(1) The earnings per share amounts prior to 1997 have been restated as required to comply with Statement of Financial Accounting Standards (Statement) No. 128, "Earnings Per Share". For further discussion of earnings per share and the impact of Statement 128, see the notes to the consolidated financial statements.
Liquidity is the ability of an enterprise to generate adequate amounts of cash to meet its financial commitments. The major needs for cash are to enable Central to pay claims and expenses as they come due. Central's primary sources of cash are premiums and investment income. Central's payments consist of current
Liabilities accrued for future policy benefits and policy claims payable increased 6% to $81,090,299 at December 31, 1997 from $76,650,884 in 1996 or about $4 million. Certain group accident and health reserves increased approximately $5.5 million, to $55.5 million from $50 million, however this increase was offset by surrenders of annuity policies during the year. Shareholders' equity decreased to $1,511,842 due to the 1997 operating loss, which included the strengthening of reserves and costs incurred relative to seeking additional capital. Although the Company's consolidated equity was $1,511,842, including unrealized gain of $611,264, Central's statutory capital and surplus was $24,650,804 at December 31, 1997. Central's capital and surplus includes the $14 million surplus note and the benefit of the $10 million ceding allowance from the Hannover reinsurance treaty.
Central, the major operating subsidiary, suffered a large decrease in its statutory capital and surplus in 1996 which was primarily due to the $9,321,633 statutory loss. This decrease caused Central to fall under the regulatory action level (RAL) imposed by the Ohio Department of Insurance under the recently adopted Risk-Based Capital (RBC) requirements on insurance enterprises.
Early in 1997, A.M. Best lowered Central's rating from B+ to B due to the losses and decrease in capital and surplus in 1996. Central continued to have losses in 1997 due to an increase in claim payments and a decrease in premiums, due to lapses, and a decrease in new business written. Because of the financial problems of Central, the Company engaged an investment banker to seek additional capital. In the fourth quarter of 1997, the Company entered into the Original Stock Purchase Agreement with Strategic Acquisition Partners (Strategic Partners) pursuant to which the Company would issue and sell 5,000,000 Common Shares and
warrants to purchase an additional 2,500,000 Common Shares at an exercise price of $6.50 per share for an aggregate purchase price of $27,500,000. On March 30, 1998, the Company revised its agreement with Strategic Partners and entered into an amended and restated Stock Purchase Agreement (the "New Stock Purchase Agreement") with Strategic Partners and two additional investors, Insurance Partners, L.P. and Insurance Partners Offshore (Bermuda), L.P. (collectively, "Insurance Partners"). Pursuant to the New Stock Purchase Agreement, the Company will issue and sell 7,300,000 Common Shares at $5.50 per share and warrants to purchase an additional 3,650,000 Common Shares at an exercise price of $5.50 per share for an aggregate purchase price of $40,150,000. The Company hopes to obtain shareholder and regulatory approval and to close the transaction by June 30, 1998. Concurrent with the signing of the Original Stock Purchase Agreement, Strategic Partners arranged for an interim loan of $20 million to the Company. The loan is due June 30, 1998 and bears interest at the prime rate. Proceeds from the loan, received in December 1997, were used to pay off a $5.2 million bank loan and a contribution of $14 million, in the form of a surplus note, to Central.
Also in December 1997, Central entered into a reinsurance treaty with Reassurance Company of Hannover (Hannover). The reinsurance is on a 50/50 quota-share basis on certain group accident and health policies in force and written during 1997. The treaty provided an initial ceding allowance of $10 million which increased the surplus of Central. The combination of the surplus note and the ceding allowance added $24 million to the statutory capital and surplus of Central. The reinsurance treaty also reduced Central's risk exposure under RBC by approximately 50% and with the additional surplus placed Central above the action levels under RBC at December 31, 1997.
