On December 30, 2003, it was announced that the Cotton States Insurance Group (which includes the Company and Mutual) and COUNTRY, located in Bloomington, Illinois, entered into definitive agreements regarding the acquisition of the Company by merger. Under the Agreement and Plan of Merger, the Company’s shareholders will receive $20.25 cash for each share of outstanding common stock of the Company. As a result, the Company will become a privately-held company. Subject to regulatory approval, shareholder approval, and other conditions to closing set forth in the Agreement and Plan of Merger, it is anticipated that the transaction will close during the second quarter of 2004.
The following discussion contains forward-looking statements that are not strictly historical and that involve risks and uncertainties. Such statements include, without limitations, any statements containing the words “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “seek,” and similar expressions. Investors are cautioned about such statements, including, without limitation, statements regarding projections of earnings, revenues, expected mortality rates, investment spreads and yields and their effects on net earnings, the ability to consummate the contemplated transaction with COUNTRY and the timing thereof, if at all, and the anticipated financial results and benefits of the proposed transaction with COUNTRY. The forward-looking statements set forth herein involve certain risks, uncertainties, estimates, and assumptions that could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These risks and uncertainties include, without limitation, the following:
Since insurance is a regulated business, with a high public profile, it is always possible that legislation may be enacted which would have an adverse effect on the Company’s business.
Increased public and regulatory concerns regarding the financial stability of insurance companies have resulted in policyholders placing greater emphasis upon company ratings and have created some measure of competitive advantage for insurance carriers with higher ratings. As of the date of this Annual Report on Form 10-K, A.M. Best & Co., a leading insurance company rating agency, has assigned a B++ (Very Good) rating to the Company. If this rating is downgraded from its current level, sales of the Company’s products could be adversely affected.
The Company’s investments are subject to risks. The Company’s invested assets are subject to customary risks of defaults and changes in market values. Factors that may affect the overall default rate on, and market value of, the Company’s invested assets include interest rate levels, financial market performance, and general economic conditions.
The Company expressly disclaims any obligation to update these forward-looking statements.
The Company has identified the following estimates as critical in that they involve a higher degree of judgment and are subject to a significant degree of variability: deferred policy acquisition costs, investments, reserves, and accounting for income taxes. In developing these estimates management makes subjective and complex judgments that are inherently uncertain and subject to material change as facts and circumstances develop. Although variability is inherent in these estimates, management believes the amounts provided are appropriate based upon the facts available upon compilation of the financial statements.
These deferred costs are recorded as an asset commonly referred to as deferred policy acquisition costs (“DAC”). The carrying value of the Company’s DAC asset was $63.8 million and $57.7 million at December 31, 2003 and 2002, respectively.
Investment income is an important source of revenue, and the Company’s return on invested assets has a material effect on net income. The Company’s investment policy is subject to the requirements of insurance regulatory authorities. In addition, certain assets are held on deposit in specified states and invested in specified securities in order to comply with state law. Although the Company closely monitors its investment portfolio, available yields on newly invested funds and gains or losses on existing investments depend primarily on general market conditions.
The Company’s investments in equity securities and the majority of its investments in fixed maturity securities are classified as “available-for-sale” as defined in SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Accordingly, these securities are carried at fair value with the after-tax difference from amortized cost reflected in stockholder’s equity as a component of accumulated other comprehensive income. Approximately 2% of the Company’s investments in fixed maturity investments are classified as “held-for-investment” as defined in SFAS No. 115 and are carried at amortized cost. Policy loans are carried at the outstanding balance, which approximates fair value. Other investments primarily consist of mortgage loans and a partnership interest. Mortgage loans on real estate are recorded at the outstanding principal balance adjusted for amortization of premiums or discounts and net of valuation allowances, if any. The partnership is carried at cost.
Securities that are depressed by 20% or more for 12 months or by 30% for six months are presumed to be other-than-temporarily impaired unless the depression is the result of rising interest rates or significant objective verifiable evidence supports that the security price is temporarily depressed and is expected to recover within a reasonable period of time. Securities depressed less than 20% or depressed 20% or more but for less than 12 months or depressed 30% or more but for less than six months are also reviewed to determine if an other-than-temporary impairment is present. The primary factors considered in evaluating whether a decline in value for securities is other-than-temporary include: (a) the length of time and the extent to which the fair value has been less than cost, (b) the financial condition, credit rating and near-term prospects of the issuer, (c) whether the debtor is current on contractually obligated interest and principal payments and (d) the intent and ability of the Company to retain the investment for a period of time sufficient to allow for recovery.
In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for financial statements issued for periods ending after December 15, 2003. There is no impact on the Company’s financial position or results of operations for 2003 under FIN 46. The Company also expects no impact in future periods under FIN 46.
The volume of life insurance business in force, which is driven by the level of sales and the persistency of the business written.
The ability to price life insurance products to earn acceptable margins over the cost of providing benefits and the expenses of acquiring and administering the products. Competitive conditions, mortality experience, persistency, investment results and our ability to maintain expenses in accordance with pricing assumptions drive the Company’s margins.
2003 results declined as compared to 2002 due primarily to a significant increase in fourth quarter 2003
Due to favorable market conditions caused by lower interest rates, the Company realized net gains of approximately $2,194,000, $2,885,000 and $27,000 in 2003, 2002, and 2001, respectively, from the sale of fixed maturity and equity securities.
During the first quarter of 2003 the Company realized a pre-tax investment loss of $356,000 from the write-down of the carrying value of 12 equity securities. These write-downs were the result of the Company determining that an other-than-temporary impairment had occurred.
During the second quarter of 2002 the Company realized a pre-tax investment loss of $850,000 from the write-down of the carrying value of a WorldCom, Inc. debt security. This write-down was the result of the Company determining that an other-than-temporary impairment had occurred. This debt security was subsequently disposed of in the third quarter of 2002 at an additional loss of $41,000.
Due to the Company’s small size, quarterly fluctuations, even when they remain within the normal range, will affect the total benefits and claims for the fiscal year. During 2003, 2002, and 2001, the Company experienced emerged mortality of 104%, 88%, and 89% of expected mortality, respectively, related to its traditional individual life insurance business. In addition, the Company’s general policy is to retain, with respect to individual life policies, generally no more than $100,000 of insurance on any one life and has also routinely purchased annual aggregate stop loss reinsurance coverage in excess of 120% of expected mortality. The Company did not experience any material impact on reinsurance costs as a result of the events of September 11, 2001.
a lawsuit was initiated by the Company in the third quarter of 2001. To date the Company has received approximately $475,000 and continues to seek additional recoveries against the reinsurance brokers through already existing legal channels. During the fourth quarter of 2003 the Company determined it to be probable that approximately $200,000 of the outstanding balance would be uncollectible. Accordingly, the Company has reduced the receivable by that amount and charged the amount to benefits expense in the accompanying financial statements. The Company believes the remaining amount outstanding to be fully recoverable and has included it in reinsurance receivable on the consolidated balance sheet.
Other benefits and claims consist of participation in a federally sponsored group life pool and benefits on a closed block of individual accident and health business.
The amortization of policy acquisition costs as a percentage of premium was 14% in 2003 compared to 11% in 2002 and 15% in 2001. Amortization for 2003 is within the Company’s expected range of 12-14%. The amortization of policy acquisition costs for 2002 reflects a favorable adjustment from updating actuarial assumptions and a decrease in the annual interest rate credited to policyholders. The adjustment represented a slow down of amortization as a result of higher estimated future profits from the improvement in mortality levels on universal life products. The after tax effect on net income for 2002 was $186,000 or $.03 per share. Amortization in 2001 reflects higher lapses in the traditional lines of business which reflects increased term rate competition in the market place.
Operating expenses as a percentage of premiums were 26% for 2003 compared to 25% in 2002 and 28% in 2001. The increase in 2003 compared to 2002 reflects normal increases in standard operating costs plus certain costs associated with the anticipated merger with COUNTRY. These costs were anticipated by management. The Company experienced some expense savings in 2002 primarily due to the reduction of certain performance based compensation costs.
It was announced on December 30, 2003 that the Cotton States Insurance Group (which includes the Company and Cotton States Mutual Insurance Company) and COUNTRY Insurance & Financial Services (“COUNTRY”), located in Bloomington, Illinois, entered into definitive agreements regarding the acquisition of the Company by merger. Under the Agreement and Plan of Merger, the Company’s shareholders will receive $20.25 cash for each share of outstanding common stock of the Company. As a result, the Company will become a privately-held company. Subject to regulatory approval, shareholder approval, and other conditions to closing set forth in the Agreement and Plan of Merger, it is anticipated that the transaction will close during the second quarter of 2004.
Premiums on life and accident and health insurance policies are recognized as income when due. Premiums on universal life policies are recognized as income when deducted from the policy’s account value.
The Company, CSI, and CSMR file a consolidated federal income tax return. Income tax expense allocation is based upon separate return calculations with credit for current losses. Inter-company balances are settled annually.
The Company applies the intrinsic value-based method of accounting prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its stock based compensation. As such, compensation expense would generally only be recorded if the current market price of the underlying stock on the date of grant exceeded the exercise price.
In December 2002, the Financial Accounting Standards Board issued SFAS No. 148 “Accounting for Stock-Based Compensation - Transition and Disclosure,” which is effective for financial statements issued after December 15, 2002. The adoption of SFAS No. 148 did not
Certain fixed maturity and equity securities were in an unrealized loss position, where the Company’s cost basis in the security exceeds the security’s fair market value, at December 31, 2003. The following table summarizes the length of time that those securities have been in a continuous unrealized loss position as of December 31, 2003:
The Company has procedures in place to monitor all debt and equity securities for possible other-than-temporary impairments. Securities are tracked comparing both unrealized losses as a percentage of original cost and the length of time the security has been below a predetermined percentage of cost. Monthly discussions are held with the Company’s investment managers to gather information and documentation as to their outlook for future recovery of the securities making the Company’s “watch list”. As of December 31, 2003 there were no debt or equity securities whose unrealized losses would be deemed by management to be other-than-temporary impairments that have not been recorded.
Bonds with an amortized cost of $2,177,000 and $1,914,000 at December 31, 2003 and 2002, respectively, were on deposit with state insurance regulatory authorities in accordance with statutory requirements.
The carrying amount of cash and short-term investments is a reasonable estimate of fair value due to the short-term nature of the investments.
The Company participates in certain business assumed from federally sponsored group pools. Further, it is the Company’s general policy to reinsure individual life insurance in excess of $100,000, group life insurance in excess of $55,000, major medical payments in excess of $85,000 annually per individual, accidental deaths, and certain disability income coverage.
The Company, in conjunction with Cotton States Mutual (“Mutual”) and Shield Insurance Company (“Shield”), its affiliates, sponsors a non-contributory defined benefit pension plan covering all eligible employees. Plan benefits are based on the age of the employee, the employee’s average salary for the highest five consecutive years of compensation and the employee’s years of service. The Company’s funding policy is to make annual contributions sufficient to fund the plan’s normal cost (current service cost) plus amortization of the unfunded prior service cost. The Company and its affiliates are charged the allocable share of such contributions based on their proportionate share of payroll.
On December 8, 2003 the Medicare Prescription Drug Improvement and Modernization Act of 2003 (the “Act”) was enacted. In accordance with Financial Staff Position No. FAS 106-1, any measure of the accumulated postretirement benefit obligation or net periodic postretirement benefit cost in the Company’s financial statements or accompanying notes do not reflect the effects of the Act on the other postretirement benefit plan.
Specific authoritative guidance on the accounting for the federal subsidy created by the Act is pending and that guidance, when issued, could require the Company to change previously reported information.
The Company’s pension plan weighted-average asset allocations at December 31, 2003 and 2002, by asset category are as follows:
The Company has examined various asset allocation structures, through consultation with the plan’s external investment advisors, and has determined the following target allocations to be best suited to meet the long-term objectives of the plan:
Fixed maturity holdings: Marketable issues are desired so the portfolio can be actively managed. Fixed maturity holdings should be reasonably diversified to the extent that it is prudent to do so without requiring the plan’s investment manager to purchase “odd lots.” The fixed maturity holdings should be comprised of high quality issues that have a credit rating of no less than investment grade
Prohibited investments: The following categories of securities are not permitted by the plan: short sales, margin purchases or lending or borrowing money, letter stock, private placements or direct placements, commodities, securities of the plan’s asset manager, custodian, their parent, or subsidiaries as well as the securities of the Company or its subsidiaries.
Mutual, through its wholly-owned subsidiary, Shield, controls approximately 33% of the Company’s outstanding common stock. In addition, most of the officers and directors of the Company hold similar positions with these affiliates.
Certain general expenses are allocated to the Company from its affiliates. These expenses, such as salaries, advertising, rents, etc., represent the Company’s share of expenses initially paid by Mutual and are allocated based on specific identification or, if undeterminable, generally on the basis of each company’s premium. Expenses allocated to the Company may not be the same as expenses incurred if the Company operated as a stand-alone entity. Expenditures allocated to the Company amounted to $3,704,114 in 2003, $3,471,048 in 2002 and $3,992,556 in 2001. At December 31, 2003 the Company owed $576,644 to Mutual and at December 31, 2002 the Company was owed $42,469 from Mutual.
The Company expensed pension costs of $99,535 in 2003, $116,174 in 2002, and $93,347 in 2001.
The per share weighted-average fair value of stock options and restricted stock granted was estimated using an option pricing model with the following weighted-average assumptions: expected life of five years for options and seven years for restricted stock awarded in 2001, and three years for restricted stock awarded in 2003 and 2002; expected dividend yield of 1.78% for 2003 grants, 1.67% for 2002
grants, 1.60% for 2001 grants; risk-free interest rate of 4.0% for 2003, 3.5% for 2002, and 4.5% for 2001; and an expected volatility of 80% for 2003 grants, 66% for 2002 grants, 65% for 2001 grants.
when making management decisions. The Company allocates net investment income and net realized gains to its individual life insurance and guaranteed issue and simplified issue life insurance segments based on the ratio of each segment’s reserves to total reserves. Net investment income and net realized gains for the Company’s brokerage segment is based on actual amounts earned by its brokerage subsidiaries.
The following is a summary of the unaudited quarterly results of operations for the three years ended December 31, 2003.