We also lease our principle 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 or will be located. As we expand our operations, we intend to execute leases for facilities in select locations throughout the United States that will house regional and field offices of our sales organization.
• Selected historical consolidated financial and other data as of December 31, 2000, 2001, 2002 and 2003, and for each of the five years ended December 31, 2004, for our predecessor. The historical consolidated financial data as of December 31, 2003, and for each of the three years ended December 31, 2004, have been derived from, and should be read together with, our predecessor’s audited consolidated financial statements and the related notes included in this report. The historical consolidated financial data as of December 31, 2000, 2001 and 2002, and for each of the two years ended December 31, 2001 have been derived from our predecessor’s audited consolidated financial statements and the related notes not included in this report;
• Selected historical financial and other data for the period from January 21, 2004 (KMG America’s date of inception), to December 31, 2004, for KMG America. For such period, KMG America had insignificant operations and cash flows. See KMG America’s audited financial statements and the related notes included in this report; and
For GAAP accounting purposes, Kanawha is treated as our predecessor entity and is referred to in this table as our “predecessor.” For financial reporting purposes, we have treated the Kanawha acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material to our predecessor’s consolidated statements of operations, cash flows, and changes in shareholders’ equity for the year ended December 31, 2004. Accordingly, selected historical consolidated financial and other data as of December 31, 2000, 2001, 2002 and 2003, and for each of the five years ended December 31, 2004, for our predecessor are reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition. Financial information relating to KMG America’s consolidated financial position as of December 31, 2004, has been adjusted for GAAP purchase accounting adjustments reflecting the acquisition.
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 Item 1 and Exhibit 99.01 attached hereto.
KMG America is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004. We commenced our operations shortly before we completed our initial public offering of common stock on December 21, 2004, and our shares trade on the New York Stock Exchange under the symbol “KMA.” Concurrently with the completion of our initial public offering, we completed our acquisition of Kanawha and its subsidiaries, which are our primary operating subsidiaries and which underwrite and sell life and health insurance products marketed primarily in the southeastern United States. For GAAP accounting purposes, Kanawha is treated as KMG America’s predecessor entity and is referred to herein as our “predecessor.” For financial reporting purposes, we have treated the acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material to our predecessor’s consolidated statements of operations, cash flows and changes in shareholders’ equity for the year ended December 31, 2004. Accordingly, financial information in the following discussion that relates to our predecessor’s consolidated results of operations, cash flows and changes in shareholders’ equity for the year ended 2004 are reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition. Financial information relating to our financial position as of December 31, 2004, has been adjusted for GAAP purchase accounting adjustments reflecting the acquisition.
while developing a new worksite marketing and distribution organization that targets larger employer groups nationwide with an expanded variety of life and health insurance products which will add a new set of employer-paid life insurance, disability and health products to our existing voluntary products. In December 2004, we opened sales offices hosting regional sales managers in Boston, Massachusetts and Irvine, California, a Los Angeles suburb. During 2005, we have opened regional sales offices in Tampa, Florida; Chicago, Illinois; New York, New York; Atlanta, Georgia; Dallas, Texas; and Cleveland, Ohio. We expect to open additional regional sales offices in 2005 and thereafter. We have begun and expect to continue to add and train additional sales and sales support staff and marketing personnel at these facilities, and will recognize the costs associated with the these additions before we recognize revenues resulting from new sales activity. Consequently, we expect negative cash flow and operating losses in the short term. This negative cash flow is expected to be $5.0 million to $6.0 million in 2005 and will be funded from the proceeds of the initial public offering. We expect cash flows from our new sales and marketing organization to be positive by 2006 but we cannot assure you that this will occur.
In addition, we have retained our predecessor’s closed block of life and health business reported in the acquired business segment and the investment and marketing activities reported in the corporate and other segment. While acquisitions of books of business from other insurance carriers is not one of our principal growth strategies, we will consider making acquisitions on an opportunistic basis if we can complete the acquisitions on favorable financial terms that we expect to be generally accretive to earnings per share and return on equity while maintaining our financial strength ratings.
• The trend to shift health care costs to employees and rising healthcare costs in general are causing individuals to purchase a wider array of life and health insurance products. We believe these trends will result in greater demand for our voluntary worksite insurance products.
• The volatility in the equity markets over the past few years has posed a number of problems for some participants in the life and health insurance industry. Even though the capital markets have recovered, not all companies have participated evenly in the recovery. We and our predecessor have historically had minimal equity exposure (less than 1% of total invested assets as of December 31, 2004) and we plan to continue to manage equity asset allocations conservatively in the future.
• Corporate bond defaults and credit downgrades, which have resulted in other than temporary impairment in the value of many securities, have had a material impact on life and health insurers in the past few years. While our debt investments have not been immune to corporate credit problems, losses from defaults have historically not been material to our predecessor’s financial condition. We intend to manage our investment portfolio conservatively in the future to attempt to mitigate the risk of losses from defaults.
• Many of the events and trends affecting the life and health insurance industry have had an equal (or greater) impact on the life and health reinsurance industry. These events led to a decline in the availability of reinsurance. While we currently cede a limited amount of our primary insurance business to reinsurers, and we plan to continue this practice, diminishing reinsurance capacity has negatively impacted our predecessor in the past and may further negatively impact our operations in the future. If we can not obtain affordable reinsurance coverage, either our net exposures will increase or we will have to reduce our underwriting commitments.
• Recently announced governmental investigations and litigation alleging the illegal use of bid-rigging schemes and contingent commissions by insurance companies and brokers may adversely affect our industry and us (1) by negatively impacting the level and volatility of stock prices of companies operating in the insurance industry, (2) if we become the subject of investigations or related litigation of this type, or (3) if industry regulation, practices and customs change in ways that are detrimental to the success of our business strategy.
