Our principal offices in Allentown, Pennsylvania occupy two buildings owned by the Company, totaling approximately 37,000 square feet of office space in a 40,000 square foot building and all of a 16,879 square foot building. We also lease additional office space for ancillary operations of our agency subsidiaries and New York staff. On October 26, 2005, we sold the 2.42 acre undeveloped parcel of land located across the street from our home offices.
The following selected consolidated statement of operations data and balance sheet data as of and for the years ended December 31, 2005, 2004, 2003, 2002 and 2001 have been derived from our Consolidated GAAP Financial Statements.
In September, 2001, we ceased new sales nationally until our Plan with the Department was approved. As a result, commission expense, which is materially higher for first year commissions compared to renewal commissions, decreased substantially after 2001.
Our 2001 Centre Agreement required us to accrue an annual expense and risk charge to the reinsurer. Primarily as a result of these anticipated charges, we impaired the value of our net unamortized policy acquisition costs by $61,800 in 2001. In the third quarter of 2002, we impaired the value of our
In 2005 we recorded $1,437 of litigation expense related to the settlement of four lawsuits, three of which had been accrued for in the prior year. In 2004 we recorded $4,150 of litigation expense related to the settlement of one lawsuit and the anticipated settlement of two other lawsuits. There were no material litigation accruals in 2003, 2002 or 2001.
Subsequent to December 31, 2005, we determined that the new administrative system that we were in the process of installing would not yield the benefits and efficiencies to operations that were originally intended. As a result of this determination we have decided not to continue to pursue this project and have impaired its capitalized value through a charge to income of $2,337. There are additional amounts of approximately $600 that were capitalized in 2006 that will also be impaired through a charge to income.
The 2001 Centre Agreement was commuted effective May 24, 2005. We recorded a termination fee of $18,300 in 2005 related to the early commutation of this agreement. As part of the 2001 Centre Agreement, the reinsurer was granted four tranches of warrants to purchase shares of non-voting convertible preferred stock. The warrants were forfeited as part of the early commutation of the agreement. The remaining value of $7,267 was recorded as an expense in 2005.
On November 4, 2005, $46,544, the remaining balance of the convertible debt due 2008, mandatorily converted to 6,649 shares of our common stock. As a result of the conversion, 2005 interest expense declined from 2004.
As a result of the adoption of SFAS No. 142 in 2002, we discontinued the amortization of goodwill. We have provided adjusted results for the fiscal period 2001 that reflects the impact of this accounting change as though SFAS No. 142 had been adopted at that time. Net income would have been increased by $853 in 2001.
impaired and recognized an impairment loss of $5,151, net of related tax effect, which we recorded as a cumulative effect of change in accounting principle.
A one-for-four reverse stock split for current holders of our common stock became effective July 11, 2005. The basic and diluted earning per share amounts, the average shares outstanding and our book value per share for 2004, 2003, 2002 and 2001 have been restated to reflect the impact of the reverse stock split.
On May 25, 2001, we issued approximately 2,887 new shares of our common stock, for net proceeds of $25,726, through a rights offering. We also issued approximately 143 new shares in 2002 through a direct equity placement. In 2003, approximately $2,000 of convertible debt due 2003 was exchanged for new convertible debt due 2008. In addition, we issued approximately $33,000 in new convertible debt due 2008 and used a portion of the proceeds to retire approximately $9,000 in convertible debt due 2003. During 2003, holders of approximately $8,000 of the convertible debt due 2008 converted their debt for approximately 1,250 shares of our common stock. During 2004, holders of approximately $29,500 of the convertible debt due 2008 converted their debt for approximately 4,625 shares of our common stock. During 2005, holders of $40,049 of the convertible debt due 2008 converted their debt for approximately 5,790 shares of our common stock. On November 4, 2005,
$46,544, the remaining balance of the convertible debt due 2008, mandatorily converted to 6,649 shares of our common stock.
On November 4, 2005, the remaining balance of the convertible debt due 2008, $46,544, mandatorily converted to 6,649 shares of our common stock.
During the fourth quarter of 2005, we revised our assumption related to the length of time a policyholder will stay on claim once they have been on claim in excess of three years. As a result of increasing our assumption for the duration of these claims we increased our claim reserves by approximately $42,000.
We accrued additional expenses related to accounting, actuarial and consulting fees, which were incurred in the fourth quarter of 2005. These fees increased due to work related to our increase in claim reserves in the fourth quarter of 2005, our written submission to the SEC related to prospective unlocking and the delay in filing our 2005 Form 10-K.
In 2005 we recorded $1,437 of litigation expense related to the settlement of a lawsuit and the anticipated settlement of two other lawsuits. In the fourth quarter of 2004 we recorded $4,150 of litigation expense related to the settlement of one lawsuit and the anticipated settlement of two other lawsuits. There were no material litigation accruals in 2003, 2002 or 2001.
A one-for-four reverse stock split for current holders of our common stock became effective July 11, 2005. The basic and diluted earning per share amounts, the average shares outstanding and our book value per share for the first quarter of 2005 and all four quarter of 2004 have been restated to reflect the impact of the reverse stock split.
taxes. The entire amount relates to return of premium benefits that should have been paid to policyholders in prior years but due to an error in our process of identifying which policyholders should be paid, not all of the policyholders were properly identified. This process has been corrected in 2005. Although these individual errors are immaterial to the prior periods, the cumulative amount is material to the 2005 financial statements because of the adoption of SAB No. 108 as mentioned above.
Because the $2,318 was recorded in the quarter ended June 30. 2005, this quarter will be restated to reflect the adoption of SAB No. 108. The quarterly data table presents the second quarter of 2005 after the adoption of SAB No. 108.
The use of a voluntary lapse rate that ranges from 1.5% to 43%, depending on the age of the policyholder, the number of years the policy has been in-force and other characteristics. The high end of the lapse rate range is 43%, which is utilized for our more recently issued policies in their first year of issue at policyholder ages of 80 and above. A significant majority of our policyholders are between the ages of 60 to 79 at the time we issue them a policy. The lapse rates for these ages range from a high of 30% in the first year a policy is issued down to 2.5% in the later durations.
We also include an estimate of premium rate increases for certain policies issued prior to 2002, based on the premium rate increases we estimated as of September 30, 2002. This is the last time we revised our assumptions and recorded an impairment to our DAC. We have achieved 100% of these premium rate increases as of June 30, 2006.
In connection with the sale of our insurance policies, we defer and amortize a portion of the policy acquisition costs over the related premium paying periods of the life of the policy. These costs include all expenses that are directly related to, and vary with, the acquisition of the policy, including commissions, underwriting and other policy issue expenses. We defer 27% of new premiums for the general and administrative expenses related to issuing a policy. The premium paying periods of the life of the policy are the same assumptions utilized for persistency in the future benefit reserves.
