Increased retention of medical stop-loss premium at Standard Life and Madison Life to an average of 30% in 2003 from 28% in 2002
Acquired 3 blocks of business with total reserves in excess of $92 million
Issued $22 million in trust preferred securities and entered into a new $12.5 million debt facility
Information pertaining to the Company's business segments is provided in Note 18 of Notes to Consolidated Financial Statements included in Item 8.
The Company maintains loss reserves to cover its estimated liability for unpaid losses and loss adjustment expenses, including legal and other fees as well as a portion of the Company's general expenses, for reported and unreported claims incurred as of the end of each accounting period.
Equity income from AMIC increased $4.2 million to $2.3 million in 2003, compared to a $1.9 million loss for 2002. The Company purchased a 19.9% equity interest in AMIC on July 30, 2002. On April 22, 2003, IHC completed a cash tender offer and acquired 1 million shares of AMIC. On December 22, 2003, IHC acquired an additional 613,401 shares of AMIC, bringing IHC's total ownership percentage to 39%. IHC accordingly recorded its percentage of AMIC's net income under the equity method of accounting. The loss of $1.9 million in 2002 relates to the wind-down of AMIC's previous Internet operations. The current year's income is due to positive results from AMIC's insurance operations.
Pre-tax income for the year ended December 31, 2003 decreased by $7.6 million, representing a loss of $2.1 million in 2003 compared to income of $5.5 million in 2002. This decrease in income is primarily attributable to the gain of $8.1 million in 2002 on the sale of First Standard Holdings Corp. to AMIC; a $1.3 million gain in 2002 on the sale of real estate; and a $.5 million increase in interest expense in 2003 due to the refinancing of existing debt and the issuance of trust preferred securities; partially offset by an increase of $1.8 million in net investment income in 2003 due to a greater amount of invested assets; a $.2 million increase in realized gains; and a $.3 million decrease in all other expenses.
Net income was $15.8 million, or $1.98 per share, diluted, for the year ended December 31, 2002 compared to $14.4 million, or $1.80 per share, diluted, for the year ended December 31, 2001. The Company's income before taxes increased $3.0 million to $25.5 million for the year ended December 31, 2002 from $22.5 million for 2001. The Company had net realized and unrealized losses of $7.6 million in 2002 compared to net gains of $4.3 million in 2001. The net realized and unrealized loss in 2002 is primarily attributable to other than temporary impairments on certain investment securities (see Liquidity). The $3.0 million increase in income before taxes approximately consists of: a pre-tax gain of $8.1 million on the sale of a subsidiary, an increase in profitability from the stop-loss line of business, an increase in income from the group business and a pre-tax gain of $1.3 million on the sale of real estate, partially offset by an increase in net realized and unrealized gains (losses) of $11.9 million. Income tax expense increased $1.5 million to $9.6 million in 2002 from $8.1 million in 2001 reflecting the increase in income and a higher effective income tax rate in 2002.
The Insurance Group's income before taxes decreased $6.2 million to $20.0 million in 2002 from $26.2 million in 2001. These results include net realized and unrealized gains (losses) of $7.5 million in 2002 compared to net gains of $4.3 million in 2001.
Insurance benefits, claims and reserves increased $13.1 million, reflecting an increase of $.2 million at Madison Life and $12.9 million at Standard Life. Madison Life's increase resulted from: a $1.6 million increase in credit life and accident and health reserves due to the increase in premiums; a $.5 million increase in stop-loss reserves due to the introduction of this line of business; and a $.1 million increase in LTD claims and reserves; such increases were offset by: a $1.5 million decrease in group term life reserves due to improved claims experience; a $.3 million decrease in interest expense due to lower rates, and a $.2 million decrease in claims and reserves in other life and health lines of business. The change at Standard Life is comprised of: a $9.9 million increase in medical stop-loss reserves due to the increase in premiums, a $.9 million increase in the HMO reinsurance line due to the increase in losses; a $4.1 million increase in individual annuity reserves resulting from new business; and a $1.6 increase in the provider excess line due to the increase in volume; partially offset by a $1.6 million decrease in personal accident policies due to the commutation of this business in the prior year; a $.6 million decrease in point of service claims due to the decrease in premiums; a $.3 million decrease in DBL claims and reserves due to slightly lower loss ratios; and a $1.1 million decrease in all other lines.