The only long-term debt the Company had at December 31, 1997, was $8,399,028, which is the principal amount payable under a loan secured by a mortgage on the Company's home office building. The Company entered into the loan agreement in 1990 for $9 million for a term of 10 years bearing interest at 9 1/2% per annum with a 30 year amortization period payment schedule. At the same time, the Company also entered into a 15 year lease agreement with Central for 100% of the space. The Company will use the monthly rental payments to pay, among other expenses, the required mortgage loan payments.
During 1997 premiums increased slightly to $258,859,307 from $258,175,337. The group life and health segment accounted for 99% of the premiums in 1997. The group certificates in force decreased about 10% to 104,687 in 1997 compared to 116,304 at the end of 1996. Certificates issued for new group policies were 30,377 in 1997, down 17% from 36,574 in 1996. Total lapses (net of additions/decreases) in 1997 were 41,994, up 24% from 33,990 in 1996. Overall the major reason for the flat growth in premiums, decrease in certificates and increase in lapses can be attributed to the financial condition of Central in 1997 and 1996. The large losses and related decrease in statutory surplus discouraged new business and required large rate increases. Although unprofitable business did terminate, it terminated faster than new profitable business was being issued. The lowering of Central's A.M. Best rating, to B from B+, also had a negative effect on the sale of ordinary life and annuity policies during 1997. With the addition of $24 million to Central's statutory surplus from the surplus note of $14 million, to the Company, and the $10 million resulting from a reinsurance treaty, the Company anticipates an increase in new business certificates and a return to a normal lapse ratio in 1998 and future years.
Net investment income decreased about 2% to $6,527,537 in 1997 from $6,700,741 in 1996. A decrease in invested assets and a negative cash flow in 1997 were the primary reasons for the decrease.
Commissions remained fairly level in 1997, $35,525,295 compared to $35,654,815 in 1996 primarily due to premiums remaining flat.
Operating expenses increased 6% to $39,242,350 or 15.2% of premiums in 1997 compared to $36,874,665 or 14.3% of premiums in 1996. Although salaries, benefits and premium taxes remain the largest portions of the total operating expenses, other operating expenses increased due to the costs incurred relative to seeking additional funds for capital and surplus during 1997 for Central.
The net loss for 1997 was $20,956,356 or $5.01 per share compared to $9,288,365 or $2.25 per share in 1996. The Company's revenues increased approximately $647,000, however claims and expenses increased over $7 million, the majority being in claims. Central's group accident and health business represented 98% of the revenues and a higher loss ratio from this segment has a negative effect on earnings. The statutory loss ratio for the group accident and health segment increased to 81.7% in 1997 compared to 77.9% in 1996. Although the losses were higher in 1997, Central received $14 million from the Company and issued a surplus
note for the $14 million and received a $10 million ceding allowance from a reinsurance treaty, both of which increased Central's statutory capital and surplus. At December 31, 1997, Central's statutory capital and surplus was $24,650,804, which was above any regulatory action levels.
The Federal income tax returns for the Company and its subsidiaries have been examined by the Internal Revenue Service (IRS) for 1991 and 1992. During the third quarter of 1994, the IRS issued a proposal for adjustments to the Company's returns for 1991 and 1992. The proposed deficiencies were approximately $2.4 million of which $215,303 was paid in 1994 and $590,000 paid in 1997. The balance primarily deals with whether or not the Company's primary subsidiary, Central, qualified as a life company, for tax purposes. The Company is vigorously protesting the proposed deficiency and based on discussions with counsel management believes existing law supports the Company's position. Therefore, the Company has not recorded a liability for the difference. The tax case is currently on the May 18, 1998 trial calendar of the United States Tax Court at Cleveland, Ohio, but it is expected that the case will be submitted as a legal issue, i.e., without the need for a trial.
During 1996, premiums increased 11% to $258,175,337 from $233,168,529 in 1995. The increase was primarily in the group life and health segment which accounted for about 98% of total premiums. Group certificates in force increased about 2% to 116,304 in 1996 compared to 113,720 at the end of 1995. Certificates issued for new group policies were 36,574 in 1996, down 18% from 44,398 in 1995. A more aggressive pricing in 1996 and additional competition were the cause for the decrease. Total lapses (net of additions/decreases) in 1996 were 33,990 up slightly from 33,637 in 1995. Overall, the lapse ratio was in line with the Company's expectations and consistent with the industry average for small group business.
