These lines of business are targeted to niche markets. The majority of group life and disability business is focused in the upper Midwest school and public entity markets. The DBL business is written in New York State and administered through Standard Life's web-based back office. Individual life and annuities are written under a nation-wide program for volunteer emergency service personnel. The credit life and disability business is marketed through a select group of producers.
While management considers a wide range of factors in its strategic planning and decision-making, underwriting profit is consistently emphasized as the primary goal in all decisions as to whether or not to increase our retention in a core line, expand into new products, acquire an entity or a block of business, or otherwise change our business model. Management's assessment of trends in healthcare and morbidity, with respect to medical stop-loss, major medical, short-term medical, dental, disability and DBL; mortality rates with respect to life insurance, and changes in market conditions in general play a significant role in determining the rates charged, deductibles and attachment points quoted, and the percentage of business retained. In addition, the Company's acquisition group assesses opportunities to acquire blocks of business based on the amount of reserves transferred and current interest rates. Finally, management focuses on managing the costs of our operations, which contributes to the Company's consistent profitability.
Net income of $22.9 million ($1.60 per share, diluted); 23.4% increase from 2003;
Increased the cash dividend 80% and began paying this dividend semi-annually;
On March 1, 2005, SHA acquired a 30% interest in CA Services, which will telemarket major medical and other products for Madison Life;
Increased retention of medical stop-loss premium at Standard Life and Madison Life to an average of 34% in 2004 from 30% in 2003 and 28% in 2002;
Generated consolidated investment yield of 6.2% in 2004, as compared to 6.5% in 2003;
Prior to November 2002, the Insurance Group included equity interests in two managing general underwriters: IndependenceCare Holdings LLC ("IndependenceCare") and Risk Assessment Strategies, Inc. ("RAS") and a Delaware property and casualty insurer, Independence American Insurance Company ("Independence American", formerly known as First Standard Security Insurance Company). On June 30, 2002, the Company acquired the remaining shares of common stock and preferred stock held by minority shareholders to increase its ownership of RAS to 100%. On November 14, 2002, the Company sold the stock of First Standard Holdings Corp., which owned 100% of the stock of IndependenceCare, RAS and Independence American, to AMIC for $31.9 million in cash. At such time, IHC owned 19.9% of the stock of AMIC. The sale of FSHC resulted in a $4.6 million gain, net of tax ($8.1 million pre-tax) to the Company. On April 22, 2003, IHC completed a cash tender offer and acquired an additional one million shares of AMIC. Following the tender offer, IHC owned 31.7% of the stock of AMIC. On December 22, 2003, IHC purchased an additional 613,401 shares (or 7.3% of the outstanding shares in AMIC) in open market and private transactions, and on June 15, 2004, IHC purchased an additional 94,488 shares which brought IHC's percentage of ownership in AMIC to 40%. Two representatives of IHC are directors of AMIC and AMIC's operations are substantially being directed by the management of IHC.
The Company computes insurance reserves primarily using the net premium method based on anticipated investment yield, mortality (morbidity on health insurance) and withdrawals. Liabilities for insurance reserves on certain short-term medical coverages were computed using completion factors and expected loss ratios derived from actual historical premium and claim data. These methods are widely used in the life and health insurance industry to estimate the liabilities for insurance reserves. Inherent in these calculations are management and actuarial judgments and estimates which could significantly impact the ending reserve liabilities and, consequently, operating results. Actual results may differ, and these estimates are subject to interpretation and change. Management believes that the Company's method of estimating the liabilities for insurance reserves provided appropriate levels of reserves at December 31, 2004 and 2003. Changes in the Company's reserves estimates are recorded through a charge or credit to its earnings.
Net income was $22.9 million, or $1.60 per share, diluted, for the year ended December 31, 2004 compared to $18.6 million, or $1.30 per share, diluted, for the year ended December 31, 2003. The Company's income before taxes increased $4.9 million to $33.6 million for the year ended December 31, 2004 from $28.7 million for 2003. The Company had net realized and unrealized gains of $2.4 million in the year ended 2004 compared to $.3 million in 2003. Income tax expense increased $.6 million to $10.7 million in the year ended December 31, 2004 from $10.1 million in 2003, primarily reflecting the increase in income before taxes, partially offset by a 2004 tax benefit related to the policyholders' surplus account. Under provisions of the Life Insurance Company Tax Act of 1959, life insurance companies were allowed certain special deductions for Federal income tax purposes that were accumulated in a memorandum tax account designated as "policyholders' surplus." Distributions of the untaxed amounts in this account would result in the Company incurring an additional tax. The Company provided tax expense of $1.1 million in 1992 and prior years for taxes related to the policyholders' surplus account. As a result of the October 2004 enactment of the American Jobs Creation Act of 2004, the Company reduced 2004 income tax expense by $1.1 million for the reversal of the prior years' income tax provisions. The Company intends to implement the distribution requirements of this tax law which will eliminate any future policyholders' surplus account tax.
