The lease on the Dallas sales office expired on January 31, 2006.
The selected audited consolidated financial data presented below as of and for each of the five years ended December 31, 2005, 2004, 2003, 2002 and 2001 have been derived from our audited consolidated financial statements. However, financial data for 2001 was reclassified to reflect the sale of Pyramid Life Insurance Company on March 31, 2003. For further information, see Note D. Discontinued Operations to our audited consolidated financial statements. The financial information for the years ended December 31, 2005, 2004, 2003, 2002 and 2001 includes the operations of all our subsidiaries for the entire year except for Pyramid Life. Pyramid Life, which is presented separately as discontinued operations, was acquired on July 26, 2000 and sold on March 31, 2003. The data for 2005, 2004 and 2003 should be read in conjunction with the more detailed information contained in the audited consolidated financial statements and accompanying notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this filing.
The exercise of options and warrants is not assumed when a loss from operations is reported and the result would be antidilutive.
“Accumulated other comprehensive income” relates primarily to the net unrealized gain (loss) on available-for-sale securities.
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, before transaction costs of $2.2 million. For more information on the Pyramid Life sale, see Note D. Discontinued Operations to our audited consolidated financial statements.
Major Medical, Medicare Supplement & Other Health. The liability for other policy claims and benefits payable (except for long-term care disabled life reserves which represented approximately 40% of the total liabilities for other policy claims and benefits payable at December 31, 2005) consists of actual claims reported but not paid and estimates of claims incurred but not reported (IBNR). Liability estimates are developed using actuarial principles and assumptions that consider, among other things, historical claims payment patterns, claims inventory levels, network reimbursement changes, historical utilization trends, current levels of authorized inpatient days, other medical cost inflation factors, in-force levels, benefit design changes, seasonality, demographic mix change and expected costs to settle unpaid claims.
We employ actuaries and consultants that have developed, refined and used the same set of reserve models over the past several years. These reserve models make use of both historical claim payment patterns as well as emerging medical cost trends to project our best estimate of claim liabilities. Within these models, historical data of paid claims is formatted into claim triangles which compare claim incurred dates to the claim payment dates. This information is analyzed to create “completion factors” that represent the average percentage of total incurred claims
that have been paid through a given date after being incurred. Completion factors are applied to claims paid through the financial statement date to estimate the ultimate claim expense incurred for the current period. Actuarial estimates of claim liabilities are then determined by subtracting the actual paid claims from the estimate of the ultimate incurred claims.
A substantial portion of liability estimates relates to the most recent four incurred months. Changes in the completion and trend factors can have a significant effect on the liability estimates. A hypothetical 2% increase in claim trend coupled with a 1% decrease in completion factors for the prior twelve months could cause an 8% increase in our liability for other policy claims and benefits payable.
The following table reflects the activity in the liability for other policy claims and benefits payable, including the claims adjustment expenses, net of reinsurance recoverables:
The above table indicates a net redundancy in reserves (“Incurred claims and claims adjustment expenses, net of reinsurance for prior years” divided by “Adjusted net beginning balance”) of 0.5% in 2004, 19.0% in 2003, and 10.9% in 2002.
Claim reserve estimates are continually monitored and reviewed, and, as estimates are adjusted, differences are reflected in current operations. We develop best estimate reserves for all lines of business and do not develop ranges of possible outcomes. Based on historical deviations from our best estimate, we have generally been within 5% to 15% of the recorded reserve estimates.
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, 2005, credited rates for universal life contracts ranged from 4.0% to 5.5%. Guaranteed base minimum rates for deferred annuities ranged from 3.0% to 5.5% depending on the duration of the contract. At December 31, 2005, credited rates for deferred annuities ranged from 3.0% to 6.0%.
Deferred Acquisition Costs. In connection with the sale of our insurance policies, we defer and amortize a portion of the policy acquisition costs over the related premium paying periods of the life of the policy. These costs include certain excess policy acquisition costs associated with issuing an insurance policy, including commissions and underwriting, all of which vary with and are primarily related to the production of new business. The amortization of deferred acquisition costs is determined using the same projected actuarial assumptions used in computing policy reserves. Deferred acquisition costs associated with traditional life and accident and health contracts are charged to expense over the premium-paying period or as premiums are earned over the life of the contract. Deferred acquisition costs associated with interest-sensitive life and annuity products are charged to expense over the estimated duration of the policies in relation to the present value of the estimated gross profits from surrender charges and investments, mortality, and expense margins.
We evaluate the recoverability of our deferred acquisition costs on an annual basis. The recoverability of our deferred acquisition costs is sensitive to judgments and assumptions made in projecting future cash flows on our various blocks of business. The most significant assumptions are claim cost trends, magnitude of rate increases, lapsation and persistency, and mortality.