Net investment income increased about 4% to $6,700,741 in 1996 from $6,454,038 in 1995. The increase was primarily due to an increase in rates. The Company continued to invest in short-term investments to provide any cash requirements needed for claims.
In the risk-based capital (RBC) plan that Central filed on March 7, 1997 with the Ohio Department of Insurance (ODI), Central identified certain conditions that contributed to the regulatory action level (RAL)
The conditions increased Central's claims expense thereby increasing its losses and reducing its capital and surplus below the levels required under the RBC rules. The Company took certain remedial steps, increasing the rates being charged for the new product and increasing the renewal rates as policyholders' anniversary dates arrived. The interim targets established by Central were designed to increase the rates on a monthly basis over a twelve month period to complete the renewal of all policyholders of the PMO product. At the end of March 31, 1997, Central reached its target of increasing rates for all renewal policyholder plans since the rate actions started on April 1, 1996.
Commissions increased 7% to $35,654,815 in 1996 from $33,411,203 in 1995 primarily due to the increase in premiums. As a percentage of premiums they were 13.8% in 1996 and 14.3% in 1995.
Inflation has had an impact on claim costs and overall operating costs and although it has been lower in the last few years, hospital and medical costs have still increased at a higher rate than general inflation. While to a certain extent these increased costs are offset by interest rates (investment income), hospital charges increased, while the rate of income from investments has not increased proportionately. The Company will continue to establish premium rates in accordance with trends in hospital and medical costs along with concentrating on various cost containment programs. However, there can be no assurance that these efforts by the Company will fully offset the impact of inflation or that premiums will equal or exceed increasing health care costs.
In 1996 Congress passed the Health Portability and Accountability Act of 1996, which provides for changes in the health insurance market and went into effect in July 1997. It guarantees the availability and renewability of health insurance coverage for certain employees and individuals, and limits the use of preexisting condition restrictions. The Act creates federal standards for insurers, health maintenance organizations (HMO's), and employer plans, including those who self-insure. It permits, however, substantial state flexibility for compliance with the requirements on insurers. The Company cannot predict the ultimate timing or effect of any legislative efforts, and no assurance can be given that any such efforts will not have a material adverse effect on the Company's business and results of operations.
In October 1995, the Financial Accounting Standards Board (FASB) has issued Statement of Financial Accounting Standards (Statement) 123, "Accounting for Stock-Based Compensation", which was effective for the Company for the year ended December 31, 1996. The Statement prescribes accounting and reporting
In 1997, FASB issued Statement No. 128, "Earnings per Share." Statement 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to Statement 128 requirements.
In 1997, FASB issued Statement No. 129, "Disclosure of Information about Capital Structure." Statement 129, which is applicable to all companies, consolidates the existing guidance in the authoritative literature relating to an entity's capital structure. Capital structure disclosures required by Statement 129 include liquidation preferences of preferred stock, information about the pertinent rights and privileges of the outstanding equity securities, and the redemption amounts for all issues of capital stock that are redeemable at fixed or determinable prices on fixed or determinable dates. Statement 129 is effective for financial statements for periods ending after December 31, 1997 and is not expected to be material to the consolidated financial statements.
In 1997, FASB issued Statement No. 131 "Disclosures About Segments of an Enterprise and Related Information." Statement 131 significantly changes the way public companies report segment information in annual financial statements and also requires those companies to report selected segment information in interim financial reports to shareholders. The Statement supersedes FASB Statement 14 on segments. It does not apply to nonpublic enterprises or to not-for-profit organizations. The FASB concluded that the "industry
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 ================================================================================
The consolidated financial statements include several major financial transactions that took place in the fourth quarter of 1997. In conjunction with the Stock Purchase Agreement entered into, the Company entered into a $20 million loan agreement. Proceeds from the loan were used to pay off a $5.2 million bank loan and to contribute $14 million to Central, in the form of a surplus note. Also, Central entered into a reinsurance treaty that provided an additional $10 million of statutory surplus. Although these amounts are eliminated from the Company's shareholder's equity, for statutory purposes they are accounted as additions to Central's capital and surplus.
