial statements for further information. Special charges of $7.1 million in the first quarter of 2001 represented a $5.9 million write-off of the DAC asset for United Benefit Life and Provident American Life and a $1.2 million write-off of costs associated with United Benefit Life. The DAC asset was written off due to the planned termination of this business.
Medical premiums for 2001 were $402.2 million compared to $372.8 million for 2000, an increase of 7.9%. The increase in medical premiums was primarily the result of new sales, premium rate increases and reduced premiums ceded under reinsurance agreements. This increase was offset by our decision to terminate or replace the policies at United Benefit Life and Provident American Life and the cancellation of other medical business in certain states.
Senior and other premiums were $153.3 million for 2001 compared to $109.6 million for 2000, an increase of 39.9%. The increase in senior and other premiums was primarily the result of increased Medicare supplement sales and premium rate increases.
Fee and other income increased to $36.2 million for 2001 compared to $32.6 million for 2000, an increase of 10.9%. 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.
Senior and other benefits, claims, losses and settlement expenses were $115.0 million for 2001 compared to $84.2 million for 2000, an increase of 36.7%. The increase was a result of claims and benefits paid on a larger volume of business in force. The senior and other loss ratio decreased to 75.0% for 2001 compared to 76.8% for 2000, primarily attributable to increased volume of new premiums and lower benefit utilization.
Selling, general and administrative expenses increased to $197.0 million in 2001 compared to $176.4 million in 2000, an increase of 11.7%. The increase in selling, general and administrative expenses represented a $5.4 million decrease in commissions, a $5.5 million increase in other operating and reinsurance expenses attributable to our increased business base, and reduced reinsurance allowances of $20.5 million resulting from a lower volume of ceded premiums. As a percentage of revenues, selling, general and administrative expenses have decreased to 31.6% in 2001 compared to 32.3% in 2000.
The net (deferral) amortization and change in acquisition costs (DAC) and value of business acquired (VOBA) resulted in a net deferral of $21.7 million for 2001 compared to a net deferral of $28.0 million for 2000. The decrease was primarily attributable to the write-off of DAC of approximately $6.7 million in six states due to the continuing unprofitability of the major medical business in those states.
Special charges of $7.1 million in the first quarter of 2001 represented a $5.9 million write-off of the DAC asset for United Benefit Life and Provident American Life and a $1.2 million write-off of costs associated with United Benefit Life. See Note P. Special Charges to our consolidated financial statements for further information. The DAC asset was written off due to the planned termination of the business.
A federal income tax benefit of $1.8 million, or 24.5% of the loss before federal taxes, was established for 2001. The 2000 effective rate was 33.5%. The decrease in the effective tax rate resulted from changes in pre-tax income (loss) in relation to permanent differences. Specifically, the 50% elimination on meals and entertainment expenses and certain other non-deductible expenses.
As a result of the foregoing, for 2001, net income was $2.3 million and net income attributable to common stockholders was $5.2 million, or $0.29 basic and diluted earnings per share of common stock, compared to net income of $16.5 million and net income attributable to common stockholders was $16.1 million, or $1.06 basic and $1.00 diluted earnings per share of common stock, for 2000. Excluding the United Benefit Life and Provident American Life operating losses and special charges, net income attributable to common stockholders would have been $17.9 million, or $1.00 per diluted share, for 2001.
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, operating expenses such as salaries, employee benefits, commissions, taxes and interest on debts. Net cash used in operating activities in 2002 was $17.6 million due primarily to the funding of a $17.3 million reinsurance trust established at December 31, 2001 and a significant reduction in the major medical claim inventory during 2002.
The total reinsurance receivable was $170.1 million at December 31, 2002. Of this amount, $153.9 million represents reserves held by our reinsurers under our various reinsurance treaties in place. Hannover holds most of these reserves. Additionally, total reinsurance receivable includes a $7.1 million receivable for investments held in trust under a commuted reinsurance agreement.
The total policy liabilities and benefits accrued were 71.1% of the total liabilities at December 31, 2002 compared to 71.6% at December 31, 2001.
