On September 15, 2005, UICI entered into a merger agreement, pursuant to which affiliates of The Blackstone Group, Goldman Sachs Capital Partners and DLJ Merchant Banking Partners will acquire UICI in a cash merger, with UICI being the surviving corporation in the merger. The Board of Directors of the Company has established February 13, 2006 as the record date for determining stockholders entitled to notice of or to vote at a special meeting of stockholders to be held on March 29, 2006 for the purpose of adopting the merger agreement. Completion of the transaction is subject to insurance regulatory approvals, the receipt of certain financing and other conditions. The parties currently expect the transaction to close on or about April 3, 2006.
The Company’s 2005 results from continuing operations benefited from improved results at its Student Insurance Division (which offers tailored health insurance programs that generally provide single school year coverage to individual students at colleges and universities). The Company’s Student Insurance Division reported operating losses of $(8.9) million in 2005, compared to operating losses of $(49.5) million in 2004, reflecting a significant improvement in loss experience on the Student Insurance book of business, lower administrative expenses as a percentage of earned premium and better utilization of network service agreements with healthcare providers.
Income from continuing operations before federal income taxes (“operating income”) for each of the Company’s business segments and divisions in 2005, 2004 and 2003 was as follows:
UICI reported revenues and income from continuing operations in 2005 of $2.121 billion and $203.0 million ($4.31 per diluted share), respectively, compared to 2004 revenues and income from continuing operations of $2.069 billion and $145.9 million ($3.07 per diluted share), respectively. Reflecting results from discontinued operations, the Company reported overall 2005 net income of $203.5 million ($4.32 per diluted share), compared to 2004 net income of $161.6 million ($3.40 per diluted share).
Revenues. UICI’s revenues increased to $2.121 billion in 2005 from $2.069 billion in 2004, an increase of $52.1 million, or 3%. The Company’s revenues were particularly impacted by the following factors:
The Company generated a 2% increase in health premium revenue (to $1.856 billion in 2005 from $1.813 billion in 2004), which increase was primarily attributable to the assumption of existing health policies acquired in October 2004 as part of the HealthMarket acquisition.
Due to a 6% year over year increase in the book value of invested assets and an increase in the yield on short-term and other investments, investment income increased to $97.8 million in 2005 compared to $85.9 million in 2004.
Other income (consisting primarily of income derived by the SEA Division from ancillary services and membership marketing and administrative services provided to the membership associations that make available to their members the Company’s health insurance products) decreased by 9% to $106.7 million in 2005 from $117.8 million in 2004. The decrease was primarily related to a year over year decrease in new business for which the Company receives membership marketing and administrative fees.
Benefits, claims and settlement expenses decreased by 4% to $1.092 billion in 2005 from $1.135 billion in 2004. Benefits, claims and settlement expenses decreased primarily as a result of a significant improvement in the loss experience at the Student Insurance Division and a decrease in loss ratio at its Self-Employed Agency Division. The actual claim payment experience during 2005 with respect to prior periods at the its Self-Employed Agency Division was more favorable than originally estimated when the claim liabilities were established in 2004.
Underwriting costs, policy acquisition costs and insurance expenses decreased by 1% to $625.6 million in 2005 from $632.1 million in 2004. The decrease is primarily due to the expenses incurred at the Student Insurance Division in 2004 related to the inefficiencies in its previous claims system including an impairment charge in the amount of $(6.6) million principally associated with the abandonment of computer hardware and software assets associated with its claims processing system.
The Company maintains for the benefit of its employees and independent agents various stock-based compensation plans, in connection with which it records non-cash variable stock-based compensation expense (benefit) in amounts that depend and fluctuate based upon the market performance of the Company’s common stock. In 2005, the Company recognized a non-cash stock based compensation expense in the amount of $(7.2) million, compared to non-cash stock based compensation expense of $(14.3) million in 2004. The decrease is principally due to the smaller change in share price during 2005 (from $33.90 to $35.51) compared to 2004 (from $13.28 to $33.90) and a decrease in the amount of unvested credits to 1,571,952 from 1,904,526.
Operating Income. Operating income increased by 42%, to $313.2 million in 2005 from $221.1 million in 2004. As discussed more fully below, the Company’s 2005 results from continuing operations benefited from a significant year-over-year increase in operating income at its SEA Division (from $260.7 million in 2004 to $310.5 million in 2005).