Management believes the amount of deferred acquisition costs as of December 31, 2005 is recoverable.
Goodwill and Other Intangible Assets. Goodwill represents the excess of purchase price over the fair value of tangible and identifiable intangible net assets acquired. At December 31, 2005, goodwill was $10.7 million and represented approximately 1.4% of our total assets. Additionally, other intangible assets represent purchased assets
that also lack physical substance but can be distinguished from goodwill because of 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. At December 31, 2005, our other intangible assets consisted of $3.4 million in licenses, or 0.4% of our total assets.
Lapsation and persistency. Other factors that affect our results of operations are lapsation and persistency, both of which relate to the renewal of insurance policies and certificates in force. Lapsation is the termination of a policy for nonrenewal and, pursuant to our practice, is automatic if and when premiums become more than 31 days overdue. However, policies may be reinstated, if approved, within 90 days after the policy lapses. Persistency
represents the percentage of total certificates in force at the end of a period less any newly-issued certificates divided by the total certificates in force at the beginning of the period.
In determining the amount to be recorded as a litigation reserve, judgments are generally made by management, in consultation with legal counsel and other experts both within and outside the Company, on a case-by-case basis based on the facts and the merits of the case, the general litigation and regulatory environment of the originating state, our past experience with outcomes of cases in particular jurisdictions, historical results of similar cases and other relevant factors. We closely monitor and evaluate developments and emerging facts of each case to determine the reasonableness of judgments and assumptions on which litigation reserves are based. Such assumptions relate to matters that are highly uncertain. Estimates could be made based on other reasonable assumptions or judgments that would differ materially from those estimates recorded. We will accrue a liability if the likelihood of an adverse outcome is probable and the amount is estimable. We will not accrue a liability if either the likelihood of an adverse outcome is only reasonably possible or an estimate is not determinable. Our evaluation of the likely outcome of these actions and the resulting estimate of the potential liability are subject to periodic adjustments that may have a material impact on our financial condition and results of operations of a future period.
Senior and Other - includes Medicare supplement, long-term care, dental, life insurance and annuities; and
Pre-tax income for our Medical segment was $4.1 million for 2005, compared to $5.2 million for 2004, including a $3.1 million pre-tax charge for the California litigation settlements. Premiums in the Medical segment decreased approximately 10.5% in 2005 due to the decline in major medical certificates in force as well as high lapse rates. Premiums increased 1.6% from the third quarter to the fourth quarter of 2005. In 2006, we expect premiums to increase by approximately 5.0%, the first annual increase in premiums since 2001. The loss ratio in the Medical segment was 73.4% in 2005, compared to 71.3% for 2004. The loss ratio was impacted by an increased severity of large claims and unfavorable experience on our partially self-funded small group (Partnership) plan. In 2006, we expect the loss ratio to remain consistent with 2005.
Pre-tax income from our Senior and Other segment was $17.9 million for 2005 compared to $18.5 million in 2004. Premiums in the Senior and Other segment increased 12.9% in 2005 due primarily to Medicare supplement new business production as well as rate increases that were filed in 2004 and implemented in 2005. In addition, we introduced new Medicare supplement products through our Provident American Life subsidiary and began selling new senior life insurance plans. We expect premiums in this segment to increase approximately 15% in 2006 due to the 2006 rate increases on our Medicare supplement blocks and new sales. The loss ratio in the Senior and Other segment was 78.7% in 2005, compared to 75.6% for 2004. The Medicare supplement loss ratio was 73.8% in 2005 compared to 71.9% in 2004. The 2005 segment results were impacted by a higher than expected loss ratio for our Medicare supplement business and unfavorable long-term care experience. In 2006, we expect the Senior and Other loss ratio to decrease to approximately 76.0% and the Medicare supplement loss ratio to decrease to approximately 72.0% due to the approval and implementation of an average 15% rate increase on this block of business (assuming a claim trend of 10%).
Senior and other premiums increased $23.6 million, or 12.9%, to $206.8 million for the year ended December 31, 2005, compared to $183.2 million for 2004. The increase in senior and other premiums was primarily the result of a $23.4 million increase in Medicare supplement premium due to new business production as well as rate increases that were filed in 2004 and implemented in the first quarter of 2005. We expect premiums in this segment to increase approximately 15% in 2006.
Total benefits, claims, losses and settlement expenses increased to $325.0 million for 2005, compared to $314.6 million for 2004, an increase of 3.3%.