We assess the recoverability of our unamortized DAC asset on a quarterly basis, through actuarial analysis. To determine recoverability, the present value of anticipated future premiums less future costs and claims are added to current reserve balances. If this amount is greater than the current unamortized DAC, then the DAC is deemed recoverable. If this amount is less than the current unamortized DAC, then we impair our DAC and record a charge in our current period results of operations.
Voluntary lapse rates based on a new study completed in November of 2006, which indicate that policies are lapsing at a slower rate than we previously assumed
The premium rate increases we are filing vary by the policy type, benefit period, underwriting class and the age of the policyholder. The aggregate average increase is approximately 34%, although the policy forms for which we have filed premium rate increase requests have an average increase ranging from 3.2% to 99.1%. The timing of state approvals for premium rate increases varies. Some states will approve the amount we filed within 3 to 4 months of the receipt of the filing while other states will take up to a year and may only approve a portion of the amount we filed. In those situations, we will file for additional premium rate increases as soon as practicable in order to obtain the remaining portion of the premium rate increase, so long as it is still actuarially justified. Therefore, to implement 100% of the premium rate increases may take as long as 3 or 4 years. We have received approval from one state for one of our policy forms in that state as of the date of the filing of the Form 10-K.
We have filed and implemented premium rate increases on most of our in-force policies. We have and are continuing to file and implement additional premium rate increases on the majority of our policies issued prior to 2002. We have been successful in obtaining premium rate increases in the past. However, there has been increased public and regulatory scrutiny and litigation over the practice of obtaining premium rate increases on long-term care insurance.
The second component of the liabilities associated with our policies is a reserve we establish for incurred, either reported or not yet reported, claims. This amount represents the benefits to be paid in the future for our current claims. The significant assumptions utilized in establishing claim reserves are expectations about the duration, cost of care being reimbursed, the interest rate utilized to discount the claim reserves, claims that have been incurred but not yet reported, claims that have been closed but are expected to reopen and assumptions about which claims that are currently in their eligibility review stage will eventually become claims that have payments associated with them. We establish our claim reserves in each period based upon our most currently available information and assumptions.
The cost of care being utilized is also based on our historical experience. In general, a significant portion of our older polices reimburse claimants that are receiving care in a facility on an indemnity basis, meaning that we pay 100% of the maximum daily benefit regardless of the cost of the care provided. Our newer generations of products pay facility claims on a cost incurred basis, meaning that we only reimburse for the cost of care provided up to the maximum daily benefit. However, all of our home health care benefits are paid on a cost incurred basis regardless of when the policy was issued. If our assumptions related to the percentage of the maximum daily benefit that we will pay on claims are higher than anticipated, it could have a material adverse affect on our financial condition and results of operations.
Because our claim payments are made over a period of time, we utilize a discount rate of 5.1% for claim reserves in order to determine the present value of future expected payments. This discount rate approximates the current yield to maturity of our assets supporting this future liability.
We make an assumption that there have been a number of claims that have been incurred but not yet reported. This assumption is based on historical studies related to the number of claims that are reported after the date of the financial statements that have been incurred prior to the date of financial statements. This assumption also reflects recent patterns relating to incidence rates.
The other significant assumption we make is for the likelihood of a reported claim that has not yet had a payment, because it is in its initial eligibility assessment, becoming a claim with payments in the future. This assumption is also based on our past experience.
The Imagine reinsurance agreements (the Imagine Agreement and the 2005 Imagine Agreement) are being accounted for using deposit accounting for reinsurance contracts. We are using deposit accounting because we believe the reinsurance contracts do not result in the reasonable possibility that the reinsurer will suffer a significant loss. We assessed these long duration reinsurance contracts 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 agreements with the intent of commuting the agreements in the future. However, the agreement meets the requirements to qualify for reinsurance treatment under statutory accounting rules, which requires a reinsurance agreement to transfer risk to the reinsurer, but does not require the reasonable probability of a significant loss required under GAAP.
projections include assumptions related to premiums (new sales, persistency, and the timing of premium rate increases), investment income, expense levels, incurred claims (paid claims plus change in claim reserves) and changes in our future policyholder benefits. If there is any negative variance in our assumptions related to these projections, we may not be able to commute the Imagine Agreement on January 1, 2009, as planned, which could have a material adverse affect on our financial condition and results of operations.
Our goodwill relates to the purchase of our insurance agencies, United Insurance Group Agency, Inc. (“UIG”) and Network Insurance Senior Health Division (“NISHD”). We test for impairment of goodwill on an annual basis unless an event occurs or circumstances change that would more likely than not indicate that an impairment has occurred. During 2004 we performed our impairment test on a quarterly basis due to declining sales. The test is done at the reporting unit level, which combines the operations of UIG and NISHD. UIG and NISHD are both insurance agencies that sell senior market insurance products, and therefore have similar economic characteristics.
During our quarterly impairment test as of December 31, 2004, we determined that the goodwill was impaired. This impairment was a result of declining sales, particularly in the fourth quarter of 2004, which led to lower than planned net income at the reporting unit level. The decline in sales is attributable to a decline in sales across the long-term care industry during 2004 as a result of higher priced policies and the negative impact of premium rate increases that have been implemented on previously issued policies. The fair value of the reporting unit is determined utilizing the present value of cash flows, which includes assumptions for future growth in sales. During the impairment test, we lowered the assumptions related to future sales growth and as a result recognized an impairment of $13,376 in 2004. There was no impairment in 2005.
Our principal products are individual, defined benefit accident and health insurance policies that consist of nursing home care and home health care. Our insurance subsidiaries are subject to the insurance laws and regulations of the states in which they are licensed to write insurance. These laws and regulations govern matters such as payment of dividends, settlement of claims and loss ratios. State regulatory authorities must approve premiums charged for insurance products. In addition, our insurance subsidiaries are required to establish and maintain reserves with respect to reported and incurred but not reported claims, as well as estimated future benefits payable under our insurance policies. These reserves must, at a minimum, comply with mandated standards. Our reserves are certified annually by our consulting actuary as to standards required by the insurance departments for our domiciliary states and for the other states in which we conduct business. We believe we maintained adequate reserves as mandated by each state in which we are currently writing business at December 31, 2005 and 2006.
Premium revenue. Total premium revenue earned in the twelve months ended December 31, 2005, decreased 3.2% to $309,516, compared to $319,885 in the same period in 2004.
Net investment income. Net investment income earned in 2005 increased 8.5% to $50,833 from $46,839 in 2004.
Net realized capital (losses) gains. We recorded capital losses of $1,134 in 2005 compared to capital gains of $167 in 2004. We reduced our cost basis on bonds in 2005 by $508 due to differences deemed other than temporary. We reduced our cost basis for these bonds because the fair value for these bonds was below amortized cost for a period of greater than 12 months. The remaining capital losses in 2005 were due to sales of securities that were part of our strategy of shortening the duration of our portfolio and increasing the yield on our portfolio.
