Effective March 31, 2003, Continental General sold its subsidiary, Pyramid Life Insurance Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. See Note D. Discontinued Operations to our audited consolidated financial statements for further information.
Ceres Group, through its insurance subsidiaries, provides a wide array of health and life insurance products through two primary business segments. The Medical segment includes major medical health insurance for individuals, families, associations, and small to mid-size businesses. The Senior segment includes senior health, life and annuity products for Americans age 55 and over. To help control medical costs, Ceres also provides medical cost management services to its insureds.
Our insurance subsidiaries include Central Reserve Life Insurance Company, Provident American Life & Health Insurance Company, United Benefit Life Insurance Company and Continental General Insurance Company. Central Reserve markets and sells major medical health insurance to individuals, families, associations, and small employer groups and, in late 2003, began marketing and selling senior products. Continental General markets and sells both major medical and senior health and life products to individuals, families, associations and Americans age 55 and over. Provident American Life discontinued new sales activities and currently has less than 400 active major medical certificate holders and 400 life policyholders. In 2005, Provident American Life will begin marketing and selling senior products in certain states. United Benefit Life discontinued new sales activities in July 2000 and terminated all of its existing business at the end of 2001. United Benefit Life has no active policyholders.
Effective March 31, 2003, Ceres sold its subsidiary, Pyramid Life Insurance Company to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. For more information on the Pyramid Life sale, see Note D. Discontinued Operations to our audited consolidated financial statements.
Actual conditions could differ from those assumed in the estimation process. Due to the uncertainties associated with the factors used in these assumptions, materially different amounts could be reported in our Statement of Operations for a particular period under different conditions or using different assumptions. As is common in the health insurance industry, we believe that actual results may vary within a reasonable range of possible outcomes. Management believes that our reasonable range of actual outcomes may vary up to 10% to 15% (excluding provisions for adverse deviation) of the total liabilities for other policy claims and benefits payable recorded at the end of a period.
Note J. Liabilities for Other Policy Claims and Benefits Payable to our audited consolidated financial statements provides historical information regarding the accrual and payment of our unpaid claims liability. Components of the total incurred claims for each year include amounts accrued for current year estimated claims expense, as well as adjustments to prior year estimated accruals.
Revenue recognition. Life insurance premiums are recognized as revenue when they become due. Health premiums are recognized as revenue over the terms of the policies. Revenues from interest sensitive contracts, principally universal life and annuity products, consist of mortality charges for the cost of insurance, contract administration charges, and surrender charges assessed against policyholder account balances during the period. Amounts received from interest sensitive contracts are not reflected in premium revenue; rather, such amounts are accounted for as deposits with the related liabilities included in future policy benefits, losses and claims.
Value of business acquired. A portion of the purchase price paid for Continental General Corporation was allocated to the value of business acquired based on the actuarially determined present value of the expected pre-tax future profits from the business assuming a discount rate of 15.0%. Interest is accrued on the balance annually at a rate consistent with the rate credited on the acquired policies on the acquisition date, which ranges from 4.0% to 8.75%. Recoverability of the value of business acquired is evaluated periodically by comparing the current estimate of the present value of expected pre-tax future profits to the unamortized asset balance. If the current estimate is less than the existing asset balance, the difference would be charged to expense, and if the current estimate is higher than the existing asset balance, the difference will emerge into profits as earned.
For accident and health and ordinary life business, the value of business acquired is amortized over the estimated life of the in force business using assumptions consistent with those in computing reserves. Interest of 6.5% for Continental General is credited to the unamortized balance. For interest sensitive products such as universal life and deferred annuities, the value of business acquired is amortized over the expected profit stream of the in force business. The expected profit stream is based upon actuarial assumptions as to mortality, lapses and expenses. Earned interest was assumed to be 6.0% for Continental General, the market rate at the time of acquisition.
Liabilities for Litigation. We are involved in various litigation and regulatory actions. Such actions typically involve disputes over policy coverage and benefits, but may also relate to premium rates, agent and employment related issues, regulatory compliance and market conduct, contractual relationships, and other matters. These disputes are resolved by settlement, dismissal or upon a decision rendered by a judge, jury or regulatory official.
Inherent uncertainties surround legal proceedings and actual results could differ materially from those assumed in estimating the liabilities. The possibility exists that a decision could be rendered against us, and, in some circumstances, include punitive or other damage awards in excess of amounts reserved, that may have a material impact on our financial condition, results of operations or cash flows of a future period.
Insurance. We use a combination of insurance and self-insurance for a number of our risks including property, general liability, directors’ and officers’ liability, workers’ compensation, vehicle liability, and
The financial information for the years ended December 31, 2004, 2003 and 2002, includes the operations of all our subsidiaries for the entire period with the exception of Pyramid Life.
Discontinued Operations. On March 31, 2003, we sold our indirect subsidiary, Pyramid Life Insurance Company, to the Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. Consistent with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, Pyramid Life was classified as held for sale as of December 31, 2002, and was measured at its fair value less costs to sell. Therefore, the financial information for the years ended December 31, 2003 and 2002 excludes the operations of Pyramid Life and the $13.8 million loss from the sale, net of taxes and expenses incurred (except where specifically noted). The net assets, results of operations, and cash flows of Pyramid Life have been reported separately as discontinued operations of a subsidiary in our audited consolidated financial statements for 2003 and 2002. See Note D. Discontinued Operations to our audited consolidated financial statements for further information.
Pre-tax income from our Senior and Other segment was $18.5 million for 2004 compared to $19.9 million in 2003. Premiums in the Senior and Other segment increased 6.0% in 2004 due primarily to the introduction of new standardized Medicare supplement plans at our Central Reserve subsidiary. We expect premiums in this segment to increase approximately 13% in 2005. In addition, we will begin to sell Medicare supplement plans through our Provident American Life subsidiary. The 2004 segment results were impacted by a higher than expected loss ratio for our Medicare supplement business, partially offset by improved long-term care experience and favorable reserve development. The increase in the Medicare supplement loss ratio was caused by an increase in claims frequency on Medicare Part B physician claims. In addition, claims trend in 2004 exceeded our 2004 rate increases by 100%. We expect the 2005 Senior and Other loss ratio to be consistent with the 2004 loss ratio, or approximately 75%.
Pre-tax income for our Medical segment was $5.2 million, including a $3.1 million charge for the California litigation settlements, for 2004, compared to $8.8 million for 2003. Premiums in the Medical segment decreased approximately 19.1% in 2004 due to the decline in major medical certificates in force as well as higher than expected lapse rates. By the end of 2004, the decline in premiums had moderated to approximately 7% on an annualized basis. In 2005, we expect premiums to decrease approximately 5% on an annualized basis as new business production begins to approach the level of renewal business that is lapsing. The loss ratio in the Medical segment was 71.3% in 2004, compared to 74.1% for 2003. This improvement was primarily due to favorable run-off of prior year claim reserves. In 2005, we expect the loss ratio to remain consistent with 2004.
However, new business production increased in 2004, compared to the same period in 2003, partially offsetting the higher than anticipated lapse rates. We plan to continue to focus sales in a select number of geographic locations which have historically produced favorable underwriting results. From the third quarter to the fourth quarter of 2004, the decline in major medical premium has moderated to approximately 1.8% (or approximately 7% on an annualized basis), as the increased level of new business production is beginning to approach the level of renewal business which is lapsing. The decline in major medical premium is expected to moderate to approximately 5% on an annualized basis in 2005.
Net realized gains decreased to $0.4 million for 2004, compared to $1.9 million for 2003. The decrease was primarily attributable to gains generated on the sale of mortgage-backed securities and corporate bonds in 2003.
Selling, general and administrative expenses decreased to $134.6 million in 2004, compared to $146.9 million in 2003, a decrease of 8.4%. Included in selling, general and administrative expenses for 2004, is a $3.1 million pre-tax charge ($2.0 million after-tax or $0.06 per share) relating to the settlement of two California lawsuits. Although the final amount of the settlement payout may vary, the ultimate payout is not expected to materially exceed this amount. For more information, see Note L. Contingencies and Commitments to our audited consolidated financial statements. Excluding this charge, other operating expenses decreased $14.3 million and commissions decreased $4.4 million as a direct result of the decline in medical premiums offset by reduced reinsurance allowances of $3.3 million resulting from a lower volume of ceded premium. As a percentage of premium, selling, general and administrative expenses, including the California litigation settlements, were 31.3% in 2004, compared to 30.7% in 2003. The increase in the selling, general and administrative expense ratio was primarily due to the $3.1 million charge from the California litigation settlements and an increase in consulting expenses and salaries of approximately $1.0 million due to bringing our Cleveland data processing and programming back in-house from a third party vendor.
Income from continuing operations before federal income taxes, including the $3.1 million charge from the California litigation settlements, was $21.9 million for 2004, compared to $26.0 million for 2003.
loss (NOL) carryforwards against 2004 taxable income, the deferred tax valuation allowance was reduced by $5.0 million, or $0.14 per share, to $0 in 2004. At December 31, 2004, we have a deferred tax asset of approximately $4.8 million established related to the remaining NOLs. The effective tax rate, including the $5.0 million reduction to the deferred tax valuation allowance, was 12.6% of the income from continuing operations before federal income taxes. In 2003, a federal income tax expense of $6.6 million was recorded, which included a $2.7 million reduction to the deferred tax valuation allowance, or $0.08 per share, as a result of the improved profitability of certain subsidiaries in the Medical segment. The effective tax rate for 2003, including the $2.7 million reduction to the deferred tax valuation allowance, was 25.6% of the income from continuing operations before federal income taxes. See Note I. Federal Income Taxes for a detailed reconciliation of our effective tax rate.
a 58.3% decline in new business production from $89.2 million in annualized premium in 2002 to $37.2 million in 2003. We discontinued Continental General major medical brokerage sales in 2003 due to adverse claim experience, which accounted for $18.0 million of the decreased production levels. In addition, Continental General did not write major medical business in Florida for half of 2003, due to capital constraints. Florida accounted for approximately 19% of our major medical production in 2002. Continental General is currently writing major medical business in Florida.
renewal premium increases averaging between 25-30% prior to any benefit downgrades or deductible changes.
