The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts and related disclosures. Such estimates and assumptions significantly affect various reported amounts of assets and liabilities. Management has made estimates in the past that we believed to be appropriate but were subsequently revised to reflect actual experience. If our future experience differs materially from these estimates and assumptions, our results of operations and financial condition could be affected. Management considers an accounting estimate to be critical if:
The second reserve we establish is for incurred, either reported or not yet reported, policy and contract claims. This amount represents the benefits for our current claims. The significant assumptions utilized in establishing the policy and contract claims are expectations about the duration and incidence of claims and the interest rate utilized to discount the claim reserves. These assumptions are based on our past experience, industry experience and current trends.
Long-term care insurance has fixed annual premiums that can be adjusted only upon approval of the insurance departments of the states where the premiums were written. The adjustment of these fixed annual premium rates is referred to as rate increases. The process for filing for rate increases requires the company to demonstrate to the insurance department that expected claims experience is anticipated to exceed original assumptions. The approval of rate increases is at the discretion of the insurance department.
Over the past two years, we have had success in obtaining rate increases for a majority of our products. However, we have a continuing need to obtain rate increases on the remaining products that have not yet received rate increases and, in certain cases, additional rate increases on products where we have already received rate increases. There has been increased public and regulatory scrutiny over the practice of obtaining rate increases on long-term care insurance.
We base our rate increase assumptions on our past experience and our expectations of the amounts of actual rate increases that we will be able to achieve. If we are unsuccessful in obtaining the assumed level of rate increases, we could recognize an impairment in the future, which could have a material adverse effect on our results of operations and financial position.
We are involved in lawsuits relating to our operations. These lawsuits include, but are not limited to, allegations as to improper sales practices in connection with the recent rate increases on our long-term care policies.
We are also involved in a dispute with one of our reinsurers over an alleged breach of contract by the Company as a result of the Company entering into the 2001 Centre reinsurance agreement without obtaining prior written approval of the reinsurer.
The 2001 Centre reinsurance agreement is being accounted for utilizing deposit accounting for reinsurance contracts. We are using deposit accounting because we believe the reinsurance contract does not result in the reasonable possibility that the reinsurer will suffer a significant loss. We assessed this long-duration reinsurance contract using the reasonable possibility of significant loss criteria due to certain contract provisions that limit the risk to the reinsurer, including an aggregate limit of liability for the reinsurer, experience refund provisions, and expense and risk charges provided to the reinsurer. We also entered into the reinsurance agreement with the intent of commuting the agreement at December 31, 2007, which further supports the use of deposit accounting.
We have established the accounting model for this reinsurance agreement assuming that we will commute the contract on December 31, 2007, the first available commutation date. We intend, but are not required, to commute the agreement on December 31, 2007. We have significant incentive to commute the agreement on December 31, 2007 as the expense and risk charges applied to the experience account for the benefit of the reinsurer begin to escalate after December 31, 2007 and the reinsurer may exercise warrants at a common stock equivalent price of $2.00 per share, representing approximately 20% of the then outstanding common stock on a fully diluted basis.
As of December 31, 2002, the statutory-basis policy reserves and policy and contract claim liabilities of $905,330 exceed the value of the experience account of $708,982. We expect that the growth in the experience account will exceed the growth in the policy reserve and policy and contract claim liabilities, such that the experience account value will exceed the policy and contract claim liabilities at December 31, 2007. Our ability to commute is dependent upon our assumptions regarding the future performance of the underlying insurance policies from now until December 31, 2007. Additionally, the experience account value is susceptible to market interest rate changes. A market interest rate increase of 100 basis points could reduce the value of the experience account by approximately $70,000 and jeopardize the Company's ability to commute as planned. We cannot anticipate future increases or decreases in market interest rates.
o The fixed debt host yields a fixed return based on the yield to maturity of the underlying benchmark indices. The fixed debt host is reported as investment income in the Statement of Operations.
o The change in fair value of the embedded derivative, represented by the percentage change in the underlying indices applied to the notional experience account, is similar to that of an unrealized gain or loss on a bond. The change in the fair value of the embedded derivative is reported as a market gain (or loss) on experience account in the Statement of Operations.
Our conclusion that the return on the notional experience account represents a hybrid instrument with an embedded derivative is based on our belief that the economic characteristics and risk of the fixed debt host contract are not clearly and closely related to those of the embedded derivative. When we determine the yield on the fixed debt host and the value of the embedded derivate, we reconcile these amounts to the amount credited to the experience account by the reinsurer, as we believe the actual return credited by the reinsurer should equal the sum of the amounts recognized in our Statement of Operations.
