Over the past 18 months, the board and management of the Company considered a variety of strategic alternatives that might provide it with adequate financing to pursue its growth strategies for the health services business it embarked on in 2002 and maximize long-term shareholder value. After considering various options, management, in early 2005, committed to the sale of 100% of Standard Life, including Dixie Life. Pursuant to this decision and following months of negotiating, on February 9, 2005, Standard Management entered into a definitive Stock and Asset Purchase Agreement (the “Agreement”) with Capital Assurance Corporation (“Capital Assurance”). The Agreement provides for the sale to Capital Assurance of (i) 100% of the capital stock of Standard Life, and (ii) $27 million aggregate principal amount of surplus debentures issued by Standard Life in favor of Standard Management. The Agreement represents the definitive terms for the transactions contemplated by the previously reported letter of intent between the parties. Standard Management expects the transaction to close in the second quarter of 2005.
Standard Management and Capital Assurance have made customary representations, warranties and covenants in the Agreement, including, among others, covenants by Standard Management (i) to conduct the business of Standard Life in the ordinary course and maintain necessary permits and insurance policies during the interim period between the execution of the Agreement and closing, (ii) to not engage in certain types of transactions during such period, (iii) to cause a meeting of the shareholders of Standard Management to be held to approve the Agreement and the transactions contemplated thereby, (iv) to not solicit proposals relating to an alternative sale or business combination transaction and (v) subject to certain exceptions, not to enter into discussions concerning or provide confidential information in connection with proposals for alternative sale or business combination transactions. In addition, Standard Management has agreed to purchase certain assets from Standard Life at closing for approximately $6 million.
Consummation of the transactions contemplated by the Agreement is subject to customary conditions, including (i) approval of the shareholders of Standard Management, (ii) absence of any law or order prohibiting the closing, (iii) approval of the Indiana Department of Insurance, and (iv) expiration or termination of the Hart-Scott-Rodino waiting period. In addition, each party’s obligation to consummate the transactions contemplated by the Agreement is subject to certain customary conditions, including (i) with certain exceptions, the accuracy of the representations and warranties of the other party and (ii) material compliance of the other party with its covenants.
Standard Management also agreed to undertake a solicitation of the preferred security holders of SMAN Capital Trust I, a wholly owned subsidiary of Standard Management (the “Trust”) at an estimated cost of approximately $1 million to fund incentive payments in connection with obtaining the consent of the trust preferred holders. If adopted, the amendment would provide us additional financing flexibility by allowing us to enter into certain business transactions, such as the sale of substantially all of our assets, without the acquirer of such assets being required to assume our responsibilities under the indenture. In the event the requisite consents to amend the indenture are not received, Standard Management has the right to require Capital Assurance to assume Standard Management’s obligations under the indenture. If this event were to occur, Standard Management would receive less net cash proceeds from the sale of Standard Life by the net face amount outstanding of the trust preferred securities.
Also in this Agreement, Standard Management agreed to indemnify Capital Assurance and Standard Life for any losses arising from breaches of any representation or warranty of Standard Management made in the Agreement subject to the applicable survival periods and for certain allocated tax losses, if any of such losses exceed $500,000 in the aggregate. If such indemnification threshold is exceeded, Standard Management would be responsible for paying $250,000 plus the amount of such loss in excess of $500,000, up to a maximum amount equal to the purchase price for losses related to the breach of certain representations and warranties, and up to a maximum amount equal to 50% of the purchase price for breaches of certain other specified representations and warranties. In addition, Standard Management agreed to indemnify Capital Assurance and Standard Life for losses arising out of any litigation pending against Standard Life as of the Closing Date to the extent the loss exceeds Standard Life’s litigation reserve, for any breach of the covenants and agreements made by Standard Management in the Agreement and for certain other tax losses. Standard Management has agreed to pledge the preferred stock to be received as part of the consideration in the transaction to secure up to $5 million of indemnification liabilities.
Capital Assurance also agreed to indemnify us with respect to any breach of a representation, warranty or covenant made by it under the Agreement, subject to the same limits and the applicable survival periods.