Set forth below is certain summary financial and operating data for the Company’s Student Insurance Division for each of the three most recent fiscal years:
The Company’s Student Insurance Division (which offers tailored health insurance programs that generally provide single school year coverage to individual students at colleges and universities) reported operating losses of $(8.9) million in 2005 compared to operating losses of $(49.5) million in 2004.
Results for 2005 at the Student Insurance Division reflected a significant improvement in loss experience on the Student Insurance book of business. The loss ratio decreased to 78.7% in 2005, from 89.4% in 2004. For 2005, operating results also benefited from lower administrative expenses as a percentage of earned premium and from better utilization of network service agreements with healthcare providers. Results in 2004 also reflected a second quarter impairment charge in the amount of $(6.3) million, which was principally associated with the abandonment of computer hardware and software assets associated with a claims processing system.
The Company’s Star HRG Division reported operating income in 2005 in the amount of $1.4 million, compared to operating income of $3.3 million in 2004. The loss ratio associated with the Star HRG business increased slightly to 63.7% in 2005 from 63.6% in 2004, and the underwriting and acquisition expense ratio decreased slightly to 36.7% in 2005 from 37.4% in 2004. The decrease in “Other income” from 2004 to 2005 was associated with the decrease in administrative fees on business underwritten by a third party insurance carrier and a decrease in fees received on ancillary products.
Earned premium revenue at the Star HRG Division was $144.6 million in 2005, compared to $145.7 million in 2004.
The Company’s Life Insurance Division reported operating income in 2005 of $8.6 million compared to operating income of $4.4 million in 2004. The year-over-year increase in operating income was attributable to an increase in revenue and a decrease in fixed administrative costs as a percentage of earned premium revenue.
During 2003, through a newly formed company, ZON Re USA LLC (an 82.5%-owned subsidiary), we began to underwrite, administer and issue accidental death, accidental death and dismemberment (AD&D), accident medical and accident disability insurance products, both on a primary and on a reinsurance basis. In 2005, ZON Re generated revenues and operating income of $34.8 million and $4.7 million, respectively, compared to revenues and operating income of $14.4 million and $1.4 million, respectively, in 2004.
Revenues. UICI’s revenues increased to $2.069 billion in 2004 from $1.825 billion in 2003, an increase of $243.9 million, or 13.4%. The Company’s revenues were particularly impacted by the following factors:
The Company generated a 17% increase in health premium revenue (to $1.813 billion in 2004 from $1.547 billion in 2003), which increase resulted from new business, as well as increased renewal business derived from new health business originally written in 2001 and 2002.
Other income (consisting primarily of income derived by the SEA Division from ancillary services and membership marketing and administrative services provided to the membership associations that make available to their members the Company’s health insurance products) decreased by 4%, to $117.8 million in 2004 from $124.6 million in 2003. The decrease was primarily related to a year over year decrease in new business for which the Company receives membership marketing and administrative fees.
Benefits, claims and settlement expenses increased by 9% to $1.135 billion in 2004 from $1.046 billion in 2003. Benefits, claims and settlement expenses grew at a rate lower than premium revenues primarily as a result of a decrease in loss ratio due in significant part to the reduction of claim liabilities established in 2003 at the Company’s SEA Division in response to a rapid pay down of an excess pending claims inventory. The actual claim payment experience during 2004 with respect to prior periods at the SEA Division was lower than originally estimated when the claim liabilities were established in 2003.
The SEA Division’s operating margin in 2004 was 19.2%, compared to 9.1% in 2003. The significant year-over-year increase in operating margin was attributable primarily to a decrease in the loss ratio, a decrease in general administrative expenses as a percentage of earned premium revenue and a decrease in the effective commission rate (due to a decrease in the amount of first year premium relative to renewal premium, which carries a lower commission rate compared to commissions on first year premium). In addition, 2003 results included a $(25.0) million charge associated with a reassessment of loss accrual established for certain then-pending litigation.
Results in 2004 at SEA include results at the Company’s HealthMarket unit, which was acquired by the Company in October 2004 and provides consumer driven health plans to the small employer group market. Results at HealthMarket during 2004 were not material to overall operating results at SEA.
