The Company's principal office, located at 2500 DeKalb Pike, Norristown, Pennsylvania, is owned by PILIC. This property is comprised of approximately 6.5 acres of land and buildings containing approximately 44,000 square feet of space. PILIC also owns a three-story office building located in Abington, Pennsylvania, which is leased to unaffiliated third parties. NIA, a wholly owned subsidiary of PILIC, leases commercial office space in Lakewood, Colorado for the operation of a regional sales office. NIA's lease is for 3,300 square feet. The Company believes its existing facilities are suitable to conduct its present business.
The following selected consolidated financial information has been derived from the consolidated financial statements of the Company and should be read in conjunction with the Consolidated Financial Statements and notes thereto included elsewhere in this report has been audited by BDO Seidman, LLP for 1997, and by Coopers and Lybrand, LLP for all prior years.
(1) Assumes conversion of Series A and Series B Cumulative Convertible Preferred stock into common stock of the Company on a share-for-share basis in years 1995, 1994 and 1993 and conversion of Series A Cumulative Convertible Preferred stock in 1997 and 1996 on a share-for-share basis.
Policy claims are based on a variety of estimation methods, which are continually revised incorporating the Company's most recent benefit experience. As a result of higher than expected out-of-network claim utilization and greater than expected claim frequency, the Company increased its loss ratio assumptions during the year, which, in turn, resulted in an underwriting loss for 1997. In reaction to these items, the Company began a series of corrective actions, including premium rate increases, more stringent underwriting and revised policy designs providing for more severe penalties for those policyholders who elect to receive medical treatment outside of the authorized PPO networks. Although the Company believes policy claim liabilities are adequate, experience with these newer managed care products is limited and continues to evolve. A greater than anticipated claim experience could have a materially adverse impact on the financial position and results of operations.
At December 31, 1997 and 1996, gross annualized accident and health premium inforce on small group and managed care business amounted to $96.8 million and $68.2 million, respectively, consisting of approximately 50,000 and 36,000 certificate holders, respectively. The $28.6 million net increase in annualized premium resulted from new business issued in 1997 of $68.1 million, plus premium rate increases of approximately $10.0 million less lapses amounting to approximately $49.5 million. Managed care products accounted for 82% and 65% of the inforce premium at year end 1997 and 1996, respectively, of the group accident and health business.
The lapse ratio on small group and managed care accident and health insurance business based on annualized premium was 45% for 1997 compared to 38% for 1996. The lapse ratios reflect the results of premium rate increases as well as the Company's continued shift toward managed care plans and away from traditional healthcare insurance. The Company's traditional healthcare insurance plans have higher premiums and higher policy benefits than its managed care plans. The accident and health lapse ratios include small group medical plans which by their nature have high lapsation. In an effort to improve the lapse ratio, the Company continues to follow the practice of pooling claim experience for re-rating of all cases with less than 25 participants. In addition, the Company has a conservation program which, as part of the renewal process, offers alternatives such as increased deductibles and different benefit structures designed to enable policyholders to maintain insurance protection without increased premium rates. While some policyholders have switched to lower premium insurance plans, the Company does not believe the plans are less profitable.
Accident and health policy benefits ratio net of reinsurance increased to 86.3% for 1997 compared to 60% for 1996 as a result of higher than expected claim experience on the Company's managed care products.
1997 1996 ---- ---- Accident and health policy claims, net of reinsurance $38,981 $18,963
Other operating expenses of $16 million for 1997 increased from $11.7 million for 1996, due to increased policy administration expenses caused by increased sales volume and transition expenses associated with the HPS outsourcing.
Amortization of deferred policy acquisition costs of $10.9 million for 1997 increased from $0.6 million for 1996 primarily due to accelerated amortization in 1997 due to higher than expected lapses and worse than expected loss ratios. Increased lapsation over current levels or future unprofitability in managed care and certain life products could result in an increase in the amortization rate of unamortized deferred policy acquisition costs, which would adversely impact future earnings.
Net income applicable to common stock was $15.9 million or $1.36 per diluted share in 1996 compared to a loss of $4.0 million or $.44 per diluted share for 1995. The Company's 1996 net income was primarily the result of a litigation settlement, representing $14.6 million of net income plus related realized gains on the sale of stock received as a result of the settlement. 1996 results were favorably impacted by improved overall average accident and health policy benefits ratio offset by the Company's decision to recapture reinsurance ceded on certain multi-pay pre-need life insurance policies which resulted in a non-recurring pre-tax charge in 1996 of $1.0 million.
Accident and health gross premium for 1996 was $57.2 million compared to $39.0 million for 1995. Accident and health ceded premium in 1996 was $25.7 million compared to $15.9 in 1995. These increases are as a result of increased new business from managed care health insurance products.
With the NIA acquisition the Company acquired 3,500 policyholders representing approximately $6.5 million of annualized premium at the date of acquisition. This business consists primarily of the "HealthQuest" product, a managed care one-life PPO product similar to "The Provident Solution" plan. The NIA Acquisition and the HealthQuest business accounted for the following during 1996; accident and health premiums, gross before reinsurance ceded of $6.1 million; accident and health premiums, net of reinsurance ceded of $3.1 million; total revenue of $3.6 million; benefits, net of reinsurance of $1.7 million; total expenses of $3.5 million; and pre-tax income of $0.1 million. These amounts represent the business acquired on May 1, 1996 together with post-acquisition HealthQuest sales and lapses and NIA's operations.
Life and annuity reinsurance ceded of ($1.9 million) was $5.5 million higher compared to 1995 due to the Company's 1996 recapture of reinsurance originally ceded in 1995 on certain multi-pay pre-need life insurance policies. The Company recaptured this business as a result of the availability of additional capital resulting from the litigation settlement. The recapture impact on 1996 results accounted for the following amounts: premium - life and annuity reinsurance ceded of $2.4 million; death and other life policy benefits of $3.1 million; and commissions, net of ceding allowance of $0.3 million. The cession impact on 1995 results accounted for the following amounts: premium - life and annuity reinsurance ceded of $3.2 million; death and other policy benefits of $3.2 million; and commissions, net of ceding allowance of ($1.0) million.
Net investment income of $3.3 million for 1996 increased from $2.9 million in 1995, primarily due to an increase in bond investments in late 1996.
The Company realized $2.1 million in capital gains in 1996 as a result of selling Loewen stock received in connection with the litigation settlement.
Accident and health premiums Gross before reinsurance ceded $57,195 $39,028 Less reinsurance ceded (25,670) (15,882) -------- -------- Premiums,net of reinsurance $31,525 $23,146 ======== ========
Amortization of deferred policy acquisition costs of $0.6 million for 1996 increased $0.5 million from 1995 primarily due to $0.4 million of managed care amortization in the second half of 1996 relating to deferrals in the third and fourth quarters of 1996.
The primary sources of cash are premiums, investment income and investment sales and maturities. The primary uses of cash are benefit payments to insureds, operating costs including policy acquisition costs and investment purchases. The Company's liquidity requirements are primarily created and met by PILIC and PALHIC. Starting in 1998, Insurion's sources of cash will be primarily private placements, a public offering and to a lessor extent marketing fee income. Insurion's primary uses of cash will be fee payments to AOL and other Internet sites, WEB site development and start-up expenses.
The Company entered into a line of credit with a bank during 1997 in the amount of $1 million with interest at 1% above the prime rate. The outstanding borrowing at December 31, 1997 amounted to $1.0 million. The Company anticipates repaying this amount in 1998.
Net cash used in operating activities of $5.4 million in 1997 reflects higher than expected paid claims on the Company's managed care products. Change in future policy benefits and claims of $17 million increased in 1997 compared to 1996 due to managed care health insurance product sales at higher than expected loss ratios. The Company anticipates the majority of its unpaid accident and health claims incurred during 1997 will be paid during 1998. The Company has sufficient cash available at December 31, 1997 to adequately fund these claim payments as they arise in 1998.
In connection with the HPS Outsourcing Agreement, the Company received a $5.0 million cash advance in 1997 to be repaid over the 60-month term of the agreement at the rate of $85,000 per month.