If the sale of Standard Life is consummated, Standard Management will no longer operate in the insurance industry (other than certain de minimis activities). At such time, virtually all of our operations will consist of the business of our U.S. Health Services subsidiary and its several operating subsidiaries which comprise our health services operations. If the sale is consummated,
Standard Life and its subsidiaries will be treated for accounting purposes as a discontinued operation of Standard Management and the financial statements for all prior periods will be restated to show the operations of Standard Life separately from Standard Management’s continuing operations.
The discussion of our financial condition and results of operations that follows provides a discussion of both of our historical business segments.
• Our ability to satisfy the contractual conditions necessary to consummate the sale of Standard Life.
• Our ability to achieve anticipated levels of operational efficiencies at recently acquired companies, as well as through other cost-saving initiatives.
• Customer response to new products, distribution channels and marketing initiatives.
This Annual Report on Form 10-K also contains forward-looking statements specifically relating to our insurance business. If the proposed sale of Standard life is not consummated and we continue to operate in the financial services sector, the following additional factors may cause actual results to differ from those contemplated by the forward-looking statement:
• Mortality, morbidity and other factors which may affect the profitability of our insurance products.
• Changes in the federal income tax laws and regulation which may affect the relative tax advantages of some of our products.
Historically we have specialized primarily in the sale of individual annuities. Under accounting principles generally accepted in the United States, or GAAP, premium collections for annuities are reported as insurance policy liabilities instead of as revenues. Sources of revenues for products accounted for as insurance policy liabilities are net investment income, surrender charges deducted from the account balances of policyholders in connection with withdrawals, realized gains and losses on investments and call option income. Components of expenses for products accounted for as insurance policy liabilities are interest credited to account balances, amortization of deferred policy acquisition costs, and other operating costs and expenses.
Earnings from products accounted for as insurance policy liabilities are primarily generated from the excess of net investment income earned over the interest credited to the policyholder, or the “investment spread”. Our investment spread is summarized as follows for the year ended December 31:
The weighted average effective credited rate represents interest on interest sensitive liabilities, including equity indexed annuities, offset by gains on call option assets used to mitigate changes in equity indexed annuity liabilities.
Interest spreads represent a major profit source on annuity and interest sensitive life products. Margins on these products are sensitive to interest rate fluctuations. In general, we are able to maintain spreads by adjusting credited interest rates for changes in our earned rates, subject to competitive and timing constraints. However, there are corollary effects of interest rate changes.
We seek to closely match the estimated duration of our invested assets to the expected duration of our liabilities. When the estimated durations of assets and liabilities are similar, exposure to interest rate risk is minimized because a change in the value of assets should be largely offset by a change in the value of liabilities. A significant mismatch of the durations of invested assets and liabilities could have an impact on our future financial results.
The average expected remaining life of Standard Life’s traditional life and annuity business in force at December 31, 2004 was 6.3 years. This calculation was determined based upon our actuarial models and assumptions as to expected persistency and mortality. Persistency is the extent to which insurance policies sold are maintained by the insured. The persistency of life insurance and annuity products is a critical element of their profitability. However, a surrender charge often applies in the early contract years and declines to zero over time.
Life insurance policyholders sometimes do not pay scheduled premiums, thus causing their policies to lapse. For the years 2004, 2003, and 2002 Standard Life experienced total policy lapses, excluding surrenders, of 1.9%, 3.1% and 3.4% of total policies in force at December 31 of each year, respectively. Ongoing premiums are not required for annuity policies, so annuities do not experience policy lapses.
Present Value of Future Profits. In accordance with industry practice, when we purchase a block of existing insurance business (which we have not done since 1998), we assign a portion of the purchase price, PVFP, as the pre-tax value of the business acquired. The asset is the discounted value of future cash flows arising from the existing block of business. The discount rate used is based upon many elements, such as yields generated on similar business, our cost of capital and the interest rate environment as of the purchase date. Discount rates used in determining our PVFP assets range from 8% to 18%.
Deferred Policy Acquisition Costs. Insurance policies we issue ourselves will generate significant costs that vary directly with and relate to issuance of that new business. Under GAAP, these acquisition costs on new policies are to be capitalized and recorded as DAC. For universal and interest sensitive life and annuity products, the DAC asset is amortized in proportion to estimated gross profits over the life of the contract. For immediate annuities, DAC is amortized so as to produce a constant yield on the net policyholder liability. Virtually all of our DAC is a result of writing annuity products.
