The selected audited consolidated financial data presented below as of and for each of the five years ended December 31, 2003, 2002, 2001, 2000 and 1999 have been derived from our audited consolidated financial statements. However, financial data for 2001 and 2000 was reclassified to reflect the sale of Pyramid Life. See Note E. Discontinued Operations to our audited consolidated financial statements for further information. The acquisitions of Provident American Life and Continental General occurred on December 31, 1998 and February 17, 1999, respectively. Results for United Benefit Life are included from August 1, 1998 to July 20, 1999 under a reinsurance agreement and thereafter as an acquired entity. The financial information for the year ended December 31, 1999 includes the operations of Continental General since February 1, 1999 and for Provident American Life and United Benefit Life (through reinsurance) for the entire period. The financial information for the years ended December 31, 2003, 2002, 2001, and 2000 includes the operations of all our subsidiaries for the entire year except for Pyramid Life. Pyramid Life, which is presented separately as discontinued operations, was acquired on July 26, 2000 and sold on March 31, 2003. The data for 2003, 2002, and 2001 should be read in conjunction with the more detailed information contained in the audited consolidated financial statements and accompanying notes, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other financial information included elsewhere in this filing.
(3) We received proceeds from a December 2001 public offering and private placement offerings in 2000 and 1999. For more information, see Note B. Equity Transactions to our audited consolidated financial statements.
(4) "Accumulated other comprehensive income" relates primarily to the net unrealized gain (loss) on available-for-sale securities.
Ceres Group, through its insurance subsidiaries, provides a wide array of health and life insurance products through two primary business segments. The Senior segment includes senior health, life and annuity products for Americans age 55 and over. The Medical segment includes major medical health insurance for individuals, families, associations, and small to mid-size businesses.
Our insurance subsidiaries include Central Reserve Life Insurance Company, Provident American Life & Health Insurance Company, United Benefit Life Insurance Company and Continental General Insurance Company. Central Reserve markets and sells major medical health insurance to individuals, families, associations, and small employer groups and, in late 2003, began marketing and selling senior products. Continental General markets and sells both major medical and senior health and life products to individuals, families, associations and Americans age 55 and over. United Benefit Life discontinued new sales activities in July 2000 and terminated all of its existing business at the end of 2001. United Benefit Life has no active policyholders and its business was substantially wound down at December 31, 2003. Provident American Life also has discontinued new sales activities and currently has approximately 1,300 active policyholders.
Effective March 31, 2003, Ceres sold its subsidiary, Pyramid Life Insurance Company to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. For more information on the Pyramid Life sale, see Note E. Discontinued Operations to our audited consolidated financial statements.
LIABILITIES FOR OTHER POLICY CLAIMS AND BENEFITS PAYABLE. The most significant accounting estimate in our audited consolidated financial statements is our liability for other policy claims and benefits payable.
We recognize claim costs in the period the service was provided to our insureds. However, claim costs incurred in a particular period are not known with certainty until after we receive, process and pay the claim. The receipt and payment date of claims may lag significantly from the date the service was provided. Consequently, we must estimate our liabilities for claims that are incurred but not yet reported.
Liabilities for unpaid claims are based on an estimation process that is complex and uses information obtained from both company specific and industry data, as well as general economic information. These estimates are developed using actuarial methods based upon historical data for payment patterns, medical inflation, product mix, seasonality, utilization of health care services, and other relevant factors. The amount recorded for unpaid claims liabilities is sensitive to judgments and assumptions made in the estimation process. The most significant assumptions used in the estimation process include determining utilization and inflation trends, the expected consistency in the frequency and severity of claims incurred but not yet reported,
Note K. Liabilities for Other Policy Claims and Benefits Payable to our audited consolidated financial statements provides historical information regarding the accrual and payment of our unpaid claims liability. Components of the total incurred claims for each year include amounts accrued for current year estimated claims expense, as well as adjustments to prior year estimated accruals.
Management considered the volatile claims experience in recent periods when it established its liabilities for unpaid claims at December 31, 2003. Management believes that the recorded liabilities for unpaid claims at December 31, 2003 is within a reasonable range of outcomes. Management closely monitors and evaluates developments and emerging trends in claims costs to determine the reasonableness of judgments made. A retrospective test is performed on prior period claims liabilities and, as adjustments to the liabilities become necessary, the adjustments are reflected in current operations. Management believes that the amount of medical and other benefits payable is adequate to cover our liabilities for unpaid claims as of December 31, 2003.
DEFERRED ACQUISITION COSTS. In connection with the sale of our insurance policies, we defer and amortize a portion of the policy acquisition costs over the related premium paying periods of the life of the policy. These costs include certain excess policy acquisition costs associated with issuing an insurance policy, including commissions and underwriting, all of which vary with and are primarily related to the production of new business. The amortization of deferred acquisition costs is determined using the same projected actuarial assumptions used in computing policy reserves. Deferred acquisition costs associated with traditional life and accident and health contracts are charged to expense over the premium-paying period or as premiums are earned over the life of the contract. Deferred acquisition costs associated with interest-sensitive life and annuity products are charged to expense over the estimated duration of the policies in relation to the present value of the estimated gross profits from surrender charges and investments, mortality, and expense margins.
