The Company owns, through Citizens Security, a three-story, 63,000 square foot office building in suburban Louisville, Kentucky completed in 1988. The Company and Citizens Security occupy about 13,200 square feet in the building for their headquarters and home offices. Another 49,600 square feet of the remaining space are leased to unaffiliated tenants under leases of various duration.
The following table sets forth selected historical consolidated financial information for the Company as of December 31, 1996, 1995, 1994, 1993 and 1992 and the years then ended. Such information should be read in conjunction with the Consolidated Financial Statements of the Company and its subsidiaries, and the related Notes. Factors affecting the comparability of certain indicated periods are discussed in
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company makes forward-looking statements from time to time and desires to take advantage of the "safe harbor" which is afforded such statements under the Private securities Litigation Reform Act of 1995 when they are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statements.
The aggregate purchase price for the Acquisition, as finally adjusted, was $9,419,000 (including $437,000 of net transaction costs associated with the purchase and, the purchase of minority shareholders' stock as part of the merger discussed above).
The Acquisition was financed with working capital of Citizens Security and approximately $6,100,000 of the $6,400,000 proceeds under a Term Loan Agreement with a commercial bank (the "Term Loan Agreement"). Borrowings under the Term Loan Agreement are evidenced by a $4,400,000 note that matures on October 1, 2002 (the "2002 Note") and a $2,000,000 note that matures on October 1, 2003 (the "2003 Note"). See Note 6 to the Consolidated Financial Statements.
In order to obtain required approvals from insurance regulatory authorities of Pennsylvania, the Company issued $1,727,000 of preferred stock in December 1995 and applied $1,500,000 of the proceeds to prepay the first installment
1 Net of write-downs on bonds whose decline in value is believed to be other-than-temporary 2 Fair values as of December 31, 1996 were obtained from the Company's investment advisor's portfolio review, which used market prices from Shaw Data Services.
The Company believes it has a well diversified portfolio and has no definitive plans to decrease its non-investment grade portfolio significantly below its current level, unless necessary to satisfy requirements of state regulators or rating agencies. The Company purchases non-investment grade bonds to obtain higher yields or convertible features and attempts to reduce credit risk by portfolio diversification. However, publicized failures of significant insurers, attributed partially or principally to non-investment grade bonds, led the Company to decrease such bond holdings in most years since 1990.
Non-Investment Grade December 31, 1996 Carrying Value Fair Value - --------------------------- -------------- ---------- Largest $ 750,566 $ 690,000 Second largest 621,272 532,500 Third largest 500,000 500,000 Fourth largest 500,000 494,375 - --------------------------- -------------- ---------- Total $2,371,838 $2,216,875 - --------------------------- -------------- ----------
The Company had no guarantee or other type of investment associated with the issuers represented above.
As more extensively discussed under Consolidated Results and Analysis, below, the Company realized significant net capital gains from its marketable investments over the three-year period ended December 31, 1996. Management believes these net gains (losses) which total $2,102,000, [$967,000, $1,534,000, and $(399,00) for 1996, 1995 and 1994, respectively], are greater than would have been obtained from a more conservative investment strategy involving only investment grade bonds. The Company's strategy has in some years subjected it to fluctuations in income and shareholders' equity of a magnitude significantly larger than would be anticipated under a more conservative investment strategy. Net capital gains or losses for a given period are not necessarily indicative of those for future periods.
The Company maintained relatively high balances in cash and short-term securities over the past several years through 1995, principally due to the uncertainty as to future interest rates and anticipation of potential surrenders and withdrawals. The $9,777,000 balance in cash and short-term securities at December 31, 1995 was invested in longer term securities during 1996, including a net increase in equity securities of $2,822,000 (on a cost basis) and $4,124,000 was used to prepay a mortgage loan.
At December 31, 1996, the Company holds a $156,000 mortgage loan from a real estate limited partnership in which the Company also has a 20% equity interest. The mortgage loan, maturing March 31, 1998, permits revolving credit advances, not to exceed at any time, the lesser of $750,000 or 80% of the collateral fair value. Stockholders of the partnership's general partner personally guarantee 80% of the loan.
Liabilities. Shown below is a progression of the Company's policyholder deposit activity for the year ended December 31, 1996.
