The Company owns, through Citizens Security, a three-story, 63,000 square foot office building in suburban Louisville, Kentucky completed in 1988. The Company and its Subsidiaries occupy about 32% of the building for their headquarters and home offices. The remaining 68% of the building space is available for lease to tenants under leases of various durations. Market conditions for this property are generally favorable and, in management’s opinion, the property is adequately covered by insurance. Currently, the Company’s policy is not to invest in additional real estate or real estate mortgages, although a change in such policy would not require a vote of security holders. In addition, the Company’s current bank lending agreement precludes investment in additional real estate and in mortgages with a loan-to-appraised-value ratio of more than 75%.
• positioned itself for expansion of its group product line by:
obtaining the backing, through reinsurance, of a highly rated reinsurer for all new group products issued
recruiting several Group Product marketing representatives, setting the stage for significant premium growth for these products in 2008 and beyond
earning an operating profit (see page 28 of this Management Discussion and Analysis of Financial Condition and Results of Operation and Note 8 to the Consolidated Financial Statements for a discussion of statutory accounting)
continuing to solidify the ratings from A.M. Best and setting the stage for a future rating upgrade (see the section titled “Competition” in Item 1 in this Form 10-K for a discussion of the Company’s rating)
for Group Products: exploring non-traditional methods of growth, such as third party administration, marketing partnerships and acquisitions
for Home Service: minimizing the lapse rate, improving 13-month persistency, strengthening controls over field premium collection, maintaining distribution relationships and controlling expenses
for Preneed: maintaining current distribution relationships and controlling costs and expenses
The following discussion is presented to provide the reader with a clearer understanding of some of the operational elements impacting the financial position and results as reported in the accompanying consolidated balance sheets and related consolidated statements of operations, shareholders’ equity and cash flows.
For the year 2006, the Company reported a consolidated pretax operating loss (which excludes net realized investment gains of $4,000) of $486,000, compared to a pretax operating loss of $648,000 (which excludes net realized investment gains of $780,000) for 2005 and a net loss of $836,000 for 2006, compared to a net income of $132,000 for 2005. The net realized investment gains of $4,000 in 2006 are net of write downs of $687,000 of available-for-sale equity securities which management deemed to be other-than-temporarily impaired. There were no such write downs in 2005.
General expenses and depreciation for 2006 were up $428,000, or 6.2%, compared to 2005, principally due to the costs of employing a marketing executive for life insurance products in the second quarter of 2005 and one marketing executive for the group dental product in the fall of 2005 and one in the fall of 2006. We also placed in service, and therefore began to depreciate, the new group administration system in January 2006.
The Company manages its operations in five business segments, Home Service Life, Broker Life, Preneed Life, Dental, and Other Health. Products in all five segments are sold through independent agency operations. Home Service Life consists primarily of traditional life insurance coverage sold in amounts of $10,000 and less to middle and lower income individuals. This distribution channel is characterized by a significant amount of agent contact with customers throughout the year. Broker Life product sales consist primarily of simplified issue and graded-benefit policies in amounts of $10,000 and less, as well as our new Final Expense product in amounts of $10,000 to $25,000. Other products in the Broker Life segment that comprise a significant portion of existing business include group life, universal life, annuities and participating life policies. Preneed Life products are sold to individuals in connection with prearrangement of their funeral and include single and multi-pay policies, generally in amounts of $10,000 and less. These policies are generally sold to middle aged
and elderly individuals. Dental products are term policies generally sold to small and intermediate size employer groups. Other Health products include various accident and health policies sold to individuals and employer groups. Profit or loss for each segment is reported on a pretax basis, without an allocation of realized investment gains or interest expense.
Segment income (loss) increased $270,000 to $1,000 in 2006 compared to a segment loss of $(269,000) in 2005 primarily due to the positive impact of: (a) a decrease in policyholder benefits of $3,554,000; (b) a decrease in commissions of $113,000; (c) a decrease in amortization of deferred policy acquisition costs and value of insurance acquired of $194,000, and (d) an increase in policy acquisition costs deferred of $208,000, offset by the negative impact of: (e) a decrease in net premiums earned of $3,175,000 (Pre-need decreased $2,300,000, Dental decreased $376,000, Home Service decreased $330,000, Other Health decreased $41,000, and Broker Life decreased $128,000 (net of the increase in new final expense premiums of $901,000)); (f) a decrease in investment and other income of $196,000 and (g) an increase in general expenses and depreciation of $428,000.