In 1996, Central experienced substantial losses incurred in connection with the newly-issued insurance plans, greater utilization than anticipated, new state mandates, such as guaranteed issue and preventive benefits, and overall reductions in profitability arising out of industry-wide pricing competition. In response to these losses, the Company pursued a variety of alternatives to raise equity capital for the purpose of resolving the Company's immediate financial concerns created by the magnitude of these losses.
Additionally, Central entered into a retroactive reinsurance treaty in December 1997 with Reassurance Company of Hannover (Hannover). The reinsurance was effective January 1, 1997 and is on a 50/50 quota-share basis on certain group accident and health policies in force and written during 1997. The treaty provided an initial ceding allowance of $10 million which was accounted for as a deferred reinsurance gain in the consolidated financial statements and accounted for as special surplus on a statutory basis. The Hannover treaty, in combination with the $14 million surplus note provided to Central through the Bridge Loan described above, is an integral part of returning Central to statutory surplus levels in excess of the regulatory risk-based capital requirements (RBC). Central, in accordance with section 3907.12 of the Ohio Revised Code, was not required to have written permission of the Ohio superintendent of insurance to enter into the treaty, since it was less than 80% of its risk. However, as a matter of normal practices, Central did discuss and communicate the terms of the Hannover treaty with the Ohio Department of Insurance (ODI) and did not receive any objection. Central did receive an opinion from an outside actuary that the Hannover treaty was in compliance with the relevant sections of Rule 3901-3-07 of the Ohio Insurance Regulations that establishes accounting requirements for insurers regarding reinsurance ceded. As with any agreement, a risk exists that the ODI could question the statutory accounting treatment by Central at its next examination. If, for some reason, the ODI were to reverse the reinsurance accounting treatment, Central's RBC levels would fall below the regulatory action level requiring specific communications to and response form the ODI. Central has had meetings and discussions with the ODI and has no reasons to believe the accounting treatment currently being used would be reversed.
The Health Insurance Portability and Accountability Act of 1996, which provides for changes in the health insurance market became effective in July 1997. It guarantees the availability and renewability of health insurance coverage for certain employees and individuals, and limits the use of preexisting condition restrictions. The Act creates federal standards for insurers, health maintenance organizations (HMOs), and employer plans, including those who self-insure. It permits, however, substantial state flexibility for compliance with the requirements on insurers.
Liabilities for future policy benefits on ordinary life insurance have generally been provided on a net-level premium method based upon estimates of future investment yield, mortality and withdrawals using Central's experience and actuarial judgment with an allowance for possible unfavorable deviation from the expected experience. Future policy benefits for annuity policies in the accumulation phase have been calculated based on the participant's aggregate account values. The Company amortizes deferred costs of all ordinary life policies for Central over the benefit period. The liability for future policy benefit reserves has been computed using the following assumptions:
Life premiums are recognized as revenues as they become due. Benefits and expenses are reported in a manner which results in the recognition of profits over the life of the policy. Such recognition is accomplished
through the provision of liabilities for future benefits over the life of the contract and the amortization of acquisition costs over the benefit period.
The Company follows Statement 109, "Accounting for Income Taxes". Under the asset and liability method of Statement 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Following is a listing of investments, except for bonds and notes of the U.S. Government or of a U.S. Government agency or authority, which exceeds ten percent of shareholders' equity at December 31, 1997:
Claim reserves are estimates of amounts needed to pay reported and unreported claims based on facts and circumstances known at the time the reserves are established. Reserves are based on historical claims information, industry statistics and other factors. The establishment of appropriate reserves is an inherently uncertain process, and there can be no assurance that the ultimate liability will not exceed recorded claim reserves. A larger number of unexpected and unanticipated prior year claims were paid in 1997, resulting in a large reserve deficiency at December 31, 1996.
