The Company's 2003 net income was $712,000 compared a net loss of $2,572,000 in 2002 and net loss of $6,206,000 in 2001. Comprehensive gains and losses (which combine net gains and losses and net unrealized gains and losses) were a comprehensive gain of $3,084,000, and comprehensive losses of $2,105,000, and $2,875,000 for 2003, 2002, and 2001, respectively. During 2003, the Company continued to be adversely affected by declining yields on its fixed income investment portfolio. The 2003 increase in net income and the comprehensive gain were attributable to a turn around, particularly in the fourth quarter, in the equity market. Equity markets continue to be volatile but were much more favorable during 2003 than results experienced during the prior three years. Late in the second quarter of 2003, interest yields on fixed maturity investments finally began to rise. Although this adversely impacts market value of the Company's bond portfolio, the opportunity to invest new money at higher yields would have a positive impact on the Company's operating earnings. Additionally, improving economic activity and equity valuations have resulted in a lower level of securities impairment writedowns during 2003. The 2003 environment as described continues to generate a relatively high level of qualitative investment risk. However, measures of quantitative investment risk are not believed to have changed significantly from those previously disclosed in the Company's 2002 Form 10-K. The majority of the 2002 and 2001 declines in net income and the comprehensive losses were attributable to adverse securities markets during those years, including the effects of declines in the telecommunications and technology sectors, a general economic recession and terrorist events.
During 2003, the Company saw a 12.43% or $4,940,000 decrease in premiums. A 27% decrease in the Preneed Life segment accounts for essentially all of the net decrease, along with an approximate 2.5% increase in the Dental segment, partially offset by moderate reductions in Home Service Life, Broker Life and Other Accident and Health. Pretax segment profit (loss), excluding realized investment gains and losses and interest expense, was ($973,000), ($554,000) and $460,000 for 2003, 2002, and 2001 respectively. The decline in pretax segment profit in 2003 was primarily attributable to decreased Preneed Life premium and adverse mortality, the decline in 2002 was primarily attributable to lower interest yields and adverse mortality, while the 2001 improvement was primarily attributable to increased Preneed Life production.
o Asset and Capital and Surplus growth o General interest rate movements o Investment yields o Diversity (e. g. by industry) and mix (e.g. between fixed income securities and equity securities) of our portfolios o Segment performance and trends
Goodwill and Intangible Impairment. The balance of our goodwill and intangible assets was $3.8 million at December 31, 2003. The recovery of this asset is dependent on the fair value of the business to which it relates. Effective in 2002, pursuant to SFAS No. 142, "Goodwill and Other Intangible Assets", ("SFAS No. 142"), goodwill is no longer amortized but 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 2003 and 2002, the Company concluded that no impairment adjustment was necessary for its goodwill or other intangible assets.
On May 12, 1998, the Company and Citizens Security acquired 100% of the common stock of United Liberty from an unaffiliated insurance holding company (the "United Acquisition"). The aggregate purchase price for the United Acquisition was approximately $7,076,000 (including net costs associated with the acquisition of approximately $445,000). In conjunction with the acquisition, the seller retained approximately $2,100,000 of United Liberty's real estate related and other assets, which were replaced with cash by Citizens Security.
The Company believes it has a well diversified portfolio and has no plans to adjust its non-investment grade portfolio significantly, unless necessary to satisfy requirements of state regulators or rating agencies. The Company purchases non-investment grade bonds to obtain higher yields or convertible features and attempts to reduce credit risk by portfolio diversification. Non-investment grade securities comprised 8.5% and 5.1% of the fixed maturities portfolio, on an amortized cost basis, at December 31, 2003 and 2002, respectively. During 2003, the Company recognized approximately $83,000 of impairment losses on fixed maturities, with the majority of these related to the airline and health care industries. The Company is monitoring its fixed maturity portfolio and, although it has no specific projections, if the overall economy does not improve, additional impairments could occur during 2004.