At December 31, 2002, the balance of our goodwill was $20,360. Effective January 1, 2002, we adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets." The adoption of SFAS 142 resulted in the elimination of goodwill amortization, the allocation of the goodwill to reporting units, and the establishment of an annual impairment test based on the fair value of the reporting units to which the goodwill has been allocated. Different valuation methods and assumptions can produce significantly different results, which could affect the amount of any goodwill impairment charge.
We have identified two reporting units (agency operations and insurance operations) as defined in SFAS 142. The goodwill was allocated between the two reporting units as follows: agency operations $20620 and insurance operations $5151. Our impairment analysis involved an assessment of the fair value of each reporting unit utilizing a discounted cash flow analysis. Upon completion of the analysis, we determined that the goodwill associated with the agency operations was fully recoverable and that the goodwill allocated to the insurance operations was impaired. As a result, we recognized an impairment loss of approximately $5151 which has been recorded as a cumulative effect of change in accounting principle.
The agency valuation assumed, among other things, future growth in our agency business that is consistent with our growth in the past. In the event that our actual growth and profitability does not meet our expectations, we may realize a goodwill impairment in the future.
Our results of operations are affected significantly by the following other factors:
Level of required reserves for policies in-force. Our insurance policies are accounted for as SFAS 60 long duration contracts. As a result, there are two components of policyholder liabilities. The first is a policy reserve liability as required by SFAS 60 for future policyholder benefits, represented by the present value of future benefits less future premium collection. These reserves are calculated based on assumptions that include estimates for mortality, morbidity, interest rates, premium rate increases and policy persistency. The assumptions are consistent with industry experience and historical results, as modified for our own experience.
The second is a reserve for incurred, either reported or not yet reported, policy and contract claims, which represents the benefits for current claims. The amount of reserves relating to reported and unreported claims incurred is determined by periodically evaluating statistical information with respect to the number and nature of historical claims. We compare actual experience with estimates and adjust our reserves on the basis of such comparisons to the extent that our analysis suggests that adverse development is likely to continue in future periods.
Additions to, or reductions in, reserves are recognized in our current consolidated statements of operations and comprehensive income as expense or income, respectively, through benefits to policyholders and are a material component of our net income or loss. A portion of premium collected in each period is set aside to establish reserves for future policy benefits. Establishing reserves is based upon current assumptions and we cannot assure you that actual claims expense will not differ materially from the claims expense anticipated by the assumptions used in the establishment of reserves. Any variance from these assumptions could affect our profitability in future periods.
Policy premium levels. We attempt to set premium levels to maximize profitability. Premium levels on new products, as well as rate increases on existing products, are subject to government review and regulation.
In connection with our reinsurance agreement with Centre, we transferred substantially all of our investment portfolio to the reinsurer as the initial premium payment. The initial and future premium for the reinsured policies, less claims payments, ceding commissions and risk charges is credited to a notional experience account, the balance of which also receives an investment credit. The notional experience account balance represents an amount to be paid to us in the event of commutation of the agreement. Based on our analysis of SFAS 133, we believe that the experience account represents a hybrid instrument, containing both a fixed debt host contract and an embedded derivative.
Premiums. Total premium revenue earned in the twelve months ended December 31, 2002 (the "2002 period"), including long-term care, disability, life and Medicare supplement, decreased 4.8% to $333,643, compared to $350,391 in the same period in 2001 (the "2001 period").
Effective September 10, 2001, we determined to discontinue the sale nationally of all new long-term care insurance policies until the Plan was completed and approved by the Department. This decision resulted from our concern about further depletion of statutory surplus from new policy sales prior to the completion and approval of the Plan and from increasing concern with respect to the status of the Plan expressed by many states in which the Company is licensed to conduct business. Upon the Department's approval of the Plan in February 2002, we recommenced new policy sales in 23 states, including Pennsylvania. We have now recommenced new policy sales in 10 additional states, including Florida, Virginia and Texas, which have historically represented approximately 18%, 7% and 5% of our new policy sales, respectively. We are actively working with the remaining states to recommence new policy sales in all jurisdictions. We have recently agreed upon terms for the recommencement of sales in California, which is pending subject to certain conditions. California has historically represented approximately 15% of our new policy sales.