Year Ended December 31, 1996 Total Annuity Universal Life Other - ---------------------------- ------------- ----------- ------------ ----------- Beginning Balance $15,925,201 $9,457,887 $5,274,027 $1,193,287 Deposits 818,849 278,675 497,962 42,212 Withdrawals (1,730,273) (807,501) (802,139) (120,633) Interest credited 916,494 561,024 306,773 48,697 - --------------------------- ------------- ----------- ----------- ----------- Ending Balance $15,930,271 $9,490,085 $5,276,623 $1,163,563 - --------------------------- ------------- ----------- ----------- -----------
Year Ended December 31, 1996 1995 1994 - ---------------------------- -------------- ------------- -------------- Ordinary Life $39,566,891 $39,515,527 $12,419,309 Accident and Health 1,934,980 1,913,638 1,432,125 - ---------------------------- -------------- ------------- -------------- Total $41,501,871 $41,429,165 $13,851,434 - ---------------------------- -------------- ------------- --------------
Premiums and Other Considerations. The following table presents premiums and other considerations received during the past three fiscal years.
The Company's net life and annuity premium increased $3,764,000 in 1996, essentially all of which was attributable to the Integrity acquisition. Although the Company's other traditional life and graded death benefit gross premiums have increased; this sales growth, net of reinsurance, is significantly offset by lapses of older policies with minimal reinsurance. The $3,130,000 increase in life and annuity premium during 1995 includes $2,996,000 from the Integrity acquisition, while substantially all of the remaining increase resulted from sales of the Company's traditional life graded death benefit product.
Although 1996 life and annuity sales increased substantially, the acquired Integrity annualized premium inforce declined approximately eight percent during the year. This was primarily due to loss of Integrity's licenses in New Jersey and Delaware at the Merger date and some disruption of sales momentum during the merger process. Citizens Security obtained a license to transact business in Delaware in January, 1997, and a license application is pending in New Jersey. The Company has also devoted significant attention towards building a solid relationship with the Integrity agency force, including: hiring a new Senior Vice President of Agency who has significant experience in the home service market, developing additional home service products, and ongoing personal visits with agents in the field and in the home office. Additionally, the Company has developed several sales initiative programs which management believes will result in attainment of pre-acquisition production levels within the next year.
Accident and health premiums increased 33.3% during 1996. Approximately three-quarters of this increase is attributable to a continued emphasis on aggressively growing the group dental business. The remaining increase is primarily attributable to the individual accident and health business acquired from Integrity. During 1995, accident and health premiums increased 18.3%, which was also due primarily to sales of group and voluntary dental products, offset to an extent by declines in its individual accident and health products.
The Company's significant growth in dental premium has also increased its loss ratio over the past two years. As discussed further below, during 1997 the Company will concentrate its efforts on introducing new designs of its dental products and other procedures to improve the product's loss ratio to pre-1995 levels. These efforts should significantly enhance product margins, however, they will likely abate the rate of premium increase experienced during the past two years.
Investments. The Company monitors its available-for-sale fixed maturities and equity securities to assure they are strategically positioned within the current interest rate environment. This practice has historically resulted in equity securities comprising 10% to 20% of the Company's cash and invested assets, which tends to dampen current income yields in favor of an overall total return focus.
Year Ended December 31, 1996 1995 1994 - --------------------- ------------ ----------- ----------- Investment Income Yield 5.9% 6.1% 5.3% Total Return Yield 7.2% 9.7% 4.2%
Segment Earnings. The $594,000 increase in income from operations before federal income taxes between 1995 and 1996 resulted from a $567,000 decrease in net realized capital gains and a $1,161,000 increase in pretax earnings before realized capital gains. The $1,161,000 increase in 1996 pretax earnings before capital gains resulted primarily from successful completion of the Integrity acquisition and a decrease in variable investment management fees. The $1,414,000 increase in income from operations before federal income taxes in 1995 over 1994 resulted from increased realized capital gains, offset in part by increased expenses related to the integration of Integrity's operations and investment management fees, which are paid based upon performance of the portfolio.
Shown below is segment income (loss) before realized gains on investment securities and federal income taxes for 1996, 1995, and 1994.
Year Ended December 31 1996 1995 1994 - ---------------------- ----------- ----------- ------------ Life and Annuity $120,956 $(1,036,184) $(402,480) Accident and Health 247,733 243,301 128,556 - ---------------------- ----------- ----------- ------------ Total $368,689 $ (792,883) $(273,924) - ---------------------- ----------- ----------- ------------
The $1,157,000 increase in the Life and Annuity segment's income in 1996 as compared with 1995 was principally attributable to successfully completing the integration of Integrity's operations in 1996 and certain nonrecurring costs in 1995, including $281,000 of Integrity assimilation costs and $246,000 of variable investment performance management fees. The $634,000 increase in the segment's loss between 1994 and 1995 was principally attributable to the nonrecurring Integrity assimilation costs and variable investment management fees noted above.
Shown below is a comparison of the contribution of each of the group accident and health products toward profit and overhead (direct premium minus: claims, change in reserves and commissions) and loss ratios for the years ended December 31, 1996, 1995 and 1994.
