On May 1, 1998, the Company moved its principal offices from 777 Main Street, Fort Worth, Texas, to 110 West Seventh Street, Fort Worth, Texas. The lease for the new facility expires in April, 2003. Westbridge Printing Services, Inc. ("WPS"), the Company's wholly owned printing subsidiary which prints all policies, forms and brochures of the Insurance Subsidiaries, maintains its facility at 7333 Jack Newell Boulevard North, Fort Worth, Texas, under a lease agreement which expires in October, 2005. The Company also leases certain sales offices for its affiliated marketing agencies in Arizona and California. The Company believes that the newly leased facilities will meet its existing needs and that the leases can be renewed or replaced on reasonable terms if necessary.
The information set forth below was selected or derived from the Consolidated Financial Statements of the Company. The information set forth below should be read in conjunction with
KEY EVENTS LEADING TO THE COMMENCEMENT OF THE CHAPTER 11 CASE IN SEPTEMBER 1998
During the second and third quarters of 1997, the Company's Insurance Subsidiaries experienced an increase in claim loss ratios on various Medical Expense and Medicare Supplement products. Two independent reviews of the Company's claim reserves were performed as of September 30, 1997 on the Company's old lines of insurance business. Additionally, an independent benefit analysis of claims was completed, which indicated that significant rate increases would be required to offset the adverse claims experience. During the months prior to the commencement of the Chapter 11 Case in September 1998, the Insurance Subsidiaries continued to experience adverse loss ratios and declining persistency on certain old Medical Expense and Medicare Supplement products.
The Insurance Subsidiaries continued to experience adverse loss ratios and declining persistency on such old Medical Expense and Medicare Supplement products in the months prior to the commencement of the Chapter 11 Case in September 1998, although the loss ratios for the third quarter of 1998 reflected an improvement over the first and second quarters of 1998. As a result of these factors, the Company undertook a further revaluation of the recoverability of DPAC in the third quarter of 1998. Based on the results of this review, the Company determined that an additional premium deficiency existed and recorded a non-cash charge to expense of approximately $5.0 million for the quarter and nine months ended September 30, 1998. This adjustment had no impact on the Company's cash position or on the statutory capital and surplus of the Insurance Subsidiaries as of September 30, 1998.
The increase in claim loss ratios resulted in significant cash contributions by Westbridge to its Insurance Subsidiaries beginning in the third quarter of 1997, which threatened the Company's ability to meet its interest and dividend payments. In November 1997, the Company suspended its payment of interest and dividends. On September 16, 1998, Westbridge filed the Chapter 11 Case in the Bankruptcy Court for the District of Delaware, along with the Disclosure Statement and the Plan which culminated months of negotiations between Westbridge and an ad hoc committee of holders of its Senior Notes and its Convertible Notes. The Disclosure Statement and the Plan were amended on October 28, 1998 and the Disclosure Statement was approved by entry of an order by the Bankruptcy Court on October 30, 1998. Following the approval of the Plan by the holders of allowed claims and equity interests, the Bankruptcy Court confirmed the Plan on December 17, 1998. The Plan became effective on March 24, 1999. Under the Plan, among other things, the Senior Notes, the Convertible Notes, the Old Preferred Stock, the Old Common Stock and all outstanding options and warrants were canceled, certain prepetition claims were discharged and new equity interests were issued. (See ITEM 1 - "Business")
CHANGE IN MANAGEMENT STRUCTURE AND CORPORATE OVERHEAD EXPENSE REDUCTIONS: In the fourth quarter of 1997, the Company announced the termination of approximately 25 senior officers, managers and other employees in order to create a new management framework focused on correcting the problems of the past and restoring the Company to profitability. In addition, the Company initiated other efforts to reduce corporate overhead expenses by completing the relocation of its corporate headquarters in May 1998. The changes effected in the fourth quarter of 1997 and the relocation of corporate headquarters will result in considerable annual savings to the Company.
In addition, Westbridge Management Corp., an indirect wholly owned subsidiary, and the Insurance Subsidiaries entered into an Administrative Service and Management Agreement dated as of March 1, 1998, in an effort to avoid duplication of costs, to increase efficiency, and to otherwise reduce common expenses in equipment, office space, personnel, data processing and information system services, as well as to provide other centralized management and administrative services for the Insurance Subsidiaries.
REVISED MARKETING STRUCTURE: In addition to commission reductions, the marketing structure was completely revised to consolidate fragmented agency operations into a single, career agency force. The Company believes that this restructuring has resulted in better deployment of marketing resources and stronger controls over the Company's distribution channel.
POLICYHOLDER CONSERVATION: The Company has also implemented a detailed policyholder conservation program designed to mitigate the possible impact of adverse selection. As indicated above, the Company suffered declining persistency resulting from increased competitor solicitation of its policyholders, as well as from the implementation of rate increases. The Company is working on several fronts to retain a loyal and profitable base of satisfied policyholders.