Accounting for Deferred Annuities and Universal and Interest-Sensitive Life Products. We primarily account for our deferred annuity, universal and interest-sensitive life policy deposits in accordance with Statement of Financial Accounting Standards No. 97 (“SFAS 97”), “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses on the Sale of Investments”. Under SFAS 97, a benefit reserve is established at the time of policy issuance in an amount equal to the deposits received. Thereafter, the benefit reserve is adjusted for any additional deposits, interest credited and partial or complete withdrawals. Revenues for annuities and universal and interest-sensitive life policies, other than certain non-interest sensitive annuities, consist of policy charges for surrenders and partial withdrawals, mortality and administration, and investment income earned. These revenues do not include the annuity, universal and interest-sensitive life policy deposits. Expenses related to these products include interest credited to policyowner account balances, operating costs for policy administration, amortization of DAC and mortality costs in excess of account balances.
Costs related to the acquisition of new business, primarily commissions paid to agents, which vary with and are directly related to the production of new business, are deferred to the extent that such costs are recoverable from future profit margins. At the time of issuance, the acquisition expenses are capitalized as DAC. In accordance with SFAS 60, DAC with interest is amortized over the lives of the policies in a constant relationship to policy premiums.
Accounting for Immediate Annuities. Immediate annuities with no life contingent payments, which comprise the majority of our immediate annuities in force and the majority of new immediate annuity sales, are accounted as investment contracts in accordance with SFAS 97. Revenues consist of investment income, and expenses consist of the imputed interest credits to policies as well as operating costs for policy administration. An initial net premium policy liability is established as initial premium less acquisition costs. The imputed credited rate is the rate, which equates this net premium to the guaranteed payments. After issue, the liability changes by the amount of imputed interest credits and benefit payments. For balance sheet purposes, this net premium liability is presented as a gross premium liability offset by a DAC asset.
Equity indexed call options are derivative instruments linked to the major stock indices (S&P 500 Index and DJIA Index) which are used to mitigate changes in the equity benefits of our equity indexed annuity products. We purchase call options whose payoff characteristics offset the equity benefits of our products. These securities are carried at fair value and the change in fair value is included in net investment income.
The combined balance of our DAC and PVFP was $174.2 million at December 31, 2004. The recovery of these costs is dependent on the future profitability of the related business.
The balance of our goodwill and intangible assets was $8.8 million at December 31, 2004. The recovery of this asset is dependent on the fair value of the business to which it relates. Pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), goodwill is subject to annual impairment tests based on the estimated fair value of the business units. There are numerous assumptions and estimates underlying the determination of the estimated fair value of these businesses. Different valuation methods and assumptions can produce significantly different results that could affect the amount of any potential impairment charge that might be required to be recognized. A charge of $1.0 million resulting from the impairment of goodwill was recorded in 2004 in the Health Services segment.
The total balance of our liabilities for insurance products was $1.8 billion at December 31, 2004. These liabilities are often payable over an extended period of time and the profitability of the related products is dependent on the pricing of the products and other factors. Differences between pricing assumptions and actual experience will impact future financial results.
We calculate and maintain reserves for the estimated future payment of claims to our policyholders based on actuarial and other assumptions. These assumptions are generally best estimates, with moderate provision for adverse deviation. Many factors can affect the adequacy of these reserves and liabilities, such as economic and social conditions, inflation, changes in doctrines of legal liability and extra contractual damage awards. Therefore, the reserves and liabilities we establish are necessarily based on extensive estimates, assumptions and historical experience, all consistently applied. Establishing reserves is an uncertain process, and it is possible that actual claims will materially exceed our reserves and have a material adverse effect on our results of operations and financial condition. Our financial results depend significantly upon the extent to which our actual claims experience is consistent with the assumptions we used in determining our reserves and pricing our products. If our assumptions with respect to future claims are incorrect, and our reserves are insufficient to cover our actual losses and expenses, we would be required to increase our liabilities, negatively affecting our operating results.
Results of operations by segment for the three years ended December 31, 2004:
Net loss from continuing operations for 2004 was $10.9 million compared to a loss of $10.2 million for 2003.