Total renewal premiums earned in the 2002 period increased 7.0% to $327,207, compared to $305,852 in the 2001 period. Renewal long-term care premiums earned in the 2002 period increased 8.8% to $316,338, compared to $290,632 in the 2001 period. The majority of this increase resulted from the receipt of increased revenue following the implementation of premium rate increases averaging approximately 20% on 70% of our policies in force. We may experience reduced renewal premiums if policies lapse, especially given our recent premium rate increases. Persistency decreased from 88% in the 2001 period to 85.6% in the 2002 period. Current declines in first year premiums, as discussed above, will negatively impact future renewal premium growth as well.
As a result of our new reinsurance agreement, substantially all of our investable assets from business written prior to December 31, 2001, were transferred to the reinsurer. The reinsurer maintains a notional experience account on our behalf in the event that the reinsurance agreement is later commuted. As discussed above in "Overview," the notional experience account is credited with an investment credit equal to the most recent yield to maturity of a series of benchmark indices and hedges, which are designed to closely match the duration of our liabilities. See "Liquidity and Capital Resources."
Our average yield on invested assets at cost, including cash and cash equivalents, was 5.91% and 5.62%, respectively, in the 2002 and 2001 periods. Although market rates have declined, the higher yield in the 2002 period resulted from a significant change in our portfolio. In 2002, primarily all of our investment income is derived from the investment credit attributable to the fixed debt host component of our experience account return, which has a duration of approximately 11 years and correspondingly, a higher yield. In 2001, we held a portfolio of bonds with a duration of approximately 5 years and common stocks. The investment income component of our experience account investment credit generated $38,375 in the 2002 period, with an average yield of 6.51%.
The total return of the Lehman Brothers US Aggregate Bond Index was 10.26% and 8.44% for 2002 and 2001, respectively. The total return on our experience account, which comprises the majority of our investible assets was 15.65% in the 2002 period and the total return of our fixed income portfolio in 2001 was 8.92%. Management attributes the favorable return achieved from its experience account in 2002 to a longer duration of the underlying benchmark indices, which were positively impacted by declining market interest rates during 2002. The performance of our portfolio in 2001, which did not include an experience account, was similar to the total return of the Lehman Brothers US Aggregate Bond Index.
As discussed in "Overview" and "Net Investment Income" above, the reinsurer maintains a notional experience account for our benefit in the event of future recapture. The notional experience account receives an investment credit based upon the total return of a series of benchmark indices and derivative hedges, which are designed to closely match the duration of our reserve liabilities. Periodic changes in the market values of the benchmark indices and derivative hedges are recorded in our financial statements as a realized gain or loss in the period in which they occur. As a result, our future financial statements are subject to significant volatility (See
Consolidated Statements of Income and Comprehensive Income for the Years Ended December 31, 2002, 2001 and 2000
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income and comprehensive income, of shareholders' equity and of cash flows present fairly, in all material respects, the financial position of Penn Treaty American Corporation and Subsidiaries (the "Company") at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 2 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets," effective January 1, 2002.
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (amounts in thousands, except per share information)
The accompanying consolidated financial statements of Penn Treaty American Corporation and its Subsidiaries (the "Company") have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") and include Penn Treaty Network America Insurance Company ("PTNA"), American Network Insurance Company ("ANIC"), American Independent Network Insurance Company of New York ("AIN"), Penn Treaty (Bermuda), Ltd. ("PTB"), United Insurance Group Agency, Inc. ("UIG"), Network Insurance Senior Health Division ("NISHD") and Senior Financial Consultants Company ("SFCC"). Significant intercompany transactions and balances have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year presentation.
Debt and equity securities are regularly evaluated to determine if market values below amortized cost are as a result of credit quality, performance or general market decline. If market value declines are determined to be other than temporary, the amortized cost is adjusted to the market value of the security, with the loss recognized in the current period. Purchases and sales of securities are recorded on the trade-date basis. Interest income is recorded on the accrual basis. Dividends are recorded on the ex-dividend date.
During 2002, the Company recognized an impairment of its deferred acquisition costs of approximately $1,100 due to its anticipation of reduced future investment earnings rates and accelerated claims costs, substantially offset by increased premium rate expectations.
Management believes the current assumptions and other considerations used to estimate, and evaluate the recoverability of, DAC are appropriate. However, in the event actual experience, including planned rate increases, differ from the assumptions, the Company could recognize an additional impairment of its deferred acquisition costs in the future, which could have a material adverse affect upon its results of operations and financial condition.
Property and equipment are stated at cost, less accumulated depreciation and amortization. Expenditures for improvements, which materially increase the estimated useful life of the asset, are capitalized. Expenditures for repairs and maintenance are charged to operations as incurred. Depreciation is provided principally on a straight-line basis over the related asset's estimated life. Upon sale or retirement, the cost of the asset and the related accumulated depreciation are removed from the accounts and the resulting gain or loss, if any, is included in operations.
