Statements made in the following discussion that state the Company’s or management’s intentions, hopes, beliefs, expectations or predictions of the future are forward-looking statements. Without limiting the foregoing, forward-looking statements include statements which represent the Company’s beliefs concerning future levels of sales and redemption of the Company’s products, investment spreads and yields, or the earnings and profitability of the Company’s activities, and the sufficiency of the Company’s cash flows for liquidity purposes.
Guaranteed issue and simplified issue life insurance premiums continued to show significant growth for the three year period from 2000 to 2002, primarily as a result of sustained production by the Company’s independent agency force which had approximately 4,300 agents under contract at December 31, 2002 compared to approximately 4,400 in 2001 and approximately 3,900 in 2000. This product is also distributed by the Company’s multi-line exclusive agents and is available for purchase over the Internet at the Company’s home page (www.cottonstatesinsurance.com).
Individual life insurance products are principally sold by the Company’s exclusive agent producers. Growth in individual life premiums largely reflects an increase in production of the Company’s participating whole life product.
The exclusive agency force of 272 as of December 31, 2002 compares to 266 as of the same date in 2001 and 252 in 2000. Other premiums consist of the Company’s participation in a Federally sponsored group life pool and income from a closed block of individual accident and health business.
During the fourth quarter of 2002 the Company realized a pre-tax investment loss of $460,000 from the write-down of the carrying value of ten equity securities and a pre-tax investment loss of $418,000 from the write-down of the Company’s investment in a limited partnership. These write-downs were the result of the Company determining that an other-than-temporary impairment had occurred.
Life benefits and claims, including reserve increases on traditional life and guaranteed issue and simplified issue products are as follows (dollars in thousands):
Interest credited to universal life contracts increased 7% in 2002 as compared to 2001 and 6% in 2001 as compared to 2000 reflecting growth in universal life policy accumulations. The annual interest rate credited to policyholders of universal life contracts was 6.25% for the first nine months of 2002 and for the years 2001 and 2000. Effective October 1, 2002 the annual rate credited to policyholders changed to 5.75%.
Operating expenses as a percentage of premiums were 25% for 2002 compared to 28% in 2001 and 2000. The Company experienced some expense savings in 2002 primarily due to the reduction of certain performance based compensation costs.
Continued growth in premiums, mortality that was consistent with management’s expectations, and lower operating expenses accounted primarily for the improved results in 2002 compared to 2001. In addition, 2002 and 2000 results reflect a favorable adjustment to the amortization of policy acquisition costs resulting from updating actuarial assumptions. 2001 results reflect higher mortality experienced in the first quarter in comparison to the prior year, resulting in a decrease in the Company’s net income.
The accounting policies described below are those the Company considers critical in preparing its consolidated financial statements. These policies include significant estimates made by management using information available at the time the estimates are made. However, as described below, these estimates could change materially if different information or assumptions were used.
The Company establishes an insurance related asset for deferred policy acquisition costs, and insurance related liabilities for future policy benefits and claims relating to its insurance policies under contract. Such asset and liabilities are developed using actuarial principles and assumptions which consider a number of factors, including: investment yields, withdrawal rates, mortality and morbidity which are described in the Notes to the Consolidated Financial Statements (“Notes”). As described in the Notes, the Company accounts for its traditional individual life insurance policies using a net level premium method and assumptions as to the factors enumerated above and as disclosed in Note 5. Generally, the Company’s earnings in any given calendar year will not be impacted by differences in emerging experience on its traditional individual business unless such differences are severe enough to call into question the profitability of the entire block of traditional life business. The Company does, however, experience fluctuations in its earnings as a result of current mortality experience differing from that expected in any given year. During 2002, 2001, and 2000, the Company experienced emerged mortality of 88%, 89%, and 84% of expected, respectively, related to its traditional individual life insurance business. The Company routinely purchases annual aggregate stop loss reinsurance coverage which limits experience to 120% of expected mortality in any one year.
Each period, the Company estimates the relevant factors, based primarily on its emerging experience and uses this information to determine the assumptions underlying its asset and liability calculations. An extensive degree of judgment is used in this estimation process.
The Company has procedures in place to monitor all debt and equity securities for possible other-than-temporary impairments. Securities are tracked comparing both unrealized losses as a percentage of original cost and the length of time the security has been below a predetermined percentage of cost. Monthly discussions are held with Company’s investment managers to gather information and documentation as to their outlook for future recovery of the securities making the Company’s “watch list”. As of December 31, 2002 there were no debt or equity securities whose unrealized losses would be deemed by management to be other-than-temporary impairments that have not been recorded.
The Company accounts for income taxes using the asset and liability method prescribed by SFAS No. 109, Accounting for Income Taxes. Under the asset and liability method of SFAS No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities, and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which these temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
The Company’s principal financing activity is payment of dividends to the Company’s shareholders. Dividends are normally declared quarterly and must be approved by the Board of Directors. Under regulatory requirements, the amount of dividends that may be paid in 2003 by the Company to its shareholders without prior regulatory approval is approximately $3.0 million.