Health Services: Net loss for 2004 was $10.3 million, compared to a loss of $7.2 million for 2003. The 2004 loss included a goodwill impairment charge of $1 million and net realized investment loss of $1 million. Also, 2004 results were reduced by $3.5 million as a result of recording a valuation allowance on the tax benefits on this segment’s operating and capital losses.
Deposits collected consist of deposits from our flexible premium deferred annuities, equity-indexed annuities, single premium immediate annuities and other financial products that do not incorporate significant mortality features. Under GAAP, these premium deposits are not shown as premium income in the statement of operations. A change in premium deposits in a single period does not directly cause our operating income to change, although continued increases or decreases in premiums may affect the growth rate of assets on which investment spreads are earned.
• Deposits collected for interest sensitive annuities and other financial products for 2003 decreased $178.5 million or 30%, to $421.0 million. Deferred annuities decreased $191.3 million or 60%, to $129.3 million. Equity indexed annuities decreased $1.4 million or 1%, to $125.3 million. Single premium immediate annuities and other deposits increased $14.3 million or 9%, to $165.8 million.
• Premium income for 2004 decreased $1.1 million or 13%, to $7.8 million.
Policy income represents 1) surrender income earned as a result of terminated universal life and annuity policies and 2) mortality income and administrative fees earned on universal life products.
• During 2004, policy income increased $5.9 million or 55%, to $16.8 million.
• During 2003, policy income increased $2.8 million or 34%, to $10.8 million.
Call option gain (loss) relates to equity-indexed products that are used to limit risk against unusually high crediting rates on our equity indexed financial products from favorable returns in the equity market. The market value of these options fluctuates from period to period and are substantially offset by amounts credited to policyholder account balances.
• During 2004, call option gain decreased by $9.5 million to $2.4 million.
The change in call option results for each period reflects changes in the changes in the S&P 500 Index and the DJIA Index during those periods.
Interest credited to interest sensitive annuities and other financial products represents interest credited to insurance liabilities of the deferred annuities, single premium immediate annuities, equity-indexed annuities and other financial products. This expense fluctuates with changes in 1) the average interest-sensitive insurance liabilities, 2) the average credited rate on those liabilities, 3) changes in the market values of securities underlying our equity-indexed annuities and 4) the impact of SFAS No. 133, Accounting for Derivatives Instruments and Hedging Activities.
• During 2003, interest credited increased $29.0 million to $71.6 million, of which $23.0 million related to equity indexed annuity products and the remaining $48.6 million related to all other interest sensitive annuity and life insurance products. Interest credited increased $22.0 million due to the impact of improved equity market performance on equity products. Interest credited increased $12.5 million due to a 33% increase in average interest sensitive liabilities of $381 million compared to 2002, partially offset by $5.5 million of reductions due to reduced crediting rates.
Acquisition costs for deferred annuity contracts and equity-indexed annuity contracts are required to be amortized over the lives of the contracts in relation to the incidence of estimated gross profits. Estimated gross profits on fixed and equity indexed annuity contracts include investment spread, surrender income, expense margins, and realized investment gains and losses. Gross profit estimates are evaluated regularly, with historical gross profit estimates adjusted to actual results and projected gross profit estimates updated to reflect current expectations. DAC amortization is adjusted both retrospectively and prospectively (unlocked) in accordance with the revised profit stream, and retrospective adjustments are reported in the current reporting period.
Operating expenses - affiliated consist of general operating expenses, including rent and management fees paid to Standard Management in the Other Services segment.
• During 2004, affiliated operating expenses remained unchanged from 2003 at $5.5 million.
• During 2003, affiliated operating expenses increased $.6 million or 12%, to $5.5 million due to increased rental expense.
• During 2003, affiliated interest expense and financing costs decreased by $.1 million or 7%, to $1.7 million. The decline in interest expense resulted from the decline in the prime rate.
The weighted average interest rate for 2004, 2003, and 2002 was 6.30%, 6.20%, and 6.67%, respectively.
General: Our Health Services segment consists of revenues earned and expenses incurred from our pharmaceutical operations. Our primary customer base consists of academic institutions, skilled nursing facilities, assisted living facilities, home health care agencies, mental health facilities, correctional facilities and consumers. The profitability of this segment is primarily a function of gross margin on sales (the difference between sales and cost of sales) and management of our operating expenses.