Other assets consist primarily of estimates of premiums due but not yet collected and deferred reinsurance premiums.
The Company has historically purchased corporate owned life insurance ("COLI") to fund the future payment of employee benefit expenses. The Company has purchased $50,000 of COLI, of which it purchased $10,000 in each of 2001 and 2000. No additional purchases were made in 2002. The Company includes the cash value of these policies, which is invested in investment grade corporate bonds, as a separate financial statement caption. Increases in the cash surrender value are recorded as other income.
Income taxes consist of amounts currently due plus deferred tax expense or benefits. Deferred income tax liabilities, net of assets, have been recorded for temporary differences between the reported amounts of assets and liabilities in the accompanying financial statements and those in the Company's income tax return.
Commission override revenue from unaffiliated insurers is included in other income when the underlying premium is due, net of an allowance for unissued or cancelled policies.
There are two components to the Company's policyholder liabilities. The first is a policy reserve for future policy benefits and the second is a policy and contract claim reserve for incurred claims, either reported or unreported.
The establishment of appropriate reserves is an inherently uncertain process that requires management to make critical accounting estimates. Management believes the current assumptions and other considerations used to estimate policy reserves and policy and contract claim liabilities are appropriate. However, if the actual experience differs from the assumptions and other considerations (including mortality, morbidity (claims experience), withdrawals, expenses, premium rate increases and investment yields) used in estimating the Company's policy reserves and policy and contract claims, the resulting change could have a material adverse effect on the Company's results of operations and financial condition. Due to the inherent uncertainty of estimating reserves, it has been necessary, and may over time continue to be necessary, to revise estimated future liabilities as reflected in the Company's policy reserves and policy and contract claims.
The Company discounts all policy and contract claims, which involve fixed periodic payments extending beyond one year. This is consistent with the method allowed for statutory reporting, the long duration of claims, and industry practice for long-term care policies. Benefits are payable over periods ranging from six months to five years, and are also available for lifetime coverage.
The Company reports all reserve amounts gross of reinsurance. The amounts receivable from unaffiliated reinsurers are reported as receivables from reinsurers.
A reconciliation of the numerator and denominator of the basic earnings per share computation to the numerator and denominator of the diluted earnings per share computation follows. Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Anti-dilutive effects are not included. As such, the Company has not included securities of 7,192 and 2,727, for 2002 and 2001, respectively that could potentially dilute basic earnings per share in the future.
SFAS No. 142, "Goodwill and Other Intangible Assets," primarily addresses the accounting for goodwill and intangible assets subsequent to their acquisition. The Company adopted SFAS No. 142 on January 1, 2002 and ceased amortizing goodwill at that time. During the second quarter 2002, the Company completed an impairment analysis of goodwill, in accordance with SFAS No. 142. The Company's goodwill was recorded as a result of the purchase of its agencies and its insurance subsidiaries. As part of its evaluation, the Company completed numerous steps in determining the recoverability of its goodwill. The first required step was the measurement of total enterprise fair value versus book value. Because the Company's fair market value, as measured by its stock price, was below book value at January 1, 2002, goodwill was next evaluated at a reporting unit level which comprised its insurance agencies and insurance subsidiaries.
No goodwill was amortized in 2002. In 2001 and 2000, the Company amortized $1,293 of goodwill. For comparative purposes, the following table adjusts net (loss) income and basic and diluted earnings per share for 2001 and 2000, as if goodwill amortization had ceased at the beginning of 2000 and no cumulative effect of accounting change had been recorded.
On January 10, 2000, PTNA entered a purchase agreement to acquire all of the common stock of NISHD, a Florida brokerage insurance agency for cash of $6,000. The acquisition was effective January 1, 2000. The Company accounted for the acquisition as a purchase and recorded $6,000 of goodwill, which, until January 1, 2002, was being amortized over 20 years.
Gross Gross Realized Realized Proceeds Gains Losses -------- ----- ------ 2002 $ 478,808 $ 18,728 $ 3,822 2001 $ 158,182 $ 4,970 $ 7,697 2000 $ 209,229 $ 8,613 $ 9,114
Gross Gross Realized Realized Proceeds Gains Losses -------- ----- ------ 2002 $ 9,547 $ 1,861 $ 1,094 2001 $ 20,026 $ 1,055 $ 6,123 2000 $ 30,163 $ 4,241 $ 3,088
The Company assesses whether declines in market value are other than temporary. Upon such determination, the Company will impair the security's amortized cost and record an impairment charge in its results of operations. At December 31, 2000, the Company reduced its cost basis on a bond, whose issuer had declared bankruptcy, to its market value, realizing an impairment charge of approximately $3,200. In 2001, the Company reduced its cost basis of equity securities by $5,767 as a result of differences deemed other than temporary. The Company reduced its cost basis on bonds in 2002 by $12 due to differences deemed other than temporary.
