The Selected Financial Data should be read in conjunction with the accompanying Consolidated Financial Statements and Notes thereto included in Item 8.
Certain statements and materials contained in this report, such as statements relating to management’s views with respect to future events and financial performance, may be considered "forward-looking statements”,. Such forward-looking statements are subject to risks, uncertainties and other factors which could cause actual results to differ materially from historical experience or from future results expressed or implied by such forward-looking statements. For a discussion of risk factors affecting the Company’s business and prospects, see Item 1A Risk Factors.
The following is a summary of the results of operations for the Company (in thousands):
Premiums increased 3% to $67.8 million for the year ended December 31, 2006 from $66.1 million for the year ended 2005.
Of the Company's investment assets, approximately 94.3% was invested in investment grade fixed income securities, resale agreements, and cash and cash equivalents at December 31, 2006. Also at such date, 99.6% of the Company's fixed maturities had the highest NAIC rating designation (NAIC ratings of 1 and 2 designation).
In 2006, the MGUs wrote an aggregate of $94.3 million of annualized gross premium which generated pre-tax income of $1.4 million, as compared to $101.3 million and $4.0 million in 2005, respectively. The MGUs wrote less premiums due, in part, to stricter underwriting guidelines and the continuing generally "soft" market.
In 2006, the MGUs generated revenues of $10.8 million, as compared to $14.4 million in 2005, a decrease of 25%, due to lower volume of premium underwritten and lower profit commissions.
The Company’s medical stop-loss business is comprised of employer stop-loss, HMO Reinsurance and Provider Excess. All of the Company’s medical stop-loss policies are short-duration and are accounted for based on actuarial estimates of the amount of loss inherent in that period’s claims or open claims from prior periods, including losses incurred for claims that have not been reported (“IBNR”). Short-duration contract loss estimates rely on actuarial observations of ultimate loss experience for similar historical events.
The two “primary” or “key” assumptions underlying the calculation of loss reserves for medical stop-loss business are (i) projected net loss ratio, and (ii) claim development patterns. The projected net loss ratio is set at expected levels consistent with the underlying pricing assumptions (“Projected Net Loss Ratio”). Claim development patterns are set quarterly as reserve estimates are developed and are based on recent claim development history (“Claim Development Patterns”). The Company uses the Projected Net Loss Ratio to establish reserves until developing losses provide a better indication of ultimate results and it is feasible to set reserves based on Claim Development Patterns. The Company has concluded that a reasonably likely change in the Projected Net Loss Ratio assumption could have a material effect on the Company’s financial condition, results of operations, or liquidity (“Material Effect”) but a reasonably likely change in the Claim Development Pattern would not have a Material Effect.
While the Company establishes a best estimate of the Projected Net Loss Ratio, actual experience may deviate from this estimate. While the Company believes that larger variations are possible (as was the case with the 2004 and 2005 underwriting years which deviated by 12.5 and 7.1 Net Loss Ratio points, respectively), based on a review of historical Net Loss Ratios experienced by the Company, the reasonably likely deviation from the expected Net Loss Ratio is between three and five Net Loss Ratio points. Therefore, based on its experience to date, it is reasonably likely that the actual experience will fall within a range up to five loss ratio points above or below the expected pricing loss ratio. The impact of these reasonably likely changes at December 31, 2006, would be an increase in net reserves (in the case of a higher ratio) or a decrease in net reserves (in the case of a lower ratio) of up to approximately $1.2 million with a corresponding increase or decrease in the pre-tax expense for insurance benefits, claims and reserves in the 2006 Consolidated Statement of Operations.
Predicting ultimate claims and estimating reserves in medical stop-loss is more complex than first dollar medical and disability business due to the “excess of loss” nature of these products with very high deductibles applying to specific claims on any individual claimant and in the aggregate for a given group. The level of these deductibles makes it more difficult to predict the amount and payment pattern of such claims. Fluctuations in results for specific coverage are primarily due to the severity and frequency of individual claims, whereas fluctuations in aggregate coverage are largely attributable to frequency of underlying claims rather than severity. Liabilities for first dollar medical reserves and disability coverages are computed using completion factors and expected loss ratios derived from actual historical premium and claim data.