• During 2004, sales increased $4.2 million or 141.5%, to $7.1 million primarily due to the acquisition of Apothecary Solutions during the early part of 2004.
• During 2004, expenses increased $3.6 million or 50.5% to $10.6 million primarily related to the increased expenses resulting from the Apothecary Solutions acquisition of $3.8 million, primarily salaries for their employees, a $1.0 million goodwill impairment charge, $.4 million related to acquisition costs and other expenses associated with the continued development of U. S. Health Service’s operating platform and infrastructure, as well as ongoing concentrated marketing initiatives.
• During 2004, interest income - affiliated remained unchanged at $1.7 million.
• During 2003, interest income - affiliated decreased $.1 million or 7%, to $1.7 million. The decline in interest income resulted from the decline in the prime rate.
• During 2004, interest expense and financing costs remained unchanged at $4.4 million.
• During 2004, federal income tax benefit increased $.3 million or 77%, to $.7 million. During 2004 we utilized partial valuation a allowance of $.4 million.
• During 2003, federal income tax benefit decreased $1.9 million or 82%, to $.4 million. Federal income tax benefit decreased due to a valuation allowance related to the operating losses recorded in 2003. Also, in 2002, there was a utilization of a previously reserved net operating loss carryforward of $1.0 million.
We are a holding company whose capital requirements are met through payments received from our subsidiaries. These payments have historically included 1) surplus debenture interest, 2) dividends, 3) management fees, 4) equipment rental fees, 5) lease income and 6) allocation of income taxes, all of which have been subject to restrictions under applicable insurance laws and are used to pay our operating expenses and meet our debt service obligations. Historically, the vast majority of our dividend income, management fee income, rental fee income and lease income have come from Standard Life, which accounted for approximately 94% of our consolidated revenues in 2004. If the proposed sale of Standard Life is consummated, we will no longer have this source of funds and will rely primarily on our health services operations. In addition, we will no longer receive interest on the Surplus Debentures, which we intend to sell to Capital Assurance along with the stock of Standard Life. However, if the sale of Standard Life is consummated, we will receive a substantial amount of cash proceeds as described below.
Additionally, we have borrowed significant amounts from Standard Life to finance the operations of our Health Services business. As of December 31, 2004, the aggregate amount of such borrowings was $20.7 million. As part of the purchase price for Standard Life, Capital Assurance would assume this indebtedness. These internal sources of liquidity are supplemented by external sources such as revolving credit agreements and long-term debt and equity financing in the capital markets. We currently have $18.5 million outstanding with our senior secured credit agreement with a bank. There is currently no availability under this agreement. If the proposed sale of Standard Life is consummated, we intend to repay this agreement in full.
In conjunction with our efforts to sell Standard Life, Standard Management also agreed to undertake a solicitation of the preferred security holders of SMAN Capital Trust I, a wholly owned subsidiary of Standard Management (the “Trust”) at an estimated cost of approximately $1 million to fund incentive payments in connection with obtaining the consent of the trust preferred holders. If adopted, the amendment would provide us additional financing flexibility by allowing us to enter into certain business transactions, such as the sale of substantially all of our assets, without the acquirer of such assets being required to assume our responsibilities under the indenture. In the event the requisite consents to amend the indenture are not received, Standard Management has the right to require Capital Assurance to assume Standard Management’s obligations under the indenture. If this event were to occur, the cash proceeds to be received by us in the sale would be reduced by the approximately $20.7 million aggregate liquidation amount of trust preferred securities outstanding, which would reduce the net amount of cash expected to be available to us to operate and expand our health services business from approximately $27.5 million to approximately $7 million. Such an event would make it more likely that we would have to secure additional debt or equity financing to carry out our business plan, and there can be no assurance that we could obtain such financing on acceptable terms or at all.
2033. The interest and principal payments are subject to quarterly approval by the Indiana Department of Insurance, depending upon satisfaction of certain financial tests relating to levels of Standard Life’s capital and surplus and general approval of the Commissioner of the Indiana Department of Insurance (“Commissioner”). For the quarters ended September 30, 2004 and December 31, 2004 the Commissioner had not yet approved our request of $.8 million in aggregate interest payments. Assuming the approvals are granted and the December 31, 2004 interest rate of 7.5% continues, we expect to receive interest income of $2.0 million from the Surplus Debentures in 2005, assuming a full year ownership of Standard Life.
