The Company owns, through Citizens Security, a three-story, 63,000 square foot office building in suburban Louisville, Kentucky completed in 1988. The Company and its Subsidiaries occupy about 29% of the building for their headquarters and home offices. The Company leases the remaining space to tenants under leases of various duration. Market conditions for this property are generally favorable and, in management's opinion, the property is adequately covered by insurance. Currently, the Company's policy is not to invest in additional real estate or real estate mortgages, although a change in such policy would not require a vote of security holders. In addition, the Company's current bank lending agreement precludes investment in additional real estate and in mortgages with a loan-to-appraised-value ratio of more than 75%.
During 2001, the Company achieved a 21% or $4,922,000 increase in premiums. The majority of the increase was in the Preneed Life segment, although increases were also achieved in the other four segments. Pretax segment earnings, excluding realized investment gains and losses and interest expense, were $460,000 and $36,000 for 2001 and 2000 respectively. This improvement is primarily attributable to increased Preneed Life production.
On May 12, 1998 the Company and Citizens Security acquired 100% of the common stock of United Liberty from an unaffiliated insurance holding company (the "United Acquisition"). The United Acquisition was accounted for as a purchase and United Liberty's results of operations are included in the consolidated statements since the date of acquisition. The aggregate purchase price for the United Acquisition was approximately $7,076,000 (including net costs associated with the acquisition of approximately $445,000). In conjunction with the acquisition, the seller retained approximately $2,100,000 of United Liberty's real estate related and other assets, which were replaced with cash by Citizens Security. The United Acquisition was financed with working capital of Citizens Security and approximately $3,400,000 of additional bank borrowings.
Assets. At December 31, 2001, the Company's available-for-sale fixed maturities had a fair value of $77,534,516 and amortized cost of $75,872,277. The Company's fixed maturities portfolio increased approximately 5% during both 2001 and 2000, on an amortized cost basis. The 2001 increase is primarily attributable to Preneed Life sales growth, while the 2000 increase resulted primarily from the NAIL acquisition. Shown below is a distribution by rating category of the Company's fixed maturities portfolio as of December 31, 2001.
Shown below are the Company's four largest holdings in non-investment grade bonds by a single issuer as of December 31, 2001.
The Company reviews its marketable investments each quarter to determine if there have been declines in their value that in management's opinion are other-than-temporary. These reviews can involve qualitative and quantitative information relating to an individual company or industry and general factors impacting the economy. However, due to wide market fluctuations occurring during the past two years, determining whether declines are temporary has become much more complex and judgmental. These reviews resulted in the recognition of impairment losses on equity securities totaling $1,533,000 during 2001 ($332,000, $1,123,000, and $78,000 for the second through fourth quarters, respectively). In addition, $739,000 of impairment losses were recognized on fixed maturities during 2001 ($7,000, $4,000, and $728,000 during the first, second, and fourth quarters, respectively). During 2001, equity securities and fixed maturities were sold which contained impairment writedowns of $5,160,000 and $940,000, respectively.
At December 31, 2001 the Company has recorded $756,000 of goodwill and $12,757,000 of other intangible assets for deferred policy acquisition costs and value of insurance acquired. As noted in the above discussion of critical accounting policies and estimates, these intangibles, and the recorded value of policy liabilities, are based on many assumptions that require substantial estimates and judgment. In connection with adoption of SFAS No. 142, the Company will be perform a detailed reassessment of the assumptions supporting these values.
Shown below is a progression of the Company's policyholder deposit activity for the year ended December 31, 2001.
Year Ended December 31, 2001 Total Annuity and Universal Other Life - -------------------------------- --------------- --------------- --------------- Beginning Balance $16,381,247 $ 10,004,531 $ 6,376,716 Deposits 1,006,892 426,098 580,794 Withdrawals (2,205,095) (951,457) (1,253,638) Interest Credited 734,687 428,769 305,918 - -------------------------------- --------------- --------------- --------------- Ending Balance $15,917,731 $ 9,907,941 $ 6,009,790 - -------------------------------- --------------- --------------- ---------------
Premiums and Other Considerations. The following table details premiums and other considerations received during the past three fiscal years.