During 2006, the Company repurchased 83,617 shares of its common stock at an average price of $6.16 per share. There were no repurchases in 2005 and in 2004 13,600 shares were repurchased at an average price of $7.50 per share.
DAC is also subject to periodic recoverability and loss recognition testing. These tests ensure that the present value of future contract-related cash flows will support the capitalized DAC balance to be amortized in the future. The present value of these cash flows, less the benefit reserve, is compared with the unamortized DAC balance and if the DAC balance is greater, the deficiency is charged to expense as a component of amortization and the asset balance is reduced to the recoverable amount. For more information about accounting for DAC see Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements.
The Company believes it has a well-diversified portfolio and has no plans to adjust its non-investment grade portfolio significantly, unless necessary to satisfy requirements of state regulators or rating agencies. The Company purchases non-investment grade bonds to obtain higher yields or convertible features and attempts to reduce credit risk by portfolio diversification. Non-investment grade securities comprised 4.0% and 3.8% of the fixed maturities portfolio, on an amortized cost basis, at December 31, 2006 and 2005, respectively. During 2006 and 2005, the Company did not recognize any impairment losses on fixed maturities. The Company reviews its fixed maturity portfolio quarterly for impairment losses which might be other than temporary losses and recognizes all such losses in the quarter they are deemed other than temporary.
Shown below are the Company's four largest holdings in non-investment grade bonds by a single issuer as of December 31, 2006.
These reviews resulted in the recognition of impairment losses on equity securities totaling $687,000 during 2006 ($218,000, $257,000, $142,000 and $70,000 for the first, second, third and fourth quarters, respectively). During 2006, equity securities were sold which contained $465,000 of impairment write downs and fixed securities were sold which contained $183,000 of impairment write downs. There were no impairments on fixed securities in 2006. During 2005, equity securities were sold which contained impairment write-downs of $358,000 and no fixed maturities were sold which contained impairment write downs. During 2004, the recognition of impairment losses on equity securities totaled $473,000 ($101,000, $319,000 and $53,000 for the first, third and fourth quarters, respectively). In addition, $334,000 of impairment losses were recognized on fixed maturities during 2004, all in the third quarter. During 2004, equity securities were sold which contained $640,000 of impairment write downs and fixed securities were sold which contained $425,000 of impairment write downs.
Citizens Security owns the building in which the Company and its subsidiaries maintain their home offices. They occupy approximately 32% of the building with the balance available for lease to third-party tenants. Market conditions for this property are generally favorable. An updated appraisal obtained during 2002 indicates the market value of the property is approximately $2,725,000 higher than its carrying amounts.
At December 31, 2006, the Company has recorded $756,000 of goodwill and $12,571,000 of deferred policy acquisition costs and value of insurance acquired. As noted in the above discussion of critical accounting policies and estimates, these intangibles, and the recorded value of policy liabilities, are based on many assumptions that require substantial estimates and judgment. At December 31, 2006 and December 31, 2005 the Company reassessed the assumptions supporting these values in accordance with SFAS No. 142. Although no impairment was considered necessary, management will continue to monitor the appropriateness of the recorded values of these intangibles and will make adjustments to such values in the future as management deems necessary.
Liabilities. A comparison of total policy liabilities as of December 31, 2006, 2005 and 2004 is shown below. Approximately 89% of the 2006 total consists of insurance policy benefit reserves while policyholder deposit liabilities represent 11% of the total.
Home Service Life premiums decreased 4.7% in 2006 from 2005 (Home Service Life revenue, including net investment and other income, decreased by 1.9% in 2006 from 2005) with net growth in policy liabilities of 1.7% and 2.2% in 2006 and 2005, respectively due to the ageing of the policy portfolio for this segment. Broker Life premiums decreased 3.3% in 2006 compared with an increase of 9.8% in 2005. Pre-need Life premiums decreased dramatically in 2006 (46.0%) as the result of the Company’s earlier modification of certain policy benefits and commissions (which resulted in the loss of a number of producers) as well as an intentional refocusing of marketing efforts towards segments that the Company believes offer more positive potential in the current environment. During 2006, Dental premiums decreased 4.3% from 2005 due to continued competition in this market and more aggressive renewal underwriting procedures by the Company. The Company has strengthened renewal underwriting standards in an effort to improve the loss ratio on this product. The Other Health Premiums decreased 4.7% compared to 2005 because these products are not being actively marketed as the company continues to redirect its focus to other segments in an effort to improve profitability in those segments.
As indicated above, total policyholder deposits decreased by a net $396,540 during 2006. The Company is not devoting significant marketing effort toward Annuity, Universal Life and other deposit products and has elected not to aggressively compete in crediting excess interest on such products.