REPLACEMENT OF CLAIMS AND POLICYHOLDER ADMINISTRATION DATA PROCESSING SYSTEMS: The Company is working toward a replacement of its claims and policyholder administration data processing systems during 1999. Not only will this data processing system replacement ensure that the Company is Year 2000 compliant, but resulting system efficiencies will allow the Company to further reduce and control its overhead expense levels.
The Company derives its revenue primarily from premiums from its insurance products and, to a significantly lesser extent, from fee and service income, income earned on invested assets and gains on the sales or redemptions of invested assets. The Company's primary expenses include benefits and claims in connection with its insurance products, amortization of DPAC, commissions paid on policy renewals, general and administrative expenses associated with policy and claims administration, taxes, licenses and fees and interest on its indebtedness under the Credit Agreement. Prior to the filing of the Chapter 11 Case, Westbridge was obligated to pay interest on its Senior Notes and Convertible Notes, and dividends on its Old Preferred Stock if, and when, declared by the Board of Directors.
Fee and service income is generated from (i) commissions received by the Company for sales of managed care and senior products underwritten primarily by unaffiliated managed care organizations, (ii) telemarketing services, and (iii) printing services.
Benefits and claims are comprised of (i) claims paid, (ii) changes in claim reserves for claims incurred (whether or not reported), and (iii) changes in policy benefit reserves based on actuarial assumptions of future benefit obligations not yet incurred on policies in force.
Under GAAP, a DPAC asset is established to properly match the costs of writing new business against the expected future revenues or gross profits from the policies. The costs, which are capitalized and amortized, consist of first-year commissions in excess of renewal commissions and certain home office expenses related to selling, policy issue, and underwriting. The DPAC for accident and health policies is amortized over future premium revenues of the business to which the costs are related. The rate of amortization depends on the expected pattern of future premium revenues for the block of policies. The scheduled amortization for a block of policies is established when the policies are issued. However, the actual amortization of DPAC will reflect the actual persistency and profitability of the business. For example, if actual policy terminations are higher than expected or if future losses are anticipated, DPAC could be amortized more rapidly than originally scheduled or written-off, which would reduce earnings in the applicable period. See "Key Events - Determination of Premium Deficiency". Also included in DPAC is the cost of insurance purchased relating to acquired blocks of business.
ACQUISITIONS. Since 1992, the Company has from time to time acquired seasoned blocks of business to supplement its revenue. These acquisitions included blocks of insurance policies from American Integrity Insurance Company ("AII"), Life and Health Insurance Company of America ("LHI"), Dixie National Life Insurance Company ("DNL"), NFIC, AICT and FLICA.
Premiums (1) ------------------------------ Year Ended December 31, ------------------------------ 1998 1997 1996 -------- -------- --------
The decrease in first-year premiums from Company-issued policies was attributable to a decrease in Medical Expense premiums of $11.1 million, or 41.2%, a decrease in Medicare Supplement premiums of $7.3 million, or 83.4%, and a decrease in other premiums of $0.1 million, or 75.5%, and was offset by an increase in Specified Disease premiums of $0.3 million, or 30.4%.
The decrease in renewal premiums from Company-issued policies was attributable to a decrease in Medicare Supplement premiums of $4.1 million, or 15.1%, and was offset by an increase in Medical Expense premiums of $1.2 million, or 3.1%, and an increase in Specified Disease premiums of $1.8 million, or 14.8%.
The decrease in first-year premiums from acquired policies was primarily attributable to a decrease of $0.5 million, or 61.0%, from the policies acquired from FLICA.
NET INVESTMENT INCOME. Net investment income increased $1.0 million, or 9.1%, from $11.0 million to $12.0 million for the year ended December 31, 1998, related to agents' debit balances.
BENEFITS AND CLAIMS. During the year ended December 31, 1998, the Insurance Subsidiaries continued to experience adverse loss ratios and declining persistency on certain old Medical Expense and Medicare Supplement products. The Insurance Subsidiaries have developed new insurance products with more stringent underwriting procedures and lower agent commissions. In addition, the Insurance Subsidiaries are implementing rate increases to the extent approved by state regulatory authorities or offering higher deductible benefit options on certain old lines of business in order to mitigate the effect of adverse claims experience on such old lines. The Insurance Subsidiaries have also implemented a policyholder retention program designed to mitigate the impact of declining persistency on such old lines receiving rate increases. However, the Company expects that the Insurance Subsidiaries will continue to incur operating losses (i) until such time as the necessary rate increases can be fully implemented and realized, and (ii) until sales of new products reach targeted production levels. There can be no assurance that the full extent of such rate increase requests will be approved, that the impact of these rate increases will result in profitability on such old lines, or that targeted production levels will be reached and sustained.
Benefits and claims expense decreased $37.5 million, or 27.4%, from $136.9 million to $99.4 million. This decrease was attributable to the decline in premium revenue during 1998 and to the significant strengthening of claim reserves during the second and third quarters of 1997 as a result of substantial increases in claim loss ratios on certain Medical Expense and Medicare Supplement products.