The Company’s Student Insurance Division (which offers tailored health insurance programs that generally provide single school year coverage to individual students at colleges and universities) reported operating losses of $(49.5) million in 2004, compared to operating losses of $(9.8) million in 2003. Results for 2004 at Student Insurance reflected an increase in the loss ratio, which was primarily attributable to a higher-than-expected amount of paid claims (which resulted from the reduction of the Student Insurance unit’s claims inventory to levels more closely approximating historical levels), the failure of the Company’s claim system to effectively utilize discounts afforded by the Company’s network provider contracts and to an impairment charge in the amount of $(6.6) million principally associated with the abandonment of computer hardware and software assets associated with its claims processing system. The Company has taken steps to modify its claims processing system to better utilize network provider discounts.
Earned premium revenue at the Student Insurance unit increased to $297.0 million in 2004 from $239.6 million in 2003 (a 24% increase). The Company’s Student Insurance unit imposed significant rate increases for its 2004-2005 school year during 2004, however, the impact of such rate increases were not be fully realized until 2005.
The Company determined that, effective May 31, 2003, it would no longer issue new life insurance policies under the College Fund Life Division program and, effective June 30, 2003, it ceased all operations at the Company’s Norcross, Georgia facility. In connection with such closedown and relocation to the Oklahoma City office, the Company incurred exit costs (consisting primarily of employee severance and relocation expenses and lease termination costs) in the amount of approximately $1.1 million which costs were expensed as incurred in 2003.
The Company’s reported results in 2004 and 2003 reflected income (loss) (net of tax) from discontinued operations (consisting of the Company’s AMS unit, its Senior Market Division and its Special Risk Division) in the amount of $15.7 million ($0.33 per diluted share) and $(73.0) million ($(1.52) per diluted share), respectively.
Results from discontinued operations for the full year 2004 reflected a favorable resolution of a dispute relating to its former Special Risk Division (which resulted in pre-tax income in the amount of $10.7 million recorded in the second quarter of 2004), a tax benefit associated with the reduction of a tax accrual and the release of a portion of the valuation allowance on the capital loss carryover due to the realization of capital gains during 2004, and a pre-tax gain recorded in the first quarter of 2004 in the amount of $7.7 million generated from the sale of the remaining
uninsured student loan assets formerly held by the Company’s former Academic Management Services Corp subsidiary (which the Company disposed of in November 2003). These favorable factors were offset in part by the recording in the second quarter of 2004 of a loss accrual with respect to multiple lawsuits that were filed arising out of UICI’s announcement in July 2003 of a shortfall in the type and amount of collateral supporting securitized student loan financing facilities of the Company’s former AMS subsidiary.
The Company sponsors a series of stock accumulation plans established for the benefit of the independent insurance agents and independent sales representatives associated with its independent agent field forces, including UGA - Association Field Services and Cornerstone America. In connection with these plans, the Company has from time to time recorded and will continue to record non-cash variable stock-based compensation expense in amounts that depend and fluctuate based upon the market performance of the Company’s common stock. For financial reporting purposes, the Company reflects all non-cash variable stock based compensation associated with its agent stock plans in its “Other Key Factors” business segment. See Note M of Notes to Consolidated Financial Statements.
optional benefit to its scheduled/basic health insurance products a rider that provides for catastrophic coverage for covered expenses under the base insurance contract that exceed $100,000 or $75,000, depending on the benefit level chosen. This rider pays benefits at 100% after the stop loss is reached, up to the aggregate maximum amount of the contract. Prior to January 1, 2005, the SEA Division utilized a technique that is commonly used to estimate claims liabilities with respect to developing blocks of business, until sufficient experience is obtained to allow more precise estimates. The Company believed that the technique produced appropriate reserve estimates in all prior periods. During the first quarter of 2005, the Company believed that there were sufficient claims paid on this benefit to produce a reserve estimate utilizing the completion factor technique. As a result, effective January 1, 2005, the SEA Division refined its technique used to estimate claim liabilities to utilize completion factors for older incurral dates. The technique continues to utilize anticipated loss ratios in the most recent incurral months. This completion factor technique is currently utilized with respect to all other blocks of the SEA Division’s health insurance business.
As a result of these changes, the liability for future ROP benefits increased, and operating income correspondingly decreased, by $12.9 million during the first quarter of 2003.