Market gain on notional experience account. We recorded a gain on our notional experience account of $48,799 and $39,749 in 2005 and 2004, respectively. Following the commutation of our 2001 Centre agreement in May 2005, we no longer record gains or losses attributable to a notional experience account.
Benefits to policyholders. Total benefits to policyholders in 2005 increased 23.4% to $287,188 compared to $232,698 in 2004. Our loss ratio, or policyholder benefits to premiums, was 92.8% in 2005, compared to 72.7% in 2004. In 2005 our long-term care claim reserves increased approximately $32,400 compared to a decrease of approximately $17.2 million in 2004. The increase in 2005 was primarily a result of an adjustment to our assumption related to the length of time a claim will stay open after it has been open for more than three years along with a change in the discount rate used to set our claim reserves from 5.9% to 5.1%, based on the yield of our portfolio at December 31, 2005. The decrease in 2004 is attributable to:
During 2004, fewer claims that were closed as of December 31, 2003 reopened than we had estimated, resulting in a reduction of approximately $4,500; and
We evaluate our prior year assumptions by reviewing the development of reserves for the prior period. During 2005, reserve amounts relating to December 31, 2004 and prior had an unfavorable development of $28,783. These changes to prior year reserve amounts (particularly when calculated as a percentage of the prior year-end reserve balance) provide a relative measure of deviation in actual performance as compared to our initial assumptions. The adjustments to reserves for claims incurred in prior periods are primarily attributable to claims incurred from our long-term care insurance policies, which represent approximately 96% of our premium in-force. The unfavorable development in 2005 is attributable to the change in our assumption related to the mortality of policyholders that are on claim in excess of three years.
Commissions. Commissions to agents decreased 2.5% to $38,121 in 2005, compared to $39,115 in 2004.
Renewal commissions on accident and health business in 2005 decreased 5.7% to $32,732, compared to $34,708 in 2004 primarily due to the decrease in renewal accident and health premiums. The ratio of renewal accident and health commissions to renewal accident and health premiums was 11.1% in 2005 and 11.3% in 2004. We have implemented premium rate increases on a majority of policies written prior to December 31, 2002. We do not pay commissions on the additional premium collected as a result of a premium rate increase, which reduces the ratio of renewal commissions to renewal premium revenue. We anticipate that this ratio will continue to decline until all premium rate increases are fully implemented.
Net policy acquisition costs amortized. The net deferred policy acquisition costs amortized in 2005 decreased to $5,480, compared to $11,578 in 2004.
General and administrative expenses. General and administrative expenses in 2005 increased 13.6% to $60,185, compared to $52,970 in 2004. The ratio of total general and administrative expenses to premium revenues was 19.4% in 2005, compared to 16.6% in 2004.
Litigation Accrual Expense. During 2005, we accrued $737 for the final resolution of the two lawsuits related to the sale of long-term care policies. In addition we accrued $700 related to the final resolution of two additional lawsuits in 2005. During 2004, we accrued $3,000 related to the anticipated resolution of two lawsuits related the sale of long-term care policies. In addition, we accrued $1,150 in 2004 related to the settlement of a separate lawsuit. (See Item 3 - “Legal Proceedings” for details.)
Loss due to impairment of property, plant and equipment. Subsequent to December 31, 2005, we determined that the new administrative system that we were in the process of installing would not yield the benefits and efficiencies to operations that were originally intended. As a result of this determination we have decided not to continue to pursue this project and have impaired its capitalized value through a charge to income of $2,337. There are additional amounts of approximately $600 that were capitalized in 2006 that will also be impaired through a charge to income.
Excise tax expense. We were subject to an excise tax for premium payments made to a foreign reinsurer under the 2001 Centre Agreement equal to one percent of the net premium revenue ceded to the foreign reinsurer. We recorded $749 and $2,969 for excise tax expenses in 2005 and 2004, respectively. The amount decreased in 2005 due to the commutation of the 2001 Centre Agreement effective May 24, 2005. There are no excise taxes related to the Imagine Agreements.
expense in 2005 and 2004 is primarily related to our convertible subordinated notes, which bore interest at an annual rate of 6.25%. We incurred additional interest expense related to the conversion of our convertible subordinated notes prior to October 15, 2005. Holders of our convertible subordinated notes were entitled to convert their notes into shares of our common stock before October 15, 2005 and receive a discounted amount of interest that they would have otherwise received through October 15, 2005 had they not converted the notes. We incurred $691 of interest expense from the conversion of $40,049 in convertible subordinated notes during 2005. We incurred $2,809 of interest expense from the conversion of $29,499 in convertible subordinated notes during 2004.
In addition, interest expense decreased due to a reduction in outstanding notes as a result of the conversions. The 2008 Notes automatically converted to shares of the Company’s common stock on November 4, 2005. The conversion occurred under the terms of the Notes because the average closing price of the Company’s common stock on the fifteen trading days following October 15, 2005 was greater than 110% of the conversion price of $7.00. There was $46,544 of 2008 Notes outstanding on November 4, 2005. Immediately after the conversion on November 7, 2005, there were 23,269 shares of common stock issued and outstanding.
Benefit (Provision) for federal income taxes. In 2005, we recorded a benefit for Federal income taxes of $8,634 compared to a provision for Federal income taxes of $15,676 in 2004. The effective tax rate was 41.0% in 2005 compared to 43.3% in 2004.
Total renewal premium revenue earned in 2004 decreased 1.7% to $308,699, compared to $314,004 in 2003. Renewal long-term care premiums earned in 2004 decreased 2.0% to $295,959, compared to $301,916 in 2003. The decrease in renewal premium revenue is due to the lapsation of existing policies. We anticipate that we will continue to experience reduced levels of renewal premium revenue until such time as the combination of an increased level of new premiums and the implementation of premium rate increases on policies issued prior to 2002 is sufficient to offset the lapsation of existing policies. Our persistency was 88.7% and 88.1% for the 2004 and 2003 periods, respectively.
Net investment income. Net investment income earned in 2004 increased 8.2% to $46,839, from $43,273 in 2003.
Change in preferred interest on early conversion. The fair value of the embedded derivative as of the date that the option to receive discounted interest was granted was $2,038. Due to the issuance of additional convertible debt in February and November of 2004, we recorded an additional $622, representing the fair values of these embedded derivatives. As of December 31, 2004, we adjusted the embedded derivative to its then fair value of $1,403 by recording a gain of $2,237 compared to a loss of $981 in 2003. The value decreased in 2004 as a result of $29,499 of conversions and the decrease in the value of the interest we would pay upon the conversion due to the shortening of the time period between the date of conversion and October 2005. During 2003, the liquidity of our common stock rose significantly, as did the average daily trading volume, which indicated that the market could absorb additional shares without significant reduction of the market price. As a result, we increased our estimates of the value of the embedded derivative based on an assumption that conversions were more likely to occur without stock price deflation.