Senior and other benefits, claims, losses and settlement expenses were $162.7 million for 2005, compared to $138.5 million for 2004, an increase of 17.5%. The senior and other loss ratio was 78.7% for 2005, compared to 75.6% for 2004. This increase was primarily due to an increase in the Medicare supplement loss ratio from 71.9% in 2004 to 73.8% in 2005, unfavorable long-term care experience in the third quarter of 2005 and an increase in long-term care benefit reserves in the fourth quarter of 2005 related to revisions to our long-term care model. Our long-term care model was adjusted to reflect the higher 2005 rate levels and persistency. The Medicare supplement loss ratio is expected to decrease to approximately 72.0% in 2006 compared to 73.8% in 2005 due to the approval and implementation of an average 15% rate increase on this block of business. The overall loss ratio in this segment is expected to be approximately 76% in 2006.
Selling, general and administrative expenses decreased to $131.6 million in 2005, compared to $134.6 million in 2004, a decrease of 2.2%. 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 against the Company and its subsidiaries. These lawsuits related primarily to challenges to premium increases for California holders of major medical policies issued by United Benefit Life and Provident American Life. For more information, see Note L. Contingencies and Commitments to our audited consolidated financial statements. Excluding this charge, selling, general and administrative expenses were $131.6 million in 2005 compared to $131.5 million in 2004, an increase of $0.1 million. The increase was primarily due to a $2.0 million increase in commissions attributable to a higher overall commissions rate due to an increase in first year premium, reduced reinsurance allowances of $3.2 million due to expected lapsation of closed blocks of reinsured business, and an increase in regulatory fees due to routine regulatory exams in 2005 at both of our major insurance companies. The increases were partially offset by the following:
a decrease in fees charged by third party administrators for claims processing and other administrative services due to a decline in medical business in force.
As a percentage of premium, selling, general and administrative expenses were 30.8% in 2005 compared to 31.3% in 2004, including the California litigation settlements.
The net (deferral) amortization and change in deferred acquisition costs (DAC) and value of business acquired (VOBA) resulted in a net deferral of $5.2 million for 2005, compared to net amortization of $4.6 million for 2004. In the Senior segment, the DAC asset increased by $9.0 million in 2005 compared to $5.4 million in 2004. The increase was primarily due to a higher level of costs capitalized due to an increase in Medicare supplement business and a decrease in DAC amortization on our long-term care business due to higher 2005 rate levels and persistency. In addition, the amortization of VOBA decreased $1.4 million for 2005 compared to 2004 related to a slowdown in
amortization on our universal life block of business due to improving mortality and an increase in expected future gross profits. The decline in the DAC asset in the Medical segment was $3.1 million in 2005 compared to $7.7 million in 2004. Higher lapse rates on new and existing medical business caused a higher-than-expected increase in the level of DAC amortization in 2004. In addition, new sales in the Medical segment increased 35% over 2004 levels.
Net income was $15.0 million, or $0.44 per diluted share, for 2005, compared to $19.1 million, or $0.55 per diluted share, for 2004.
However, new business production increased in 2004, compared to the same period in 2003, partially offsetting the higher than anticipated lapse rates. We had planned to continue to focus sales in a select number of geographic locations which had historically produced favorable underwriting results. From the third quarter to the fourth quarter of 2004, the decline in major medical premium moderated to approximately 1.8% (or approximately 7% on an annualized basis), as the increased level of new business production approached the level of renewal business which was lapsing. The decline in major medical premium was expected to moderate to approximately 5% on an annualized basis in 2005.
Net investment income was $25.4 million for 2004, compared to $25.1 million for 2003, an increase of 1.3%. This increase was the result of an increase in average invested assets due to the investment of most of the proceeds from the sale of Pyramid Life on March 31, 2003 and the assumption of a related block of life business with approximately $12.1 million in invested assets. The book yield of our available-for-sale investment portfolio at December 31, 2004 was 5.34% compared to a book yield of 5.39% at December 31, 2003.
Net realized gains decreased to $1.2 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, which were partially offset by $0.8 million in realized gains on our trading portfolios in 2004.
Medical benefits, claims, losses and settlement expenses were $176.1 million for 2004, compared to $226.2 million for 2003, a decrease of 22.1%. The decrease was primarily the result of a smaller volume of business in force due to the reduction in medical business as a result of higher than anticipated lapse rates. In
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 against the Company and its subsidiaries. These lawsuits related primarily to challenges to premium increases for California holders of major medical policies issued by United Benefit Life and Provident American Life. 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 pre-tax 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.
The net amortization and change in acquisition costs (DAC) and value of business acquired (VOBA) resulted in net amortization of $4.6 million for 2004, compared to net amortization of $6.0 million for 2003. In the Senior segment, a net deferral of $3.3 million was recorded for 2004 compared to net amortization of $1.2 million for 2003. In 2004, the level of costs capitalized increased due to higher levels of Medicare supplement new business production. In the Medical segment, net amortization was $7.9 million for 2004 compared to $4.8 million in 2003. The $3.1 million increase in the net amortization was due to higher assumed lapsed rates on existing business which caused an increase in the level of DAC amortization in the first quarter of 2004. The rate of decline on the DAC asset in the Medical segment moderated in the balance of the year.