Pursuant to certain statutory licensing requirements, as of December 31, 2002, the Company had on deposit investments aggregating $10,848 (fair value) in insurance department safekeeping accounts. The Company is not permitted to remove the bonds from these accounts without approval of the regulatory authority.
The initial premium and future cash flows from the reinsured policies, less claims payments, ceding commissions, risk charges and certain other charges, is credited to a notional experience account, which is held by the reinsurer for the Company's benefit in the event of commutation and recapture on or after December 31, 2007 (See Note 13). The notional experience account balance receives an investment credit based upon the total return from a series of benchmark indices and derivative hedges that are intended to match the duration of the reserve liability.
The notional experience account represents a hybrid instrument, containing both a fixed debt host contract and an embedded derivative. The economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the fixed debt host contract. In accordance with SFAS No. 133, the Company is accounting for the investment credit received on the experience account as follows:
The benchmark indices are comprised of US treasury strips, agencies and investment grade corporate bonds, with weightings of approximately 25%, 15% and 60%, respectively, and have a duration of approximately 11 years. The hybrid instrument subjects the Company to significant volatility as the estimated value of the embedded derivative is highly sensitive to changes in interest rates. A 100 basis point increase in interest rates would reduce the current experience account balance by approximately $70,000.
2002 2001 ---- ---- Accident and health $ 464,318 $ 382,660 Annuities and other 137 131 Ordinary life, individual 12,416 13,255
Accident and health: Morbidity and withdrawals based on actual and projected experience. Morbidity represents the claim costs we expect to incur in the future. The assumption for these future claim costs is based on past company experience modified for both industry experience and recent trends, withdrawals represent the lapsation of policies due to either death or cancellation.
In 2002, the Company added approximately $80,948 to its claim reserves for 2001 and prior period incurred claims. During 2002, the Company completed an analysis of the adverse deviation recognized in the past development of its reserves for current claims. The analysis included a comparison of actual to expected experience.
As a result of this analysis, the Company refined its process and assumptions for developing claims reserves. The most significant changes were as follows:
In the past 10 years, more policies have been sold offering benefits for both nursing facility and in-home health care coverage. Increasing numbers of claims have been reported on these policies over the past few years. The Company has historically recorded claims that begin in one type of care and later move to another type of care as two separate claims. Defining claims in this manner has projected a greater number of expected claims from certain types of policies, while projecting a shorter expected length of claims. The Company has now determined to define this as one claim, using the earliest date of service as the incurral date. This redefinition of claims results in fewer expected future claims, but anticipates that each claim will last longer.
Once a claim occurs, the Company develops claim reserves by using continuance tables, which measure the likelihood of a claim continuing in the future. Historically, the Company has applied every claim to a set of uniform continuance tables. The Company's actuarial modeling suggests that this uniform continuance assumption no longer reflects the increasing number of claims from policies with longer benefit periods or increased benefit amounts. The Company has developed an improved methodology by creating separate continuance tables for facility, home health and comprehensive care, as well as for tax qualified and non-qualified plans. In addition, the Company has established separate continuance tables for claims caused by cognitive impairment. The Company's 2002 analysis indicates that the duration of its existing claims has been increasing in recent years and will be longer than was previously expected. The Company revised its continuance assumption to reflect this trend.
In 2001, excluding the impact of imputed interest of $8,632, the Company added $8,845 to its claim reserves for 2000 and prior claim incurrals. Two factors affected the reserves the Company held for claims incurred in prior years. (1) In 2001, the Company engaged a new consulting actuary that provided the Company with additional industry data to incorporate in its continuance expectations (the probability that a claim in one duration will continue to another). The Company's analysis of this supplemental data suggested that it would recognize higher future payments on currently incurred claims than was previously anticipated. As a result, the Company lengthened its continuance tables for claim durations beyond the third year, and increased its reserves held for claims incurred to record this liability. This resulted in an increase of reserves incurred in prior years of $7,262; and (2) In 2001, the Company reduced the discount rate used in the establishment of reserves to appropriately reflect the current investment rate earned on assets supporting this liability. As a result, reserves for claims incurred in prior years were increased $1,582.