U.S. Federal and California tax laws impose substantial restrictions on the utilization of net operating loss and credit carryforwards in the event of an "ownership change" for tax purposes, as defined in Section 382
The Company accounts for its investments in debt and equity securities under SFAS No. 115 ("SFAS 115"), Accounting for Certain Investments in Debt and Equity Securities. The Company has classified all of its investments as available-for-sale or trading securities. These investments are carried at fair value based on quoted market prices with unrealized gains and losses reported in either accumulated other comprehensive income (loss) in the Consolidated Balance Sheets for available-for-sale securities or as unrealized gains or losses in the Consolidated Statements of Operations for trading securities. The Company also had $4.0 million and $3.6 million, on average, in trading accounts at December 31, 2006 and 2005, respectively. All such trading securities were liquidated at December 31, 2006 and 2005. Net realized gains and losses on investments are computed using the specific identification method and are reported in the Consolidated Statements of Operations.
Declines in value of securities available-for-sale that are judged to be other-than-temporary are determined based on the specific identification method and are reported in the Consolidated Statements of Operations as net realized losses. The factors considered by management in determining when a decline is other than temporary include but are not limited to: the length of time and extent to which the fair value has been less than cost; the financial condition and near-term prospects of the issuer; adverse changes in ratings announced by one or more rating agencies; whether the issuer of a debt security has remained current on principal and interest payments; whether the decline in fair value appears to be issuer specific or, alternatively, a reflection of general market or industry conditions (including, in the case of fixed maturities, the effect of changes in market interest rates); and the Company's intent and ability to hold the security for a period of time sufficient to allow for a recovery in fair value. For securities within the scope of Emerging Issues Task Force Issue 99-20, such as purchased interest-only securities, an impairment loss is recognized when there has been a decrease in expected cash flows combined with a decline in the security's fair value below cost.
Goodwill and intangible assets with indefinite lives, which consist of licenses, are not amortized but are tested for impairment, on a reporting unit basis, at the end of the third quarter of each fiscal year, or more frequently if indicators arise. The Company defines its reporting units on a segment basis.
Net Realized Investment Gains. Net realized investment gains decreased $179,000 to $66,000 for fiscal 2006, compared to $245,000 for fiscal 2005. The Company's decision as to whether to sell securities is based on management’s ongoing evaluation of investment opportunities and economic market conditions, thus creating fluctuations in realized gains or losses from period to period. Included in fiscal 2006 is an unrealized loss of $96,000 representing an increase in the value of the derivative liability relating to the agreement with EDH (see Note 5 of Notes to Consolidated Financial Statements). For fiscal 2006 and 2005, there were no unrealized losses on securities that the Company deemed to be other than temporary in nature. See Note 6 of Notes to Consolidated Financial Statements for additional information.
Insurance Benefits, Claims and Reserves. Insurance benefits claims and reserves increased $3,077,000 to $47,799,000 for fiscal 2006, compared to $44,722,000 for fiscal 2005, an increase of 7%. The increase is mainly the result of a Net Loss Ratio of 100.5% for fiscal 2006 versus 97.1% for fiscal 2005 on its medical stop-loss business. The increase in the net loss ratio is primarily related to further development of business incepting in 2005 and 2004. In addition, there was an increase in the volume of group major medical and STM premium assumed from IHC. The increase of $3,077,000 for fiscal 2006 is comprised of a $1,153,000 increase in medical stop-loss expense, a $1,881,000 increase in group major medical and STM expense, and an increase of $43,000 relating to DBL expense. Insurance benefits, claims and reserves for 2006 includes a charge of $1,969,000 to reflect loss development in its medical stop-loss business from prior years. While management sets reserves based on its best estimate of ultimate claim settlement cost, the Company adjusts reserves as claims mature, approach settlement or are otherwise resolved.
Minority Interest. The Company recorded $262,000 for fiscal 2006 and $544,000 for fiscal 2005 of expense related to the 20% minority interest in Marlton. This reduction is due to lower income earned by Marlton.
Income Taxes. The provision for income taxes increased $840,000 to $960,000, an effective rate of 38.9%, for fiscal 2006, compared to $120,000 an effective rate of 2.1%, for fiscal 2005. Net income for fiscal 2006 and 2005 includes a non-cash provision for federal income taxes of $778,000 and $1,785,000 respectively. The effective rate of 38.9% for fiscal 2006 represents a combination of state and federal tax expense. In 2005, the Company further reduced the valuation allowance by $2,079,000 relating to the deferred tax asset, which caused a corresponding increase in such deferred tax asset. The valuation allowance relates to the probability that AMIC might not be able to fully utilize its prior tax year federal net operating loss carryforwards ("NOLs"). AMIC reviews the valuation allowance quarterly to determine the reasonableness of the amount, and previously reduced it in connection with the Company's acquisitions in 2002, 2003 and 2004. Based upon AMIC's profitability in 2005 and projected continuing profitable results, it was management's view that it was appropriate to further reduce the valuation allowance in the fourth quarter of 2005 which resulted in an increase in net income and income from continuing operations. There was no such adjustment in 2004 or 2006. For as long as AMIC utilizes its net operating loss carryforwards, it will not pay any income taxes, except for federal alternative minimum taxes and state income taxes.
Net Realized Investment Gains. Net realized investment gains increased $23,000 to $245,000 for fiscal 2005, compared to $222,000 for fiscal 2004. The Company's decision as to whether to sell securities is based on cash flow needs, investment opportunities, and economic market conditions, thus creating fluctuations in realized gains or losses from period to period. See Note 6 of Notes to Consolidated Financial Statements for additional information.
Selling, General and Administrative. Selling, general, and administrative expenses increased $1,564,000 to $31,192,000 for fiscal 2005, compared to $29,628,000 for fiscal 2004. The increase is primarily due to commission expense recorded by Independence American. Commission expense for Independence American increased $1,801,000 to $19,954,000 for fiscal 2005, compared to $18,153,000 for fiscal 2004.
Amortization and Depreciation. Amortization and depreciation expense decreased $566,000 to $1,100,000 for fiscal 2005, compared to $1,666,000 for fiscal 2004. The expense primarily relates to the amortization of the intangible assets for the value of broker/TPA relationships of the MGUs. These intangible assets were acquired as part of acquisitions made by the Company. Amortization expense for these intangible assets will decline over the useful lives of the assets.
Gain/Loss on Discontinued Operations. Loss on discontinued operations was $59,000 for fiscal 2005, compared to a gain of $240,000 for fiscal 2004, a decrease of $299,000. The loss in 2005 is primarily due to the
re-estimation of lease expenses related to Intellicom, a discontinued operation. The gain in 2004 is primarily attributable to lower than expected expenses related to Intellicom, MTC, ISP Channel and KCI.
Net Income. The Company had net income of $5,460,000, or $.64 per share diluted, for fiscal 2005, compared to net income of $5,904,000, or $.69 per share diluted, for fiscal year 2004.
Corporate derives cash flow funds principally from: dividends and tax payments from its subsidiaries and investment income from corporate liquidity. There are no regulatory constraints on the MGUs’ ability to dividend to the parent company, however, state insurance laws have provisions relating to the ability of the parent company to use cash generated by Independence American. For the twelve months ended December 31, 2006, the MGUs have paid $4,060,000 in dividends to Corporate.
As of December 31, 2006, the Company had $59,155,000 of cash, cash equivalents, and investments net of amounts due to/from brokers compared with $55,720,000 as of December 31, 2005.
Net cash provided by operating activities of continuing operations for the fiscal year ended December 31, 2006 was $6,565,000. Net cash flows were the result of insurance revenues and fees from MGUs, partially offset by higher than expected claims and losses.
At December 31, 2006, the Company had $17,646,000 of restricted cash at the MGUs. The amount at the MGUs is directly offset by corresponding liabilities for Premium and Claim Funds Payable of $17,646,000. This asset, in part, represents the premium that is remitted by the insureds and is collected by the MGUs on behalf of the insurance carriers they represent. Each month the premium is remitted to the insurance carriers by the MGUs. Until such remittance is made the collected premium is carried as an asset on the balance sheet of each MGU with a corresponding payable to each insurance carrier. In addition to the premium being held at the MGUs, the MGUs are in possession of cash to pay claims “Claim Funds”. The cash is deposited by each insurance carrier into a bank account that the MGUs can access. The cash is used by the MGUs to pay claims on behalf of the insurance carriers they represent. The availability of cash enables the MGUs to reimburse claims in a timely manner.
The Company reviews its investments regularly and monitors its investments continually for impairments. For the years ended December 31, 2006 and 2005, the Company had no realized losses for other than temporary impairments. The Company's gross unrealized losses on fixed maturities totaled $1,172,000 and $1,017,000 at December 31, 2006 and 2005 respectively. Substantially all of these securities were investment grade. The unrealized losses have been evaluated in accordance with the Company's policy and were determined to be temporary in nature at December 31, 2006. The Company holds all fixed maturities as available-for-sale and accordingly marks all of its securities to market through accumulated other comprehensive income (loss).
Total investments increased $8,734,000 to $57,215,000 at December 31, 2006 from $48,481,000 at December 31, 2005, due to net income. The $1,614,000 increase in total stockholders' equity is primarily due to net income of $1,454,000 generated during fiscal 2006.
In accordance with SFAS No. 115, the Company may carry its portfolio of fixed income securities either as held to maturity (carried at amortized cost), as trading securities (carried at fair value) or as available-for-sale (carried at fair value). The Company has chosen to carry its debt securities as available-for-sale. The Company experienced a change in net unrealized loss of $127,000 reflecting a net unrealized loss of $1,191,000 at December 31, 2006 from a net unrealized loss of $1,064,000 at December 31, 2005. From time to time, as warranted, the Company employs investment strategies to mitigate interest rate and other market exposures.
The Company enters into a variety of contractual obligations with third-parties in the ordinary course of its operations. These obligations, as of December 31, 2006, are set forth in the table below. However, we do not believe that our cash flow requirements can be fully assessed based upon an analysis of these obligations. Future cash outflows, whether they are contractual obligations or not, also will vary based upon our future needs. Although some outflows are fixed, others depend on future events. The Company has expected contractual obligations relating to non-cancelable leases and insurance reserves of the following at December 31, 2006 (in thousands):
Independence American is primarily a reinsurer, and currently derives most of its business from pro rata quota share medical stop-loss reinsurance treaties (the “IHC Treaties”) with Standard Security Life and Madison National Life, which are wholly owned subsidiaries of Independence Holding Company (“IHC”). IHC owns 48% of the Company’s common stock. The IHC Treaties were entered into in 2002 and terminate on December 31, 2014, unless terminated sooner by Independence American. There are three factors that determine the amount of premiums assumed by Independence American: (i) the percentage of business ceded to Independence American pursuant to the IHC Treaties or otherwise; (ii) the amount of gross premium produced by the MGU Subsidiaries and other distribution sources written by Standard Security Life or Madison National Life that is
ceded to Independence American under the IHC Treaties; and (iii) the amount of gross premium produced by the MGU Subsidiaries and other distribution sources written by carriers other than Standard Security Life or Madison National Life that is ceded to Independence American.
With respect to medical stop-loss, IHC has agreed to cede a minimum of 15% of its medical stop-loss business to Independence American, and IHC has increased this percentage each year since inception of the IHC Treaties. Standard Security Life, Madison National Life and Independence American have received regulatory approval for Standard Security Life and Madison National Life to cede up to 30% to Independence American under most of IHC’s medical stop-loss programs. For the twelve months ended December 31, 2006 and December 30, 2005, Standard Security Life and Madison National Life ceded an average of 22.2% and 21.9%, respectively, of their gross medical stop-loss premiums written to Independence American. This increase in ceding percentage was offset by a decrease in gross medical stop-loss premiums written by IHC (including business written by the MGU Subsidiaries and otherwise) resulting in a small decrease in premiums earned by Independence American. In 2006 and beyond, any increase in the percentage of medical stop-loss ceded to Independence American will depend on how much IHC determines it has available to reinsure and Independence American’s desire to increase the percentage. Since the percentage being ceded is now well in excess of the contractual minimum, there is no guaranty that IHC will continue to increase the percentage of business ceded to Independence American or, in fact, cede in excess of 15%. However, the AMIC MGUs are the largest producers of medical stop-loss business for IHC, controlling a majority of this premium in 2006.
Commencing in July 2004, Independence American began reinsuring 20% of Standard Security Life’s short-term statutory disability benefit product (“DBL”). Standard Security Life is not contractually obligated to continue to cede this business to Independence American after termination of the current treaty year. In 2005, Standard Security Life and Madison National Life began ceding 10% of the majority of its fully insured business to Independence American. Standard Security Life and Madison National Life are not contractually obligated to continue to cede this business to Independence American after termination of the current treaty years. The Company does not expect the percentage ceded to it from IHC will change significantly in the next twelve months
Upon renewal of each of the programs underlying the IHC Treaties, Standard Security Life and Madison National Life determine the maximum percentage of risk to be offered to Independence American and Independence American determines the percentage that it wishes to accept. A typical pro rata quota share reinsurance treaty is for a twelve month period in which the ceding company and the reinsurer share the premiums as well as the losses and expenses in an agreed proportion for all policies written with an effective date within this period. Most treaties run from January 1 to December 31, but others could begin and end in other periods. Therefore the percentage ceded could change as the year progresses. If Independence American, Standard Security Life, and Madison National Life had agreed to increase the average percentage ceded to Independence American by 1% (from the 22.2% ceded for the twelve months ended December 31, 2006) and Standard Security Life’s and Madison National Life’s gross written premium had remained unchanged, Independence American’s premium would have increased by approximately $2.1 million, which is approximately 3.1% of total net premiums earned for the year ended December 31, 2006. That increase in premium, however, would not have flowed directly to pre-tax operating income because of corresponding changes in insurance benefits, claims and reserves and other expenses attributable to the increase in premiums.
Therefore, the impact on the Company’s operating results relating to the IHC Treaties can be summarized as follows: (i) assuming continuing profitability of the underlying business, the Company’s results would be positively impacted if IHC were to cede a higher percentage and adversely affected if IHC were to cede less; (ii) Independence American’s income would be negatively impacted if IHC’s gross premium written were to decrease, and (iii) Independence American’s income in future years would be positively affected if IHC were to produce higher profit margins, and negatively impacted if loss ratios increase.
Consolidated Balance Sheets as of December 31, 2006 and December 31, 2005
KPMG LLP, the independent registered public accounting firm that audited the financial statements in this Annual Report, has issued an attestation report on management's assessment of, and the effective operation of, AMIC's internal control over financial reporting as of December 31, 2006, which is included herein on page 36.
We have audited management's assessment, included in the accompanying “Report of Management on Internal Control Over Financial Reporting”, that American Independence Corp. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company'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.
In our opinion, management's assessment that American Independence Corp. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, American Independence Corp. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of American Independence Corp. and subsidiaries’ internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 15, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
Accrued fee income ($239 and $370, respectively, due from related parties)
Due to reinsurers ($1,914 and $1,304 respectively, due to related parties)
Net cash provided by (used by) operating activities of continuing operations
Net cash provided by (used by) operating activities of discontinued operations
Since November 2002, AMIC has been affiliated with Independence Holding Company ("IHC"), an insurance holding company, which held 48% of AMIC’s outstanding common stock at December 31, 2006. The senior management of IHC provides direction to the Company through a service agreement between the Company and IHC. IHC has also entered into long-term reinsurance treaties to cede medical stop-loss to the Company. Additionally, the Company began reinsuring IHC’s New York statutory disability business in the third quarter of 2004 and IHC’s short-term medical (“STM”) and consumer-driven group major medical business in 2005.
The Company's intangible assets consisting of broker/third party relationships and marketing agreements are amortized accordingly (see Note 4 of Notes to Consolidated Financial Statements).
The carrying amount of the Company's financial instruments, which include cash and cash equivalents, restricted cash, short-term investments, due from reinsurers and premiums receivable approximates their fair values.
Securities Purchased Under Agreements to Resell and Securities Sold Under Agreements to Repurchase
(b) Securities which may or may not be held to maturity ("available-for-sale securities") are carried at fair value. Unrealized gains or losses are credited or charged, as appropriate, directly to accumulated other comprehensive income (a component of stockholders' equity). Realized gains and losses on sales of available-for-sale securities, and unrealized losses considered to be other than temporary, are credited or charged to net realized investment gains in the Consolidated Statements of Operations.
(vi) The Company reviews its investment securities regularly and determines whether other than temporary impairments have occurred. If a decline in fair value is judged by management to be other than temporary, a loss is recognized by a charge to the Consolidated Statements of Operations, establishing a new cost basis for the security. The factors considered by management in its regular review include, but are not limited to: the length of time and extent to which the fair value has been less than cost; the financial condition and near-term prospects of the issuer; adverse changes in ratings announced by one or more rating agencies; whether the issuer of a debt security has remained current on principal and interest payments; whether the decline in fair value appears to be issuer specific or, alternatively, a reflection of general market or industry conditions (including, in the case of fixed maturities, the effect of changes in market interest rates); and the Company's intent and ability to hold the security for a period of time sufficient to allow for a recovery in fair value. For securities within the scope of Emerging Issues Task Force Issue 99-20, such as purchased interest-only securities, an impairment loss is recognized when there has been a decrease in expected cash flows combined with a decline in the security's fair value below cost.
The Company maintains loss reserves to cover its estimated liability for unpaid losses and loss adjustment expenses, including legal, other fees, and costs not associated with specific claims but related to the claims payment function, for reported and unreported claims incurred as of the end of each accounting period. These loss reserves are based on actuarial assumptions and are maintained at levels that are in accordance with US generally accepted accounting principles. Many factors could affect these reserves, including economic and social conditions, frequency and severity of claims, medical trend resulting from the influences of underlying cost inflation, changes in utilization and demand for medical services, and changes in doctrines of legal liability and damage awards in litigation. Therefore, the Company’s reserves are necessarily based on estimates, assumptions and analysis of historical experience. The Company’s results depend upon the variation between actual claims experience and the assumptions used in determining reserves and pricing products. Reserve assumptions and estimates require significant judgment and, therefore, are inherently uncertain. The Company cannot determine with precision the ultimate amounts that will be paid for actual claims or the timing of those payments. The Company's estimate of loss represents management's estimate of the Company's liability at the balance sheet date.
Liabilities for insurance reserves on STM and disability coverages are computed using claim development patterns and projected loss ratios derived from actual historical premium and claim data.
On January 1, 2006, the Company adopted the provisions of SFAS No. 123 (R), "Share Based Payment", which requires compensation cost relating to share-based payment transactions to be recognized in the financial statements, based upon the fair value of the instruments issued. SFAS No. 123 (R) covers a wide range of share-based compensation arrangements including share options, restricted stock plans, performance-based awards, share appreciation rights and employee purchase plans. SFAS No. 123 (R) replaces SFAS No. 123. In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 107 (SAB 107)
Basic income per common share is computed using the weighted average number of common stock shares outstanding during the period. Diluted income per common share is computed using the weighted average number of common stock shares and common stock equivalent shares outstanding during the period. Common stock equivalents consist of stock options (using the "treasury stock" method). Common Stock equivalent shares are excluded from the computation if the effect is anti-dilutive. As a result of the anti-dilutive effect, common stock equivalent shares have been excluded from the computation of diluted earnings per share for periods presented with a net loss. Included in the diluted earnings per share calculation for fiscal years 2006, 2005 and 2004, are 54,000, 79,000 and 101,000 shares, respectively, from the assumed exercise of options using the treasury stock method. Net income does not change as a result of the assumed dilution of options.
In February 2006, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”), which amends Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) and Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”). SFAS 155 simplifies the accounting for certain derivatives embedded in other financial instruments by allowing them to be accounted for as a whole if the holder elects to account for the whole instrument on a fair value basis. SFAS 155 also clarifies and amends certain other provisions of SFAS 133 and SFAS 140. SFAS 155 is effective for all financial instruments acquired, issued or subject to a re-measurement event occurring in fiscal years beginning after September 15, 2006. Adoption of SFAS 155 is not expected to have a material effect on the Company’s consolidated financial statements.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Adoption of SFAS 157 is not expected to have a material effect on the Company’s consolidated financial statements.
Additions of $3,243,000 to intangible assets represent the cash paid of $2,500,000 and a derivative issued to EDH according to terms set forth in Note 5 of Notes to Consolidated Financial Statements.
On February 22, 2006, AMIC entered into an agreement with Employers Direct Health (“EDH”). Under this agreement, EDH began writing employer medical stop-loss through Independence American in 2006, and will move the majority of its existing block of employer-sponsored group major medical and medical stop-loss to Independence American during 2007. Independence American paid EDH $2,500,000, which EDH simultaneously paid to Independence Holding Company (“IHC”) in consideration of IHC issuing 125,000 shares of IHC common stock (“IHC Stock”) to EDH. The IHC Stock is held in escrow by Independence American until such time as the aggregate annualized premiums written through EDH reaches $30 million.
The Company has classified the $2,500,000 payment and $743,000 derivative as an intangible asset that will be amortized over the five year contract period. Such amortization will start in 2007 to coincide with the transfer of business on January 1, 2007.
As part of the agreement, an affiliate of EDH and Independence American agreed to a profit/loss sharing arrangement, whereby Independence American will pay to, or receive from, such affiliate 35% of the underwriting profit or loss of the business written by Independence American. Independence American will receive customary carrier fees on the business written on its paper.