The credit agreement, as amended, contains financial and other covenants that among other things:
- excludes intercompany tax sharing payments in the calculation of the fixed charge coverage ratio at December 31, 2002;
- increases the interest rate on the tranche A and tranche B term loans for the Base Rate Loans to Base Rate plus 3.0% and 3.5%, respectively and for the Eurodollar Loans to LIBOR plus 4.0% and 4.5%, respectively;
- restructured the tranche A term loan debt payments as follows: quarterly principal payments of $547,000 through November 17, 2003, $509,000 through November 17, 2004, and a payment of approximately $5,040,000 on February 17, 2005; and
- restructured the tranche B term loan debt payments as follows: quarterly principal payments of $223,000 through December 17, 2003, $216,000 on March 17, 2004, $412,000 through December 17, 2004, $434,000 on March 17, 2005, and $820,000 through December 17, 2005.
The following schedule summarizes current and future contractual obligations as of December 31, 2002:
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, 2002, we were in compliance with our credit agreement, as amended or waived.
At December 31, 2002, we had a tax net operating loss, or NOL, carryforward of approximately $21.7 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. 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 $21.7 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.
We determine a valuation allowance of our deferred tax asset 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, 2002 and 2001, estimates were made as to the potential financial impact of recent NOLs and our financial condition.
The following table presents the revenues, expenses and profit (loss) from continuing operations before federal income taxes, for the last three years attributable to our industry segments. We do not separately allocate investments or other identifiable assets by industry segment, nor are income tax expenses (benefits) allocated by industry segment.
Investment Impairment Risk is the risk that all amounts due (both principal and interest) on our fixed maturity investments will not be collected according to the security's contractual terms. We attempt to minimize this risk by adhering to a conservative investment strategy. With the exception of short-term investments and securities on deposit with various state regulators, investment responsibilities have been delegated to external investment managers within the investment parameters established by the company.
Our external investment managers prepare a monthly investment surveillance list to analyze our fixed maturity portfolio for potential other-than-temporary impairment. The following factors are reviewed for inclusion on our surveillance list:
- debt downgrades or other events that adversely affects an investee's access to, or cost of, financing;
- adverse changes in the regulatory environment specific to the issuers industry;
- corporate bond prices that move more then 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, 2002. The amortized cost and estimated fair value of fixed maturities on our investment surveillance list at December 31, 2002 were $10.1 million and $8.3 million, respectively.
Credit Risk is the risk that parties, including reinsurers that have obligations to us, will not pay or perform. We attempt to minimize this risk by maintaining sound reinsurance and credit collection policies.
We also have long-term debt that bears interest at variable rates. Therefore, our results of operations would be affected by interest rate changes. We do not expect a significant rate change in the near future that would have a material effect on our near-term results of operations.
- our ability to implement increases in premium rates and to develop, distribute and administer competitive products and services in a timely, cost-effective manner;
- our ability to obtain additional debt or equity financing on terms favorable to us to facilitate our long-term growth;
required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions.
The provisions of SFAS No. 145, related to the rescission of SFAS No. 4, require any gain or loss on extinguishment of debt that was classified as an extraordinary item in prior periods presented that does not meet the criteria in APB Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for classification as an extraordinary item to be reclassified. The adoption of SFAS No. 145 on May 15, 2002 did not have a material effect on our results of operations, financial position or liquidity.
In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations, which addressed financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This Statement is effective for financial statements issued for fiscal years beginning after June 15, 2002. The adoption of this standard on June 15, 2002 did not have a material effect on our results of operations, financial position or liquidity.
DECEMBER 31, 2002 AND 2001 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
Ceres Group, Inc. operated in 1998 and prior periods primarily through its wholly-owned subsidiary, Central Reserve Life Insurance Company. As of December 31, 2002, 2001 and 2000, 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, and 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. On December 20, 2002, we entered into a definitive agreement to sell the stock of Pyramid Life. See Note F. Discontinued Operations and Subsequent Event for further information. As a result of the sale of Pyramid Life, our previously reported consolidated financial statements for 2001 and 2000 have been reclassified to present the discontinued operations of Pyramid Life separate from continuing operations to conform to the current year's presentation.