Interest expense and financing costs decreased to $0.7 million in 2004, compared to $1.6 million in 2003, as a result of a decrease in outstanding debt and a decrease in the amortization of deferred debt costs in 2004 as compared to 2003. The early pay-off of our former credit agreement resulted in the immediate amortization of the capitalized loan fees relating to that debt, causing additional interest expense of $0.3 million in 2003.
A federal income tax expense of $2.8 million was recorded for 2004, which included a $5.0 million reduction to the deferred tax valuation allowance. As a result of our continued profitability, a projection of continued taxable income in future periods, and the corresponding utilization of a portion of the net operating 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 had 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.
Income from continuing operations was $19.1 million, or $0.55 per share, for 2004, compared to $19.4 million, or $0.56 per share for 2003. Income from the discontinued operations of Pyramid Life for 2003 was $3.6 million, or $0.11 per share (which included $3.9 million of net realized investment gains, $1.9 million of operating income and an additional loss on the sale of $2.2 million). For 2004, net income was $19.1 million, or $0.55 per share, compared to $22.9 million, or $0.67 per share, for 2003, which included $3.6 million, or $0.11 per share, from Pyramid Life.
Liquidity is our ability to generate adequate amounts of cash to meet our financial commitments. Our major needs for cash are to enable our insurance subsidiaries to pay claims and expenses as they come due and for Ceres to pay interest on, and to repay principal of, its indebtedness. The primary sources of cash are premiums, investment income, fee income, equity and debt financings, and reimbursements from reinsurers. Payments consist of current claim payments to insureds, medical cost management expenses, and operating expenses such as salaries, employee benefits, commissions, taxes, and interest on debts. Net cash provided by operating activities in 2005 was $40.5 million compared to net cash used in operating activities of $15.4 million in 2004. The increase was primarily the result of the following:
Assets increased 0.7% to $771.0 million at December 31, 2005 from $766.0 million at December 31, 2004. Assets of $488.9 million, or 63.4% of the total assets, were in investments at December 31, 2005. Fixed maturities, our primary investment, were $447.5 million, or 91.5% of total investments, at December 31, 2005. Other investments consist of equity securities, an investment in a limited partnership, policy loans, and mortgage loans. During the second quarter of 2005, we invested approximately $20.0 million in a collateralized securities fund which invests in asset-backed and mortgage-backed securities. This fund invests a minimum of 80% of its total assets in investment-grade securities. The shares in the fund are classified as equity securities available-for-sale at December 31, 2005.
The total reinsurance receivable was $131.2 million at December 31, 2005. Of this amount, $127.2 million represents reserves held by our reinsurers under our various reinsurance treaties in place. Hannover holds substantially all of these reserves.
Contractual Obligations. The following schedule summarizes current and future contractual obligations as of December 31, 2005:
The interest associated with our variable-rate term loans is based upon interest rates in effect at December 31, 2005. The contractual amounts to be paid on variable-rate obligations are affected by changes in market interest rates. Future changes in market interest rates could materially affect the contractual amounts to be paid.
In addition, we committed to invest $5.0 million in the aggregate, in two commercial mortgage loan trusts in 2005. At December 31, 2005, we had outstanding unfunded commitments totaling $2.0 million related to these commercial mortgage loan trusts.
Dividends from our regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. On February 24, 2005, Central Reserve received approval from the Ohio Department of Insurance to pay an extraordinary dividend of up to $12.0 million to Ceres Group, the parent company. On May 4, 2005, Central Reserve paid Ceres a dividend of $10.0 million, which was used for the stock repurchase program. On December 30, 2005, Continental General paid Ceres a dividend of $7.0 million. In 2006, Continental General could pay a dividend to Ceres of up to $6.2 million without prior approval of its state regulator. However, in 2006, Central Reserve would be prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus.
The following table presents the revenues, expenses, and profit (loss) from continuing operations before federal income taxes, for the last three years attributable to our industry segments. Investment income is allocated by segment based on the level of policy liabilities and benefits accrued and allocated capital. We assume that the longer duration, higher yielding investments support the life, annuity and long-term care blocks of business. The remaining investments, which tend to be shorter in duration, support the major medical and Medicare supplement blocks of business. We do not separately allocate assets or income tax expenses (benefits) by industry segment. Revenues from each segment are primarily generated from premiums charged to external policyholders and interest earned on cash and investments.
