In December 2001, we signed a promissory note and mortgage due December 31, 2011, with a current outstanding principal amount of $6.4 million at December 31, 2004, used to finance our home office building consisting of 56,000 square feet and located at 10689 North Pennsylvania Street, Indianapolis, Indiana. Approximately 43,000 square feet of the building is leased to Standard Life pursuant to a lease agreement entered into on December 28, 2001. The remaining space is used by Standard Management and U.S. Health Services. We expect that Standard Life will continue to lease approximately 22,000 square feet from us in the event that the sale of Standard Life is consummated as anticipated.
U.S. Health Services leases approximately 30,000 square feet in an office and warehouse building located at 6210 N. Technology Center Drive, Indianapolis, Indiana. The lease expires April 2007.
The purchase price under the Agreement is $79.5 million, subject to adjustment as described below, which will be payable as follows: (i) $5 million of a new class of 7% cumulative exchangeable preferred stock of Capital Assurance, (ii) assumption by Capital Assurance of approximately $21 million in intercompany obligations of Standard Management to Standard Life and (iii) the balance of the purchase price in cash. The cash portion of the purchase price will be adjusted, post-closing, based on certain changes in the business of Standard Life occurring between October 1, 2004 and the closing of the transaction, including adjustments for, among other things, statutory gains from operations of Standard Life, credit related capital gains and losses, including impairment losses, principal payments on the surplus debentures and capital expenditures by Standard Life. Management currently estimates that based on anticipated adjustments, the post-closing, as adjusted purchase price will be approximately $83 million.
The Agreement provides termination rights for both Standard Management and Capital Assurance, and further provides that, upon termination of the Agreement under specified circumstances, Standard Management may be required to pay Capital Assurance a termination fee ranging from $1.6 million to $3.2 million, depending on the circumstance leading to the termination, plus reimbursement of up to $2 million of expenses incurred by Capital Assurance in connection with the transaction since November 21, 2004.
If the proposed sale is consummated, we estimate that, for federal income tax purposes, we will recognize a capital loss on the sale of approximately $22 million, equal to the difference between our adjusted tax basis in Standard Life and the amount realized from the proposed sale. We may recognize a tax benefit in future periods from this capital loss provided that we recognize capital gains within five years. In addition, for accounting purposes, we would expect to record a loss on the sale of approximately $35 million, which is equal to the difference between the expected net book value of the assets sold on the sale date and the purchase price expected to be paid by Capital Assurance in the proposed transaction, plus transaction related expenses.
This Annual Report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Exchange Act of 1934. All statements, trend analyses, and other information contained in this Annual Report on Form 10-K relative to markets for our products, trends in our operations or financial results, statements relating to our ability to consummate the proposed sale of Standard Life and our belief as to the ultimate purchase price for Standard Life, if such sale is consummated, as well as other statements that include words such as “anticipate”, “believe”, “plan”, “estimate”, “expect”, “intend” and other similar expressions, constitute forward-looking statements. These forward-looking statements
are subject to known and unknown risks, uncertainties and other factors, which may cause actual results to be materially different from those contemplated by the forward-looking statements. Such factors include, but are not limited to:
• The ability of our management team to successfully operate a health services business with the limited industry experience.
• Our ability to expand our health services business both organically and through acquisitions, including our ability to identify suitable acquisition candidates, acquire them at favorable prices and successfully integrate them into our business.
• General economic conditions and other factors, including prevailing interest rate levels, and stock market performance, which may affect our ability to obtain additional capital when needed and on favorable terms.
• The availability and terms of future acquisitions in our health services segment.
• The risk factors or uncertainties listed from time to time in any document incorporated by reference herein.
• Regulatory changes or actions, including those relating to regulation of financial services affecting bank sales and underwriting of insurance products, regulation of the sale, underwriting, and pricing of insurance products.