The 4.1% Broker Life premium increase during 2001 is primarily attributable to receiving a full year of premium on the NAIL business compared to receiving six months of additional premium during 2000. In addition, during the past two years, the Company experienced some softening in sales growth for simplified issue and graded benefit life policies.
The 111% increase in Preneed Life premium during 2001 and the 73% increase during 2000 resulted from intensified marketing efforts aimed at defining the Company as a committed participant in this market, successfully negotiating competitive third-party marketing agreements, implementing various product enhancements, and positive referrals from customers who comment favorably on the Company's organization and customer service.
The 1% growth in Dental premium during 2001 resulted from normal inflationary rate increases, partially offset by the loss of a large group case. The 11% increase during 2000 included inflationary increases and net new production. During 2001 new business production has become increasingly competitive as larger providers expand their marketing initiatives. However, the Company has historically maintained strong customer and agent loyalty by continuing to improve customer service, including sales and administrative support functions.
Investments. The Company monitors its available-for-sale fixed maturities and equity securities to assure they are strategically positioned within the current market environment. This practice has historically resulted in equity securities comprising 10% to 20% of the Company's cash and invested assets, which tends to dampen current income yields in favor of an overall total return focus. Investment income yields were 5.6%, 4.9%, and 5.1% for 2001, 2000, and 1999, respectively. The 2001 yield increase resulted primarily from carrying significantly lower levels of equity securities and higher levels of fixed maturity investments. The 2000 yield decrease resulted primarily from higher short-term investment balances along with a temporary increase in real estate vacancy rates. Although the Company's total return on investments has generally been very favorable, returns for 2001 and 2000 were severely impacted by declines in the telecommunications and technology sectors, a general economic recession and the effect of terrorist events on the securities markets. As detailed below, net realized and unrealized investment losses totaled approximately $(10,200,000) for the two years ended December 31, 2001,while net realized and unrealized gains totaled approximately $14,200,000 for the two years ended December 31, 1999. The Company does not anticipate continued severe deterioration in the securities markets. At December 31, 2001, the Company's investment portfolios are positioned more conservatively compared to the prior two years, and they contain a net unrealized gain of $2,316,000. Below is an approximate calculation of investment income yields and total return rates for the four years ending December 31, 2001.
increases for certain cancer and disability coverages. In addition, during 2001 the Company began implementing significant rate increases on certain older blocks of Other Health business.
The small life insurance company deduction allows the Life Insurance Subsidiaries to reduce their taxable income by 60% before computing its current provision for regular or alternative minimum tax. However, for purposes of computing deferred income tax liabilities under the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes", the Company is precluded from assuming the small life insurance company deduction will be available in the future. Accordingly, by disallowing this deduction, SFAS No. 109 significantly increases the deferred taxes on the Life Insurance Subsidiaries' temporary differences. Thus, when a significant increase or decrease occurs in the Company's net temporary differences, the related deferred tax is computed using the 34% federal tax rate, whereas tax may actually be paid on these net liabilities (when realized) at a rate potentially as low as 17% (the alternative minimum tax rate after application of the allowable small life insurance company deduction). The Company's gross deferred federal income tax liabilities and assets are more fully discussed in Note 8 to the Consolidated Financial Statements. All deferred tax assets of the Company are realizable by offset against existing deferred tax liabilities or by carryback to recapture prior years' taxes paid on operating income and capital gains. The deferred tax assets are offset, to some extent, by valuation allowances related to the Company and to the Life Insurance Subsidiaries. Due to the impact of the small life insurance company deduction, the Life Insurance Subsidiaries record a valuation allowance to reduce deferred tax assets (associated with temporary differences) to their expected benefit rate of approximately 17%, rather than 34%. The Company's valuation allowance is designed to reduce deferred tax assets to their estimated ultimate realization value.