In addition, the Company has entered into an agreement with a national, career agent marketing organization to begin marketing health plans to individuals and families utilizing Independence American as the carrier. The agency projects that it will have $10 million of annualized premiums ($6 million on an earned basis) on Independence American paper as of December 31, 2007. Independence American initially anticipates retaining 50% of the risk on this business. The program will be administered by Insurers Administrative Corporation, a wholly owned subsidiary of IHC. These amounts are less than what was initially disclosed due to a later than anticipated launch date as a result of product design changes and filing requirements.
The amortized cost and fair value of fixed maturities at December 31, 2006 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. The average life of mortgage backed securities is affected by prepayments on the underlying loans and, therefore, is materially shorter than the original stated maturity.
The following tables summarizes, for all securities in an unrealized loss position at December 31, 2006 and December 31, 2005, the aggregate fair value and gross unrealized loss by length of time, those securities that have continuously been in an unrealized loss position (in thousands):
months or longer as of December 31, 2005. For fixed maturities, there are no securities past due or securities for which the Company currently believes it is not probable that it will collect all amounts due according to the contractual terms of the investment. Based on management's review of the portfolio, which considered the various factors described in Note 2, including the extent and duration of the unrealized losses and the Company's intent and ability to hold securities for a period of time sufficient to allow for a recovery in fair value, the Company did not consider these investments to be other-than-temporarily impaired at December 31, 2006 and 2005.
The Company maintains a securities trading account in addition to its securities classified as available-for-sale. The Company realized net gains from trading securities of $392,000 in 2006, $248,000 in 2005 and $249,000 in 2004. The Company had $4.0 million and $3.6 million, on average, in trading securities during 2006 and 2005, respectively. All such trading securities were liquidated at December 31, 2006 and 2005.
Net realized investment gains for years 2006, 2005 and 2004 are as follows:
At December 31, 2006 and December 31, 2005, the Company had an equity investment in Majestic with a carrying value of $1,009,000 and 1,082,000, respectively. For fiscal years 2006 and 2005, the Company recorded $102,000 and $26,000, respectively, for its share of income from its investment in Majestic.
On March 29, 2002, the Company and its wholly owned subsidiary, Intellicom, entered into an agreement to sell its operating business and certain assets to Loral Cyberstar, Inc. Following the sale of its operating business and certain assets to Loral Cyberstar, Inc., the Company's board of directors unanimously agreed to cease the operations of Intellicom on April 3, 2002. Principally due to the Company's guaranty of Intellicom's lease for its facility in Livermore, California, the Company has reserves for discontinued operations of Intellicom of $555,000 for this liability at December 31, 2006, and $808,000 at December 31, 2005. In October of 2006, the Company entered into an agreement with a third party to sublease the property in Livermore, California for the remaining life of the lease. The income associated with the sublease was previously estimated in the reserve balance. Loss from disposition of discontinued operations results from re-estimation of certain expected expenses.
On January 24, 2000, the Company founded Aerzone (formerly SoftNet Zone, Inc.) to provide high-speed Internet access to global business travelers. As part of the Aerzone business, the Company acquired Laptop Lane, on April 21, 2000. On December 19, 2000, the Company decided to discontinue the Aerzone business in light of significant long-term capital needs and the difficulty of securing the necessary financing because of the current state of the financial markets. The Company has no remaining reserve for Aerzone at December 31, 2006.
On December 7, 2000, the Company's board of directors approved a plan to discontinue providing cable-based Internet services through its ISP Channel subsidiary by December 31, 2000, because consolidation in the cable television industry made it difficult for ISP Channel to achieve the economies of scale necessary to provide such services profitably, and the Company was no longer able to bear the costs of maintaining the ISP Channel. The Company has no remaining reserve for ISP Channel at December 31, 2006.
As a result of the February 12, 1999 sale of the assets of the telecommunications segment, KCI, to Convergent Communications Services, Inc., the Company discontinued this segment. The Company has no remaining reserve for KCI at December 31, 2006.
The minimum lease payments shown above do not include $315,000 of sublease income to be received in the future under non-cancelable subleases.
Independence American maintains a revolving Letter of Credit (“LOC”) with a financial institution to support reinsurance obligations of Independence American in the ordinary course of business. The LOC has an outstanding face amount up to $5,000,000 although Independence American has not drawn upon funds to date. The LOC renews October 15 of each year, unless cancelled by Independence American.
The Company is involved in legal proceedings and claims which arise in the ordinary course of its businesses. The Company has established reserves that it believes are sufficient given information presently available related to its outstanding legal proceedings and claims. The Company believes the results of pending legal proceedings and claims are not expected to have a material adverse effect on its financial condition or cash flows, although there could be a material effect on its results of operations for a particular period.