We caution you that, while forward-looking statements reflect out good faith beliefs, these statements are not guarantees of future performance. In addition, we disclaim any obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise, except as required by law.
Our profitability depends in large part upon the amount of assets under our management, investment spreads we earn on our policyholders’ account balances, our ability to manage our investment portfolio to maximize returns and minimize risks such as interest rate changes, defaults or impairment of assets, our ability to manage costs of the options purchased to fund the interest credits on our equity indexed annuities, our ability to manage the costs of acquiring new business (principally commissions to agents and first year bonuses credited to policyholders) and our ability to manage our operating expenses.
The long-term profitability of life insurance and annuity products depends on the accuracy of the actuarial assumptions that underlie the pricing of such products. Actuarial calculations for such insurance products, and the ultimate profitability of such products, are based on four major factors: 1) mortality, 2) persistency, 3) return on cash invested by the insurer during the life of the policy and 4) expenses of acquiring and administering the policies.
Variances Between Actual and Expected Profits. Actual experience on purchased and produced insurance may vary from projections due to differences in investment spreads, mortality costs, persistency, administrative costs and other factors. Variances from original projections, whether positive or negative, are included in net income as they occur. To the extent that these variances indicate that future experience will differ from the estimated profits reflected in the capitalization and amortization of the PVFP and DAC assets, current and future amortization rates may be adjusted.
Net amortization of DAC related to operations was $26.1 million, $22.9 million and $19.0 million for the years ended December 31, 2004, 2003 and 2002, respectively. The increase in current year amortization expense resulted primarily from the emergence of gross profits from business sold in recent years. Future expected amortization of DAC, assuming no new business after December 31, 2004 and current assumptions, is as follows (in thousands):
Costs relating to the acquisition of new business, primarily commissions paid to agents, which vary with and are directly related to the production of new business, are deferred to the extent that such costs are recoverable from future profit margins. At the time of issuance the acquisition expenses, approximately 10% of our initial annuity premium deposits are capitalized as DAC. In accordance with SFAS 97, DAC with interest is amortized over the lives of the policies in a constant relationship to the present value of estimated future gross profits.
Accounting for Equity Indexed Annuities. Revenues and expenses for equity-indexed annuities are recognized in accordance with the SFAS 97 model, described above. Policy liabilities for equity-indexed annuities are computed in accordance with SFAS 133, which requires that an equity-indexed annuity liability be bifurcated into a “host contract” and a “derivative contract”. The host contract liability is a book value liability providing for the equity-indexed annuity policy’s guaranteed benefits. The derivative contract liability is a market value liability providing for the equity-linked benefits available in the policy. The derivative liability includes a liability for equity-linked benefits accruing during the current contract year, as well as liability amounts for future equity benefits which have not yet been granted.
Accounting for Traditional Life Products. Traditional life insurance products are accounted as long-duration insurance contracts in accordance with Statement of Financial Accounting Standards No. 60 (“SFAS 60”), “Accounting and Reporting by Insurance Enterprises”. Under SFAS 60, benefit reserves are actuarially calculated using the net level reserve method. Revenues consist of policy premiums and investment income on assets supporting policy liabilities. Expenses consist of policy benefits incurred, increases in policy liabilities, and operating costs for policy administration, and amortization of DAC.
Immediate annuities with payments contingent on the survival of the annuitant are accounted as limited-payment contracts in accordance with SFAS 60, with revenue recognition, expense recognition, and liabilities computed as described above for traditional life products.
The accounting polices described below require us to make significant estimates and assumptions using information available at the time the estimates are made. Such estimates and assumptions significantly affect various reported amounts of assets and liabilities. We have made estimates in the past that we believed to be appropriate but were subsequently revised to reflect actual experience. If our future experience differs materially from these estimates and assumptions, our results of operations and financial condition could be affected. Accordingly, we consider them to be critical in preparing our consolidated financial statements. A more detailed description of our accounting policies is included in the Notes to our Consolidated Financial Statements.