The 46.0% and 27.9% decrease in Preneed Life premium during 2006 and 2005, respectively, resulted from the Company’s modification of certain policy benefits and commissions (which resulted in a loss in the number of producers) and an intentional refocusing of marketing efforts toward segments that the Company believes offer more positive potential in the current environment.
The 2006 decrease in pretax income of $614,000 results from the negative effects of: (a) a decrease in net premiums earned of $3,175,000 or 12.4% (Pre-need decreased $2,300,000, Dental decreased $376,000, Home Service decreased $330,000, Broker Life decreased $128,000 (net of an increase in new final expense premiums of $901,000) and Other Health decreased $41,000); (b) a decrease in investment and other income of $196,000; (c) a decrease in net realized investment gains of $776,000; (d) an increase in general expenses and depreciation of $428,000 and (e) an increase in interest expense of $107,000, offset by the positive effects of: (f) a decrease in policyholder benefits of $3,554,000; (g) a decrease in commissions of $113,000; (h) an increase in acquisition costs deferred of $208,000 and (i) a decrease in amortization of deferred policy acquisition costs and value of insurance acquired of $194,000.
The $88,000 decrease in profit in the Preneed life segment for 2006 is the result of a decrease of $2,300,000 in premiums, and a decrease of $45,000 in investment and other income, offset by a decrease of $1,849,000 in policyholder benefits, a decrease in commissions of $247,000 and a decrease of $161,000 in expenses (including net deferral of policy acquisition costs). During 2002, the Company accepted a significant amount of single-premium business, which generally has higher than average mortality rates. At that time, significant management and marketing resources were devoted to this business. To improve profitability, annual benefit growth rates were reduced in early 2003 and again in September 2004. Also, twice during 2002, certain commission rates were reduced and agent contracts revised to encourage production of the more profitable multi-pay products. Management has not focused marketing resources on this segment for the past several years. As a result, we have experienced significant declines in premiums and policy benefits, generating a segment profit for the past two years.
The contribution margin increased in 2006 by $472,000 due primarily to the Company’s aggressive renewal underwriting and re-rating. Although premiums decreased $376,000 in 2006, benefits decreased $745,000, and commissions decreased $104,000. Expenses for the Dental segment increased $328,000 due to the increased marketing resources allocated to this segment (the Company employed a senior marketing executive for this segment in August of 2005, a regional representative in the fourth quarter of 2005 and an additional senior executive in September 2006).
Income Taxes. Historically, the Company has experienced a relatively low effective current income tax rate, due primarily to the small life insurance company deduction, along with operating loss carryforwards and capital loss carryforwards. The effective expense (benefit) rate is 54% in 2006 and 0.0% in 2005.
During December 2002, the Company strengthened the statutory capital position of Citizens Security by acquiring $2,000,000 of Citizens Security redeemable preferred stock. During January 2001, the Company contributed 100% of the capital stock of Citizens Insurance to Citizens Security. The statutory value of this contribution was $3,540,555. Citizens Security has reported its investments in United Liberty and Citizens Insurance on the equity method of accounting, since their acquisitions in 1998 and 2001, respectively. However, beginning in 2001, new rules changed the statutory equity method of accounting to preclude a parent insurer from recording as income, its share of undistributed subsidiary earnings. For 2006, 2005, and 2004, Citizens Security reported as income the $99,900, $250,000 and $1,174,000 respectively, of dividend distributions that it received from United Liberty and Citizens Insurance. At December 31, 2006, Citizens Security reported its investments in United Liberty and Citizens Insurance at their statutory equity values of $2,281,472 and $2,501,700 respectively. To provide a more detailed understanding of Citizens Security's operations, shown below are SAP basis net income (loss), pretax net operating income (loss), statutory capital and surplus, asset valuation reserves, and capital ratios for Citizens Security for the five years ended December 31, 2006.
The following table shows the changes to Citizens Security’s statutory capital and surplus for the five years ended December 31, 2006.
The Company completed a strategic review of its products and operations, resulting in the mitigation of the significant losses incurred in the Preneed Life business segment in prior years and strengthening the potential for future profitability in the Broker Life, Home Service Life and Dental segments by increasing premiums, strengthening underwriting policies, modifying commissions, and where possible, lowering interest crediting or policy growth rates.