The following table presents net premiums by major product line for the years ended December 31, 2005, 2004 and 2003:
Notes to Consolidated Financial Statements for the years ended December 31, 2005, 2004 and 2003
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, 2005 and 2004, and the results of its operations and its cash flows for each of the years in the three year period ended December 31, 2005, 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.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Ceres Group, Inc. as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three year period ended December 31, 2005, and our report dated March 16, 2006 expressed an unqualified opinion on those consolidated financial statements.
For further information, see Note D. Discontinued Operations to our audited consolidated financial statements.
Ceres Group, Inc. (formerly known as Central Reserve Life Corporation) operated in 1998 and prior periods primarily through its wholly-owned subsidiary, Central Reserve Life Insurance Company. As of December 31, 2005, 2004 and 2003, the Company’s consolidated statements also include the continuing operations of Provident American Life & Health Insurance Company acquired on December 31, 1998, Continental General Corporation and its wholly-owned subsidiary, Continental General Insurance Company, acquired on February 17, 1999, United Benefit Life Insurance Company under a reinsurance arrangement effective August 1, 1998 and acquired on July 21, 1999 (through foreclosure), and the discontinued operations of Pyramid Life Insurance Company acquired on July 26, 2000. 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 before transaction costs of $2.2 million. See Note D. Discontinued Operations for further information.
We provide, through our insurance subsidiaries, a wide array of health and life insurance products. While our insurance subsidiaries are licensed in 49 states, the District of Columbia, and the U.S. Virgin Islands, approximately 62.5% of our total premium volume is generated from ten states: Ohio, Florida, Pennsylvania, Texas, Indiana, Illinois, Virginia, Kansas, Nebraska, and Michigan.
The accompanying audited consolidated financial statements have been prepared in accordance with U.S generally accepted accounting principles, which differ from accounting practices prescribed or permitted by the various state departments of insurance in which the insurance subsidiaries are domiciled. See Note Q. Statutory Financial Information for further information.
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 and a collateralized securities fund which invests in asset-backed and mortgage-backed securities. 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 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 realized gains.
The investment in the limited partnership is carried on the equity method of accounting. Investments in policy notes and mortgage loans are reported at cost, which approximates fair value. There is no allowance for losses based on the current status of mortgage loans.
our ability and intent to retain the investment for a period of time to allow for a recovery in value;
Certain excess policy acquisition costs associated with issuing an insurance policy, including commissions and underwriting, all of which vary with and are primarily related to the production of new business, have been deferred and reported as deferred acquisition costs. Deferred acquisition costs associated with traditional life and accident and health contracts are charged to expense over the premium-paying period or as premiums are earned over the life of the contract. Deferred acquisition costs associated with interest-sensitive life and annuity products are charged to expense over the estimated duration of the policies in relation to the present value of the estimated gross profits from surrender charges and investments, mortality, and expense margins. The assumptions used to amortize acquisition costs with regard to interest, mortality, morbidity, and persistency are consistent with those used to estimate the liability for future policy benefits. For interest-sensitive and annuity products, these assumptions are reviewed on a regular basis and are revised if actual experience differs significantly from original expectations. Deferred acquisition costs are subject to periodic recoverability and loss recognition testing. These tests ensure that the present value of future contract-related cash flows will support the capitalized deferred acquisition cost asset. These cash flows consist primarily of premium income, less benefits and expenses. The present value of these cash flows, less the benefit reserve, is then compared with the unamortized deferred acquisition cost balance. In the event the estimated present value of net cash flows is less, this deficiency would be charged to expense as a component of amortization and the asset balance is reduced by a like amount. Different assumptions with regard to deferred acquisition costs could produce materially different amounts of amortization.
from 1999 to 2001. The net amortization of these costs began in 2002 and will continue over the remaining life of the Medicare supplement policies. 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% is credited to the unamortized balance for Continental General Corporation. 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 Corporation, which was the market rate at the time of acquisition. If estimated gross profits, gross margins or premiums differ from expectations, the amortization of VOBA is adjusted on a retrospective or prospective basis, as appropriate. Changes in assumptions can have a significant impact on the amount of VOBA reported for all products and their related amortization patterns.
As certain fixed maturities available-for-sale related to our interest-sensitive life insurance products are carried at fair value, an adjustment is made to deferred acquisition costs and the value of business acquired equal to the change in amortization that would have occurred if such securities had been sold at their stated fair value and the proceeds reinvested at current yields. The change in this adjustment is included with the change in fair value of fixed maturity securities available-for-sale, net of tax, that is credited or charged directly to stockholders’ equity and is a component of other comprehensive income. At December 31, 2005, the remaining adjustment to deferred acquisition costs and value of business acquired was minimal. At December 31, 2004, deferred acquisition costs were decreased by $1.0 million and the value of business acquired was also decreased by $1.0 million related to this adjustment.