Statutory Insurance Information. For insurance regulatory and rating purposes, the Insurance Subsidiaries report on the basis of statutory accounting principles ("SAP"). As described in Note 9 to the Consolidated Financial Statements, effective January 1, 2001 portions of SAP were revised by "Codification". In recent years, various state insurance departments and the NAIC have expressed concern, essentially about the "rate of return" earned by holders of small face amount life policies, potentially including Preneed policies. Although the Company does not believe calculating a simple "rate of return" or premium "pay-back" measure is meaningful for traditional life insurance products, certain state insurance regulators are considering actions that could alter the profitability of existing contracts or eliminate small face amount policies as a viable product offering. During 2001, A.M. Best Company ("Best") downgraded Citizens Security's rating to B- from B. United Liberty's rating has remained at B- by Best since it was acquired in 1998, and Citizens Insurance, due to its lack of insurance operations, is not rated.
During 2001, statutory capital and surplus and asset reserves increased approximately, $760,000. This increase resulted primarily from the Citizens Insurance capital contribution noted above, plus $1,082,000 of unrealized gains offsetting the $3,498,000 net loss and a $572,000 increase in nonadmitted assets. During 2000, statutory capital and surplus and asset reserves decreased by approximately $7,413,000. This decrease resulted primarily from $1,869,000 of statutory net income offset by $7,875,000 of unrealized losses and a $1,200,000 redemption of Citizens Security's preferred capital stock. During 1999, statutory capital and surplus and asset reserves increased by approximately $2,443,000. This increase resulted primarily from $4,946,000 of statutory net income offset by a $1,200,000 redemption of preferred capital stock, and a $1,000,000 shareholder dividend paid. During 1998, statutory capital and surplus and asset reserves increased by approximately $2,454,000. This increase resulted primarily from $3,662,000 of statutory net income offset by a $1,500,000 redemption of preferred capital stock, along with unrealized investment gains. During 1997, statutory capital and surplus and asset reserves increased by approximately $1,808,000. This increase resulted primarily from $1,709,000 of statutory net income and $1,130,000 of unrealized investment gains, partially offset by a $1,050,000 redemption of preferred capital stock.
Regarding interest rate risk, the value of the Company's fixed-maturity investment portfolio will increase or decrease in an inverse relationship with fluctuations in interest rates while net investment income earned on newly-acquired fixed-maturities increases or decreases in direct relationship with interest rate changes. Management estimates that a 100 basis point increase in interest rates ("rate shock") would have decreased the fair value of its $77.5 million fixed maturity portfolio by approximately 2.8% or $2.2 million at December 31. 2001 and 2.8% or $2.0 million at December 31, 2000. From an income perspective, the Company does not believe rising interest rates present a significant risk, as essentially all of the Company's policy liabilities bear fixed rates. However, approximately 40% of policy liabilities contain provisions permitting interest or benefit adjustments at the discretion of the Boards of Directors of the Insurance Subsidiaries. The Company's cash flow testing (described below) indicates that overall profitability will generally be enhanced in rising interest rate scenarios. From a liquidity perspective, the Company's fixed rate policy liabilities have been relatively insensitive to interest rate fluctuations. Accordingly, the Company believes gradual increases in interest rates do not present a significant liquidity exposure. The Company monitors economic conditions on a regular basis and manages this interest rate risk primarily by adjusting the duration of its fixed-maturity portfolio. Historically, the Company has maintained conservative durations in its fixed-maturity portfolio. At December 31, 2001 cash and fixed-maturity investments with maturities of less than five years equaled more than 48% of total policy liabilities. Notwithstanding the foregoing, if interest rates rise significantly in a short timeframe, there can be no assurance that the life insurance industry, including the Company, would not experience increased levels of surrenders and reduced sales, and thereby be materially adversely affected.
the projected market value of assets and liabilities at the end of the analysis period (typically 10-20 years). Deficits could indicate the need for corrective action depending upon the severity and the number of scenarios in which a deficit appeared. A second measure involved distributable earnings. Negative earnings for extended durations might impair the ability of the Life Insurance Subsidiaries to continue without exhausting surplus. Again, depending upon severity and frequency, corrective measures might be needed. Based on results of the testing, no corrective measures were indicated at the current time. However, such testing is ongoing and dynamic in nature and future events in the interest and equity markets or a significant change in the composition of Life Insurance Subsidiaries' business could negatively impact testing results and require the initiation of corrective measures.