Assumptions used in the estimation of the Company’s ROP liability, such as interest or the annual increases in future gross premiums, will continue to be used in subsequent accounting periods for those benefits already issued, including the future gross premiums anticipated by the reserve factors. Changes in assumptions may be applied to newly issued policies as well as for adjustments in the level of premium for existing policies other than those already anticipated. The new assumptions used will be those appropriate at the time the change is made.
The ROP liabilities in the amount of $88.1 million and $86.0 million at December 31, 2005 and 2004, respectively, are reflected in future policy and contract benefits on the Company’s consolidated balance sheet.
Prior to January 1, 2003, the Company utilized the original incurred date coding definition to establish the date a policy claim is incurred under the developmental method. Under the original incurred date coding definition, prior to the end of the period in which a health policy claim was made, the Company estimated and recorded a liability for the cost of all medical services related to the accident or sickness relating to the claim, even though the medical services associated with such accident or sickness might not be rendered to the insured until a later financial reporting period.
The following table presents the information for each of the Company’s fiscal quarters in 2005 and 2004. This information is unaudited and has been prepared on the same basis as the audited Consolidated Financial Statements of the Company included herein and, in management’s opinion, reflects all adjustments necessary for a fair presentation of the information for the periods presented. The operating results for any quarter are not necessarily indicative of results for any future period.
At December 31, 2005 and 2004, the Company had an aggregate of $130.9 million and $150.0 million, respectively, of indebtedness outstanding under a secured student loan credit facility, which indebtedness is represented by Student Loan Asset-Backed Notes (the “SPE Notes”) issued by a bankruptcy-remote special purpose entity (the “SPE”). At December 31, 2005 and 2004, indebtedness outstanding under the secured student loan credit facility was secured by alternative (i.e., non-federally guaranteed) student loans and accrued interest in the carrying amount of $115.3 million and $114.9 million, respectively, and by a pledge of cash, cash equivalents and other qualified investments in the amount of $20.5 million and $37.4 million, respectively. At December 31, 2005, $12.2 million of such cash, cash equivalents and other qualified investments was available to fund the purchase from the Company of additional student loans generated under the Company’s College First Alternative Loan program, which purchases may be made in accordance with the terms of the agreements governing the securitization until February 2007.
All indebtedness issued under the secured student loan credit facility is reflected as student loan indebtedness on the Company’s consolidated balance sheet; all such student loans and accrued investment income pledged to secure such facility are reflected as student loan assets and accrued investment income, respectively, on the Company’s consolidated balance sheet; and all such cash, cash equivalents and qualified investments specifically pledged under the student loan credit facility are reflected as restricted cash on the Company’s consolidated balance sheet. The SPE Notes represent obligations solely of the SPE and not of the Company or any other subsidiary of the Company. For financial reporting and accounting purposes the student loan credit facility has been classified as a financing. Accordingly, in connection with the financing the Company has recorded and will in the future record no gain on sale of the assets transferred to the SPE.
The SPE Notes were issued by the SPE in three tranches ($50.0 million of Series 2001A-1 Notes and $50.0 million of Series 2001A-2 Notes issued on April 27, 2001, and $50.0 million of Series 2002A Notes issued on April 10, 2002). The Series 2001A-1 Notes and Series 2001A-2 Notes have a final stated maturity of July 1, 2036; the Series 2002A Notes have a final stated maturity of July 1, 2037. However, the SPE Notes are subject to mandatory redemption in whole or in part (a) on the first interest payment date which is at least 45 days after February 1, 2007, from any monies then remaining on deposit in the acquisition fund not used to purchase additional student loans and (b) on the first interest payment date which is at least 45 days after July 1, 2005, from any monies then remaining on deposit in the acquisition fund received as a recovery of the principal amount of any student loan securing payment of the SPE Notes, including scheduled, delinquent and advance payments, payouts or prepayments. After July 1, 2005, the SPE Notes are also subject to mandatory redemption in whole or in part on each interest payment date from any monies received as a recovery of the principal amount of any student loan securing payment of the SPE Notes, including scheduled, delinquent and advance payments, payouts or prepayments. During 2005 the Company made principal payments in the aggregate amount of $19.1 million on the Notes.