Our profitability depends on the adequacy of our product pricing and underwriting, the accuracy of assumptions about future experience used in establishing reserves for future policyholder benefits and claims, returns on invested assets and our ability to manage our costs and expenses. Factors affecting these items may have a material adverse effect on our business, results of operations or financial condition. In addition, our profitability depends in large part on accurately predicting benefits, claims and other costs, including medical and dental costs. It also depends on our ability to manage future benefit and other costs through product design, underwriting criteria, utilization review or claims management and, in health and dental insurance, negotiation of favorable provider contracts. Changes in market conditions and numerous other factors may also materially adversely affect our ability to manage claim costs. As a result of one or more of these factors or other factors, claims could substantially exceed our expectations, which could have a material adverse effect on our business, results of operations or financial condition.
We derive our revenues primarily from the sale of our insurance policies and, to a lesser extent, fee income from administrative services and commissions on the placement of third-party insurance products. Sales of insurance policies are recognized in revenue when earned as insurance premiums, while sales of administrative services and commission income are recognized as fee income on our consolidated statements of operations when earned.
Our expenses primarily consist of policyholder benefits, insurance commissions, premium taxes, licenses, fees, amortization of deferred acquisition costs, or DAC, and value of business acquired, or VOBA, interest on the $15.0 million promissory note issued in connection with the Kanawha acquisition, and general insurance operating expenses.
In December 2003, our predecessor sold its fixed annuity block of insurance for contracts still in the accumulation phase to Madison National Life Insurance Company (“Madison National”). The business was sold 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
We have completed a thorough review of our predecessor’s accounting policies and we believe that our predecessor’s accounting policies are consistent with our accounting policies and we do not foresee the need to make any significant changes in our predecessor’s accounting policies in the foreseeable future.
Policy benefit reserves and other claim reserves are established according to generally accepted actuarial principles and are based on a number of factors. These factors include historical claim payments experience and actuarial assumptions used to estimate expected future claims experience. These assumptions and other factors include trends in claims severity, frequency and other factors discussed below, the incidence of incurred claims, the extent to which all claims have been reported and internal claims processing changes. The methods of making these estimates and establishing the related reserves are periodically reviewed and updated.
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 and related expenses 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.
In accordance with GAAP purchase accounting requirements, our predecessor’s policy and contract reserves were recorded at fair value upon the closing of the Kanawha acquisition. The policy and contract reserves were calculated as the present value of future benefits and expenses less the present value of future premiums. These values were actuarially determined and were based upon assumed future interest rates, administrative expenses, mortality, morbidity and policy lapse rates as appropriate for the particular benefit on the purchase date. For long-term care insurance, the assumptions in the fair value calculation for future policy lapses and future premiums are different than the corresponding assumptions in the reserve calculations in our predecessor’s historical GAAP financial statements, with lapses less than and future premiums more than in the historical GAAP calculation. Assumptions for future long term care insurance premiums in the fair value calculation are consistent with current and anticipated premium increases, including those approved in the last twelve to eighteen months in certain jurisdictions for policies currently in force.
The discount rate is the interest rate at which future benefit cash flows are discounted to determine the present value of those future 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 claim cost 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
Effective December 31, 2004, as a part of the application of GAAP purchase accounting requirements, we reestablished our predecessor’s discount rate to provide margin for moderately adverse movements in the future investment portfolio yield rate.
Future policy benefit and expense reserves for fixed annuities (which we no longer offer) consist of policy account balances before applicable surrender charges and deferred policy initiation fees that are being recognized in income over the terms of the policies. Policy benefits charged to expense during the period include amounts paid in excess of policy account balances and interest credited to policy account balances. Interest crediting rates for investment products (i.e., primarily fixed annuity products which we no longer offer) ranged from 3.5% to 5.0% in 2003, and did not change in 2004. We do not intend to underwrite annuity or other products in which interest is credited to policyholder account balances.
We maintain unearned premium reserves for the portion of the premiums on short duration contracts such as accident and health insurance that is related to the unexpired period of the policy.
For most insurance products, amortization of DAC is recognized in proportion to the ratio of annual premium revenue to the total anticipated premium revenue, which gives effect to expected terminations. DAC is amortized over the premium-paying period of the related policies. Anticipated premium revenue is determined using assumptions consistent with those utilized in the determination of liabilities for insurance reserves.
For fixed and variable annuities, interest-sensitive life insurance and fixed and variable universal life insurance policies (none of which we currently offer), DAC 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.
We regularly monitor our investment portfolio to ensure that investments that may be other than temporarily impaired are identified in a timely fashion and properly valued and that any impairment is charged
Reinsurance recoverables represent the portion of the policy and contract liabilities that are covered by reinsurance. These liabilities include reserves for life, annuity, accident and health, policy and contract claims and other policyholder liabilities as shown in the consolidated balance sheets. The cost of reinsurance is accounted for over the terms of the underlying reinsured policies using assumptions consistent with those used to account for the policies reinsured. Amounts recoverable from reinsurers are estimated in a manner consistent with the methods used to determine the underlying liabilities reported in our and our predecessor’s consolidated balance sheets.
• Historical financial information for the period from January 21, 2004 (KMG America’s date of inception), to December 31, 2004, for KMG America.
For financial reporting purposes, we have treated the Kanawha acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material to our predecessor’s consolidated results of operations, cash flows and changes in shareholders’ equity for the year ended December 31, 2004. Accordingly, financial information in the table below that relates to our predecessor’s consolidated statements of operations for the year ended 2004 are reported on a historical basis without GAAP purchase accounting adjustments reflecting KMG America’s acquisition of Kanawha.