The RBC guidelines define specific capital levels based on a company's ACL that are determined by the ratio of the company's total adjusted capital (TAC) to its ACL. TAC is equal to statutory capital, plus or minus certain other specified adjustments. The specific capital levels, in declining order, and applicable ratios are generally as follows: "Company Action Level" where TAC is less than or equal to 2.0 times ACL; "Regulatory Action Level" where TAC is less than or equal to 1.5 ACL; "Authorized Control Level" where TAC is less than or equal to 1.0 times ACL; and, "Mandatory Control Level" where TAC is less than or equal to 0.7 times ACL. Companies at the Company Action Level must submit a RBC financial plan to the insurance commissioner of the state of domicile. Companies at the Regulatory Action Level are subject to a mandatory examination or analysis by the commissioner and possible required corrective actions. At the Authorized Control Level, a company is subject to, among other things, the commissioner placing it under regulatory control. At the Mandatory Control Level, the insurance commissioner is required to place a company under regulatory control. At December 31, 1996, Central's TAC was $17,137,515 or 1.4 times its ACL and accordingly, Central was at the Regulatory Action Level.
At December 31, 1997, the Company has a tax net operating loss (NOL) carryforward of approximately $10 million for Federal income tax purposes which expires in 2012. The Company also has an Alternative Minimum Tax (AMT) credit carryforward for Federal income tax purposes which can be used indefinitely. Future changes in ownership, as defined by sections 382 and 383 of the Internal Revenue Code, could limit the amount of NOL and AMT carryforwards used in any one year.
The Company determines a valuation allowance based on an analysis of amounts recoverable in the statutory carryback period, anticipated future taxable income and available tax planning strategies. In assessing the valuation allowance established at December 31, 1997 and 1996, estimates were made as to the potential financial impact on the Company of recent NOLs and the Company's financial condition described in Note 1. In establishing the valuation allowance, management considered the recent magnitude of operating losses, the anticipated closing of the New Stock Purchase Agreement (see Note 1) and the Company's revised business plan, including institution of expense controls and revised product development and underwriting guidelines developed in connection with entering into the New Stock Purchase Agreement. Management believes that the Company will generate sufficient future taxable income to realize the entire deferred tax asset prior to the expiration of any NOLs and that the realization of a $1.3 million net deferred tax asset is more likely than not. There can be no assurance, however, that the Company will generate enough taxable income to realize the net deferred tax asset prior to the NOLs expiring.
Concurrent with the signing of the Original Stock Purchase Agreement, the Company entered into a $20 million loan on December 16, 1997. The note is due June 30, 1998 and interest is payable monthly at the prime rate as in effect from time to time (8.5% at December 31, 1997). The note is collateralized by 100% of the common shares of Central. If Shareholder approval of the New Stock Purchase Agreement is not obtained, it is likely that the Company will not have the ability to repay the $20 million loan and will be required immediately to locate an alternate source of financing to meet its obligations and to fund its operations. There can be no assurance that the Company would be able to obtain such a refinancing at all or on terms that are favorable to the Company or its Shareholders, particularly in light of Central's current financial position and its recent efforts to obtain financing. The Company's failure to obtain sufficient financing within the requisite time may entitle Strategic Partners to exercise its rights as a secured creditor, including by foreclosing upon all of the common shares of Central which were pledged to Strategic Partners as collateral for the loan. As the Company is a holding company with no operations and limited assets, such foreclosure upon the Company's principal asset could result in the Common Shares having little or no value, make it impossible for the Company to continue operations, and/or force the Company to seek protection under federal bankruptcy law.