The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States, which differ from accounting practices prescribed or permitted by the various state departments of insurance in which the insurance subsidiaries are domiciled. See Note S. Statutory Financial Information for further information.
Accordingly, following the guidance of both SFAS No. 141 and EITF D-100 and in conjunction with our goodwill testing (see Goodwill and Other Intangible Assets below), we have reclassed licenses of $3.6 million as a separate indefinite-lived intangible asset from goodwill.
On January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets. Under the provisions of SFAS No. 142, goodwill is no longer ratably amortized into the income statement over an estimated life, but rather is tested at least annually for impairment. Intangible assets which have finite lives continue to be amortized over their estimated useful lives and also continue to be subject to impairment testing. Prior to the adoption of SFAS No. 142, goodwill was amortized on a straight-line basis over periods of 25 years or less. See Note J. Goodwill and Other Intangible Assets for a summary of our goodwill and other intangible assets, as well as further detail related to the impact of the adoption of SFAS No. 142.
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Cash and cash equivalents include cash and all liquid securities with maturities of 90 days or less when purchased. See Note D. Cash and Investments for further information.
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.
- our ability and intent to retain the investment for a period of time to allow for a recovery in value;
Certain excess policy acquisition 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 determines that these amounts are recoverable.
Comprehensive income in 2002, 2001 and 2000 includes a change in unrealized gains or losses on available-for-sale securities, in addition to reported net income as prescribed by SFAS No. 130, Reporting Comprehensive Income. See Note T. Comprehensive Income for further information.
Life premiums are recognized as revenue when they become due. Accident and health premiums are recognized as revenue over the terms of the policies. Amounts received from interest sensitive contracts, principally universal life and annuity products, are not reflected in premium revenue; rather, such amounts are accounted for as deposits with the related liabilities included in future policy benefits, losses and claims.
Deferred reinsurance gain consists of initial ceding allowances received from reinsurers, less amounts amortized into income over the estimated remaining life of the underlying policies reinsured, except for interest sensitive products that are amortized over the expected profit stream of the in force business.
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 U. Computation of Net Income Per Common Share for further information.
anticipate that the adoption of this standard will not have a material effect on our results of operations, financial position or liquidity.
In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. This Statement rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, SFAS No. 44, Accounting for Intangible Assets of Motor Carriers, and SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This Statement amends SFAS No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions.
- repay $10.0 million of our tranche A term loan (See Note O. Debt for further information);
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, 2002 and 2001.
The amortized cost and estimated fair value of invested assets as of December 31, 2002 by contractual maturity were as follows:
At December 31, 2002 and 2001, the Company's insurance subsidiaries had certificates of deposit and fixed maturity securities with a carrying value of $33.1 million and $32.4 million, respectively, on deposit with various state insurance departments to satisfy regulatory requirements.
At December 31, 2002 and 2001, $6.5 million and $7.4 million, respectively, of cash was held for fully insured employer shared risk plans, which is restricted to use. The Company is entitled to investment income from these funds.
At December 31, 2002, the Company held no unrated bonds and 6.0% of fixed maturity investments were in less-than-investment grade securities. Corporate bonds representing approximately 1.8% of fixed maturities were downgraded by rating agencies. Approximately 4.2% 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. In June 2002, the Company wrote down approximately $0.9 million for other-than-temporary impairment on bonds held in WorldCom. The bonds were subsequently sold. 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.
Rent expense for the Cleveland headquarters was approximately $1.7 million in 2002, $0.7 million in 2001, and zero in 2000. Future rent payments for the Cleveland headquarters are as follows (dollars in thousands):
A portion of the purchase price paid by the Company 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 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 6.5% is credited to the unamortized balance for Continental General Corporation. 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 which was the market rate at the time of acquisition.
The increased expense reserve is primarily a result of the higher commission rates paid in the initial policy years of the Medicare supplement business acquired. Under the current assumptions, amortization for the next five years is expected to be as follows (dollars in thousands):
Goodwill represents the excess of purchase price over the fair value of tangible and identifiable intangible net assets acquired. At December 31, 2002, goodwill was $10.7 million and represented approximately 1.2% 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 assets are capable of being sold or exchanged either on its own or in combination with a related contract asset or liability. At December 31, 2002, our other intangible assets consisted of $3.6 million in licenses, which represented 0.4% of our total assets.