Contribution Margin Loss Ratio ------------------------------- -------------------------- Year Ended December 31, 1996 1995 1994 1996 1995 1994 - ------------------ --------- ---------- ---------- -------- --------- ------- Dental $741,525 $939,857 $943,705 75.6 % 68.6% 64.7% Short-term disability 73,500 $ 42,885 $ 59,072 9.3 % 52.4% 42.2% Long-term disability 42,667 $ 18,903 $ 17,893 (30.1)% 18.9% 14.5%
$148,000 of net premium in 1996. Relatively minor changes in claim and corresponding reserve levels can significantly impact their relative contribution margins and loss ratios. Dental's relatively flat contribution in 1995 as compared with 1994 was the result of a 23.7% increase in premium offset by a 3.9% increase in the loss ratio. The increases in premiums and the loss ratio during 1995 were also principally attributable to the Company's strategy of replacing coverage for groups which have previously obtained coverage from other carriers.
Performance of the Company's individual accident and health line improved in 1996 over 1995 due to approximately $100,000 of additional margins from the acquired Integrity business and $50,000 of additional margins from the cancer product's performance. The cancer product's loss ratio has steadily improved over the past three years (30.5%, 36.4%, and 51.7% in 1996, 1995, and 1994 respectively).
Federal Income Taxes. The Company has a relatively low effective federal income tax rate, which can fluctuate significantly due to the application of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." The most significant provision under SFAS No. 109 affecting the Company is the disallowance of the small life insurance company deduction when computing deferred taxes. The small life insurance deduction allows Citizens Security to reduce its taxable income by 60% before computing its current provision for regular or alternative minimum tax. By disallowing this deduction in the computation of deferred taxes, SFAS No. 109 significantly increases the deferred taxes on Citizens Security's temporary differences. Thus, when a significant increase or decrease occurs in the Company's net temporary differences, the related deferred tax is computed using the 34% federal tax rate, whereas tax will actually be paid on these net liabilities (when realized) at a 17% rate (the alternative minimum tax rate after application of the allowable small life insurance company deduction). The Company's gross deferred federal income tax liabilities and assets are more fully discussed in Note 8 to the Consolidated Financial Statements. All operating deferred tax assets of the Company are realizable by offset against existing deferred tax liabilities. Capital deferred tax assets of Citizens Security can be realized through the carry back of such assets to recapture prior years' taxes paid on capital assets. Capital deferred tax assets of the Company must be offset against future capital gains. The Company believes such gains will materialize and the deferred tax assets will be realized. The deferred tax assets are offset, to some extent, by valuation allowances related to the Company and to Citizens Security. Due to the impact of the small life insurance company deduction, Citizens Security records a valuation allowance to reduce deferred tax assets (associated with temporary differences) to their expected benefit rate of 17%, rather than 34%. The Company's valuation allowance is designed to reduce deferred tax assets to their estimated ultimate realization value.
Net Operating Statutory Asset Year Ended Net Income Capital and Valuation Capital December 31 Income (Loss) Surplus Reserves1 Ratio2 - --------------- --------- ----------- ----------- ----------- --------- 1996 $3,062,421 $871,089 $9,145,830 $1,426,918 16.05% 1995(3) $ 883,003 $494,588 $8,406,313 $1,087,020 14.63% 1994 $ 591,998 $296,809 $5,651,136 $ 768,664 18.46% 1993 $1,381,537 $126,887 $5,690,048 $1,648,343 20.08% 1992(4) $1,101,725 $319,802 $4,309,785 $2,322,379 19.06%
The decrease in statutory capital and surplus and asset reserves in 1994 as compared with 1993 was due to unrealized losses in the equity portfolio offset to an extent by increased operating income.
Statutory capital and surplus, specifically the component called surplus, is used to fund the expansion of an insurance company's first year individual life and accident and health sales. The first year commission and underwriting expenses on such sales will normally consume a very high percentage of, if not exceed, first year premiums. Accordingly, a statutory loss often occurs on these sales during the first year of the policy. Citizens Security's first year sales of these type of products have not been of a magnitude to have a significant impact on statutory surplus.
The NAIC promulgated Standard Valuation Law ("SVL") specifies minimum reserve levels and prescribes methods for determining them, with the intent of enhancing solvency. Some of the states in which Citizens Security is licensed have enacted this law. The primary method required by the SVL for verifying reserve adequacy is cash flow testing, in which projected cash inflows from assets are matched with cash outflows for liabilities. Various future economic and yield curve scenarios are assumed. This is a dynamic process, whereby the performance of the assets and liabilities is directly related to the scenario assumptions. (An example would involve the credited interest rate on annuity products and how such rates vary depending upon projected earnings rates, which are based upon asset performance under a particular economic scenario.)