The carrying value of our investment portfolio was $1.7 billion in Financial Services at December 31, 2004. The accounting risks associated with these assets relate to the recognition of income, our determination of other-than-temporary impairments and our estimation of fair values.
When we sell a security, we report the difference between the sales proceeds and amortized cost (determined based on specific identification) as a realized investment gain or loss.
Determining what constitutes an other-than-temporary decline involves significant judgment. Declines in fair value below cost not considered other-than-temporary in the current period could be considered other-than-temporary in a future period and reduce earnings to the extent of the write-down.
Each year, we evaluate the recoverability of the unamortized balance of the DAC and PVFP. We consider estimated future gross profits or future premiums, expected mortality or morbidity, interest earned and credited rates, persistency and expenses in determining whether the balance is recoverable. If we determine a portion of the unamortized balance is not recoverable, it is charged to amortization expense.
The assumptions we use to amortize and evaluate the recoverability of the DAC and PVFP involve significant judgment. A significant revision to these assumptions will impact future financial results. We recorded no charge for 2004 and a charge of $7.9 million for 2003 related to the acceleration of DAC amortization due to DAC unlocking.
Our income tax expense includes deferred income taxes arising from temporary differences between the financial reporting and tax basis of assets and liabilities and capital loss carryforwards. We have gross deferred income tax assets of $69.5 million at December 31, 2004. In assessing the realization of our deferred income tax assets, we consider whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of our deferred income tax assets depends upon generating future taxable income during the periods in which our temporary differences become deductible and capital gains before our capital loss carryforwards expire. We evaluate the recoverability of our deferred income tax assets by assessing the need for a valuation allowance on a quarterly basis. If we determine that it is more likely than not that our deferred income tax assets will not be recovered, a valuation allowance will be established against some or all of our deferred income tax assets. This could have a significant effect on our future results of operations and financial position.
Other Services : Net loss for 2004 was $2.7 million, compared to a net loss of $2.8 million for 2003.
General: Our Financial Services segment consists of revenues earned and expenses incurred from our insurance operations. Our primary products include deferred annuities, equity-indexed annuities and single premium immediate annuities. The profitability of this segment is primarily a function of net investment spread (the difference between the investment income earned on our investments less the interest we credit to our policyholders), persistency of the in force business, mortality experience and management of our operating expenses.
• Deposits collected for interest sensitive annuities and other financial products for 2004 decreased $173.3 million or 41%, to $247.8 million. Deferred annuities decreased $77.0 million or 60%, to $52.4 million. Equity indexed annuities decreased $54.7 million or 44%, to $70.6 million. Single premium immediate annuities and other deposits decreased $41.5 million or 25%, to $124.3 million.
Deposits collected decreased in 2004 and 2003 due to management actions to preserve spread income in response to market conditions. These actions included reducing crediting rates, and temporarily suspending sales of selected products. Additionally, deposits collected decreased in 2004 due to the market’s reaction to the announced sale of Standard Life, as more fully described in “Recent Developments” above.
Premium income consists of premiums earned from 1) annuity products that incorporate significant mortality features and 2) traditional life products.
• Premium income for 2003 decreased $.2 million or 3%, to $8.9 million.
Premium income decreased during 2004 and 2003 primarily as a result of policy lapses and surrenders.
Policy income increased during 2004 and 2003 primarily as a result of an increase in policy surrender charges.
• During 2004, net investment income increased $.4 million or 1% to $83.3 million. Average cash and invested assets, at book value, increased by $122.7 million or 8% due to the growth in insurance liabilities from annuity sales in recent periods.
• During 2003, net investment income increased $7.1 million or 9% to $82.9 million. Average cash and invested assets, at book value, increased by $348.6 million or 29% due to the growth in insurance liabilities from annuity sales in recent periods.
Fees and other income consist of fee income related to servicing unaffiliated blocks of business and experience refunds.