Lease Debt Obligations Total ---- ----------- ----- 2003 $ 12,902 $ 344 $ 13,246 2004 - 252 252 2005 - 18 18 2006 - 18 18 2007 - 18 18 2008 63,343 18 63,361 -------- ----- -------- Total $ 76,245 $ 668 $ 76,913 ======== ===== ========
In the fourth quarter of 2002, the Company exchanged $63,343 of its 6.25% Subordinated Convertible Notes due 2003 for a like amount of newly issued 6.25% Subordinated Convertible Notes due 2008. Subsequent to December 31, 2002, the Company modified the terms of the Notes. The primary differences between the 2003 Notes and the exchanged 2008 Notes, as modified, are as follows:
1) Conversion Price - lowered from $28.44 per share to $5.31. The conversion price was subsequently reduced to $4.50 and then $2.50 prior to December 31, 2002. In the first quarter of 2003, the Company reduced the conversion price further to $1.75.
3) Mandatory Conversion - the new notes will mandatorily convert after October 15, 2005 in the event that the Company's average stock price for 15 trading days exceeds $1.75.
The (benefit) provision for federal income taxes for the years ended December 31 consisted of:
2002 2001 2000 ---- ---- ---- Current $ (2,548) $ (3,503) $ 3,045 Deferred (10,478) (12,777) 8,675 -------- -------- -------- $(13,026) $(16,280) $ 11,720 ======== ======== ========
2002 2001 ---- ---- Net operating loss carryforward $ 20,189 $ 26,547 Other than temporary decline in market value - 3,187 Other 369 691 Valuation allowance (5,775) (5,775) -------- -------- Total deferred tax assets $ 14,783 $ 24,650 ======== ========
Deferred policy acquisition costs $ (25,183) $(36,822) Present value of future profits acquired (346) (678) Premiums due and unpaid (1,267) (767) Unrealized gains on investments (583) (5,451) Policy reserves (4,124) (13,830) Deferred reinsurance premium (4,625) (5,549) Other (1,756) - --------- -------- Total deferred income liabilities $ (37,884) $(63,097) ========= ========
2002 2001 2000 ---- ---- ---- Computed federal income tax (benefit) provision at statutory rate $(15,212)(1) $ (22,704) $ 12,065 Valuation allowance - 5,775 - Impairment of goodwill 1,803 - - Small life insurance company deduction - (363) - Tax-exempt income (1,225) (1,147) (585) Other 1,608 2,159 240 -------- --------- -------- $(13,026) $ (16,280) $ 11,720 ======== ========= ========
The insurance subsidiaries prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the insurance department of the state of domicile. Net income and capital and surplus as reported in accordance with statutory accounting principles for the Company's insurance subsidiaries are as follows:
2002 2001 2000 ---- ---- ---- Net income (loss) $ 7,963 ($32,222) ($28,984) Capital and surplus $34,909 $17,807 $29,137
On February 12, 2002, the Department approved the Plan. It requires the Company's Pennsylvania insurance subsidiaries to comply with certain agreements at the direction of the Department, including, but not limited to:
o The entrance into the reinsurance agreement for substantially all of its existing business at December 31, 2001.
o New investments are limited to those rated by the National Association of Insurance Commissioners ("NAIC") as 1 or 2.
o An agreement to increase statutory reserves by an additional $125,000 over a three year period, of which $48,000 remains to be increased throughout 2003-2004.
The reinsurance agreement entered into as part of the Corrective Action Plan is accounted for as reinsurance for statutory accounting purposes, but does not qualify for reinsurance for GAAP accounting purposes (See Note 13). As the agreement is treated as reinsurance for statutory accounting purposes, it results in the ceding (or removal) of substantially all of the insurance subsidiaries' policy reserve and policy and contract claim liabilities for statutory accounting purposes. Furthermore, any adverse development of the 2001 and prior policy reserve and contract claim liabilities, including the $125,000 of reserve increases mentioned above, is ceded to the reinsurer and not reflected on the insurance subsidiaries' statutory financial statements.
The agreement is subject to certain coverage limitations, including an aggregate limit of liability that is a function of certain factors and that may be reduced in the event that the rate increases that the reinsurance agreement may require are not obtained. The Company is required to perform annual comparisons of its actual to expected claims experience. If the Company has reason to believe, whether from this analysis or other available information, that at least a 5% premium rate increase is necessary, the Company is obligated to file and obtain such premium rate increases in order to comply with the requirements of the agreement. If the Company does not file and obtain such premium rate increases, the aggregate limit of liability would be reduced by 50% of the premium amount that would have otherwise been received.