A summary of all known commitments of the Company as of December 31, 2006, including the aforementioned borrowings, and an estimate (based on reasonable assumptions and anticipated trends) of payments to be made for future policy benefits and contract claims, is as follows:
(a) Anticipated cash benefit payments not including any future earnings or additional premium
The Company provided (used) approximately $(2,668,000), $138,000 and $913,000 of cash flow from operating activities during 2006, 2005 and 2004, respectively. The fluctuations are principally attributable to a decrease in Preneed Life premiums in all three years.
Cash used in financing activities during 2006 of $1,024,000 includes $1,167,000 of debt repayments, $672,000 of net withdrawals of policyholder deposits and $515,000 used to repurchase common stock of the Company, offset by additional borrowings of $1,330,000 from the Company’s Chairman. The $1,592,000 of cash used in financing activities during 2005 includes $1,416,000 of debt repayments and $1,176,000 of net withdrawals of policyholder deposits, offset by additional borrowings of $1,000,000 from the Company’s Chairman. The $2,346,000 of cash used in financing activities during 2004 includes $1,342,000 of debt repayments, $902,000 of net withdrawals of policyholder deposits and $102,000 used to repurchase common stock of the Company.
The Company is subject to various market risks. However, the most significant such risks relate to fluctuations in prices of equity securities and interest rates (which affect market prices of fixed maturity securities). Historically, total returns on the Company’s equity portfolio have been favorable and the Company has successfully managed the risk of equity security price fluctuations over many years. The Company devotes significant attention to the equity markets and repositions the Company’s portfolio upon detection of adverse risk trends associated with individual securities or overall markets. The Company also manages market risks associated with investments in option securities, as described in Note 3 of the Notes to Consolidated Financial Statements. The fair value of the Company’s equity portfolio was approximately $9,429,000 and $8,580,000 at December 31, 2006 and 2005, respectively. Accordingly, a 10% decline in equity prices would have reduced the fair value of the Company’s equity portfolio by $943,000 and $858,000 at December 31, 2006 and 2005, respectively. The average cost value of the Company’s equity portfolio was $7,995,000 and $7,559,000 during 2006 and 2005, respectively.
Regarding interest rate risk, the value of the Company’s fixed-maturity investment portfolio will increase or decrease in an inverse relationship with fluctuations in interest rates while net investment income earned on newly-acquired fixed-maturities increases or decreases in direct relationship with interest rate changes. Management estimates that a 100 basis point increase in interest rates (“rate shock”) would have decreased the fair value of its $101.1 million fixed maturity portfolio by approximately 5.5% or $5.3 million at December 31, 2006 and 6.3% or $7.1 million at December 31, 2005. From an income perspective, the Company does not believe rising interest rates present a significant risk, as essentially all of the Company’s policy liabilities bear fixed rates. However, approximately 38% of policy liabilities contain provisions permitting interest or benefit adjustments at the discretion of the Boards of Directors of the Insurance Subsidiaries. The Company’s cash flow testing (described below) indicates that overall profitability will generally be enhanced in rising interest rate scenarios. From a liquidity perspective, the Company’s fixed rate policy liabilities have been relatively insensitive to interest rate fluctuations. Accordingly, the Company believes gradual increases in interest rates do not present a significant liquidity exposure. The Company monitors economic conditions on a regular basis and manages this interest rate risk primarily by adjusting the duration of its fixed-maturity portfolio. Historically, the Company has maintained conservative durations in its fixed-maturity portfolio. During 2006 and 2005, the Company decreased durations of the fixed maturity portfolio. At December 31, 2006 cash and fixed-maturity investments with maturities of less than five years equaled approximately 24% of total policy liabilities compared to approximately 19% at December 31, 2005. Notwithstanding the foregoing, if interest rates rise significantly in a short timeframe, there can be no assurance that the life insurance industry, including the Company, would not experience increased levels of surrenders and reduced sales, and thereby be materially adversely affected.
Interest expense on the Company’s debt varies quarterly and is therefore also subject to interest rate risk. For its commercial bank debt, the Company elects the lower of the prime lending rate or the one-month LIBOR rate plus 2.75%. For its related party debt, the interest rate is the higher of 6% or the commercial bank prime lending rate plus 1%. At December 31, 2006, the weighted average rate on the Company’s $5,538,337 borrowings was 9.20%. The Company believes its current liquidity position and profitability levels are adequate to guard against this interest rate risk.
time. However, such testing is ongoing and dynamic in nature and future events in the interest and equity markets or a significant change in the composition of Life Insurance Subsidiaries’ business could negatively impact testing results and require the initiation of corrective measures.
the Company’s ability to achieve anticipated levels of operating efficiencies and meet cash requirements based upon projected liquidity sources;