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.
developing a more flexible group dental product for introduction in 2007
• experienced significant growth in the new Final Expense premium and distribution channel.
continuing to control operating expenses while expanding distribution and implementing the reviews required for compliance with the federal Sarbanes-Oxley Act
for Final Expense: continuing to increase premiums at a steady pace
The Company is subject to various market risks. The most significant risks relate to fluctuations in interest rates (which impact prices of fixed maturity securities) and prices of equity securities. The Company has at times experienced negative total returns (defined as investment income and realized and unrealized investment gains and losses) on its investment portfolio, however the total return for 2006 was 3.50% (the Company recorded pre-tax unrealized losses of $2,534,000 on debt securities and unrealized gains of $301,000 on equities) compared to a total return of 2.60% in 2005. Historically these returns have been favorable and the Company has successfully managed the risk over many years. Company management devotes significant attention to the capital markets, and repositions the Company’s portfolio upon detection of adverse risk trends associated with individual securities or overall markets.
In an effort to increase levels of risk adjusted statutory surplus at the insurance subsidiary level, management repositions the portfolio to take advantage of opportunities and increased its investment in equity securities on a market value basis by $849,000 or 9.9 % and decreased fixed maturity securities by $11,863,000 or 10.5% (principally, securities with longer maturity dates resulting in greater risks) during 2006. Management anticipates that this action will negatively impact long-term total returns, however, the Company will further reposition the portfolios, as opportunities become available, in order to increase total returns and maintain an acceptable risk-adjusted statutory surplus at the insurance subsidiary level.
The Company’s 2006 net loss was $(836,000) compared to a net income of $132,000 and $256,000 in 2005 and 2004, respectively. These results reflect the segment losses described above (including nonrecurring items) and net realized investment gains of $4,000, $780,000 and $2,868,000 in 2006, 2005 and 2004, respectively. The Company realized significant investment gains in both 2005 and 2004 due to restructuring the investment portfolio to include a greater proportion of fixed maturity investments with shorter durations and fewer equity investments while taking advantage of an upturn in the equities market. After the restructuring, our equities portfolio did not present opportunities for similar levels of realized gains in 2006. Net realized investment gains and losses include losses resulting from the write down of securities deemed by management to be other than temporarily impaired of $687,000, $0 and $653,000 in 2006, 2005 and 2004, 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 issuer’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.
Goodwill and Intangible Impairment. The balance of the Company’s goodwill and value of insurance acquired (VIF) was $2.7 million at December 31, 2006. The recovery of these assets is dependent on the fair value of the business to which they relate. Pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets”, goodwill is subject to annual impairment tests based on the estimated fair value of the respective assets. There are numerous assumptions and estimates underlying the determination of the estimated fair value of these assets. Different valuation methods and assumptions can produce significantly different results that could affect the amount of any potential impairment charge that might be required to be recognized. During both 2006 and 2005, the Company concluded that no impairment adjustment was necessary for its goodwill or VIF.
Policy Liabilities. Establishing policy liabilities for the Company’s long-duration insurance contracts requires making many assumptions, including policyholder persistency, mortality rates, investment yields, discretionary benefit increases, new business pricing, and operating expense levels. The Company evaluates historical experience for these factors when assessing the need for changing current assumptions. However, since many of these factors are interdependent and subject to short-term volatility during the long-duration contract period, substantial estimates and judgment are required. Accordingly, if actual experience emerges differently from that assumed, any such difference would be recognized in the current year’s Consolidated Statement of Operations.
Assets. At December 31, 2006, the Company's available-for-sale fixed maturities had a fair value of $101,062,000 and amortized cost of $102,759,000. The Company’s fixed maturities portfolio decreased approximately 8.3% during 2006 and increased 0.6% during 2005, on an amortized cost basis. Shown below is a distribution by rating category of the Company's fixed maturities portfolio as of December 31, 2006.
1 Net of write-downs on bonds whose decline in value is believed to be other-than-temporary
2 Fair values as of December 31, 2006 were obtained primarily from Interactive Data Corporation.
Realized investment losses included $687,000, $0 and $807,000 of pretax impairment losses in 2006, 2005 and 2004, respectively. The impairments recorded were the result of the continued credit deterioration of specific issuers in the bond and equity markets, especially in the biomedical and technology industries.
During 2006, the Company's investment in equity securities increased $548,000 on a cost basis, and increased $849,000 on a fair value basis, after increasing $1,001,000 on a cost basis, and decreasing $363,000 on a fair value basis during 2005. As of December 31, 2006, 2005 and 2004, there were $589,000, $288,000 and $1,652,000 respectively, of unrealized gains on equity securities.
The Company reviews its marketable investments each quarter to determine if there have been declines in their value that in management’s opinion is other-than-temporary. These reviews involve qualitative and quantitative information relating to an individual company or industry and general factors impacting the economy. However, due to wide market fluctuations occurring during recent years, determining whether declines are temporary has become much more complex and judgmental.
Shown below is a progression of the Company's policyholder deposit activity for the year ended December 31, 2006.
The decrease in Broker Life premium of 3.3% during 2006 resulted primarily from decreases in ordinary and group products, offset by the growth of $518,000 in the Final Expense product introduced in early 2005 in an effort to strengthen the growth of this segment by better meeting the desires of our policyholders and agents. The increase in Broker Life premium of 9.8% from 2004 to 2005 resulted primarily from the premiums on the final expense product introduced in 2005.
Dental premiums decreased 4.3% during 2006 as competition in this market continues to intensify. The company has strengthened renewal underwriting standards in an effort to improve the loss ratio for this product. The result, as expected, was a decrease in premium and a decrease in the overall claims loss ratio from 69.7% in 2005 to 63.9 % in 2006. During recent years, new business production has become increasingly competitive as larger providers expand their marketing initiatives. However, the Company has historically maintained strong customer and agent loyalty by continuing to improve customer service, including sales and administrative support functions. In January 2005 the Company began expanding its capacity to administer more Dental business without increasing administration costs by replacing our group administration system with a current state of the art system. The new system was placed in service in January 2006 and the Company added additional functionality features throughout 2006 including a group website and a preferred provider network. The Company plans to add future enhancements to include third party administration capability, online enrollment and auto adjudication of claims. The Company also employed a senior marketing executive and a regional sales representative in 2006 to focus marketing efforts on the Dental segment.
The Company has not been actively marketing Other Health policies for several years. However, in response to agent requests, certain cancer and disability protection products have been updated and promoted. Pricing, underwriting, and claims experience on these products are closely monitored. Due to unsatisfactory financial results in this product line, the Company discontinued selling new disability policies in October 2004, and increased premium rates approximately 35% effective February 1, 2006 in the state of New Jersey, where the majority of such policies have been issued, resulting in a decrease of $276,000 in the Net Loss for this segment in 2006 compared to 2005.
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 focus. The Company’s equity securities comprised 8.5% and 7.1% of its total investment portfolios at December 31, 2006 and 2005, respectively. The Company’s investment income yields were 5.3%, 5.1%, and 4.7% for 2006, 2005, and 2004, respectively. The 2006 yield increase resulted primarily from increasing interest rates on new investments, as well as improved short-term yields during the year. Although the Company’s total return on investments has historically been favorable, returns in recent years have been severely impacted by declines in the airline, biomedical, automobile, telecommunications and technology sectors, declines in the fixed maturities market (due to increasing rates), a general economic slump and the effect of terrorist events on the securities markets.
As detailed in the following table, net realized and unrealized investment (losses) totaled approximately ($2,228,000) and ($3,356,000) for the years ended December 31, 2006 and 2005, respectively. The Company does not anticipate severe deterioration in the securities markets although there is considerable volatility in the equities markets. At December 31, 2006 and 2005, the Company’s investment portfolios contained net unrealized gains (losses) outstanding of $(1,107,000) and $1,124,000, respectively. Below is an approximate calculation of investment income yields and “total return” (defined as yields including net investment income, net realized investment gains or losses and net change in the excess or deficit of market values over book values of the investment portfolios or unrealized gains (losses)) yields for the five years ended December 31, 2006.
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 and 2006, 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 decrease in pretax income of $75,000 results from the positive effects of: (a) an increase in investment and other income of $577,000; (b) a decrease in policyholder benefits and commissions of $2,849,000; (c) a decrease in general expenses and depreciation of $864,000 and (d) a decrease in amortization of deferred policy acquisition costs and value of insurance acquired of $236,000, offset by the negative effects of: (e) a decrease in net premiums earned of $2,425,000, or 8.7% (Preneed decreased $1,937,000, Dental decreased $545,000, Home Service decreased $135,000, Other Health decreased $150,000, while Broker Life increased $343,000 (including new final expense premiums of $537,000)); (f) a decrease in net realized investment gains of $2,088,000; (g) an increase in interest expense of $25,000 and (h) a decrease in acquisition costs deferred of $63,000.
In 2006 the Home Service Life segment benefited by $160,000 of higher investment and other income and a decrease of $322,000 in benefits and reserves, offset by a $329,000 decrease in premium and a $317,000 increase in expenses (including net deferral of policy acquisition costs), resulting in an increase in the segment loss of $164,000.
The $111,000 decrease in loss in the Broker Life segment is the result of a decrease of $334,000 in policyholder benefits, a decrease in expenses of $197,000, offset by a decrease in premiums of $128,000 (primarily from decreases in ordinary and group products, offset by the growth of $901,000 in the Final Expense product), and a decrease in investment and other income of $292,000.
The contribution margin increased in 2005 by $213,000 from 2004 due primarily to the Company’s aggressive renewal and re-rating as well as not renewing a large group with a particularly high morbidity rate in December 2004. 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. We are also focusing significant marketing resources to this segment to create significant long-term premium growth in the segment.
The decrease in the segment loss of $276,000 in the Other Health is primarily the result of a decrease in policyholder benefits of $304,000 partially offset by a decrease in premiums of $41,000. 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 implemented 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.
The small life insurance company deduction allows the Life Insurance Subsidiaries to reduce their taxable income by 60% before computing their current provisions for regular or alternative minimum tax. However, for purposes of computing deferred income tax liabilities under the provisions of SFAS No. 109, “Accounting for Income Taxes”, the Company is precluded from assuming the small life insurance company deduction will be available in the future. Accordingly, by disallowing this deduction, SFAS No. 109 significantly increases the deferred taxes on the Life Insurance Subsidiaries’ temporary differences. Thus, when a significant increase or decrease occurs in the Company’s net temporary differences, the related deferred tax is computed using the 34% federal tax rate, whereas tax may actually be paid on these net liabilities (when realized) at a rate potentially as low as 17% (the alternative minimum tax rate after application of the allowable small life insurance company deduction). The Company’s gross deferred federal income tax liabilities and assets are more fully discussed in Note 6 of the Notes to Consolidated Financial Statements. The gross deferred tax assets are offset, to some extent, by valuation allowances related to the Company and to the Life Insurance Subsidiaries and then offset against existing deferred tax liabilities. The Company’s valuation allowance is designed to reduce deferred tax assets to their estimated ultimate realization value.
Statutory Insurance Information. For insurance regulatory and rating purposes, the Insurance Subsidiaries report on the basis of statutory accounting principles (“SAP”). In recent years, various state insurance departments and the NAIC have expressed concern, essentially about the “rate of return” earned by holders of small face amount life policies, potentially including Preneed policies. Although the Company does not believe calculating a simple “rate of return” or premium “pay-back” measure is meaningful for traditional life insurance products, certain state insurance regulators are considering actions that could alter the profitability of existing contracts or eliminate small face amount policies as a viable product offering.
In addition to the statutory totals shown above, Citizens Insurance generated statutory net income of approximately $20,000, $56,000, and $76,000 during 2006, 2003 and 2002, respectively without remitting any dividends to its parent. Citizens Insurance generated statutory net income of $22,000 and $56,000 and paid dividends of $250,000 and $1,174,000 to Citizens Security in 2005 and 2004, respectively. United Liberty generated statutory net income (loss) of approximately $280,000, $117,000, ($692,000), 536,000, and ($328,000), during 2006, 2005, 2004, 2003 and 2002, respectively and remitted dividends to its parent of $99,900, and $54,000 in 2006 and 2003, respectively.
The Company borrowed $2,000,000 from its Chairman in December 2002 to strengthen the statutory capital position of its principal insurance subsidiary. The Company borrowed an additional $1,000,000, $1,000,000 and $1,330,000 in 2003, 2005 and 2006, respectively from its Chairman for general operating capital, including bank debt service. These borrowings are considered current debt as a result of a 90-day call provision in the loan agreement. The Company also has $208,337 of commercial bank debt outstanding, with an equal amount maturing in April 2007 and July 2007. During the first half of 2005 the Company did not comply with a loan covenant (debt to earnings ratio) and did not comply with another covenant (borrower’s equity) at June 30, 2006 on this debt and received a waiver from the lender of each violation through June 30, 2006. 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 2006. Regarding the currently scheduled debt repayments, the Company believes its available resources will be adequate to service 2007 commercial bank debt obligations. In addition, the Company’s Chairman has expressed potential willingness to loan the Company an additional $200,000 if necessary, which would service debt obligations through 2007. Additional information regarding debt obligations is included in Note 5 of the Notes to Consolidated Financial Statements.
Management is not aware of any other commitments or unusual events that could materially affect the Company’s capital resources.
Cash provided by (used in) investment activities of $8,106,000, $316,000, and $(2,464,000) during 2006, 2005, and 2004 respectively, relates primarily to investing additional Preneed Life premiums in fixed maturity securities in 2004, primarily from the sale of short-term investments for $612,000, less approximately $300,000 used to acquire new equipment in 2005 and primarily sales and maturities of securities in excess of new investments, offset by approximately $652,000 used to acquire new equipment in 2006.
The above discussion centers on asset management. Other possible corrective measures might involve liability realignment. The Company’s marketing plan could be modified to emphasize certain product types and reduce others. New business levels could be varied in order to find the optimum level. Management believes that the Company's current liquidity, current bond portfolio maturity distribution and cash flow from operations give it substantial resources to administer its existing business and fund growth generated by direct sales.
unanticipated adverse litigation outcomes (see Item 3 - Legal Proceedings); and
changes in the Federal income tax laws and regulations, which may affect the relative tax advantages of some of the Company’s products.