The above discussion centers around asset management. Other possible corrective measures might involve liability realignment. The Company's marketing plan could be modified to emphasize certain product types and reduce others. New business levels could be varied in order to find the optimum level. Management believes that the Company's current liquidity, current bond portfolio maturity distribution and cash flow from operations give it substantial resources to administer its existing business and fund growth generated by direct sales. However, due to securities losses incurred during 2001 and 2000, the Company has negotiated less stringent debt covenants. Although the Company anticipates being able to meet these covenants, further significant deterioration of the securities markets could jeopardize this situation. The Company expects to service debt and other expenses by:
|X| Redemption of Citizens Security preferred stock as necessary, with such redemption also requiring approval by the Kentucky Department of Insurance
|X| Dividends from the Insurance Subsidiaries, which are limited by law to the lesser of prior year net operating income or 10% of prior year-end capital and surplus unless specifically approved by the Kentucky Department of Insurance
Consolidated Statements of Operations for the years ended December 31, 2001, 2000 and 1999.............................27
Consolidated Statements of Financial Condition at December 31, 2001 and 2000...............................................28
Schedule I - Summary of Investments - Other than Investments In Related Parties..........................47
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Citizens Financial Corporation and subsidiaries at December 31, 2001 and 2000, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
The Life Insurance Subsidiaries market their portfolio of products through the personal producing general agent distribution system and presently have approximately 3,000 sales representatives. Many of these agents also represent other insurance carriers. Approximately 450 of the agents specialize in the home service market while approximately 500 are preneed representatives who market through funeral homes. These markets consist primarily of individuals who desire whole life policies with policy limits typically below $10,000.
Fixed maturities and equity securities having a decline in value considered by management to be other than temporary are adjusted to an amount which, in management's judgment, reflects such declines. Such amounts are included in net realized investment gains and losses. For purposes of computing realized gains and losses on fixed maturities and equity securities sold, the carrying value is determined using the specific-identification method. Mortgage loans and policy loans are carried at unpaid balances. Investment real estate is carried at depreciated cost. Short-term investments, which consist of certificates of
Goodwill and Value of Insurance Acquired. Goodwill represents the excess of purchase price of purchased subsidiaries, over amounts assigned (based on estimated fair values at the date of acquisition) to the identifiable net assets acquired. Goodwill is amortized over 10 to 20 years using the straight-line method. At December 31, 2001, accumulated amortization was $412,861 ($316,848 at December 31, 2000).
Value of insurance acquired is recorded for the estimated value assigned to the insurance in force of the purchased subsidiaries at the dates of acquisition. The assigned value is amortized over the expected remaining life of the insurance in force using methods consistent with that used for amortization of policy acquisition costs (as described under Premiums, Benefits and Expenses). At December 31, 2001, accumulated amortization was $5,118,467 ($4,411,694 at December 31, 2000).
Reserves on insurance policies acquired by purchase are based on assumptions considered appropriate as of the date of purchase. Assumed investment yields for such acquired policies range from 6.6% to 9.0%.
Premiums, Benefits and Expenses. Premiums for traditional individual life (including Preneed life) and accident and health policies are reported as earned when due. Benefit claims (including an estimated provision for claims incurred but not reported), benefit reserve changes and expenses (except those deferred) are charged to expense as incurred. Deferred policy acquisition costs related to traditional life and accident and health policies are charged to expense over the life of the policy using methods and assumptions consistent with those used in estimating liabilities for future policy benefits. In determining whether a premium deficiency exists on short-duration policies, management does not give consideration to investment income.