The Company anticipates that it will fund surrenders and benefit payments along with other operating expenses through net cash from operating activities, scheduled investment maturities, and the liquidation of short-term investments. Excess cash flow from operations and financing are transferred to the investment portfolio where it is available for investment and future cash needs. Anticipated capital expenditures are discussed later.
To the Shareholders and Board of Directors of Provident American Corporation
Also, in our opinion, the financial statement schedules present fairly, in all material respects, the information set forth therein.
We have audited the consolidated financial statements and the financial statement schedules of Provident American Corporation and Subsidiaries as of December 31, 1996 and for each of the two years in the period ended December 31, 1996. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Provident American Corporation and Subsidiaries as of December 31, 1996, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 1996 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein.
In 1997, the Company incurred capital lease obligations in connection with the acquisition of certain equipment.
In 1996, the Company issued stock in connection with certain business acquisitions described in Note C and received stock in connection with a litigation settlement described in Note K.
Provident American Corporation and Subsidiaries Notes to Consolidated Financial Statements December 31, 1997
PAMCO is a Pennsylvania corporation and is regulated as an insurance holding company by the 42 states in which PILIC and PALHIC are licensed. The Company markets and underwrites group life and accident and health coverages as well as individual life insurance policies through independent agents and brokers. The Company's major line of combined group life and health business is written through several association groups and discretionary group trusts.
Principles of consolidation: The consolidated financial statements of PAMCO and subsidiaries have been prepared in accordance with generally accepted accounting principles (GAAP) and include the accounts of PAMCO and all of its subsidiaries. All significant intercompany accounts and transactions have been eliminated.
Use of estimates: The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of revenues, expenses, assets, and liabilities and disclosure of contingencies. Actual results could differ from those estimates.
Equity securities are classified as "available-for-sale" and carried at fair value.
Real estate is stated at cost, less accumulated depreciation; policy loans are stated at the aggregate unpaid principal balances.
Unrealized gains and losses on securities available-for-sale are excluded from earnings and included as a separate component of stockholders' equity, net of applicable deferred income taxes.
Income taxes: Income taxes are calculated using the liability method specified by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes".
Policy claims: The liability for life and health policy claims is based upon the aggregate of claim estimates for reported and unreported losses based upon the Company's experience. The methods for making such estimates and establishing the resulting liabilities are continually revised and updated and any changes resulting therefrom are immediately charged or credited to income (loss) in the periods in which they are made.
Reclassifications and restatement of prior year amounts: Certain prior year amounts have been reclassified to conform to the current year's presentation.
Recent accounting standards: SFAS 129 "Disclosure of "Information about Capital Structure" establishes standards for disclosing information about an entity's capital structure. SFAS 129 requires the disclosure of the pertinent rights and privileges of various securities outstanding (stock, options, warrants, preferred stock, debt and participating rights), call prices and dates, conversion or exercise prices and redemption requirements. SFAS 129 has been adopted by the Company.
SFAS 130 "Reporting Comprehensive Income" establishes standards for reporting and display of comprehensive income, its components and accumulated balances. Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distributions to owners. Among other disclosures, SFAS 130 requires that all items that are required to be recognized under current accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the prominence as other financial statements.
SFAS 133 "Accounting for Derivative Instruments and Hedging activities establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS 133 is effective for all periods beginning after December 15, 1997. The Company had no derivative instruments as of December 31, 1997.
On June 18, 1996, the Company acquired, effective January 1, 1996, all of the issued and outstanding stock of Richard E. Field & Associates, Inc., d/b/a REF & Associates, Inc. ("REF"), from its shareholders Richard E. Field and Arthur Ivey for 610,000 shares of PAMCO's common stock. REF, a California corporation, is engaged in marketing certain life and health insurance products of PILIC. This transaction was accounted for as a pooling of interests.
Summary of net unrealized gain or loss balances and change for the year ended December 31, 1997 and 1996:
Changes in fair value of bonds were a direct result of the overall change in interest rates. The Company's bond investments are comprised of high-quality investment-grade securities.
Fair values of bond investments in good standing are principally a function of current interest rates, which are not considered in computing related future liabilities to contract holders. The presentation of estimated values for assets based on current interest yields without a corresponding revaluation of contractholder liabilities can be misinterpreted.
The Company has various financial assets and liabilities outstanding at December 31, 1997. Management believes that the book value of these financial instruments (cash and invested assets, future policy benefits and notes payable) approximates their fair values since the instruments carry interest rates which approximate market or that the amounts involved are not material.
Note F - Loans Receivable - Officer and Director and Shareholder
As described in Note R, the Company received $5,000 from HPS, of which, $3,978 has been accounted for as a loan payable discounted at the Company's recent historical borrowing rate of 9.25% payable in 60 monthly payments of principal and interest of $85 commencing in March 1998.
The Company and its subsidiaries have a net operating loss carryforward amounting to $7,600 some of which is available to offset future taxable income through 2012. Approximately $6,500 of the tax loss carryforwards result from a 1989 acquisition and expire between 1998 and 2004 and are subject to annual limitations of approximately $100. This limitation will significantly reduce their utilization. The net operating loss carryforwards included as deferred tax assets have been reduced to exclude the estimated amount of carryforwards which are unavailable due to certain limitations.
The reconciliation of income tax expense (benefit) to the amount computed by applying the appropriate statutory income tax rate (35%) to income (loss) before income taxes is summarized as follows:
Dividend restrictions: Dividends paid by the Company over and above the financial assets of PAMCO are dependent on the ability of PILIC to pay dividends to PAMCO and the ability of PALHIC to pay dividends to its parent, PILIC. The payment of dividends by PILIC and PALHIC is dependent upon a number of factors including earnings and financial condition, business needs and capital and surplus requirements as well as applicable regulatory restrictions. Under Pennsylvania law, PILIC and PALHIC are currently unable to pay dividends without the prior approval of the Pennsylvania Insurance Commissioner as a result of PILIC's and PALHIC's statutory unassigned deficit of $13,538 and $4,147, respectively which excludes common stock and additional paid-in capital amounts.
At December 31, 1997, PILIC and PALHIC calculated their respective Risk Based Capital ("RBC") utilizing a formula required by the NAIC. PALHIC's amounts are included in PILIC, PALHIC's parent. The results of this computation are indicated in the table below. RBC standards are designed to measure the acceptable amounts of statutory capital and surplus an insurer should have based on inherent and specific risks of an insurer's business. Insurers failing to meet their benchmark capital and surplus level may be subject to scrutiny by its domiciled insurance department and, ultimately, rehabilitation or liquidation.
The insurance department of Pennsylvania in which PILIC and PALHIC are domiciled recognizes as net income and capital and surplus (Stockholders' Equity) those amounts determined in conformity with statutory accounting practices prescribed or permitted by the department which differ in certain respects from generally accepted accounting principles. The amounts of statutory net income for the year ended and surplus as of December 31 were as follows:
Options: The Company has stock option plans which provide for the granting of options to directors and key employees of the Company and its subsidiaries, and certain field representatives and agents.
The Incentive Stock Option Plan for Employees authorized the granting of options for up to 650,000 shares of the Company's Common Stock to key managerial employees of the Company, which are exercisable for up to five years at a price not less than the fair market value of the shares on the date of grant. All options granted under the Incentive Stock Option Plan have been granted at 100% of the fair market value of the shares on the date of grant. The Incentive Stock Option Plan for Employees expired, and during 1996 the Company adopted the 1996 Employee Incentive Stock Option Plan ("1996 Employee Plan"), which was approved by the Company's shareholders at the 1997 Annual Meeting of Shareholders. The 1996 Employee Plan was amended in 1997 to increase the number of shares issuable thereunder from 950,000 shares to 1,250,000 shares of the Company's Common Voting Stock to key employees of the Company and its subsidiaries and affiliates, exercisable for up to five years from the effective date of the grant at a price not less than the fair market value of the shares on the effective date of grant. All options granted under the 1996 Employee Plan have been granted at 100% of the fair market value of the shares on the effective date of the grant, with the exception of an option granted Mr. Clemens, which was granted at 110% of the fair market value on the date of the grant.
The following table lists changes during 1997, 1996 and 1995 in outstanding stock options for the 1996 Employee Plan, the Directors' Plan, the Premium Production Stock Option Plan, the Military Stock Option Plan all stock option plans:
On June 6, 1996, the Company issued 100,000 stock purchase warrants to an unaffiliated party at $9.00 per share and are exercisable through June 6, 2001. The Company issued a warrant to an exclusive consultant of the Company to purchase 100,000 shares of the Company's Common Stock at the market price per share as of each of January 1, 1996, January 1, 1997, and January 1, 1998, provided PILIC has realized new annualized premium sales production of at least $35,000, $45,000, and $50,000, respectively, for each of these calendar years. PILIC has realized the annualized premium threshold for the years ending December 31, 1996 and 1997, and accordingly, the consultant is entitled to exercise 100,000 warrants at $7.375 per share for 1996 and 100,000 at $14.00 per share for 1997.
Effective January 1, 1996, the Company adopted the disclosure-only provisions of SFAS 123 "Accounting for Stock Based Compensation." Accordingly, no compensation cost has been recognized for stock option and warrant grants that occurred in 1997 and 1996. Had compensation cost for the Company's stock option grants been determined based on the fair value at the date of grants in accordance with the provisions of SFAS 123, the Company would have amortized the cost over the vesting period of the option which generally is five years for the 1996 Employee Plan and three years for the Directors Plan. The Company's 1997 and 1996 net income and net income per common share would have been reduced to the following pro-forma amounts:
The fair value of the options and warrants granted during 1997 and 1996 are estimated on the date of grant using the Black-Scholes option-pricing model. The major assumptions used and the estimated fair value include no dividends paid, assumed forfeitures of 10% annually for non-vested options and warrants granted in 1996, and the following:
The Company received from the Loewen Group, Inc. and Loewen Group International, Inc. (collectively "Loewen") on April 1, 1996, $3,000 in cash and 718,519 shares of the common stock of Loewen Group (NYSE: LWN) to compensate the Company for damages sustained pursuant to a February 12, 1996 agreement between the Company and Loewen to settle certain litigation filed by the Company against Loewen. The settlement, net of legal expenses, was valued at $22,400. The impact on net income was approximately $14,600, which is net of approximately $7,800 of income taxes.
The Company has various capital leases that are primarily related to office space, data processing and other equipment. Annual payments under all capital and operating leases was approximately $857, $427 and $294 in 1997, 1996 and 1995, respectively. The future minimum rental commitments under noncancelable leases at December 31, 1997, are: 1998 - $537; 1999 - $537; 2000 - $537; 2001 - $183; and 2002 - $0.
Unfavorable economic conditions have contributed to an increase in the number of insurance companies that are under regulatory supervision. This is expected to result in an increase in mandatory assessments by state guaranty funds of solvent insurance companies to cover losses to policyholders of insolvent or rehabilitated companies. Mandatory assessments, which are subject to statutory limits, can be partially recovered through a reduction in future premium taxes in some states. Although the Company is not able to reasonably estimate the potential effect on it of any such future assessments, such amounts charged against operations for 1997, 1996 and 1995 have not been material.
The Company sponsors a defined contribution retirement savings plan under section 401(k) of the Internal Revenue Code covering substantially all employees. Employees may contribute up to 15% of compensation, of which the Company will match 50% of the first 5%. All contributions are subject to limitations imposed by IRS regulations. Effective January 1, 1995, employees were given the option to invest the "employer match" portion of their contribution in common stock of the Company. At December 31, 1997 and 1996, the plan held 1,379 and 3,496 shares of the Company's common stock, respectively. All contributions are subject to limitations imposed by the Internal Revenue Code on 401(k) plans.
Note N - Liability for Unpaid Claims and Claim Adjustment Expenses
Activity in the liability for unpaid claims and claim adjustment expenses is summarized as follows.
The 1997 provision for prior year unpaid losses of $3,272 reflects higher than expected claim costs on the Company's managed care plans for business written during 1996. The 1996 and 1995 benefit for prior year unpaid losses of $499 and $794, respectively, reflects better than expected claim costs on the Company's stop loss plans.
Reinsurance does not relieve the Company of its primary obligation to its policyholders. Reinsurance varies according to the age of the insured, type of risk and type of policy. Retention amounts for life insurance range up to $50 of coverage per individual life and for health insurance up to $85 per individual.
Under the terms of a Quota Share Reinsurance Agreement, the Company ceded 47.5% of the liability on its accident and health insurance business. The Company received a ceding commission of 45.5% on all first year business, and 25.5% to 30.5% on renewal business, depending on product, in 1997, received 41.5% on all first year business , and 26.5% to 30.5% on renewal business, depending on product, in 1996, and received 41.5% on all first year business , and 26.5% to 30.5% on renewal business, depending on product, in 1995. The combined ceding commissions amounted to approximately 37%, 38.9% and 32.5% of ceded earned premium for 1997, 1996, and 1995 respectively. The Company was notified by its reinsurer, Swiss Re, that the Quota Share Reinsurance Agreement would not be renewed effective January 1, 1998. Swiss Re's obligation to assume paid losses incurred prior to January 1, 1998 remains in effect. Accordingly, the Company notified Swiss Re that it would not be renewing the Excess of Loss Agreement. The Company is currently negotiating with a group of reinsurers and has placement slips regarding a replacement Quota Share Agreement and Excess of Loss Agreement with a group of reinsurers to be effective January 1, 1998. Effective January 1, 1998, the Company's new reinsurance will be on a no loss, no gain basis for all policies inforce as of December 31, 1997 until those policies are rate increased. The new agreements, when executed, may not be as comprehensive as the old agreement. Policies are generally rate increased on their six month or twelve month anniversary. Once policies inforce as of December 31, 1997 have been rate increased, and for all policies sold during 1998, the Company will cede approximately 47.5% of group medical benefits. Furthermore, the Company will retain any profit in excess of 3% of ceded premium. The effect of any differences has not been determined; however, management believes that the effect, if any, will not be material to the accompanying financial statements.
The Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk of the reinsurers to minimize exposure to significant losses from reinsurer insolvencies. Reinsurance receivables associated with a single reinsurer as of December 31, 1997 and 1996 amounting to approximately $17,225 and $8,985, respectively.
A summary of insurance in-force, premium income, benefits and commission expense with respect to reinsurance operations is as follows:
Gross commissions and expense allowances paid or payable to entities which are controlled by former Directors in 1996 and 1995, amounted to approximately $314 and $313, respectively.
Consulting expenses paid to a shareholder of the Company and former Chief Executive Officer of REF amounted to $300 in both 1997 and 1996. The shareholder provides the Company with exclusive marketing, sales and product design services as part of a 36-month consulting agreement effective January 1, 1996.
If PHS elects the two-year renewal term, then PHS shall make an additional payment to AOL of $32,500 on or before September 30, 1999. Under certain circumstances the AOL Agreement can be extended by AOL. If PHS exercises its right to renew the AOL Agreement then the AOL Agreement also provides for the issuance of warrants subject to the terms and conditions of the AOL Agreement.
HPS E-Commerce Agreement: In May 1998 the Company and HPS entered into an agreement ("the E-Commerce Agreement") for the period February 1, 1998 through October 1, 1999 where-by: 1) HPS paid Insurion $750 as an off-set against the Holding Fee paid by PHS to AOL, 2) HPS shall have certain third party administrator rights over policies sold by the Company over its web site or other e-commerce methods, 3) HPS shall have equal prominence to the Company on the Company's Web pages, 4) the Company shall pay HPS 4% of certain fees paid to the Company by co-sponsors of the Company's web site and 5) PAMCO agrees to issue to HPS a warrant to purchase 100,000 shares of PAMCO's common stock at $9.00 for a period of 2 years. The fair value of these warrants (approximately $164) will be recognized in the second quarter of 1998.