Shown below are the Company's four largest holdings in non-investment grade bonds by a single issuer as of December 31, 2003. Non-Investment Grade December 31, 2003 Amortized Cost Fair Value ------------------------------- ------------------- ------------------ Largest $1,498,184 $1,590,748 Second largest 430,475 1,445,950 Third largest 873,700 1,340,000 Fourth largest 1,026,711 1,050,000 ------------------------------- ------------------- ------------------ Total $3,829,070 $5,426,698 ------------------------------- ------------------- ------------------
respectively, during 2002. As of December 31, 2003 2002 and 2001, there were $3,275,000, $653,000 and $1,062,000 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 are other-than-temporary. These reviews can 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 the past two years, determining whether declines are temporary has become much more complex and judgmental. These reviews resulted in the recognition of impairment losses on equity securities totaling $52,000 during 2003 ($28,000 and $24,000 for the first and second quarters, respectively). In addition, $83,000 of impairment losses were recognized on fixed maturities during 2003 ($40,000 and $43,000 during the first and second quarters, respectively). During 2003, equity securities were sold which contained impairment writedowns of $741,000.
Liabilities. A comparison of total policy liabilities as of December 31, 2003, 2002 and 2001 is shown below. Approximately 88% of the 2003 total consists of insurance policy benefit reserves while policyholder deposit liabilities represent 12% of the total.
Shown below is a progression of the Company's policyholder deposit activity for the year ended December 31, 2003.
Year Ended December 31, 2003 Total Annuity and Universal Other Life - ------------------------------- --------------- --------------- --------------- Beginning Balance $15,743,293 $ 9,805,082 $ 5,938,211 Deposits 620,188 58,246 561,942 Withdrawals 1,528,220 600,672 927,548 Interest Credited 695,563 453,218 242,345 - -------------------------------- --------------- --------------- --------------- Ending Balance $15,530,824 $ 9,715,874 $ 5,814,950 - -------------------------------- --------------- --------------- ---------------
The 3% and 5% decrease in Broker Life premium during 2003 and 2002, respectively, resulted from reduction of business provided by certain larger brokers during 2002 and continuing pressure from the overall economic slowdown on middle and lower-income consumers. The Company is evaluating opportunities for revising its product design and commission rates to counteract the softening in demand for its simplified issue and graded benefit life policies.
The 27% decrease in Preneed Life premium during 2003 resulted from the Company's modification of certain policy benefits and commissions. The 114% increase in Preneed Life premium during 2002 resulted from intensified marketing efforts aimed at defining the Company as a committed participant in this market, successfully negotiating competitive third-party marketing agreements, implementing various product enhancements, and positive referrals from customers who comment favorably on the Company's organization and customer service.
historically maintained strong customer and agent loyalty by continuing to improve customer service, including sales and administrative support functions.
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 8.8% and 6.5% of its total investment portfolios at December 31, 2003 and 2002, respectively. The Company's investment income yields were 4.5%, 4.8%, and 5.6% for 2003, 2002, and 2001, respectively. The 2003 and 2002 yield declines resulted primarily from substantially lower interest rates on new investments, the Company's 4% and 33% net addition to its fixed maturity portfolio during the years and a 13% increase in equity holdings during 2003, much of which is attributable to new Preneed Life business. Although the Company's total return on investments has historically been very favorable, returns for the past three years have been severely impacted by declines in the telecommunications and technology sectors, a general economic recession and the effect of terrorist events on the securities markets. As detailed below, net realized and unrealized investment gains totaled approximately $862,000 for the three years ended December 31, 2003, while net realized and unrealized gains totaled approximately $3,522,000 for the two years ended December 31, 2000. The Company does not anticipate continued severe deterioration in the securities markets, although some additional losses on fixed income securities may occur if the overall economic slowdown returns. At December 31, 2003, the Company's investment portfolios contain a net unrealized gain outstanding of $6,894,000. Below is an approximate calculation of investment income yields and total return rates for the five years ending December 31, 2003.
Segment Earnings. The 2003 gain before income tax was $642,000 compared to a loss of $3,329,000 in 2002 and $7,984,000 in 2001. Pretax profit (loss) is shown below for the Company's five business segments, along with total realized investment gains and interest expense.
Year Ended December 31 2003 2002 2001 - -------------------------- ----------------- ---------------- ----------------- Premium $8,385,774 $8,182,483 $7,988,620 Claims and Reserves $5,778,191 $5,634,940 $5,551,624 Contribution Margin $1,611,198 $1,560,208 $1,465,017 Claim Ratio 68.9% 68.9% 69.5%
Income Taxes. Historically, the Company has experienced a relatively low effective current income tax rate, due primarily to the small life insurance company deduction. The effective rate was approximately (11%) and 23% in 2003 and 2002, respectively.
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 Statement of Financial Accounting Standards ("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 7 of the Notes to Consolidated Financial Statements. All deferred tax assets of the Company are realizable by offset against existing deferred tax liabilities or by carryback to recapture prior years' taxes paid on operating income and capital gains. The deferred tax assets are offset, to some extent, by valuation allowances related to the Company and to the Life Insurance Subsidiaries. The Company's valuation allowance is designed to reduce deferred tax assets to their estimated ultimate realization value.
During December 2002, Citizens Financial strengthened the statutory capital position of Citizens Security by acquiring $2,000,000 of Citizens Security redeemable preferred stock. During January 2001, Citizens Financial contributed 100% of the capital stock of Citizens Insurance to Citizens Security. The statutory value of this contribution was $3,540,555. Citizens Security has reported its investments in United Liberty and Citizens Insurance on the equity method of accounting, since their acquisition in 1998 and 2001, respectively. However, beginning in 2001, new rules changed the statutory equity method of accounting to preclude a parent insurer from recording as income, its share of undistributed subsidiary earnings. Accordingly, Citizens Security's net income includes United Liberty's net earnings of $289,489 and $234,853, in 2000 and 1999, respectively. For 2003, 2002, and 2001, Citizens Security reported as income the $116,400, $214,000 and $292,000 respectively, of dividend distributions that it received from United Liberty and Citizens Insurance. At December 31, 2003, Citizens Security reported its investments in United Liberty and Citizens Insurance at their statutory equity values of $2,610,375 and $3,777,624, respectively. To provide a more detailed understanding of Citizens Security's operations, shown below are SAP basis net income, net operating income, statutory capital and surplus, asset reserves, and capital ratios for Citizens Security for the five years ended December 31, 2003.
During 2003, statutory capital and surplus and asset valuation reserves increased approximately $3,000,000. This increase resulted primarily from $706,000 of net income for the year and $2,415,000 of unrealized gains. During 2002, statutory capital and surplus and asset valuation reserves increased approximately $101,000. This increase resulted primarily from the $2,000,000 issuance of preferred stock described above, net of the $1,184,000 net loss for the year and $950,000 of unrealized losses. During 2001, statutory capital and surplus and asset valuation reserves increased approximately $760,000. This increase resulted primarily from the Citizens Insurance capital contribution noted above, plus $1,082,000 of unrealized gains offsetting the $3,498,000 net loss and a $572,000 increase in nonadmitted assets. During 2000, statutory capital and surplus and asset reserves decreased by approximately $7,413,000. This decrease resulted primarily from $1,869,000 of statutory net income offset by $7,875,000 of unrealized losses and a $1,200,000 redemption of Citizens Security's preferred capital stock. During 1999, statutory capital and surplus and asset reserves increased by approximately $2,443,000. This increase resulted primarily from $4,946,000 of statutory net income offset by a $1,200,000 redemption of preferred capital stock, and a $1,000,000 shareholder dividend paid.