The Insurance Group's pre-tax income increased $5.2 million to $36.0 million in 2004 from $30.8 million in 2003. These results include net realized and unrealized gains of $2.2 million in 2004 compared to $.2 million in 2003.
Total net investment income of the Insurance Group increased $6.1 million, primarily due to an increase in investable assets. The annualized return on investments of the Insurance Group was 6.0% for the year 2004 and 6.4% for the year 2003.
Equity income from AMIC increased $.1 million primarily due to the increase in ownership, partially offset by a decrease in AMIC's net income.
Other income increased $3.5 million primarily due to MGU fee income generated from the acquisition of Majestic.
Amortization of deferred acquisition costs and general and administrative expenses for the Insurance Group increased $7.4 million due to increases at Madison Life of $1.0 million, at Standard Life of $6.2 million and $.2 million from other subsidiaries. The increase at Madison Life is due to increased general expenses of $1.4 million due to increased salaries, administrative fees and costs associated with implementation of the internal control reporting requirements and other provisions of the Sarbanes-Oxley Act, partially offset by a $.2 million decrease in net commissions and a $.2 million decrease in deferred acquisition costs. The increase at Standard Life is due to increases in: commissions of $3.4 million due to the increase in premiums, general expenses of $.3 million, taxes licenses and fees of $1.2 million, amortization of deferred acquisition costs of $.9 million and minority interest in earnings of acquired companies of $.4 million .
The pre-tax loss for corporate increased $.3 million to $2.4 million for the year ended December 31, 2004 from $2.1 million for the year ended December 31, 2003. The higher pre-tax loss is primarily attributable to increases in interest expense of $1.4 million due to the increase in debt and general expense of $.3 million primarily from costs related to Sarbanes-Oxley Act compliance, partially offset by increases in net investment income of $1.0 million due to an increase in invested assets and other income of $.4 million.
Other income decreased $5.4 million primarily due to the loss of fee income resulting from the sale of IndependenceCare and RAS to AMIC in the fourth quarter of 2002.
Insurance benefits, claims and reserves increased $3.3 million, reflecting an increase of $4.5 million at Madison Life and a decrease of $1.2 million at Standard Life. Madison Life's increase resulted from: a $4.1 million increase in stop-loss reserves due to the growth of this line since its introduction in the third quarter of 2002; a $2.4 million increase in credit life and accident and health reserves due to the increase in premiums; and a $.2 million increase in all other lines of business; partially offset by a $1.3 million decrease in the ordinary life and annuity line due to a decrease from surrenders and interest credited; and a $.9 million decrease in LTD claims and reserves. The change at Standard Life is comprised of: a $3.6 million decrease in the annuity line due to the previously mentioned assumption reinsurance transaction which negatively impacted 2002; a $1.9 million decrease in provider excess reserves resulting from improved experience; a $1.0 million decrease in ordinary life due to the continued runoff of this line; a $.9 million decrease in point of service claims due to the cancellation of one large group as previously mentioned; a $.6 million decrease in DBL claims and reserves due to slightly lower loss ratios; a $.5 million decrease in the behavioral health line due to a reduction in retention; and a $.4 million decrease in group life due to lower retention; partially offset by a $7.6 million increase in medical stop-loss reserves due to the increase in premiums; and a $.1 million increase in all other lines.
The nature and quality of insurance company investments must comply with all applicable statutes and regulations which have been promulgated primarily for the protection of policyholders. Of the aggregate carrying value of the Insurance Group's investment assets, approximately 96.6% was invested in investment grade fixed income securities, cash and cash equivalents, resale agreements and policy loans and at December 31, 2004. Also at such date, approximately 99.1% of the Company's fixed maturities were investment grade. These investments carry less default risk and, therefore, lower interest rates than other types of fixed maturity investments. At December 31, 2004 approximately .9% of the carrying value of fixed maturities was invested in a non-investment grade fixed income security (investments in such securities have different risks than investment grade securities, including greater risk of loss upon default, and thinner trading markets). The Company does not have any mortgage loans or non-performing fixed maturities.
