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%.
The Company’s management continuously monitors the performance of and outlook for the Company by analyzing several indicators that they judge to be critical. The Key indicators of particular interest to management are (a) the general economic environment relative to outlook, (b) trend of premium volume, (c) lapse rates, (d) mortality and morbidity rates (e) trend of general expense levels, (f) asset and capital and surplus growth, (g) general interest rate movements, (h) investment yields, (i) diversity (e.g. by industry) and mix (e.g. between fixed income securities and equity securities) of our investment portfolios and (j) segment performance and trends.
The Company’s management has identified the following as major financial, operational and marketing accomplishments during 2004:
• The Company earned a modest profit for the second straight year in spite of experiencing reduced premiums and incurring major nonrecurring costs associated with the settlement of legal proceedings, consulting and severance agreements.
• The Company significantly restructured management including hiring Joseph M. Bost as Chief Operating Officer and eliminating several management positions in an effort to streamline operations and control costs.
• The Company implemented many recommendations of the process redesign and incentive compensation consultants also to streamline operations and control costs, as well as to provide incentives to all employees to strive for efficiency in all functional areas of operation.
• The Company purchased a new group administration system to create a platform for Group Dental growth.
solidifying A.M. Best rating and setting the stage for a rating upgrade after 2005 (see ITEM I under Competition for a discussion of the Company’s rating)
using a portion of 2005 statutory profit to fund higher sales growth in 2006 without straining capital and surplus
for Home Service; improving 13-month persistency and strengthening controls over field premium collection
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 under 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 under. 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 at increased premium rates. 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.
The Company’s 2004 segment loss was $2,307,000 compared to $972,000 in 2003 and $553,000 in 2002. The segment losses in 2004 and 2003 excluding nonrecurring items described below was $481,000 and $485,000, respectively.
The nonrecurring items in 2004 and 2003 include costs of $1,200,000 (settlement and legal costs) incurred in 2004 associated with the legal proceedings described in Item 3, and additional one time consulting expenses ($636,000 in 2004 and $487,000 in 2003) related to redesign and other organizational restructuring begun in 2003, as well as severance agreements.
Although the Company’s 2004 segment loss of $481,000 excluding nonrecurring items was comparable to the 2003 loss of $485,000, operating result comparisons between years included unfavorable results related to (a) a decrease in premiums and other considerations of $5,600,000 (pre-need premium decreased $6,200,000 while dental premium increased $900,000 and premium for other segments experienced modest decreases), (b) a decrease in net deferral of policy acquisition costs and amortization of value of insurance in force of $648,000, offset by (c) a decrease in policyholder benefits and commissions totaling $5,800,000, and (d) an increase of $440,000 in investment income.
The Company’s 2004 net income was $256,000 compared to a net income of $712,000 in 2003 and net loss of $2,572,000 in 2002. These results reflect the segment losses described above (including nonrecurring items) and net realized gains (losses) of $2,868,000, $1,977,000 and ($2,469,000) in 2004, 2003 and 2002, respectively. The Company realized significant increases in realized capital gains in both 2004 and 2003 due to restructuring the investment portfolio to include a greater proportion of fixed maturity investments and fewer equity investments while taking advantage of an upturn in the equities market.
on fixed maturity investments began to rise. Although this adversely impacts the market value of the Company’s bond portfolio, the opportunity to invest new money at higher yields would have a positive impact on the Company’s operating earnings. The 2004 environment as described continues to generate a relatively high level of qualitative investment risk, as discussed in the Cash Flow and Liquidity section. The majority of the 2003 and 2002 declines in net income and the comprehensive losses were attributable to adverse securities markets during those years, including the effects of declines in the telecommunications and technology sectors, a general economic recession and terrorist events.
Investment in Debt and Equity Securities. The Company holds debt and equity interests in a variety of companies, many of which are seeking to exploit recent technology advancements. The majority of these are publicly traded and many have experienced volatile market prices. Company management periodically evaluates whether the declines in fair value of investments are other-than-temporary. These evaluations involve significant judgment. The evaluations consist of a review of qualitative and quantitative factors, including analysis of the Company’s competitive position in its markets, deterioration in the financial condition of the issuer, downgrades of the security by a rating agency, and other publicly available issuer-specific news or general market conditions. Declines in fair values of securities deemed to be temporary and which the Company has the ability and intent to hold until recovery are included as an unrealized loss in shareholders’ equity. Declines in fair values of securities deemed to be other-than-temporary are included in net income as realized investment losses. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the current carrying value of the investments, thereby possibly requiring an impairment charge in the future.