In February 1997, FASB issued Statement No. 128, "Earnings Per Share". The Company adopted Statement 128, as required, for its December 31, 1997 consolidated financial statements. Prior years have been restated where appropriate. For the years presented, the Company presents both basic and diluted earnings (loss) per share. Basic earnings (loss) per share is computed by dividing the income (loss) available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings (loss) per share reflects the potential dilution that could occur if common stock equivalents (options/warrants) were exercised and then shared in the earnings of the Company.
As a result of the adoption of Statement 128 in 1997, the Company's reported earnings (loss) per share for 1996 and 1995 were restated. The effect of this accounting change on previously reported earnings (loss) per share was as follows:
The maximum amount of exposure that Central retains is $50,000 on ordinary life and group life. No retention is maintained over age 70. Maximum retention on impaired risks is $10,000. Central also has reinsurance on group accident and health claims. Effective January 1, 1995, Central's reinsurance treaty provides that all individual claims in excess of $500,000 are 100% reinsured. In 1997, Central recovered only about $12,000 in claims. Central also entered into a 50/50 quota-share retroactive reinsurance treaty effective January 1, 1997 on certain group accident and health policies. Under the provisions of the treaty, Central cedes 50% of the premiums for these policies and in return receives reimbursement for 50% of the claims plus a commission and expense allowance. The overall effect of reinsurance is normally not material to Central's financial position and results of operations however, in 1997, the Hannover treaty provided surplus relief (see Note 11) which was material for Central in 1997. Reinsurance treaties in effect at December 31, 1997 were with The Cologne Life Reinsurance Company, Life Reassurance Corporation of America, Business Men's Assurance Company and Reassurance Company of Hannover.
Charges for the leases were $1,080,372, $768,352 and $1,069,723 for 1997, 1996 and 1995, respectively. Future net minimum payments for the operating leases are as follows:
The Company's Chief Executive Officer entered into a five year Employment Contract effective January 1, 1997 through December 31, 2001. However, effective January 1, 1998, he entered into a new Employment Contract, which supplanted the prior five year contract, and his compensation is set at $500,000 for 1998 and 1999 and predicated on an incentive based compensation program for 2000 and 2001. His compensation in 1997 was $966,994.
The Company has authorized 2,000,000 Non-Voting Preferred Shares, without par value. The Company has never issued any Non-Voting Preferred Shares, however, the Board of Directors is authorized at any time to provide for the issuance of, such shares in one or more series, and to determine the designations, preferences, limitations and other rights of the shares issued. Holders of Non-Voting Preferred Shares shall have no voting rights except as required by law. For each series, the Board of Directors shall determine, prior to the issuance of any shares thereof, the designations, preferences, limitations and relative or other rights thereof, including but not limited to the dividend rate, liquidation price, redemption rights and price, sinking fund requirements, conversion rights and restrictions on the issuance of such shares.
The Company adopted a noncontributory pension plan in 1978. The plan is a defined contribution money purchase pension plan with an outside company, covering substantially all full-time employees of age 20 1/2 or more who have completed six months or more of service. Participants in the plan begin vesting after two years of service and are fully vested after seven years. The contribution was approximately $1,308,000 for 1997, $1,214,000 for 1996 and $1,137,000 for 1995. In November 1997, the Company amended its pension plan, effective January 1, 1998, to a 401(k) plan, which does not require Company contributions, but permits eligible employees to contribute, subject to certain limitations.
Effective December 31, 1995, the Company redefined its reporting segments, merging the group life and group accident health segments together, as well as combining the life and annuity segments. These alignments fit the Company's current operating organization and produce three segments: group life and health; life insurance and annuities; and corporate and other, which consists of primarily interest income and interest expense.
These techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Although fair value estimates are calculated using assumptions that management believes are appropriate, changes in assumptions could cause these estimates to vary materially. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in the immediate settlement of the instruments. Statement 107 excludes certain assets and liabilities from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
INVESTMENT SECURITIES: Fair value for fixed maturity securities is based on quoted market prices, where available. For fixed maturity securities not actively traded, fair value is estimated using values obtained from independent pricing services.