Pre-tax income for the year ended December 31, 2002 increased by $9.2 million, representing income of $5.5 million in 2002 compared to a loss of $3.7 million in 2001. This increase in income is primarily attributable to the gain of $8.1 million on the sale of FSHC, a $1.3 million gain on the sale of real estate, a $.2 million increase in other income and a $.4 million decrease in interest expense due to lower interest rates and debt repayments in 2002, partially offset by a decrease of $.4 million in investment income due to lower returns on certain equity investments and an increase of $.4 million in general and administrative expenses due to salary related expenses.
The Insurance Group normally provides cash flow from (i) operations; (ii) the receipt of scheduled principal payments on its portfolio of fixed income securities; and (iii) earnings on investments. Such cash flow is used partially to finance liabilities for insurance policy benefits. These liabilities represent long-term and short-term obligations which are calculated using certain assumed interest rates.
The nature and quality of insurance company investments must comply with all applicable statutes and regulations which have been promulgated primarily for the protection of policyholders. Of the aggregate carrying value of the Insurance Group's investment assets, approximately 89% was invested in investment grade fixed income securities, cash and cash equivalents, resale agreements and policy loans and at December 31, 2003. Also at such date, approximately 96.3% of the Company's fixed maturities were investment grade. These investments carry less default risk and, therefore, lower interest rates than other types of fixed maturity investments. At December 31, 2003 approximately 3.7% of the carrying value of fixed maturities was invested in diversified non-investment grade fixed income securities (investments in such securities have different risks than investment grade securities, including greater risk of loss upon default, and thinner trading markets). The Company does not have any mortgage loans or non-performing fixed maturities.
The following summarizes the estimated pre-tax change in fair value (based upon hypothetical parallel shifts in the U.S. Treasury yield curve) of the fixed income portfolio assuming immediate changes in interest rates at specified levels at December 31, 2003:
In the Company's analysis of the asset-liability model, a 100 to 200 basis point change in interest rates on the Insurance Group's liabilities would not be expected to have a material adverse effect on the Company. With respect to its liabilities, if interest rates were to increase, the risk to the Company is that policies would be surrendered and assets would need to be sold. This is not a material exposure to the Company since a large portion of the Insurance Group's interest sensitive policies are burial policies that are not subject to the typical surrender patterns of other interest sensitive policies, and many of the Insurance Group's universal life and annuity policies come from liquidated companies which tend to exhibit lower surrender rates than such policies of continuing companies. Additionally, there are charges to help offset the benefits being surrendered. If interest rates were to decrease substantially, the risk to the Company is that some of its investment assets would be subject to early redemption. This is not a material exposure because the Company would have additional gains in its portfolio to help offset the future reduction of investment income. With respect to its investments, the Company employs (from time to time as warranted) investment strategies to mitigate interest rate and other market exposures.
Total investments and cash and cash equivalents increased $107.1 million at December 31, 2003 largely due to the purchase of policy blocks in the fourth quarter of 2003. The $25.9 million increase in insurance policy benefits and the $90.4 million increase in funds on deposit is primarily a result of the purchase in the fourth quarter of 2003. The Company issued $22.7 million in junior subordinated debt securities to its wholly owned unconsolidated trusts, during 2003. The $15.2 million increase in total stockholders' equity is due to net income generated in the year ended December 31, 2003, partially offset by a decrease in unrealized gains on investments and by the net purchase of the Company's common stock.
The Company had the following expected contractual obligations relating to debt, trust preferred securities repayments (junior subordinated debt) and non-cancelable leases at December 31, 2003:
The Company anticipates continued favorable operating performance in 2004 as a result of (i) expansion of the distribution of its Medical Stop-Loss business through greater production by current MGUs, (ii) increased retention of its Employer Medical Stop-Loss business, (iii) its increased equity interest in AMIC, and AMIC's anticipated increase in income, and (iv) increased premium and improved loss ratios from Madison Life's group LTD, group term life and government employees lines and (v) acquisition of blocks of business.
The Company and its affiliates own or have significant equity investments in 7 MGUs, including the AMIC MGUs. The Company anticipates that, taken as a whole, these MGUs will continue to contribute a high percentage of the Insurance Group's premiums in the Medical Stop-Loss line of business in 2004. IHC and its affiliates continue to seek additional strategic MGU investments.
Madison Life anticipates moderate growth in its group LTD, credit and term life lines as a result of increased production and improved loss ratios. In 2000, as a result of Madison Life's 1999 acquisition of a block with $78.0 million in reserves, Madison Life began marketing an individual life product (with annuity riders) to military and civilian government employees, primarily through payroll deduction. This business, which is distributed through independent general agents and brokers who receive commissions, generated $3.6 million of premiums in 2003, which represented a 56.5% increase over 2002. More blocks of business became available in the fourth quarter of 2003 than in prior quarters. The Company believes this trend will continue in 2004 as a result of underwriting, investment and capital losses suffered by the insurance industry in recent years. The Company will continue to review actively acquisitions, and believes that it is well positioned to consummate additional acquisitions should the opportunity arise.
The Company owns 39% of the common stock of AMIC. AMIC is an insurance holding company that is currently engaged in the Medical Stop-Loss business through Independence American and the AMIC MGUs. AMIC's net income for the 2003 fourth quarter and year were positively impacted by a further reduction of the valuation allowance primarily related to AMIC's federal net operating loss carryforward (NOL) deferred tax asset. This reduction increased AMIC's net income by $4.5 million, but did not affect the Company's net income. Rather, in accordance with GAAP, IHC accounted for its share of the deferred tax benefit, amounting to $1.5 million, as a reduction of its goodwill. In the event that AMIC makes further reductions in the valuation allowance in the future, to the extent of its equity interest, the Company will first reduce goodwill until there is none, and then report the balance as equity income.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under Statement 133. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The provisions of SFAS No. 149 are to be applied prospectively. Provisions that relate to Statement 133 implementation issues that have been effective for fiscal quarters than began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. The adoption of SFAS No. 149 did not have an impact on the Company's consolidated financial statements.
At December 31, 2003, $490.3 million of the Company's $593.4 million investment portfolio was invested in fixed income securities. The fair market value of these fixed income securities and the investment income from these fixed income securities fluctuate depending on general economic and market conditions. With respect to the Company's investments in fixed income securities, the fair market value of these investments generally increases or decreases in an inverse relationship with fluctuations in interest rates, while net investment income realized by the Company from future investments in fixed income securities will generally increase or decrease with interest rates. In addition, actual net investment income and/or cash flows from investments that carry prepayment risk, such as mortgage-backed and other asset-backed securities, may differ from those anticipated at the time of investment as a result of interest rate fluctuations. An investment has prepayment risk when there is a risk that the timing of cash flows that result from the repayment of principal might occur earlier than anticipated because of declining interest rates or later than anticipated because of rising interest rates. Historically, the impact of market fluctuations has affected the Company's financial statements. Because all of the Company's fixed income securities are classified as available for sale, changes in the fair market value of the Company's securities are reflected in the Company's accumulated other comprehensive income. No adjustment is made for liabilities to reflect a change in interest rates. Therefore, interest rate fluctuations and economic conditions could adversely affect the Company's stockholders' equity, total comprehensive income and/or cash flows.
Standards of solvency, including risk-based capital measurements, which are a measure developed by the National Association of Insurance Commissioners and used by state insurance regulators to identify insurance companies that potentially are inadequately capitalized;
State insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to the financial condition of insurance companies, holding company issues and other matters.