We evaluate the recoverability of our deferred acquisition costs on a quarterly basis. The recoverability of our deferred acquisition costs is sensitive to judgments and assumptions made in projecting future cash flows on our various blocks of business. The most significant assumptions are claim cost trends, magnitude of rate increases, lapsation and persistency, and mortality.
Inherent uncertainties surround legal proceedings and actual results could differ materially from those assumed in estimating the liabilities. The possibility exists that a decision could be rendered against us, and, in some circumstances, include punitive or other damage awards in excess of amounts reserved, that may have a material impact on our financial condition, results of operations or cash flows, of a future period.
DISCONTINUED OPERATIONS. On March 31, 2003, we sold our indirect subsidiary, Pyramid Life Insurance Company, to the Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. Consistent with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, Pyramid Life was classified as held for sale as of December 31, 2002, and was measured at its fair value less costs to sell. Therefore, the financial information for the years ended December 31, 2003, 2002 and 2001 excludes the operations of Pyramid Life for all periods presented and the $13.8 million loss from the sale, net of taxes and expenses incurred (except where specifically noted). Financial data for 2001 was reclassified to reflect the sale of Pyramid Life. The net assets, results of operations, and cash flows of Pyramid Life have been reported separately as discontinued operations of a subsidiary in our audited consolidated financial statements for all periods presented. See Note E. Discontinued Operations to our audited consolidated financial statements for further information.
- a 58.3% decline in new business production from $89.2 million in annualized premium in 2002 to $37.2 million in 2003. We discontinued Continental General major medical brokerage sales in 2003 due to adverse claim experience, which accounted for $18.0 million of the decreased production levels. In addition, Continental General did not write major medical business in Florida for half of 2003, due to capital constraints. Florida accounted for approximately 19% of our major medical production in 2002. Continental General is currently writing major medical business in Florida.
- renewal premium increases averaging between 25-30% prior to any benefit downgrades or deductible changes.
- a slight increase in Medicare supplement premium of $124.7 million in 2003 compared to $124.5 million in 2002, which includes a 8.5% decrease in policies in force offset by annual rate increases and reduced levels of reinsurance. Medicare supplement production is expected to increase significantly in 2004 due to the introduction of new standardized plans and expanded distribution into our Central Reserve subsidiary. Medicare supplement premium is projected to increase approximately 10% in 2004.
- a $4.0 million increase in life and annuity premium due to the growth of senior life new business production.
Fee and other income decreased to $27.1 million for 2003 compared to $30.7 million for 2002, a decrease of 11.6%. This decrease was primarily attributable to the decline in major medical policies and the associated policy fee income and was partially offset by $5.7 million of third party administrator fees in the Senior and Other segment related to the transition processing of senior business for Pyramid Life. This transition agreement terminated on December 31, 2003. Due to the decline in our medical business and the termination of this transition agreement, we expect total policy fee income to decline approximately 35% in 2004.
The amortization of deferred reinsurance gain of $1.7 million for 2003 represented the recognition of the ceding commission allowances received under our reinsurance agreements. The unamortized amount of $9.5 million at December 31, 2003 was accounted for as a deferred reinsurance gain on the consolidated balance sheet. The amortization of deferred reinsurance gain decreased from $2.8 million for 2002 as a result of lower amortization due to diminishing levels of in force certificates.
- a higher level of severity in the December 31, 2001 claim inventory adversely impacted 2002 loss ratios.
Federal income tax expense was $6.6 million, or 25.5% of the income from continuing operations before federal taxes for 2003. In 2002, the federal income tax expense was $1.3 million, or 39.4% of the income from continuing operations before federal taxes. The lower effective tax rate in 2003 was primarily due to the reduction in the deferred tax valuation allowance of $2.7 million on the Company's net operating loss carryforwards due to the utilization of the net operating loss carryforward in the current period.
Medical premiums for 2002 were $370.0 million compared to $402.2 million for 2001, a decrease of 8.0%. The decrease in medical premiums was primarily the result of a 28% decrease in major medical certificates in force due to our decision in July 2001 to terminate or replace the policies at United Benefit Life and Provident American Life, to cancel other medical business in certain states and to target market in more profitable states, offset by the increase in new and renewal premium rates averaging 20% to 30%.
Fee and other income decreased to $30.7 million for 2002 compared to $36.2 million for 2001, a decrease of 15.1%. This decrease was primarily attributable to a smaller volume of business in force in the Medical segment due to the United Benefit Life and Provident American Life termination or replacement program and the cancellation of other medical business in certain states.
Total benefits, claims, losses and settlement expenses decreased to $421.0 million for 2002 compared to $443.8 million for 2001, a decrease of 5.1%.
Medical benefits, claims, losses, and settlement expenses were $291.8 million for 2002 compared to $328.8 million for 2001, a decrease of 11.3%. The decrease was primarily the result of a smaller volume of business in force due to the termination or replacement program, and cancellation of other medical business as previously mentioned. The medical loss ratio was 78.9% for 2002 compared to 81.7% for 2001. The medical loss ratio decreased due to the termination or replacement program and the cancellation of business in poor performing markets, as well as pricing increases and benefit changes to keep pace with medical inflation. However, the decrease was partially offset by a higher severity of claims than anticipated in the December 31, 2001 claim inventory.