2004 includes $25.0 million dividends from a non-insurance subsidiary related to the sale of the remaining uninsured student loans retained by the Company at the sale of AMS.
Includes borrowings from and/or repayments on loans from subsidiaries in the amount of $358,000, $3.9 million and $8.3 million in 2005, 2004 and 2003, respectively, and proceeds from subsidiaries related to agent stock plans in the amount of $11.1 million, $19.7 million and $10.5 million in 2005, 2004 and 2003, respectively.
At December 31, 2005 and 2004, UICI at the holding company level held cash and cash equivalents in the amount of $151.4 million and $39.6 million, respectively. The Company currently anticipates that the cash requirements at the holding company level for the coming year will be funded by cash on hand and dividends to be paid from insurance and non-insurance subsidiaries.
Prior approval by insurance regulatory authorities is required for the payment by a domestic insurance company of dividends that exceed certain limitations based on statutory surplus and net income. During the 2005 year, Mega and Mid-West paid dividends in the amount of $82.0 million and $64.0 million, respectively, to the holding company.
During 2006, the Company’s domestic insurance companies could pay, without prior approval of the regulatory authorities, aggregate dividends in the ordinary course of business to the holding company of approximately $213.3 million. However, as it has done in the past, the Company will assess the results of operations of the regulated domestic insurance companies to determine the prudent dividend capability of the subsidiaries, consistent with UICI’s practice of maintaining risk-based capital ratios at each of the Company’s domestic insurance subsidiaries significantly in excess of minimum requirements.
During 2005, 2004 and 2003, the Company’s cash and liquidity at the holding company were positively impacted by the following significant factors and developments:
During 2005, the Company received an aggregate of $146.0 million in dividends from its domestic insurance subsidiaries, compared to $23.0 million of dividends in 2004.
On March 31, 2004, the Company completed the sale of all of the remaining uninsured student loan assets formerly held by the Company’s former Academic Management Services Corp. subsidiary. These assets had been retained by the Company at the November 18, 2003 sale of Academic Management Services Corp. and reflected as held-for-sale assets on the Company’s consolidated balance sheet. The sale of the uninsured student loans generated gross cash proceeds in the amount of approximately $25.0 million.
During the fourth quarter of 2005 the holding company incurred and paid approximately $8.4 million of expenses related to the pending merger by a group of private equity firms.
In July 2003, we announced that we had uncovered collateral shortfalls in the type and amount of collateral supporting two of the securitized student loan financing facilities of our AMS unit and the failure to comply with reporting obligations under the financing documents at seven of those facilities. We subsequently entered into waiver and release agreements with all of the financial institutions that were parties to the securitized student loan financing facilities, which agreements required us in July 2003 to contribute $48.25 million in cash to the capital of AMS (which amount is reflected as “Contribution to AMS” in the table above). See Note Q of Notes to Consolidated Financial Statements.
Through the Company’s former College Fund Life Division, the Company previously offered an interest-sensitive whole life insurance product issued with a child term rider, under which the Company committed to provide private student loans to help fund the named child’s higher education if certain restrictions and qualifications are satisfied. At December 31, 2005, the Company had outstanding commitments to fund student loans under the College Fund Life Division program for the years 2006 through 2025. Loans are limited to the cost of school or prescribed maximums. These loans are generally guaranteed as to principal and interest by a private guarantee agency and are also collateralized by either the related insurance policy or the co-signature of a parent or guardian. The total student loan funding commitments for each of the next five school years and thereafter, as well as the amount the Company expects to be required to fund based on historical utilization rates and policy lapse rates, are as follows as of December 31, 2005:
The Company has historically funded its College Fund Life Division student loan commitments with the proceeds of indebtedness issued by a bankruptcy-remote special purpose entity (the “SPE Notes”). At December 31, 2005, $12.2 million of cash, cash equivalents and other qualified investments was available to fund the purchase by the bankruptcy-remote special purpose entity from the Company of additional student loans generated under the
Company’s College First Alternative Loan program. The indenture governing the terms of the SPE Notes provides, however, that the proceeds of such SPE Notes may be used to fund student loan commitments only until February 1, 2007, after which any monies then remaining on deposit in the acquisition fund created by the indenture not used to purchase additional student loans must be used to redeem the SPE Notes. See discussion above under the caption “Liquidity and Capital Resources - Consolidated” and Note H of Notes to Consolidated Financial Statements.