Any necessary corrective measures could take one or more forms. The duration of existing assets might not match well with those of the liabilities. Certain liabilities, such as those associated with indemnity accident and health, short-term disability and group dental products, are short-term in nature and are best matched with cash and short-term investments. By contrast, whole life insurance, which involves lifetime obligations, is usually best matched by longer duration maturities. In the event there are insufficient assets of these types, a repositioning of the investment portfolio might be undertaken.
The above discussion centers around asset management. Other possible corrective measures might involve liability realignment. The Company's marketing plan could be modified to emphasize certain product types and reduce others. New business levels could be varied in order to find the optimum level.
Management believes that the Company's current liquidity, current bond portfolio maturity distribution and positive cash flow from operations give it substantial resources to administer its existing business and fund growth generated by direct sales. The Company will service debt, dividends, redemption of preferred stock, and other expenses by:
- Redemption of Citizens Security preferred stock as necessary, with such redemption also requiring approval by the Kentucky Department of Insurance.
Consolidated Statements of Operations for the years ended December 31, 1996, 1995 and 1994 .................... 25
Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1995 and 1994..................... 29
We have audited the consolidated financial statements of Citizens Financial Corporation and subsidiaries listed in the accompanying index to financial statements at Item 8. Our audit also included the financial statement schedules listed in the index at Item 8. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
LIABILITIES POLICY LIABILITIES: FUTURE POLICY BENEFITS $41,501,871 $41,429,165 POLICYHOLDER DEPOSITS 15,930,271 15,925,201 POLICY AND CONTRACT CLAIMS 1,210,393 1,139,777 UNEARNED PREMIUMS 183,613 201,772 OTHER 214,305 163,100 - ------------------------------------------------------------------------------- TOTAL POLICY LIABILITIES 59,040,453 58,859,015
SHAREHOLDERS' EQUITY: COMMON STOCK, 6,000,000 SHARES AUTHORIZED; 1,275,724 SHARES ISSUED AND OUTSTANDING 1,275,724 1,275,724 ADDITIONAL PAID-IN CAPITAL 5,198,250 5,198,250 UNREALIZED APPRECIATION OF INVESTMENTS 428,780 1,871,652 RETAINED EARNINGS 4,233,003 3,525,894 COMMON STOCK HELD IN TREASURY-AT COST (200,109 SHARES) (562,302) (562,302) - ------------------------------------------------------------------------------- TOTAL SHAREHOLDERS' EQUITY 10,573,455 11,309,218 - ------------------------------------------------------------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $80,262,708 $84,255,261 - -------------------------------------------------------------------------------
Citizens Security is licensed to sell products in the District of Columbia and 18 states primarily located in the south and southeast. Citizens Security markets its portfolio of products through the personal producing general agent distribution system and presently has approximately 1,520 sales representatives, all of whom are independent agents and all, or substantially all, of whom also represent other insurers. Approximately 320 of these agents are former agents of Integrity Life Insurance Company ("Integrity") who specialize in the home service market. That market consists primarily of individuals who desire whole life policies with policy limits typically below $10,000.
Principles of Consolidation and Presentation. The accompanying consolidated financial statements include the accounts of Citizens Financial Corporation, its wholly-owned subsidiaries, Citizens Financial Properties, Inc., Citizens Security, and Integrity since the date of its acquisition, September 22, 1995 (see Note 2), and a wholly-owned partnership, Marketplace I Limited Partnership (collectively hereinafter referred to as the "Company"). Effective December 31, 1995, Integrity was merged into Citizens Security. All significant intercompany accounts and transactions are eliminated in consolidation. Certain balances in prior years have been reclassified to conform to current year classifications.
Use of Estimates. The preparation of financial statements in conformity with generally accepted accounting principles 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.
Goodwill and Value of Insurance Acquired. Goodwill represents the excess of the purchase price of a former wholly-owned subsidiary, which was merged into Citizens Security effective September 30, 1992, over amounts assigned (based on estimated fair values at the date of acquisition) to the identifiable net assets acquired. Goodwill is amortized over 15 years using the straight-line method. At December 31, 1996, accumulated amortization was $130,216 ($109,254 at December 31, 1995).
Benefit Reserves and Policyholder Deposits. Traditional life and accident and health insurance products include those contracts with fixed and guaranteed premiums and benefits and consist principally of whole-life and term insurance policies, limited-payment life insurance policies and certain annuities with life contingencies. Reserves on such policies are based on assumed investment yields which range from 6% to 7%. Reserves on traditional life and accident and health insurance products are determined using the net level premium method based on future investment yields, mortality, withdrawals and other assumptions, including dividends on participating policies. Such assumptions are based on past experience and include provisions for possible unfavorable deviation.