The following list includes definitions of insurance terms used in the discussion of our predecessor’s consolidated results of operations. Terms are listed in the order in which they appear in our predecessor’s consolidated statements of operations.
• Revenues: Revenues consist primarily of premiums, net investment income, commission and fee income, realized investment gains and losses and other income.
• Direct Premiums: Direct premiums represent premiums on insurance products written and issued by us.
• Assumed Premiums: Assumed premiums represent premiums written and issued by other insurance companies and subsequently reinsured by us.
• Ceded Premiums: Ceded premiums represent premiums either written by or assumed by us and subsequently reinsured by other insurance companies.
• Renewal premiums: Renewal premiums represent the premiums derived from policies greater than twelve months from the original policy date.
• Commission and fee income: Commission and fee income consists of the commissions received by our insurance marketing business for the sale by us of insurance products underwritten by other insurance companies and fees generated by our third-party administration business. In addition, both of these businesses provide services to us. The commission and fee income for services that these businesses provide to us is eliminated from the financial statement amounts referenced in this report.
• Benefits and expenses: Benefits and expenses consist primarily of policyholder benefits, insurance commissions, general insurance expenses, insurance taxes, licenses and fees, depreciation and amortization and the amortization of DAC and VOBA.
• Policyholder benefits: Policyholder benefits consist of the policy benefit claims paid to policyholders and the increase or decrease in benefit reserves. The primary factors affecting policyholder benefits are premium growth, claims experience and reserve assumptions including persistency, morbidity, mortality and interest rates.
• Insurance commissions: Insurance commissions represent renewal commissions on products after the first anniversary date as well as first year commissions that are not deferred.
• Insurance taxes, licenses and fees: Insurance taxes, licenses and fees are primarily comprised of employment taxes, premium taxes and various filing fees required by the jurisdictions in which we do business.
• 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 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.
• New sales: New sales represent annualized premiums on new policies issued.
The following discussion reflects our predecessor’s historical results for the years ended December 31, 2004, 2003, and 2002.
Our future results may not be consistent with the historical results of our predecessor. The following discussion should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this report.
The following represents a summary of 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.
The following represents a summary of KMG America’s income statement and asset composition as of December 31, 2004. KMG America’s operations are aggregated into the following reportable segment, as the effects of its operations were not material to its predecessor’s reportable segments.
Acquired business premiums decreased $2.0 million, or 30.3%, for the year ended December 31, 2004. We and our predecessor have not acquired any blocks of business since 1999 and the decline is a result of policy lapses
Total assets attributed to the worksite insurance business have not experienced any significant fluctuations. Total assets attributed to the senior market insurance business have increased significantly due to the accumulation of long-term care insurance premiums retained to establish policy reserves for the payment of future policyholder benefits. Assets attributed to the third-party administration business consist primarily of operating cash and receivables with respect to administrative claims payments awaiting settlement. These assets are subject to significant variations due to timing of payments made, and there is no investment income attributed to them. Assets attributed to the acquired business have declined since 1999 as a result of policy lapses and the fact that we and our predecessor have not acquired any blocks of business since 1999. Assets attributed to the corporate and other segment are subject to significant fluctuations because changes in unrealized gains are all allocated to the corporate and other segment. In conjunction with the application of GAAP purchase accounting requirements, assets attributed to the worksite insurance business, the senior insurance business and the acquired business all increased.
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
Worksite marketing policyholder benefits decreased $0.8 million, or 1.8%, to $44.3 million for the year ended December 31, 2004, from $45.1 million for the year ended December 31, 2003. This produced benefits to premium ratios of 78.7% for the year ended December 31, 2004, compared to 77.2% for the year ended December 31, 2003. While policyholder benefits decreased, a sales decline of $2.6 million resulting from the discontinuation of annuities also produced a similar reduction in policyholder benefits, as reserve increases associated with this business were no longer required. The benefits to premium ratio increased primarily as a result of unfavorable short term disability claims experience at a particular employer worksite. Actions have been taken to cease any new sales in that worksite.
Senior market policyholder benefits increased $2.7 million, or 8.2%, to $35.8 million for the year ended December 31, 2004, from $33.1 million for the year ended December 31, 2003. This produced benefits to premium ratios of 85.2% for the year ended December 31, 2004, compared to 79.8% for the year ended December 31, 2003. The primary reason for the ratio increase is an increase in open active claims, due to an increase in the number of policies in force and the aging of our predecessor’s insureds, which resulted in increases in actual claims paid as well as additional claims reserves.
General insurance expenses decreased $1.7 million, or 5.8%, to $27.8 million in the year ended December 31, 2004, from $29.5 million in the year ended December 31, 2003. General insurance expenses for 2004 and 2003 include approximately $2.2 million and $2.8 million, respectively, of costs to develop our predecessor’s worksite marketing business. In November 2003, our predecessor outsourced the functions of its information technology department to CGI Group, Inc, which had a positive impact on expenses. In addition, general expenses (primarily in the third party administration business) were negatively impacted in 2003 by information technology expenses attributable to administrative system conversions, as well as costs to comply with HIPAA. As a result, the third party administration business experienced a decrease in expenses in 2004 compared to 2003, despite an increase in revenues. Overhead expenses that are not directly associated with a particular business segment are allocated to the various business segments on a pro rata basis based on different factors, such as headcount, policy count, number of policies issued, premiums and other relevant factors.
Insurance taxes, licenses and fees were unchanged at $4.7 million in the years ended December 31, 2004 and 2003. Premium income, which drives premium taxes, was relatively flat between 2003 and 2004.
We eliminated all of our predecessor’s DAC upon the closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements. We began recording DAC prospectively on January 1, 2005.