The Company reviews its investments regularly and monitors its investments continually for impairments. For the years ended December 31, 2004, 2003 and 2002, the Company recorded a realized loss for other than temporary impairments on securities not yet sold of $.6 million, $5.2 million and $7.2 million, respectively. In 2004, 2003 and 2002, $.4 million, $5.0 million and $6.4 million, respectively, of the loss relates to an interest related impairment recognized on certain interest only securities ("IO Securities") resulting from unexpected prepayments of the mortgage obligations underlying the IO Securities due to falling interest rates. The Company has invested in IO Securities to help actively manage its interest rate exposure. Typically these securities account for less than 2% of IHC's total portfolio assets and are rated AAA or better. In a rising interest rate environment, IO Securities will increase in value which acts to mitigate the unrealized loss on the balance of the bond portfolio. In a decreasing interest rate environment, IO Securities will decline in value, but there will be an unrealized gain in the rest of the bond portfolio. Although these securities performed as expected, the Company applies the methodology of Emerging Issues Task Force 99-20, "Recognition of Interest Income and Impairment of Purchased and Retained Beneficial Interests in Securitized Financial Assets" ("EITF 99-20") in determining when an IO Security is considered other than temporarily impaired. The Company records realized losses under EITF 99-20 when there is a decrease in expected cash flows combined with a decline in the IO Securities' fair value below cost.
The Company's gross unrealized losses on fixed maturities totaled $9.3 million at December 31, 2004. Substantially all of these securities were investment grade. The unrealized losses, primarily within the corporate securities portfolio, have been evaluated in accordance with the Company's policy and were determined to be temporary in nature at December 31, 2004. The Company holds all fixed maturities as available-for-sale and accordingly marks all of its securities to fair value through accumulated other comprehensive income or loss.
The following table summarizes information with respect to the share repurchase program:
The Company monitors its investment portfolio on a continuous basis and believes that the liquidity of the Insurance Group will not be adversely affected by its current investments. This monitoring includes the maintenance of an asset-liability model that matches current insurance liability cash flows with current investment cash flows. This is accomplished by first creating an insurance model of the Company's in-force policies using current assumptions on mortality, lapses and expenses. Then, current investments are assigned to specific insurance blocks in the model using appropriate prepayment schedules and future reinvestment patterns.
Due to its strong capital ratios, broad licensing and excellent asset quality and credit-worthiness, the Insurance Group remains well positioned to increase or diversify its current activities. It is anticipated that future acquisitions or other expansion of operations will be funded internally from existing capital and surplus and parent company liquidity. In the event additional funds are required, it is expected that they would be borrowed or raised in the public or private capital markets to the extent determined to be necessary or desirable. In November 2004, March 2004 and December 2003, the Company borrowed $15 million, $10 million and $12 million, respectively, through pooled trust preferred issuances by subsidiary trusts. In September 2003, the Company entered into a $12.5 million line of credit, all of which was drawn down. The cash proceeds of the line of credit and the trust preferred securities issued in 2003 were used to repay existing debt and for general corporate purposes. See Note 11 of the Notes to Consolidated Financial Statements in Item 8.
IHC enters into a variety of contractual obligations with third-parties in the ordinary course of its operations. These obligations, as of December 31, 2004, are set forth in the table below. However, we do not believe that our cash flow requirements can be fully assessed based upon an analysis of these obligations. Future cash outflows, whether they are contractual obligations or not, also will vary based upon our future needs. Although some outflows are fixed, others depend on future events. The Company had the following expected contractual obligations relating to debt, trust preferred securities (junior subordinated debt), non-cancelable leases, insurance reserves and funds on deposit at December 31, 2004:
Under certain circumstances set forth in the Limited Liability Company Agreement of Majestic, the Company has the right and/or obligation to purchase some or all of the minority interests in Majestic.
The Company anticipates continued favorable operating performance in 2005 as a result of (i) marketing of its new strategic health products including the rollover of the $50 million block of employer-sponsored group major medical administered by Insurers Administrator Corporation ("IAC"), a market leader in sales of consumer driven medical plans to the small and medium size employer group maket; (ii) cross-selling of products through controlled distribution sources, including its affiliates, Health Plan Administrators, Inc. ("HPA") and CA Insurance Services ("CA Services"); (iii) improved profitability of its Medical Stop-Loss business through stricter underwriting and anticipation of a somewhat "harder" market; (iv) the appointment of new stop-loss MGUs; and (v) acquisition of blocks of business.
IHC began marketing employer-sponsored group major medical in one state in the first quarter of 2005. Beginning in 2005, the Company is preparing to market this product in 36 states. Standard Life will also 100% reinsure, with the intent of assuming, a $50 million block of this business as of January 1, 2005. In addition, during 2005, IHC will begin distributing short-term medical, dental and vision products. The major medical, dental and vision products, will be marketed through IAC and CA Services. The short-term medical and other products will be written through HPA, a market leader in these products. These products, taken together, provide IHC with a full array of health products. In addition, the Company should generate cross-selling opportunities for IHC's current life and health products and others currently under development. IHC will continue to seek other strategic acquisitions of TPAs and other distribution sources.
Madison Life anticipates moderate growth in its group LTD, credit and term life lines as a result of increased production and improved loss ratios. In 2000, as a result of Madison Life's 1999 acquisition of a block with $78.0 million in reserves, Madison Life began marketing an individual life product (with annuity riders) to military and civilian government employees, primarily through payroll deduction. The Company will continue to review acquisitions, and believes that it is well positioned to consummate additional acquisitions should the opportunity arise.
The Company entered into an Aggregate Excess of Loss Retrocessional Reinsurance Agreement with a reinsurer for its 2004 Medical Stop-Loss business, effective as of January 1, 2005, pursuant to which the Company will provide such reinsurer with a loss ratio cover to cap the reinsurer's losses, excluding certain losses, at a 90% net loss ratio. Approximately $43 million of net premium was ceded to such reinsurer during such period and the Company charged 8% of the premium ceded to the reinsurer for such coverage. In addition, the Company entered into a Commutation Agreement with this same reinsurer, pursuant to which, effective as of January 1, 2005, the reinsurer will return 94% of the net premium collected to date with respect to the 2003 Medical Stop-Loss business ceded to such reinsurer, and the Company will release most future liabilities of such reinsurer with respect to such business. To date, approximately $27 million of net premium was ceded to such reinsurer for such year.
Madison National and Independence American entered into a reinsurance agreement to protect Independence American against certain losses occurring during the period from January 1, 2005 to December 31, 2005. In the event that Independence American's claims, loss adjustment expenses, and incurred but not reported reserves ("Net Losses") exceeds 95% of the net premiums earned by Independence American, then Madison National will pay Independence American an amount equal to the excess over the Net Losses. In no event shall Madison National pay Independence American more than $5,000,000. Independence American will pay Madison National, quarterly, a premium of 0.175% of net retained premium subject to a minimum premium of $50,000 and a maximum premium of $100,000.
On September 30, 2004, the Financial Accounting Standards Board ("FASB") issued Staff Position No. EITF Issue 03-1-1, "Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," which delays the effective date for the measurement and recognition guidance contained in Emerging Issues Task Force ("EITF") Issue No. 03-1. EITF Issue No. 03-1 provides guidance for evaluating whether an investment is other-than-temporarily impaired and was originally to be effective for other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004 (July 1, 2004 for the Company). The delay in the effective date for the measurement and recognition guidance contained in EITF Issue No. 03-1 does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. Subsequent to the issuance of Staff Position No. EITF Issue 03-1-1, the FASB announced plans for a full reconsideration of existing authoritative literature concerning other-than-temporary impairment of securities. The outcome of this reconsideration and the impact, if any, on the Company's impairment recognition cannot be predicted at this time.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004) ("FASB 123(R)"), "Share-Based Payment", which supercedes SFAS No. 123, "Accounting for Stock-Based Compensation," and APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123(R) addresses the accounting for share-based payment transactions with employees and other third parties; eliminates the ability account for share-based compensation transactions using APB 25; and requires that the compensation costs relating to such transactions be recognized in the statement of operations. The revised statement is effective as of the first interim period beginning after June 15, 2005 and, therefore, the Company will adopt the statement on July 1, 2005 as required. SFAS 123(R) applies to all awards granted after the required effective date and to awards modified, repurchased, or cancelled after that date. Additionally, beginning on the required effective date, compensation expense will be recognized for the portion of outstanding awards for which the requisite service (vesting) has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. The impact of adoption cannot be predicted at this time because it will depend, in part, on levels of share-based payments granted in the future. However, had the Company adopted SFAS 123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the pro forma disclosure included in Note 1(R) of the Notes to Consolidated Financial Statements in Item 8.