Dividends paid from Standard Life are limited by laws applicable to insurance companies. As an Indiana domiciled insurance company, Standard Life may pay a dividend or distribution from its surplus profits, without the prior approval of the Commissioner, if the dividend or distribution, together with all other dividends and distributions paid within the preceding 12 months, does not exceed the greater of 1) net gain from operations or 2) 10% of surplus, in each case as shown in its preceding annual statutory financial statements. In 2004 and 2003, there were no dividends received from our subsidiaries. In 2005, we could receive dividends of $1.1 million from Standard Life, without regulatory approval and an additional $5.6 million with regulatory approval. However, we do not expect to receive dividends from our subsidiaries in 2005.
Anticipated Sale of Standard Life. Based on management’s expectations regarding the estimated adjusted purchase price for Standard Life, and assuming a final, post-adjustment purchase price of $83 million, we expect the net cash proceeds from the sale, before deducting transaction related fees and expenses, to be approximately $57 million. We intend to use such cash proceeds as follows:
• approximately $4.3 million for professional fees (investment bankers, attorneys, accountants) and miscellaneous other expenses (filing fees, printing and mailing proxy materials, prepayment penalties, severance payments, etc.);
• $.5 million to reduce the principal amount outstanding under the mortgage on our home office; and
• the remaining approximately $27.5 million as working capital to support and expand our health services business, including through selected strategic acquisitions.
The following are the characteristics of our mortgages payable, promissory notes, notes payable and subordinated debentures, including estimated required payments in 2005.
The following are characteristics of our mortgages payable agreement at December 31, 2004:
• mortgage may be prepaid on or before January 2005 at 105% and declining to 101% after December 2008;
The following are characteristics of our promissory notes at December 31, 2004:
• principal and interest payments: $1 million in 2005, $.5 million in 2006, $.3 million in 2007 and $.1 million in 2008.
• principal payments: $2.0 million to be paid in 2005, $2.1 million to be paid in 2006, $2.2 million to be paid in 2007, and $12.2 million to be paid in 2008;
• interest payments required in 2005 based on current balances will be $1.0 million;
• entire balance to be repaid upon sale of Standard Life.
The following are characteristics of our 7% Convertible Notes Due 2009 at December 31, 2004:
The following are characteristics of our trust preferred securities at December 31, 2004:
• distributions required in 2005 based on current balances will be $2.1 million;
The proceeds from the offering were immediately loaned to Standard Management by the Trust in the form of an equal amount of subordinated debentures. The debentures have similar terms as the preferred securities, including a 10.25% interest rate. Although the Trust is wholly-owned by Standard Management, Standard Management does not consolidate the Trust because all of the income and cash flows of the Trust benefit the preferred security holders rather than Standard Management. As such, the subordinated debentures and related interest expense are reflected in our consolidated results.
Off-Balance Sheet Arrangements. We have no off-balance sheet financing arrangements, other than the Trust as discussed above.
Statutory surplus is computed according to rules prescribed by the NAIC as modified by the Indiana Department of Insurance, or the state in which our insurance subsidiaries do business. Statutory accounting rules are different from GAAP and are intended to reflect a more conservative perspective. With respect to new business, statutory accounting practices require that: 1) acquisition costs (primarily commissions and policy issue costs) and 2) reserves for future guaranteed principal payments and interest in excess of statutory rates, be expensed in the year the new business is written. These items cause a reduction in statutory surplus or surplus strain in the year written for many insurance products. We design our products to minimize such first-year losses, and in 2004 none of our products caused a statutory loss in the year written. Absent the sale of Standard Life, our long-term growth goals contemplate continued growth in our insurance businesses. To achieve these growth goals, our insurance subsidiaries will need to increase statutory surplus. Additional statutory surplus may be secured through various sources such as internally generated statutory earnings, infusions with funds generated through our debt or equity offerings, or mergers with other life insurance companies. If additional capital is not available from one or more of these sources, we believe that we could reduce surplus strain through the use of reinsurance or through reduced writing of new business.
We believe that the operational cash flow of our Health Services segment will not be sufficient to meet our anticipated operational needs for 2005. Therefore, this segment is expected to continue to fund its cash needs through the proceeds of the sale of Standard Life, external borrowings and capital contributions from Standard Management.
During 2003 and 2004, the financial services segment of our business generated 97% and 95%, respectively, of our total revenues and generated positive cash flows from operations. All such revenues and cash flows would cease upon closing of the sale of Standard Life. Following the proposed sale, our future prospects, and our value as an ongoing enterprise, will depend on the performance of our health services business, which is subject to the risks described below.
If the sale of Standard Life is not completed, we could be materially adversely affected. We would be forced to determine whether to attempt to sell the financial services business again, continue to operate the financial services business or explore another strategic alternative. If we try to sell the financial services business, we would need to expend significant time and resources that would otherwise be used to operate the health services business and we would likely have to sell the financial services business on terms that could be less favorable to us than the terms currently being offered by Capital Assurance. In addition, if we were to engage in some form of alternative transaction, there could be no assurance that it would not be significantly dilutive to shareholders.
If we fail to receive sufficient consents for the amendment to the indenture in the trust preferred consent solicitation, we intend to nevertheless proceed with the proposed sale of Standard Life to Capital Assurance (assuming all other conditions to such sale are satisfied) by exercising our right to require Capital Assurance to assume our obligations under the indenture. In such event, the cash proceeds to be received by us in the sale would be reduced by the approximately $20.7 million aggregate liquidation amount of trust preferred securities outstanding. As a result, our cash proceeds from the sale would reduce from approximately $57 million to approximately $36.3 million which, unless we adjust our expected use of such proceeds, would reduce the amount of cash available to operate and expand our health services business from approximately $27.5 million to approximately $7 million. Such an event would make it more likely that we would have to seek additional debt or equity financing to carry out our business plan, and there can be no assurance that we could obtain such financing on acceptable terms or at all.
U.S. Health Services and its subsidiaries have incurred substantial net losses since we have operated them. U.S. Health Services on a consolidated basis incurred a net loss of $10.3 million and $7.1 million, for 2004 and 2003, respectively. We expect net losses to continue until we generate significant revenues and achieve economies of scale in our operations. There can be no assurance that we will ever be able to successfully develop and market these products. Our future profitability will depend on several factors including:
We are subject to a number of factors affecting our business, including intense competition in the industry and the ability to attract and retain suppliers, clients and employees. If we are unable to respond appropriately to any of these factors, business and financial results could suffer.
Our profitability and ability to conduct business in the health services segment could be negatively impacted by a change in our relationships with our largest institutional clients.
Because we have only recently entered the health services segment, we do not have an operating history upon which an investor can evaluate our prospects. In attempting to implement our business model, we may need to significantly change our business operations, sales and implementation practices, customer service and support operations and management focus. We are also facing new risks and challenges, including a lack of meaningful historical financial data upon which to plan future budgets, the need to develop strategic relationships and other risks in this report.
As of December 31, 2004, approximately 26% of our health services’ pharmacy revenues were from government sponsored programs. Government sponsored programs include Medicaid and, to a lesser extent, Medicare. Our remaining billings are currently paid or reimbursed by individual residents, long-term care facilities and other third-party payors,
The Medicaid and Medicare programs are highly regulated. The failure, even if inadvertent, of us and/or our client institutions to comply with applicable reimbursement regulations could adversely affect our reimbursement under these programs and our ability to continue to participate in these programs. In addition, our failure to comply with these regulations could subject us to other penalties.
• consolidation of financial and managerial functions and elimination of operational redundancies;
We cannot be sure of the successful integration of any acquisition or that an acquisition will not have an adverse impact on our results of operations or financial condition.
Our health services business has had negative cash flows and net losses since its inception in 2002. We expect negative cash flows from operations to continue until we achieve substantial sales increases of our health services products. The proceeds of the proposed sale of Standard Life, if consummated, would provide us with significant funding, but we would lose the positive cash flows generated by our financial services business. Even though we would receive significant cash proceeds from the sale, our health services business has significant cash needs, including in connection with making strategic acquisitions. As a result, we will likely need to seek additional capital, which we may do through public or private equity or debt financing. There can be no assurance that such funding will be available to us on acceptable terms, if at all.