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 acquisition and the rate was approximately 6.0% at December 31, 2004.
Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% due to tax-advantaged investments and a Kanawha subsidiary’s net operating loss carry forward, and because any losses incurred in that subsidiary do not generate tax benefits because of the uncertainty of future operating gains. Our predecessor’s effective tax rates for the periods from January 1 through December 31, 2004, and 2003 were 36.5% and 31.1%, respectively. In 2003, our predecessor qualified for the small life insurance company deduction,
Total revenues for 2003 increased $18.8 million, or 13.7%, to $156.4 million from total revenues of $137.6 million in 2002. The primary factors causing the increase are explained in the revenue related discussion below.
Commission and fee income for 2003 was $13.0 million, unchanged from 2002. This amount represented administrative fees for third-party administrative services.
Other income increased $0.4 million, or 21.1%, to $2.3 million in 2003 from $1.9 million in 2002, reflecting the increased commission and expense allowances from reinsurance companies generated from the increase in ceded premiums that is described in the discussion of premiums above.
Worksite marketing policyholder benefits increased $3.0 million, or 7.1%, to $45.1 million for 2003 from $42.1 million for 2002. This produced benefits to premium ratios of 77.2% for 2003 compared to 79.1% for 2002. This ratio decrease reflects the premium growth over the last two years and the assumption that claims will be smaller in the earlier years that policies are in force.
General insurance expenses increased $1.1 million, or 3.9%, to $29.5 million in 2003 from $28.4 million in 2002. General insurance expenses were negatively impacted in 2003 and 2002 by information technology expenses attributable to administrative system conversions, as well as costs to comply with HIPAA. General insurance expenses for the years ended December 31, 2003, and 2002 include approximately $2.8 million and $2.2 million, respectively, of costs to develop our predecessor’s worksite marketing business. Expenses in 2002 (primarily relating to the third party administration business) were negatively affected by the costs associated with the conversion by our predecessor of a client’s existing information management system to a new HIPAA compliant system. This project produced fees for our predecessor in 2002 and 2003, although the project’s associated expenses decreased in 2003 compared to 2002. Overhead expenses that are not directly associated with a particular business segment are allocated to the various business segments on a pro rata basis based on different factors, such as headcount, policy count, number of policies issued, premiums and other relevant factors.
Our predecessor also assigned a value to the insurance in force of acquired companies or blocks of insurance business at the date of acquisition. No companies or blocks of business were acquired in 2003. Approximately $1.0 million of costs to acquire an insurance agency were deferred in 2002.
The amortization of DAC and VOBA increased $0.1 million, or 1.1%, to $9.6 million in 2003 from $9.5 million in 2002. The 2003 amortization is composed of DAC amortization of $5.6 million and VOBA amortization of $4.0 million. The 2002 amortization is composed of DAC amortization of $5.3 million and VOBA amortization of $4.2 million.
The following table shows the carrying value of our and our predecessor’s investments by type of security as of the dates indicated.
The following table provides the cumulative net unrealized gains (pre-tax) on our and our predecessor’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.
Unrealized losses in 2003 were reviewed by our predecessor for other than temporary impairment in conjunction with our predecessor’s investment policies during the year ended December 31, 2003. Impairment charges of $0.7 million were taken in the year ended 2003 on one bond issue that was determined to be other than temporarily impaired due to the length of time that it was in a loss position.
• length of time and the extent to which the market value of the security has been below amortized cost;
• when the issuer is experiencing significant financial difficulties, a review of all securities of the issuer, including its known subsidiaries and affiliates;
• other subjective factors, including information obtained from regulators and rating agencies.
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
Life and annuity reserves increased by $10.0 million, or 3.3%, to $309.9 million as of December 31, 2004, from $299.9 million as of December 31, 2003. The increase in the reserve balance for the year ended December 31, 2004 includes an increase of $20.2 million attributed to the application of GAAP purchase accounting requirements. Excluding the effects of GAAP purchase accounting, life and annuity reserves decreased $10.2 million for the year ended 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, as expected because no new blocks of business have been acquired since 1999. These reserves represented $182.1 million as of December 31, 2004, and $180.1 million as of December 31, 2003. The increase in the acquired life reserve balance for the year ended December 31, 2004, includes an increase of $12.6 million attributed to the application of GAAP purchase accounting requirements. Excluding the effects of GAAP purchase accounting, these blocks represented $10.6 million of the decrease in reserves for the year ended December 31, 2004, and $10.9 million of the decrease in reserves for the year ended December 31, 2003. Accident and health reserves increased by $59.6 million or 42.2%, to $200.8 million as of December 31, 2004, from $141.2 million as of December 31, 2003. The increase in the reserve balance for the year ended December 31, 2004, includes an increase of $24.1 million attributed to the application of GAAP purchase accounting requirements. The remaining reserve increases of $35.5 million 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, decreased by $1.2 million, or 11.4%, to $9.3 million as of December 31, 2004, from $10.5 million as of December 31, 2003. This decrease 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.
Participating policies are policies where the policyholder participates in the performance of the underlying product profitability. Policyholder dividends on participating insurance products are recognized over the term of the related policies. Participating business represented approximately 30% and 31% of total ordinary life insurance in force at December 31, 2004, and 2003, respectively. Dividends paid to policyholders were $2.2 million and $2.1 million for the years ended 2004 and 2003, respectively, and are recorded as policyholder benefits in the consolidated statements of operations.
Reinsurance recoverables increased by $10.2 million, or 16.7%, to $71.4 million as of December 31, 2004, from $61.2 million as of December 31, 2003. The increase in the recoverable balance for the year ended December 31, 2004, includes an increase of $3.5 million attributed to the application of GAAP purchase accounting requirements. The remaining increase is attributable to underlying business growth, specifically the growth in long-term care business reinsured.