Deferred Taxes. The Company records a valuation allowance to reduce its deferred tax assets to the amount that it believes is more likely than not to be realized. In assessing the need for the valuation allowance, the Company has not assumed future taxable income. In the event the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to deferred tax assets would increase income in the period such determination was made. Likewise, should the Company determine that it would not be able to realize all or part of its net deferred tax assets in the future, an adjustment to deferred tax assets would be charged to income in the period such determination was made.
2 Fair values as of December 31, 2004 were obtained primarily from Interactive Data Corporation.
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 5.7% and 8.7% of the fixed maturities portfolio, on an amortized cost basis, at December 31, 2004 and 2003, respectively. During 2004, the Company recognized approximately $334,000 of impairment losses on fixed maturities related to the airline industry. 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.
Realized investment losses included $807,000, $135,000 and $1,255,000 of pretax impairment losses for the three years ended December 31, 2004, 2003 and 2002. The impairments recorded were the result of the continued credit deterioration of specific issuers in the bond and equity markets, especially in the airline and telecommunications industries.
During 2004, the Company's investment in equity securities decreased $771,000 and $2,394,000 on a cost and fair value basis, after increasing $953,000 and $3,575,000 on a cost and fair value basis, respectively, during 2003. As of December 31, 2004, 2003 and 2002, there were $1,652,000, $3,275,000 and $653,000 respectively, of unrealized gains on equity securities.
The Company reviews its marketable investments each quarter to determine if there have been declines in their value that in management’s opinion are other-than-temporary. These reviews can involve qualitative and quantitative information relating to an individual company or industry and general factors impacting the economy. However, due to wide market fluctuations occurring during the past two years, determining whether declines are temporary has become much more complex and judgmental. These reviews resulted in the recognition of impairment losses on equity securities totaling $473,000 during 2004 ($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 impairment write-downs of $559,000 and fixed maturities were sold which contained impairment write downs of $334,000.
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 leased 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 value.
At December 31, 2004 the Company has recorded $756,000 of goodwill and $12,798,000 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. In connection with adoption of SFAS No. 142, the Company reassessed the assumptions supporting these values. Although no impairment was considered necessary, a continued historically low interest rate environment could require adjustment of these recorded values.
Home Service Life sales have decreased only moderately in recent years, with net growth in policy liabilities of 3.0% in both 2004 and 2003, through a combination of attracting new producers and continuing to focus on meeting the needs of existing customers and agents. Only modest changes were experienced in 2004 in the broker life segment. Preneed Life premiums are lower, due in part to the Company’s decision to emphasize the lower annual premium “multi-pay” policies rather than “single-pay” policies and some loss of volume attributable to reducing commission levels and the rate of annual growth credited to policies. The Company is not currently focusing any marketing effort to this segment because of the adverse effects of the recent low interest rate environment. During 2004, Dental premiums were favorably impacted by additional broker relationships and normal premium increases. The Other Health segment products are not being actively marketed.
As indicated above, total policyholder deposits decreased by a net $249,000 during 2004. 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.
Home Service Life premium decreased modestly in both 2004 and 2003. New sales levels continue to be favorable, at levels that exceed normal policy lapses. The Company continues to attract a number of successful, experienced Home Service agents without subsidizing inexperienced agents. In addition, the Company’s program to automate and streamline agent field accounting continues to expand with favorable reaction among the agency force. To mitigate effects of the lower interest rate environment, during the second quarter of 2003 the Company introduced premium rate increases on its Home Service products. In the fourth quarter of 2004, the Company began to geographically expand the Home Service market, hiring two new regional representatives to recruit new agents in Ohio and Pennsylvania, as well as in Florida and Georgia.
The Company has not been actively marketing Other Health policies for several years. However, in response to agent requests, certain cancer and disability protection products have been updated and promoted. Pricing, underwriting, and claims experience on these products are closely monitored.