PTNA and ANIC have not paid any dividends to the parent company for the past three years and are unlikely in the foreseeable future to be able to make dividend payments due to insufficient statutory surplus and anticipated earnings. However, AINIC is not subject to the Plan and was permitted by New York statute to make a dividend payment in 2002 of $651. AINIC will not be able to make a dividend payment in 2003.
In 1998, the NAIC adopted the Codification of Statutory Accounting Principles ("Codification") guidance, which replaced the current Accounting Practices and Procedures manual as the NAIC's primary guidance on statutory accounting as of January 1, 2001. The Codification provides guidance for areas where statutory accounting has been silent and changes current statutory accounting in some areas, including the recognition of deferred income taxes.
The Company's 1987 Employee Incentive Stock Option Plan provided for the granting of options to purchase up to 1,200 shares of common stock. This plan expired in 1997 and was subsequently replaced by the 1998 Employee Non-Qualified Incentive Stock Option Plan ("1998 Plan"). The 1998 Plan allows for the grant of options to purchase up to 600 shares of common stock. No new options may be granted under the 1987 Plan. The term of each option granted in 2001 and 2002 is ten years.
Effective May 1995, the Company adopted a Participating Agent Stock Option Plan which provides for the granting of options to purchase up to 300 shares of common stock. The exercise price of all options granted under the plan may not be less than the fair market value of the shares on the date of grant. The term of each option is ten years, and the options become exercisable in four equal, annual installments commencing one year from the option grant date. SFAS No. 123 requires that the fair value of options granted to non-employees (agents) be recognized as compensation expense over the estimated life of the option. Options were granted to agents in 1997, 1996 and 1995. No agent options have been granted since 1997. The Company recognized $0, $51 and $86 of compensation expense in 2002, 2001 and 2000, respectively as a result of these grants.
Basic Earnings Per Share As reported $ (1.58) $ (3.41) $ 3.13 Pro forma $ (1.58) $ (3.41) $ 3.07
The total net rental expenses under all leases amounted to approximately $928, $1,059 and $1,003 for the years ended December 31, 2002, 2001 and 2000 respectively.
The Company's required payments due under non-cancelable leases in each of the next five years are as follows:
Our Company and certain of our key executive officers are defendants in consolidated actions that were instituted on April 17, 2001 in the United States District Court for the Eastern District of Pennsylvania by our shareholders, on their own behalf and on behalf of a putative class of similarly situated shareholders who purchased shares of our common stock between July 23, 2000 through and including March 29, 2001. The consolidated amended class action complaint seeks damages in an unspecified amount for losses allegedly incurred as a result of misstatements and omissions allegedly contained in our periodic reports filed with the SEC, certain press releases issued by us, and in other statements made by our officials. The alleged misstatements and omissions relate, among other matters, to the statutory capital and surplus position of our largest subsidiary, Penn Treaty Network America Insurance Company. On July 1, 2002, the defendants filed an answer to the complaint, denying all liability. Plaintiffs filed a motion for class certification on August 15, 2002, which is currently pending. On February 26, 2003, the parties reached an agreement in principle to settle the litigation for $2.3 million, to be paid entirely by our directors and officers liability insurance carrier. The settlement remains subject to documentation and court approval.
Effective December 31, 2001, PTNA and ANIC entered a reinsurance transaction to reinsure, on a quota share basis, substantially all of the Company's long-term care insurance policies then in-force ("the 2001 Agreement").
The reinsurance agreement contains commutation provisions and allows the Company to recapture the reserve liabilities and the current experience account balance as of December 31, 2007, or on December 31 of any year thereafter. The Company intends, but is not required, to commute the agreement on December 31, 2007. In the event the Company does not commute the agreement on December 31, 2007, the expense and risk charges applied to the experience account will increase significantly. Additionally, the reinsurance provisions contain covenants and conditions that, if breached, may result in the immediate commutation of the agreement and the payment of $2,500 per quarter from the period of the breach through December 31, 2007.
As part of the reinsurance agreement, the reinsurer was granted four tranches of warrants to purchase shares of non-voting convertible preferred stock. The first three tranches of warrants are exercisable through December 31, 2007 at common stock equivalent prices ranging from $4.00 to $12.00 per share. If exercised for cash, at the reinsurer's option, the warrants could yield additional capital and liquidity of approximately $20,000 and the convertible preferred stock would represent, if converted, approximately 15% of the then outstanding shares of our common stock on a fully diluted basis. If the agreement is not commuted on or after December 31, 2007, the reinsurer may exercise the fourth tranche of convertible preferred stock purchase warrants at a common stock equivalent price of $2.00 per share, representing an additional 20% of the then outstanding common stock on a fully diluted basis.