AMORTIZATION OF DPAC. The Company recognized a $5.0 million non-cash charge to write off unrecoverable DPAC during the third quarter of 1998 and recognized a $65.0 million non-cash charge to write off unrecoverable DPAC during the fourth quarter of 1997. See "Key Events - Determination of Premium Deficiency."
As a result, the Company is currently recording commission expense on such old lines of business that would ordinarily be deferred and amortized as a component of DPAC. For comparative purposes, current period DPAC amortization is lower than prior periods and commission expense is higher than prior periods.
REORGANIZATION EXPENSE. The Company was responsible for paying the fees of certain professional advisors in connection with the Chapter 11 Case. During the year ended December 31, 1998, the Company incurred approximately $9.2 million in expense related to these efforts. During the year ended December 31, 1997, the Company incurred approximately $4.4 million in reorganization expense related to the fees of certain professional advisors and to an internal reorganization of management.
EXTRAORDINARY ITEM. During the second quarter ended June 30, 1997, the Company recognized an extraordinary loss on the early extinguishment of debt in the amount of $1.0 million, net of taxes. This extraordinary charge was related to the termination and recapture of a block of reinsured policies and the recognition of unamortized financing fees associated with the prepayment and refinancing of the Company's revolving credit facility.
PREMIUMS. Premiums increased $4.3 million, or 2.7%, from $156.8 million to $161.1 million. This increase resulted from an increase in renewal premiums from Company-issued policies of $33.7 million, or 75.5%, and was offset by a decrease in renewal premiums from acquired policies of $5.4 million, or 10.7%, a decrease in first-year premiums from Company-issued policies of $22.8 million, or 38.0% and a decrease in first-year premiums from acquired policies of $1.2 million, or 61.4%.
The decrease in renewal premiums from acquired policies was attributable to a decrease of $3.7 million, or 15.2%, from the policies acquired in the NFIC and AICT acquisition, a decrease of $0.7 million, or 5.3%, from the policies acquired from AII, LHI and DNL, and a decrease of $1.0 million, or 7.9%, from the policies acquired in the FLICA acquisition.
The decrease in first-year premiums from Company-issued policies was attributable to a decrease of $13.4 million, or 33.1% in Medical Expense premiums, a decrease of $9.2 million, or 51.1% in Medicare Supplement premiums, and a decrease of $0.2 million, or 50.0%, in other premiums.
The decrease in first-year premiums from acquired policies was attributable to a decrease of $1.2 million, or 60.0%, from the policies acquired in the FLICA acquisition.
BENEFITS AND CLAIMS. Benefits and claims expense increased $42.7 million, or 45.3%, from $94.2 million to $136.9 million. This increase was attributable to an increase in benefits and claims expense from Company-issued and acquired policies of $39.2 million and $3.5 million, or 65.7% and 10.1%, respectively.
AMORTIZATION OF DPAC. Amortization of DPAC increased $8.0 million, or 34.9%, from $22.9 million to $30.9 million. This increase was attributable to an increase in amortization of DPAC from Company-issued policies of $10.9 million, or 63.7%, and was offset by a decrease of $2.9 million, or 50.0%, from acquired policies.
The increase in amortization of DPAC from Company-issued policies was primarily attributable to an increase of $7.6 million and $3.9 million, or 71.0% and 97.5%, from Medical Expense and Medicare Supplement products, respectively, and was offset by a decrease of $0.5 million, or 23.8% from Specified Disease products and a decrease of $0.1 million from other products.
The decrease in amortization of DPAC from acquired policies was primarily attributable to a decrease of $2.4 million, or 104.3%, from the policies acquired in the NFIC and AICT acquisition, a decrease of $0.7 million, or 43.8%, from the policies acquired from AII, LHI and DNL, and was offset by an increase of $0.2 million, or 10.5%, from the policies acquired in the FLICA acquisition.
COMMISSIONS. Commissions increased $8.8 million, or 111.4%, from $7.9 million to $16.7 million. This increase was attributable to an increase of $4.1 million in commissions on sales of Company-issued policies and an increase of $5.6 million, or 114.3%, on sales of non-affiliated, managed care insurance products, and was offset by a decrease of $0.9 million, or 14.8%, from acquired policies.
RECOGNITION OF PREMIUM DEFICIENCY. As more fully described in "Key Events," in response to the significant increases in loss ratios on the Company's Medical Expense and Medicare Supplement products and the decline in policy persistency, the Company undertook a revaluation of the recoverability of DPAC in the fourth quarter. Based on the results of this review and the impact of future projected premium revenues and the discontinuance of certain lines of business, the Company determined that a premium deficiency for certain lines of business existed as of December 31, 1997. In this connection, for the quarter and year ended December 31, 1997, the Company recorded a non-cash charge to expense of approximately $65.0 million. This adjustment had no impact on the Company's cash position at December 31, 1997 and did not impact the statutory capital and surplus of the Insurance Subsidiaries.
TAXES, LICENSES AND FEES. Taxes, licenses and fees remained relatively unchanged from the prior year at $6.0 million as increases in premium taxes due to higher premium levels in 1997 were offset by decreases in state levied fees and special assessments during the same period.