Our 2004 marketing strategy continued to focus on a reduced number of geographic locations which have historically produced favorable underwriting results. We had expected increased production levels in 2004 and the decline in major medical premium to moderate to 10-15%.
Senior and other premiums were $172.9 million for 2003 compared to $170.1 million for 2002, an increase of 1.6%. The change in senior and other premiums was primarily the result of the following:
a slight increase in Medicare supplement premium of $124.7 million in 2003 compared to $124.5 million in 2002, which includes a 8.5% decrease in policies in force offset by annual rate increases and reduced levels of reinsurance. Medicare supplement production was expected to increase significantly in 2004 due to the introduction of new standardized plans and expanded distribution into our Central Reserve subsidiary. Medicare supplement premium was projected to increase approximately 10% in 2004.
a $4.0 million increase in life and annuity premium due to the growth of senior life new business production.
Selling, general and administrative expenses decreased to $146.9 million in 2003 compared to $175.2 million in 2002, a decrease of 16.2%. Commissions decreased $25.2 million and other operating expenses decreased $8.7 million as a direct result of our cancelled business offset by reduced reinsurance allowances of $5.6 million resulting from a lower volume of ceded premiums. As a percentage of premium, selling, general and administrative expenses decreased to 30.7% in 2003 compared to 32.4% in 2002 due to the decrease in the overall commissions rate as a result of lower new sales, and a reduced workforce.
Interest expense and financing costs decreased to $1.6 million in 2003 compared to $2.0 million in 2002 as a result of a decrease in outstanding debt.
The special charge for 2002 represented a pre-tax non-recurring charge of $2.7 million ($2.4 million in continuing operations and $0.3 million in discontinued operations) related to the retirement of Peter W. Nauert, our former CEO. See Note N. Special Charge to our audited consolidated financial statements for further information.
Federal income tax expense was $6.6 million, or 25.6% of the income from continuing operations before federal taxes for 2003. In 2002, the federal income tax expense was $1.3 million, or 38.8% of the income from continuing operations before federal taxes. The lower effective tax rate in 2003 was primarily due to the reduction in the deferred tax valuation allowance of $2.7 million on our net operating loss carryforwards due to the utilization of the net operating loss carryforwards in the current period.
the prior year included a $12.1 million increase in future policy benefits, claims and funds payable due to Continental General’s assumption of certain interest sensitive whole-life policies from Pyramid Life on March 31, 2003;
The total reinsurance receivable was $130.3 million at December 31, 2004. Of this amount, $128.8 million represents reserves held by our reinsurers under our various reinsurance treaties in place. Hannover holds most of these reserves.
The total policy liabilities and benefits accrued were 87.3% of the total liabilities at December 31, 2004 compared to 85.7% at December 31, 2003.
Credit Agreement. On December 23, 2003, we entered into a new credit agreement among Ceres, the subsidiaries of Ceres which are signatories thereto, CIT Group, and National City Bank as Administrative Agent. Proceeds of the new $13.0 million term loan facility were used to pay-off the then existing term loan balance and to repurchase most of the stock of one of our non-regulated subsidiaries from certain agents of the company. The early pay-off of the former credit agreement resulted in the immediate amortization of the capitalized loan fees relating to that debt, causing a pre-tax expense of approximately $0.3 million. The loan origination fee on the new credit agreement of 1.0% is being amortized over the lives of the new term loans.
Contractual Obligations. The following schedule summarizes current and future contractual obligations as of December 31, 2004:
Represents estimated timing for fulfilling unfunded commitments for investments in a limited partnership. Outstanding commitments with this limited partnership are included in payments due in less than one year since the timing of funding these commitments cannot be reasonably estimated.
Represents estimated payments required under interest sensitive life and annuity contracts. The actual payments could vary based on changes in assumed crediting rates, persistency, and mortality levels.
Excludes claims and benefits payable on our major medical, Medicare supplement, and other health products since over 90% of the claims are paid within the subsequent six month period and virtually all of the claims are paid within twelve months.
We believe that cash flow from operating activities will be sufficient to meet the currently anticipated operating and capital expenditure requirements of our subsidiaries over the next 12 months. Funds to meet our debt obligations are generated from fee income from our non-regulated subsidiaries. Our ability to make scheduled payments of the principal and interest on our indebtedness depends on our future performance and the future performance of our non-regulated subsidiaries, which are subject to economic, financial, competitive and other factors beyond our control. Fee income is derived from fees charged primarily on our major medical business. As that business continues to decline, fee income has and will continue to decline.
At December 31, 2004, we had a tax net operating loss, or NOL, carryforward of approximately $13.6 million for federal income tax purposes, which expires through 2021. Changes in ownership, as defined by Sections 382 and 383 of the Internal Revenue Code, could limit the amount of NOL carryforwards used in any one year. Our December 2001 public offering resulted in an “ownership change” as defined in Section 382 of the Code and the regulations issued thereunder. Pursuant to Section 382, our ability to use our NOLs originating prior to the offering, accounting for approximately $12.3 million, is subject to certain restrictions, including an annual limitation of approximately $5.9 million. Losses incurred subsequent to this offering are available without annual limitation to offset future income.
We determine whether a valuation allowance for our deferred tax asset is necessary based on an analysis of amounts recoverable in the statutory carryback period and available tax planning strategies. During 2004, we evaluated our valuation allowance for deferred taxes and determined that no valuation allowance was required on the remaining NOL carryforwards of $13.6 million due to our continued profitability and the projection of a continued pattern of taxable income in future periods sufficient to utilize these NOLs. Accordingly, our net change in the deferred tax valuation allowance during 2004, including the current year utilization, was $5.0 million, or $0.14 per share. In 2003, the deferred tax valuation allowance was reduced by $2.7 million, or $0.08 per share, as a result of the utilization of NOL carryforwards of certain subsidiaries in the Medical segment.
Legal/ Regulatory Risk is the risk that changes in the legal or regulatory environment in which an insurer operates will create additional expenses not anticipated by the insurer in pricing its products. For example, regulatory initiatives designed to reduce insurer profits or otherwise affecting the industry in which the insurer operates, new legal theories or insurance company insolvencies through guaranty fund assessments, may create costs for the insurer beyond those recorded in the financial statements. We attempt to mitigate this risk by offering a wide range of products and by operating in many states, thus reducing our exposure to any single product and by employing underwriting practices that identify and minimize the adverse impact of this risk.
In addition, insurance companies are subject to extensive federal and state regulation and compliance with these regulations could increase our insurance companies’ operating costs. In some circumstances, failure to comply with certain insurance regulations could subject an insurance company to regulatory actions by such insurance company’s state of domicile. For example, states have statutory risk-based capital (RBC) requirements for health and other insurance companies based on the RBC Model Act. These RBC requirements are intended to assess the capital adequacy of life and health insurers, taking into account the risk characteristics of an issuer’s investments and products. In general, under these laws, an insurance company must submit a report of its RBC level to the insurance department of its state of domicile as of the end of the previous calendar year. These laws provide for four different levels of regulatory attention depending on the ratio of an insurance company’s total adjusted capital (defined as the total of its statutory capital, surplus, and asset valuation reserve) to its risk-based capital. As of December 31, 2004, our risk-based capital levels for each of our insurance subsidiaries exceeded the levels required by regulatory authorities.
Investment Impairment Risk is the risk that all amounts due (both principal and interest) on our fixed maturity investments will not be collected according to the security’s contractual terms. We attempt to minimize this risk by adhering to a conservative investment strategy. With the exception of short-term investments and securities on deposit with various state regulators, investment responsibilities have been delegated to external investment managers within the investment parameters established by the Company.
adverse changes in the regulatory environment specific to the issuer’s industry;
corporate bond prices that move more than 10% over the past week, 20% over the past month, or 30% over the past three months.
Inflation has had an impact on claim costs and overall operating costs and although it has been lower in the last few years, hospital and medical costs have still increased at a higher rate than general inflation, especially prescription drug costs. New, more expensive and wider use of pharmaceuticals is inflating health care costs. We will continue to establish premium rates in accordance with trends in hospital and medical costs along with concentrating on various cost containment programs. However, there can be no assurance that
In particular, forward-looking statements can be identified by the use of words such as “may,” “will,” “should,” “expect,” “anticipate,” “estimate,” “continue” or similar words. In light of the risks and uncertainties inherent in all future projections, the inclusion of forward-looking statements in this report should not be considered as a representation by us or any other person that our objectives or plans will be achieved. Numerous factors could cause our actual results to differ materially and adversely from those in the forward-looking statements, including those risks outlined above in “Market Risk and Management Policies,” and the following:
our ability to successfully implement our business plans, including our growth strategy;
changes or developments in healthcare reform and other regulatory issues, including Medicare reform and the Health Insurance Portability and Accountability Act of 1996 and increased privacy and security regulation, and changes in laws and regulations in key states in which we operate, could increase our costs, cause us to discontinue marketing products in certain states or cause us to change our business or operations significantly;
changing regulations of corporate governance and public disclosure that has increased both our costs and the risk of non-compliance, including Section 404 of the Sarbanes-Oxley Act of 2002;
rising healthcare costs, especially the rising costs of prescription drug costs that are rising faster than other medical costs, and rising utilization rates;
the adequacy of funds, including fee income, received from our non-regulated subsidiaries, and the restrictions on our insurance subsidiaries’ ability to pay dividends to Ceres, to meet our debt obligations;
our ability to obtain additional debt or equity financing on terms favorable to us to facilitate our long-term growth;
the risk that issuers of securities owned by Ceres will default or that other parties will not pay or perform;
the failure to successfully manage our operations and integrate future acquisitions, if any, including the failure to achieve cost savings;
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123R (Revised 2004), Share-Based Payment (SFAS 123R), which amends SFAS 123 and will be effective for public companies for interim or annual periods beginning after June 15, 2005. SFAS 123R eliminates the intrinsic value method under APB Opinion 25 as an alternative method of accounting for stock-based compensation. SFAS 123R also revises the fair value-based method of accounting for share-based payment liabilities, forfeitures and modifications of stock-based awards and clarifies SFAS 123’s guidance in several areas, including measuring fair value, classifying an award as equity or as a liability and attributing compensation cost to reporting periods. In addition, SFAS 123R amends SFAS No. 95, Statement of Cash Flows, to require that excess tax benefits be reported as a financing cash flow rather than as a reduction to taxes paid, which is included within operating cash flows. We currently use the intrinsic value method of APB Opinion 25 to value stock options, and accordingly, do not recognize compensation expense in our Consolidated Statements of Operations. On a quarterly and annual basis, we disclose the pro forma effect of stock-based compensation on net income (loss) and earnings (loss) per share. Upon adoption, pro forma disclosure will no longer be an alternative. The new statement may be adopted in one of three ways - the modified prospective transition method, a variation of the modified prospective transition method, or the modified retrospective method. We are currently evaluating the method of adoption and the effect that the adoption of SFAS 123R will have on our consolidated results of operations, cash flows and financial position.