At each of December 31, 2005 and 2004, the Company had $5.2 million and $5.0 million, respectively, of letters of credit outstanding relating to its insurance operations.
Set forth below is a summary of the Company’s investments by category at December 31, 2005 and 2004:
Included in the fixed maturity portfolio is an allocation of mortgage-backed securities, including collateralized mortgage obligations and mortgage-backed pass-through certificates, and commercial mortgage-backed securities. To limit its credit risk, the Company invests in mortgage-backed securities that are rated investment grade by the public rating agencies. The Company’s mortgage-backed securities portfolio is a conservatively structured portfolio that is concentrated in the less volatile tranches, such as planned amortization classes and sequential classes. The Company seeks to minimize prepayment risk during periods of declining interest rates and minimize duration extension risk during periods of rising interest rates. The Company has less than 1% of its investment portfolio invested in the more volatile tranches.
Set forth below is a summary of the Company’s gross unrealized losses in its fixed maturities as of December 31, 2005:
At December 31, 2005, the Company had $26.7 million of unrealized losses in its fixed maturities portfolio. Of the $11.4 million in unrealized losses that have existed for less than twelve months, only three securities had an unrealized loss in excess of 10% of the security’s cost. The aggregate amount of unrealized loss attributed to the securities in excess of 10% of the securities’ cost was $893,000 at December 31, 2005. Of the $15.3 million in unrealized losses that have existed for twelve months or longer, only one security had an unrealized loss in excess of 10% of the security’s cost. The amount of unrealized loss with respect to that security was $122,000 at December 31, 2005. The Company continually monitors these investments and believes that, as of December 31, 2005, the unrealized loss in these investments is temporary.
Company’s aggregate investment portfolio at December 31, 2005 and 2004, excluding investments in U.S. Government securities:
The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to health and life insurance claims, bad debts, investments, intangible assets, income taxes, financing operations and contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
The Company believes that its recorded claim liabilities are reasonable and adequate to satisfy its ultimate claims liability. Each of the Company’s major operating units has an actuarial staff that has primary responsibility for assessing the claim liabilities. The Company’s Corporate Risk Management staff has an oversight process in place to provide final review of the establishment of the claim liabilities. The Company uses its own experience as appropriate and relies on industry loss experience as necessary in areas where the Company’s data is limited. Our estimate of claim liabilities represents management’s best estimate of the Company’s liability as of December 31, 2005. Assuming a hypothetical 1% difference in the loss ratio (i.e., benefits, claims and settlement expenses stated as a percentage of earned premiums) for the year ended December 31, 2005, net income would increase or decrease by approximately $12.5 million and diluted net earnings per common share would increase or decrease by approximately $0.26 per share.
claims that are pending. When the level of pending claims appears to be in excess of “normal” levels, the Company typically establishes a liability for excess pending claims. The Company believes that such an “excess pending claims liability” is appropriate under such circumstances because of the operation of the developmental method used by the Company to calculate the principal claim liability, which method “develops” or “completes” paid claims to estimate the claim liability. When the pending claims inventory is higher than would ordinarily be expected, the level of paid claims is correspondingly lower than would ordinarily be expected. This lower level of paid claims, in turn, results in the developmental method yielding a smaller claim liability than would have been yielded with a normal level of paid claims, resulting in the need for an augmented claim liability.
Set forth below is a summary of claim liabilities by business unit at each of December 31, 2005, 2004 and 2003:
The total favorable claims liability development experience for 2005 in the amount of $121.4 million represented 24.6% of total claim liabilities established for the SEA Division at December 31, 2004. The favorable claims liability development experience in 2005 reflected a benefit of $33.3 million recorded in the third quarter of 2005 attributable to a refinement of the Company’s estimate for its claim liability on its health insurance products, which adjustment resulted from a refinement of the estimate of the unpaid claim liability for the most recent incurral months and an update of the completion factors used in the developmental method of estimating the unpaid claim liability to reflect more current claims administration practices. The favorable claims liability development experience at the SEA Division in 2005 also reflected the effects of a favorable adjustment in the amount of $7.6 million recorded in the first quarter of 2005 attributable to a refinement of an estimate for the Company’s claim liability established with respect to a product rider that provides for catastrophic coverage on the SEA Division’s scheduled health insurance products. Excluding the impact of the refinements discussed above, the remaining favorable experience in 2005 in the claims liability was $80.5 million, or 16.3% of total claim liabilities established for the SEA Division at December 31, 2004.