INTEREST EXPENSE. Interest expense increased $2.6 million, or 57.8%, from $4.5 million to $7.1 million. This increase is attributable to the accrued interest expense related to the issuance of $70.0 million of the Company's Convertible Notes.
(BENEFIT FROM) PROVISION FOR INCOME TAXES. During 1996, the provision for income taxes was calculated by applying the 35% statutory federal tax rate to the Company's pre-tax income for the year ended December 31, 1996. The change in the (benefit from) provision for income taxes during 1997 is directly attributable to the net loss recorded by the Company for the year ended December 31, 1997. This net loss generated a significant amount of net operating loss carryforwards ("NOLs") that will be available for offset against taxable income generated in future reporting periods. The Company has determined that it is more likely than not that it will be unable to utilize all of these NOLs prior to the related expiration dates. In this connection, the Company recorded a valuation allowance that significantly reduced its benefit from income taxes from the amount that would have been derived by applying the 35% statutory federal tax rate to the Company's pre-tax loss for the year ended December 31, 1997. See NOTE 10 - "Income Taxes" to the Company's Consolidated Financial Statements.
The Company's principal assets consist of the capital stock of its operating subsidiaries and invested assets. Accordingly, the Company's sources of funds are comprised of dividends from its operating subsidiaries, advances and management fees from non-insurance company subsidiaries, and tax payments under a tax sharing agreement among the Company and its subsidiaries. In addition, for the year ended December 31, 1998, Westbridge made capital contributions totaling approximately $5.7 million to its Insurance Subsidiaries. As of December 31, 1998, Westbridge had approximately $10.3 million in unrestricted cash and invested assets.
Dividends paid by the Insurance Subsidiaries are determined by and subject to the regulations of the insurance laws and practices of the insurance departments of their respective state of domicile. NFL, a Delaware domestic company, may not declare or pay dividends from any source other than earned surplus without the Delaware Insurance Commissioner's approval. The Delaware Insurance Code defines earned surplus as the amount equal to the unassigned funds as set forth in NFL's most recent statutory annual statement including surplus arising from unrealized gains or revaluation of assets. Delaware insurance companies may generally pay ordinary dividends or make distributions of cash or other property within any twelve month period with a fair market value equal to or less than the greater of 10% of surplus as regards policyholders as of the preceding December 31 or the net gain from operations for the twelve month period ending on the preceding December 31. During 1999, NFL is precluded from paying dividends without the prior approval of the Delaware Insurance Commissioner, as its earned surplus is negative. Further, NFL has agreed to obtain prior approval for any future dividends.
FLICA, a Mississippi domestic company, may make dividend payments only from its actual net surplus computed as required by law in its statutory annual statement. Mississippi life insurance companies may generally pay ordinary dividends or make distributions of cash or other property within any twelve month period with a fair market value not exceeding the lesser of 10% of surplus as regards policyholders as of the preceding December 31 or the net gain from operations for the twelve month period ending on the preceding December 31. Any dividend exceeding the applicable threshold amount requires prior approval of the Mississippi Insurance Commissioner. FLICA is precluded from paying dividends to NFL during 1999 without the prior approval of the Mississippi Insurance Commissioner as it recorded a net loss from operations for the year ended December 31, 1998.
Inflation will affect claim costs on the Company's Medicare Supplement and Medical Expense products. Costs associated with a hospital stay and the amounts reimbursed by the Medicare program are each determined, in part, based on the rate of inflation. If hospital and other medical costs that are reimbursed by the Medicare program increase, claim costs on the Medicare Supplement products will increase. Similarly, as the hospital and other medical costs increase, claim costs on the Medical Expense products will increase. The Company has somewhat mitigated its exposure to inflation by incorporating certain limitations on the maximum benefits which may be paid under its policies and by filing for premium rate increases as necessary.
Net cash (used for) provided by financing activities totaled $(6.0) million, $60.4 million and $3.5 million for the years ended December 31, 1998, 1997 and 1996, respectively. Cash flows for financing activities for the year ended December 31, 1998 were related to the net borrowings and repayments associated with the Company's Receivables Financing program (defined below). The Company's net financing cash outflows declined as a result of the reduction in the Company's marketing results for its underwritten products, which in turn resulted in a decrease in cash flows used to finance agents' debit balances. Cash flows provided by financing activities for the year ended December 31, 1997, included approximately $70.0 million in cash inflows resulting from the issuance of Westbridge's Convertible Notes that was offset, in part, by cash payments of $7.0 million to retire a note payable associated with a recaptured reinsurance agreement, $1.0 million to retire a note with a related party, and $0.1 million in net borrowings and repayments associated with the Company's Receivables Financing program. For 1996, cash was provided by borrowings under the Receivables Financing program with Fleet National Bank.
