We own six office buildings in Lancaster, South Carolina, where most of our operations are located. We also own an office building in Fort Mill, South Carolina. Our owned properties had an aggregate book value of approximately $6.7 million as of December 31, 2005. We also lease our principal executive offices in Minnetonka, Minnesota, a suburb of Minneapolis, where some members of our executive management team, some holding company and underwriting operations and a regional sales office are located. We lease offices in Greenville, South
While Kanawha is our predecessor for accounting purposes, we caution you that the financial information presented in this report is neither comparable with nor representative of the actual results that we expect to achieve in the future. Many factors may cause our actual results to differ materially from our predecessor’s historical results including, but not limited to, the following:
The financial data set forth below should be read in conjunction with, and is qualified in its entirety by reference to Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and our predecessor’s and our audited financial statements and the related notes included in this report.
You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our audited financial statements and related notes included in this report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this report, particularly in Items 1and 1A of this report.
Worksite insurance business. Our worksite insurance business is a provider of voluntary life and health insurance products to employers and their employees which have been historically marketed primarily in the southeastern United States but are now being marketed nationwide. The primary insurance products that we underwrite include: life insurance; short-term disability insurance; dental insurance; indemnity health insurance; critical illness insurance; and employer excess risk insurance. For the year ended December 31, 2005, our worksite insurance business produced premiums, commissions and fees, excluding intercompany payments, of $60.5 million,
On October 5, 2005, we sold our agency office in Ft. Myers, Florida that was primarily responsible for distributing our senior market insurance products. In conjunction with the sale of the Ft. Myers agency office, we decided not to continue actively underwriting long-term care insurance policies after December 31, 2005. We intend to retain and actively manage the existing block of in-force long-term care insurance policies (including the right to receive future premiums and the liability for future claims). We also intend to continue offering through our worksite distribution channel Medicare supplement insurance written by another carrier, which generates commission income for us.
Third-party administration business. Our third-party administration business provides a wide range of insurance product administration, claims handling, eligibility administration, call center and support services. This business primarily administers the insurance plans offered by our worksite insurance business and senior market insurance business. Our third-party administration business also provides administrative and managed care services to third parties, such as employers with self-funded health care plans, other insurance carriers, reinsurers and managed care plans. For the year ended December 31, 2005, our third-party administration business produced commissions and fees, excluding intercompany payments, of $14.3 million, which accounted for 11.7% of our premiums, commissions and fees, excluding intercompany payments, in that period. Our primary business strategy for this business is to grow this business as it administers the increasing volume of policies and products that we anticipate will be sold by the worksite insurance business as we attempt to grow that business. In addition, as our national worksite marketing business develops, we intend to opportunistically market our third-party administration services to self-insured plans, stop loss insurers, pharmacy benefit organizations, managed care service providers, other insurance carriers and reinsurers nationwide. It is expected that any incremental costs associated with this expanded marketing will be modest and will be funded out of the operations of our third-party administration business.
Interest rate volatility can reduce unrealized gains or create unrealized losses in our portfolios. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. Fluctuations in interest rates affect our returns on, and the market value of, fixed maturity and short-term investments.
In December 2003, our predecessor transferred its fixed deferred annuity block of insurance for contracts still in the accumulation phase to Madison National Life Insurance Company (“Madison National”). The business was transferred pursuant to a 100% coinsurance agreement under which our predecessor ceded to Madison National substantially all assets and liabilities related to its fixed annuity business. The transaction resulted in a transfer of $15.1 million of reserves and $15.0 million of related assets. The ceding commission of $0.1 million combined with the write-off of the remaining DAC asset of $0.1 million resulted in no gain or loss being reflected on our predecessor’s GAAP financial statements as a result of the transaction. Total premium considerations of $0, $0 and $2.6 million generated by our predecessor’s fixed deferred annuity business were recognized in the years ended December 31, 2005, 2004 and 2003, respectively.
Policy benefit reserves for life insurance, long-term care insurance, individual and group accident and health insurance, disability insurance and group life and health insurance are recorded at the present value of future benefits to be paid to policyholders less the present value of the future net premiums (this method is called the “net level premium method”). These amounts are estimated and include assumptions made when the policy is issued as to the expected investment yield, inflation, mortality, morbidity, claim termination rates, awards for social security and withdrawal rates, as well as other assumptions that are based on our experience. These assumptions reflect anticipated trends and include provisions for possible unfavorable deviations. Throughout the life of the policy, reserves are based on these original assumptions and cannot be modified pursuant to GAAP unless policy reserves prove inadequate. We also record an unearned premium reserve which represents the portion of premiums collected or due and unpaid which is intended to pay for insurance coverage in a period after the current accounting period.
account, where necessary, any deferred profits to be recognized in income over the policy term. Policy benefit claims are charged to expense in the period that the claims are incurred.
The discount rate is the interest rate at which future net cash flows are discounted to determine the present value of such cash flows. If the discount rate chosen is higher than actual future investment returns, our investment returns will be insufficient to support the interest rate assumed when reserves were established. In this case, the reserves may eventually be insufficient to support future benefit payments. Alternatively, if a discount rate is chosen that is lower than actual future investment results, the reserves, and, for products such as long-term care insurance, the claims incurred in the current period will be overstated and profits will be accumulated in the reserves rather than reported as current earnings. We set our discount rate assumptions in conjunction with the current and expected future investment income rate of the assets supporting the reserves. If the investment yield at which new investments are purchased is below or above the investment yield of the existing investment portfolio, it is likely that the discount rate chosen at future financial reporting dates will vary accordingly.