Statutory capital and surplus, specifically the component called surplus, is used to fund the expansion of an insurance company's first year individual life and accident and health sales. The first year commission and underwriting expenses on such sales will normally consume a very high percentage of, if not exceed, first year premiums. Accordingly, a statutory loss (surplus strain) often occurs on these sales during the first policy year. Historically, the Company's level of life insurance sales has not significantly impacted statutory surplus. However, as multi-pay Preneed Life sales increase, the Company anticipates that surplus strain will dampen statutory earnings.
Due to losses during the past three years 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 its principal insurance subsidiary. The Company borrowed an additional $1,000,000 from its chairman in 2003 for general operating capital. 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 $4,133,335 of commercial bank debt outstanding, with scheduled repayments due through 2007. During 2003 and 2002, the Company did not comply with a loan covenant (debt to earnings ratio) on this debt and received a waiver of such violation through December 31, 2003. For the quarter ended September 30, 2003, the Company did not meet one of its bank debt covenants (debt to earnings ratio), however the lender has waived this violation. In return for the waiver the Company's Chairman agreed to personally guarantee the outstanding bank debt. However, since the Company is not assured of meeting this covenant throughout 2004, the full balance of $4,133,335 can be considered payable within one year. Although the Company does not expect the full balance to be called during 2004, it believes such an obligation could be met through a refinancing arrangement or sale of selected assets or a block of insurance business. Regarding the currently scheduled debt repayments, the Company believes its available funds will be adequate to service
2004 debt obligations. In addition, the Company's Chairman has expressed potential willingness to loan the Company an additional $2,000,000 if necessary, which could service debt obligations through the majority of 2006. Additional information regarding debt obligations is included in Note 5 of the Notes to Consolidated Financial Statements.
Cash used by investment activities of $2,618,000, $27,877,000, and $5,555,000 during 2003, 2002, and 2001 respectively, relates primarily to investing additional Preneed Life premiums in fixed maturity securities, although the 2002 total also includes investing $11,734,000 of cash and short term balances outstanding at December 31, 2001. The $1,562,000 of cash used by financing activities during 2003 includes $1,646,000 of debt repayments and $903,000 of net withdrawals of policyholder deposits, partially offset by additional borrowings of $1,000,000. The quarterly bank loan payment due January 1, 2004 was paid by December 31, 2003, accordingly, the outstanding bank loan balance decreased by five quarterly installments during 2003. Cash used by financing activities during 2002 includes net withdrawals of policyholder deposits of approximately $956,000, debt repayments of $1,317,000, partially offset by additional borrowings of $2,000,000. Cash used by financing activities during 2001 includes net withdrawals of policyholder deposits of approximately $1,200,000 and debt repayments of $904,000. The policyholder deposit withdrawals are principally due to the Company's decision not to aggressively compete in crediting higher interest returns on such funds.
$108.6 million fixed maturity portfolio by approximately 6.0% or $6.5 million at December 31. 2003 and 3.2% or $3.3 million at December 31, 2002. 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 45% 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 2003, the Company increased durations of the fixed maturity portfolio significantly. At December 31, 2003 cash and fixed-maturity investments with maturities of less than five years equaled approximately 32% of total policy liabilities compared to approximately 60% at December 31, 2002. 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.
Interest expense on the Company's debt varies quarterly and is therefore also subject to interest rate risk. For its commercial bank debt, the Company elects the lower of the prime lending rate or the one-month LIBOR rate plus 2.75%. For its related party debt, the interest rate is the higher of 6% or the commercial bank prime lending rate plus 1%. At December 31, 2003, the weighted average rate on the Company's $7,133,335 of borrowings was 5.07%. The Company believes its current liquidity position and profitability levels are adequate to guard against this interest rate risk.
Initially balanced durations do not guarantee positive future results. Asset type, quality, and yield will vary depending upon the economic scenario tested. Liabilities will be similarly affected. Projected reinvestment yields may cause
overall yields to fall below those required to support projected liabilities. In that event, portfolio realignment might involve the type, quality and yield of investments rather than duration. Alternatively, additional reserve amounts could be allocated to cover any future shortfalls.
The above discussion centers around 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.