The Company has guaranteed WFC's obligations under the Credit Agreement, and has pledged all of the issued and outstanding shares of the capital stock of WFC, NFL and NFIC as collateral for that guaranty. The Company's obligations under the Guaranty Agreement continue following confirmation of the Plan. As of the Effective Date, there were no events of default under the Credit or Guaranty Agreements. See NOTE 6 to the Company's Consolidated Financial Statements.
The Company is highly reliant upon computer systems and software, as are many of the Company's principal businesses with which it interacts. The Company's ability to service its policyholders and agents is dependent upon accurate and timely transaction reporting. Transaction reporting in turn is dependent upon the Company's highly complex interdependent computer hardware, software, telecommunications and desktop applications, and the information obtained from its critical business partners.
The Company has also completed the assessment of its non-I/T systems and is currently remediating and upgrading those systems. The non-I/T systems have been prioritized to remediate critical systems early in 1999 and non-critical systems later in the year.
Another significant component of the Company's enterprise-wide remediation effort is to determine whether critical business partners and vendors are Year 2000 compliant. The assessment and testing of the Year 2000 readiness of these critical business partners and vendors have been integrated with the Company's I/T and non-I/T Year 2000 system strategies. As a part of this process, the Company has written letters and corresponded with its outside vendors and critical business partners to determine whether they are also prepared for the Year 2000.
The Company expects its Year 2000 program to be completed in a timely manner; however, the Year 2000 computer problem creates risk for the Company from unforeseen problems in its own computer systems and from third parties with whom the Company deals on financial transactions. Such potential, unforeseen problems in the Company's and/or third parties' computer systems could have a material, adverse impact on the Company's ability to conduct its business.
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Westbridge Capital Corp. and its subsidiaries at December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
During the year ended December 31, 1998, seven thousand and sixty-five (7,065) shares of the Company's Old Preferred Stock were converted into shares of Old Common Stock. The converted shares of Old Preferred Stock had an aggregate liquidation preference of $7,065,000 and were converted into 840,071 shares of Old Common Stock.
The Company purchased the outstanding capital stock of Freedom Holding Company ("FHC") in the second quarter of 1996 for a cash purchase price of $6.3 million. This purchase resulted in the Company receiving assets and assuming liabilities as follows:
The Plan provides for the recapitalization of certain old debt and equity interests in Westbridge and the issuance of new equity securities and warrants. Key terms of the Plan include the following:
To the holders of Senior Notes other than CSFB (defined below), cash payments totaling approximately $15.2 million, which are equal to the total Allowed 11% Senior Note Claims (as defined in the Plan) held by creditors other than Credit Suisse First Boston Corporation ("CSFB"), will be distributed subject to completion of the exchange of securities as contemplated by the Plan. In order to provide the Company with sufficient funds to make the cash distribution to the holders of the Allowed 11% Senior Notes under the Plan, an affiliate of CSFB (the "CSFB Affiliate") purchased all of the shares of the New Preferred Stock which were not otherwise distributed under the Plan.
Pursuant to the Plan and the purchase of New Preferred Stock on the Effective Date, 6,500,000 shares of New Common Stock and 23,257 shares of New Preferred Stock were issued on the Effective Date as follows:
To holders of Old Preferred Stock, 260,000 shares as of December 10, 1998, or 4%, of the New Common Stock issued on the Effective Date and Warrants ("New Warrants") to purchase an additional 277,505 shares, or 2%, of the number of shares of New Common Stock issued and outstanding on the Effective Date, on a fully diluted basis, subject to the completion of the exchange of securities as contemplated by the Plan.
In connection with the approval and effectiveness of the Plan, the Company settled a putative class action brought on behalf of certain purchasers and sellers of Westbridge's Convertible Notes and Old Common Stock during the period October 31, 1996 through October 31, 1997.
CASH EQUIVALENTS. Cash equivalents consist of highly liquid instruments with maturities at the time of acquisition of three months or less. Cash equivalents are stated at cost, which approximates market.
CONCENTRATIONS OF CREDIT RISK. Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents, investments and receivables from agents. The Company maintains cash and investments with various major financial institutions. The Company performs periodic evaluations of the relative credit standing of these financial institutions. Concentrations of credit risk with respect to receivables from agents are limited due to the large number of agents and their dispersion across many geographic areas. The Company establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of specific agents, historical trends and other information. The Company's historical experience in collection of these receivables falls within the recorded allowances. Due to these factors, no additional credit risk beyond the amounts provided for collection losses is believed inherent in the Company's receivables from agents.
DEFERRED POLICY ACQUISITION COSTS ("DPAC"). Policy acquisition costs consisting of commissions and other policy issue costs, which vary with and are primarily related to the production of new business, are deferred and amortized over periods not to exceed the estimated premium-paying periods of the related policies. Also included in DPAC is the cost of insurance purchased on acquired business. The amortization of these costs is based on actuarially estimated future premium revenues, and the amortization rate is adjusted periodically to reflect actual experience. Projected future levels of premium revenue are estimated using assumptions as to interest, mortality, morbidity and withdrawals consistent with those used in calculating liabilities for future policy benefits.