Premiums, Benefits and Expenses. Premiums for traditional individual life and accident and health policies are reported as earned when due. Benefit claims (including an estimated provision for claims incurred but not reported), benefit reserve changes and expenses (except those deferred) are charged to expense as incurred. Deferred policy acquisition costs related to traditional life and accident and health policies are charged to expense over the life of the policy using methods and assumptions consistent with those used in estimating liabilities for future policy benefits. In determining whether a premium deficiency exists on short-duration policies, management does not give consideration to investment income.
Deferred policy acquisition costs related to universal life and investment-type products are amortized in relation to the incidence of expected gross profits over the life of the policies. Expected gross profits are reviewed at each reporting period, and to the extent actual experience varies from that previously assumed, the effects of such variances are recorded in the current period.
Federal Income Taxes. The Company uses the liability method of accounting for income taxes. Deferred income taxes are provided for cumulative temporary differences between balances of assets and liabilities determined under generally accepted accounting principles and balances determined for tax reporting purposes.
The aggregate purchase price for the Acquisition, was $9,419,000 (including net cost associated with the purchase of $437,000 and the purchase of minority shareholders stock as part of the merger discussed above). No goodwill was recorded relating to the acquisition.
Prior to the closing, Integrity entered into a coinsurance and assumption reinsurance agreement with Union Bankers Insurance Company ("Union Bankers"), another affiliate of Southwestern, covering Integrity's 14,500 individual long-term care and Medicare supplement insurance policies with annualized premiums of approximately $14,800,000, leaving the remaining life and accident and health insurance business with Integrity. In conjunction with this reinsurance transaction, Integrity transferred approximately $9,200,000 in reserves to Union Bankers. Completion of these transactions was a condition to the Company's obligations under the Stock Purchase Agreement with Southwestern because the reinsured business did not fit into the Company's current business plans. Under the agreement, Union Bankers directly assumed the liability for these policies.
Fair Value DECEMBER 31, 1996 Amortized Gross Unrealized (Carrying Cost Gains Losses Value) ----------- ---------- -------- ----------- Fixed Maturities: U. S. government obligations $10,132,155 $ 35,502 $210,194 $ 9,957,463 Corporate securities 25,663,794 308,374 312,780 25,659,388 Mortgage-backed securities 11,784,829 120,605 139,475 11,765,959 - --------------------------------- ----------- ---------- -------- ----------- Total $47,580,778 $ 464,481 $662,449 $47,382,810 - --------------------------------- ----------- ---------- -------- ----------- Equity securities $ 7,085,104 $1,291,042 $412,596 $ 7,963,550 - --------------------------------- ----------- ---------- -------- -----------
----------- ---------- -------- ----------- Equity securities $ 4,263,273 $1,549,368 $ 69,727 $ 5,742,914 ----------- ---------- -------- -----------
December 31, 1996 Amortized Cost Fair Value - ------------------------------ ------------- ------------ Due in one year or less $ 2,488,374 $ 2,500,832 Due after one year through five years 10,442,500 10,478,608 Due after five years through ten years 19,372,180 19,312,757 Due after ten years 3,492,895 3,324,654 - ------------------------------ ------------- ------------- Subtotal 35,795,949 35,616,851 Mortgage-backed securities 11,784,829 11,765,959 - ------------------------------ ------------- ------------- Total $47,580,778 $47,382,810 - ------------------------------ ------------- -------------
Gross gains of $551,881, $376,889 and $135,280 and gross losses of $317,685, $18,892, and $411,484 were realized on the sale of available-for-sale fixed maturities during 1996, 1995 and 1994, respectively. Included in gross realized losses during 1994 is a net adjustment to the carrying value of available-for-sale fixed maturities of $91,000, relating to declines in value which were considered by management to be other than temporary. Net realized gains from the sale of fixed maturities have been reduced in 1996 by $16,008 associated with the amortization deferred policy acquisition costs.
Net unrealized appreciation (depreciation) of available-for-sale securities is summarized as follows:
Year Ended December 31 1996 1995 1994 - ------------------------------ ------------------------------------- Fixed maturities $3,361,210 $2,088,980 $1,241,705 Equity securities 152,025 248,796 187,492 Mortgage loans on real estate 18,298 18,975 44,938 Policy loans 154,845 114,191 113,743 Investment real estate 323,498 288,259 323,662 Short-term investments and other 367,324 206,596 280,517 - ------------------------------ ------------------------------------- Subtotal $4,377,200 $2,965,797 $2,192,057 Investment expenses (218,918) (358,491) (172,131) - ----------------------------- -------------------------------------- Net Investment Income $4,158,282 $2,607,306 $2,019,926 - ----------------------------- --------------------------------------
Pursuant to requirements of certain state insurance departments, the Company has investments with a carrying value of $22,425,130 at December 31, 1996, placed on deposit at various financial institutions which are restricted from withdrawal without prior regulatory approval.