Investments. The Company monitors its available-for-sale fixed maturities and equity securities to assure they are strategically positioned within the current market environment. This practice has historically resulted in holding significant equity security positions, which tend to dampen current income yields in favor of an overall total return focus. The Company’s equity securities comprised 6.8% and 8.8% of its total investment portfolios at December 31, 2004 and 2003, respectively. The Company’s investment income yields were 4.7%, 4.5%, and 4.8% for 2004, 2003, and 2002, respectively. The 2003 yield decline resulted primarily from substantially lower interest rates on new investments, the Company’s 4% net addition to its fixed maturity portfolio during the year and a 13% increase in equity holdings, much of which is attributable to new Preneed Life business. Although the Company’s total return on investments has historically been very favorable, returns for the past three years have been severely impacted by declines in the airline, telecommunications and technology sectors, a general economic recession and the effect of terrorist events on the securities markets.
The 2004 decrease in pretax income of $434,000 primarily results from (a) a decrease in premiums and other considerations of $5,600,000, or 16.7% (preneed premium decreased $6,200,000, or 47.1% while dental premium increased $900,000, or 11.2% and premium for other segments experienced modest decreases), (b) costs of $1,200,000 (settlement and legal costs) associated with the legal proceedings described in Item 3, (c) a decrease in net deferral of policy acquisition costs and amortization of value of insurance in force of $648,000, (d) additional one time expenses related to consulting and severance of $139,000, offset by (e) a decrease in policyholder benefits and commissions totaling $5,800,000, (f) an increase of $440,000 in investment income and (g) an increase of $891,000 in net realized investment gains.
In 2004 the Home Service Life segment experienced lower investment income of $166,000 and increased expenses (including net deferral of policy acquisition costs) of $501,000, associated primarily with one-time consulting costs, severance and legal costs, resulting in a decrease in segment profit of $690,000.
The $840,000 increase in the loss in the Broker Life segment is primarily the result of settlement and legal costs of $1,200,000 related to legal proceedings described in Item 3, reduced investment income of $278,000, and a decrease in other expenses (including net deferral of policy acquisition costs) of $651,000.
The Company has not devoted significant marketing effort toward its Other Health products in recent years. However, during 2002 through 2004, a significant increase in disability claims occurred, with a concentration in New Jersey. The Company has strengthened underwriting practices in this area, has taken steps toward filing for a rate increase on its disability products, and has discontinued accepting applications for this policy in New Jersey in the fall of 2004.
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 carry forwards and capital loss carry forwards. The effective expense (benefit) rate was approximately (23)% and (11)% in 2004 and 2003, respectively.
The small life insurance company deduction allows the Life Insurance Subsidiaries to reduce their taxable income by 60% before computing their current provisions for regular or alternative minimum tax. However, for purposes of computing deferred income tax liabilities under the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes", the Company is precluded from assuming the small life insurance company deduction will be available in the future. Accordingly, by disallowing this deduction, SFAS No. 109 significantly increases the deferred taxes on the Life Insurance Subsidiaries’ temporary differences. Thus, when a significant increase or decrease occurs in the Company’s net temporary differences, the related deferred tax is computed using the 34% federal tax rate, whereas tax may actually be paid on these net liabilities (when realized) at a rate potentially as low as 17% (the alternative minimum tax rate after application of the allowable small life insurance company deduction). The Company’s gross deferred federal income tax liabilities and assets are more fully discussed in Note 6 of the Notes to Consolidated Financial Statements. The gross deferred tax assets are offset, to some extent, by valuation allowances related to the Company and to the Life Insurance Subsidiaries and then offset against existing deferred tax liabilities. The Company’s valuation allowance is designed to reduce deferred tax assets to their estimated ultimate realization value.
Statutory capital and surplus, specifically the component called surplus, is used to fund the expansion of an insurance company’s first year individual life and accident and health sales. The first year commission and underwriting expenses on such sales will often exceed first year premiums. Accordingly, a statutory loss (surplus strain) often occurs on these sales during the first policy year. Historically, the Company’s level of life insurance sales has not significantly impacted statutory surplus.