FUTURE POLICY BENEFITS AND CLAIMS. Liabilities for future policy benefits not yet incurred are computed primarily using the net level premium method including actuarial assumptions as to investment yield, mortality, morbidity and withdrawals. Claim reserves represent the estimated liabilities on claims reported plus claims incurred but not yet reported. These liabilities are subject to the impact of future changes in claim experience and, as adjustments become necessary, they are reflected in current operations.
RECOGNITION OF REVENUE. Accident and health premiums are recognized as revenue when earned. Benefits and expenses are associated with related premiums so as to result in a proper matching of revenues with expenses. Fee and service income and investment income are recognized when earned.
USE OF ESTIMATES. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
INCOME TAXES. The Company records income taxes based on the asset and liability approach, which requires the recognition of deferred tax liabilities and assets for the expected future tax consequence of temporary differences between the carrying amounts and the tax basis of assets and liabilities.
The Statement also requires a reconciliation of the numerator and denominator of the basic earnings per share computation to the numerator and denominator of the diluted earnings per share computation. The Company adopted SFAS No. 128 for the year ended December 31, 1997 and has restated the earnings per share computations for 1996 to conform to this pronouncement.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS. On January 1, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income" ("SFAS 130"). Comprehensive income (loss) equals the total of net income (loss) and all other non-owner changes in equity. This pronouncement requires comprehensive income (loss) and its components to be reported either in a separate financial statement, combined and included with the statement of income or included in a statement of changes in stockholders' equity. The Company has elected to present its comprehensive income (loss) as a separate financial statement.
Proceeds from sales and maturities of investments in fixed maturity securities were approximately $25.1 million in 1998 and $34.0 million in 1997. Gross gains of $0.8 million and gross losses of $0.4 million were realized on fixed maturity investment sales during 1998. Gross gains of $0.7 million and gross losses of $0.1 million were realized on fixed maturity investment sales during 1997.
On May 31, 1996, the Company completed its acquisition of the remaining 60% equity interest in Freedom Holding Company ("FHC"). FHC is a holding company which owns 100% of FLICA, a Mississippi domiciled insurer. The purchase price was $6.3 million in cash, and the transaction was accounted for under the purchase method. Prior to the acquisition, the Company accounted for its 40% investment in FHC using the equity method. The Company's portion of FHC's earnings prior to the acquisition in 1996 accounted for using the equity method was $74,000.
Beginning June 1, 1996, the results of operations of FHC have been reflected in the Company's Consolidated Statements of Operations and of Cash Flows. The present value of future profits associated with the purchase are being amortized in relation to premium revenues over the remaining life of the business. At the time of the acquisition, the Company, through NFL, reinsured the majority of business underwritten by FLICA. Subsequent to the acquisition of the remaining interest of FHC, the coinsurance agreements between FLICA and NFL were canceled. The acquisition did not have a material pro-forma impact on operations.
Interest Issues through 1980 are 6% graded to 4.5% in 25 years; most 1981 through 1992 issues are 10% graded to 7% in 10 years except for certain NationalCare and Supplemental Hospital Income issues which are 8% graded to 6% in 8 years and LifeStyles Products which are 9% graded to 7% in 10 years. 1993 and later issues are 7% level. Policies acquired from AII in 1992 are 6.4% level. Policies acquired from LHI in 1993 and DNL in 1994 are 6% level. Policies acquired in the Acquisition of NFIC and AICT are 7% level.
The Company finances the majority of its obligations to make commission advances through Westbridge Funding Corporation ("WFC"), an indirect wholly owned subsidiary. On June 6, 1997, WFC entered into a Credit Agreement dated as of such date with LaSalle National Bank (the "Credit Agreement"). See NOTE 15 - "Extraordinary Item." This Credit Agreement provides WFC with a three-year, $20.0 million revolving loan facility (the "Receivables Financing"), the proceeds of which are used to purchase agent advance receivables from the Insurance Subsidiaries and certain affiliated marketing companies. WFC's obligations under the Credit Agreement are secured by liens upon substantially all of WFC's assets. As of December 31, 1998, $6.2 million was outstanding under the Credit Agreement (interest rate of 8.375%). The Company incurs a commitment fee on the unused portion of the Credit Agreement at a rate of 0.50% per annum. The Credit Agreement terminates on June 5, 2000, at which time the outstanding principal and interest thereunder will be due and payable.
Accrued but unpaid interest on the Senior Notes through the Petition Date was approximately $2.1 million. The Plan required the continued accrual of interest on the Senior Notes from the Petition Date to the Effective Date. Accrued but unpaid interest on the Senior Notes from the Petition Date to December 31, 1998 totaled approximately $0.6 million.
Contractual interest continued to accrue at a rate of $6,111 per day from January 1, 1999 through the Effective Date.
As of the Effective Date, these Senior Notes were canceled, extinguished and retired. As more fully described in NOTE 1, holders of Allowed 11% Senior Note Claims held by creditors other than CSFB received cash payments totaling $15.2 million, subject to completion of the exchange of securities as contemplated by the Plan.