Other income. We recorded $5,864 in other income during 2004, as compared to $9,082 in 2003. The income generated from our ownership of corporate owned life insurance policies (“COLI”) decreased to $322 in 2004, compared to $2,036 in 2003. The cash value of these policies is invested in investment grade corporate bonds and equity indexes. We receive a crediting rate, net of insurance costs and fees, for maintaining a stable value of the assets, which was reduced significantly during 2004 due to deterioration in the underlying bond and equity investments of the funds supporting the COLI. In addition, the average balance decreased from approximately $59,000 in 2003 to approximately $53,300 in 2004 due to death benefit payments. The average yield on the income generated from the corporate owned life insurance was 0.22% in 2004, compared to 3.10% in 2003. The commission income related to our agency subsidiaries decreased to $4,979 in 2004 compared to $6,947 in 2003. This decrease was a result of lower sales in 2004, primarily related to the sale of long-term care insurance. The long-term care industry experienced a 25% decrease in new policy sales in 2004 compared to 2003.
We evaluate our prior year assumptions by reviewing the development of reserves for the prior period. During 2004, reserves amounts relating to December 31, 2003 and prior had a favorable development of $19,404 compared to a favorable development of $3,095 during 2003 for reserve amounts relating to December 31, 2002 and prior. These changes to prior year reserve amounts (particularly when calculated as a percentage of the prior year-end reserve balance) provide a relative measure of deviation in actual performance as compared to our initial assumptions.
Refinements to the model we utilized to calculate claim reserves, including the addition of diagnosis code data, payment frequency data, and further delineation of policy forms for purposes of evaluation of existing continuance tables. As a result claim reserves were reduced by approximately $6,000.
Claim reserve adjudication process improvements implemented in the second half of 2003 and throughout 2004.
Renewal commissions on accident and health business in 2004 decreased 10.6% to $34,708, compared to $38,802 in 2003 due to the decrease in renewal accident and health premiums and a reduction in the percentage of renewal premiums paid in the form of renewal commissions. The ratio of renewal accident and health commissions to renewal accident and health premiums was 11.3% in 2004 and 12.5% in 2003. We have implemented premium rate increases on a majority of policies written prior to December 31, 2002. We do not pay commissions on the additional premium collected as a result of a premium rate increase, which reduces the ratio of renewal commissions to renewal premium revenue. We anticipate that this ratio will continue to decline until all premium rate increases are fully implemented.
Litigation Accrual Expense. During 2004, we accrued $3,000 for the anticipated resolution of two lawsuits related to the sale of long-term policies. In addition, we accrued $1,150 related to the settlement of a separate lawsuit. (See Item 3 - “Legal Proceedings” for details.)
Expense and risk charges on reinsurance and excise tax expense. Our reinsurance agreement provides the reinsurer with annual expense and risk charges, which are credited against our notional experience account in the event of future commutation of the agreement. The annual charge consists of a fixed cost and a variable component based upon reserve and capital levels needed to support the reinsured business. In 2004 and 2003, we incurred charges of $11,230 and $11,073, respectively for this item. In addition, we are subject to an excise tax for premium payments made to a foreign reinsurer equal to one percent of the premium revenue ceded to the foreign reinsurer. We recorded $2,969 and $3,065 for excise tax expenses in 2004 and 2003, respectively.
Interest expense. Interest expense in 2004 increased 28.7% to $10,443, compared to $8,112 in 2003. During February and November of 2004, we issued $16,000 and $10,000, respectively of additional convertible subordinated notes. During 2003, we issued $32,421 of additional convertible subordinated notes and paid our entire obligation of $8,957 related to convertible subordinated notes that matured in 2003. Our average outstanding convertible subordinated debt for 2003 was $97,099 compared to $84,884 in 2004. The amount of interest expense related to the outstanding principal balance was $5,302 and $5,974 in 2004 and 2003, respectively.
Our consolidated liquidity requirements have historically been met from the operations of our insurance subsidiaries, from our agency subsidiaries and from funds raised in the capital markets. Our primary sources of cash from normal operations are premiums, investment income and maturities of investments. We have obtained, and may in the future obtain, cash through public and private offerings of our common stock, the exercise of stock options and warrants and other capital markets activities including the sale or exchange of debt instruments. Our primary uses of cash are policy acquisition costs (principally commissions), claim payments to policyholders, investment purchases, deposits to our notional experience account, debt service and general and administrative expenses.
Our cash increased $4,947 in 2005 primarily due to $7,133 from operations, the receipt of $972,656 from the commutation of the 2001 Centre Agreement and the sale of $192,008 of bonds. The major source of cash from operations was premiums received. Cash decreased in 2005 primarily due to the purchase of $1,158,625 in bonds.
Cash flow needs of the Parent Company primarily include operating expenses. The funding is primarily derived from the operating cash flow of our agency subsidiary operations and dividends from the insurance subsidiaries. However, the dividend capabilities of the insurance subsidiaries are limited and we may need to rely upon the dividend capabilities of our agency subsidiaries to meet current liquidity needs.
We have never paid and do not anticipate paying any dividends from the Parent Company to our shareholders in the foreseeable future due to restrictions on the ability of our insurance subsidiaries to pay dividends to the Parent Company.
Additionally, our Plan requires the Department to approve all dividend requests made by PTNA, regardless of normal statutory requirements for allowable dividends. We believe that the Department is unlikely to consider any dividend request in the foreseeable future as a result of PTNA’s current statutory surplus position. Although not stipulated in the Plan, this requirement is likely to continue until such time as PTNA meets normal statutory allowances, including reported net income and positive cumulative earned surplus.
PTNA and ANIC have not paid any dividends to Penn Treaty in 2004, 2005 or 2006 and are unlikely in the foreseeable future to be able to make dividend payments due to insufficient statutory surplus and anticipated earnings. However, our New York subsidiary is not subject to the Plan and in March 2002 we received a dividend from our New York subsidiary of $651,000. The New York subsidiary has not paid any dividends in 2004, 2005 or 2006. Southern Security Life Insurance Company has not paid any dividends to Penn Treaty in 2004, 2005 or 2006.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123R (“SFAS 123R”) “Share-Based Payment”. SFAS 123R replaces SFAS 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion 25, “Accounting for Stock Issued to Employees.” SFAS 123R requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements. SFAS 123R applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments (except for those held by an ESOP) or by incurring liabilities (1) in amounts based (even in part) on the price of the entity’s shares or other equity instruments, or (2) that require (or may require) settlement by the issuance of an entity’s shares or other equity instruments. We have adopted the provisions of SFAS 123R on January 1, 2006, but have not yet determined the impact on our financial position or results of operations.