The special charge for 2002 represented a pre-tax non-recurring charge of $2.7 million ($2.4 million in continuing operations and $0.3 million in discontinued operations) related to the retirement of Peter W. Nauert, our former CEO. See Note O. Special Charges to our audited consolidated financial statements for further information. Special charges of $7.1 million in the first quarter of 2001 represented a $5.9 million write-off of the DAC asset for United Benefit Life and Provident American Life and a $1.2 million write-off of costs associated with United Benefit Life. The DAC asset was written off due to the planned termination of this business.
Federal income tax expense was $1.3 million, or 39.4% of the income before federal taxes, for 2002. In 2001, a federal income tax benefit was established of $1.8 million, or 24.5% of the loss before federal taxes. The higher effective tax rate in 2002 was primarily due to the 50% elimination on meals and entertainment expenses and certain other non-deductible expenses.
Income from continuing operations was $2.1 million, or $0.06 per share, for 2002 compared to a loss of $5.5 million, or $0.31 per share, for 2001. Income from the operations of Pyramid Life (classified as discontinued operations) was $7.1 million, or $0.21 per share, for 2002 compared to $7.9 million, or $0.44 per share, for 2001. Therefore, income including continuing and discontinued operations (excluding the loss on the sale of Pyramid Life) for 2002 was $9.2 million, or $0.27 per share, compared to $2.3 million, or $0.13 per share, for 2001. The loss on the sale of Pyramid Life recorded in the fourth quarter of 2002 was $11.6 million, or $0.34 per share. As a result of the foregoing, for 2002, the net loss attributable to common stockholders was $2.4 million, or $0.07 per share, compared to net income attributable to common stockholders of $5.2 million, or $0.29 per share, for 2001.
- a reduction in the level of our reinsurance receivable and reserves ceded balances due to a continued decline in the level of reinsurance; and
- a reduction in the level of deferred acquisition costs due to the decline in new business production.
Approximately 96.0% of our bonds were of investment grade quality at December 31, 2003. In addition to the fixed maturities, we also had $26.4 million in cash and cash equivalents of which $7.0 million was restricted at December 31, 2003.
The total reinsurance receivable was $143.4 million at December 31, 2003. Of this amount, $143.0 million represents reserves held by our reinsurers under our various reinsurance treaties in place. Hannover holds most of these reserves.
The new credit facility consists of a $4.0 million term loan A with National City Bank with quarterly principal payments of $250,000 through December 2005, $375,000 through December 2006, and a payment of $500,000 on March 1, 2007. The $9.0 million term loan B with CIT Group has quarterly principal payments of $312,500 through December 2004, $375,000 through December 2006, $562,500 through December 2007, and $1,250,000 through June 2008.
CONTRACTUAL OBLIGATIONS. The following schedule summarizes current and future contractual obligations as of December 31, 2003:
In addition, in December 2003, Continental General committed to invest $5.0 million in a limited partnership, NYLIM-GCR Fund I-2002, L.P. Investments by this Fund are expected to consist primarily of a diversified pool of subordinated real estate mezzanine debt and sub-tranche loans with an expected concentration in office assets located in major metropolitan areas. At December 31, 2003, the Fund had not made a capital call on Continental General's limited partner commitment.
Dividends from our regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. In 2003, none of our direct insurance subsidiaries (Central Reserve and Continental General) could pay a dividend to Ceres without the prior approval of their respective state insurance regulators as a result of their respective statutory levels of unassigned surplus at December 31, 2002. In 2004, Continental General could pay a dividend to Ceres Group, the parent company, of up to $6.0 million without prior approval of the state regulator. Central Reserve is prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus. If our non-regulated subsidiaries do not generate sufficient fee income or we are unable to take dividends from our insurance subsidiaries to service all of our debt obligations, there may be a material adverse effect on our business, financial condition and results of operations, and a significant adverse effect on the market value of our common stock. In addition, if necessary, additional financing may not be available on terms favorable to us or at all.
We determine a valuation allowance of our deferred tax asset based on an analysis of amounts recoverable in the statutory carryback period and available tax planning strategies. In assessing the valuation allowance established at December 31, 2003 and 2002, estimates were made as to the potential financial impact of recent NOLs and our financial condition.
Legal/Regulatory Risk is the risk that changes in the legal or regulatory environment in which an insurer operates will create additional expenses not anticipated by the insurer in pricing its products. For example, regulatory initiatives designed to reduce insurer profits or otherwise affecting the industry in which the insurer
In addition, insurance companies are subject to extensive federal and state regulation and compliance with these regulations could increase the insurance companies' operating costs. In some circumstances, failure to comply with certain insurance regulations could subject an insurance company to regulatory actions by such insurance company's state of domicile. For example, states have statutory risk-based capital (RBC) requirements for health and other insurance companies based on the RBC Model Act. These RBC requirements are intended to assess the capital adequacy of life and health insurers, taking into account the risk characteristics of an issuer's investments and products. In general, under these laws, an insurance company must submit a report of its RBC level to the insurance department of its state of domicile as of the end of the previous calendar year. These laws provide for four different levels of regulatory attention depending on the ratio of an insurance company's total adjusted capital (defined as the total of its statutory capital, surplus, and asset valuation reserve) to its risk-based capital. As of December 31, 2003, our risk-based capital levels for each of our insurance subsidiaries exceeded the levels required by regulatory authorities.