• During 2004, fees and other income increased by $.2 million or 54% to $.5 million.
• During 2003, fees and other income decreased by $.4 million or 55% to $.3 million. This decrease results from the termination of a marketing and administration contract in 2002.
Net realized investment gain (loss) fluctuate from period to period and generally arise when securities are sold in response to changes in the investment environment. Realized investment gains may affect the timing of the amortization of DAC and the amortization of the PVFP.
We maintain a high quality investment portfolio with 99% of our fixed maturity securities classified as investment grade securities as of December 31, 2004 and 2003.
• During 2004, benefits and claims decreased by $5.0 million or 38%, to $8.0 million. Benefits and claims were lower in 2004 primarily due to favorable mortality experience for our in-force life policies and lower premium levels.
• During 2003, benefits and claims increased by $3.0 million or 30%, to $13.0 million. Benefits and claims were higher in 2003 primarily due to increased death claims and other benefits for our in-force life policies and increased benefit payments for our supplemental contracts including life contingencies.
• During 2004, interest credited decreased $15.6 million or 21.7%, to $56.0 million, of which $11.3 million related to equity indexed annuity products and the remaining $44.7 million related to all other interest sensitive annuity and life insurance products. Interest credited decreased $15.9 million due to the impact of lower equity market returns on equity indexed products. Interest credited increased $7.4 million due to a 9% increase in average interest sensitive liabilities of $139 million compared to 2003 partially offset by $7.1 million of reductions due to reduced crediting rates.
• The weighted average credited rate on interest sensitive liabilities, including equity indexed annuities, for 2004 and 2003 were 3.30% and 4.62%, respectively. The decrease in average credited rate was due to the impact of less favorable equity market performance on equity indexed annuity crediting rates, and lower crediting rates on non- equity indexed business. When offset by gains on call option assets used to hedge equity indexed annuity liabilities, the “effective” crediting rates for 2004 and 2003 were 3.15% and 3.84%, respectively, a reduction of .69% from the prior period.
Amortization includes 1) amortization of deferred policy acquisition costs related to capitalized costs of insurance business sold and 2) amortization related to the present value of polices purchased from acquired insurance business.
• During 2004, amortization decreased $6.1 million to $27.8 million. In 2003, the amortization total included an unlocking charge of $7.9 million plus additional amortization due to capital gains of $9.1 million was partially offset by higher 2004 amortization of $10.7 million due to increased spread and policy income margins.
• During 2003, amortization increased by $23.3 million or 219%, to $33.9 million. This increase relates primarily to net realized gains and higher annuity sales volume, offset by lower gross profits. We recorded a charge of $7.9 million and $7.8 million for 2003 and 2002, respectively, related to the acceleration of DAC amortization due to DAC unlocking.
• During 2004, operating expenses increased by $1.2 million or 15%, to $9.6 million. Operating expenses increased as a result of our capitalizing $.4 million less operating expense during 2004 as a decline in annuity sales from $421 million for 2003 to $248 million in 2004, did not result in a corresponding decline in variable costs. In addition, operating expenses in 2004 increased by $.4 million due to corporate reallocations and $.3 million due to start up costs for new fee generation initiatives.
• During 2003, sales increased $1.1 million or 59.4%, to $2.9 million.
• During 2004, net realized investment loss represents the loss on the sale of Medical Care & Outcomes, LLC.
• During 2003, expenses increased $5 million or 245.1% to $7.1 million due to the continued development of U. S. Health Service’s operating platform and infrastructure, as well as ongoing concentrated marketing initiatives.
• During 2004, federal income tax benefit was $0 due to a 100% valuation allowance on the net loss in 2004.
• During 2003, we reversed the federal income tax benefit we recorded in 2002 and we recorded a 100% valuation allowance on the net loss.
• During 2004, operating income - affiliated remained unchanged at $5.5 million.