Effective October 1, 1998, the Company implemented the 1998 Plan, which the Company's stockholders approved on April 13, 1999. The 1998 Plan provides for the grants of non-statutory and incentive stock options, stock appreciation rights, restricted stock awards, performance shares, and other awards to officers, employee and other individuals. Under the terms of the 1998 Plan, stock options have a maximum term of ten years from the date of grant, and have various vesting criteria depending on the grant with most grants vesting 25% on the first year anniversary date of the grant and ratably over the next 36 months. In addition, the number of common stock shares reserved for issuance under the 1998 Plan will automatically increase on the first trading day of each calendar year, beginning in calendar year 2000, by an amount equal to seven percent of the total number of common stock shares outstanding on the last trading day of the preceding calendar year, but in no event will any such annual increase exceed 1,333,333 shares, subject to adjustment for subsequent stock splits, stock dividends and similar transactions. At December 31, 2006, a total of 5,966,867 stock shares are reserved for issuance under the 1998 Plan. At December 31, 2006, stock options for 491,500 common stock shares were outstanding, stock options for 425,999 common stock shares were vested, and 5,411,893 common stock shares remained available for future stock options grants and other awards.
The following table summarizes the outstanding options to purchase common stock shares for years 2006, 2005 and 2004:
On January 1, 2006, the Company adopted the provisions of SFAS No. 123 (R), "Share Based Payment", which requires compensation cost relating to share-based payment transactions to be recognized in the financial statements, based upon the fair value of the instruments issued. SFAS No. 123 (R) covers a wide range of share-based compensation arrangements including share options, restricted stock plans, performance-based awards, share appreciation rights and employee purchase plans. SFAS No. 123 (R) replaces SFAS No. 123, which established as preferable a fair value based method of accounting for share-based compensation with employees, but permitted the option of continuing to apply the guidance of APB Opinion No. 25, as long as the notes to the financial statements disclosed the effects of the preferable fair value method. In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 107 (SAB 107) regarding the SEC's interpretation of SFAS No. 123 (R) and the valuation of share-based payments for public companies. The company has applied the provisions of SAB 107 in its adoption of SFAS No. 123 (R) and accordingly recorded share-based payment expense in selling, general and administrative expenses. Since the Company previously adopted the provisions of SFAS No. 123, effective November 14, 2002, the adoption of SFAS No. 123 (R) did not have a material impact on the Company's Consolidated Financial Statements.
Taxes computed at the Federal statutory rate of 35% for the years ended December 31, 2006, 2005 and 2004 are reconciled to the Company's actual income tax expense (benefit) as follows:
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the period in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Management believes that it is more likely than not that the Company will realize the benefits of these net deferred tax assets recorded at December 31, 2006.
At December 31, 2006, the Company had Federal net operating loss carryforwards of approximately $275,811,000 which expire as follows (in thousands).
AMIC's ability to utilize its Federal Net Operating Loss Carrryforwards ("NOLs") would be substantially reduced if AMIC were to undergo an "ownership change" within the meaning of Section 382(g)(1) of the Internal Revenue Code. AMIC will be treated as having had an "ownership change" if there is more than a 50% increase in stock ownership during a three year '"testing period" by "5% stockholders." In order to reduce the risk of an ownership change, in November 2002, AMIC's stockholders approved an amendment to its Certificate of Incorporation restricting transfers of shares of its common stock that could result in the imposition of limitations on the use, for federal, state and city income tax purposes, of AMIC's carryforwards of net operating losses and certain federal income tax credits. The Certificate of Incorporation generally restricts any person from attempting to sell, transfer or dispose, or purchase or acquire any AMIC stock, if such transfer would affect the percentage of AMIC stock owned by a 5% stockholder. Any person attempting such a transfer will be required, prior to the date of any proposed transfer, to request in writing that the board of directors review the proposed transfer and authorize or not authorize such proposed transfer. Any transfer attempted to be made in violation of the stock transfer restrictions will be null and void. In the event of an attempted or purported transfer involving a sale or disposition of capital stock in violation of stock transfer restrictions, the transferor shall remain the owner of such shares. Notwithstanding such transfer restrictions, there could be circumstances under which an issuance by AMIC of a significant number of new shares of Common Stock or other new class of equity security having certain characteristics (for example, the right to vote or convert into Common Stock) might result in an ownership change under the Code.