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement 109” (“FIN 48”). FIN 48 prescribes a comprehensive model for how a company should
recognize, measure, present, and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. The interpretation requires public companies to recognize the tax benefits of uncertain tax positions only where the position is “more likely than not” to be sustained assuming examination by tax authorities. The amount recognized would be the amount that represents the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the taxing authority. A liability would be recognized for any benefit claimed, or expected to be claimed, in a tax return in excess of the benefit recorded in the financial statements, along with any interest and penalty (if applicable) on the excess. FIN 48 will require a tabular reconciliation of the change in the aggregate unrecognized tax benefits claimed, or expected to be claimed, in tax returns and disclosure relating to accrued interest and penalties for unrecognized tax benefits. Discussion will also be required for those uncertain tax positions where it is reasonably possible that the estimate of the tax benefit will change significantly in the next 12 months. FIN 48 is effective for fiscal years beginning after December 15, 2006. We currently are evaluating the impact of adopting FIN 48.
As of January 1, 2005, we discovered errors related to prior period financial statements for the years 1999-2004 that on a cumulative basis total $2,318 on a pre-tax basis and $1,507 net of federal income taxes. The entire amount relates to return of premium benefits that should have been paid to policyholders in prior years but due to an error in our process of identifying which policyholders should be paid, not all of the policyholders were properly identified. This process has been corrected for 2005. Although these individual errors are immaterial to the prior periods, the cumulative amount is material to the 2005 financial statements because of the adoption of SAB No. 108 mentioned above.
We have audited the accompanying consolidated balance sheet of Penn Treaty American Corporation and subsidiaries (the “Company”) as of December 31, 2005 and the related consolidated statements of income and comprehensive income, shareholders’ equity, and cash flows for the year then ended. 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 audit.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Penn Treaty American Corporation at December 31, 2005, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 3 to the consolidated financial statements, the Company changed its method of quantifying the effects of misstatements in 2005 as a result of adopting Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.”
Preferred stock, par value $1.00; 1,250 shares authorized, none outstanding (2)
(2) 2004 adjusted to reflect impact of reverse stock split (See Note 2).
(1) Includes $12,294 of cash and cash equivalents restricted as to use.
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”). PTB was liquidated with no material impact on the financial statements during the year ended December 31, 2003. Intercompany transactions and balances have been eliminated in consolidation.
The Company is licensed in all states and receives renewal premiums from policyholders, but is currently restricted from issuing new policies in six states. The Company is approved for sales in Florida, California and Pennsylvania (subject to Corrective Action Plans or Letter Agreements), which accounted for approximately 16%, 14% and 11%, respectively, of the Company’s direct premium revenue for the year ended December 31, 2005. No other state’s sales accounted for more than 10% of the Company’s direct premium revenue for the year ended December 31, 2005.
The Company regularly assesses the recoverability of DAC through actuarial analysis. To determine recoverability, the present value of future premiums less future costs and claims are added to current reserve balances. If this amount is greater than current DAC, the unamortized amount is deemed recoverable. The Company utilizes its most recent assumptions in the recoverability calculation including an assumption for premium rate increases. If premium rate increases are not approved, the Company will expense, as impaired, the attributed portion of the DAC in the current period. If the Company concludes that DAC is impaired, the Company will record an impairment loss and a reduction in the DAC. In the event of an impairment, the Company will also utilize its most recent assumptions for policy reserves and DAC to reflect current experience (referred to as “unlocking”) going forward. The primary assumptions include persistency, morbidity (claims expectations), investment yields, expenses and premium rate increases. Recoverability of DAC is highly dependent upon the Company’s ability to obtain future premium rate increases. While the Company has been successful in obtaining premium rate increases on existing policies in the past, the ability to obtain these increases is subject to regulatory approval, and is not guaranteed. Management believes the current assumptions and other considerations used to estimate and evaluate the recoverability of DAC are appropriate.
Recognition of actual premium rate increases achieved as well as an estimate related to premium rate increases that the Company began filing in November of 2006. The assumption is that most of these premium rate increases will be implemented beginning in the second half of 2007 through the end of 2008, although the Company also assumes that some of the premium rate increases will be implemented in 2009 and 2010. There is also an assumption related to an increased number of people lapsing due to the premium rate increases and therefore an assumption related to anti-selection as a result of the premium rate increases. Anti-selection is the lapsation of policies held by healthier policyholders, leading to a higher expected ratio of claims to premiums in future periods.
The Company bases its premium rate increase assumptions on its past experience and its expectations of the amounts of actual premium rate increases that it will be able to achieve. If the Company is unsuccessful in obtaining the assumed level of premium rate increases, it could recognize an impairment in the future, which could have a material adverse effect on the Company’s financial condition and results of operations.
Changes in one or a combination of these assumptions can produce significant volatility in the recoverability of DAC.
The goodwill on the Company’s Consolidated Balance Sheets at December 31, 2005 and 2004 relates to the purchase of the Company’s insurance agencies, UIG and NISHD. The Company tests for impairment of goodwill on an annual basis unless an event occurs or circumstances change that would more likely than not indicate that an impairment has occurred. The Company tested for impairment on a quarterly basis during 2004 due to declining sales and recorded an impairment of $13,376 in the fourth quarter of 2004. There was no impairment for the year ended December 31, 2005.
The Company applies deposit accounting for reinsurance agreements that do not meet the risk transfer criteria in Statement of Financial Accounting Standards No. 113 “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts.”
The initial premium and future cash flows from the reinsured policies, less claims payments, ceding commissions, risk charges and certain other charges, was credited to a notional experience account, which was held by the reinsurer for the Company’s benefit in the event of commutation and recapture. The notional experience account balance received an investment credit based upon the total return from a series of benchmark indices and derivative hedges that were intended to match the duration of the reserve liability.
The benchmark indices were comprised of US treasury strips, agencies and investment grade corporate bonds, with weightings of approximately 25%, 15% and 60%, respectively, and had a duration of approximately 14 years. The hybrid instrument subjected the Company to significant volatility as the estimated value of the embedded derivative was highly sensitive to changes in interest rates.
The policy reserve liability is determined using the present value of estimated future policy benefits to be paid to, or on behalf of policyholders, less the present value of estimated future premiums to be collected from policyholders, including anticipated premium rate increases. This liability is recognized concurrent with and as a portion of premium revenue. Policy reserves are computed based on assumptions, including estimates of expected investment yield, mortality, morbidity (claims expectations), persistency and expenses, applicable at the time insurance contracts are effective. The assumptions utilized to determine the policy reserves are established at year of policy issuance and are “locked in” for the future development of reserves (See “Unamortized Deferred Policy Acquisition Costs”). Also see Note 8 for a description of the significant assumptions utilized in establishing the policy reserves.
The Company considers the liability for claim reserves provided to be satisfactory to cover the losses that have occurred. The Company monitors actual experience, and where circumstances warrant, will revise its assumptions. The methods of determining such estimates and establishing the reserves are reviewed continuously and any adjustments are reflected in operations in the period in which they become known. Future developments may result in losses and loss expenses greater or less than the liability for claim reserves.