During the second quarter of 1997, the Company completed the sale of $70.0 million aggregate principal amount of its Convertible Notes, due 2004, in an underwritten public offering. Contractual interest on the Convertible Notes was payable in semi-annual installments on May 1 and November 1 of each year, commencing November 1, 1997. In November 1997, the Company suspended the scheduled interest payments on these Convertible Notes. At the Petition Date, approximately $7.3 million of unpaid interest was accrued. The Company did not accrue interest on its Convertible Notes after the Petition Date as it was unlikely such interest would be paid under the Plan. The amount of contractual interest that would have otherwise been accrued from the Petition Date to December 31, 1998 totaled $2.7 million, and such contractual interest would have continued to accrue at $14,583 per day from January 1, 1999 until the Effective Date.
As of the Effective Date, these Convertible Notes were canceled, extinguished and retired. Holders of the Convertible Notes and allowed general unsecured creditors will receive their pro rata share of 94% of the New Common Stock issued on the Effective Date, subject to the completion of the exchange requirements as contemplated by the Plan.
Included in reinsurance recoverables on claim reserves is approximately $0.7 million and $1.9 million relating to paid claims as of December 31, 1998 and 1997, respectively.
Each share of New Preferred Stock is convertible at any time into 204.8897 shares of New Common Stock at an initial conversion price of $4.88 per share, subject to customary anti-dilution adjustments.
On April 12, 1994, the Company issued 20,000 shares of Old Preferred Stock, at a price of $1,000 per share. The Old Preferred Stock was issued in a private placement and was subsequently registered with the Securities and Exchange Commission under a registration statement, which was declared effective in October 1994. The following summarizes the significant terms of the Old Preferred Stock:
Cumulative annual dividend rate of 8.25%, subject to increase to 9.25%, upon non-compliance by the Company with certain restrictions.
RECOGNITION OF PREMIUM DEFICIENCY. During 1997, policy persistency declined in connection with the implementation of certain rate increases together with intensified competitor solicitation of the Company's policyholders. These events affected the future profit margins available to absorb amortization of DPAC. As a result of these adverse changes, the Company undertook a revaluation of the recoverability of DPAC in the fourth quarter of 1997. Based on the results of this review and the impact of future projected premium revenues and the discontinuance of certain lines of business, the Company determined that a premium deficiency for certain old lines of business existed as of December 31, 1997.
The Company and its wholly owned subsidiaries, other than NFIC, AICT and FLICA, file a consolidated federal income tax return. NFIC, AICT and FLICA file separate federal income tax returns.
Provision has not been made for state and foreign income tax expense since such expense is minimal. In addition, as described in NOTE 15 - "Extraordinary Item," the Company recognized an extraordinary loss of approximately $1.0 million for the year ended December 31, 1997. This amount has been reflected in the accompanying financial statements, net of approximately $0.5 million in deferred taxes.
A valuation allowance of approximately $36.4 million and $28.7 million has been provided for the year ended December, 31, 1998 and 1997, respectively, for the tax effect of the Company's net operating loss carryovers and other deductible temporary differences since it appears more likely than not that such benefits will not be realized. The change in the valuation allowance for 1998 relates primarily to the increase in net operating losses and decrease in DPAC.
At December 31, 1998, the Company and its wholly owned subsidiaries have aggregate net operating loss carryforwards of approximately $80.4 million and $71.9 million for regular tax and alternative minimum tax purposes, respectively, which expire in 2003 through 2014. However, the Company's emergence from its Chapter 11 Case on March 24, 1999 is expected to significantly limit the availability of such net loss operating carryforwards to offset future taxable income.
Under applicable Delaware law, NFL must maintain minimum aggregate statutory capital and surplus of $550,000. Under applicable Texas law, NFIC and AICT must each maintain minimum aggregate statutory capital and surplus of $1.4 million. Under Mississippi law, FLICA is required to maintain minimum capital and surplus of $1.0 million. The State of Georgia requires licensed out-of-state insurers to maintain minimum capital of $1.5 million, and the Commonwealth of Kentucky requires minimum surplus of $2.0 million. These levels are higher than the requirements of any other states in which the Insurance Subsidiaries are currently licensed. Accordingly, the minimum aggregate statutory capital and surplus which NFL, NFIC and FLICA must each maintain is $3.5 million. AICT must maintain a minimum of $1.5 million. At December 31, 1998, aggregate statutory capital and surplus for NFL, NFIC, AICT and FLICA was $15.9 million, $2.1 million, $2.8 million and $11.5 million, respectively. Although NFIC's capital and surplus is below $3.5 million at December 31, 1998, NFIC voluntarily ceased writing new business effective December 15, 1997. Moreover, NFIC's capital and surplus exceeds the minimum requirements for its state of domicile, Texas. Statutory net (losses) income for NFL, NFIC, AICT and FLICA for the year ended December 31, 1998, were $(5.9) million, $(3.3) million, $(2.0) million and $0.6 million, respectively. FLICA through its parent FHC, is wholly owned by NFL, and AICT is wholly owned by NFIC. Accordingly, statutory capital and surplus of the parent includes the statutory capital and surplus of the respective subsidiary.
Dividends paid by the Insurance Subsidiaries are determined by and subject to the regulations of the insurance laws and practices of the insurance departments of their respective state of domicile. NFL, a Delaware domestic company, may not declare or pay dividends from any source other than earned surplus without the Delaware Insurance Commissioner's approval. The Delaware Insurance Code defines earned surplus as the amount equal to the unassigned funds as set forth in NFL's most recent statutory annual statement including surplus arising from unrealized gains or revaluation of assets. Delaware insurance companies may generally pay ordinary dividends or make distributions of cash or other property within any twelve month period with a fair market value equal to or less than the greater of 10% of surplus as regards policyholders as of the preceding December 31 or the net gain from operations for the twelve month period ending on the preceding December 31. During 1999, NFL is precluded from paying dividends without the prior approval of the Delaware Insurance Commissioner as its earned surplus is negative. Further, NFL has agreed to obtain prior approval for any future dividends.
FLICA, a Mississippi domestic company, may make dividend payments only from its actual net surplus computed as required by law in its statutory annual statement. Mississippi life insurance companies may generally pay ordinary dividends or make distributions of cash or other property within any twelve month period with a fair market value not exceeding the lesser of 10% of surplus as regards policyholders as of the preceding December 31 or the net gain from operations for the twelve month period ending on the preceding December 31. Any dividend exceeding the applicable threshold amount requires prior approval of the Mississippi Insurance Commissioner. FLICA is precluded from paying dividends to NFL during 1999 without the prior approval of the Mississippi Insurance Commissioner as it recorded a net loss from operations for the year ending December 31, 1998.
The statutory financial statements of the Insurance Subsidiaries are prepared using accounting methods which are prescribed or permitted by the insurance department of the respective companies' state of domicile. Prescribed statutory accounting practices include a variety of publications of the NAIC as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed.
In September 1986, the Company established a retirement savings plan for its employees. The plan permits all employees who have been with the Company for at least one year to make contributions by salary reduction pursuant to section 401(k) of the Internal Revenue Code. The plan allows employees to defer up to 3% of their salary with partially matching discretionary Company contributions determined by the Company's Board of Directors. Employee contributions are invested in any of ten investment funds at the discretion of the employee. Until July 1998, Company contributions were in the form of Old Common Stock. Subsequent to July 1998, the Company began making cash contributions. The Company's contributions to the plan in 1998, 1997 and 1996 approximated $80,000, $106,000 and $102,000, respectively.
The Company's incentive stock option plans adopted as of July 1, 1982, September 5, 1985, and March 26, 1992, and the Company's restricted stock plan adopted as of April 19, 1996, have been canceled as of the Effective Date. All outstanding grants of stock options or restricted stock have been extinguished as contemplated by the terms of the Plan.
Pursuant to the Plan, on March 24, 1999, the Company's Board of Directors adopted the 1999 Stock Option Plan (the "1999 Plan") in order to further and promote the interest of the Company, its subsidiaries and its shareholders by enabling the Company and its subsidiaries to attract, retain and motivate employees, non-employee directors and consultants (including marketing agents) or those who will become employees, non-employee directors and consultants (including marketing agents), and to align the interests of those individuals and the Company's shareholders. To do this, the 1999 Plan offers equity-based opportunities providing such employees and consultants with a proprietary interest in maximizing the growth, profitability and overall success of the Company and its subsidiaries.
In late 1993, NFL entered into a coinsurance treaty with FLICA. FLICA is a wholly owned subsidiary of FHC. Under the terms of the treaty, NFL assumed a 90% pro-rata share of certain Specified Disease business. For the years ended December 31, 1998, 1997 and 1996, $0, $0 and $2.3 million, respectively, of assumed premiums under this coinsurance treaty are included as premium revenue in the consolidated financial statements. This coinsurance treaty was canceled subsequent to the acquisition of the remaining interest of FLICA's parent FHC, on May 31, 1996.
In the normal course of their business operations, the Insurance Subsidiaries, continue to be involved in various claims, lawsuits (alleging actual as well as substantial exemplary damages) and regulatory matters. In the opinion of management, the disposition of these or any other legal matters will not have a material adverse effect on the Company's business, consolidated financial position or results of operations.
The Company's Insurance Subsidiaries are subject to extensive governmental regulation and supervision at both federal and state levels. Such regulation includes premium rate levels, premium rate increases, policy forms, minimum loss ratios, dividend payments, claims settlement, licensing of insurers and their agents, capital adequacy, transfer of control, and amount and type of investments. Additionally, there are numerous health care reform proposals and regulatory initiatives under consideration which if enacted could have significant impact on the Company's results of operations.
A reconciliation of net (loss) income as reported by the Insurance Subsidiaries under practices prescribed or permitted by regulatory authorities and that reported herein by the Company on a consolidated GAAP basis is as follows: