The Company’s management continuously monitors the performance of and outlook for the Company by analyzing several indicators that they judge to be critical. The key indicators of particular interest to management are (a) the general economic environment relative to outlook, (b) trend of premium volume, (c) lapse rates, (d) mortality and morbidity rates (e) trend of general expense levels, (f) asset and capital and surplus growth, (g) general interest rate movements, (h) investment yields, (i) diversity (e.g. by industry) and mix (e.g. between fixed income securities and equity securities) of our investment portfolios and (j) segment performance and trends.
• The Company introduced a new Final Expense product and distribution channel to create an opportunity for growth, with adequate first year performance.
• The Company reduced costs and expenses associated with the Preneed line of business, realizing segment profit in that line for the first time since 1998.
continuing to solidify the ratings from A.M. Best and setting the stage for a rating upgrade after 2006 (see the section titles “Competition” In Item 1 for a discussion of the Company’s rating)
for Group Dental: creating a plan to offer Preferred Provider networks and Third Party Administration products in 2006, building on the Company’s strength of providing high quality service and exploring plans to sell other products through the Dental marketing channel
for Final Expense: performing a controlled growth path through select Managing General Agents who focus on this type of product
The nonrecurring items in 2004 include costs of $1,190,000 (settlement and legal costs) incurred in 2004 associated with the legal proceedings described in Item 3, and additional one time consulting expenses of $636,000 related to redesign and other organizational restructuring begun in 2003, as well as severance agreements.
Comprehensive Income (Loss) Comprehensive Income (Loss) (which combine net income (loss) and net unrealized gains and losses) were ($2,318,000), ($977,000), and $3,084,000 for 2005, 2004, and 2003, respectively. During 2005, the Company continued to be adversely affected by relatively low yields on its fixed income investment portfolio. The increase of $1,341,000 in comprehensive loss in 2005 is attributable to the increase in net income of $68,000 described above offset by the change in unrealized losses of ($1,409,000). Late in the second quarter of 2005, interest yields on fixed maturity investments began to rise. Although this adversely impacts the market value of the Company’s bond portfolio, the opportunity to invest new money at higher yields has a positive impact on the Company’s operating earnings. The 2005 environment continues to generate a relatively high level of qualitative investment risk, as discussed in the Cash Flow and Liquidity section. The majority of the 2004 declines in net income and the comprehensive losses were attributable to adverse securities markets, including the effects of declines in the airlines, telecommunications and technology sectors and general economic sluggishness.
The Company did not repurchase any shares of its common stock during 2005. The Company repurchased 13,600 and 1,600 shares of its common stock during 2004 and 2003 respectively, at average prices of $7.50 and $4.79 per share, respectively.
Investment in Debt and Equity Securities. The Company holds debt and equity interests in a variety of companies, many of which are seeking to exploit recent technology advancements. The majority of these are publicly traded and many have experienced volatile market prices. Company management periodically evaluates whether the declines in fair value of investments are other-than-temporary. These evaluations involve significant judgment. The evaluations consist of a review of qualitative and quantitative factors, including analysis of the Company’s competitive position in its markets, deterioration in the financial condition of the issuer, downgrades of the security by a rating agency, and other publicly available issuer-specific news or general market conditions. Declines in fair values of securities deemed to be temporary and which the Company has the ability and intent to hold until full recovery are included as an unrealized loss in shareholders’ equity. Declines in fair values of securities deemed to be other-than-temporary are included in net income as realized investment losses. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the current carrying value of the investments, thereby possibly requiring an impairment charge in the future.
Deferred Income Taxes. The Company records a valuation allowance to reduce its deferred tax assets to the amount that it believes is more likely than not to be realized. In assessing the need for the valuation allowance, the Company has not assumed future taxable income. In the event the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to deferred tax assets would increase income in the period such determination was made. Likewise, should the Company determine that it would not be able to realize all or part of its net deferred tax assets in the future, an adjustment to deferred tax assets would be charged to income in the period such determination was made.
2 Fair values as of December 31, 2005 were obtained primarily from Interactive Data Corporation.
Realized investment losses included $807,000 of pretax impairment losses for the year ended December 31, 2004. The impairments recorded were the result of the continued credit deterioration of specific issuers in the bond and equity markets, especially in the airline and telecommunications industries.
Shown below are the Company's four largest holdings in non-investment grade bonds by a single issuer as of December 31, 2005.