• During 2003, operating income - affiliated increased $.6 million or 12%, to $5.5 million due to increased rental income.
• During 2004, commission income decreased to $0 due to the sale of the assets of Savers Marketing.
• During 2003, commission income decreased $1.8 million or 73%, to $.6 million due to the sale of the assets of Savers Marketing.
• During 2004, commission expenses decreased to $0 due to the sale of the assets of Savers Marketing.
• During 2003, commission expenses decreased $.8 million or 99%, to $10,000 due to the sale of the assets of Savers Marketing.
• During 2003, other operating expenses remained unchanged at $6.5 million.
• During 2003, interest expense and financing costs increased $.1 million or 2%, to $4.4 million.
Our International Operations (discontinued operations) were sold in 2002. The 2002 results included revenues earned and expenses incurred from abroad, primarily Europe, and included fees collected on our deposits from unit-linked assurance products. The profitability of this segment primarily was dependant on the amount of separate account assets under management, the management fee charged on those assets and management of our operating expenses. Net income for this operation before we sold it for 2002 was $1.1 million and we realized an initial gain of $6.9 million that year upon the sale. Loss from the sale of discontinued operations in 2003 is due to the Company settling a purchase price adjustment resulting in a $.3 million charge.
Historically, from a parent company perspective, available cash from our existing working capital and from the sources described above would be anticipated to be sufficient to fund our cash requirements for the following year. However, while we expect that such sources will be sufficient to fund our operations until the completion of our pending sale of Standard Life, we expect to have available approximately $27.5 million of net cash proceeds from that sale to fund our subsequent operations and our growth strategies for our U.S. Health Services business. Should the cash proceeds from the sale of Standard Life be substantially reduced from our current expectation (as may be the case as described in the following paragraph), we will need to obtain additional sources of funds in order to grow our health services business in accordance with our current plan. There can be no assurances that such funding will be available under terms and conditions that are favorable to use, if at all.
While we fully anticipate the sale of Standard Life to be consummated and for such sale to provide significant net cash proceeds to the Company, the following paragraphs assume that such sale does not occur in order to describe our liquidity circumstances in that event (as well as our circumstances up through the date of sale.)
Surplus Debenture Interest. We loaned $27.0 million to Standard Life pursuant to unsecured surplus debenture agreements (“Surplus Debentures”), which requires Standard Life to make quarterly interest payments at a variable corporate base rate plus 2% per annum, and annual principal payments of $1.0 million per year beginning in 2007 and concluding in
Management Fees. Pursuant to a management services agreement, Standard Life paid $ 3.6 million during 2004 and 2003 for certain management services related to the production of business, investment of assets and evaluation of acquisitions. In addition, Dixie Life paid Standard Life $.9 million and $.7 million in 2004 and 2003, respectively, for certain management services provided. Both of these agreements provide that they may be modified or terminated by the applicable Departments of Insurance in the event of financial hardship of Standard Life or Dixie Life. In 2005, we expect to receive management fees of $3.6 million from Standard Life, assuming a full year ownership of Standard Life.
Equipment Rental Fees. In 2004, we received $1.1 million from Standard Life for the use of our equipment and we expect to receive the same amount in 2005, assuming a full year ownership of Standard Life.
Lease Income. Effective January 1, 2002, we entered into a lease agreement with Standard Life whereby Standard Life leases approximately 43,000 square feet of our corporate headquarters in Indianapolis. During 2004, we received approximately $.8 million in lease income from Standard Life and we expect to receive the same amount in 2005, assuming a full year ownership of Standard Life. Also associated with this lease, Standard Life is responsible for its share of building maintenance expenses. During 2004, we received $.3 million in maintenance expenses. We expect to receive $.3 million in maintenance expense in 2005, assuming a full year ownership of Standard Life.