- negative economic factors and conditions specific to the issuer's industry;
- changes or developments in healthcare reform and other regulatory issues, including Medicare reform and the Health Insurance Portability and Accountability Act of 1996 and increased privacy and security regulation, and changes in laws and regulations in key states in which we operate, could
increase our costs, cause us to discontinue marketing products in certain states or cause us to change our business or operations significantly;
- the performance of others on whom we rely for insurance and reinsurance, particularly Hannover Life Reassurance Company of America upon whom we have relied for substantially all of our reinsurance;
The factors listed above should not be construed as exhaustive. We undertake no obligation to release publicly the results of any future revisions we may make to forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events.
In July 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (SOP 03-1). SOP 03-1 addresses a number of topics, the most significant of which is the accounting for contracts with guaranteed minimum death benefits. SOP 03-1 requires companies to evaluate the significance of guaranteed minimum death benefits to determine whether the contract should be accounted for as an investment or insurance contract. If the contract is determined to be an insurance contract, companies are required to establish a reserve to recognize a portion of the assessment (revenue) that compensates the insurance company for benefits to be provided in future periods. SOP 03-1 also provides guidance on separate account presentation, interest in separate accounts, gains and losses on the transfer of assets from the general account to a separate account, liability valuation, return based on a contractually referenced pool of assets or index, annuitization options, and sales inducements to contract holders. The effective date of SOP 03-1 is for fiscal years beginning after December 15, 2003, with earlier adoption encouraged. If adopted early, the provisions of SOP 03-1 must be applied as of the beginning of the fiscal year. We do not expect the adoption of SOP 03-1 to have a material effect on our consolidated results of operations, cash flows or financial position.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining on a test basis evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ceres Group, Inc. as of December 31, 2003, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
We have audited the accompanying consolidated balance sheets of Ceres Group, Inc. and subsidiaries as of December 31, 2002, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the two years in the period ended December 31, 2002. We have also audited the information related to 2002 and 2001 presented in the financial statement schedules listed in the Index at Item 15(a). These financial statements and financial statement schedules are the responsibility of Ceres Group's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
As described in Notes A, E and I, Ceres Group adopted Statements of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, and No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, as of January 1, 2002.
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
We provide, through our insurance subsidiaries, a wide array of health and life insurance products. While our insurance subsidiaries are licensed in 48 states, the District of Columbia, and the U.S. Virgin Islands, approximately 59.4% of our total premium volume is generated from ten states: Ohio, Florida, Pennsylvania, Texas, Indiana, Georgia, Kansas, Nebraska, Illinois, and Missouri.
The accompanying audited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, which differ from accounting practices prescribed or permitted by the various state departments of insurance in which the insurance subsidiaries are domiciled. See Note R. Statutory Financial Information for further information.
On January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets. Under the provisions of SFAS 142, goodwill is no longer ratably amortized into the income statement over an estimated life, but rather is tested at least annually for impairment. Intangible assets which have finite lives continue to be amortized over their estimated useful lives and also continue to be subject to impairment testing. Prior to the adoption of SFAS 142, goodwill was amortized on a straight-line basis over periods of 25 years or less. See Note I. Goodwill and Other Intangible Assets for a summary of our goodwill and other intangible assets, as well as further detail related to the impact of the adoption of SFAS 142 in 2002.
The preparation of the audited consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Investments in bonds are designated at purchase as held-to-maturity or available-for-sale. Held-to-maturity investments are securities, which management has the positive intent and ability to hold until maturity, and are reported at amortized cost. Available-for-sale investments and surplus notes are stated at fair value, with unrealized holding gains and losses reported in accumulated other comprehensive income (loss), net of deferred federal income taxes. All investments as of December 31, 2003 are designated as available-for- sale.
Investments in policy notes and mortgage loans are reported at cost, which approximates fair value.
The Company evaluates the recoverability of deferred acquisition costs on a quarterly basis and determines whether these amounts are recoverable.
A portion of the purchase price paid by the Company for Continental General Corporation was allocated to the value of business acquired based on the actuarially-determined present value of the expected pre-tax future profits from the business assuming a discount rate of 15.0%. Interest is accrued on the balance annually at a rate consistent with the rate credited on the acquired policies on the acquisition date, which ranges from 4.0% to 8.75%. Recoverability of the value of business acquired is evaluated periodically by comparing the current estimate of the present value of expected pre-tax future profits to the unamortized asset balance. If such current estimate is less than the existing asset balance, the difference would be charged to expense.
For accident and health and ordinary life business, the value of business acquired is amortized over the estimated life of the in force business using assumptions consistent with those in computing reserves. Interest of 6.5% is credited to the unamortized balance for Continental General Corporation. For interest sensitive products such as universal life and deferred annuities, the value of business acquired is amortized over the expected profit stream of the in force business. The expected profit stream is based upon actuarial assumptions as to mortality, lapses, and expenses. Earned interest was assumed to be 6.0% for Continental General Corporation, which was the market rate at the time of acquisition.