Recorded ceded loss recoveries from reinsurers (recorded as a reduction in policyholder benefits) were $7.9 million and $5.6 million for the years ended 2004 and 2003, respectively.
The following table sets forth our individual reinsurance recoverables exposure to specific reinsurers and their corresponding A.M. Best financial strength rating as of December 31, 2004:
KMG America is a holding company and had minimal operations of its own prior to the completion of its initial public offering and the Kanawha acquisition. KMG America’s assets consist primarily of the capital stock of Kanawha and its other non-insurance subsidiaries. Accordingly, KMG America’s cash flows depend upon the availability of dividends and other statutorily permissible payments, such as payments under tax allocation agreements and under management agreements, from Kanawha. Kanawha’s ability to pay dividends and to make other payments is limited primarily by applicable laws and regulations of South Carolina, the state in which Kanawha is domiciled, which subjects insurance operations to significant regulatory restrictions. These laws and regulations require, among other things, that Kanawha, KMG America’s insurance subsidiary, maintain minimum solvency requirements and limit the amount of dividends it can pay to the holding company. Solvency regulations, capital requirements, types of insurance offered and rating agency status are some of the factors used in determining the amount of capital available for dividends. In general, South Carolina will permit annual dividends from insurance operations equal to the greater of (1) the most recent calendar year’s statutory net income or (2) 10% of total capital and surplus of the insurance operations at the end of the previous calendar year, provided that the dividend payment does not exceed earned surplus, in which case further limitations apply.
For 2005, the maximum amount of dividends that Kanawha can pay to KMG America under applicable laws and regulations without prior regulatory approval is $8.4 million. If KMG America is able to successfully execute its business plan and accelerate Kanawha’s earnings growth in its insurance operations, KMG America expects that the maximum allowable dividend from Kanawha to the holding company will increase at an accelerated rate year-over-year. If the ability of Kanawha to pay dividends or make other payments to KMG America is materially restricted by regulatory requirements, it could adversely affect KMG America’s ability to pay any dividends on its common stock and/or service its debt and pay its other corporate expenses.
and is added to the principal balance on December 31 of each year and is payable on the maturity date. No cash payments are required under the promissory note until maturity, at which time approximately $19.1 million of principal and accrued interest will be due and payable. The terms of the promissory note limit KMG America’s and Kanawha’s ability to incur additional debt. KMG America maintains a $2.0 million line of credit available to meet short-term cash flow needs. We are seeking to expand our available credit facilities in order to maximize financial flexibility and are considering adding leverage to our capital structure.
Our predecessor’s qualified defined benefit pension plan was under-funded by $2.0 million as of December 31, 2004, with an actuarially determined projected benefit obligation of $15.4 million as opposed to plan assets of $13.4 million. In 2004, our predecessor made contributions to the pension fund of $3.1 million. In accordance with ERISA, there was no expected minimum funding requirement for this plan for the year ended December 31, 2004. Based on the plan’s current funding status and ERISA and IRS guidelines, no required contributions to the plan are anticipated for 2005.
We anticipate that these costs will be offset over time by increased sales production resulting from hiring additional sales personnel and increased cross-selling, as well as efficiencies resulting from greater scale. However, during 2005, we do not expect that the anticipated costs described above to implement our business strategy will be offset by incremental revenues, resulting in a net use of cash of approximately $5.0 million to $6.0 million during this period. This cash outlay will be funded with a portion of the proceeds from the initial public offering. We expect that net incremental cash flows resulting from the increased sales production and efficiencies anticipated from our new business strategy will be positive after 2005 but can provide no assurance that this will occur.
operations representing premium income that was placed in reserves, proceeds from the sales and maturities of invested assets that were not yet reinvested, and the capital contribution related to the exercise of stock options. Our predecessor’s significant cash flows for the year ended 2002, 2003 and 2004, are as follows:
Other assets increased by $3.2 million in 2003 as the result of a reclassification of assets pertaining to an employee deferred compensation plan from “available-for-sale” to “trading,” offset by a decrease in common stock. In 2004, other assets decreased by $2.2 million, primarily due to the timing of payments and receipts between our predecessor and its reinsurers.
Realized losses occurred in 2002 resulting from the sales of distressed investments. Sales and purchases were higher in 2002 than 2001 because of a restructuring of the portfolio in 2002. Realized gains were higher in 2003 due to the decision made by our predecessor’s investment committee to take advantage of favorable market conditions by selling securities to recognize gains. These sales activities kept the sales and purchases of investments at a comparable level with 2002. In 2004, our predecessor had realized gains of $9.4 million primarily due to its decision to sell its convertible bond portfolio and the majority of its equity securities. These realized gains were higher than the gains in 2003, although the activity levels for sales and purchases was significantly lower than in 2003.
In connection with our acquisition of Kanwha in 2004, outstanding Kanawha stock options were exercised, resulting in cash receipts of $6.1 million and a tax benefit of $3.3 million. The exercise of these outstanding stock options produced both the $9.4 million capital contribution and the majority of the $3.8 million increase in federal income tax recoverable.
We have obligations and commitments to third parties as a result of our operations. These obligations and commitments, as of December 31, 2004, are detailed in the table below:
In December 2003, the FASB issued Statement No. 132 (revised 2003), Employers’ Disclosures about Pensions and Other Postretirement Benefits (“Statement 132 (revised 2003)”). Statement 132 (revised 2003) revises employers’ disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition provisions of FASB Statements No. 87, Employers’ Accounting for Pensions, No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, and No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions. Statement 132 (revised 2003) retains the disclosure requirements contained in FASB Statement No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits (“Statement 132”), which it replaces. It requires additional disclosures about the assets, obligations, cash flows and net periodic benefit cost of defined benefit pension plans and other postretirement benefit plans. The required information will be provided separately for pension plans and for other postretirement benefit plans.
In March 2004, the Emerging Issues Task Force (“EITF”) reached a final consensus on EITF 03-1, which is effective for fiscal periods beginning after June 15, 2004. EITF 03-1 requires that when the fair value of an investment security is less than its carrying value, an impairment exists for which a determination must be made as to whether the impairment is other-than-temporary. An impairment loss should be recognized equal to the difference between the investment’s carrying value and its fair value when an impairment is other-than-temporary. Subsequent to an other-than-temporary impairment loss, a debt security should be accounted for in accordance with Statement of Position No. 03-3, Accounting for Loans and Certain Debt Securities Acquired in a Transfer, which allows the accretion of the discount between the carrying value and expected value of a security if the amount and timing of the recognition of that difference in cash is reasonably estimable. EITF 03-1 also indicates that, although not presumptive, a pattern of selling investments prior to the forecasted recovery may call into question an investor’s intent to hold the security until it recovers its value.
• Accelerate the timing of recognition of certain impairment losses or otherwise result in impairment losses being recognized when they previously may not have been;
In December 2004, the FASB enacted SFAS No. 123 (revised 2004) (“FAS 123 (revised 2004)”), Share-Based Payment, which replaces SFAS No. 123 (“FAS 123”), Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25 (“APB 25”), Accounting for Stock Issued to Employees. FAS 123 (revised 2004) requires the measurement of all employee share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in our consolidated statements of operations. The accounting provisions of FAS 123 (revised 2004) are effective for reporting periods beginning after June 15, 2005. We are required to adopt FAS 123 (revised 2004) in the second quarter of 2005.
Consolidated Statements of Cash Flows for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the Predecessor for the years ended December 31, 2002, 2003 and 2004
* All other required financial statement schedules are omitted because the information required is either not applicable or is included in the financial statements or the related notes included in this report.
We have audited the accompanying consolidated balance sheets of the Predecessor, as defined in Note 1, as of December 31, 2003 and KMG America Corporation (“the Company”) as of December 31, 2004, and the Predecessor’s consolidated statements of operations, shareholders’ equity and cash flows for the years ended December 31, 2002, 2003 and 2004 and the Company’s statements of operations, shareholders’ equity and cash flows for the period January 21, 2004 (inception) through 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.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
and KMG America Corporation from January 21, 2004, through December 31, 2004
The Company’s sales are primarily in the southeastern United States, predominantly in Florida, South Carolina and North Carolina, and are marketed through full-time agents, general agents and brokers. Premium revenues are concentrated in the individual life and accident and health lines of business.
Fixed maturities classified as available-for-sale are stated at fair value with unrealized gains and losses reported directly in shareholders’ equity as accumulated other comprehensive income. Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities that are not actively traded, fair values are estimated using values obtained from independent pricing services.
Assets supporting the deferred compensation plan are classified as trading and are included in other investments. Trading account assets are held for resale in anticipation of short-term market movements. Trading account assets, consisting of mutual funds, are stated at fair value. Gains and losses, both realized and unrealized, are included in realized gains and losses effective January 1, 2003, when these assets were moved to a trading portfolio.
• Industry factors or conditions related to a geographic area negatively affecting the security;
Company-occupied real estate, primarily buildings, are carried at cost less accumulated depreciation and are depreciated principally by the straight-line method over estimated useful lives generally ranging from 15 to 30 years. Equipment is stated at cost, less accumulated depreciation, and depreciated principally by the straight-line method over their estimated useful lives, generally 3 to 5 years. Effective December 31, 2004, the Company recorded at fair value real estate occupied by the Predecessor and equipment owned by the Predecessor as part of the application of GAAP purchase accounting requirements.
The Predecessor’s historical value of business acquired was eliminated upon the closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements. Value of business acquired was simultaneously re-established, by the Company, 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, 2004.
Long-lived assets include property and equipment, other intangible assets, systems development and other deferred costs and other assets. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”), the Company regularly evaluates whether events and circumstances have occurred which indicate that the carrying amount of long-lived assets may warrant revision or may not be recoverable. When factors indicate that long-lived assets should be evaluated for possible impairment, the Company uses an estimate of the future undiscounted net cash flows of the related business over the remaining life of the asset in measuring whether the carrying amount of the related asset is recoverable. To the extent these projections indicate that future undiscounted net cash flows are not sufficient to recover the carrying amounts of the related assets, the underlying assets are written down by charges to expense so that the carrying amount is equal to fair value, primarily determined based on future discounted cash flows. In the opinion of management, the Company’s long-lived assets are appropriately valued at December 31, 2004, and the Predecessor’s long-lived assets were appropriately valued at December 31, 2003.
Claim reserves relating to short duration contracts generally are recorded when insured events occur. The liability is based on the expected ultimate cost of settling the claims. The claims and benefits payable reserves include: (1) case base reserves for known but unpaid claims as of the balance sheet date; (2) incurred but not reported (“IBNR”) reserves for claims where the insured event has occurred but has not been reported as of the balance sheet date; and (3) loss adjustment expense reserves for the expected handling costs of settling the claims. Case base reserves and the IBNR reserves are recorded at an amount equal to the net present value of the expected future claims payments. Factors considered when setting IBNR reserves include patterns in elapsed time from claim incidence to claim reporting, and elapsed time from claim reporting to claim payment. Claim reserves generally equal the Company’s estimate, at the end of the current reporting period, of the present value of the liability for future benefits and expenses to be paid on claims incurred as of that date. A claim reserve for a specific claim is based on assumptions derived from Kanawha’s actual historical experience as to claim duration, as well as the specific characteristics of the claimant such as benefits available under the policy, the benefit period, and the age and occupation of the claimant. Although considerable variability is inherent in such estimates, management believes that the reserves for claims and claim adjustment expenses are adequate. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known; such adjustments are included in current operations.