For fixed and variable annuities, interest-sensitive life insurance and fixed and variable universal life insurance policies (none of which we currently offer), DAC (and VOBA) is amortized in proportion to the present value of estimated gross margins or profits from investment, mortality, expense margins and surrender charges over the estimated life of the policy or contract. The assumptions used for the estimates are consistent with those used in computing the policy or contract liabilities.
The interest rate our predecessor used to amortize deferred acquisition costs in 2003 and 2004 was 6.58%.
Our predecessor has historically accounted for VOBA in a manner similar to DAC. The interest rate used to amortize VOBA in 2003 and 2004 was approximately 7%. Periodically, our predecessor performed tests to determine if VOBA remained recoverable from future premiums on the acquired business. Our predecessor did not incur any write-offs in 2004 or 2003 from impairments as a result of these recoverability tests.
We eliminated all of our predecessor’s historical VOBA upon the closing of the Kanawha acquisition as part of our application of GAAP purchase accounting requirements. We simultaneously re-established VOBA for
the value of our predecessor’s in force business. VOBA interest rate assumptions to amortize the VOBA were also reset upon the closing of the Kanawha acquisition and the rate was approximately 6.0% at December 31, 2005.
There are risks and uncertainties involved in making these judgments. Changes in circumstances and critical factors such as a continued weak economy, a pronounced economic downturn or unforeseen events which affect one or more companies, industry sectors or countries could result in additional write-downs in future periods for impairments that are deemed to be other-than-temporary.
Under indemnity reinsurance transactions in which we are the ceding insurer, we remain liable for policy claims if the assuming company fails to meet its obligations. In the event one or more assuming companies were to
default on its obligations, it could have an adverse effect on our business, results of operations and financial condition. To limit this risk, we have implemented procedures to evaluate the financial condition of reinsurers and to monitor the concentration of credit risk to minimize this exposure. In some cases, the reinsurers have placed amounts in trust that would be the equivalent of the recoverable amount and for which we are the beneficiary. The selection of reinsurance companies is based on criteria related to solvency and reliability and, to a lesser degree, diversification. An estimated allowance for doubtful accounts is recorded on the basis of periodic evaluations of balances due from reinsurers, reinsurer solvency, management experience and current economic conditions. As of December 31, 2005, 2004 and 2003, there was no allowance for doubtful accounts.
Historical consolidated financial information for each of the two years ended December 31, 2004 and 2003 for our Predecessor.
Historical financial information for the period from January 21, 2004 (KMG America’s date of inception), to December 31, 2004 and for the year ended December 31, 2005, for KMG America.
Net investment income for the year ended December 31, 2004, was negatively impacted by a $1.6 million incentive payment to one of our predecessor’s outside investment managers at the conclusion of the contract period. There are no other incentive arrangements of this type in effect, and this contract was terminated upon the closing of KMG America’s acquisition of Kanawha.
risk and critical illness. The earnings reported in any period for our worksite insurance business generally depends on growth in underwritten business, business mix, persistency of business in force, benefit payouts and administrative expenses incurred. Revenues are generated primarily from new and renewal premiums. The worksite insurance business also includes business sold through our career agency distribution channel, which is a group of agents and managers that are our employees that sell life and health insurance products directly to individuals and small businesses.
Senior market insurance business. Throughout the reporting period, the senior market insurance business provided individual insurance products, primarily long-term care insurance, tailored to the needs of older individuals. The level of operating earnings reported in any period during the reporting period for our senior market insurance business generally depended on growth in underwritten business, business mix, risk concentration, the ability to adjust premium rates, persistency of business in force, benefit payouts and administrative expenses incurred. Revenues were generated primarily from new and renewal premiums. As a result of our decision to cease actively underwriting long-term care insurance after December 31, 2005, operating earnings from this business segment will be dependent on our ability to adjust premium rates, persistency of business in force, benefit payouts and administrative expenses incurred. Revenues will be generated primarily from renewal premiums.
The following list includes definitions of insurance terms used in the discussion of our consolidated results of operations. Terms are listed in the order in which they appear in our consolidated statements of operations.
Ceded Premiums: Ceded premiums represent premiums either written by or assumed by us and subsequently reinsured by other insurance companies.
Depreciation and amortization: This item includes depreciation of fixed assets such as information technology hardware and amortization of intangible assets such as software licenses. This item is not discussed in detail in this Management’s Discussion and Analysis of Financial Condition and Results of Operations because it does not generally fluctuate significantly from period to period and is not a significant performance statistic considered by our management.
Other income: Other income is comprised primarily of commission and expense allowances from reinsurance companies relating to insurance ceded from us to the reinsurance companies.
Other Operating Measures: These are measures that do not appear in the consolidated statement of operations, but are used by our management to evaluate our operating results.
premium growth, claims experience and reserve assumptions including persistency, morbidity, mortality and interest rates.
The following discussion reflects our and our predecessor’s results for the years ended December 31, 2005, 2004, and 2003.
The following represents a summary of our and our predecessor’s statement of operations and asset composition by reportable segment. Except as noted, the financial statement information set forth below is reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition of the predecessor:
Total benefits and expenses increased $2.5 million, or1.7%, to $146.8 million in the year ended December 31, 2005, from $144.3 million in the year ended December 31, 2004. The primary factors causing this increase are explained below under the captions “Policyholder Benefits” , “Insurance Commissions”, “General Insurance Expenses”, “Insurance Taxes, Licenses and Fees” and “Amortization of DAC and VOBA.”
Policyholder benefits decreased $5.9 million, or 6.5 %, to $84.3 million in the year ended December 31, 2005, from $90.2 million in the year ended December 31, 2004. This produced a benefits to premium ratio of 78.9% in 2005 compared to 87.7% in 2004. The benefits to premium ratio declined primarily as a result of the GAAP purchase accounting adjustments described in the next three paragraphs.
Senior market policyholder benefits decreased $0.4 million, or 1.1 %, to $35.4 million for the year ended December 31, 2005, from $35.8 million for the year ended December 31, 2004. This produced benefits to premium ratios of 83.7% for the year ended December 31, 2005, compared to 85.2% for the year ended December 31, 2004. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the near future. The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves, partially offset by an increase in open active claims due to an increase in the number of policies in force and the aging of our policyholders, which resulted in increases in actual claims paid and additional claims reserves.
Commission expenses decreased $0.1 million, or 1.0 %, to $9.6 million in the year ended December 31, 2005, from $9.7 million in the year ended December 31, 2004. This change resulted from normal fluctuations related to renewal premiums.
First year commissions and general insurance expenses associated with the acquisition of new business are deferred and amortized over the premium-paying period of the related policies. The total deferrals of policy acquisition costs were $15.0 million and $13.1 million for the years ended December 31, 2005 and 2004, respectively. The increase in deferrals was primarily due to the increase in net new premiums in the worksite segment somewhat offset by the decrease in net new long-term care premiums in the senior market.
Total revenues for the year ended December 31, 2004, decreased $2.3 million, or 1.5%, to $154.1 million from total revenues of $156.4 million in 2003. The primary factors causing the decrease are explained in the revenue-related discussion below.
The average yield on invested assets on an amortized cost basis was 5.62% in the year ended December 31, 2004, compared to an average yield of 6.02% in the year ended 2003. The continuing decline in prevailing interest rates and the sale of some higher yield investments, both in 2003 and 2004, contributed to the decline in net investment income in the year ended December 31, 2004, compared to the year ended December 31, 2003. The $1.6 million incentive payment paid to an outside investment manager in 2004, which was recorded as a reduction of investment income, was charged directly to the corporate and other segment, resulting in a significant decline in investment income in this segment compared to 2003. All other net investment income is allocated to the various business segments on a pro rata basis based on the invested assets attributed to the business segment.
Commission and fee income increased $0.5 million, or 3.8%, to $13.5 million for the year ended December 31, 2004, from $13.0 million for the year ended December 31, 2003. Most of the commission and fee income was from administrative fees relating to third-party administration. The increase was due to an increase in business in force resulting from increases in sales of our predecessor’s administrative services.
Realized investment gains and losses occur as a result of the sale or impairment of investments. The net realized investment gain in the year ended December 31, 2004, increased by $1.8 million to $9.4 million from $7.6 million in the year ended December 31, 2003. The net gain realized on fixed maturity securities in the year ended December 31, 2004, totaled $7.1 million compared to a net gain realized on fixed maturity securities of $6.3 million in the year ended December 31, 2003. In both 2003 and 2004, our predecessor’s investment committee elected to
take advantage of favorable market conditions for fixed maturity securities by selling certain fixed maturity securities to recognize gains. Realized gains on fixed maturity securities in 2004 and 2003 were negatively impacted by impairment charges of $0.5 million and $0.7 million, respectively. The net gain realized on equity securities in the year ended December 31, 2004, totaled $2.4 million compared to a net gain realized on equity securities of $1.4 million for the year ended December 31, 2003. These net gains on equity securities were due to our predecessor’s investment committee’s election to take advantage of favorable market conditions by selling certain common stocks to recognize gains on these sales. Realized gains on equity securities in 2004 and 2003 were negatively impacted by impairment charges of $0.2 million and $0, respectively. Realized investment gains and losses are allocated entirely to the corporate and other business segment.
The amortization of DAC and VOBA decreased $0.1 million, or 1.0%, to $9.5 million in the year ended December 31, 2004, from $9.6 million in the year ended December 31, 2003. In the year ended December 31, 2004, amortization is composed of DAC amortization of $6.4 million and VOBA amortization of $3.1 million. The 2003 amortization is composed of DAC amortization of $5.6 million and VOBA amortization of $4.0 million.
which had the effect of lowering its overall tax rate. Kanawha did not qualify for the small life insurance company deduction in 2004.
Of the fixed maturity securities shown above, 77.6% and 80.9% (based on total carrying value) were invested in securities rated “A” or better as of December 31, 2005, and 2004, respectively.
The following table provides the cumulative net unrealized gains (pre-tax) on the Company’s fixed maturity securities and equity securities as of the dates indicated. Effective December 31, 2004, our investments were recorded at fair value, thereby eliminating all unrealized gains and losses, as part of the application of GAAP purchase accounting requirements.
Net unrealized losses on equity securities were $0.0 as of December 31, 2005.
Unrealized losses were reviewed for other than temporary impairment in conjunction with our investment policies. Impairment charges of $0.2 million and $0.7 million were taken in 2005 and 2004, respectively.
The review of fixed maturity securities for impairments includes an analysis of the total gross unrealized losses for three categories of securities: (1) securities where the estimated fair value had declined and remained below amortized cost by less than 20%; (2) securities where the estimated fair value had declined and remained below amortized cost by 20% or more for less than six months; and (3) securities where the estimated value had declined and remained below amortized cost by 20% or more for six months or greater. Securities in the first two categories have generally been adversely impacted by the downturn in the financial markets, overall economic conditions and certain industry trends. The first category generally includes securities that have declined in value as a result of fluctuations in interest rates, rather than due to difficulties experienced by the issuer of the securities. While all of these securities are monitored for potential impairment, our and our experience indicates that securities in the first two categories do not present as great a risk of impairment, and securities in these categories often recover their fair value over time as the factors that caused the declines improve. In addition, the Company has the intent and ability to hold these securities until they recover in value.
Writedowns are recorded as investment losses and the cost bases of the securities are adjusted accordingly. The revised cost basis is not changed for subsequent recoveries in value. Writedowns of fixed maturities were $0.2 million and $0.5 million for the years ended December 31, 2005 and 2004, respectively. These writedowns reflected other than temporary impairments on Delta Airlines and Triton Aviation fixed income securities. Both of these securities have been impacted by the negative conditions affecting the airline industry generally. Delta’s credit rating was downgraded twice during 2004 and the value of the Triton securities continued a decline for which an impairment of $0.7 million was recognized in 2003. Writedowns of equity securities were $0.2 million for the year ended December 31, 2004, reflecting poor operating results and a market value decline in excess of 75 percent on Verso Technologies, Inc.
Life and annuity reserves decreased by $10.4 million, or 3.4%, to $299.5 million as of December 31, 2005, from $309.9 million as of December 31, 2004. A large portion of the life and annuity reserves relates to acquired blocks of business that are lapsing at a steady pace because no new blocks of business have been acquired since 1999. These blocks represented $7.8 million of the decrease in reserves for the year ended December 31, 2005, and $9.3 million of the decrease in reserves for the year ended December 31, 2004. Accident and health reserves increased by $26.9 million or 13.4%, to $227.7 million as of December 31, 2005, from $200.8 million as of December 31, 2004. These reserve increases are consistent with growth in the underlying business, with the majority of the reserve growth being accumulated from long-term care premiums received. Policy and contract claims, which represent liabilities for actual claims reported and payable, increased by $0.7million, or 7.5%, to $10.0 million as of December 31, 2005, from $9.3 million as of December 31, 2004. This increase represents timing of claims received and processed, and although there are always fluctuations in policy and contract claim reserves from period to period, there were no significant events or trends during the periods discussed in this paragraph that would produce any material changes in our claims reserves.
Other policyholder liabilities, which are comprised primarily of dividend accumulations and advance premiums, decreased by $0.1million, or 0.9%, to $10.7 million as of December 31, 2005, from $10.8 million as of December 31, 2004.
Recorded ceded loss recoveries from reinsurers (recorded as a reduction in policyholder benefits) were $8.4 million and $7.9 million for the years ended 2005 and 2004, respectively.
The primary sources of funds for KMG America’s subsidiaries consist of insurance premiums and other considerations, fees and commissions collected, proceeds from the sales and maturity of investments and investment income. Cash is primarily used to pay insurance claims, agent commissions, operating expenses, product surrenders and withdrawals and taxes. KMG America generally invests its subsidiaries’ excess funds in order to generate income. The primary use of dividends and other distributions from subsidiaries to KMG America will be to pay certain expenses of the holding company. We currently have no intention of paying dividends to our shareholders and will reinvest cash flows from operations into our businesses for the foreseeable future.
Our qualified defined benefit pension plan was under-funded by $2.1 million as of December 31, 2005, with an actuarially determined projected benefit obligation of $17.2 million as opposed to plan assets of $15.1 million. In 2005, we made contributions to the pension fund of $2.5 million. In accordance with ERISA, there was no expected minimum funding requirement for this plan for the year ended December 31, 2005. Based on the plan’s current funding status and ERISA and IRS guidelines, no required contributions to the plan are anticipated for 2006.
We are not currently planning to make any other significant capital expenditures or acquisitions in 2006 or subsequent years. However, we plan to significantly expand outlays relating to marketing and sales activities over the next several years including outlays required to build a national sales organization, which is a key component of our strategy. These outlays will include expenses such as salaries and cash incentive compensation, employee benefits, occupancy and information technology expenses of additional sales personnel, advertising and marketing costs, consulting and recruiting. The execution of our business plan will require additional outlays associated with the development of a national insurance company including home office expenses for executive management and additional financial, actuarial and underwriting personnel, infrastructure development and back-office expenses, as well as costs associated with our being a public company.
Other changes in cash flows for the years ended December 31, 2005, 2004, and 2003 are as follows:
We held approximately $117.4 million in cash at December 31, 2004, primarily consisting of cash proceeds from sales and maturities of our invested assets and from our initial public offering of common stock. We invested a significant portion of this cash in fixed maturity securities in 2005, resulting in the net cash outflow from investing activities of $96.0 million. This produced a corresponding increase in invested assets.
Other assets increased by $0.8 million in 2005, primarily representing a $2.9 million prepaid pension asset, offset by the receipt of a $2.2 million receivable for a securities trade that had not settled as of December 31, 2004.
Accounts payable and accrued expenses increased by $1.3 million in 2005, primarily due to a $1.6 million increase in reinsurance settlements due related to the acquired business.
The liability for benefits for employees and agents increased by $1.5 million in 2005, primarily resulting from additional pension plan liability accruals of $1.0 million established to fund future payments under the pension plan as well as additional deferred compensation balances of $0.3 million.
Federal income tax recoverable increased by $0.9 million in 2005 as a result of losses incurred in Kanawha Insurance Company that will be carried back to prior years. The deferred tax asset increased by $5.8 million and the deferred tax liability increased by $6.6 million. The combination of the three items resulted in a net decrease in tax liabilities of $0.1 million, inclusive of a decrease of $2.7 million related to the decrease in fair market value of invested assets.
The liability for benefits for employees and agents decreased by $2.3 million in 2003 as the result of payments for accrued pension plan contributions of $4.4 million. The remaining increase is attributable to additional pension plan liability accruals of $1.3 million established to fund future payments under the pension plan.
In 2003, our predecessor had realized gains of $7.6 million primarily due to its decision made by our predecessor’s investment committee to take advantage of favorable market conditions by selling securities to recognize gains.
The information technology and document management outsourcing contract is a ten-year contract that began in November 2003. This contract is subject to cancellation by us at any time starting in November 2006, with the payment of a termination penalty that is based on the number of months remaining in the contract.
Consolidated Balance Sheets for KMG America Corporation as of December 31, 2005, and 2004
Consolidated Statements of Cash Flows for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the year ended December 31, 2005, and for the Predecessor for the years ended December 31, 2003 and 2004
KMG’s internal control system was designed to provide reasonable assurance to the company’s management and board of directors regarding the preparation and fair presentation of published financial statements.
We have audited management’s assessment, included in the accompanying Report of Management on the Consolidated Financial Statements and Management’s Assessment of Internal Control over Financial Reporting, that KMG America Corporation maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). KMG America Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies or procedures may deteriorate.
We have audited the accompanying consolidated balance sheets of KMG America Corporation as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity and cash flow of KMG America Corporation for the year ended December 31, 2005 and the period January 21, 2004 (inception) through December 31, 2004, and the consolidated statements of operations, shareholders’ equity and cash flow of the Predecessor, as defined in Note 1, for each of the two years in the period ended December 31, 2004. Our audits also included the financial statement schedule listed in the Index at Item 15(2). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
Fixed maturity securities available for sale, at fair value (amortized cost of $505,848,751 and $409,613,186 for 2005 and 2004, respectively)
Equity securities available for sale, at fair value (cost of $286,809 and $36,000 for 2005 and 2004, respectively)
Real estate and equipment (net of accumulated depreciation of $1,748,519 in 2005)
Common Stock: par value $0.01 per share, 75,000,000 shares authorized and 22,125,998 and 22,071,641 shares issued and outstanding at December 31, 2005 and 2004, respectively.
KMG America Corporation (“KMG America” or the “Company”) is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004. KMG America commenced operations shortly before it completed its initial public offering of common stock on December 21, 2004, and its shares trade on the New York Stock Exchange under the symbol “KMA.” Concurrently with the completion of its initial public offering, KMG America completed its acquisition of Kanawha Insurance Company (“Kanawha” or the “Predecessor”) and its subsidiaries, which are KMG America’s primary operating subsidiaries and which underwrite and sell life and health insurance products that historically have been marketed primarily in the southeastern United States but are now being actively marketed nationwide.
The Company’s sales historically have been primarily in the southeastern United States, predominantly in Florida, South Carolina and North Carolina, but are now expanding nationwide. Sales made through an internal sales force, full-time agents, general agents and brokers. Premium revenues are concentrated in the individual life and accident and health lines of business.
The accompanying consolidated financial statements include the accounts of the Company and the Predecessor after elimination of all significant intercompany balances and transactions. The Company also submits financial statements to insurance industry regulatory authorities. Those financial statements are prepared on the basis of statutory accounting practices (“SAP”) and are significantly different from financial statements prepared in accordance with GAAP (see Note 11).
notes. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein.
Interest on loans is generally recorded over the term of the loan based on the unpaid principal balance. Accrual of interest is discontinued when either principal or interest becomes 90 days past due or when, in management’s opinion, collection of such interest is doubtful. In addition, any previously accrued interest is reversed when the loan becomes 90 days past due.
Amortization of premiums and accrual of discounts on investments in fixed maturity securities is reflected in earnings over the contractual terms of the investments in a manner that produces a constant effective yield. Realized gains and losses on dispositions of securities are determined by the specific-identification method.
Industry factors or conditions related to a geographic area negatively affecting the security;
Should the Company conclude that the decline is other-than-temporary, the security is written down to fair value through a charge to realized investment gains and losses. The Company adjusts the amortized cost for securities that have experienced other-than-temporary impairments to reflect fair value at the time of the impairment. The Company considers factors that lead to an other-than-temporary impairment of a particular security in order to determine whether these conditions have impacted other similar securities.
Acquisition costs incurred by the Predecessor and the Company in the process of acquiring new business are deferred and amortized into income as discussed below. Costs deferred consist primarily of commissions and certain policy underwriting, issue and agency expenses that vary with and are primarily related to production of new business.
reserves on a net level premium method based on assumptions deemed appropriate at the date of issue as to future investment yield, mortality, morbidity, withdrawals and maintenance expenses, and including margins for adverse deviations. Interest assumptions are based on the Company’s experience. Mortality, morbidity and withdrawal assumptions are based on recognized actuarial tables or the Company’s experience, as appropriate. Life reserves are calculated using mean reserve factors. Accident and health reserves are calculated using mid-terminal reserve factors. Benefit reserves for investment products are computed under a retrospective deposit method and represent policy account balances before applicable surrender charges. Policy benefits and claims that are charged to expense include benefit claims incurred in the period in excess of related policy account balances.
Loss recognition testing of the Company’s policy benefit reserves is performed annually. This testing involves a comparison of the Company’s actual net liability position (all liabilities less DAC) to the present value of future liabilities calculated using then-current assumptions. These assumptions are based on the Company’s best estimate of future experience. To the extent a premium deficiency exists, it would be recognized immediately by a charge to the statement of operations and a corresponding reduction in DAC. Any additional deficiency would be recognized as a premium deficiency reserve. Historically, loss recognition testing has not resulted in an adjustment to DAC or reserves. These adjustments would occur only if economic, mortality and/or morbidity conditions significantly deviated from the underlying assumptions.
Reinsurance premiums, benefits and reserves are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the insurance contracts. Benefit reserves and claim liabilities are reported gross of reinsured amounts. An estimated allowance for doubtful accounts is recorded on the basis of periodic evaluations of balance due from reinsurers, reinsurer solvency, Company experience and current economic conditions.
Revenue from annuity products includes charges for the cost of insurance, for initiation and administration of the policy and for surrender of the policy. Revenue from these products is recognized in the year assessed to the policyholder, except that any portion of an assessment, which relates to services to be provided in future years, is deferred and recognized over the period during which services are provided.
The Company has adopted the disclosure-only requirements of SFAS No. 123, Accounting for Stock-Based Compensation, as amended by FASB Statement No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure (SFAS 148). As permitted by the provisions of this Statement, the Predecessor accounted for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and Related Interpretations.
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects
Policyholder dividends are recognized over the term of the related policies. Participating business represents approximately 30% and 30%, respectively, of the Company’s total ordinary life insurance in force at December 31, 2005, and 2004. Dividends paid to policyholders in 2005, 2004 and 2003 were approximately $2.1 million, $2.2 million and $2.0 million, respectively. Participating premiums as a percentage of direct life premiums were 46% in 2005, 51% in 2004 and 52% in 2003.
The EITF 03-1 impairment model applies to all investment securities accounted for under Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investment in Debt and Equity Securities, and to investment securities accounted for under the cost method to the extent an impairment indicator exists or the reporting entity has estimated the fair value of the investment security in connection with SFAS No. 107, Disclosures about Fair Value of Financial Instruments.
Accelerate the timing of recognition of certain impairment losses or otherwise result in impairment losses being recognized when they previously may not have been;
Result in the designation of certain investment securities as trading; and
Changes in the timing of the recognition of the difference between carrying value and expected settlement value of debt securities for which an other-than-temporary impairment is taken.
In November 2005, the Financial Accounting Standards Board (FASB) issued FSP (FASB Staff Position) FAS 123(R) - Transition Election Related to Accounting for the Tax Effects of Share - Based Payment Awards. FSP FAS 123(R) requires the calculation of excess tax benefits available to absorb tax deficiencies (termed an additional paid - in- capital or “APIC” pool) recognized subsequent to the adoption of Statement 123(R). Because most companies did not adopt the recognition provisions in Statement 123 as is the case with our company, and instead opted for the disclosure -only approach, many companies concluded they do not have the information to comply with the transition requirements in Statement 123R. Accordingly, the FASB has adopted an elective short-
In June 2005, the Financial Accounting Standards Board (FASB) issued SFAS No. 154 (SFAS154), “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 requires retrospective application to prior periods’ financial statements for all voluntary changes in accounting principle, unless impracticable, SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 31, 2005. SFAS 154 will have no immediate impact on our consolidated financial statements, though it will impact our presentation of future voluntary accounting changes, should such changes occur.
Aggregate amortized cost, aggregate fair value and gross unrealized gains and losses of investments in fixed maturity and equity securities are summarized in the following table. Effective December 31, 2004, the Company recorded the Predecessor’s investments at fair value and thereby eliminated all unrealized gains and losses in the Predecessor’s portfolio, as part of the application of GAAP purchase accounting requirements.
Proceeds from the sales of investments in fixed maturity securities during the years ending December 31, 2005, 2004 and 2003, were $61.6 million, $99.2 million and $165.7 million, respectively. Gross gains of $0.8 million and gross losses of $.3 million were realized in 2005 on those sales. Gross gains of $7.9 million and gross losses of $0.7 million were realized in 2004 on those sales. Gross gains of $9.8 million and gross losses of $3.5 million were realized in 2003 on those sales.
At December 31, 2005, the Company held certain fixed income investments with unrealized losses. Information regarding these investments is as follows:
Major categories of the Company’s and Predecessor’s net investment income for the years ended December 31, 2005, 2004 and 2003, are summarized as follows:
There were no new mortgage loans originated in 2005. At the issuance of a loan, the percentage of loan to value on any one loan does not exceed 75%. All properties covered by mortgage loans have fire insurance equal to at least the loan excess over the maximum loan that would be allowed on the land without the building.
The Company’s mortgage loan portfolio is comprised of conventional real estate mortgages collateralized primarily by office (6.1%), apartment (3.9%) and residential (90.0%) properties. Mortgage loan underwriting standards emphasize the credit status of a prospective borrower, quality of the underlying collateral and conservative loan-to-value ratios. Approximately 97.6% of the loans are on properties located in the South Atlantic region. No other geographic region includes mortgaged property representing 2.2% of the aggregate principal amount of the Company’s mortgage loans as of December 31, 2005.
Interest is recognized as revenue when earned according to the terms of the loans and when, in the opinion of management, it is collectible. The accrual of interest on the loans is discontinued at the time the loan is 90 days past due or when, in management’s opinion, collection of such interest is doubtful. Past due status is based on the contractual terms of the loan. Loans are placed on non-accrual or charged off at an earlier date if collection of principal or interest is considered doubtful. The Company maintains an allowance for potentially uncollectible loans. Additions to the allowance are based on assessments of certain factors, including but not limited to historical loan loss experience of similar types of loans, the Company’s loan loss experience, the amount of past due and non-performing loans and current and anticipated economic and interest rate conditions. Evaluation of these factors involves subjective estimates and judgments that may change. Additions to the allowance are provided through a charge to earnings. There was no balance in the allowance account at December 31, 2004. There were no additions to the allowance for the years ended December 31, 2005, 2004 and 2003.
Other-than-temporary impairment losses on available-for-sale securities totaled approximately $0.2 million, $0.7 million and $0.7 million for the years ended December 31, 2005, 2004, and 2003, respectively.
The Company completed its acquisition of the Predecessor and its subsidiary on December 21, 2004. The acquisition has been recorded as if it were completed on December 31, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material.