Accounts payable and other liabilities consist primarily of amounts payable to agents, reinsurers and vendors, accrued post retirement benefits, as well as deferred income items.
Holders of the 2008 Notes (as described in Note 9) were entitled to convert their notes into shares of common stock before October 2005 and receive a discounted amount of interest that they would have otherwise received until that date. This feature was an embedded derivative as defined in Statement of Financial Accounting Standards No. 133 “Accounting for Derivative Instruments and Hedging Activities.” This embedded derivative was not clearly and closely related to the host contract, the convertible subordinated notes, because it could at least double the investor’s initial rate of return on the host contract and could also result in a rate of return that is at least twice what otherwise would be the market return for a contract that has the same terms as the host contract and that involves a debtor with a similar credit quality.
The Company had valued and bifurcated the embedded derivative from the host contract. At each balance sheet date, the embedded derivative was recorded at fair value, with any change in fair value recognized in current operations. The fair value of the embedded derivative was determined based on a number of assumptions including the liquidity and volatility of the Company’s common stock. The amount of time remaining between the date of early conversion and October 15, 2005 also had a significant impact on the fair value of the embedded derivative. As the date got closer to October 15, 2005, the amount of interest to be paid at the time of early conversion was reduced. The 2008 Notes were all converted to shares of common stock in November, 2005, therefore there is no amount recorded for preferred interest on early conversion at December 31, 2005.
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 reflect 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 159, 4,286 and 16,565 for 2005, 2004 and 2003, respectively, which could potentially dilute basic earnings per share in the future.
The Company continues to maintain its accounting for stock-based compensation in accordance with APB No. 25, but has adopted the disclosure provisions of SFAS No. 148.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123R (“SFAS 123R”) “Share-Based Payment.” SFAS 123R replaces SFAS 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion 25, “Accounting for Stock Issued to Employees.” SFAS 123R requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements. SFAS 123R applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments (except for those held by an ESOP) or by incurring liabilities (1) in amounts based (even in part) on the price of the entity’s shares or other equity instruments, or (2) that require (or may require) settlement by the issuance of an entity’s shares or other equity instruments. The Company has adopted the provisions of SFAS 123R on January 1, 2006 but has not yet determined the impact on its financial position or results of operations.
In September 2006, the staff of the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” The interpretations in this SAB express the staff’s views regarding the process of quantifying financial statement misstatements. Specifically, the SEC staff believes that registrants must quantify the impact on current period financial statements of correcting all misstatements, including both those occurring in the current period and the effect of reversing those that have accumulated from prior periods. This SAB should be applied beginning with the first fiscal year ending after November 15, 2006, with early adoption encouraged. The Company has elected to adopt SAB No. 108 early, and it is therefore effective for the Company’s financial statements for the year ended December 31, 2005.
SAB No. 108 permits companies to initially apply its provision either by (1) restating prior financial statements or (2) recording the cumulative effect of initially applying the methodology for quantifying errors described in SAB No. 108 as adjustments to the carrying values of assets and liabilities as of January 1, 2005 with an offsetting adjustment recorded to the opening balance of retained earnings. The Company has elected to record the effects of applying SAB No. 108 using the cumulative effect transition method. The following table summarizes the effects of applying the guidance in SAB No. 108:
The Company reduced its cost basis on bonds in 2005 by $508 due to differences deemed other than temporary. The Company reduced its cost basis for these bonds because the fair value for these bonds was below amortized cost for a period of greater than 12 months. There were no differences deemed to be other than temporary during 2004 or 2003. The following table describes the Company’s debt securities at December 31, 2005, which had a market value below cost:
All of the securities were evaluated considering factors such as financial conditions, near-term, and long-term prospects of the issuer and were determined to have adequate resources to fulfill contractual obligations. As of December 31, 2005, the Company had the ability and intent to hold these investments for a period of time sufficient for them to recover in value.
Net investment income is applicable to the following types of investments:
Effective June 30, 2005, the Company entered into a reinsurance agreement with an unaffiliated reinsurer for policies issued prior to January 1, 2002 on a funds withheld basis. As a condition precedent to withholding the funds due to the reinsurer, the Company has agreed to hold assets in trust for the benefit of the reinsurer. The amount required to be held in trust at December 31, 2005 was $920,525.
During 2005 and 2004, the notional experience account activity was as follows (See Note 1 for a description of the notional experience account):
Policy reserves have been computed principally by the net premium method based upon estimated future investment yield, mortality, morbidity (claims experience), withdrawals, expenses and other benefits. The Company employs a prospective net premium methodology, which incorporates premium rate increases expected to be implemented in the near term in the net premium used to establish policy reserves. The composition of the policy reserves at December 31, 2005 and 2004, and the assumptions pertinent thereto are presented below:
The use of a voluntary lapse rate that ranges from 1.5% to 43%, depending on the age of the policyholder, the number of years the policy has been in-force and other characteristics. The high end of the lapse rate range is 43%, which is utilized for the more recently issued policies in their first year of issue at policyholder ages of 80 and above. A significant majority of policyholders are between the ages of 60 to 79 at the time they are issued a policy. The lapse rates for these ages range from a high of 30% in the first year a policy is issued down to 2.5% in the later durations.
An estimate of premium rate increases for certain policies issued prior to 2002, based on the premium rate increases that were estimated as of September 30, 2002. This is the last time the assumptions utilized in our policy reserves were locked-in following a DAC impairment. The Company has achieved 100% of these premium rate increases as of June 30, 2006.
Because the Company’s claim payments are made over a period of time, the Company utilizes a discount rate of 5.1% at December 31, 2005 for claim reserves in order to determine the present value of future expected payments. This discount rate approximates the current yield to maturity of the Company’s assets supporting this future liability. The Company utilized a discount rate of 5.9% at December 31, 2004.
The Company also makes an assumption related to improvements in our claims adjudication processes that the Company believes will result in lower benefits expense than historical experience would indicate. These improvements, some of which have been fully implemented and some of which are in the process of being implemented, include, but are not limited to:
The use of an in-house nursing staff to establish and manage plans of care for a larger number of claims than in the past,
The Company evaluates its prior year assumptions by reviewing the development of reserves for the prior period (i.e. incurred from prior years). This amount includes imputed interest from prior year-end reserve balances plus adjustments to reflect actual versus estimated claims experience. These adjustments (particularly when calculated as a percentage of the prior year-end reserve balance) provide a relative measure of deviation in actual performance as compared to its initial assumptions. The adjustments to reserves for claims incurred in prior periods are primarily attributable to claims incurred from our long-term care insurance policies, which represent approximately 96% of our premium in-force.
In 2004, prior year incurred claims developed favorably by $19,404 compared to prior period expectations. The favorable development is due to:
purposes of evaluation existing continuance tables. As a result claims reserves were reduced by approximately $6,000.