The total favorable claims liability development experience for 2004 in the amount of $91.7 million represented 20.2% of total claim liabilities established for the SEA Division at December 31, 2003. The favorable claims liability development experience at the SEA Division in 2004 reflected the effect of $47.8 million in claim liabilities established during 2003 in response to a rapid pay down during 2003 of an excess pending claims inventory. In particular, during 2003 the Company observed a change in the distribution of paid claims by incurred date; more paid claims were assigned to recent incurred dates than had been the case on paid claims in prior years. Assignment of paid claims with more recent incurred dates typically results in an understatement of the claim development liability, resulting in the need for augmented claim liabilities. The Company believes that the deviation from historical experience in incurred date assignment was a natural consequence of the effort required to reduce a claims backlog, which the Company was experiencing at the SEA Division during the course of 2003. However, as the actual claims experience developed in 2004, these augmented claim liabilities in the amount of $47.8 million proved to be redundant. These claim liabilities were released during 2004 and, as a result, did not influence the level of claim liabilities redundancies in 2005 and will not influence the level of claim liabilities redundancies in future periods. Excluding the impact of the augmented claim liabilities established at December 31, 2003 in response to the rapid pay down during 2003 of an excess pending claims inventory, the favorable experience in 2004 in the
claims liability was $43.9 million, or 9.6% of total claim liabilities established for the SEA Division at December 31, 2003.
The total favorable claims liability development experience for 2003 in the amount of $54.0 million represented 14.9% of total claim liabilities established for the SEA Division at December 31, 2002. The favorable experience in the SEA Division for 2003 included the effect of the $17.7 million decrease in claims liability due to the refinements made effective January 1, 2003 to the claims liability calculation ($12.3 million) and changes in estimate ($5.4 million). See the discussion above under the caption “2003 Change in Claims and Future Benefit Liability Estimates”. Excluding the impact of these refinements and changes in estimate, the favorable experience in 2003 in the claims liability was $36.3 million, or 10.0% of the total claim liabilities established for the SEA Division at December 31, 2002.
Impact on Student Insurance Division and Star HRG Division. The products of the Student Insurance and Star HRG Divisions consist principally of medical insurance. In general, medical insurance business, for which incurred dates are assigned based on date of service, has a “short tail,” which means that a favorable development or unfavorable development shown for prior years relates primarily to actual experience in the most recent prior year.
The favorable claim liability development experience at the Student Insurance Division in 2005 in the amount of $5.2 million is due to claims in 2005 developing more favorably than indicated by the loss trends used to determine the claim liability at December 31, 2004. The unfavorable claims liability development experience in 2004 in the amount of $4.7 million reflects the effects of a delay in processing of prior-year claims and higher-than-expected claim experience associated with the business written for the 2003-2004 school year. The Student Insurance Division experienced favorable claims liability development for 2003.
The unfavorable claim liability development at the Star HRG Division in 2005 of $410,000 is within the normal statistical variation in the model used to develop the reserve. The actual development of prior years claims exceeded the expected development of the claims liability. The favorable claims liability development experience of $3.0 million in 2004 includes the effects of claims in 2004 developing more favorably than indicated by the loss trends in 2003 used to determine the claim liability at December 31, 2003. The Star HRG Division also experienced favorable claims liability development for 2003. Since the Star HRG business was new to the Company (acquired in 2002), an expected loss ratio was used to set the claims liability at December 31, 2002.
Impact on Life Insurance Division. The varied claim liability development experience at the Life Insurance Division for each of the years presented is due to the development of a closed block of workers’ compensation business. The Life Insurance Division previously wrote workers’ compensation insurance and similar group accident coverage for employers in a limited geographical market. In May 2001, the Company made the decision to terminate this operation, and all existing policies were terminated as the policies came up for renewal over the succeeding twelve months. The closing of new and renewal business starting in July of 2001 had the effect of concentrating the claims experience into existing policies and eliminating any benefits that might accrue from improved underwriting of new business or liabilities released on newer claims that might settle more quickly. The effect of closing a block of this type of business is difficult to estimate at the date of closing, due to the longer claims tail usually experienced with workers compensation coverage, the tendency of claims to concentrate in severity but without an associated degree of predictability as the number of cases decreases, and the unpredictable costs of protracted litigation often associated with the adjudication of claims under workers’ compensation policies.