• approximately $17.7 million for the repayment in full of a bank line of credit;
• approximately $6 million to purchase certain assets from Standard Life at closing pursuant to the Agreement;
• approximately $1 million to fund incentive payments in connection with obtaining the consent of the trust preferred holders;
• principal and interest payments: $57,000 per month through December 2011;
• interest payments required in 2005 based on current balances will be $.4 million;
The following are characteristics of our senior secured credit agreement at December 31, 2004:
The following are characteristics of our 6% Convertible Notes Due 2008 at December 31, 2004:
• interest payments: $.17 million to be paid in each of 2005, 2006 and 2007.
• Conversion price of $4.20 per share of Standard Management common stock.
• interest payments: $.12 million to be paid in 2005, $.23 million to be paid in each of 2006, 2007 and 2008, $.12 million to be paid in 2009;
• annual distribution rate of 10.25%; distributions may be deferred up to 20 consecutive quarters;
General. On a consolidated basis, we reported net cash provided by operations of $53.5 million and $26.8 million for 2004 and 2003, respectively. Although deposits received on our interest-sensitive annuities and other financial products are not included in cash flow from operations under GAAP, these funds, after returns to policyholders, are also available. Cash generated on a consolidated basis is available to the parent company only to the extent that it is generated at the holding company level or is available through interest, dividends, management fees or other payments from our subsidiaries.
At December 31, 2004, we had “parent company only” cash and short-term investments of $.4 million. These funds are available for general corporate purposes. Our “parent company only” operating expenses, not including interest expense, were $6.1 million and $5.5 million for 2004 and 2003, respectively.
Contractual Obligations. In our day-to-day business activities, we incur certain commitments to make future payments under contracts such as operating leases and purchase orders. Maturities under these contracts, excluding policyholders contracts, are set forth in the following table as of December 31, 2004 (in thousands) and do not assume the sale of Standard Life and related transactions:
The policies and annuities issued by Standard Life contain provisions that allow certain policyholders to withdraw or surrender their policies under defined circumstances. These policies and annuities generally contain provisions, which apply penalties or otherwise restrict the ability of policyholders to make such withdrawals or surrenders. Standard Life closely monitors the surrender and policy loan activity of its insurance products and manages the composition of its investment portfolios, including liquidity, to ensure it has sufficient cash resources in light of such activity.
Changes in interest rates may affect our incidence of policy surrenders and other withdrawals. In addition to the potential effect on liquidity, unanticipated withdrawals in a changing interest rate environment could adversely affect our earnings if we were required to sell investments at reduced values to meet liquidity demands. We manage our asset and liability portfolios in order to minimize the adverse earnings effect of changing market interest rates. We seek assets that have duration characteristics similar to the liabilities that they support. We also prepare cash flow projections and perform cash flow tests under various market interest rate scenarios to assist in evaluating liquidity needs and adequacy. Our insurance subsidiaries currently expect available liquidity sources and future cash flows to be adequate to meet the demand for funds.
We believe that the operational cash flow of Standard Life will be sufficient to meet our anticipated needs for 2005. As of December 31, 2004, Standard Life had statutory capital and surplus for regulatory purposes of $69.2 million. As the annuity business produced by Standard Life increases, Standard Life expects to satisfy statutory capital and surplus requirements through statutory profits and through additional capital contributions by Standard Management. Net cash flow from operations on a statutory basis of Standard Life, after payment of benefits and operating expenses, was $(48.7) million and $139.8 million for 2004 and 2003, respectively. The decrease is primarily due to a decline in annuity premium deposits and an increase in surrenders. If the need arises for cash, which is not readily available, additional liquidity could be obtained from the sale of invested assets.
If the sale of Standard Life takes place, we will no longer derive revenues or cash flows from our financial services business and our future value will depend almost entirely on our health services business.
The possibility of a failure to complete the sale of Standard Life could have serious negative implications.
If we fail to obtain the necessary consents in the trust preferred consent solicitation and nevertheless elect to proceed with the proposed sale of Standard Life under the terms of the Agreement, the net cash proceeds available for the operation and expansion of our health services business will be significantly reduced.