Effective January 1, 2002, we adopted Statement of Financial Accounting Standards, or SFAS, No. 142, Goodwill and Other Intangible Assets issued by the Financial Accounting Standards Board, or 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, together with our independent consultants, 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 and analysis prepared by independent consultants indicated that no reduction of goodwill and licenses was required.
In 2001, goodwill and licenses amortization was $0.7 million ($0.4 million on an after-tax basis, or $0.02 per diluted shared). In 2000, goodwill and licenses amortization was $0.9 million ($0.6 million on an after-tax basis, or $0.04 per diluted share).
The following table reflects the consolidated results adjusted as though the adoption of SFAS No. 142 occurred as of the beginning of fiscal 2000:
The Company files a consolidated federal income tax return with its subsidiaries, except for Continental General, which is required to file a separate return through fiscal year 2003.
At December 31, 2002, the Company had a tax net operating loss carryforward, or NOL, of approximately $21.7 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. 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 $21.7 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 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 will pay Central Reserve on a quarterly basis, an experience refund, the amount of which shall be based upon the earnings derived from the business reinsured. Concurrent with this transaction, Hannover will reinsure 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% thereafter. In exchange for coverage under the stop loss reinsurance, Hannover pays Continental General a stop loss premium on the business reinsured. The effects of the transaction, except the net risk charge to Hannover, are eliminated in consolidation. This reinsurance agreement was terminated effective December 31, 2002 by mutual consent of the parties.
Prior to the acquisition of Provident American Life, all of the insurance business of Provident American Life in force at December 31, 1998 was ceded to Provident Indemnity. Hannover reinsured all the individual and small group health insurance in force at December 31, 1998, of Provident Indemnity for a ceding
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.
On December 31, 2002, United Benefit Life and Hannover entered into an agreement which amended these reinsurance arrangements. For claims incurred June 30, 2002 and prior, Hannover continues to be responsible for its quota share percentage. For claims incurred July 1, 2002 and subsequent, Central Reserve retains 100% of the risk.
The insurance companies remain obligated for amounts ceded in the event that the reinsurers do not meet their obligations. Initial ceding allowances received from reinsurers are accounted for as deferred reinsurance gain and are amortized into income over the estimated remaining life of the underlying policies reinsured, except for interest sensitive products that are amortized over the expected profit stream of the in force 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, 2002, 2001 and 2000 was $2.8 million, $5.0 million, and $6.1 million, respectively.
We are involved in various legal and regulatory actions occurring in the normal course of business. Based on current information, we believe any ultimate liability that may arise from these actions would not materially affect our consolidated financial position or results of operations. However, 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 flow of a future period.
- a risk-based capital (RBC) ratio at year end for any of our regulated insurance company subsidiaries of not less than 125.0% of the RBC Company Action level;
- requires $10.0 million of sale proceeds to be used as a partial pay down of bank debt;
- waives the minimum risk-based capital ratio requirement of 125% for Continental General at December 31, 2002;
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, 2002, we were in compliance with our credit agreement, as amended and waived.
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 primarily in connection with our major medical business. As that business declines, fee income declines. Dividends from the regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. In 2003, none of the insurance subsidiaries (Central Reserve Life and Continental General) can 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.
From 1998 to 2001, we experienced excessive losses at United Benefit Life and Provident American Life due to high benefit utilization and higher-than-anticipated claims costs. In July 2001, we implemented a program to mitigate future losses of United Benefit Life and Provident American Life by notifying policyholders that their policies would be terminated or replaced with a different Provident American Life product. The business was substantially wound down by the end of 2002.
As a result of the termination of the business in these subsidiaries, these blocks had a $2.5 million pre-tax loss in 2002 compared to $17.9 million pre-tax loss in 2001 including special charges and legal expenses.
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, 2002, there were options outstanding under the plan to purchase 243,000 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, 2002, there were options outstanding under the plan to purchase 815,000 shares.
We also have a 2000 Agent Stock Purchase Plan similar to the employee plan under which certain of our agents may purchase shares of our common stock at the same discount from fair value. The agent stock purchase plan does not qualify as an employee stock purchase plan within the meaning of Section 423 of the Code. As of December 31, 2002 and 2001, 164,164 and 76,621 shares, respectively, had been issued under the agent plan. There are 1,000,000 shares of common stock reserved for issuance in the aggregate under both plans. Both of the plans will terminate when all of the shares reserved for issuance under the plans have been purchased unless sooner terminated by the Board of Directors.
Also, pursuant to employment contracts, the Company provided an award of common shares to Peter W. Nauert. The number of shares awarded was 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 May 31, 2002, which was revised from July 1, 2003 due to his retirement as Chief Executive Officer. For the year ended December 31, 2002, 88,661 shares were awarded.
The Company recognized stock compensation expense of $0.2 million, $0.9 million, and $1.1 million in 2002, 2001 and 2000, respectively. As required by FASB Statement 123, Accounting for Stock-Based Compensation, the Company has estimated the pro forma impact on net income and earnings per share of stock-based compensation under the fair value method, using the Black-Scholes option valuation model.
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, 2002 and 2001.
(1) Statutory capital and surplus for Central Reserve includes Provident American Life and United Benefit Life. Central Reserve's statutory net gain (loss) for the years ended December 31, 2002 and 2001 includes losses of 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. Ceres' insurance subsidiaries cannot pay any dividends in 2003 without prior regulatory approval.
The NAIC also has Risk-Based Capital (RBC) requirements for life and health insurers to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks associated with asset quality, mortality and morbidity, asset and liability matching and other business factors. The RBC formula is used by state insurance regulators to monitor trends in statutory capital and surplus for the purpose of initiating regulatory action. The Company calculated the risk-based capital for its insurance subsidiaries as of December 31, 2002 using the applicable RBC formula. Based on these calculations, the RBC levels of each of the insurance subsidiaries, except Continental General, exceeded the levels required by regulatory authorities. Continental General's statutory capital level was below "Company Action Level" at December 31, 2002. However, after the addition of the statutory capital generated from the sale of Pyramid Life, Continental General's RBC level will exceed the levels required by regulatory authorities.
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. In 2001, the diluted earnings per share calculation was adjusted for a one time net gain on repurchase of the convertible voting preferred stock. All stock options and warrants were antidilutive for the
year ended December 31, 2002 and therefore are excluded from the calculation of diluted earnings per share. Basic and diluted weighted average shares of common stock are as follows:
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 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.
In addition, Ceres may contribute a Profit Sharing Contribution to the Plan, as determined by the Board of Directors. All eligible, active employees who have worked over 1,000 hours during the plan year and who are employed on the last day of the plan year share in this contribution. Participants who leave employment during the plan year due to retirement, death or disability will also share in the contribution. There were no Profit Sharing Contributions made for the 2002, 2001 and 2000 plan years, respectively.
We apply SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, which requires us to report information about our operating segments according to the management approach for determining reportable segments. This approach is based on the way management organizes segments within a company for making operating decisions and assessing performance. We have three distinct operating segments based upon product types: medical, senior and other, and corporate and other. Products included in the medical segment include catastrophic and comprehensive medical plans. Significant products in the senior and other segment include Medicare supplement, long-term care, dental, life insurance, and annuities. The corporate and other segment encompasses all other activities, including investment income, interest expense, and corporate expenses of the parent company.
The following methods and assumptions were used by the Company in estimating its fair value disclosures:
The Company maintains cash and short-term investments with various financial institutions, and performs periodic evaluations of the relative credit standings of those financial institutions.
The following is a summary of quarterly results of operations for the years ended December 31, 2002 and 2001. All prior quarters have been reclassed to reflect the pending sale of Pyramid Life:
CERES GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CERES GROUP, INC. (PARENT ONLY) BALANCE SHEETS DECEMBER 31, 2002 AND 2001 (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, 2002, 2001 AND 2000 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
(1) Represents dividend income from non-regulated subsidiaries, which is eliminated in consolidation.
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, 2002, 2001 AND 2000 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------