We are subject to a number of factors affecting our insurance business, including intense competition in the industry and the ability to attract and retain agents, suppliers, clients and employees. If we are unable to respond appropriately to any of these factors, business and financial results could suffer.
Our operating results are affected by many factors, including competition, lapse rates, interest rates, maintenance of insurance ratings, changes in the regulatory, general governmental regulation and general business conditions, many of which are outside our control.
Our financial services division operates in a highly competitive environment and is in direct competition with a large number of insurance companies, many of which offer a greater number of products through a greater number of agents and have greater financial and other resources. In addition, we may be subject, from time to time, to new competition resulting from additional insurance carriers introducing products similar to those offered by us. Moreover, as a result of recent federal legislation, commercial banks, insurance companies, and investment banks may now combine, provided certain requirements are satisfied, and we can expect to encounter increased competition from these providers of financial services. This competitive environment could result in lower premiums, loss of sales and reduced profitability.
Our Financial results could suffer if our A.M. Best ratings are downgraded.
The NAIC and state insurance regulators continually reexamine existing laws and regulations and their application to insurance companies. Changes in the NAIC or state regulations, including, for example, changes in the risk-based capital requirements, which are determined by the NAIC and state regulators, could affect the ability of our subsidiaries to pay dividends to us which could affect our ability to make payments upon our contractual obligations.
In addition, the federal government has become increasingly involved with insurance regulation in recent years, including the passage of the Gramm-Leach-Bliley Act, and more comprehensive federal legislation in this area is still being considered by Congress. Federal legislation and administrative policies in several areas, including pension regulation, age and sex discrimination, financial services regulation and federal taxation, affect us specifically and the insurance business in general. New state or federal laws or regulations, as well as a more strict interpretation of existing laws or regulations, may adversely affect our current claims exposure, adversely affect the profitability of our current and future products, and materially affect our future operations by increasing the costs of regulatory compliance. We cannot predict the impact of future state or federal laws or regulations on our business. See “Business of Standard Management - Regulatory Factors.”
Under the Internal Revenue Code of 1986, as amended (“Code”), income tax payable by policyholders on investment earnings is deferred during the accumulation period of certain life insurance and annuity products. The favorable tax treatment may give certain of our products a competitive advantage over other non-insurance products. On May 28, 2003, President Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003, which reduces the federal income tax rates applicable to certain dividends and capital gains realized by individuals. This legislation may lessen the competitive advantage of certain of our products relative to other investments that generate dividend or capital gain income. As a result, demand for certain of our products that offer income tax deferral may be negatively affected. Additionally, Congress has from time to time considered other legislation that would reduce or eliminate the relative benefits to policy owners of the deferral of taxation on the accretion of value within certain insurance products or might otherwise affect the taxation of insurance products and insurance companies. In particular, President Bush recently proposed legislation, currently under consideration by Congress, that would increase the amount that taxpayers may contribute each year to individual retirement accounts, which provide deferral benefits similar to those offered by our tax-deferral products. To the extent that the Code is revised in accordance with these proposals or otherwise in a manner that reduces the tax-deferred status of insurance products, or reduces the taxation of, or expands the market for, competing products, all life insurance companies, including us, could be adversely affected.
Our invested assets, approximately $1.7 billion, represented approximately 87% of our total assets at December 31, 2004. These investments are subject to customary risks of credit defaults and changes in market values. In addition, the value of our investment portfolio depends in part on the financial condition of the companies in which we have made investments. Factors beyond our control, including interest rate levels, financial market performance, and general economic conditions may have a significant negative impact on our investment income and the value of our investment assets, which would have a material adverse affect on our financial condition.
As of December 31, 2004, approximately 75.3% or $1.2 billion of annuity contracts in force were surrenderable. Approximately 16.5% of those contracts or approximately $205.7 million of annuity contracts in force are surrenderable without charge. Changes in prevailing interest rates, ratings or other factors, which result in, or lead to significant levels of surrenders of existing annuity contracts could have a material adverse effect on our financial condition and results of operations. Surrenders result in a reduction of invested assets that earn investment income and a reduction of policyholder account balances that credit interest.