(2) Includes the results of the companies acquired in the 1999 Acquisition, since their acquisition on July 30, 1999.
(4) Includes the results of AIAG since its acquisition on January 6, 2000, and CHCS since its acquisition on August 10, 2000.
(6) Represents the ratio of intangible assets (the sum of deferred acquisition costs, goodwill and present value of future profits) to shareholders' equity.
(8) Includes capital and surplus of PennCorp Life (Canada) of C$32,314 as of December 31, 2001, C$30,421 as of December 31, 2000, and C$31,531 as of December 31, 1999 as reported to the Office of the Superintendent of Financial Institutions Canada, converted at the related exchange rates of C$0.6261 per U.S. $1.00 as of December 31, 2001, C$0.6671 per U.S. $1.00 as of December 31, 2000 and C$0.6900 per U.S. $1.00 as of December 31, 1999.
You should read the following together with our financial statements and the notes to financial statements included elsewhere herein.
We offer life and health insurance designed for the senior market and the self-employed market in all fifty states, the District of Columbia and all of the provinces of Canada. We also provide administrative services to other issuers by servicing their senior market products. Our principal insurance products are Medicare supplemental health insurance, fixed benefit accident and sickness disability insurance, long term care insurance, senior life insurance, annuities and other individual life insurance. Our principal business segments are: career agency, senior market brokerage, special markets and administrative services. We also report the corporate activities of our holding company in a separate segment. A description of these segments follows:
CAREER AGENCY -- Our career agency segment is comprised of the operations of Pennsylvania Life Insurance Company and PennCorp Life Insurance Company of Canada, both of which we acquired in 1999. PennCorp Life (Canada) operates exclusively in Canada, while Pennsylvania Life operates in both the United States and Canada. The career agency segment includes the operations of a career agency field force, which distributes fixed benefit accident and sickness disability insurance, life insurance and supplemental senior health insurance in the United States and Canada. The career agents are under exclusive contract with either Pennsylvania Life or PennCorp Life (Canada) and sell only products that we provide. During the first quarter of 2002, the Canadian Branch of Pennsylvania Life was merged into PennCorp Life (Canada), consolidating our Canadian operations into a single entity. This transaction was approved by the Office of the Superintendent of Financial Institutions and the Pennsylvania Department of Insurance.
SENIOR MARKET BROKERAGE -- Our senior market brokerage segment focuses on selling insurance products designed for the senior market, such as Medicare supplement, long term care, senior life insurance and annuities. We distribute these products through independent marketing organizations and general agencies.
SPECIAL MARKETS -- We have accumulated various blocks of business, primarily as a result of acquisitions, that are not part of our core business focus. We manage the run off of these blocks of business in our special markets segment. The products in this segment include traditional, interest-sensitive and group life insurance, individual major medical and other accident and health insurance.
ADMINISTRATIVE SERVICES -- We act as a third party administrator and service provider for both affiliated and unaffiliated insurance companies, primarily with respect to various senior market products and a growing portion of non-insurance products. The services that we perform include policy underwriting, telephone verification, policyholder services, claims adjudication, clinical case management, care assessment and referral to health care facilities.
Intersegment revenues and expenses are reported on a gross basis in each of the operating segments but are eliminated in our consolidated results. These eliminations affect the amounts reported on the individual financial statement line items, but do not change operating income before taxes. The significant items eliminated include intersegment revenue and expense relating to services performed by the administrative services segment for the career agency, senior market brokerage and special market segments and interest on notes issued by the corporate segment to the other operating segments.
The cost of acquiring new business, principally commissions and certain expenses of the agency, policy issuance and underwriting departments, all of which vary with, and are primarily related to the production of new and renewal business, have been deferred. These costs are being amortized in relation to the present value of expected gross profits on the policies arising principally from investment, mortality and expense margins in accordance with Statement of Financial Accounting Standards No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments", for interest sensitive life and annuity products and in proportion to premium revenue using the same assumptions used in estimating the liabilities for future policy benefits in accordance with Statement of Financial Accounting Standards No. 60, "Accounting and Reporting by Insurance Enterprises", for non-interest sensitive life and all accident & health products.
The determination of gross profits is an inherently uncertain process, and relies on assumptions including the persistency of the policies issued as well as anticipated losses, commissions and expenses. It is possible that the actual profits from the business will vary materially from the assumptions used in the determination and amortization of deferred acquisition costs. Deferred policy acquisition costs are written off to the extent that it is determined that future policy premiums and investment income or gross profits would not be adequate to cover related losses and expenses.
We regularly evaluate the amortized cost of our investments compared to the fair value of those investments. Impairments of securities generally are recognized when a decline in fair value below the amortized cost basis is considered to be other-than-temporary. We consider a decline in fair value to be other than temporary when the fair value of an individual security is below amortized cost for an extended period and we do not believe that recovery in fair value is probable. Impairment losses for certain mortgage and asset-backed securities are recognized when an adverse change in the amount or timing of estimated cash flows occurs, unless the adverse change is solely a result of changes in estimated market interest rates. The cost basis for securities determined to be impaired are reduced to their fair value, with the excess of the cost basis over the fair value recognized as a realized investment loss.
In the third quarter of 2001, we completed a secondary equity offering in which we sold 5.7 million shares of our common stock and raised $26.0 million, net of expenses. In addition, 2.2 million shares were sold by some of our shareholders as part of the offering. The primary reason for the offering was to enhance the capital of our insurance subsidiaries to support our growth and to improve our risk based capital ratios. Out of the proceeds of the offering, $9.3 million was contributed to the capital and surplus of our insurance subsidiaries, $5.5 million was used to reduce intercompany obligations and the balance was held for general corporate purposes.
In July 1999, we acquired six insurance companies, including the subsidiaries that comprise our career agency segment, and other assets from PennCorp Financial Group. This acquisition enhanced our prospects for future growth by expanding our geographic reach and through the addition of a career agency marketing channel to supplement our senior market brokerage agency marketing channel. We have included in the comparison of our 2000 and 1999 results of operations a simple extrapolation to annualize the five months of activity during 1999 for the acquired business to a twelve-month amount in order to provide a meaningful basis of comparison with the full twelve-month period ended December 31, 2000.
In the fourth quarter of 2000, we decided to exit our under-performing individual major medical business to the extent possible. We believe that we will be able to cancel, by the end of 2002, all but $3.3 million of the annualized major medical premium that was in force on December 31, 2001.
Beginning in 1998, many HMO's realized that their Medicare programs were unprofitable and therefore decided to terminate these programs. As a result, millions of seniors were involuntarily disenrolled from these programs. This development contributed to our increased new sales of Medicare supplement products in 2001, 2000 and 1999. Under applicable legislation, such disenrollees may have the right to acquire Medicare supplement insurance without underwriting or pre-existing condition limitations. We expect that, over time, the effect of disenrollment on new Medicare supplement sales will abate.
The following table reflects each of our segment's operating income contribution and contains a reconciliation to net income for these items.
Operating income from our Career Agency segment decreased by $0.4 million or 1%, compared to 2000. This decrease was due primarily to a reduction in the underwriting profit of the U.S. Operations, offset by a reduction in general expenses.
Our senior market brokerage segment improved results by more than 51%, increasing operating income by $2.8 million. This improvement is the result of continued internally generated growth of business in this segment, primarily in the Medicare supplement and long term care lines.
Operating income from our administrative services segment improved by $2.8 million or 72% in 2001 compared to 2000. The increase is due primarily to the growth in the Medicare supplement business administered by this segment.
The operating income for our special markets segment for 2000 improved by approximately 4% over 1999. This reflects the inclusion of a full year of operating income in 2000 from the business acquired in 1999 compared to only five months in 1999. However, underwriting results for the segment were negatively impacted by a deterioration of the loss ratios in the major medical line of business. Based in part on the poor performance of this block of business, and in an effort to focus more on strategic core business lines, we decided to exit the major medical business during 2000. As a result, we wrote off $1.4 million of deferred acquisition costs relating to that line of business.
Our effective tax rate was 30.8% for 2000 as compared to 38.9% in 1999. As a result of the increased profitability of the administrative services segment, valuation allowances on certain of the non-life tax loss carryforwards were no longer considered necessary as of December 31, 2000. The amount of the valuation allowance released was $1.3 million and was recorded as a benefit in the deferred income tax expense.
REVENUES. Net premiums for the 2001 fell by approximately 2.5% compared to 2000. In the U.S. the decrease is due to a greater amount of annuities, which are not reported as premiums for GAAP purposes. The decrease in Canadian net premium is due to the run-off of the older block of Canadian business. Canadian operations accounted for approximately 37% of the net premiums for the segment for both 2001 and 2000.
Net investment income increased by approximately 3% over 2000. The increase is due to an increase in the segment's invested assets, offset by a decrease in the overall yield.
BENEFITS, CLAIMS AND OTHER DEDUCTIONS. Policyholder benefits, including a change in reserves, increased by approximately 12% compared to 1999 on an annualized basis. This was due to higher overall loss ratios.
Operating income from our Senior Market Brokerage segment increased by $2.8 million, or 51%, in 2001 compared to 2000. This improvement is the result of continued internally generated growth of business in the segment, primarily in the Medicare Supplement/Select and long term care lines.
REVENUES. Total gross premium written increased $86.0 million, or 34%, over 2000. This increase consisted of an increase of $79.1 million, or 96%, on Medicare supplement business written by our insurance companies, an increase of $3.3 million in Medicare supplement premium acquired through acquisition, an increase of $1.9 million in other senior supplemental health premium and an increase of $1.7 million in senior life insurance premium.
This increase in gross premium for the Senior Market portfolio products by our insurance company subsidiaries was the result of strong sales in the prior year together with continued increase in new sales in the current year. New production of our Senior Market products amounted to $109.7 million for 2001 compared to $85.1 million for 2000.
The increase in Medicare supplement acquired gross premium is due to new sales by our insurance subsidiary, Constitution Life Insurance Company, which are substantially ceded, and the effect of rate increases, offset by expected lapses.
Net premiums for 2001 increased by approximately $25.8 million, or 49%, compared to 2000. Net premiums did not increase in line with the gross premiums due to a change in the mix of annualized premium in force. The amount of premium retained increased from 20% in 2000 to 23% in 2001 due to the increase in Medicare Supplement/Select premiums written, which we retain 30% on average.
BENEFITS, CLAIMS AND OTHER DEDUCTIONS. Policyholder benefits, including the change in reserves, increased by approximately $21.0 million, or 52%, compared to 2000, due primarily to the increase in the annualized premium in force.
The ratio of commissions to gross premiums increased to 17.6% in 2001 from 16.9% in 2000. Other operating costs as a percentage of gross premiums decreased to 12.1% in 2001 from 13.1% in 2000. Commission and expense allowances received from reinsurers as a percentage of the premiums ceded were relatively flat at 29.9% in 2001 compared to 29.2% in 2000.
Operating income from our Senior Market Brokerage segment increased by $1.6 million, or 42%, in 2000 compared to 1999.
The 1999 amount of gross premium for Medicare supplement acquired included approximately $36.7 million of gross premiums received on policies from the business acquired in 1999 for the five months ended December 31, 1999. On a annualized basis, the gross premium on this acquired business would have been $88.1 million. Gross premiums for this acquired business were $89.7 million in 2000, a $1.6 million increase compared to annualized 1999.
The increase of $7.9 million in other supplemental health gross premiums was the result of increased new sales of long term care products and an increase of $2.8 million due to the inclusion in 2000 of twelve months of long term care premiums from the business acquired in 1999 compared to the inclusion of only five months of such premiums in 1999. Senior life insurance premium increased in 2000 as a result of increased sales resulting from more general agents under contract.
Net premiums for 2000 increased by approximately $19.5 million, or 60%, compared to 1999. Net premiums did not increase in line with the gross premiums due to a decrease in the amount of retained Medicare supplement written premium from 34% in 1999 to 31% in 2000. This reduction in retained premium was a result of increased premiums written by our American Pioneer Life Insurance Company subsidiary for which 75% quota share reinsurance agreements are in force. The Retained Medicare supplement acquired premium decreased from 13% in 1999 to 8% in 2000 as a result of the inclusion of a full year of the Medicare supplement premium from the business acquired in 1999, which premium was 100% reinsured under agreements that predated the acquisition. The other supplemental senior health insurance retained decreased from 60% in 1999 to 56% in 2000 as result of the increased writing of long term care insurance that is reinsured pursuant to 50% quota share reinsurance agreements.
Net investment income increased by approximately 21% over 1999, as a result of the increase in the average invested assets for the comparable periods. Average invested assets increased primarily as a result of increased cash flow from operations.
BENEFITS, CLAIMS AND OTHER DEDUCTIONS. Policyholder benefits, including the change in reserves, increased by approximately $17.0 million, or 72%, compared to 1999. Net policyholder benefits increased more than net premium primarily due to an increase in loss ratios on our Medicare supplement written policies from approximately 70% in 1999 to 75% in 2000. In response to this increase in the loss ratio, we have implemented rate increases, which will be effective during 2001. The loss ratios on the Medicare supplement acquired policies increased slightly from 82% in 1999 to 84% in 2000. In addition, the net benefits incurred from the business acquired in 1999 increased $2.0 million as a result of including twelve months of operations in 2000 compared to only five months of operations in 1999.
Interest credited to policyholders decreased by approximately $0.6 million, or 10%, as a result of the decrease in the effective interest rate credited to the policies in 2000 compared to 1999 and the expected lapses of policies in force.
The increase in deferred acquisition costs was approximately $1.3 million more in 2000, compared to the increase in 1999. The increase in deferred acquisition costs related to the increase in premiums issued during 2000 compared to 1999.
The ratio of commissions to gross premiums remained relatively flat at 16.9% in 2000 and 16.5% in 1999. Other operating costs as a percentage of gross premiums decreased to 13.1% in 2000 from 14.5% in 1999. Commission and expense allowances received from reinsurers as a percentage of the premiums ceded were relatively flat at 29.2% in 2000 compared to 28.9% in 1999.
Operating results from our Special Markets segment for 2001 improved by $0.6 million compared to 2000.
Commissions and general expenses, net of allowances, decreased by $2.2 million, or 19%, during 2001, compared to 2000. This reflects the lower costs associated with the reduction in premium.
REVENUES. Net premiums for 2000 increased by $11.0 million or 40% compared to 1999. Approximately $10.6 million of the increase, including $3.3 million of life premium and $7.3 million of accident and health premium, related to the inclusion of a full year of operating results in 2000 for the business acquired in 1999, compared to the inclusion of only five months in 1999.
Net investment income increased by $6.0 million compared to 1999, primarily due to the inclusion in 2000 of twelve months of investment income on assets relating to the business acquired in 1999, compared to the inclusion of only five months in 1999.
For the year ended December 31, 2000, our Administrative Services segment generated $24.1 million in service fee income with 42% of its revenues from the administration of business on behalf of affiliates, 25% from unaffiliated third party clients and 33% from the reinsurer of 100% of a certain block of business of one of our insurance subsidiaries.
As of December 31, 2000, the Administrative Services segment administered more than $308.5 million of annualized in force premium. Approximately $276.7 million of annualized premium in force was administered on behalf of affiliates. This, combined with fees for telephone support and managed care and claims services on behalf of the affiliated insurance subsidiaries, generated $18.1 million of affiliated revenue for 2000. The remaining $6.0 million was generated from services provided to unaffiliated companies.
The decrease in the operating loss from our corporate segment is due primarily to the reduction in interest cost. This reduction was due to a combination of the declining balance of debt outstanding as a result of principal repayments and reductions in the weighted average interest rates for the year, compared to 2000. During 2001, we repaid $8.2 million of our term loan while at the same time the weighted average interest rate on our debt decreased to 7.84% from 10.05% in 2000.
The Corporate segment reflects the elimination of revenues and expenses associated with services performed by our Administrative Services segment for our insurance company subsidiaries. These eliminations amounted to $23.6 million for 2001, $18.1 million for 2000 and $7.3 million for 1999. The Corporate segment also reflects the elimination of interest income and expense on debentures issued by our parent holding company to our American Progressive subsidiary of $0.5 million for 2001, $0.7 million for 2000 and $0.7 million for 1999.
We believe that our current cash position, the availability of the revolving credit facility, the expected cash flows of the administrative service company and the surplus note interest payments from American Exchange can support our parent holding company obligations for the foreseeable future. However, there can be no assurance as to our actual future cash flows or to the continued availability of dividends from our insurance company subsidiaries.
Our $80 million credit facility consists of a $70 million term loan and a $10 million revolving loan facility. The loans call for interest at LIBOR for one, two, three or six months plus 350 basis points (currently 5.37%). Principal repayments are due on a quarterly basis over a seven-year period that commenced on July 31, 2000. The final maturity date of the facility is July 31, 2006. We pay a commitment fee of 50 basis points on the unutilized portion of the revolving facility. The term loan is secured by a first priority security interest in 100% of the outstanding common stock of American Exchange, American Progressive, and WorldNet Services and 65% of the outstanding under common stock of UAFC (Canada) Inc. (the parent of PennCorp Life (Canada)) and a subordinate interest in 100% of the outstanding common stock of American Pioneer. As of December 31, 2001, $58.5 million was outstanding under the term loan and $3.0 million was outstanding under the revolving loan facility. We incurred the revolving indebtedness in connection with our acquisition of CHCS in August 2000. During January 2002, we made a regularly scheduled repayment that further reduced the outstanding balance of the term loan to $55.9 million. During 2001, we paid $5.2 million in interest and repaid $8.2 million in principal on the term loan. For 2000, we paid $7.1 million in interest and repaid $3.4 million in principal on the term loan.
The following table shows the schedule of remaining principal payments on the Company's outstanding term loan, with the final payment in July 2006:
On July 12, 2001, the Company entered into an Underwriting Agreement with Banc of America Securities LLC and Raymond James & Associates, Inc., as representatives of the underwriters named therein, and certain shareholders of the Company, with respect to the sale of up to 7,950,000 shares of the Company's common stock (including 750,000 shares of Common Stock subject to an over-allotment option granted to the Underwriters by the Company and some of the selling shareholders). As a result, on July 12, 2001, the Company issued five million shares of common stock at a price of $5.00 per share, generating proceeds of $25 million. Expenses for this transaction, including the underwriters' discounts and commissions, amounted to $2.4 million, resulting in net proceeds of $22.6 million to the Company. The proceeds from this offering were used to enhance the capital and surplus of certain of our insurance subsidiaries through capital contribution totaling $9.3 million ($5.0 million to American Pioneer and $4.3 million to American Exchange), to reduce intercompany obligations by $5.5 million and to hold the balance at the parent company for general corporate purposes. In connection with this offering, certain shareholders of the company, none of whom were management, sold 2.2 million shares at $5.00 per share, less the underwriters' discounts and commissions of $0.3187 per share.
On August 13, 2001, the over-allotment option was exercised and, as a result, the Company issued an additional 720,000 shares of common stock at a price of $5.00 per share, less the underwriters' discounts and commissions of $0.3187 per share, generating additional net proceeds of $3.4 million. In connection with the over-allotment option, certain shareholders sold an additional 30,000 shares at $5.00 per share, less the underwriters' discounts and commissions of $0.3187 per share.
The total offering, including the over-allotment raised $26.0 million, net of total expenses of $2.6 million.
In connection with an agreement entered into in 1996 under which American Pioneer became a direct subsidiary of our holding company rather than an indirect subsidiary owned through American Progressive, our holding company issued $7.9 million in debentures to American Progressive. A portion of the proceeds from our equity offering in July 2001 was used to pay down $5.5 million of the debentures. At December 31, 2001, $2.4 million of the debentures remained outstanding and are due between December 2002 and May 2003. Our holding company pays interest on the remaining debentures quarterly at a rate of 8.50%. During 2001 our parent holding company paid $0.5 million in interest on these debentures to American Progressive and $0.7 million in 2000, which was eliminated in consolidation.
Liquidity for our administrative service company is measured by its ability to pay operating expenses. The primary source of liquidity is fees collected from clients. We believe that the sources of cash for our administrative service company exceed scheduled uses of cash and results in amounts available to dividend to our parent holding company. We measure the ability of the administrative service company to pay dividends based on its earnings before interest, taxes, depreciation and amortization ("EBITDA"). For the year ended December 31, 2001, EBITDA for our administrative services segment was $9.7 million.
Changes in interest rates may affect the incidence of policy surrenders and withdrawals. In addition to the potential impact on liquidity, unanticipated surrenders and withdrawals in a changed interest rate environment could adversely affect earnings if we were required to sell investments at reduced values in order to meet liquidity demands. We manage our asset and liability portfolios in order to minimize the adverse earnings impact of changing market rates. We seek to invest in assets that have duration and interest rate characteristics similar to the liabilities that they support.
As of December 31, 2001 and 2000, we carried valuation allowances of $6.8 million and $10.4 million, respectively, with respect to our tax loss carryforwards (deferred tax assets). We determine a valuation allowance based upon an analysis of projected taxable income and our ability to implement prudent and feasible tax planning strategies. The tax planning strategies include the expense reductions anticipated from our recent reorganization and from the income generated by our administrative services companies. As a result of the increased profitability of the insurance subsidiaries acquired in 1999, valuation allowances on certain of the life tax loss carryforwards were considered not necessary at December 31, 2001. The amount of the valuation allowance released during 2001 was $3.6 million and was recorded as a reduction of goodwill of $2.9 million and as a benefit in the deferred income tax expense of $0.7 million. As a result of the increased profitability of the Administrative Services segment, valuation allowances on certain of the non-life tax loss carryforwards were considered not necessary as of December 31, 2000. The amount of the valuation allowance released during 2000 was $1.3 million and was recorded as a benefit in the deferred income tax expense. This decrease was partially offset by the establishment of a valuation allowance for the purchased net operating losses of CHCS, which are subject to limitation on their use. We believe it is more likely than not that we will realize the recorded net deferred tax assets.
In August 2001, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. This Statement supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, and the accounting and reporting provisions of Accounting Principles Board Opinion, or APB Opinion No. 30, Reporting the Results of Operations -- Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business. This Statement also amends Accounting Research Bulletin No. 51, Consolidated Financial Statements.
This Statement requires that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and by broadening the presentation of discontinued operations to include more disposal transactions. Additionally, this Statement resolves significant implementation issues, which will improve compliance.
In the second quarter, 2001, we adopted the provisions of EITF No. 99-20, "Recognition of Interest Income and Impairment of Purchased and Retained Beneficial Interests in Securitized Financial Assets." EITF No. 99-20 changed the method of assessing other than temporary impairments for certain mortgage and asset-backed securities classified as available for sale. The guidance requires the recognition of impairment when a change in the amount or timing of estimated cash flows results in a decline in fair value below the amortized cost basis, unless the decrease is solely a result of changes in estimated market interest rates. The new guidance also revised he method of recognizing interest income for the investments within its scope, requiring a prospective approach to account for changes in estimated future cash flows. The adoption of the new Statement did not have a material effect on our earnings for 2001or our financial position at December 31, 2001.
In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This Statement is effective for financial statements issued for fiscal years beginning after June 15, 2002. We anticipate that the adoption of this standard will not have a significant effect on our results of operations, financial position or liquidity.
The effective date of this Statement is for fiscal years beginning after December 15, 2001. Impairment losses are to be reported as resulting from a change in accounting principle. We will apply the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of 2002. Application of the non-amortization provisions of the Statement is expected to result in an increase in net income of $0.4 million (less than $0.01 per diluted share) per year. We performed the first of the required impairment tests of goodwill and indefinite lived intangible assets as of January 1, 2002 and we expect that the adoption of this statement will not have a material effect on our earnings or our financial position.