The price of our common stock has demonstrated increased volatility upon the announcement of a proposed sale of Standard Life and may continue to do so upon the consummation of the sale and could decline below recent levels. In the event of a significant and sustained decline, our stock could be delisted from the NASDAQ National Market.
Our common stock has exhibited increased volatility upon the announcement of the sale of Standard Life and may continue to do so on the consummation of the sale of Standard Life. Depending upon investor acceptance of the proposed transaction, the price of the stock could decline below recent levels. If such decline were severe and sustained, NASDAQ could initiate action to delist our shares from the NASDAQ National Market, which could further negatively impact the price and/or marketability of the shares.
• our ability to access reasonably priced capital that will provide long-term flexibility for the Company;
• our ability to execute a planned strategy that will provide for cash flow from operations which will fund growth; and
• our ability to acquire appropriately priced and profitable businesses that provide cash flow and synergies to our current business.
Our operating results are affected by many factors, including competition, changes in the regulatory environment with respect to pharmacy service providers, relationships with suppliers of inventory, relationships with large institutional clients, general governmental regulation and general business conditions, many of which are outside our control.
Our health services segment operates in a highly competitive environment and is in direct and indirect competition with a number of other companies that operate in the pharmaceutical market, including other retail, institutional and wholesale pharmacies, health insurers, health management organizations, pharmacy benefit managers and discount drug programs offered directly by pharmaceutical manufacturers. In addition, the provision of drugs and pharmacy benefits is a highly dynamic and evolving business which is tied closely to changes in the Medicare/Medicaid reimbursement environment, governmental entitlement program budget restrictions exercised at both the state and federal levels, cost controls imposed by third-party payors in an attempt to exercise control over increasing health care costs, and increasing competition from pharmacies operating outside the United States which ship drugs to U.S. residents over the Internet and using other distribution channels. There are currently a number of active initiatives being pursued by local and national legislatures. On December 8, 2003, President Bush signed into law the Medicare Prescription Drug Improvement and Modernization Act of 2003, a comprehensive voluntary prescription drug benefit administered under Medicare Part D effective January 1, 2006. The new act also provides certain cost-sharing government subsidies for individuals who might otherwise qualify for drug coverage under Medicaid or similar government-funded aid programs.
A large portion of the present and future growth of our institutional pharmacy business is contingent upon our ability to acquire and retain long-term contracts at favorable terms with institutional care facilities. Currently we have more than 20 contractual relationships with institutional clients. We are presently attempting to grow and diversify the number, type and terms of these contracts, but a number of factors - including the ability to favorably compete with respect to pricing, our relationships with drug and supplement manufacturers and suppliers, and the economic solvency and profitability of our institutional clients - can impact our profitability and opportunities for future growth. In addition, although we believe our current relationship with our institutional clients is strong, the loss of key institutional clients would materially affect the operation of our health services segment.
Because our health services business model is relatively new and unproven, our limited operating history in this segment is not indicative of future performance, and this part of our business is difficult to evaluate.
If we fail to comply with licensure requirements, fraud and abuse laws or other applicable laws, it may need to curtail operations, and could be subject to significant penalties.
Our pharmacy business is subject to extensive and often changing federal, state and local regulations, and our pharmacy is required to be licensed in the states in which it is located or does business. While we continuously monitor the effects of regulatory activity on its operations and believe we currently have all necessary pharmacy licenses, the failure to obtain or renew any required regulatory approvals or licenses could adversely affect the continued operation of the business. The long-term care facilities that contract for our services are also subject to federal, state and local regulations and are required to be licensed in the states in which they are located. The failure by these long-term care facilities to comply with these or future regulations or to obtain or renew any required licenses could result in our inability to provide pharmacy services to these facilities and their residents. We are also subject to federal and state laws that prohibit some types of direct and indirect payments between healthcare providers. These laws, commonly known as the fraud and abuse laws, prohibit payments intended to induce or encourage the referral of patients to, or the recommendation of, a particular provider of items or services. Violation of these laws can result in loss of licensure, civil and criminal penalties and exclusion from the Medicaid, Medicare and other federal healthcare programs.