Due to losses in 2001 and 2002 and the adverse impact of the low interest rate environment on operating results, during 2002 the Company borrowed $2,000,000 from its Chairman to strengthen the statutory capital position of Citizens Security. The Company borrowed an additional $1,000,000 from its Chairman in 2003 for general operating capital. The borrowings from the Company’s Chairman are considered current debt as a result of a 90 day call provision in the loan agreement. The Company also has $2,791,669 of commercial bank debt outstanding, with scheduled repayments due through 2007. During 2004, 2003 and 2002 the Company did not comply with a loan covenant (debt to earnings ratio) on this debt and received a series of waivers of such violation through December 31, 2004. In return for the waivers the Company’s Chairman agreed to personally guarantee the outstanding bank debt. However, since the Company is not assured of meeting this covenant throughout 2005, the full balance of $2,791,669 can be considered payable within one year. Although the Company does not expect the full balance to be called during 2005, it believes such an obligation could be met through a refinancing arrangement or sale of selected assets or a block of insurance business. Regarding the currently scheduled debt repayments, the Company believes its available funds will be adequate to service 2005 debt obligations. In addition, the Company’s Chairman has expressed potential willingness to loan the Company an additional $2,000,000 if necessary, which could service debt obligations through 2006. Additional information regarding debt obligations is included in Note 4 of the Notes to Consolidated Financial Statements.
The Company generated approximately $913,000, $6,069,000 and $16,554,000 of cash flow from operations during 2004, 2003, and 2002, respectively. The fluctuations are principally attributable to growth of Preneed Life premiums in 2002 and a decrease in Preneed Life premiums in 2003 and 2004.
Cash used by investment activities of $2,464,000, $2,618,000, and $27,877,000 during 2004, 2003, and 2002 respectively, relates primarily to investing additional Preneed Life premiums in fixed maturity securities, although the 2002 total also includes investing $11,734,000 of cash and short term balances outstanding at December 31, 2001.
Cash used by financing activities during 2004 of $2,346,000 includes $1,342,000 of debt repayments, $902,000 of net withdrawals of policyholder deposits and $102,000 used to repurchase 13,600 shares of the Company’s common stock. The $1,562,000 of cash used by financing activities during 2003 includes $1,646,000 of debt repayments and
$908,000 of net withdrawals of policyholder deposits, partially offset by additional borrowings of $1,000,000. The quarterly bank loan payment due January 1, 2004 was paid by December 31, 2003; accordingly, the outstanding bank loan balance decreased by five quarterly installments during 2003. Cash used by financing activities during 2002 includes debt repayments of $1,317,000, net withdrawals of policyholder deposits of approximately $956,000 and $139,000 used to repurchase 29,987 shares of the Company’s common stock, partially offset by additional borrowings of $2,000,000.
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 $115.1 million fixed maturity portfolio by approximately 6.3% or $7.3 million at December 31, 2004 and 6.0% or $6.5 million at December 31, 2003. 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 45% 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 2004 and 2003, the Company increased durations of the fixed maturity portfolio. At December 31, 2004 cash and fixed-maturity investments with maturities of less than five years equaled approximately 26% of total policy liabilities compared to approximately 32% at December 31, 2003. 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, 2004, the weighted average rate on the Company’s $5,791,669 of borrowings was 5.84%. The Company believes its current liquidity position and profitability levels are adequate to guard against this interest rate risk.
products and how such rates vary depending upon projected earnings rates, which are based upon asset performance under a particular economic scenario.)
The Life Insurance Subsidiaries’ most recent cash flow testing, which was completed in February 2005, involved a review of two basic measures. The first was the value of free market surplus, which is defined as the difference between the projected market value of assets and liabilities at the end of the analysis period (typically 10-30 years). Deficits could indicate the need for corrective action depending upon the severity and the number of scenarios in which a deficit appeared. A second measure involved distributable earnings. Negative earnings for extended durations might impair the ability of the Life Insurance Subsidiaries to continue without exhausting surplus. Again, depending upon severity and frequency, corrective measures might be needed. Based on results of the testing, no corrective measures were indicated at the current 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.
regulatory changes or actions, including those relating to regulation of insurance products and insurance companies (see the State Insurance Regulation section of Item 1 - Business);
ratings assigned to the Company and its subsidiaries by independent rating organizations which the Company believes are important to the sale of its products;
changes in the Federal income tax laws and regulations which may affect the relative tax advantages of some of the Company’s products.