At December 31, 2005 the Company has recorded $756,000 of goodwill and $12,511,000 of deferred policy acquisition costs and value of insurance acquired. As noted in the above discussion of critical accounting policies and estimates, these intangibles, and the recorded value of policy liabilities, are based on many assumptions that require substantial estimates and judgment. At December 31, 2005 and December 31, 2004 the Company reassessed the assumptions supporting these values in accordance with SFAS No. 142. Although no impairment was considered necessary, management will continue to monitor the appropriateness of the recorded values of these intangibles and will make adjustments to such values in the future as management deems necessary.
Shown below is a progression of the Company's policyholder deposit activity for the year ended December 31, 2005.
As indicated above, total policyholder deposits decreased by a net $565,000 during 2005. The Company is not devoting significant marketing effort toward Annuity, Universal Life and other deposit products and has elected not to aggressively compete in crediting excess interest on such products.
The 27.9% and 47.1% decrease in Preneed Life premium during 2005 and 2004, respectively, resulted from the Company’s modification of certain policy benefits and commissions (which resulted in a loss in the number of producers) and an intentional refocusing of marketing efforts toward segments that the Company believes offer more positive potential in the current environment.
Investments. The Company monitors its available-for-sale fixed maturities and equity securities to assure they are strategically positioned within the current market environment. This practice has historically resulted in holding significant equity security positions, which tend to dampen current income yields in favor of an overall total return
As detailed in the following table, net realized and unrealized investment gains (losses) totaled approximately ($3,400,000) and $982,000 for the years ended December 31, 2005 and 2004, respectively. The Company does not anticipate severe deterioration in the securities markets as experienced during the years 2000 through 2002 although there is still some volatility in the equities markets. At December 31, 2005 and 2004, the Company’s investment portfolios contained net unrealized gains outstanding of $1,124,000 and $5,261,000, respectively. Below is an approximate calculation of investment income yields and “total return” (defined as yields including net
The Company realized significant gains on the sales of equity securities and high yield, below investment grade bonds during 2004 and 2003 as we repositioned our portfolio to include a greater proportion of investment grade bonds. As bond interest rates began to increase in 2005 we experienced significant unrealized losses on our fixed maturity portfolio (due to lower than market yields on our portfolio). Company management continues to monitor the equities and fixed maturity markets, and to reposition the portfolios as considered appropriate.
The 2005 increase in pretax income of $118,000 results from the negative effects of: (a) a decrease in premiums and other considerations of $2,317,000, or 8.3% (Preneed decreased $1,937,000, Dental decreased $545,000, Home Service decreased $135,000, Other Health decreased $150,000, while Broker Life increased $450,000 (including new final expense premiums of $324,000)), (b) a decrease in net realized investment gains of $2,088,000, and (c) an increase in interest expense of $25,000 offset by the positive effects of: (d) an increase in investment and other income of $577,000, (e) a decrease in policyholder benefits and commissions of $2,934,000, (f) a decrease in general expenses and depreciation of $864,000, and (g) a decrease in amortization of deferred policy acquisition costs and value of insurance acquired of $236,000, offset by a decrease in acquisition costs deferred of $63,000.
The 2004 decline in pretax income of $435,000 was attributable to the negative effects of: (a) a decrease in premiums and other considerations of $5,600,000, or 16.7% (Preneed premium decreased $6,200,000, or 47.1% while Dental premium increased $900,000, or 11.2% and premium for other segments experienced modest decreases), (b) costs of $1,200,000 (settlement and legal costs) associated with the legal proceedings described in Item 3, (c) a decrease in net deferral of policy acquisition costs and amortization of value of insurance in force of $648,000, and (d) additional one time expenses related to consulting and severance of $139,000, offset by the positive effects of: (e) a decrease in policyholder benefits and commissions totaling $5,800,000, (f) an increase of $357,000 in investment and other income (g) an increase of $891,000 in net realized investment gains (h) a decrease in interest expense of $9,100, and (e) a decrease other recurring general expenses of $95,000
The contribution margin increased in 2005 by $213,000 due primarily to the Company’s aggressive renewal underwriting and re-rating and not renewing a large group with a particularly high morbidity rate in December 2004. Although premiums decreased $545,000 in 2005, benefits decreased $615,000, and commissions decreased $142,000. Expenses for the Dental segment increased $261,000 due to the increased marketing resources allocated to this segment (the Company employed a senior marketing executive for this segment in August of 2005, and employed a regional representative in the fourth quarter of 2005).
The contribution margin decreased in 2004 by $217,000 from 2003 due to adverse morbidity (especially related to one large group) and inadequate premium for groups renewing. Also, the Company has encountered more competition as additional insurers continue to expand in the Dental market and Dental providers continue to provide higher levels of care to patients. The Company is continuing its ongoing efforts to maintain profitability in this line by reconfiguring products to provide adequate margins for the various dental procedures, utilizing a third-party company to provide expert assistance with ongoing adjudication of claims, and continuing its program of aggressive renewal underwriting and re-rating.
The Company has not devoted significant marketing effort toward its Other Health products in recent years. However, during 2002 through 2004, a significant increase in disability claims occurred, with a concentration in New Jersey. The Company received approval for a 35% rate increase on its disability products in New Jersey effective in early 2006, and discontinued accepting applications for this policy in New Jersey in the fall of 2004.
1 Asset Valuation Reserves are statutory liabilities that act as contingency reserves in the event of extraordinary losses on invested assets and as a buffer for policyholders’ surplus to reduce the impact of realized and unrealized investment losses. The 2001 through 2005 amounts also include United Liberty’s asset valuation reserves. Citizens Insurance does not have an Asset Valuation Reserve.
The following table shows the changes to Citizens Security’s statutory capital and surplus for the five years ended December 31, 2005.
Due to losses in 2001 and 2002 and the adverse impact of the low interest rate environment on operating results, during 2002 the Company borrowed $2,000,000 from its Chairman to strengthen the statutory capital position of Citizens Security. The Company borrowed an additional $1,000,000 from its Chairman in 2003 and an additional $1,000,000 in 2005 for general operating capital, including bank debt service. The borrowings from the Company’s Chairman are considered current debt as a result of a 90-day call provision in the loan agreement. The Company also has $1,375,003 of commercial bank debt outstanding, with scheduled repayments due through April 2007. During 2004, 2003 and 2002 the Company did not comply with a loan covenant (debt to earnings ratio) on this debt and received a series of waivers of such violation through December 31, 2004. In return for the waivers the Company’s Chairman agreed to personally guarantee the outstanding bank debt. The Company was in compliance with the debt covenant for the last two quarters of 2005. Regarding the currently scheduled debt repayments, the Company believes its available funds will be adequate to service 2006 debt obligations. In addition, the Company’s Chairman has expressed potential willingness to loan the Company an additional $1,000,000 if necessary, which could service debt obligations through 2006. Additional information regarding debt obligations is included in Note 4 of the Notes to Consolidated Financial Statements.
Regarding interest rate risk, the value of the Company’s fixed-maturity investment portfolio will increase or decrease in an inverse relationship with fluctuations in interest rates while net investment income earned on newly-acquired fixed-maturities increases or decreases in direct relationship with interest rate changes. Management estimates that a 100 basis point increase in interest rates (“rate shock”) would have decreased the fair value of its $112.9 million fixed maturity portfolio by approximately 6.3% or $7.1 million at December 31, 2005 and 6.3% or $7.3 million at December 31, 2004. From an income perspective, the Company does not believe rising interest rates present a significant risk, as essentially all of the Company’s policy liabilities bear fixed rates. However, approximately 39% of policy liabilities contain provisions permitting interest or benefit adjustments at the discretion of the Boards of Directors of the Insurance Subsidiaries. The Company’s cash flow testing (described below) indicates that overall profitability will generally be enhanced in rising interest rate scenarios. From a liquidity perspective, the Company’s fixed rate policy liabilities have been relatively insensitive to interest rate fluctuations. Accordingly, the Company believes gradual increases in interest rates do not present a significant liquidity exposure. The Company monitors economic conditions on a regular basis and manages this interest rate risk primarily by adjusting the duration of its fixed-maturity portfolio. Historically, the Company has maintained conservative durations in its fixed-maturity portfolio. During 2005 and 2004, the Company increased durations of the fixed maturity portfolio. At December 31, 2005 cash and fixed-maturity investments with maturities of less than five years equaled approximately 19% of total policy liabilities compared to approximately 26% at December 31, 2004. Notwithstanding the foregoing, if interest rates rise significantly in a short timeframe, there can be no assurance that the life insurance industry, including the Company, would not experience increased levels of surrenders and reduced sales, and thereby be materially adversely affected.
customer and agent response to new products, distribution channels and marketing initiatives, including exposure to unrecoverable advanced commissions;
general economic conditions and increasing competition which may affect the Company’s ability to sell its products;
There can be no assurance that other factors not currently anticipated by management will not also materially and adversely affect the Company’s results of operations.