Impact on Other Insurance. Through our 82.5%-owned subsidiary, ZON Re USA LLC (“ZON Re”), we underwrite, administer and issue accidental death, accidental death and dismemberment (AD&D), accident medical and accident disability insurance products, both on a primary and on a reinsurance basis. The unfavorable claim liability development experience at ZON Re in 2005 in the amount of $805,000 was due to certain large claims reported in 2005 associated with claims incurred in the prior year.
The Company records deferred tax assets to reflect the impact of temporary differences between the financial statement carrying amounts and tax bases of assets. The Company establishes a valuation allowance when management believes, based on the weight of the available evidence, that it is more likely than not that some portion of the deferred tax asset will not be realized. Realization of the net deferred tax asset is dependent on generating sufficient future taxable income. However, the amount of the deferred tax asset considered realizable,
however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced.
During 2003, the Company realized $59.3 million of net capital losses for federal tax purposes. The capital losses were generated in 2003 primarily from the sale of AMS, the sale of its interest in Healthaxis and the sale of an agency specializing in the sale of long-term care and Medicare supplement insurance products and were partially offset by the gain from the sale of a substantial portion of the Company’s equity stake in AMLI Residential. During 2005, the Company realized an additional capital loss of $2.3 million from sales of investments. To the extent not utilized to offset capital gains generated in prior years, the net capital losses generated in 2003 and 2005 will be carried forward to future years, with the ability to utilize the remaining capital losses generated in 2003 and 2005 expiring in 2008 and 2010, respectively.
The Company is subject to proceedings and lawsuits related to insurance claims and other matters. See Note L of Notes to Consolidated Financial Statements. The Company is required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. A determination of the amount of accruals required, if any, for these contingencies is made after careful analysis of each individual issue. The required accruals may change in the future due to new developments in each matter or changes in approach, such as a change in settlement strategy in dealing with these matters.
2005, the risk-based capital ratio of each of the Company’s domestic insurance subsidiaries significantly exceeded the ratios for which regulatory corrective action would be required.
Dividends paid by domestic insurance companies out of earned surplus in any year are limited by the law of the state of domicile. See Item 5 - Market for Registrant’s Common Stock and Related Stockholder Matters and Note J of Notes to Consolidated Financial Statements.
In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement 154 Accounting Changes and Error Corrections which changes the requirements for the accounting and reporting of a change in accounting principle. Statement 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement that does not include specific transition provisions. Statement 154 requires that changes in accounting principle be retrospectively applied. Under retrospective application, the new accounting principle is applied as of the beginning of the first period presented as if that principle had always been used. The cumulative effect of the change is reflected in the carrying value of assets and liabilities as of the first period presented and the offsetting adjustments would be recorded to opening retained earnings. Statement 154 replaces APB Opinion No. 20 and FASB Statement 3. Statement 154 is effective for the Company beginning in fiscal year 2006. The Company does not contemplate any accounting changes or error corrections and accordingly, does not believe the adoption of this statement will have a material effect upon its financial condition or results of operations.
This report and other documents or oral presentations prepared or delivered by and on behalf of the Company contain or may contain “forward-looking statements” within the meaning of the safe harbor provisions of the United States Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements based upon management’s expectations at the time such statements are made. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Forward-looking statements are subject to risks and uncertainties that could cause the Company’s actual results to differ materially from those contemplated in the statements. Readers are cautioned not to place undue reliance on the forward-looking statements. When used in written documents or oral presentations, the terms “anticipate,” “believe,” “estimate,” “expect,” “may,” “objective,” “plan,” “possible,” “potential,” “project,” “will” and similar expressions are intended to identify forward-looking statements. In addition to the assumptions and other factors referred to specifically in connection with such statements, factors that could impact the Company’s business and financial prospects include, but are not limited to, those discussed under the caption “Item 1A. Risk Factors” and those discussed from time to time in the Company’s various filings with the Securities and Exchange Commission or in other publicly disseminated written documents.