Revenue from commission and fee income is recognized over the related contract periods.
The following is a reconciliation of reported net income and pro forma information as if the Company and the Predecessor had adopted SFAS 123 for its employee and director stock option awards:
Policyholder dividends are recognized over the term of the related policies. Participating business represents approximately 31% and 30%, respectively, of the Predecessor’s and the Company’s total ordinary life
The final consensus on EITF 03-1 included additional disclosure requirements incremental to those adopted by the Predecessor effective December 31, 2003, that are effective for fiscal years ending after June 15, 2004.
In October 2004, the FASB delayed the implementation of the accounting requirements included in EITF 03-1 until further study could be completed regarding the impact of this guidance, particularly with respect to “available-for-sale” portfolios. The disclosure requirements included in EITF 03-1 remain in effect.
• Result in the designation of certain investment securities as trading; and
• The potential recognition of unrealized losses in situations where the Company anticipates a full recovery of certain unrealized losses but does not want to indicate a permanent intent to hold the affected securities, regardless of internal and external facts and circumstances, until such time as they fully recover or mature; and
Mutual funds held for a deferred compensation plan with a cost of $5.0 million and a market value of $4.2 million were transferred from the available-for-sale category to the trading category effective January 1, 2003.
The amortized cost and fair value of fixed maturity securities at December 31, 2004, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from the sales of investments in fixed maturity securities during the years ending December 31, 2002, 2003 and 2004, were $175.1 million, $165.7 million and $99.2 million, respectively. Gross gains of $9.2 million and gross losses of $12.2 million were realized in 2002 on those sales. Gross gains of $9.8 million and gross losses of $3.5 million were realized in 2003 on those sales. Gross gains of $7.9 million and gross losses of $0.7 million were realized in 2004 on those sales.
At December 31, 2004, fixed maturity securities and short-term investments with an amortized cost and fair value of $6.9 million were on deposit with state insurance departments to satisfy regulatory requirements. At December 31, 2004, the Company holds bonds with an amortized cost and fair value of $86.2 million which are held in trust accounts for certain reinsurance transactions (see Note 9).
Changes during the years ended December 31, 2002, 2003 and 2004, in amounts affecting the Predecessor’s net unrealized gains and losses, reduced by deferred income taxes, included in the Predecessor’s shareholders’ equity as accumulated other comprehensive income are as follows:
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 unless the credit is well secured and in the process of collection. 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
The total purchase price paid by the Company in the acquisition was $145.0 million, $130.0 million of which was paid in cash at closing and $15.0 million of which was paid pursuant to a five-year subordinated promissory note bearing interest at five percent per annum, added to the principal on December 31 of each year and payable in full with the principal on the maturity date. The $145.0 million purchase price was less than the Company’s estimated fair value of the net assets acquired. Accordingly, the Company’s value of business acquired (“VOBA”), as reflected on the December 31, 2004, balance sheet, was reduced so that the value of the net assets acquired, including VOBA, was equal to the purchase price.
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 purchased 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, 2003, and 2004 were as follows:
Amortization expense relating to intangible assets was $0 million in 2004 and $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 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, 2004.
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 6.56%, 6.58% and 6.58% in 2002, 2003 and 2004, respectively.
3.0% to 8.5%. Such liabilities are, for some plans, graded to equal statutory values or cash values at or prior to maturity. The weighted average assumed investment yield for all life and accident and health policy reserves was 7.0% in 2002, 6.95% in 2003, and 6.84% in 2004. Benefit reserves for individual life insurance policies include certain deferred profits on limited-payment policies that are being 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 4.25% to 4.50% in 2002, 3.5% to 5.0% in 2003, and 3.5% to 5.0% in 2004.
The Predecessor’s benefit reserves, net of related reinsurance recoverable, at December 31, 2004, were adjusted to reflect the closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements. The valuation interest rate assumptions were generally lowered to reflect the current and expected interest rate environment. This change resulted in an increase in benefit reserves. Valuation assumptions for mortality, morbidity and withdrawal were selectively changed, which resulted in an increase in benefit reserves. Finally, the valuation assumptions for future premium rates on long term care coverage were increased to account for implemented and expected rate increases. This change reduced benefit reserves for this coverage. Taken together, these adjustments to the benefit reserve valuation assumptions had the combined effect of increasing reserves at December 31, 2004, by $40.7 million, or 10.5%.
The Company has provided for federal income taxes incurred at the statutory income tax rate.
In connection with the Company’s application of GAAP purchase accounting requirements to reflect the Kanawha acquisition, the Company marked to fair value the Predecessor’s assets and liabilities. The revaluation of assets and liabilities to fair value resulted in a $21.6 million reduction in net deferred federal tax liability, which otherwise increased by $5.1 million.
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 $0.8 million in 2003 and $0.2 million in 2004. The Predecessor paid income taxes of $0, $0.9 million and $0.6 million, during the years ended December 31, 2002, 2003 and 2004, 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 2005, dividends, loans or advances by Kanawha in excess of $8.4 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, 2004, the Company’s adjusted SAP capital and surplus exceeded its authorized control level RBC.
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.
The assets of the plan are held in a trust account and are invested primarily in common stock. 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 2005.