Gross gains of $463,679, $2,268,554, and $1,260,650 and gross losses of $1,778,519, $1,127,299, and $969,136 were realized on the sale of available-for-sale fixed maturities during 2001, 2000, and 1999, respectively. Included in gross realized losses during 2001, 2000, and 1999 are net adjustments to the carrying value of available-for-sale fixed maturities of $739,000, $912,000, and $55,000 respectively, relating to declines in value which were considered by management to be other than temporary. Net realized gains from the sale of fixed maturities have been increased (decreased) by $63,492, $(80,166), and $(20,021) in 2001, 2000, and 1999 respectively, due to amortization of deferred policy acquisition costs. In addition, net realized gains from the sale of fixed maturities have been reduced by $8,744 and $27,544 in 2001 and 1999 respectively, for incentive fees earned by the portfolio manager.
The following table is a reconciliation of the net unrealized gain (loss) arising during the period and the change in net unrealized gains (losses) as reported on the accompanying statements of shareholders' equity.
Pursuant to requirements of certain state insurance departments, the Company has investments with a carrying value of $52,020,396, at December 31, 2001, placed on deposit at various financial institutions which are restricted from withdrawal without prior regulatory approval.
The Company owns the building and land in which it currently resides. At December 31, 2001 and 2000, the Company occupied approximately 29% of the building with the remaining space leased or available for lease to third-party tenants. The accompanying financial statements reflect the proportionate Company occupied share of the building and related operating expense as property and equipment and general expense, respectively. The remaining portion is reflected as investment real estate and as a reduction of investment income, respectively. Accumulated depreciation at December 31, 2001 and 2000 on the investment real estate portion of the building was $1,041,432 and $950,962, respectively.
The value of insurance acquired is an asset which represents the present value of future profits on business acquired, using interest rates of 6.6% to 9%. Balances outstanding relate primarily to the purchase of United Liberty and two additional companies which have been merged into Citizens Security (Integrity National Life Insurance Company and Old South Life Insurance Company) along with the NAIL total of $355,360 added during 2000. An analysis of the value of insurance acquired for the years ended December 31, 2001, 2000 and 1999 is as follows:
Activity in the accident and health liability portion of policy and contract claims ($415,601 and $414,454 at December 31, 2001 and 2000, respectively) and the incurred but not reported portion of accident and health reserves ($1,141,089 and $1,188,515 at December 31, 2001 and 2000, respectively) is summarized as follows:
The Company's outstanding borrowings relate primarily to various insurance company acquisitions. On October 14, 1999, the Company borrowed $2,500,000 in conjunction with the Citizens Insurance Acquisition and on May 12, 1998 borrowed $3,400,000 in conjunction with the United Acquisition. Interest is payable quarterly at the lower of the bank's prime lending rate or the one month LIBOR rate plus 2.75%. Principal installments are due as follows: 2002 through 2004 - $1,316,666; 2005 and 2006 - $1,416,666; and 2007 - $312,503. The Company has pledged the issued and outstanding common and preferred stock of Citizens Security as collateral for the commercial bank notes. The bank notes also contain covenants regarding asset acquisitions, shareholder dividends and maintenance of certain earnings ratios. Due to losses incurred during 2001, the Company did not meet covenants relating to a particular earnings ratio and a specified capital amount. Accordingly, in a letter dated March 25, 2002, the lender agreed to waive its right to call the debt as a result of these violations through December 31, 2001. In addition, effective January 1, 2002 the bank has revised the financial covenants governing the debt. Based on these revised terms, the Company believes it is probable that violations will not recur.
Income taxes paid (refunded) in 2001, 2000 and 1999 were $(1,293,000), $3,100,000, and $2,459,000, respectively. The Company utilized $236,000 of net operating loss carryforwards in 1999 and has $240,000 of net operating loss carryforwards which expire in 2016. The change in the valuation allowance is due principally to the limitation in the recovery of prior year taxes at the full statutory rate.
Under the tax law in effect prior to 1984, a portion of income of Citizens Security was not taxed when earned. It was accumulated in a tax account known as policyholders' surplus. Under the provisions of the Deficit Reduction Act of 1984, policyholders' surplus accounts were frozen at their December 31, 1983 balance of $859,000 for Citizens Security on a merged basis. Distributions from the policyholders' surplus would be subject to income tax. At December 31, 2001,
Citizens Security could have paid additional dividends of approximately $12,000,000 before paying tax on any part of its policyholders' surplus accounts. No provision has been made for the related deferred income taxes which total $292,000, based on current tax rates as of December 31, 2001.