An increase in the discount rate used for claims reserves from 5.7% to 5.9%, reflecting improved investment portfolio performance, which reduced claims reserves by approximately $1,000.
During 2005 and 2004 the activity in long-term debt was as follows:
During 2005 and 2004, holders of $40,049 and $29,499 of the Notes elected to convert their Notes into 5,721 and 4,214 shares of the Company’s common stock, respectively, and also received 69 and 373 shares, respectively, as payment for preferred interest on early conversion. In addition, $38 was paid in cash. In connection with these conversions, the Company recognized additional interest expense of $691 and $2,809 for the years ended December 31, 2005 and 2004, respectively. On November 4, 2005, $46,544, the remaining balance of the convertible debt due 2008, mandatorily converted to 6,649 shares of our common stock.
The Company has net operating loss carryforwards of $34,188, or $11,966 on a tax effected basis, which have been generated by taxable losses by the nonlife group, and if unused will expire between 2012 and 2025. The Company has net operating loss carryforwards of $25,016, or $8,755 on a tax effected basis, which have been generated by taxable losses at the Company’s life insurance subsidiaries, and if unused, will expire in 2016.
The nonlife group’s net operating loss carryforwards can be utilized by the Company’s life insurance subsidiaries subject to certain limitations. The Company has recorded a valuation allowance of $8,275 against its net operating loss carryforwards.
A reconciliation of the income tax benefit (provision) computed using the federal income tax rate to the (benefit) provision for federal income taxes is as follows:
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 for these subsidiaries as reported in accordance with statutory accounting principles, are as follows:
Total reserves, including claim reserves, reported to regulatory authorities were approximately $927,655 and $861,820 less than those recorded for GAAP as of December 31, 2005 and 2004, respectively. This difference is primarily attributable to reinsurance agreements in force as of December 31, 2005 and 2004.
required the Company to enter into a reinsurance treaty with Centre Solutions (Bermuda) Limited through which PTNA and ANIC reinsured 100% of their individual long term
care insurance business in effect on December 31, 2001. This treaty was commuted effective May 24, 2005 and the Company entered into a new reinsurance agreement with Imagine International Reinsurance Limited effective June 30, 2005.
Submit quarterly reports to the Department of Insurance demonstrating all claims that have been assumed by Imagine.
In August of 2006 PTNA agreed to temporarily suspend new sales of Florida insurance policies pending the filing of its 2005 statutory audit report and the review by the Florida OIR. Florida represented approximately 6% of new business applications prior to the temporary suspension. In November of 2006 PTNA entered into a revised voluntary consent agreement with the Florida OIR to recommence sales. The major provisions of the voluntary consent agreement, with which PTNA must comply in order to continue writing new policies in Florida include, but are not limited to the following:
PTNA will continue to file monthly financial reports, as it has since 2002, with the Florida OIR.
The Company is in compliance with all the terms of the consent orders as of the date of this filing. In the event that PTNA fails to maintain compliance with Florida laws or the above requirements, the Florida OIR
will notify PTNA and could require it to take corrective action. If the Department of Insurance determines that the corrective action is not timely, PTNA’s Certificate of Authority could be suspended and it could be required to cease writing new direct business in Florida until such time as it took any required corrective action. The voluntary consent agreement may be modified by the Florida OIR in the event of deteriorating financial performance on the part of PTNA. In addition PTNA may seek removal of the conditions of the voluntary consent agreement in the future if its financial strength improves or its ratings with either A.M. Best Company or Standard and Poor’s increases.
The Company has a 401(k) retirement plan, covering substantially all employees with at least one year of service. Under the plan, participating employees may contribute up to 25% of their annual salary on a pre-tax basis. The Company, under the plan, equally matches 100% of employee contributions up to the first 3% of the employee’s salary. The Company and employee portion of the plan is vested immediately. The Company’s expense related to this 401(k) plan was $326, $269 and $240 for the years ended December 31, 2005, 2004 and 2003, respectively. The Company may elect to make a discretionary contribution to the plan, which will be contributed proportionately to each eligible employee. The Company did not make a discretionary contribution in 2005, 2004 or 2003.
A 6.0% weighted average discount rate was assumed in determining both the benefit obligation at December 31, 2005 and 2004 and to determine the net periodic benefit cost for the years ended December 31, 2005 and 2004.
The assumed health care cost trend rates at December 31, 2005 and 2004 are:
At December 31, 2005, the Company had three stock-based compensation plans, which are described below. The Company applies APB Opinion No. 25 in accounting for its plans. The Company issues options at the current market value and does not record a charge to earnings upon the issuance of options. While the Company continues to maintain its accounting for stock-based compensation in accordance with APB Opinion No. 25, it has adopted the disclosure provisions of SFAS No. 148.
The Company’s 1987 Employee Incentive Stock Option Plan provided for the granting of options to purchase up to 300 shares of common stock. This plan expired in 1997 and was subsequently replaced by the 1998 Employee Non-Qualified Incentive Stock Option Plan. No new options may be granted under the 1987 Plan. The 1998 Plan allows for the grant of options to purchase up to 150 shares of common stock.
In May 2005, PTNA initiated arbitration against a reinsurer with respect to certain reinsurance agreements that cede the risk of certain home health care claims that extend beyond 36 months. The reinsurer alleged that PTNA was in breach of its agreement as a result of entering into the 2001 Centre Agreement without the prior written approval of the reinsurer. PTNA contested this assertion of breach based upon its verbal and written notification to the reinsurer prior to entering into the 2001 Centre Agreement, and its belief that the 2001 Centre Agreement substantially improved PTNA’s financial strength and actually benefited the reinsurer. The arbitration proceeding was held in November 2006, however prior to the arbitration panel’s issuance of its final award, the parties entered into a confidential settlement agreement under which the reinsurer agreed to resume its obligations under the excess coverage reinsurance agreement and the parties agreed to reconcile all premiums and losses for the period from 2002 through June 30, 2006.
requirements to qualify for reinsurance treatment under statutory accounting rules, which requires a reinsurance agreement to transfer risk to the reinsurer, but does not require the reasonable probability of a significant loss required under GAAP.
The Imagine Agreement allows the Company to withhold all funds due to the reinsurer as a funds withheld liability, which is only recorded for statutory accounting purposes. In addition, the agreement allows the Company to recapture the reinsured policies on any January 1, commencing January 1, 2008. In the event the Company elects to commute the agreement and recapture the reinsured policies, it will be entitled to an experience refund equal to the funds withheld liability (except as further described below). For deposit accounting purposes, the experience refund and the funds withheld liability are offset as a net deposit amount.