The Company owns the building and land in which it currently resides and occupies approximately 21% of the building with the majority of the remaining space being leased to tenants. The accompanying financial statements reflect 21% of the building and its operating expense as property and equipment and general expense, respectively, with the remaining 79% as investment real estate and as a reduction of investment income, respectively. Accumulated depreciation at December 31, 1996 and 1995 on the investment real estate portion of the building was $588,097 and $474,840, respectively.
The Company leases office space to third party tenants under noncancellable lease agreements. Future minimum rental income is $721,816, $651,913, $178,941, and $7,400 for years 1997 through 2000, respectively.
NOTE 5--LIABILITY FOR ACCIDENT AND HEALTH UNPAID CLAIMS AND INCURRED, BUT NOT REPORTED CLAIMS PORTION OF RESERVES
Activity in the accident and health liability portion of policy and contract claims ($425,095 and $346,902 at December 31, 1996 and 1995, respectively) and the incurred but not reported portion of accident and health reserves ($1,195,361 and $1,316,799 at December 31, 1996 and 1995, respectively) are summarized as follows:
Year Ended December 31, 1996 1995 - ----------------------------------- ---------------------------- Balance at January 1 $1,663,701 $1,147,942 Less reinsurance recoverable 735,100 527,133 - ----------------------------------- ---------------------------- Net balance at January 1 928,601 620,809 Integrity balance at acquisition --- 245,688 Incurred related to: Current year 5,848,067 4,227,868 Prior years --- 1,654 - ----------------------------------- ---------------------------- Total incurred 5,848,067 4,229,522 Paid related to: Current year 5,243,068 3,605,337 Prior years 489,189 562,081 - ----------------------------------- ---------------------------- Total paid 5,732,227 4,167,418 Net balance at December 31 1,044,441 928,601 Plus reinsurance recoverable 576,015 735,100 - ----------------------------------- ---------------------------- Balance at December 31 $1,620,456 $1,663,701 - ----------------------------------- ----------------------------
December 31 1996 1995 - ----------------------------------- ------------ ------------ Commercial bank note, prime plus 1/2%, due 2002 $2,125,000 $2,900,000 Commercial bank note, prime, due 2003 1,750,000 2,000,000 Subordinated guaranty note, prime, due 2003 220,869 205,326 Mortgage note, 8%, due 1998 --- 4,201,656 - ----------------------------------- ------------ ------------ Total 4,095,869 9,306,982 Less: Current Portion (225,000) (277,539) - ----------------------------------- ------------ ------------ Long Term Portion $3,870,869 $9,029,443 - ----------------------------------- ------------ ------------
The two commercial bank notes were issued in 1995, to finance the Integrity acquisition. The notes were both originally issued at the bank's prime lending rate plus 1%, with interest payable quarterly. The 2002 Note and the 2003 Note had original note amounts of $4,400,000 and $2,000,000, respectfully, and have outstanding balances at December 31, 1996 of $2,125,000 and $1,750,000, respectively. Remaining principal installments due in each succeeding year for the 2002 Note are $225,000, $400,000, and $500,000 thereafter through the year of maturity, 2002. The 2003 Note is to be repaid in three (3) consecutive quarterly installments of $500,000 each beginning on January 1, 2003, with the final installment of $250,000 due on October 1, 2003. During 1996, the interest rate on the 2002 Note was reduced by 1/2% to prime plus 1/2%, while the interest rate on the 2003 Note was reduced by 1% to prime. No prepayments are permitted on the 2003 Note until the 2002 Note has been paid in full, except from proceeds of equity security offerings or other subordinated indebtedness. During 1996, the Company elected to prepay $500,000 and $250,000 of principal on 2002 and 2003 Notes, respectively, utilizing net proceeds deemed available from issuance of redeemable convertible preferred stock (see Note 7). Additional payments made during 1996 on the 2002 Note included $200,000 of scheduled installments and prepayment of a $75,000 installment due January 1, 1997. The Company has pledged all of the issued and outstanding common and preferred stock of Citizens Security as collateral for the commercial bank notes. In addition, the Company's principal shareholder (the "Principal Shareholder"), who is also its Chairman and President, has personally guaranteed the 2003 Note.
In consideration of the personal guarantee noted above, the Company entered into a Guarantor's Compensation Agreement (the "Guarantor's Compensation Agreement"), dated September 22, 1995, with its Principal Shareholder whereby the Company will pay an annual guaranty fee based on an applicable percentage of the outstanding principal balance of the 2003 Note on its date of issuance and each anniversary thereof. The applicable percentage ranged from 10% in the first two years and thereafter decreased in stages to 0.5% on the last anniversary before maturity, for an average of 4.21% over the term of the 2003 Note. However, the Guarantor's Compensation Agreement was amended effective September 22, 1996 to replace the 10% fee due on September 22, 1996 with an Interim Fee equal to 15% of the net realized and unrealized investment gains and losses earned on the parent company's (nonconsolidated) investment portfolio during the period from October 1, 1996 to September 30, 1997. This 15% fee is reduced in proportion to average principal repayments on the 2003 Note. During the three months ended December 31, 1996, no net realized and unrealized gains were earned on this portfolio (which totaled $2,359,238 at December 31, 1996); therefore, no guaranty fee has been earned for such period.
December 31, 1996 1995 - ------------------------------------------------------------------------------- DEFERRED TAX LIABILITIES: Value of insurance acquired $1,727,834 $2,060,092 Net unrealized gains on available-for-sale securities 220,887 1,029,192 Other 179,543 217,074 - ------------------------------------------------------------------------------- Total deferred tax liabilities 2,128,264 3,306,358
DEFERRED TAX ASSETS: Policy and contract reserves 1,808,358 2,200,490 Deferred policy acquisition costs 438,105 502,531 Fixed maturities and equity securities 192,075 151,386 Real estate 531,709 --- Alternative minimum tax credit carry forwards 317,165 241,415 Net operating loss carry forwards 464,146 424,029 Other 118,170 122,030 - ------------------------------------------------------------------------------- Total deferred tax assets 3,869,728 3,641,881 Valuation allowance for deferred tax assets (993,451) (668,989) - ------------------------------------------------------------------------------- Net deferred tax assets 2,876,277 2,972,892
The following is a reconciliation of the federal statutory income tax rate to the Company's effective income tax rate:
Federal income taxes paid in 1996, 1995 and 1994 were $91,766, $55,000, and $230,000, respectively. The Company utilized $1,180,000 and $176,621 of net operating loss carry forwards in 1996 and 1994 respectively. The Company has $1,365,134 of net operating loss carry forwards which will expire between 2007 and 2011.
Under the tax law in effect prior to 1984, a portion of income of Citizens Security was not taxed when earned. It was accumulated in a tax account known as policyholders' surplus. Under the provisions of the Deficit Reduction Act of 1984, policyholders' surplus accounts were frozen at their December 31, 1983, balance of $859,000 for Citizens Security on a merged basis. Distributions from
the policyholders' surplus would be subject to income tax. At December 31, 1996, Citizens Security could have paid additional dividends of approximately $7,875,000 before paying tax on any part of its policyholders' surplus accounts. Since the Company believes that tax will not be paid on any part of the policyholders' surplus accounts in the foreseeable future, no provision has been made for the related deferred income taxes which total $292,000, based on current tax rates.
Citizens Security is domiciled in Kentucky and prepares its statutory-basis financial statements in accordance with statutory accounting practices ("SAP") prescribed or permitted by the Kentucky Department of Insurance ("KDI"). Net income for 1996 and capital and surplus for the Company's insurance operations as reported in accordance with SAP for the three years ended December 31, 1996 are shown below.
Principal differences between SAP and GAAP include: a) costs of acquiring new policies are deferred and amortized for GAAP; b) value of insurance inforce acquired is established as an asset for GAAP; c) benefit reserves are calculated using more realistic investment, mortality and withdrawal assumptions for GAAP; d) deferred income taxes are provided for GAAP; e) assets and liabilities of acquired companies are adjusted to their fair values at acquisition with the excess purchase price over such fair values recorded as goodwill under GAAP; f) available-for-sale fixed maturity investments are reported at fair value with unrealized gain and losses reported as a separate component of shareholders' equity for GAAP; and g) statutory asset valuation reserves and interest maintenance reserves are not required for GAAP.
The Company essentially operates in two segments as shown in the following tables. Both segments include individual and group insurance. Identifiable revenues, expenses and assets are assigned directly to the applicable segment. Net investment income and invested assets are allocated to the operating segments generally in proportion to policy liabilities.
Segment information as of December 31, 1996, 1995 and 1994, and for the years then ended is as follows:
Year Ended December 31, 1996 1995 1994 - ------------------------------- ------------- ------------- ------------- REVENUES:
Life and Annuities $14,446,080 $ 9,709,671 $ 4,139,901 Accident and Health 8,655,980 6,576,906 5,448,053 - ------------------------------- ------------- ------------- ------------- Total $23,102,060 $16,286,577 $ 9,587,954
Life and Annuities $76,384,118 $77,504,054 $41,334,707 Accident and Health 3,878,590 6,751,207 3,205,155 - ------------------------------- ------------- ------------- ------------- Total $80,262,708 $84,255,261 $44,539,862
Life and Annuities $ 1,462,051 $ 1,315,897 $ 620,071 Accident and Health 94,693 123,662 118,739 - ------------------------------- ------------- ------------- ------------- Total $ 1,556,744 $ 1,439,559 $ 738,810
As discussed in Note 2, on September 22, 1995, Integrity entered into a coinsurance and assumption reinsurance agreement with Union Bankers covering Integrity's long term care and Medicare supplement business. Under the agreement, Union Bankers directly assumed these liabilities.
Fixed Maturities: The fair values for fixed maturities are based on quoted market prices, where available. For those fixed maturities which are not actively traded, fair values are estimated using values obtained from independent pricing services. Available-for-sale fixed maturities are carried at fair value in the accompanying statements of financial condition. At December 31, 1996 and 1995, the fair value of available-for-sale fixed maturities was $47,040,591 and $46,917,198, respectively.
Investment Contracts: The carrying amount of investment-type fixed annuity contracts approximates their fair value. At December 31, 1996 and 1995, the fair value of investment-type fixed annuity contracts was $9,490,085 and $9,457,887, respectively.
Notes Payable: The carrying amounts of notes payable approximate their fair values. At December 31, 1996 and 1995, the fair value of notes payable was $4,095,869 and $9,306,982, respectively.
The Company has various transactions with its President and Chairman of the Board (the "Chairman") or entities he controls. The Chairman provides investment portfolio management for the Company and Citizens Security, through SMC Advisors, Incorporated (of which the Chairman is the principal officer, a director, and the sole shareholder). The investment portfolio management contracts provide for total annual fixed fees of $30,000 and incentive compensation equal to five percent (5%) of the sum of the net realized and unrealized capital gains in the fixed maturities and equity securities portfolios of the Company and Citizens Security during each contract year. No incentive fees were earned for 1996 or 1994. An incentive fee of $245,578 was earned and paid for 1995. Any excess of net realized and unrealized capital losses over net realized and unrealized capital gains at the end of a contract year is not carried forward to the next contract year. The Company also maintains a portion of its investments under a Trust Agreement with a bank controlled by its Chairman. Fees to the bank are based on assets held. In 1996 and 1995, such fees were $17,316 and $11,121, respectively. No such fees were paid during 1994. In addition, the Chairman guarantees certain debt of the Company for which he is compensated as described in Note 6.
LIABILITIES AND STOCKHOLDERS' EQUITY Note payable to insurance subsidiary* $ 781,441 $ 3,498,798 Note payable to bank 3,875,000 4,900,000 Note payable to guarantor 220,869 205,326 Other liabilities 326,332 636,008 Dividends payable - redeemable convertible preferred stock 101,750 --- - ------------------------------------------------- -------------- ------------- Total Liabilities $ 5,305,392 $ 9,240,132
Year ended December 31, 1996 1995 1994 - ------------------------------------ ---------------- ------------- ------------
- ------------------------------------ ---------------- ------------- ------------ Income (loss) before income taxes and equity in undistributed earnings (66,192) 302,298 (660,639) Income tax benefit 149,697 194,000 202,020 - ------------------------------------ ---------------- ------------- ------------ Income (loss) before equity in undistributed earnings of subsidiaries 83,505 496,298 (458,619) Equity in undistributed earnings of subsidiaries 1,025,818 235,933 12,950 - ------------------------------------ ---------------- ------------- ------------ Net Income (Loss) $1,109,323 $732,231 $(445,669) - ------------------------------------ ---------------- ------------- ------------
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) CITIZENS FINANCIAL CORPORATION Notes to Condensed Financial Statements
The Registrant's investment in the Insurance Subsidiaries is stated at the Insurance Subsidiaries' equity at the date of reorganization (cost for non-insurance subsidiaries) plus equity in undistributed earnings and net unrealized appreciation (depreciation) of securities since date of reorganization or organization if later.
The loan payable to insurance subsidiary is a $3,500,000 revolving credit facility maturing December 31, 2003. The loan pays interest at prime plus 2% and is collateralized by securities having a market value of $392,259 at December 31, 1996.
1Net investment income is allocated based upon average policy reserves and deposits. 2Includes interest on policyholder deposits and dividends credited to participating policyholders.
1996 1995 1994 ----------- ----------- ------------ 3Amortization of deferred acquisition costs $911,543 $790,140 $446,290 Amortization of present value of acquired 390,688 419,516 70,780 ----------- ----------- ------------ $1,302,231 $1,209,656 $517,070 ----------- ----------- ------------ 4Includes commissions, salaries and wages, general expense and depreciation expense.