The risks and uncertainties described below are not the only ones that the Company faces. Additional risks and uncertainties not presently known to the Company or that the company currently deems immaterial may also impair the Company's business operations. If any of the following risks actually occur, the Company's business, financial condition or results of operations could be materially adversely affected. In such case, the trading price of the Company's common stock could decline.
Losses related to terrorist activities, random acts of violence or declared or undeclared war;
The Company maintains loss reserves to cover its estimated liability for unpaid losses and loss adjustment expenses, including legal and other fees as well as a portion of the Company's general expenses, for reported and unreported claims incurred as of the end of each accounting period. Because setting reserves is inherently uncertain, the Company cannot be sure that current reserves will prove adequate in light of subsequent events. If the Company's reserves are insufficient to cover its actual losses and loss adjustment expenses, the Company would have to augment its reserves and incur a change to its earnings, and these charges could be material. Reserves do not represent an exact calculation of liability. Rather, reserves represent an estimate of what the Company expects the ultimate settlement and administration of claims will cost. These estimates, which generally involve actuarial projections, are based on the Company's assessment of facts and circumstances then known, as well as estimates of future trends in claims severity, frequency, judicial theories of liability and other factors. These variables are affected by both internal and external events, such as changes in claims handling procedures, inflation, judicial trends and legislative changes. Many of these items are not directly quantifiable in advance. Additionally, there may be a significant reporting lag between the occurrence of the insured event and the time it is reported to the Company. The inherent uncertainties of estimating reserves are greater for certain types of liabilities, particularly those in which the various considerations affecting the type of claim are subject to change and in which long periods of time may elapse before a definitive determination of liability is made. Reserve estimates are continually refined in a regular and ongoing process as experience develops and further claims are reported and settled. Adjustments to reserves are reflected in the results of the periods in which such estimates are changed.
Certain Proposed Federal and State Legislation May, if Adopted, Adversely Affect the Company's Employer Medical Stop-Loss Business
The Company's success is dependent on its ability to assess accurately the risks associated with the businesses on which the risk is retained. If the Company fails to assess accurately the risks it retains, the Company may fail to establish the appropriate premium rates and the Company reserves may be inadequate to cover its losses, requiring augmentation of the Company's reserves, which in turn could reduce the Company's net income.
At December 31, 2004, $546.4 million of the Company's $722.2 million investment portfolio was invested in fixed income securities. The fair market value of these fixed income securities and the investment income from these fixed income securities fluctuate depending on general economic and market conditions. With respect to the Company's investments in fixed income securities, the fair market value of these investments generally increases or decreases in an inverse relationship with fluctuations in interest rates, while net investment income realized by the Company from future investments in fixed income securities will generally increase or decrease with interest rates. In addition, actual net investment income and/or cash flows from investments that carry prepayment risk, such as mortgage-backed and other asset-backed securities, may differ from those anticipated at the time of investment as a result of interest rate fluctuations. An investment has prepayment risk when there is a risk that the timing of cash flows that result from the repayment of principal might occur earlier than anticipated because of declining interest rates or later than anticipated because of rising interest rates. Historically, the impact of market fluctuations has affected the Company's financial statements. Because all of the Company's fixed income securities are classified as available for sale, changes in the fair market value of the Company's securities are reflected in the Company's accumulated other comprehensive income. No adjustment is made for liabilities to reflect a change in interest rates. Therefore, interest rate fluctuations and economic conditions could adversely affect the Company's stockholders' equity, total comprehensive income and/or cash flows.
The Insurance Group's business depends on compliance with applicable laws and regulations and its ability to maintain valid licenses and approvals for its operations. Regulatory authorities have broad discretion to grant, renew, or revoke licenses and approvals. Regulatory authorities may deny or revoke licenses for various reasons, including the violation or regulations. In some instances, the Insurance Group follows practices based on its interpretations of regulations, or those that it believes to be generally followed by the industry, which may be different from the requirements or interpretations of regulatory authorities. If the Insurance Group does not have the requisite licenses and approvals and does not comply with applicable regulatory requirements, the insurance regulatory authorities could preclude or temporarily suspend the Insurance Group from carrying on some or all of its activities or otherwise penalize it. That type of action could have a material adverse effect on the Insurance Group's business. Also, changes in the level of regulation of the insurance industry (whether federal, state or foreign), or changes in laws or regulations themselves or interpretations by regulatory authorities, could have a material adverse effect on the Insurance Group's business.