In the event the Company determines that commutation of the reinsurance agreement on December 31, 2007 is unlikely, but likely at some future date, it will include additional annual reinsurer expense and risk charges in its DAC recoverability analysis. As a result, it could impair the value of its DAC asset and record the impairment in its financial statements at that time. However, the Company currently believes that it will have a sufficient amount of statutory capital and surplus to commute the agreement by December 31, 2007 or that sufficient alternatives, such as additional capital issuance or new reinsurance opportunities, will be available to enable it to commute the agreement by December 31, 2007.
The Company currently reinsures with unaffiliated companies any life insurance policy to the extent the risk on that policy exceeds $50.
In addition to the reinsurance agreement to cede certain home health care claims beyond 36 months, PTNA is also party to a coinsurance agreement with the same reinsurer on a previously acquired block of long-term care business whereby 66% is ceded to a third party. At December 31, 2002 and 2001 reinsurance recoverables taken related to this treaty were approximately $6,020 and $2,639, respectively.
December 31, 2001 - ----------------- Ordinary life insurance In-force $ 52,322 $ 10,543 $ 5,437 $ 47,216 Premiums: Accident and health 355,574 13,760 5,749 347,563 Life 3,586 759 1 2,828 Benefits to policyholders: Accident and health 211,849 3,935 1,153 209,067 Life 2,356 394 - 1,962 Inc in policy reserves: Accident and health 32,019 7,244 2,656 27,431 Life 1,515 820 - 695 Commissions $ 76,095 $ 1,178 $ 1,888 $ 76,805
December 31, 2000 - ----------------- Ordinary life insurance In-force $ 58,907 $ 12,675 $ - $ 46,232 Premiums: Accident and health 352,534 3,010 4,512 354,036 Life 3,304 228 1 3,077 Benefits to policyholders: Accident and health 164,728 2,346 713 163,095 Life 2,469 441 - 2,028 Inc (dec) in policy reserves: Accident and health 76,514 77 1,053 77,490 Life 931 (27) - 958 Commissions $ 100,681 $ 255 $ 1,887 $102,313
Irv Levit Insurance Management Corporation, an insurance agency which is owned by our Chairman and Chief Executive Officer, produced approximately $11, $10 and $43 of renewal premiums for some of our subsidiaries for the years ended December 31, 2002, 2001 and 2000, respectively, for which it received commissions of approximately $2, $2 and $10, respectively. Irv Levit Insurance Management Corporation also received commission overrides on business written for some of our subsidiaries by certain agents, principally general agents who were its agents prior to January 1979 and any of their sub-agents hired prior and subsequent to January 1979. These commission overrides totaled approximately $510, $544 and $551 for the years ended December 31, 2002, 2001 and 2000, respectively.
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and investments. The Company places its cash and cash equivalents and investments with high quality financial institutions, and attempts to limit the amount of credit exposure to any one institution. However, at December 31, 2002, and at other times during the year, amounts in any one institution exceeded the Federal Deposit Insurance Corporation limits. The Company is also party to certain reinsurance transactions whereby the Company remains ultimately liable for claims exposure under ceded policies in the event the assuming reinsurer is unable to meet its commitments due to default or insolvency.
Subsequent to December 31, 2002, the Company exchanged $2,450 of its 6.25% Convertible Subordinated Notes due 2008 ("the Exchange Notes") for a like amount of its Convertible Subordinated Notes due 2003.
In December 2002, the Company commenced the sale of up to $45,000 in 6.25% Convertible Subordinated notes due 2008 ("the 2008 Notes"). The 2008 Notes were offered, with identical terms to the Exchange Notes. In February 2003, the Company completed the sale of 2008 Notes and received proceeds of $28,722. It contributed $16,000 of the proceeds to PTNA in order to satisfy the premium to surplus requirements of its voluntary consent order with the Florida Insurance Department. In March 2003, the Company issued an additional $3,550 of 2008 Notes under a new prospectus supplement.
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES (PARENT COMPANY) Statements of Operations for the Years Ended December 31, 2002, 2001 and 2000 (amounts in thousands)
Loss before equity in undistributed net earnings of subsidiaries* (8,894) (5,844) (5,105)
Retained earnings, end of year $ 61,703 $ 92,141 $140,730 ======== ======== ========