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 life of the equipment, principally three to seven years.
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 6.125%. We review actual experience with respect to investment yields, mortality, morbidity, and lapses to help insure that existing liabilities, together with the present value of future premiums, will be sufficient to cover the present value of future benefits and maintenance costs and to recover unamortized acquisition costs.
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, 2005, 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. At December 31, 2005, credited rates for deferred annuities ranged from 3.0% to 6.0%.
Liabilities for long-term care disabled life reserves consist of estimates of claims in the course of settlement, case reserves, and IBNR. Claims in the course of settlement represent the amount of payments expected to be owed on existing claims for services received prior to the valuation date but for which benefits have not been paid. Case reserves are calculated for each open case and represent the present value of future benefits expected to be incurred for services subsequent to the valuation date. At December 31, 2005, a discount rate of 6.125% was used to determine the case reserves. Finally, an IBNR reserve is calculated to represent the liability for claims incurred but not reported as of the valuation date.
Comprehensive income in 2005, 2004 and 2003 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.
Life premiums are recognized as revenue when they become due. Accident and 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.
Fee and other income consists of monthly collection, management, and administrative fees, and are recognized when the services are performed.
The following table illustrates the effect on net income and net income per share if we had applied the fair-value-based method and recognition provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS No. 123), to stock-based compensation.
On February 16, 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 155, Accounting for Certain Hybrid Financial Instruments (SFAS 155). SFAS 155 amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 140). SFAS 155 also resolves issues addressed in SFAS No. 133 Implementation Issue No. D1, Application of Statement 133 to Beneficial Interests in Securitized Financial Assets. The following is a summary of SFAS 155: (1) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; (2) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133; (3) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; (4) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; (5) amends SFAS 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective on January 1, 2007, although earlier adoption is permitted as of the beginning of an entity’s fiscal year. We are currently evaluating the impact of the adoption of SFAS 155 on our consolidated results of operations, cash flows and financial position.
In November 2005, the FASB issued Staff Position (FSP) No. FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” (FSP 115-1). FSP 115-1 addresses the determination as to when an investment is considered impaired, whether that impairment is other-than-temporary, and the measurement of the impairment loss. It also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in FSP 115-1 amends SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and was effective January 1, 2006. We do not
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS 154), which replaces Accounting Principles Board (APB) Opinion No. 20, Accounting Changes (APB 20), and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, with earlier adoption permitted. We will apply the provisions of SFAS 154 when applicable in future reporting periods.
In December 2004, the FASB issued SFAS No. 123R (Revised 2004), Share-Based Payment (SFAS 123R), which amends SFAS 123 and supersedes APB 25. SFAS 123R requires that all share-based payment transactions, including grants of employee stock options, be recognized in the Consolidated Statement of Operations based on their fair values. 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. Upon adoption, pro forma disclosures are no longer an alternative. The provisions of SFAS 123R, as amended by the Securities and Exchange Commission, are effective on January 1, 2006 for calendar year companies. We plan to adopt SFAS 123R using the modified prospective transition method effective January 1, 2006. Under the modified prospective transition method, fair value accounting and recognition provisions of SFAS 123R are applied to share-based awards granted or modified subsequent to the date of adoption and prior periods are not restated. In addition, for awards granted prior to the effective date, the unvested portion of the awards shall be recognized in periods subsequent to the adoption based on the grant date fair value determined for recognition or pro forma disclosure purposes under SFAS 123. We do not expect the adoption of SFAS 123R to have a significant impact on our consolidated results of operations, cash flows or financial position.
In July 2003, the AICPA issued SOP 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (SOP 03-1). SOP 03-1 addresses a number of topics, the most significant of which is the accounting for contracts with guaranteed minimum death benefits. SOP 03-1 requires companies to evaluate the significance of guaranteed minimum death benefits to determine whether the contract should be accounted for as an investment or insurance contract. If the contract is determined to be an insurance contract, companies are required to establish a reserve to recognize a portion of the assessment (revenue) that compensates the insurance company for benefits to be provided in future periods. SOP 03-1 also provides guidance on separate account presentation, interest in separate accounts, gains and losses on the transfer of
assets from the general account to a separate account, liability valuation, return based on a contractually referenced pool of assets or index, annuitization options and sales inducements to contract holders. The effective date of SOP 03-1 was for fiscal years beginning after December 15, 2003, with earlier adoption encouraged. We adopted SOP 03-1 on January 1, 2004. The adoption of SOP 03-1 did not have a significant impact on our consolidated results of operations, cash flows or financial position.
At December 31, 2005 and 2004, our insurance subsidiaries had certificates of deposit, money market funds and fixed maturity securities with a carrying value of $25.4 million and $25.8 million, respectively, on deposit with various state insurance departments to satisfy regulatory requirements.
Other property and equipment consists principally of software, leasehold improvements, and office equipment. Depreciation expense for the years ended December 31, 2005, 2004 and 2003 was $1.0 million, $1.2 million, and $1.5 million, respectively.
Goodwill represents the excess of purchase price over the fair value of tangible and identifiable intangible net assets acquired. At December 31, 2005, goodwill was $10.7 million, all of which related to the Senior and Other segment which, is identified as the reporting unit, and represented approximately 1.4% of our total assets. Additionally, other intangible assets represent purchased assets that also lack physical substance, but can be distinguished from goodwill because of other legal rights or because the assets are capable of being sold or exchanged either on its own or in combination with a related contract asset or liability. At December 31, 2005, our other intangible assets consisted of $3.4 million in licenses, which represented 0.4% of our total assets.
We file a consolidated federal income tax return with our subsidiaries. In 2005, Continental General will be included in the consolidated filing for the first time since its acquisition on February 17, 1999.
At December 31, 2005, we had a tax net operating loss carryforward, or NOL, of approximately $1.6 million for federal income tax purposes, which expires through 2021.
In 2004, we determined 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 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 of the Medical segment.
Prior to 1984, the Life Insurance Company Income Tax Act of 1959, as amended by the Deficit Reduction Act of 1984 (DRA), permitted the deferral from taxation of a portion of statutory income under certain circumstances. In these situations, the deferred income was accumulated in the Policyholders’ Surplus Account (PSA). On January 1, 1984 the balance of the PSA was fixed and only subject to taxation in the event amounts in the PSA were distributed to shareholders, or if the balance of the account exceeded certain limitations prescribed by the IRS. On October 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004. Included among the various provisions of the Act was a two-year suspension of the taxation on distributions of amounts from a company’s PSA and reordering rules for current distributions. At December 31, 2004, the accumulated untaxed PSA balance at Central Reserve was $2.9 million.
During the third quarter of 2005, the IRS concluded the 2003 audit for all companies except Continental General. Accordingly, we reduced our tax reserves due to elimination of tax contingencies associated with the closed tax years and recognized a federal income tax benefit of $0.8 million in 2005.
The foregoing indicates that a $0.4 million redundancy in the 2004 reserves emerged in 2005 primarily due to a lower level of severity on fourth quarter 2004 major medical incurreds partially offset by a deficiency in long-term care reserves. In 2004, a $19.6 million redundancy in the 2003 reserves emerged 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 the moderation of the higher than expected medical claim trend experienced in 2002 related to 2001 reserves and improvement in long-term care actual claim experience.
In December 2000, Central Reserve entered into a reinsurance transaction with Lincoln National Reassurance Company, or Lincoln, for a ceding allowance of $4,000,000. The policies reinsured, on a combined coinsurance and modified coinsurance basis, were 80% of all group term life insurance and 35% of all individual deferred annuities in force on and after December 31, 2000. The ceding allowance was accounted for as a deferred reinsurance gain in the accompanying audited consolidated financial statements and was amortized into income based upon the
Our insurance companies remain obligated for amounts ceded in the event that the reinsurers do not meet their obligations. Initial ceding allowances received from reinsurers are accounted for as deferred reinsurance gain and are amortized into income over the estimated remaining life of the underlying policies reinsured, except for interest sensitive products that are amortized over the expected profit stream of the in force business. The above table does not include the amortization of initial ceding allowances received from reinsurers. Amortization of deferred reinsurance gain for the years ended December 31, 2005, 2004 and 2003 was $1.0 million, $1.5 million, and $1.7 million, respectively.
A California lawsuit was filed against United Benefit Life, Central Reserve, Ceres, the American Association for Consumer Benefits (AACB), and Does 1 through 100 inclusive in the Superior Court for San Luis Obispo County, California (Case No.: CV 020275, filed April 2002) by Annelie and Joseph Purdy, on behalf of themselves and all others similarly situated, seeking class action certification on behalf of individuals in California who purchased group health insurance from United Benefit Life through the AACB. Plaintiffs alleged causes of action for breach of contract, bad faith, violations of California’s Unfair Competition Law and fraud in the inception. Plaintiffs sought unspecified damages, including the return of premium rate increases during the relevant period of time. Plaintiffs’ motion for statewide class certification was granted in November 2003 and the case was scheduled to go to trial in January 2005. The plaintiffs also filed an action against Provident American Life containing somewhat similar allegations. On September 15, 2004, we announced that we had agreed to settle these lawsuits. The settlements contemplated payments to class members and others, as well as certain attorneys’ fees and costs. In 2004, we recorded (in selling, general and administrative expenses) a pre-tax charge of $3.1 million ($2.0 million after-tax). All of the settlements were paid in 2005 and did not materially exceed that amount. These California litigation settlements did not involve any admission of wrongdoing by the Company or any subsidiary.