As certain fixed maturities available-for-sale related to the Company's interest-sensitive life insurance products are carried at fair value, an adjustment is made to deferred acquisition costs and the value of business acquired equal to the change in amortization that would have occurred if such securities had been sold at their stated fair value and the proceeds reinvested at current yields. The change in this adjustment is included with the change in fair value of fixed maturity securities available-for-sale, net of tax, that is credited or charged
directly to stockholders' equity and is a component of other comprehensive income. Deferred acquisition costs and the value of business acquired were decreased by $0.8 million and $1.1 million at December 31, 2003, respectively. Deferred acquisition costs were increased by $0.5 million at December 31, 2002. The value of business acquired was not adjusted at December 31, 2002.
This Statement requires that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and broadens the presentation of discontinued operations to include more disposal transactions. The adoption of SFAS 144 on January 1, 2002 did not have a material effect on our results of operations, financial position or liquidity. See Note E. Discontinued Operations for further detail related to the adoption of SFAS 144.
Liabilities for future policy reserves for accident and health and traditional life business are based on the net level premium basis and estimates of future claims, investment yield, lapses using the Company's experience and actuarial judgment with an allowance for possible future adverse deviations from expected experience. Interest rates used range from 4.5% to 6.0%. Liabilities for interest sensitive products such as deferred annuities and universal life are based on the retrospective deposit method. This is the policyholder fund balance before adjusting for any surrender charges. Guaranteed minimum rates for universal life contracts are 4.0% to 5.5%. At December 31, 2003, credited rates ranged from 4.0% to 5.5%. Guaranteed base minimum rates for deferred annuities range from 3.0% to 5.5% depending on the duration of the contract. Current rates credited range from 3.0% to 6.0%.
Liabilities for unpaid life and accident and health claims, which include a provision for estimated costs to investigate and settle claims, are estimated based upon past experience for pending, incurred, but not reported, and reopened claims. Accident and health claims incurred but not reported are computed using actuarially-determined factors based on a combination of claim completion and projected claim cost methods, utilizing durational experience, seasonal cycle, changes in health care practice, changes in inflation rates, and any claims backlog.
Other policyholders' funds consist of supplementary contracts without life contingencies, premiums and annuity considerations received in advance and remittance and items not allocated.
Life premiums are recognized as revenue when they become due. Accident and health premiums are recognized as revenue over the terms of the policies. Amounts received from interest sensitive contracts, principally universal life and annuity products, are not reflected in premium revenue; rather, such amounts are accounted for as deposits with the related liabilities included in future policy benefits, losses, and claims.
Stock-based compensation plans are accounted for using the intrinsic value method prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees (APB Opinion 25). In accordance with the intrinsic value method, compensation cost is measured as the excess, if any, of the quoted market price of the equity instrument awarded at the measurement date over the amount an employee must pay to acquire the equity instrument. Stock-based compensation costs are recognized over the period in which employees render services associated with the awards.
We adopted SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), which permits entities to continue to apply the provisions of APB Opinion 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants as if the fair-value-based method, as defined in SFAS 123, had been applied. Additionally, in December 2002, the FASB issued SFAS No. 148, Accounting For Stock-Based Compensation-Transition and Disclosure (SFAS 148). SFAS 148 amends SFAS 123, to provide alternative methods of transition to SFAS 123's fair value method of accounting for stock-based employee compensation, but does not require companies to account for employee stock options using the fair value method. SFAS 148 also amends the disclosure provisions of SFAS 123 and APB Opinion No. 28, Interim Financial Reporting. We elected to continue to apply provisions of APB Opinion 25 and provide the pro forma disclosure required by SFAS 123 and the amended disclosures required by SFAS 148. See Note P. Stock Plans for further information.
The following table illustrates the effect on net income, net income attributable to common stockholders, and earnings per share if we had applied the fair value recognition provisions of SFAS 123.
Effective January 31, 2003, the Company adopted FASB Interpretation (FIN) No. 46, Consolidation of Variable Interest Entities, and effective December 31, 2003, the Company adopted FIN 46 (revised December 2003) (FIN 46R). FIN 46R is an interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements, which requires an enterprise to assess whether consolidation of an entity is appropriate based upon its interests in a variable interest entity (VIE). FIN 46R provides guidance on how to identify a VIE and how an enterprise assesses its interests in a VIE. It also requires VIEs to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among the parties involved. Implementation of FIN 46R did not have a material impact on our consolidated results of operations, cash flows or financial position.
In June 2002, the FASB, issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (SFAS 146), which supercedes Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)(EITF Issue 94-3). The provisions of this Statement are effective for exit or disposal activities initiated after December 31, 2002. SFAS 146 requires recognition of a liability for costs associated with an exit or disposal activity when the liability is incurred, rather than when the entity commits to an exit plan under EITF Issue 94-3. This Statement applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a disposal activity covered by SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144). Additionally, this Statement does not apply to costs associated with the retirement of a long-lived asset covered by SFAS No. 143, Accounting for Asset Retirement Obligations (SFAS 143). The adoption of this Standard did not have a material effect on our consolidated results of operations, cash flows or financial position.