Liquidity pertains to a company’s ability to meet the demand for cash requirements of its business operations and financial obligations. The Company’s two sources of short-term liquidity include its positive cash flow from operations and its portfolio of marketable securities as described above. The Company believes that these sources are sufficient to meet its liquidity needs in 2003.
Since December 31, 2002, there has not been a material change in mix or credit quality of the Company’s investment portfolio. All bond purchases have been available for sale and over 91% of the holdings at December 31, 2002 and 86% in 2001 are rated “A” or better by Standard & Poor’s Corporation. For all fixed maturities, 9% in 2002 and 14% in 2001 are rated BBB. Ratings of BBB and higher are considered investment grade by the rating services. Due to the improvement in bond market conditions, the Company experienced an increase in the fair value of bonds of approximately $4,487,000 in 2002.
The amortized cost and estimated fair value of debt securities at December 31, 2002, by contractual maturity, are shown on the following page. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The Company’s mortgage loan policy limits the amounts of loans to no more than 80% of the collateral value on residential loans and no more than 75% of the collateral value on commercial loans. The Company grants loans only to employees (excluding officers and directors) and agents.
The Financial Accounting Standards Board also issued SFAS No. 143 “Accounting for Asset Retirement Obligations,” which is effective for fiscal years beginning after June 15, 2002, with early adoption encouraged. SFAS No. 143 applies to legal obligations associated with the retirement of long-lived assets
The Financial Accounting Standards Board also issued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” which supercedes SFAS No. 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,” and the accounting and reporting provisions of APB Opinion No. 30 “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” and is effective for fiscal years beginning after December 15, 2001. SFAS No. 144 establishes a single accounting model for the disposal of long-lived assets. The adoption of SFAS No. 144 did not affect the Company’s results of operations or financial position.
In October 2002, the Financial Accounting Standards Board issued SFAS No. 147 “Acquisitions of Certain Financial Institutions,” which is effective October 1, 2002. The adoption of SFAS No. 147 did not affect the Company’s results of operations or financial position.
In December 2002, the Financial Accounting Standards Board issued SFAS No. 148 “Accounting for Stock-Based Compensation - Transition and Disclosure,” which is effective for financial statements issued after December 15, 2002. The adoption of SFAS No. 148 did not affect the Company’s results of operations or financial position.
CSI and CSMR receive commissions on insurance policies written by the Company’s agents on behalf of unaffiliated insurance companies. This income is recognized when the related insurance policies are written as reported by the insurance companies with which the business is placed.
Deferred taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date.
The Company applies the intrinsic value-based method of accounting prescribed by Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for its stock based compensation. As such, compensation expense would generally only be recorded if the current market price of the underlying stock on the date of grant exceeded the exercise price.
In November 2002 the Financial Accounting Standards Board issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” for which accounting requirements are effective for guarantees issued or modified after December 31, 2002 and disclosure requirements are effective for financial statements issued after December 15, 2002. The adoption of Interpretation No. 45 did not, and is not expected to, affect the Company’s results of operations or financial position.
Effective January 1, 2001, the State of Georgia adopted the National Association of Insurance Commissioner’s Codification of Statutory Accounting Practices. The impact on the Company’s statutory surplus upon adoption of the codification standards was not material.
During 2003, the Company became aware that the obligations under its employee and directors’ stock-based compensation programs, which may be settled only with shares of the Company’s common stock, were incorrectly classified as liabilities instead of shareholders’ equity. Accordingly, the Company has restated the affected balances for all prior periods in these consolidated financial statements. Such restatements do not impact net income as reported in the accompanying consolidated statements of earnings or retained earnings for any periods presented. The effects of the restatements were as follows:
During 2003, the Company became aware that the pension plan disclosures in 2001 had been based on the actuarial report issued as of January 1, 2001 rather than the actuarial report issued as of December 31, 2001, which had been used in the computation of the pension expense and accrued pension liability. These corrections do not impact the accompanying consolidated balance sheets, consolidated statements of earnings or retained earnings for any period presented. The revised disclosures are included in Note 7 and consist of the benefit obligation at end of year which changed from $1,215,750 to $2,169,044, the fair value of plan assets at end of year which changed from $1,670,770 to $1,425,129, the accrued liabilities which changed from $(394,150) to $(487,497), the discount rate which changed from 6.21% to 7.25%, and the expected long-term rate of return which changed from 8.25% to 9.00%.