Principal differences between SAP and GAAP include: a) costs of acquiring new policies are generally deferred and amortized for GAAP; b) value of insurance inforce acquired is established as an asset for GAAP; c) benefit reserves are calculated using more realistic investment, mortality and withdrawal assumptions for GAAP; d) the change in SAP deferred income taxes associated with timing differences is recorded directly to equity rather than as a component of net income as required for GAAP; e) assets and liabilities of acquired companies are adjusted to their fair values at acquisition with the excess purchase price over such fair values recorded as goodwill under GAAP; f) available-for-sale fixed maturity investments are reported at fair value with unrealized gain and losses reported as a separate component of shareholders' equity for GAAP; and g) statutory asset valuation reserves and interest maintenance reserves are not required for GAAP.
Statutory restrictions limit the amount of dividends which the insurance companies may pay. Generally, dividends during any year may not be paid, without prior regulatory approval, in excess of the lesser of (a) 10% of statutory shareholder's surplus as of the preceding December 31, or (b) statutory net operating income for the preceding year. During 2001, the Company contributed the stock of Citizens Insurance and $150,000 to Citizens Security. The statutory value of the contributed Citizens Insurance stock was $3,540,555. Citizens Security contributed the $150,000 received from the Company to Citizens Insurance. During both 2000 and 1999, with appropriate prior regulatory approval, Citizens Security redeemed $1,200,000 of its outstanding preferred stock from the Company. In addition, during 1999, with appropriate regulatory approval, Citizens Security paid a dividend of $1,000,000 to the Company. During 2001 and 2000, United Liberty paid dividends to Citizens Security of $292,000 and $200,000, respectively. The Insurance Subsidiaries must each maintain $1,250,000 of capital and surplus, the minimum required for insurance companies domiciled in Kentucky. The KDI imposes minimum risk-based capital ("RBC") requirements on insurance enterprises that were developed by the NAIC. The formulas for determining the amount of RBC specify various weighting factors that are applied to financial balances and various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio (the "Ratio") of the enterprise's regulatory total adjusted capital, as defined by the NAIC, to its required authorized control level RBC, as defined by the
Segment information as of December 31, 2001, 2000 and 1999, and for the years then ended is as follows:
Below are the net investment income amounts which are included in the revenue totals above.
Below is selected consolidated quarterly financial data for each of the two years in the period ended December 31, 2001.
Mortgage Loans: The carrying amount of mortgage loans approximates their fair value. At December 31, 2001 and 2000, the fair value of mortgage loans was $156,000.
The Company has various transactions with its President and Chairman of the Board (the "Chairman") or entities he controls. The Chairman provides investment portfolio management for the Company and its subsidiaries through SMC Advisors, Inc. (of which the Chairman is the principal officer, a director, and the sole shareholder). The investment portfolio management contracts provide for total annual fixed fees of $45,000 and incentive compensation equal to five percent (5%) of the sum of the net realized and unrealized capital gains in the fixed maturities and equity securities portfolios of the Company during each contract year. Any excess of net realized and unrealized capital losses over net realized and unrealized capital gains at the end of a contract year is not carried forward to the next contract year. Fixed fees totaled $45,000, $48,000, and $39,000 in 2001, 2000, and 1999, respectively. Incentive fees of $48,168, $207,369, and $617,524 were incurred and paid for 2001, 2000, and 1999, respectively. The Company also maintains a portion of its investments under a Trust Agreement with a bank controlled by the Chairman. Fees to the bank are based on assets held. Such fees were $94,199, $94,660, and $85,396 in 2001, 2000, and 1999, respectively. During 1999, the Company began managing certain commercial real estate affiliated with its Chairman. The Company charges the real estate projects management and leasing fees at market rates, which totaled $174,746, $150,672, and $114,628 during 2001, 2000, and 1999, respectively.
These condensed financial statements should be read in conjunction with the Consolidated Financial Statements and accompanying footnotes of Citizens Financial Corporation and Subsidiaries.