On December 27, 2001, we sold 16.1 million shares of common stock, at $3.20 per share, which included the exercise of the underwriter's over-allotment option of 2.1 million shares, in a follow-on public offering (the December 2001 public offering). We used the net proceeds of $46.5 million from this sale to:
The amortized cost and estimated fair value of invested assets as of December 31, 2003 were as follows:
Proceeds, gross realized gains and gross realized losses from the sales (excluding calls, maturities and pay downs) of fixed maturities available-for-sale during each year were as follows:
At December 31, 2003 and 2002, $6.5 million of cash was held for fully insured employer shared risk plans, which is restricted to use. The Company is entitled to investment income from these funds.
Goodwill represents the excess of purchase price over the fair value of tangible and identifiable intangible net assets acquired. At December 31, 2003, goodwill was $10.7 million, all of which related to the Senior and Other segment, and represented approximately 1.4% of our total assets. Additionally, other intangible assets represent purchased assets that also lack physical substance, but can be distinguished from goodwill because of other legal rights or because the assets are capable of being sold or exchanged either on its own or in combination with a related contract asset or liability. At December 31, 2003, our other intangible assets consisted of $3.4 million in licenses, which represented 0.4% of our total assets.
Effective January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142) issued by the FASB, which provides that goodwill and intangibles with indefinite useful lives should not be amortized but instead be tested for impairment annually at the reporting unit level. In accordance with SFAS 142, we completed a transitional goodwill impairment test, which indicated that an impairment loss against our goodwill and other intangible assets was not required. Goodwill and intangibles with indefinite useful lives are tested for impairment on an annual basis and more often if indications of impairment exist. The estimated fair value of goodwill of a reporting unit is determined by applying the appropriate discount rates to estimated future cash flows for the reporting unit. The estimated fair value of licenses was determined by independent appraisals. The results of our analysis indicated that no reduction of goodwill was required. A slight reduction of $0.1 million was made to the carrying value of licenses in 2003 due to the cancellation of business in certain unprofitable states.
Federal income tax expense (benefit) from continuing operations was composed of the following:
Income tax expense (benefit) are recorded in various places in our consolidated financial statements. A summary of the amounts and places are as follows:
The Company determines a valuation allowance based on an analysis of amounts recoverable in the statutory carryback period and available tax planning strategies. In assessing the valuation allowance established at December 31, 2003 and 2002, estimates were made as to the potential financial impact on the Company of recent NOLs and our financial condition.
In accordance with federal tax law, a portion of insurance companies' net income, prior to 1984, is not subject to federal income taxes (within certain limitations) until it is distributed to policyholders, at which time it is taxed at regular corporate rates. For federal income tax purposes this untaxed income is accumulated in a memorandum account designated "policyholders' surplus." At December 31, 2003, the accumulated untaxed policyholders' surplus for the Company, all of which relates to Central Reserve, was $2.9 million.
The following table reflects the activity in the liability for other policy claims and benefits payable, including the claims adjustment expenses, net of reinsurance recoverables, as follows:
In December 2000, Central Reserve entered into a reinsurance transaction with Lincoln National Reassurance Company, or Lincoln, for a ceding allowance of $4,000,000. The policies reinsured, on a combined coinsurance and modified coinsurance basis, were 80% of all group term life insurance and 35% of all individual deferred annuities in force on and after December 31, 2000. The ceding allowance is being accounted for as a deferred reinsurance gain in the accompanying audited consolidated financial statements and is being amortized into income based upon the emerging profit stream of the in force business.
In December 2001, Continental General entered into a reinsurance transaction with London Life International Reinsurance Corporation, or London, for a 75% quota share of certain health policies issued after February 1, 1999. Under the provisions of the treaty, effective January 1, 2001, Continental General ceded 75% of the premiums of the eligible policies, and in return received reimbursement for 75% of the claims paid, plus a commission and expense allowance. If the combined loss ratio (defined as benefits plus expense allowances divided by premium) was less than 100%, an experience refund was paid from London to Continental General. The expense and profit charge was 200 basis points and 85 basis points of reinsurance premium for 2002 and 2001, respectively. Beginning January 1, 2002, London retroceded any losses on these policies in excess of a combined ratio of 110% to Central Reserve. In exchange for coverage on this business,
Effective August 1, 1998, Central Reserve entered into a reinsurance treaty with United Benefit Life, a life and accident and health insurer in Texas. Under the terms of the treaty, Central Reserve agreed to assume 100% of United Benefit Life's block of business, until such time as profits earned by Central Reserve on the assumed block reached a contractual threshold, which approximated $20.0 million of pre-tax income. Central Reserve paid to United Benefit Life a $20.0 million ceding allowance in connection with this transaction.
consolidated financial statements, and was amortized into income over the duration of the underlying block of business. In 1999, Central Reserve acquired through foreclosure the stock of United Benefit Life.
In the ordinary course of business, the Company maintains other reinsurance arrangements with other insurers. These arrangements are designed to limit the maximum amount of exposure that the Company retains on a given policy. For ordinary and group life claims, Continental's maximum retention is $125,000 and Central Reserve's maximum retention is $50,000 with no retention maintained over age 70. For accident and health claims, maximum retention on individual claims is $500,000.