The net periodic retirement benefit cost of the plan included the following components:
The defined benefit plan’s change in benefit obligation, change in plan assets, funded status and amounts recognized in the Predecessor’s and the Company’s consolidated balance sheets are as follows:
* Included in liability for employees and agents in the accompanying consolidated balance sheets.
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 (as discussed above) and expectations regarding future market returns for both equity and debt securities.
The key assumptions used in the calculation of the accrued benefit obligations above are as follows:
The balance of the portfolio is invested in an absolute return hedge fund, the Mangan & McColl Offshore Arbitrage Fund. The performance is measured against the HFR Merger Arbitrage index.
The Company offers a 401(k) qualified savings plan for which substantially all employees and agents are eligible. Each year, plan participants may contribute up to 15% of pretax annual compensation, which includes overtime, bonuses and commissions. Participants may also contribute amounts representing distributions from other qualified defined benefit or defined contribution plans. The Company contributes 25% of the first 6% of base compensation that a participant contributes to the Plan. The Company may contribute amounts greater than 25% at its discretion. Amounts contributed to the plan by the Company are not significant.
The Predecessor granted options for a total of 371.8 shares of the Predecessor’s common stock. Stock options for 191 shares were granted in 1985 and the exercise price was 100% of the estimated fair market value of the common stock on the date of the grant, $16,534 per share. These options were fully vested at the closing of the Company’s acquisition of the Predecessor. In 1998, options for the remaining 180.8 shares were granted with an exercise price of $16,536 per share, and an estimated fair market value at the grant date of $45,688 per share. Approximately $5.3 million of compensation expense was recorded as unearned upon the issuance of these options.
These options generally vested 30% in 1998 and 10% annually thereafter. Amortization of deferred stock option compensation expense of approximately $0.3 million, $0.2 million and $0.2 million was recognized in 2002, 2003 and 2004, respectively.
Through December 31, 2004, the Company issued options to purchase a total of 1,246,000 shares of Company common stock, all of which were granted on December 15, 2004, 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 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. 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 option holder’s employment with the Company by the Company without cause or 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.
On January 1, 2000, the Predecessor established its Performance Share Plan and authorized the issuance of up to 80,000 stock units to attract and retain quality employees and to allow such employees to participate in the
growth of the Predecessor. Awards could be made to participants in the form of stock units. The Performance Share Plan provides for vesting over the 10 years subsequent to date of grant (10% per year). Compensation expense was recorded based on the vesting and the change in the book value of the Predecessor’s common stock from the date of grant to the date of exercise, adjusted for dividends, stock redemption proceeds and capital contributions subsequent to the date of grant. Eligible participants under the Performance Share Plan included executives or key employees of the Predecessor. During 2002, 2003 and 2004, the Predecessor granted 6,500 units, 12,000 units and 0 units, respectively, and recognized compensation expense of approximately $0.4 million, $0.7 million and $0.0 million, respectively, related to these units. During 2002, 2003 and 2004, 1,482 units, 2,918 units and 7,354 units, respectively, were forfeited or redeemed resulting in 65,864 outstanding units at December 20, 2004. The plan continued in effect through the closing of the Company’s acquisition of the Predecessor on December 21, 2004, when it terminated and all outstanding stock units were redeemed. No additional stock units may be awarded under the plan. The Company does not intend to implement a stand-alone successor performance share plan, but the Company’s 2004 Equity Incentive Plan permits the Company to award performance shares.
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 2002, 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 had no commitments to fund mortgage loans at December 31, 2004.
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, 2003, and 2004.
The Company leases office equipment under noncancellable leases. Total rental expense incurred during 2002 and 2003 was not significant and amounted to $0.1 million in 2004. As of December 31, 2004, future minimum lease payments under noncancellable operating leases with initial or remaining terms in excess of one year are as follows:
During November 2003, the Predecessor entered into a contract for IT and document management. Expenses incurred during 2003 and 2004 were $0.5 million and $5.0 million, respectively. This ten-year contract is subject to cancellation by the Company at any time after 42 months, with the payment of a termination penalty that is subject to the number of months remaining in the contract. Future payments under this contract are as follows:
At December 31, 2003 and 2004, the Predecessor and the Company, respectively, had no significant exposure to unrated or less-than-investment grade bonds.
Mortgage Loans: The fair values for mortgage loans are estimated using discounted cash flow analyses based on interest rates currently being offered for similar loans to borrowers with similar credit ratings. Loans with similar characteristics are aggregated for purposes of the calculations.
Additional data with respect to fair values of the Company’s investments is disclosed in Note 3.
The carrying amounts and fair values of the Company’s and the Predecessor’s cash and investments at December 31 are summarized in the following table. Effective December 31, 2004, as part of the application of GAAP purchase accounting requirements, the Company recorded the Predecessor’s investments at fair value and thereby eliminated all unrealized gains and losses in the Predecessor’s portfolio.
The carrying amounts and fair values of the Predecessor’s liabilities for investment-type insurance contracts at December 31 are summarized in the following table. Effective December 31, 2004, as part of the application of GAAP purchase accounting requirements as if the acquisition of the Predecessor closed on December 31, 2004, the Company recorded the Predecessor’s investment-type insurance contracts at fair value and thereby eliminated all differences between the carrying value and the fair value of the Predecessor’s investment-type insurance contracts.
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 provides individual insurance products, primarily long-term care insurance, tailored to the needs of older individuals.
The following represents a summary of the 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.
The following represents a summary of the Company’s income statement and asset composition as of December 31, 2004. The Company’s operations are aggregated into the following reportable segment, as the effects of the Company’s operations were not material to the predecessor’s reportable segments.
*Balance sheet amounts at December 31, 2004, are those of KMG America.