Also during 2003, the Company became aware that it reported stock issued under its employee stock-based compensation program in 2000 and proceeds from the sale of investments in 2001 and 2000 incorrectly in the consolidated statements of cash flows. Accordingly, the Company restated the affected components of the consolidated statements of cash flows for all periods presented in these consolidated financial statements. Such restatements do not impact net income as reported in the accompanying consolidated statements of earnings or retained earnings for any period presented. The effects of the restatements were as follows:
The amortized cost and estimated fair values of investments in debt and equity securities as of December 31, 2002 and 2001 are as follows:
The amortized cost and estimated fair value of debt securities at December 31, 2002, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
During 2002 the Company sold a security out of its held-to-maturity portfolio due to evidence of a significant deterioration in the issuer’s creditworthiness. At the time of sale the security had an amortized cost of $499,768. The Company realized a loss of $49,768 on the transaction.
The estimated fair values and carrying values of the Company’s financial instruments at December 31, 2002 and 2001 are the same except for investment securities which are detailed in footnote 3 and mortgage loans as follows:
Deferred income taxes reflect the net tax effects of temporary differences between the carrying values of assets and liabilities for financial reporting purposes and Federal income tax purposes. The net deferred tax liability at December 31, 2002 and 2001 is composed of the tax-effected temporary differences related to the following amounts:
SFAS No. 109, Accounting for Income Taxes, specifically identifies certain temporary differences for which deferred tax liabilities are not recognized unless it becomes apparent that those temporary differences will reverse in the foreseeable future. The Company has not recorded a deferred tax liability for one such item entitled “policyholders’ surplus” created by Federal income tax regulations in effect prior to 1984. Certain untaxed income accumulated in this special memorandum tax account will become taxable if distributions, other than stock dividends, are made in excess of certain amounts
Federal income tax expense is less than amounts determined by multiplying earnings before Federal income taxes by the Federal tax rate of 35%. The reasons for such difference and the tax effect of each are as follows:
(7) Retirement Plans, Other Postretirement Benefit Plans and Deferred Compensation Plans
The Company, in conjunction with Cotton States Mutual (“Mutual”) and Shield Insurance Company (“Shield”), affiliates, sponsors a non-contributory defined benefit pension plan covering all eligible employees. Plan benefits are based on the age of the employee, the employee’s average salary for the highest five consecutive years of compensation and the employee’s years of service. The Company’s funding policy is to make annual contributions sufficient to fund the plan’s normal cost (current service cost) plus amortization of the unfunded prior service cost. The Company and its affiliates are charged the allocable share of such contributions based on their proportionate share of payroll.
The following table summarizes plan assets, obligations, pension cost and assumptions of the pension plan and other postretirement benefit plan as of December 31, 2002 and 2001.
The Company expensed pension costs of $116,174 in 2002, $93,347 in 2001, and $61,645 in 2000.
Rent for use of software of $106,000 in 2002, 2001, and 2000, has been charged to the affiliated companies.
Under the employee plan, options may be granted to purchase up to 937,500 shares of the Company’s common stock at a per share price of not less than 100% of fair market value at date of grant. Under the directors’ plan, options are granted based on the level of directors’ fees at a per share price of 50% of fair market value at date of grant. The employee and directors’ options have a term of 10 years and are not subject to any vesting requirements. The weighted-average remaining contractual life on options outstanding at December 31, 2002 is 7.0 years. The weighted-average grant date fair value of options granted during 2002, 2001, and 2000 was $9.61, $7.69, and $5.42, respectively. Stock option transactions are summarized below:
The per share weighted-average fair value of stock options and restricted stock granted was estimated using an option pricing model with the following weighted-average assumptions: expected life of five
Net income and shareholders’ equity, as reported to regulatory authorities in conformity with statutory accounting practices for each of the years in the three-year period ended December 31, 2002 are as follows:
The Company is a defendant in various actions incidental to the conduct of its business. While the ultimate outcome of these matters cannot be estimated with certainty, management does not believe the actions will result in any material loss to the Company.
third party products distributed through the Company’s exclusive and independent agents. The Company does not group items on the consolidated balance sheet into segments, nor does it analyze those items by segment when making management decisions. The Company allocates net investment income and net realized gains to its individual life insurance and guaranteed issue and simplified issue life insurance segments based on the ratio of each segment’s reserves to total reserves. Net investment income and net realized gains for the Company’s brokerage segment is based on actual amounts earned by its brokerage subsidiaries.
We have audited the accompanying consolidated balance sheet of Cotton States Life Insurance Company and subsidiaries (the “Company”) as of December 31, 2001, and the related consolidated statements of earnings, shareholders’ equity, cash flows, and comprehensive income for each of the years in the two-year period ended December 31, 2001. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cotton States Life Insurance Company and subsidiaries at December 31, 2001, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America.
As discussed in note 2 to the consolidated financial statements, the Company restated its consolidated financial statements for the years ended December 31, 2001 and 2000.
The following is a summary of the unaudited quarterly results of operations for the three years ended December 31, 2002.