The insurance companies remain obligated for amounts ceded in the event that the reinsurers do not meet their obligations. Initial ceding allowances received from reinsurers are accounted for as deferred reinsurance gain and are amortized into income over the estimated remaining life of the underlying policies reinsured, except for interest sensitive products that are amortized over the expected profit stream of the in force
On December 23, 2003, we entered into a new credit agreement among Ceres, the subsidiaries of Ceres which are signatories thereto, CIT Group, and National City Bank as Administrative Agent. Proceeds of the new $13.0 million term loan facility were used to pay off the existing term loan balance under the Chase agreement and to repurchase most of the stock of one of our non-regulated subsidiaries from certain agents of the Company. The early pay off of the Chase agreement resulted in the immediate amortization of the capitalized loan fees relating to that debt, causing a pre-tax expense of approximately $0.3 million. The loan origination fee on the new credit agreement of 1.0% will be amortized over the lives of the new term loans.
The new credit agreement contains various covenants including financial covenants relating to leverage, fixed charge coverage, risk-based capital of regulated insurance subsidiaries and tangible net worth. It also has a number of affirmative and negative covenants, including limitations relating to indebtedness, liens, mergers, purchases and sales of assets, investments, dividends and stock repurchases. At December 31, 2003, we were in compliance with these covenants.
We do not have transactions or relationships with variable interest entities, and we do not have any off balance sheet financing other than normal operating leases.
We believe that cash flow from operating activities will be sufficient to meet the currently anticipated operating and capital expenditure requirements of our subsidiaries over the next 12 months. Funds to meet our debt obligations are generated from fee income from our non-regulated subsidiaries. Our ability to make scheduled payments of the principal and interest on our indebtedness depends on our future performance and the future performance of our non-regulated subsidiaries, which are subject to economic, financial, competitive and other factors beyond our control. Fee income is derived from fees primarily in connection with our major medical business. As that business continues to decline, fee income will decline. Dividends from the regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. In 2003, none of our direct insurance subsidiaries (Central Reserve and Continental General) could pay a dividend to Ceres without the prior approval of their respective state insurance regulators as a result of their respective statutory levels of unassigned surplus at December 31, 2002. In 2004, Continental General could pay a dividend to Ceres Group, the parent company, of up to $6.0 million without prior approval of the state regulator. Central Reserve is prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus.
As a result of the termination of the business in these subsidiaries, these blocks had a $2.5 million pre-tax loss in 2002 compared to a $17.9 million pre-tax loss in 2001 including special charges and legal expenses.
In 1999, 373 employees each received 1,000 common stock options under the 1998 Employee Stock Option Plan. A second grant was made for new employees hired from January 1, 1999 through September 30, 1999, and still employed as of December 31, 1999. Under this second grant in 2000, 75 employees received 1,000 common stock options. Each grant vests after three years and expires ten years from the date of the grant, with accelerated vesting upon an event of a change in control. The Company terminated this plan in December 2000. At December 31, 2003, there were options outstanding under the plan to purchase 215,000 shares.
In 1998, pursuant to the 1998 Key Employee Share Incentive Plan, the Company granted common stock options to certain key employees. In 1999 through 2003, the Company granted additional common stock options to certain employees under the 1998 Key Employee Share Incentive Plan. In general, such grants vest over three years and expire ten years from the date of the grant. In the event of a change in control, all options granted immediately vest and become exercisable in full. There are 2,000,000 shares of our common stock reserved for issuance under this plan. At December 31, 2003, there were options outstanding under the plan to purchase 1,131,561 shares.
In 1998 and 1999, pursuant to various individual employment agreements, the Company granted non-qualified options to purchase 815,000 shares of our common stock to certain key employees. Such grants generally vest over three years. At December 31, 2003, there were options outstanding under the plan to purchase 315,000 shares.
A summary of the Company's stock option activity is presented below:
Exercise prices for options outstanding at December 31, 2003 ranged from $1.95 to $9.50. While some options have no expiration date, management estimates the remaining average contractual life of options awarded is 5 years. A summary of the options by range of exercise price is as follows:
The Company also had outstanding at December 31, 2003, 3,657,743 warrants at $5.41, expiring in 2005, and 25,000 warrants at $5.27, expiring in 2008.
We also have a 2000 Agent Stock Purchase Plan similar to the employee plan under which certain of our agents may purchase shares of our common stock at the same discount from fair value. The agent stock purchase plan does not qualify as an employee stock purchase plan within the meaning of Section 423 of the Code. As of December 31, 2003 and 2002, 75,828 and 164,164 shares, respectively, had been issued under the agent plan. There are 1,000,000 shares of common stock reserved for issuance in the aggregate under both plans. Both of the plans will terminate when all of the shares reserved for issuance under the plans have been purchased unless sooner terminated by the Board of Directors.
Also, pursuant to employment contracts, the Company provided an award of common shares to Peter W. Nauert. The number of shares awarded was contingent upon the weighted average fair value of the common shares over specified periods, but was based on a stock award equal to $1.0 million per year through July 1, 2001 and $0.5 million per year through May 31, 2002, which was revised from July 1, 2003 due to his retirement as Chief Executive Officer. For the year ended December 31, 2002, 88,661 shares were awarded. The Company recognized stock compensation expense related to these awards of $0.2 million and $0.9 million in 2002 and 2001, respectively.
As required by SFAS No. 123, Accounting for Stock-Based Compensation, the Company has estimated the pro forma impact on net income and earnings per share of stock-based compensation under the fair value method, using the Black-Scholes option valuation model.
Based on the methodology and assumptions delineated above, the weighted average fair value of options was $1.48, $1.39, and $1.18 per share for 2003, 2002 and 2001, respectively. The pro forma impact on net
income and net income per share for the year ended December 31, 2003 would be to increase net income by $0.9 million or $0.02 per share. The positive pro forma impact on net income and net income per share in 2003, was due to the forfeiture of options resulting from employee terminations. The pro forma impact for the years ended December 31, 2002 and 2001 would be to decrease net income by $0.4 million and $0.8 million, respectively, and to decrease net income per share by $0.01 and $0.05, respectively.
(1) Statutory capital and surplus for Central Reserve includes Provident American Life and United Benefit Life. Central Reserve's statutory net gain (loss) for the year ended December 31, 2003 includes the losses of United Benefit Life. For the years ended December 31, 2002 and 2001, the losses of Provident American Life and United Benefit Life are included in Central Reserve's statutory net gain (loss).
(3) Pyramid Life's statutory net gain for the year ended December 31, 2003 includes statutory earnings through March 31, 2003. On March 31, 2003, we sold Pyramid Life to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp. See Note E. Discontinued Operations for further information.
Generally, the capital and surplus of Ceres' insurance subsidiaries available for transfer to the parent company are limited to the amounts that the insurance subsidiaries' capital and surplus, as determined in accordance with statutory accounting practices, exceed minimum statutory capital requirements. However, payments of the amounts as dividends may be subject to approval by regulatory authorities. In 2003, none of our direct insurance subsidiaries (Central Reserve and Continental General) could pay a dividend to Ceres without the prior approval of their respective state insurance regulators as a result of their respective statutory levels of unassigned surplus at December 31, 2002. In 2004, Continental General could pay a dividend to Ceres Group, the parent company, of up to $6.0 million without prior approval of the state regulator. Central Reserve is prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus.
The NAIC revised the Accounting Practices and Procedures Manual in a process referred to as Codification. The revised manual was effective January 1, 2001. The domiciliary states of Ceres and its
insurance subsidiaries have adopted the provisions of the revised manual. The revised manual has changed, to some extent, prescribed statutory accounting practices and has resulted in changes to the accounting practices that Ceres and its subsidiaries use to prepare their statutory-basis financial statements. The impact of these changes to statutory-basis capital and surplus of Ceres insurance subsidiaries was not significant.
(1) Net of reclassification adjustments for net gains (losses) included in net income, net of tax expense, of $1,229, $1,470 and $1,472 for 2003, 2002 and 2001, respectively.
In 2001, the diluted earnings per share calculation was adjusted for a one time net gain on repurchase of the convertible voting preferred stock. Basic and diluted weighted average shares of common stock are as follows:
The Company sponsors the Ceres Group, Inc. 401(k) Plan, a defined contribution 401(k) savings plan (the Plan). Effective January 1, 2001, the Plan was amended to increase the employer match (Company Match Contribution) to 50% of the participant's contributions subject to a maximum of 6% of the participant's salary.
In addition, Ceres may contribute a Profit Sharing Contribution to the Plan, as determined by the Board of Directors. All eligible, active employees who have worked over 1,000 hours during the plan year and who are employed on the last day of the plan year share in this contribution. Participants who leave employment during the plan year due to retirement, death or disability will also share in the contribution. There were no Profit Sharing Contributions made for the 2003, 2002 and 2001 plan years, respectively.
A participant's interest in the Company Match Contribution, Stock Match Contribution and Profit Sharing Contribution allocated to the participant's account becomes vested over a five-year graded vesting schedule with 100% vesting over five years. Total matching contributions by the Company were approximately $504,000 for 2003, $642,000 for 2002, and $768,000 for 2001.
We apply SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, which requires us to report information about our operating segments according to the management approach for determining reportable segments. This approach is based on the way management organizes segments within a company for making operating decisions and assessing performance. We have three distinct operating segments based upon product types: Medical, Senior and Other, and Corporate and Other. Products included in the Medical segment include catastrophic and comprehensive medical plans. Significant products in the Senior and Other segment include Medicare supplement, long-term care, dental, life insurance, and annuities. The Corporate and Other segment encompasses all other activities, including investment income, interest expense, and corporate expenses of the parent company.
The following table presents the revenues, expenses and profit (loss) from continuing operations before federal income taxes, for the last three years attributable to our industry segments. We do not separately
The tax ramifications of the related unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.
ANNUITY CONTRACTS -- The fair value for the annuity reserves included in the liability for future policy benefits, losses, and claims is the amount payable on demand.
DEBT -- The carrying amounts reported in the consolidated balance sheets for the long-term debt approximates their fair value.
Carrying amounts and estimated fair values of financial instruments at December 31, 2003 and 2002, are summarized as follows:
Substantially all of the Company's reinsurance recoverable is due from a single reinsurer, Hannover. At December 31, 2003, Hannover has an "A" rating from the A.M. Best Company. The Company performs periodic evaluations of this reinsurer's credit standing.