Under FAS No. 142, goodwill and intangible assets with indefinite useful lives are not amortized. Effective December 31, 2004, historical goodwill of the Predecessor was eliminated as a part of the application of GAAP purchase accounting requirements. The fair value of net assets of the Predecessor was greater than the acquisition purchase price, therefore no goodwill was recorded, effective December 31, 2004. Certain other intangibles were recorded as a result of the acquisition effective December 31, 2004. The weighted-average useful life, gross carrying value, accumulated amortization and net carrying value of other intangible assets as of December 31, 2005, and 2004 were as follows:
Amortization expense relating to intangible assets was $0.57 million in 2005, $0.0 million in 2004, and $0.0 million in 2003. Estimated future amortization expense relating to intangible assets for the years ending December 31 are as follows:
The Company eliminated all of the Predecessor’s deferred acquisition costs upon the closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements. The Company began recording deferred acquisition costs prospectively on January 1, 2005.
The Company eliminated all of the Predecessor’s historical value of business acquired upon the closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements. The Company simultaneously re-established value of business acquired for the value of the Predecessor’s in force business. Interest rate assumptions used to amortize the value of business acquired were reset upon the closing of the Kanawha acquisition. The interest rate was approximately 6.0% at December 31, 2005.
Information about deferred policy acquisition costs and value of business acquired are summarized below:
The Company accounts for value of business acquired in a manner similar to deferred acquisition costs. The interest rates used to amortize deferred acquisition costs were 6.06%, 6.58% and 6.58% in 2005, 2004 and 2003, respectively.
historical GAAP purposes and for current Purchase GAAP the interest assumptions are graded and range from 5.75% to 6.60% The weighted average assumed investment yield for all life and accident and health policy reserves was 6.04% in 2005, 6.84% in 2004, and 6.95% in 2003. Benefit reserves for limited-payment policies take into account, where necessary, any deferred profits to be recognized in income over the policy term. Policy benefit claims are charged to expense in the period that the claims are incurred.
Interest crediting rates for investment products ranged from 3.5% to 5.0% in 2005, 2004, 2003, respectively.
Certain premiums and benefits are assumed from and ceded to other insurance companies under various reinsurance agreements. The assumption agreements provide the Company with increased economies of scale and the ceded agreements provide the Company with increased capacity to write larger risks and maintain its exposure to loss within its capital resources and, in some cases, effect business dispositions. However, if the assuming reinsurer is unable to meet its obligations, the Company remains contingently liable. The Company evaluates the financial condition of reinsurers and monitors concentration of credit risk to minimize this exposure. All reinsurers for which we hold an amount recoverable have a financial strength rating from A.M. Best of at least an A- (excellent) and the majority of our reinsurers have a rating of A+ (superior). In some cases, reinsurers have placed amounts in trusts equivalent to the amount recoverable from the reinsurer. The following represent reinsurance amounts included in the accompanying financial statements:
The Predecessor and its subsidiaries have filed separate federal income tax returns as required by regulations regarding the consolidation for tax purposes of life insurance and non-life insurance companies. The subsidiaries have incurred net operating losses which will expire between 2018 and 2024. Under SFAS No. 109, management must provide a valuation allowance for any deferred tax amounts that it does not believe will be realized. Management believes that the realization of the subsidiaries’ net operating losses is uncertain; therefore, a valuation allowance was established. That valuation allowance increased by $0.2 million in 2004 and decreased by $1.6 million in 2005. The Company and the Predecessor paid income taxes of $0, $0.6 million and $0.9 million, during the years ended December 31, 2005, 2004 and 2003, respectively.
Under South Carolina insurance regulations, Kanawha is required to maintain minimum capital of $1.2 million and minimum surplus of $1.2 million. Additionally, Kanawha is restricted as to amounts that can be transferred in the form of dividends, loans, or advances without the approval of the South Carolina Insurance Commissioner. Under these restrictions, during 2006, dividends, loans or advances by Kanawha in excess of $8.5 million will require the approval of the South Carolina Insurance Commissioner.
Risk-Based Capital (“RBC”) requirements promulgated by the NAIC require life insurers to maintain minimum capitalization levels that are determined based on formulas incorporating credit risk pertaining to its investments, insurance risk, interest rate risk and general business risk. As of December 31, 2005, the Company’s adjusted SAP capital and surplus exceeded its authorized control level RBC.
The foregoing reconciliation reflects a deficiency in the December 31, 2004, reserves of $0.2 million, and a redundancy in the December 31, 2003 reserves of $0.7 million that emerged in 2005 and 2004, respectively. The changes in those reserves were primarily the result in changes in estimates as more information became available.
The Company adopted the Predecessor’s defined benefit retirement plan, defined contribution plan, and deferred compensation plan. These plans were unchanged during the reporting period, but changes have been approved for the defined benefit retirement plan and defined contribution plan that will become effective later in 2006. These changes are discussed in detail below.
Currently, substantially all of the employees and agents of the Company are covered under a defined benefit pension plan. Plan benefits are based on years of service and compensation during the last five years of service. The Company’s funding policy is to make the minimum annual contributions required by applicable regulations, including amortization of unfunded prior service costs over the maximum period allowed by ERISA.
Beneficiaries may elect to receive benefits in the form of lump-sum distribution, subject to certain dollar limitations, or through one of several annuity options. Based on the plan’s current funding status and ERISA guidelines, no required contributions to the plan are anticipated for 2006.
The expected long-term rate of return on plan assets is estimated based on input from the Company’s actuaries and the Company’s investment committee using a variety of factors including long-term historical returns, inflation assumptions, targeted allocation of plan assets and expectations regarding future market returns for both equity and debt securities.
The pension plan asset allocation at December 31, 2005, and 2004 by asset category is as follows:
On January 31, 2006, the Company adopted two amendments to the defined benefit retirement plan that freeze participation in the plan and freeze accrual of any additional benefits under the plan. Effective March 31, 2006, no new participants will be allowed to enter the plan. Effective as of September 30, 2006, no additional benefits will accrue under the plan with respect to service after that date. As a result, final average earnings will be determined as of September 30, 2006, for all future benefit payments, and will not be adjusted for future changes in employee compensation.
The Predecessor followed Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related interpretations in accounting for its stock options issued to senior management. Under APB 25, for options issued where the exercise price of the issuer’s stock option equals the market value of the underlying stock on the date of grant, no compensation expense is recognized. Conversely, for options issued where the exercise price of the option is less than the market value on the date of grant, the difference between the exercise price and the market value on the date of the grant is recognized as unearned compensation, included as a component of shareholders’ equity and amortized over the vesting period.
Pro forma information regarding net income and net income per share, as presented in Note 1, is required by SFAS 123, as amended by SFAS 148, and has been determined as if the Predecessor had accounted for its employee stock options under the fair value method of SFAS 123 as of its effective date. The fair value for these options was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:
No options were issued, exercised or canceled by the Predecessor under its stock option plan during 2003. In connection with the closing of the acquisition of the Predecessor, on December 21, 2004, all 371.8 options became 100% vested and were exercised and the Predecessor stock option plan was terminated. No additional stock options can be granted under the Predecessor’s plan.
During 2005, the Company issued options to purchase a total 229,250 shares of Company common stock, at a weighted average exercise price of $9.35 per share, which is equal to 100% of the estimated fair market value of the common stock on the date of the grant. These options generally vest with respect to one fourth of the shares subject to the option on each of the first, second, third and fourth anniversaries of the date of grant. During 2005, 61,500 shares were forfeited. The Company also issued 54,357 shares of restricted common stock at a weighted average of $8.86, which is equal to 100% of the estimated fair market value of the common stock on the date of grant. These shares of restricted stock generally vest with respect to one fourth of the shares granted on each of the first, second, third and fourth anniversaries of grant. On December 15, 2004, the Company issued options to purchase a total of 1,246,000 shares of Company common stock at an exercise price of $9.50 per share, which is equal to 100% of the estimated fair market value of the common stock on the date of grant. These options generally vest with respect to one fourth of the shares subject to the option on each of the first, second, third and fourth anniversaries of the date of grant. Options to purchase 310,000 shares, however, vest one third on each of the first, second and third anniversaries of the date of grant, subject to earlier, immediate vesting upon the termination of the optionholder’s employment with the Company by the Company without cause by him with good reason, upon a change in control of the Company or upon his receipt of a notice of non-renewal of his employment agreement, or upon his death or disability.
As of December 31, 2005, 321,458 options to purchase shares of the Company’s common stock were exercisable. All options granted under the Plan are exercisable for ten years from the date of grant, subject to earlier termination of the optionholders’ rights to exercise such options under the terms of the plan and the option agreements relating to such options.
The Predecessor utilized the legal, tax and investment services of an entity that was previously affiliated with the Predecessor because they were under the common control of some of the same shareholders. The Predecessor paid $0.1 million in each of the years 2003 and 2004 for these services. Since the Company acquired Kanawha, there is no longer a common control relationship between Kanawha and the legal, tax and investment services entity.
The Company is occasionally named as a defendant in various legal actions arising principally from claims made under insurance policies and contracts. Those actions are considered by the Company in estimating the policy and contract liabilities and management believes adequate reserves have been established for such cases. Management believes that the resolution of those actions will not have a material effect on the Company’s financial position or results of operations.
The Company is assessed amounts by state guaranty funds to cover losses to policyholders of insolvent or rehabilitated insurance companies. Those mandatory assessments may be partially recovered through a reduction in future premium taxes in certain states. The Company recognizes its obligation for guaranty fund assessments and records an estimated accrual for any potential assessment. There were no such accruals as of December 31, 2004, and 2005.
At December 31, 2005 and 2004, the Predecessor and the Company, respectively, had no significant exposure to unrated or less-than-investment grade bonds.
The Company’s investment in mortgage loans principally involves residential and commercial real estate primarily in South Carolina and North Carolina. Such investments consist primarily of first mortgage liens on single-family residences; the mortgage outstanding on any individual property does not exceed $1.1 million.
The carrying amounts and fair values of the Company’s cash and investments at December 31 are summarized in the following table.
The Company has five reportable segments that are differentiated by their respective methods of distribution and the nature of the related products: worksite insurance business, senior market insurance business, third party administration business, acquired business and corporate and other. Management makes decisions regarding the business based on these segment classifications. No segments have been aggregated other than including the marketing business in the corporate and other segment.
The senior market insurance business consists primarily of the Company’s in-force block of long-term care insurance policies that the Company actively manages, including the right to receive renewal premiums and liability for future claims. Effective after December 31, 2005, the Company ceased actively underwriting long-term care
The third party administration business provides fee-based administrative and managed care services to employers with self funded health care plans, insurance carriers, reinsurance companies and others.
The following represents a summary of the Company’s and Predecessor’s statement of operations and asset composition by reportable segment. Except as noted, the financial statement information set forth below is reported on a historical basis without GAAP purchase accounting adjustments reflecting the Company’s acquisition of the Predecessor.
(2) Aggregate total assets for the Predecessor as of December 31, 2004, is not reported because the Predecessor had been acquired by KMG America at that date and the Predecessor’s assets had been consolidated into the KMG America balance sheet at that date.
*Balance sheet amounts at December 31, 2004, are those of KMG America. Statement of operations for the year ended December 31, 2004, are those of the Predecessor.