The expense allowance from the reinsurer, limited to a maximum of 25% of premiums collected, is equal to:
As noted above, the Imagine Agreement contains commutation provisions and allows the Company to recapture the reinsured policies as of January 1, 2008, or on January 1 of any year thereafter. If the agreement is commuted on January 1, 2008, the Company will be obligated to pay an early termination fee equal to two quarters of expense and risk charges. The Company intends, but is not required, to commute the agreement on January 1, 2009. Additionally, the agreement contains certain covenants and conditions that, if breached, may result in the immediate commutation of the agreement and the payment of all expense and risk charges from the period of the breach through January 1, 2008. The company was not in violation of these covenants as of and for this period ended December 31, 2005 or as of the date of the filing of this Form 10-K.
In order to commute the agreement and remain in compliance with requisite regulatory minimum standards, the Company will need to have a risk based capital ratio (“RBC”) of at least 200%. While the Company’s current modeling and actuarial projections suggest that its RBC ratio will be at or slightly above 200% and therefore it will be able to commute the 2001 Imagine Agreement on January 1, 2009, the Company also believes that it should have an additional margin for any adverse development in order to recapture the block of business. The Company believes that alternatives such as modifications to the current reinsurance agreement, new reinsurance agreements, or additional capital issuances are available to obtain the necessary margin, if needed. These projections include assumptions related to premiums (new sales, persistency, and the timing of premium rate increases), investment income, expense levels, incurred claims (paid claims plus change in claim reserves) and changes in the Company’s future policyholder benefits. If there is any negative variance in its assumptions related to these projections, the Company may not be able to commute the Imagine Agreement on January 1, 2009, as planned, which could have a material adverse affect on its financial condition and results of operations. In the event the company determines that commutation of the Imagine Agreement is unlikely on or before January 1, 2009, but likely at some future date, it will include additional annual expense and risk charges in its unamortized 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.
The agreement further requires that the Company maintain its financial position in good standing, including covenants regarding its financial strength ratings and RBC. The agreement provides for the reinsurer to require the immediate repayment of the funds withheld liability in the event of a deterioration of the Company’s financial strength. As a result of such deterioration, the Company’s expense and risk charges could be increased by 25 percent, although any additional expense and risk charges would be refunded, with interest, upon commutation of the agreement if on or before January 1, 2010.
The Company recorded an expense and risk charge of approximately $130 for the year ended December 31, 2005.
Upon the entrance of the 2001 Centre Agreement, the reinsurer was originally granted four tranches of warrants to purchase shares of non-voting convertible preferred stock. The warrants were forfeited as part of the early commutation. The value of the warrants was recorded as a deferred reinsurance premium and was being expensed over the life of the reinsurance agreement. The remaining value of approximately $7,300 was recorded as an expense in the second quarter of 2005.
In addition the Company also had a coinsurance agreement with General Re Life Corporation on a previously acquired block of long-term care business, whereby 66% was ceded to a third party. Subsequent to December 31, 2005, this coinsurance agreement was recaptured as part of our arbitration with General Re Life Corporation. The reinsurance recoverable balance was $5,871 and $5,887 at December 31, 2005 and 2004, respectively. See Note 21 “Subsequent Events” for a description of the recapture of this reinsurance agreement.
The Company has an agreement with Lincoln Heritage Life Insurance Company to cede 100% of certain whole life and deferred annuity policies on an assumption basis effective December 31, 2002. Upon approval from state insurance departments in which the policies were issued, or policyholder approval as may be prescribed by state regulation, we will no longer record these policies in our financial statements.
In 2001, the Company ceded substantially all of its disability policies to Assurity Life Insurance Company on a 100% quota share assumption basis. All policies have been legally assumed by Assurity Life Insurance Company as of December 31, 2005 and there is no reinsurance recoverable balance at December 31, 2005. The reinsurance recoverable balance at December 31, 2004 was $3,256.
Irv Levit Insurance Management Corporation, an insurance agency which is owned by our former Chairman and Chief Executive Officer, now Founding Chairman, currently produced approximately $17, $21 and $13 of renewal premiums for some of our subsidiaries for the years ended December 31, 2005, 2004 and 2003, respectively, for which it received commissions of approximately $3, $4 and $3, 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 $227, $452 and $433 for the years ended December 31, 2005, 2004 and 2003, respectively.
A member of the Company’s board of directors and the chairman of its audit committee was a senior executive with Advest, Inc., an investment banking firm, which has provided investment banking services in the past and that the Company engaged as a financial advisor in a past offering of its 6 1/4% Convertible Subordinated Notes due 2008. This firm received $580 in advisory fees in 2003. There were no advisory fees paid in 2005 and 2004.
A member of the Company’s board of directors had in the past been a principal and had an ownership interest in U.S. Care, Inc., a marketing organization to which the Company paid commissions of $181, $170 and $165 in 2005, 2004 and 2003, respectively. The Company also made a loan of $100, with interest applied at 9%, to U.S. Care, Inc. in 2001, which is guaranteed by renewal commissions payable to the Company in future periods. The outstanding balance on the loan was $90 and $106 at December 31, 2005 and 2004, respectively. The outstanding balance was paid in full in 2006.
Fair values are based on quoted market prices. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The fair value amounts presented do not purport to represent and should not be considered representative of the underlying value of the Company.
Investments - The fair values of fixed maturities are based on quoted market prices. It is not practicable to determine the fair value of policy loans since such loans are not separately transferable and are often repaid by reductions to benefits and surrenders.
Notional experience account - The fair value of the notional experience account reflects the market value of the underlying benchmark indices, which are comprised of US treasury strips, agencies and investment grade corporate bonds.
Cash and cash equivalents - The statement value approximates fair value.
Long-term debt - The convertible, subordinated debt, as a publicly traded instrument, has a readily accessible fair market value, and, as such, is reported at that value. This value incorporates the fair value of the preferred interest on early conversion liability.
In 2005 and 2004, holders of $40,049 and $29,499, respectively, of the Company’s Notes elected to convert their notes into shares of the Company’s common stock. As a result, the Company issued 5,721 and 4,214 shares and issued additional shares of 69 and 373 as early payment of interest otherwise payable through October 15, 2005 during 2005 and 2004, respectively. In addition, $38 was paid in cash. On November 4, 2005, $46,544, the remaining balance of the convertible debt due 2008, mandatorily converted to 6,649 shares of the Company’s common stock.
The Company recorded $508 in interest expense related to the lease for the year ended December 31, 2005.
In December 2006 the Company entered into a release and settlement agreement with General Re Life Corporation relating to two reinsurance agreements. Under the terms of this agreement General Re Life Corporation will resume its obligations under the excess of loss reinsurance treaties. As a result of this settlement, the Company released a contingency reserve of approximately $1,000. For the quota share agreement General Re Life Corporation has agreed to pay the Company $5,200 to recapture the business, effective October 1, 2006. As a result of the recapture, the Company has recorded the policy and claim reserves related to this business and recorded a loss of approximately $800.
Bonds available for sale at market (amortized cost of $4,345 and $2,242, respectively)
Less 229 of common shares held in treasury, at cost (1)