In March 2004, the FASB’s Emerging Issues Task Force concluded its discussion of Issue No. 03-01, The Meaning of Other-Than-Temporary Impairments and Its Application to Certain Investments (EITF 03-01). EITF 03-01 provides accounting guidance regarding the determination of when an impairment (i.e., fair value is less than carrying value) of debt and marketable equity securities and investments accounted for under the cost method should be considered other-than-temporary and recognized in earnings. EITF 03-01 also requires annual disclosures of certain quantitative and qualitative factors of debt and marketable equity securities classified as available-for-sale or held-to-maturity that are in an unrealized loss position at the balance sheet date, but for which an other-than-temporary impairment has not been recognized. The
Report of Independent Registered Public Accounting Firm - Ernst & Young LLP
Schedule II - Condensed Financial Information of Registrant - Ceres Group, Inc. (Parent Only)
We have audited the accompanying consolidated balance sheets of Ceres Group, Inc. (the “Company”) as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the years then ended. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2004 and 2003, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of Ceres Group, Inc. and subsidiaries for the year ended December 31, 2002, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules when considered in relation to the basic 2002 consolidated financial statements taken as a whole, present fairly, in all material respects, the 2002 information set forth therein.
As described in Notes A, D and H, Ceres Group adopted Statements of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, and No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, as of January 1, 2002.
Unless the context indicates otherwise, “we,” “our,” and “us” refers to Ceres Group, Inc. and its subsidiaries on a consolidated basis.
All of our acquisitions were accounted for using the purchase method of accounting. Additionally, since the issuance of SFAS No. 141, Business Combinations (SFAS 141), by the FASB, business combinations initiated after June 30, 2001, are required to be accounted for by the purchase method. Results of operations of the acquired business are included in the income statement from the date of acquisition. Additionally, SFAS 141 expanded the criteria for recording intangible assets separate from goodwill.
Accordingly, following the guidance of both SFAS 141 and EITF D-100 and upon adoption in 2002 of SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142), we reclassified licenses of $3.6 million as a separate indefinite-lived intangible asset from goodwill.
Goodwill represents the excess of purchase price over the fair value of tangible and identifiable net assets acquired. Other intangible assets, such as licenses, are defined as purchased assets that also lack physical substance, but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset or liability.
Investments in fixed maturities and equity securities are designated at purchase as held-to-maturity, available-for-sale or trading. Fixed maturities include bonds and mortgage-backed securities. Equity securities include non-redeemable preferred stock. Held-to-maturity investments are securities, which management has the positive intent and ability to hold until maturity, and are reported at amortized cost. Available-for-sale investments and surplus notes are stated at fair value, with unrealized holding gains and losses reported in accumulated other comprehensive income (loss), net of deferred federal income taxes. Trading securities are stated at fair value and are bought and held principally for the purpose of selling them in the near term. Unrealized holding gains and losses related to trading securities are included in our Consolidated Statements of Operations as part of net investment income.
The majority of our mortgage-backed securities are of high credit quality and therefore, the retrospective method is used to adjust the effective yield. Premiums and discounts on other debt instruments are amortized using the effective interest method over the remaining term of the security.
expected profit stream of the in force business. The expected profit stream is based upon actuarial assumptions as to mortality, lapses, and expenses. Earned interest was assumed to be 6.0% for Continental General Corporation, which was the market rate at the time of acquisition.
Property and equipment are carried at cost less allowances for depreciation and amortization. Office buildings are depreciated on the straight-line method over 35 years, except for certain components, which are depreciated over 15 years. Depreciation for other property and equipment is computed on the straight-line basis over the estimated useful lives of the equipment, principally three to seven years.
This Statement requires that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and broadens the presentation of discontinued operations to include more disposal transactions. The adoption of SFAS 144 on January 1, 2002 did not have a material effect on our results of operations, financial position or liquidity. See Note D. Discontinued Operations for further detail related to the adoption of SFAS 144.
Liabilities for future policy reserves for accident and health and traditional life business are based on the net level premium basis and estimates of future claims, investment yield, lapses using our experience and actuarial judgment with an allowance for possible future adverse deviations from expected experience. Interest rates used range from 4.5% to 6.0%. Liabilities for interest sensitive products such as deferred annuities and universal life are based on the retrospective deposit method. This is the policyholder fund balance before adjusting for any surrender charges. Guaranteed minimum rates for universal life contracts are 4.0% to 5.5%. At December 31, 2004, credited rates ranged from 4.0% to 5.5%. Guaranteed base minimum rates for deferred annuities range from 3.0% to 5.5% depending on the duration of the contract. Current rates credited range from 3.0% to 6.0%.
Statement of Position No. 97-3, Accounting by Insurance and Other Enterprises for Insurance-Related Assessments, provides guidance for determining when an insurance or other enterprise should recognize a liability for guaranty-fund and other insurance-related assessments and guidance for measuring the liability. At December 31, 2004 and 2003, the liability for guaranty-fund and other insurance-related assessments was $1.0 million and $1.4 million, respectively, and was included in other liabilities in our Consolidated Balance Sheets.
Comprehensive income in 2004, 2003 and 2002 includes a change in unrealized gains or losses on available-for-sale securities, in addition to reported net income as prescribed by SFAS No. 130, Reporting Comprehensive Income. See Note R. Comprehensive Income for further information.
We adopted SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), which permits entities to continue to apply the provisions of APB Opinion 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants as if the fair-value-based method, as defined in SFAS 123, had been applied. Additionally, in December 2002, the FASB issued SFAS No. 148, Accounting For Stock-Based Compensation-Transition and Disclosure (SFAS 148). SFAS 148 amends SFAS 123, to provide alternative methods of transition to SFAS 123’s fair value method of accounting for stock-based employee compensation, but does not require companies to account for employee stock options using the fair value method. SFAS 148 also amends the disclosure provisions of SFAS No. 123 and APB Opinion No. 28, Interim Financial Reporting. We elected to continue to apply provisions of APB Opinion 25 and provide the pro forma disclosure required by SFAS 123 and the amended disclosures required by SFAS 148. See Note O. Stock Plans for further information.
Basic earnings per share is computed by dividing the income by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if common stock equivalents were exercised and shared in the earnings of the Company. Only those potential common shares, which are dilutive, are included in the computation of diluted earnings per share. See Note S. Computation of Net Income Per Common Share for further information.
Certain amounts presented in the prior years’ financial statements have been reclassified to conform to the current year’s method of presentation.
The amortized cost and estimated fair value of available-for-sale securities as of December 31, 2003 were as follows:
At December 31, 2004 and 2003, our insurance subsidiaries had certificates of deposit and fixed maturity securities with a carrying value of $25.4 million and $26.4 million, respectively, on deposit with various state insurance departments to satisfy regulatory requirements.
In December 2003, Continental General committed to invest $5.0 million in a limited partnership, NYLIM-GCR Fund I-2002, L.P., for an ownership share of approximately 4.13%. Investments by this Fund are expected to consist primarily of a diversified pool of subordinated real estate mezzanine debt and sub-tranche loans with an expected concentration in office assets located in major metropolitan areas. These capital commitments can be called by the partnership at any time during the commitment period to fund working capital needs or to purchase new investments. Once the commitment period expires, we are under no obligation to fund the remaining unfunded commitments, but may elect to do so. In 2004, the partnership made capital calls on Continental General’s limited partnership commitment of $4.4 million. At December 31, 2004, we had outstanding unfunded commitments totaling $0.6 million related to this limited partnership.
At December 31, 2004, we held no unrated bonds and approximately 3.0% of fixed maturity investments classified as available-for-sale were in less-than-investment grade securities. Approximately 3.0% of the fixed maturities available-for-sale were invested in BB rated subordinated non-agency residential and commercial mortgage-backed securities. These securities include jumbo residential mortgages and commercial mortgages with strong prepayment protection. We perform periodic evaluations of the relative credit standings of the issuers of the bonds held in our portfolio. We consider these evaluations in our overall investment strategy.
We evaluate our investment policies consistent with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Trading securities are carried at fair value with unrealized gains and losses reported in our Consolidated Statements of Operations as part of net investment income. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported in accumulated other comprehensive income, net of deferred federal income taxes. Investments in fixed and equity securities are designated at purchase as held-to-maturity, available-for-sale, or trading. The investment in the limited partnership is accounted for under the equity method of accounting and accordingly, the partnership earnings are included in net investment income. Investments in policy notes and mortgage loans are reported at cost which approximates fair value.
Other property and equipment consists principally of software, leasehold improvements, and office equipment. Depreciation expense for the years ended December 31, 2004, 2003 and 2002 was $1.2 million, $1.5 million, and $1.2 million, respectively.
Effective January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142) issued by the FASB, which provides that goodwill and intangibles with indefinite useful lives should not be amortized but instead be tested for impairment annually at the reporting unit level. In accordance with SFAS 142, we completed a transitional goodwill impairment test, which indicated that an impairment loss against our goodwill and other intangible assets was not required. Goodwill and intangibles with indefinite useful lives are tested for impairment on an annual basis and more often if indications of impairment exist. The estimated fair value of goodwill of a reporting unit is determined by applying the appropriate discount rates to estimated future cash flows for the reporting unit. The estimated fair value of licenses was determined by independent appraisals. The results of our analysis indicated that no reduction of goodwill or licenses was required in 2004. A slight reduction of $0.1 million was made to the carrying value of licenses in 2003 due to the cancellation of business in certain unprofitable states.
We file a consolidated federal income tax return with our subsidiaries, except for Continental General, which is required to file a separate return through fiscal year 2004.
Income tax expense (benefit) is recorded in various places in our consolidated financial statements. A summary of the amounts and places are as follows:
Income tax expense attributable to income from continuing operations differs from the amounts computed by applying the U.S. federal income tax rate of 35%. Those effects are summarized as follows:
The federal income tax returns for the Company and its subsidiaries have been examined by the Internal Revenue Service (IRS) through 1999. Currently, there are no tax years being examined by the IRS.
At December 31, 2004, we had a tax net operating loss carryforward, or NOL, of approximately $13.6 million for federal income tax purposes, which expires through 2021. Future changes in ownership, as defined by Sections 382 and 383 of the Internal Revenue Code, could limit the amount of NOL carryforwards used in any one year. Our December 2001 public offering resulted in an “ownership change” as defined in Section 382 of the Code and the regulations issued thereunder. Pursuant to Section 382, our ability to use our NOLs originating prior to the offering, accounting for approximately $12.3 million, is subject to certain restrictions, including an annual limitation of approximately $5.9 million. Losses incurred subsequent to this offering, accounting for approximately $1.3 million, are available without annual limitation to offset future income.
We determine a valuation allowance based on an analysis of amounts recoverable in the statutory carryback period and available tax planning strategies. During 2004, we evaluated our valuation allowance for deferred taxes and determined that no valuation allowance was required on the remaining NOL carryforwards of $13.6 million due to our continued profitability and the projection of a continued pattern of taxable income in future periods sufficient to utilize these NOLs. Accordingly, our net change in the deferred tax valuation allowance during 2004, including the current year utilization, was $5.0 million. In 2003, the deferred tax valuation allowance was reduced by $2.7 million as a result of the utilization of NOL carryforwards of certain subsidiaries in the Medical segment.
The foregoing indicates that a $19.6 million redundancy in the 2003 reserves emerged in 2004 primarily as a result of favorable development of prior year major medical and long-term care claim reserves. In 2003, a $13.0 million redundancy in the 2002 reserves emerged as a result of an improvement of medical claim trends primarily on fourth quarter 2002 incurred versus our original projected levels. In 2002, a $8.4 million deficiency in the 2001 reserves emerged as a result of higher than anticipated claims costs associated with a reduction in pending claims inventory in the Medical segment.
On December 31, 2002, Provident American Life and Hannover entered into an agreement, which amended the reinsurance arrangement relative to the policies of Provident American Life and Provident Indemnity. For claims incurred June 30, 2002 and prior, Hannover continues to be responsible for its quota share percentage. For premiums earned and claims incurred July 1, 2002 and subsequent, Provident American Life retains 100% of the business and risk on the remaining closed block of policies.
In the ordinary course of business, the Company maintains other reinsurance arrangements with other insurers. These arrangements are designed to limit the maximum amount of exposure that the Company retains on a given policy. For ordinary and group life claims, Continental’s maximum retention is $125,000 and Central Reserve’s maximum retention is $50,000 with no retention maintained over age 70. For accident and health claims, maximum retention on individual claims is $500,000.
On December 23, 2003, we entered into a credit agreement among Ceres, the subsidiaries of Ceres which are signatories thereto, CIT Group, and National City Bank as Administrative Agent. Proceeds of this new $13.0 million term loan facility were used to pay-off the then existing term loan balance under the former credit agreement and to repurchase most of the stock of one of our non-regulated subsidiaries from certain agents of the company. The early pay-off of the former agreement resulted in the immediate amortization of the capitalized loan fees relating to that debt, causing a pre-tax expense of approximately $0.3 million. The loan origination fee on the credit agreement of 1.0% is being amortized over the lives of the new term loans.
through December 2004, $375,000 through December 2006, $562,500 through December 2007, and $1,250,000 through June 2008.
The credit agreement contains various covenants including financial covenants relating to leverage, fixed charge coverage, risk-based capital of regulated insurance subsidiaries and tangible net worth. It also has a number of affirmative and negative covenants, including limitations relating to indebtedness, liens, mergers, purchases and sales of assets, investments, dividends and stock repurchases. At December 31, 2004, we were in compliance with these covenants.
On April 15, 2002, Peter W. Nauert announced his retirement from his position as our chief executive officer effective June 1, 2002. He remained as chairman of our Board until May 2003. In the first quarter of 2002, we reported a pre-tax non-recurring special charge to operations of approximately $2.7 million ($2.4 million in continuing operations and $0.3 million in discontinued operations) related to the early termination of his employment agreement and the payment of certain benefits through June 2003.
December 31, 2004, there were options outstanding under the plan to purchase 1,309,042 shares. In addition, 82,996 shares of stock and restricted stock awards were granted under this plan in 2004 to officers and non-employee directors.
In 1998 and 1999, pursuant to various individual employment agreements, we granted non-qualified options to purchase 815,000 shares of our common stock to certain key employees. Such grants generally vest over three years. At December 31, 2004, there were options outstanding pursuant to these grants to purchase 315,000 shares.
In 1999, pursuant to the 1999 Special Agents’ Stock Option Plan, we granted 78,706 common stock options to certain regional sales directors and managing general agents. Each grant vested immediately and expires ten years from the date of grant. We terminated this plan at the end of 2000. At December 31, 2004, there were options outstanding under the plan to purchase 78,706 shares.
In 2004, we issued 61,931 shares of our common stock to various investors upon the cashless exercise of certain warrants that were issued in July 1998. These warrants were fully exercisable for 287,960 shares. At December 31, 2004, we had outstanding 3,369,783 warrants at $5.41, expiring in 2005, and 25,000 warrants at $5.27, expiring in 2008.
Pursuant to the 1998 Key Employee Share Plan, as amended on May 19, 2004, 55,000 shares of restricted stock awards were granted to executive officers in 2004. The awards vest 25% over four years. We recognized stock compensation expense related to these awards of $0.1 million in 2004. In addition, 27,996 shares of our common stock were granted to non-employee directors of our Board in 2004. We recognized stock compensation expense related to these awards of $0.2 million in 2004.
State insurance laws and regulations prescribe accounting practices for determining statutory net income and equity for insurance companies. In addition, state regulators may permit statutory accounting practices that differ from prescribed practices.
Statutory capital and surplus for Central Reserve includes Provident American Life and United Benefit Life. Central Reserve’s statutory net gain for the years ended December 31, 2004 and 2002 includes the losses of Provident American Life and United Benefit Life. For the year ended December 31, 2003, the losses of United Benefit Life are included in Central Reserve’s statutory net gain.
Statutory capital and surplus for Continental General for the year ended December 31, 2003, includes an additional $21.0 million from the sale of Pyramid Life. Continental General’s statutory net gain for the year ended December 31, 2003 includes $31.0 million from the sale of Pyramid Life.
Pyramid Life’s statutory net gain for the year ended December 31, 2003 includes statutory earnings through March 31, 2003. On March 31, 2003, we sold Pyramid Life to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp. See Note D. Discontinued Operations for further information.
The NAIC also has risk-based capital (RBC) requirements for life and health insurers to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks associated with asset quality, mortality and morbidity, asset and liability matching and other business factors. The RBC formula is used by state insurance regulators to monitor trends in statutory capital and surplus for the purpose of initiating regulatory action. We calculated the risk-based capital for its insurance subsidiaries as of December 31, 2004 using the applicable RBC formula. Based on these calculations, the RBC levels of each of our insurance subsidiaries at December 31, 2004 exceeded the levels required by regulatory authorities.
on repurchase of the convertible voting preferred stock. Basic and diluted weighted average shares of common stock are as follows:
Effective June 1, 2002, the Plan was amended so that participants can elect to make pre-tax contributions from 1% to 25% of their compensation and after-tax contributions were no longer permitted. In addition to the Company Match Contribution, we match 100% of each participant’s contributions (Stock Match Contribution) to the Ceres Group, Inc. Stock Fund, up to a maximum of $1,000 per year provided the participant agrees that the pre-tax contributions will not be transferred out of the fund for a minimum of one year.
In addition, we may contribute a Profit Sharing Contribution to the Plan, as determined by our Board. All eligible, active employees who have worked over 1,000 hours during the plan year and who are employed on the last day of the plan year share in this contribution. Participants who leave employment during the plan year due to retirement, death or disability will also share in the contribution. There were no Profit Sharing Contributions made for the 2004, 2003 and 2002 plan years, respectively.
A participant’s interest in the Company Match Contribution, Stock Match Contribution and Profit Sharing Contribution allocated to the participant’s account becomes vested over a five-year graded vesting schedule with 100% vesting over five years. Our total matching contributions were approximately $506,000 for 2004, $504,000 for 2003, and $642,000 for 2002.
We used the following methods and assumptions in estimating our fair value disclosures:
Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of fixed maturity investments, cash, cash equivalents, and reinsurance receivable.
The following is a summary of quarterly results of operations for the years ended December 31, 2004 and 2003. All prior quarters have been reclassified to reflect the sale of Pyramid Life:
Represents dividend income from non-regulated subsidiaries, which is eliminated in consolidation.