If we or our client institutions fail to comply with Medicaid and Medicare reimbursement regulations, our health services revenue could be reduced, we could be subject to penalties and we could lose our eligibility to participate in these programs.
including private insurers. A portion of these revenues are indirectly dependent on government programs. We anticipate that as the institutional pharmacy portion of our health services segment grows, direct reimbursement from government sponsored programs will become a material portion of our pharmacy billings.
We are subject to various risks relating to our acquisition strategy.
One component of our growth strategy contemplates our making selected acquisitions that will help grow the health services segment. Recently, we terminated the agreements to acquire two separate organizations in the health services segment that would have significantly increased the size of this part of our business. Acquisitions involve inherent uncertainties. These uncertainties include the effect on the acquired businesses of integration into a larger organization and the availability of management resources to oversee the operations of these businesses. The successful integration of acquired businesses will require, among others:
In the event that the sell of Standard Life is not consummated, and in any case, until such sale occurs, we are also subject to the following risks.
Insurers compete with other insurance companies, financial intermediaries and other institutions on the basis of a number of factors, including the ratings assigned by A.M. Best. A.M. Best assigns ratings labeled (“A++”) through (“F”) (“Superior,” “Excellent,” “Very Good,” “Fair,” “Marginal,” “Weak,” “Poor,” “Under Regulatory Supervision,” and “In Liquidation”). Standard Life and Dixie Life both have a rating of (“B”) (Fair) by A.M. Best. A.M. Best’s ratings represent their opinion based on a comprehensive quantitative and qualitative review of our financial strength, operating performance and market profile. A rating of (“B”) is assigned by A.M. Best to companies that, in their opinion, have achieved good overall performance when compared to the standards established by A.M. Best. According to A.M. Best, these companies generally have an adequate ability to meet their obligations to policyholders, but their financial strength is vulnerable to unfavorable changes in underwriting or economic conditions. In evaluating a company’s financial and operating performance, A.M. Best reviews the company’s profitability, leverage and liquidity as well as the company’s book of business, the adequacy and soundness of its reinsurance, the quality and estimated market value of its assets, the adequacy of its reserves, and the experience and competence of its management. A.M. Best reviews its ratings of insurance companies from time to time. If the A.M. Best ratings were downgraded, sales of annuity products could be significantly impacted and the financial condition and results of operations could be materially adversely affected.
Our insurance subsidiaries are subject to substantial governmental regulation in each of the jurisdictions in which they conduct business. Changes in these regulations could have a significant impact on our profitability. The primary purpose of these regulations is to protect policyholders, not investors. These regulations are vested in governmental agencies having broad administrative power with respect to all aspects of our insurance business, including premium rates, policy forms and applications, marketing illustrations, dividend payments, capital adequacy and the amount and type of investments we may have.
Our financial results are highly dependent on the financial condition of the companies in which we make investments and could suffer if the value of our investments decreases due to factors beyond our control.
The assumptions are based upon, among others, interest rate spread and rates of mortality, surrender and lapse. If, for instance, future mortality rates were higher than expected, projected margins would be lower and deferred policy acquisition cost amortization would increase. The value of these assets reflected in our December 31, 2004 balance sheet totaled $185 million, or 10% of our assets. Although we have established procedures to periodically review the assumptions used to value these assets and determine the need to make adjustments, if our assumptions are incorrect and adjustments need to be made, our financial results could be materially adversely affected.
The financial statements and supplementary data required with respect to this Item 8 are listed in Item 15(a) (1) and included in a separate section of this report and are incorporated herein by reference.