At December 31, 2004, our credit facility consisted of a $4.0 million term loan A with National City Bank and a $9.0 million term loan B with CIT Group. The term loan A had quarterly principal payments of $250,000 through December 2005, $375,000 through December 2006, and a payment of $500,000 on March 1, 2007. The $9.0 million term loan B with CIT Group had quarterly principal payments of $312,500 through December 2004, $375,000 through December 2006, $562,500 through December 2007, and $1,250,000 through June 2008.
Acknowledged that CIT Group had assigned to National City all of its rights, and National City had assumed all of the obligations of CIT Group, under the credit agreement and the term loan B;
On September 8, 2005, we purchased, in a private transaction, 1,000,000 shares of our common stock for $5.9 million from International Managed Care funds (IMC). Two of our directors, Robert A. Spass and Bradley E. Cooper, are affiliated with the IMC funds. The purchase price of $5.92 per share represented a discount of 3% to the average closing price of Ceres’ stock for the five trading days ended August 31, 2005 and a discount of 5% from the closing price of the common stock on August 31, 2005. There were no commissions paid on this transaction. We completed the authorized $10 million stock repurchase program in October 2005.
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, 2005, there were options outstanding under the plan to purchase 78,706 shares.
As required by SFAS No. 123, Accounting for Stock-Based Compensation, we have estimated the pro forma impact on net income and earnings per share of stock-based compensation under the fair value method, using the Black-Scholes option valuation model.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our employee stock options.
We also have authorized 100,000 Convertible Voting Preferred Shares, $.001 par value, of which none were outstanding at December 31, 2005.
Statutory accounting practices prescribed or permitted by regulatory authorities for our insurance subsidiaries differ from generally accepted accounting principles. Shareholders’ equity and net income, as determined in accordance with statutory accounting practices (as filed with respective state insurance departments), for our consolidated insurance subsidiaries are summarized as follows:
The consolidated statutory net gain for the year ended December 31, 2003 includes $31.0 million from the sale of Pyramid Life and $0.7 million in statutory earnings from Pyramid Life 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.
Generally, the capital and surplus of our insurance subsidiaries available for transfer to the parent company are limited to the amounts that the insurance subsidiaries’ capital and surplus, as determined in accordance with statutory accounting practices, exceed minimum statutory capital requirements. However, payments of the amounts as dividends may be subject to approval by regulatory authorities. On February 24, 2005, Central Reserve received approval from the Ohio Department of Insurance to pay an extraordinary dividend of up to $12.0 million to Ceres Group, the parent company. On May 4, 2005, Central Reserve paid Ceres a dividend of $10.0 million, which was used for the stock repurchase program. On December 30, 2005, Continental General paid Ceres a dividend of $7.0 million. In 2006, Continental General could pay a dividend to Ceres of up to $6.2 million without prior approval of its state regulator. However, in 2006, Central Reserve would be prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus.
Basic and diluted net income per share is calculated in accordance with SFAS No. 128, Earnings per Share. Basic net income per common share is computed by dividing net income by the weighted average number of shares outstanding during the period. Diluted net income per common share is computed by dividing net income by the weighted average number of shares outstanding during the period including the effect of the assumed exercise of dilutive stock options and warrants under the treasury stock method.
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 2005, 2004 and 2003 plan years, respectively.
The following table presents the revenues, expenses and profit (loss) from continuing operations before federal income taxes, for the last three years attributable to our industry segments. Investment income is allocated by segment based on the level of policy liabilities and benefits accrued and allocated capital. We assume that the longer duration, higher yielding investments support the life, annuity and long-term care blocks of business. The remaining investments, which tend to be shorter in duration, support the major medical and Medicare supplement blocks of business. We do not separately allocate assets or income tax expenses (benefits) by industry segment. Revenues from each segment are primarily generated from premiums charged to external policyholders and interest earned on cash and investments.
Annuity contracts - The fair value for the annuity reserves included in the liability for future policy benefits, losses, and claims is the amount payable on demand.
Other policyholders’ funds - The carrying amount reported in the consolidated balance sheets for these instruments approximate their fair value.
Debt - The carrying amounts reported in the consolidated balance sheets for the long-term debt approximates their fair value.
Carrying amounts and estimated fair values of financial instruments at December 31, 2005 and 2004 are summarized as follows: