The following selected consolidated statement of operations data and balance sheet data as of and for the years ended December 31, 1998, 1999, 2000, 2001 and 2002 have been derived from our Consolidated GAAP Financial Statements.
(1) Effective December 31, 2001, we entered into a reinsurance agreement for substantially all of our long-term care insurance policies, which we are accounting for as deposit accounting. The reinsurer maintains a notional experience account for our benefit in the event of commutation. The notional experience account receives an investment credit, derived from the separate components of the notional experience account. This gain represents the income from the embedded derivative portion of our notional experience account, similar to that of an unrealized gain or loss on a bond.
(2) During the third quarter of 2002, we determined to refine certain of our processes and assumptions in the establishment of our reserves for current claims. As a result of this change, we increased our reserves for current claims by approximately $83,000. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
(3) Effective September 10, 2001, we discontinued the sale, nationally, of all new long-term care insurance policies until our Corrective ActionPlan was completed and approved by the Pennsylvania Insurance Department. As a result, there was a substantial reduction in the deferral of costs associated with new policy issuance, while we continued to amortize existing deferred acquisition costs.
(4) Our reinsurance agreement requires us to accrue an annual expense and risk charge to the reinsurer. Primarily as a result of these anticipated charges, we impaired the value of our net unamortized policy acquisition costs by $61,800 in 2001. In the third quarter of 2002, we impaired the value of our deferred acquisition cost asset by approximately $1,100 as a result of the change in our assumptions regarding the future profitability of our existing business in force. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations."
(5) As a result of our December 31, 2001 reinsurance agreement with a foreign reinsurer, we must pay Federal excise tax of 1% on all ceded premium. The 2001 expense represents excise taxes due for premiums transferred at the inception of the contract. Beginning in 2002, we also accrue an annual expense and risk charge payable to the reinsurer in the event of future commutation of the agreement.
(6) During 1999, we discontinued the implementation of a new computer system, for which we had previously capitalized $2,799 of licensing, consulting and software costs. When we decided not to use this system, its value became fully impaired. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
(7) Excludes $5,151 impairment charge of goodwill from the adoption of SFAS Nos. 141 and 142, which was recorded as a cumulative effect from accounting change. In 2002, in accordance with SFAS No. 142, we determined that the goodwill associated with our insurance subsidiaries was impaired and recognized an impairment loss of $5,151, net of related tax effect, which we recorded as a cumulative effect of change in accounting principle.
(8) As a result of the adoption of SFAS No. 142 in 2002, we discontinued the amortization of goodwill. We have provided a comparison of results to 2002 for the fiscal periods 1999, 2000 and 2001 that reflects the impact of this accounting change in prior periods as though the SFAS No. 142 had been adopted at that time. Net income would have been increased in each adjusted period by $655, $853, $853 and $640, respectively.
(10) Diluted shares outstanding includes shares issuable upon the conversion of our existing convertible debt and exercise of options outstanding, except in 2001 and 2002, for which the inclusion of such shares would be anti-dilutive. The inclusion of converted shares from the our Convertible Subordinated Notes due 2008 is expected to produce significant dilution in earnings per share in future periods.
(12) We measure our combined ratio as the total of all expenses, including benefits to policyholders, related to policies in-force divided by premium revenue. This ratio provides an indication of the portion of premium revenue that is devoted to the coverage of policyholder related expenses. We depend on our investment returns to offset the amounts by which our combined ratio is greater than 100%. In 2001, reduced premium revenue, the impairment of our DAC asset in the fourth quarter (see note 4) and the payment of excise taxes on the initial premium for our new reinsurance agreement (see note 5) increased our combined ratio above what it otherwise would have been. For 2002, see note 2.
(13) Return on equity, which is the ratio of net income or losses to average shareholders' equity, measures the current period return provided to shareholders on invested equity. New or existing shareholders could be dissuaded from future investment in our common stock and may choose to sell their common stock if they are not satisfied with our return on equity.
(14) As a result of our reinsurance agreement, which was effective December 31, 2001, we transferred substantially all of our investable assets to the reinsurer.
(15) Under statutory accounting principles, ceded reserves are accounted for as offsetting negative benefits and negative premium. Our 2002, 2001 and 2000 premium is reduced by approximately $326,000, $408,000 and $226,000, respectively from reinsurance transactions.
Our unaudited quarterly data for each quarter of 2002 and 2001 have been derived from unaudited financial statements and include all adjustments, consisting only of normal recurring accruals, which we consider necessary for a fair presentation of the results of operations for these periods. Such quarterly operating results are not necessarily indicative of our future results of operations.
o Changes in the estimate or different estimated amounts that could have been selected could have a material impact on our results of operations or financial condition.
Our policies are accounted for as long duration policies. As a result there are two components to the liabilities associated with our policies. The first is a liability for future policyholder benefits, represented by the present value of future benefits less future premium collections. In calculating these reserves we utilize assumptions, including estimates for persistency, morbidity (claims expectations), mortality, interest rates, and premium rate increases. These assumptions are estimated in the year a policy is issued. Once the assumptions are established we continue to utilize those assumptions unless our assessment of deferred acquisition costs indicates that the present value of anticipated future premiums less future costs plus current reserves is less than current unamortized DAC. Any variance from the assumptions established in the year a policy is issued could have a material impact on our results of operations and financial condition.
As part of our monitoring of policy and contract claims we compare actual results to our expectations. Any deviations from our expectations are recorded in the year in which the deviation occurs. During 2002 we increased our policy and contract claim reserves by $83,000 based on new assumptions that have been applied to both claims incurred during 2002 and to claims incurred prior to 2002. Any changes in our estimates in the future may have a material impact on our financial condition and results of operations.
The DAC recoverability analysis includes assumptions for persistency, morbidity (claims expectations), interest rates, and premium rate increases. The recoverability of our DAC is dependent upon the assumption of future rate increases.
We recognize an estimated loss for contingencies when we believe it is probable that a loss has occurred and the amount of loss can be reasonably estimated. However, it is difficult to measure the actual loss that might be incurred related to litigation and contingency matters. As time passes and additional facts and circumstances become known, our estimation of the probability of loss as well as our ability to reasonably estimate a loss will change. The ultimate outcome of litigation and other contingencies could have a material adverse impact on our results of operations and financial position in the future.
As a result of our intention to commute on December 31, 2007, we assessed only estimated expense and risk charges prior to December 31, 2007 in our most recent DAC recoverability analyses. We have not included any of the escalating expense and risk charges beyond December 31, 2007. In addition, as part of the consideration for the agreement, we provided the reinsurer with warrants valued at approximately $15,855. This consideration is being recognized over the anticipated life of the contract.
In the event we determine that commutation of the reinsurance contract is unlikely on December 31, 2007, but likely at some future date, we would include the additional annual expense and risk charges in our DAC recoverability analysis. This would most likely result in an additional impairment of our DAC. The amount of the impairment would be dependent on the number of additional years beyond December 31, 2007 until commutation as well as our best estimate of the other assumptions utilized in the DAC impairment calculation (morbidity, mortality, interest rates, premium rate increases, and withdrawls) at the date the analysis is performed.
Our 2001 Centre reinsurance agreement includes a provision for the maintenance of an experience account for our benefit in the event we elect to, and are able to, commute the reinsurance agreement in the future. The experience account balances was $708,982 as of December 31, 2002. We receive a return on the experience account that is based on a series on benchmark indices and derivative hedges. The benchmark indices are comprised on US Treasury strips, agencies, and investment grade corporate bonds with weightings of approximately 25%, 15% and 60%, respectively and a duration of approximately 11 years.
We believe the return on the notional experience account represents a hybrid instrument, containing both a fixed debt host and an embedded derivative, as defined in Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133). In accordance with SFAS 133, we are accounting for the investment return on the experience account as follows:
Our principal products are individual, defined benefit accident and health insurance policies that consist of nursing home care, home health care, Medicare supplement, life and long-term disability insurance. We experienced significant reductions in new premium sales during 2001 and 2002 due to the cessation of new business generation in all states and as a result of market concerns regarding our insurance subsidiaries' statutory surplus. Under our Corrective Action Plan ("the Plan"), which was approved by the Pennsylvania Insurance Department ("the Department") in February 2002, we recommenced sales in certain states, but intend to limit new business growth to levels that will allow us to maintain sufficient statutory surplus. Our underwriting practices rely upon the base of experience that we have developed in over 30 years of providing nursing home care insurance, as well as upon available industry and actuarial information. As the home health care market has developed, we have encouraged our customers to purchase both nursing home and home health care coverage, thus providing our policyholders with enhanced protection and broadening our policy base.
Our insurance subsidiaries are subject to the insurance laws and regulations of the states in which they are licensed to write insurance. These laws and regulations govern matters such as payment of dividends, settlement of claims, and loss ratios. State regulatory authorities must approve premiums charged for insurance products. In addition, our insurance subsidiaries are required to establish and maintain reserves with respect to reported and incurred but not reported claims, as well as estimated future benefits payable under our insurance policies. These reserves must, at a minimum, comply with mandated standards. Our reserves are certified annually by our consulting actuary as to standards required by the insurance departments for our domiciliary state and for the other states in which we conduct business. We believe we maintained adequate reserves as mandated by each state in which we are currently writing business at December 31, 2002.
Deferred policy 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 all expenses that are directly related to, and vary with, the acquisition of the policy, including commissions, underwriting and other policy issue expenses. The amortization of deferred policy acquisition costs ("DAC") is determined using the same projected actuarial assumptions used in computing policy reserves. DAC can be affected by unanticipated terminations of policies because, upon such terminations, we are required to expense fully the DAC associated with the terminated policies. In addition, the assumptions underlying DAC and our policy benefit reserves are periodically reviewed and updated to reflect current assumptions. Whenever we determine that our DAC is not fully recoverable, we impair the carrying value of our DAC through an expense to our consolidated statement of operations and comprehensive income.
Investment income and experience account. Our investment portfolio, excluding our notional experience account, consists primarily of investment grade fixed income securities. Income generated from this portfolio is largely dependent upon prevailing levels of interest rates. Due to the duration of our investments (approximately 3.1 years), investment income does not immediately reflect changes in market interest rates.
1. The fixed debt host yields a fixed return based upon the yield to maturity of the underlying benchmark indices. The return on the fixed debt host is reported as investment income in the Statement of Operations.
2. The change in fair value of the embedded derivative represents the percentage change in the underlying indices applied to the notional experience account, similar to that of an unrealized gain/loss on a bond. The change in the fair value of the embedded derivative is reported as market gain on experience account in the Statement of Operations.
As a result, our results of operations are subject to significant volatility. Recorded market value gains or losses, although recognized in current earnings, are expected to be offset in future periods from the receipt of the most recent market rates for all subsequent periods. The benchmark indices are comprised of U.S. Treasury strips, agencies and investment grade corporate bonds, with weightings of approximately 25%, 15% and 60%, respectively, and have a duration of approximately 11 years.
Policies renew or lapse for a variety of reasons. We believe that our efforts to address policyholder concerns or questions help to ensure policy renewals. We work closely with our licensed agents, who play an integral role in policy persistency and policyholder communication.
Economic cycles can influence a policyholder's ability to continue the payment of insurance premiums when due. We believe that publicity regarding newly enacted Federal and state tax legislation allowing medical deductions for certain long-term care insurance premiums has raised public awareness of the escalating costs of long-term care and the value provided to the consumer of long-term care insurance. The ratings assigned to our insurance subsidiaries by independent rating agencies also influence consumer decisions.
Lapsation and persistency can both positively and adversely affect future earnings. Reduced lapsation and higher persistency generally result in higher renewal premiums and lower amortization of deferred acquisition costs, but may lead to increased claims in future periods. Higher lapsation can result in reduced premium collection, a greater percentage of higher-risk policyholders, and accelerated expensing of deferred acquisition costs. However, higher lapsation may also lead to decreased claims in future periods.
Twelve Months Ended December 31, 2002 and 2001 (amounts in thousands)
Total first year premiums earned in the 2002 period decreased 85.5% to $6,436, compared to $44,539 in the 2001 period. First year long-term care premiums earned in the 2002 period decreased 86.9% to $5,501, compared to $42,135 in the 2001 period. We experienced significant reductions in new premium sales due to the cessation of new business generation in all states and due to continued market concerns regarding our insurance subsidiaries' statutory surplus. Under our Plan, which was approved by the Department in the first quarter 2002, we recommenced sales in certain states, but intend to limit new business growth to levels that will allow us to maintain sufficient statutory surplus. See "Liquidity and Capital Resources."
Net realized capital gains and trading account activity. During the 2002 period, we recognized capital gains of $15,663, compared to capital losses of $4,367 in the 2001 period. We accounted for the transfer of the securities portion of the initial premium payment for our new reinsurance agreement as a sale of these assets. Substantially all of the recognized capital gains in the 2002 period resulted from the transfer of the initial premium of approximately $563,000 to the reinsurer. The results in the 2001 period were recorded primarily due to the impairment of all unrealized losses in our investment portfolio as other than temporary declines. This determination resulted from our decision to transfer substantially all of our investable assets to the reinsurer, which would prevent the future recovery of these unrealized losses.
Market gain (loss) on experience account. We recorded a market gain on our experience account balance of $56,555 in the 2002 period.
Financial Statements: Consolidated Balance Sheets as of December 31, 2002 and 2001
Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 2002, 2001 and 2000
To the Board of Directors and Shareholders of Penn Treaty American Corporation Allentown, Pennsylvania
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities and the reported amounts of revenues and expenses. Actual results could differ from those estimates.
The Company sells accident and health, life and disability insurance through its wholly owned subsidiaries. The Company's principal lines of business are long-term care products and home health care products. The Company distributes its products principally through independent agents and managing general agents. The Company operates its home office in Allentown, Pennsylvania, and has satellite offices in Michigan and New York, whose principal functions include marketing and underwriting new business.
The Company is licensed in all states and receives renewal premiums from policyholders, but is currently restricted from issuing new policies in 16 states. The Company recently agreed upon terms for the recommencement of sales in California, subject to certain conditions. California has historically represented approximately 15% of the Company's premium. The Company is approved for sales in Florida and Pennsylvania (subject to Corrective Action Plans), which accounted for 18% and 12%, respectively, of the Company's premiums for the year ended December 31, 2002. No other state's sales accounted for more than 10% of the Company's premiums for the year ended December 31, 2002.
Management categorizes its investment securities as available for sale since they may be sold in response to changes in interest rates, prepayments and similar factors. Investments in this classification are reported at the current market value with net unrealized gains or losses, net of the applicable deferred income tax effect, being added to or deducted from the Company's total shareholders' equity on the balance sheet.
Effective January 1, 2001, in accordance with Statement of Financial Accounting Standard No. 133 "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"), the Company transferred its convertible bond portfolio, which contained embedded derivatives, from the available for sale category of investments to the trading category. Realized gains and losses and changes in unrealized gains and losses for the trading portfolio were recorded in current operations. The unrealized loss at the time of the transfer was $1,064. During 2001, the Company sold its entire convertible bond portfolio.
The Company is subject to interest rate risk to the extent that its investment portfolio cash flows are not matched to its insurance liabilities. Management believes it manages this risk through monitoring cash flows and actuarial assumptions regarding the timing of future insurance liabilities. Management further believes that, while not currently under its direction, the benchmark indices supporting the total return of its experience account asset are appropriately matched to the duration of its ceded reserve liabilities.
The costs primarily related to and varying with the acquisition of new business, principally commissions, underwriting and policy issue expenses, have been deferred. These deferred costs are amortized over the related premium-paying periods utilizing the same projected premium assumptions used in computing reserves for future policy benefits.
During 2001, the Company recognized an impairment of its deferred acquisition costs of approximately $61,800. Effective December 31, 2001, the Company entered into a reinsurance agreement covering substantially all of its long-term care policies (see Note 13). The reinsurance agreement requires the Company to credit an annual expense and risk charge to the experience account maintained as part of the contract. The expense and risk charge will only be paid to the reinsurer in the event the Company commutes the contract. Since the Company plans to commute the contract and also believes it is probable that the contract will be commuted, expense and risk charges have been included as a reduction to the anticipated future profits for purposes of evaluating DAC impairment. This was the primary factor causing the 2001 DAC impairment.
The present value of future profits of ANIC's acquired business is being amortized over the life of the insurance business acquired. During each of the years ended 2001 and 2000, $415 was amortized to expense. Total amortization during 2002 was $1,145 due to approximately 50% of the policies under an assumption reinsurance contract legally transferring title.
At the time of purchase, the acquired ANIC premium in-force was deemed to have a remaining average life of approximately ten years. Although amortization of future profits will normally occur in accordance with actuarial assumptions over the life of the policies, the Company determined to amortize this on a straight-line basis over ten years and regularly monitors the emerging profitability of the acquired business. The Company believes that this approach is not materially different than if an actuarial methodology had been employed. The remaining unamortized carrying amount of future profits at December 31, 2002 and 2001, was $791 and $1,937, respectively.
The Company pays excise taxes related to reinsurance agreements with a foreign reinsurer. The amount recorded each year is equal to one percent of the premiums ceded to the reinsurer. The Company recorded an expense of $2,919 and $5,635 for the years ended Demcmber 31, 2002 and 2001, respectively. No expense was recorded during 2000 because the agreements did not yet exist.
The policy reserve liability is determined using the present value of estimated future policy benefits to be paid to, or on behalf of policyholders, less the present value of estimated future premiums to be collected from policyholders, including anticipated premium rate increases. This liability is accrued as policy reserves and is recognized concurrent with premium revenue. Those estimates are based on assumptions, including estimates of expected investment yield, mortality, morbidity (claims expectations), withdrawals and expenses, applicable at the time insurance contracts are effective. These reserves differ from policy and contract claims, which are recognized when insured events occur. The assumptions utilized to determine the policy reserves are established at year of policy issuance and are "locked in" for the future development of reserves (See "Unamortized Deferred Policy Acquisition Costs").
o the actual in-force amounts for reported life claims and an estimate of incurred but unreported claims; and
The methods for making such estimates and establishing the resulting liabilities are periodically reviewed and updated and any resulting adjustments are reflected in earnings currently.
The Company reviews the recoverability of its deferred acquisition costs on an annual basis, utilizing assumptions for future expected claims, premium rate increases and interest rates. If the Company determines that the future gross profits of its in-force policies are not sufficient to recover its deferred acquisition costs, the Company recognizes a premium deficiency and "unlocks" (or changes) historical assumptions to match current expectations. In 2001, the Company recognized a premium deficiency and unlocked its prior reserve assumptions. These assumptions include interest rates, premium rate increases, shock lapses and anti-selection of policyholder persistence. In 2002, the Company again recognized a premium deficiency due to anticipated investment earnings rate reductions and expected acceleration of, and increase in, the ultimate amount of claim payments, substantially offset by higher premium rate increase assumptions. As a result, the Company unlocked its prior reserve assumptions and employed its new expectations in the establishment of future reserves.
The Company applies deposit accounting for reinsurance agreements that do not meet the risk transfer criteria in SFAS No. 113.
Accounts payable and other liabilities consist primarily of amounts payable to agents, reinsurers and vendors, as well as deferred income items. During 2001, the Company reinsured its disability policies with an unaffiliated insurer, for which it received a ceding commission of approximately $5,000. This deferred ceding commission will be recognized as income over the remaining life of the policies, or when the Company's policy liability is novated through policyholder or state approval, as may be required. The Company recognized income of $2,346 in 2002 and $319 in 2001.
Upon completion of its evaluation, the Company determined that the goodwill associated with the agency purchases was fully recoverable. The deficiency of current market value to book value was attributed to the insurance subsidiary values. As a result, the Company determined that the goodwill associated with its insurance subsidiaries was impaired and recognized an impairment loss of $5,151 from its transitional impairment test of goodwill, which it recorded as a cumulative effect of change in accounting principle. The impairment has been recorded effective January 1, 2002. Management has completed an assessment of other intangible assets and has determined to continue to amortize these assets so as to closely match the future profit emergence from these assets. At December 31, 2002, the Company reclassified its intangible asset for the purchase of an agent's renewal commission stream of $260 from goodwill to other assets on the Company's financial statements.
In August 2001, the FASB issued Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Statement No. 144 supercedes statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, and provides new rules on asset impairment and a single accounting model for long-lived assets to be disposed of. Although retaining many of the fundamental recognition and measurement provisions of Statement No. 121, the new rules significantly change the criteria that would have to be met to classify an asset as held-for-sale. The new rules also supercede the provisions of APB No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and infrequently Occurring Events and Transactions", with regard to reporting the effects of a disposal of a segment of a business and require expected future operating losses from discontinued operations to be displayed in discontinued operations in the period(s) in which the losses are incurred. Statement No. 144 was effective January 1, 2002. This statement did not have a material impact on the Company's consolidated financial statements.
In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure" ("SFAS No. 148") which amends SFAS Statement No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"). The objective of SFAS No. 148 is to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 does not change the provisions of SFAS No. 123 that permit entities to continue to apply the intrinsic value method of Accounting Principles Board Opinion No. 25, " Accounting for Stock Issued to Employees" ("APB No. 25"). In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company continues to maintain its accounting for stock-based compensation in accordance with APB No. 25, but has adopted the disclosure provisions of SFAS No. 148 (See Note 11).
In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51" ( "FIN No. 46" ). FIN No. 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. FIN No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. FIN No. 46 applies to public enterprises as of the beginning of the applicable interim or annual period. FIN No. 46 may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated. The implementation of FIN No. 46 is not expected to have a material impact on the Company's financial statements.
The amortized cost and estimated market values of debt securities at December 31, 2002, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Amortized Estimated Cost Market Value ---- ------------ Due in one year or less $ 3,616 $ 3,723 Due after one year through five years 14,890 15,977 Due after five years through ten years 6,417 6,821 Due after ten years 249 252 Collateralized Mortgage Obligations 1,603 1,681 ------- ------- $26,775 $28,454 ======= =======
Gross proceeds and realized gains and losses on equity securities, including impairment losses for declines deemed other than temporary, were as follows:
At December 31, 2001, the Company entered a reinsurance agreement for which substantially all of its investment portfolio was later ceded as the initial premium for this agreement. As a result of this intended transfer or sale of assets, the Company determined that all gross unrealized losses on its debt and equity securities likely would not be recovered and were therefore deemed to be other than temporary impairments. The Company recognized a loss of $3,867 from this determination. The Company recognized other impairment charges in 2001 of approximately $1,900 due to other than temporary declines. As a result of the transfer of assets to the reinsurer and from other normal investment operations in 2002, the Company recognized net gains of $14,701 from the sale of securities.
Gross unrealized gains and losses pertaining to equity securities were as follows:
Gross Gross Original Unrealized Unrealized Estimated Cost Gains Losses Market Value ---- ----- ------ ------------ 2002 $ - $ - $ - $ - 2001 $ 8,760 $ 1,042 $ - $ 9,802 2000 $ 17,112 $ 1,758 $ (2,374) $ 16,496
2002 2001 2000 ---- ---- ---- Bonds $ 2,289 $ 28,157 $ 25,777 Equity securities - 519 665 Experience account due from reinsurer 38,375 - - Cash and short-term investments 647 3,167 1,751 -------------------------------- Investment income 41,311 31,843 28,193 Investment expense (242) (1,230) (785) -------------------------------- Net investment income $ 41,069 $ 30,613 $ 27,408 ================================
The Company maintains assets in a trust account under a reinsurance agreement with an unaffiliated insurer. The Company is required to hold assets equal to 102% of the reserves, or approximately $11,174 and $7,401 at December 31, 2002 and 2001, respectively, for policies assumed under this agreement. At both December 31, 2002 and 2001, the market value of the assets in trust exceeded the required amount.
o The fixed debt host yields a fixed return based on the yield to maturity of the underlying benchmark indices. The return on the fixed debt host is reported as investment income in the statement of income and comprehensive income.
Policy reserves have been computed principally by the net premium method based upon estimated future investment yield, mortality, morbidity (claims experience), withdrawals and other benefits. Since 2001, the Company has employed a prospective net premium methodology, which incorporates premium rate increases expected to be implemented in the near term in the net premium used to establish policy reserves. The composition of the policy reserves at December 31, 2002 and 2001, and the assumptions pertinent thereto are presented below:
Years of Issue Discount Rate Discount Rate Accident and health 1976 to 1986 5.7% 6.5% 1987 5.7% 6.5% 1988 to 1991 5.7% 6.5% 1992 to 1995 5.7% 6.5% 1996 5.7% 6.5% 1997 to 2000 5.7% 6.5% 2001 5.7% 6.5% 2002 5.3% Annuities and other 1977 to 1983 6.5% & 7.0% 6.5% & 7.0% Ordinary life, individual 1962 to 2002 3.0% to 5.5% 3.0% to 5.5%
The Company establishes reserves for the future payment of all currently incurred claims. The amount of reserves relating to reported and unreported claims incurred is determined by periodically evaluating historical claims experience and statistical information with respect to the probable number and nature of such claims. Claim reserves reflect actual experience through the most recent time period. Claim reserves include current assumptions as to type and duration of care, remaining policy benefits, and interest rates. The Company compares actual experience with estimates and adjusts its reserves on the basis of such comparisons.
As a result of its redefinition of claims and employment of new continuance tables for separate types of claims with longer claim durations, the Company strengthened its policy and contract reserves by approximately $78,000 in 2002 for claims incurred prior to January 1, 2002.
In addition, the Company reduced its assumed discount rate from 6.5% to 5.7% based upon recent investment yields. This change resulted in an increase to reserves of approximately $5,000.
In 2000, the Company added $6,564 for claims incurred in prior years. The Company believes that this increase in reserves for prior year incurred claims of 4.8% did not reflect a material variance from its expectations. However, the Company attributes the variance to the method it employed for determining incurred but not reported claims ("IBNR"). This method sought to project a ratio of incurred claims to earned premium based upon historic experience and current trends. The actual number and type of claims that were ultimately reported to the Company exceeded the amount of IBNR that it had recorded at the original estimated date.
Over time, it may continue to be necessary for the Company to increase or decrease its reserves further as additional experience develops.
Principal repayment of mortgage and other debt obligations are due as follows:
2) Call Protection - the new notes cannot be called or caused by the Company to convert until October 2005.
4) Interest Payment - holders of the new notes are entitled to convert bonds into shares of Company common stock before October 15, 2005, and, in doing so, may elect to receive a discounted amount of interest that they would have otherwise received until that date. The Company may elect to pay this interest in cash or in newly issued shares of common stock. If issued, the stock would be priced at a 10% discount to the then fair market value of traded shares.
Deferred income tax assets and liabilities have been recorded for temporary differences between the reported amounts of assets and liabilities in the accompanying financial statements and those in the Company's income tax return. Management believes the existing net deductible temporary differences are realizable on a more likely than not basis. The sources of these differences and the approximate tax effect are as follows for the years ended December 31:
The Company has net operating loss carryforwards of approximately $7,300 on a tax effected basis, which have been generated by taxable losses at the parent company, and if unused will expire between 2012 and 2022. The parent company's net operating loss carryforwards can be utilized by the Company's insurance subsidiaries subject to the lesser of 35% of the insurance subsidiary taxable income or 33% of the current aggregate carryforward amount. During 2001, the Company established a valuation allowance of $5,775 against these parent company net operating loss carryforwards. In addition, the Company has net operating loss carryforwards of approximately $12,900 on a tax effected basis, which have been generated by taxable losses at the Company's life subsidiaries, and if unused, will expire in 2016.
At December 31, 2002, the accumulated earnings of the Company for Federal income tax purposes included $1,451 of "Policyholders' Surplus", a special memorandum tax account. This memorandum account balance has not been currently taxed, but income taxes computed at then-current rates will become payable if surplus is distributed. Provisions of the Deficit Reduction Act of 1984 do not permit further additions to the "Policyholders' Surplus" account.
(1) The computed federal income tax (benefit) for the year ended December 31, 2002 is calculated by multiplying the statutory rate of 35% by ($43,464), which represents the loss before federal income taxes of $(38,313) plus the cumulative effect of the change in accounting principle of ($5,151).
Total reserves, including policy and contract claims, reported to regulatory authorities were approximately $761,042 and $584,949 less than those recorded for GAAP as of December 31, 2002 and 2001, respectively. This difference is primarily attributable to reinsurance agreements in force as of December 31, 2002 and 2001. For further discussion see Note 13, "Reinsurance".
The differences in statutory net income (loss) compared to GAAP net (loss) income are primarily due to the immediate expensing of acquisition costs, as well as differing reserving methodologies and treatment of reinsurance and deferred income taxes. Due to the differences in expensing of acquisition costs and reserving methodologies, under statutory accounting there is generally a net loss and a corresponding decrease in surplus, referred to as surplus strain, during periods of growth.
Effective December 31, 2001, the Company entered a reinsurance transaction that, according to Pennsylvania insurance regulation, required the reinsurer to provide it with letters of credit in order for the Company to receive statutory reserve and surplus credit from the reinsurance. The letters of credit were dated subsequent to December 31, 2001, as a result of the final closing of the agreement. In addition, the initial premium paid for the reinsurance included investment securities carried at amortized cost on the statutory financial statements, but valued at market value for purposes of the premium transfer. The Pennsylvania Insurance Department permitted the Company to receive credit of $29,000 for the letters of credit, and to accrue the anticipated, yet unknown, gain of $18,000 from the sale of securities at market value, in its statutory financial results for December 31, 2001. The impact of this permitted practice served to increase the statutory surplus of the Company's insurance subsidiaries by approximately $47,000 at December 31, 2001. Had the Company not been granted a permitted practice, its statutory surplus would have been negative. Upon finalization of the reinsurance agreement, transfer of funds and establishment of appropriate Letters of Credit, during 2002, the permitted practices were no longer required.
The Company's insurance subsidiaries are required to hold statutory surplus that is, at a minimum, above a calculated authorized control level at which the Pennsylvania Insurance Department (the "Department") may place its insurance subsidiaries under regulatory control, leading to rehabilitation or liquidation. Insurers are obligated to hold additional statutory surplus above the authorized control level. At December 31, 2000, Penn Treaty, the Company's primary insurance subsidiary, representing 94% of our direct premium, had Total Adjusted Capital at the Regulatory Action level. As a result, it was required to file a Corrective Action Plan (the "Plan") with the insurance commissioner.
In the event the statutory policy and contract claim reserves ultimately exceed the limit of liability established in the reinsurance agreement, either as a result of claim reserve development or reductions in the amount of the reinsurer's limit of liability, the insurance subsidiaries would have to retain any reserve liabilities in excess of the limit of liability, which could have a materially adverse impact upon the insurance subsidiaries' statutory surplus.
The estimation of policy reserves for statutory accounting purposes differs from that utilized in GAAP. For statutory accounting purposes, the assumptions utilized and the methodology applied may be at the discretion of the Department's interpretation of its regulations. As noted above, as part of the Corrective Action Plan, the Pennsylvania Insurance Department has provided the Company with guidelines for establishing its statutory policy reserves. Because the Pennsylvania insurance subsidiaries have limited statutory capital and the 2001 Centre Agreement has a limit of liability, any changes in the Department's interpretation or view of how the Company's insurance subsidiaries determine their statutory policy reserves could have a material adverse impact on the insurance subsidiaries, possibly resulting in regulatory control or liquidation.
States restrict the dividends the Company's insurance subsidiaries are permitted to pay. Dividend payments will depend on profits arising from the business of its insurance company subsidiaries, computed according to statutory formulae. Under the insurance laws of Pennsylvania and New York, where the Company's insurance subsidiaries are domiciled, insurance companies can pay ordinary dividends only out of earned surplus. In addition, under Pennsylvania law, PTNA and ANIC must give the Department at least 30 days' advance notice of any proposed "extraordinary dividend" and cannot pay such a dividend if the Department disapproves the payment during that 30-day period. For purposes of that provision, an extraordinary dividend is a dividend that, together with all other dividends paid during the preceding twelve months, exceeds the greater of 10% of the insurance company's surplus as shown on the company's last annual statement filed with Department or its statutory net income as shown on that annual statement. Statutory earnings are generally lower than earnings reported in accordance with generally accepted accounting principles due to the immediate or accelerated recognition of all costs associated with premium growth and benefit reserves. Additionally, the Plan requires the Department to approve all dividend requests made by Penn Treaty, regardless of normal statutory requirement for allowable dividends. The Company believes that the Department is unlikely to consider any dividend request in the foreseeable future, as a result of PTNA's statutory surplus position. Although not stipulated in the Plan, this requirement is likely to continue until such time as PTNA meets normal statutory requirements, including reported net income and positive cumulative earned surplus.
Under New York law, AINIC must give the New York Insurance Department 30 days' advance notice of any proposed dividend and cannot pay any dividend if the regulator disapproves the payment during that 30-day period. In addition, AINIC must obtain the prior approval of the New York Insurance Department before paying any dividend that, together with all other dividends paid during the preceding twelve months, exceeds the lesser of 10% of the insurance company's surplus as of the preceding December 31 or its adjusted net investment income for the year ended the preceding December 31.
The Company has a 401(k) retirement plan, covering substantially all employees with at least one year of service. Under the plan, participating employees may contribute up to 15% of their annual salary on a pre-tax basis. The Company, under the plan, equally matches employee contributions up to the first 3% of the employee's salary. The Company and employee portion of the plan is vested immediately. The Company's expense related to this 401(k) plan was $239, $167 and $147 for the years ended December 31, 2002, 2001 and 2000, respectively. The Company may elect to make a discretionary contribution to the plan, which will be contributed proportionately to each eligible employee. The Company did not make a discretionary contribution in 2002, 2001 or 2000.
At December 31, 2002, the Company had three stock-based compensation plans, which are described below. For 2000, and for certain options granted in 2001 and 2002, the Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"), and applies APB Opinion No. 25 "Accounting for Stock Issued to Employees," ("APB Opinion No. 25") and related Interpretations in accounting for its plans. While the Company continues to maintain its accounting for stock-based compensation in accordance with APB Opinion No. 25, it has adopted the disclosure provisions of SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure ( "SFAS No. 148" ), which amends SFAS No. 123. Accordingly, the Company is not required to recognize compensation expense when the exercise price is equal to, or greater than, the fair market value at the date of grant.
During 2001, the Company granted 566 replacement options to its employees for all existing options granted under its existing fixed option plans. As a result, these options are now subject to the variable accounting provisions of APB Opinion No. 25 until exercised, forfeited or cancelled. The Company recorded a compensation contra-expense and expense of $430 in 2002 and 2001, respectively, related to these variable options, representing the intrinsic value of the stock options at the reporting date to the extent the fair value exceeded the exercise price of the employee options at the grant date. In addition, 30 options were granted to a new senior executive in 2001 and 4 were granted to another new executive in 2002.
Compensation cost is estimated using an option-pricing model with the following assumptions for new options granted to employees in 2002, 2001 and 2000. In 2002, options were valued with an expected life of 5.3 years, volatility of 70.9% and a risk free rate of 4.4%. The weighted average fair value of options granted in 2002 was $2.37. In 2001, options were valued with an expected life of 5.3 years, volatility of 70.9% and a risk free rate of 4.9%. The weighted average fair value of options granted in 2001 was $1.71. In 2000, options were valued with an expected life of 5.3 years, volatility of 28.3% and a risk free rate of 4.8%. The weighted average fair value of options granted in 2000 was $6.80.
The Company's net income and earnings per share results would have been reduced to the pro forma amounts indicated below for the years ended December 31, 2002, 2001 and 2000, respectively.
2002 2001 2000 ---- ---- ---- Net Income As reported $ (30,438) $(48,589) $ 22,750 Pro forma $ (30,982) $(49,133) $ 22,325
Diluted Earnings Per Share As reported $ (1.58) $ (3.41) $ 2.61 Pro forma $ (1.58) $ (3.41) $ 2.57
The following is a summary of the Company's option activity, including grants, exercises, forfeitures and weighted average price information:
During May 1987, the Company assigned its rights and interests in a land lease to a third party for $175. The agreement indemnifies the Company against any further liability with respect to future lease payments. The Company remains contingently liable to the lessor under the original deed of lease for rental payments of $16 per year, the amount being adjustable based upon changes in the consumer price index since 1987, through the year 2063.
At December 31, 2002 and 2001, the Company received letters of credit of $149,339 and $29,000, respectively, which allowed its subsidiaries to receive statutory reserve credit and statutory surplus credit for its 2001 quota share reinsurance agreement with Centre. As part of the Company's financial reinsurance agreements in effect at December 31, 2000, it received a letter of credit from a bank for $5,000, which served to allow the Company to receive statutory reserve credit for its financial reinsurance with state insurance departments.
The Company's subsidiaries are parties to various lawsuits generally arising in the normal course of their business. The Company does not believe that the eventual outcome of any of the suits to which it is party will have a material adverse effect on its financial condition or results of operations. However, the outcome of any single event could have a material impact upon the quarterly or annual financial results of the period in which it occurs.
The Company and two of its subsidiaries, PTNA and Senior Financial Consultants Company, are defendants in an action instituted on June 5, 2002 in the United States District Court for the Eastern District of Pennsylvania by National Healthcare Services, Inc. The complaint seeks compensatory damages in excess of $150 and punitive damages in excess of $5,000 for an alleged breach of contract and misappropriation. The claims arise out of a joint venture related to the AllRisk Healthcare program, which was marketed first by PTNA and then later by Senior Financial Consultants Company. The defendants have denied the allegations of the complaint and will continue to defend the matter vigorously. While the Company cannot predict the outcome of this case, the Company believes that any resolution of this action will not have a material impact on its financial condition or results of operations.
This agreement meets the requirements to qualify for reinsurance treatment under statutory accounting rules. However, this agreement does not qualify for reinsurance treatment in accordance with SFAS No. 113 because, based on our analysis, the agreement does not result in the reasonable possibility that the reinsurer may realize a significant loss. This is due to a number of factors related to the agreement, including experience refund provisions, expense and risk charges credited to the experience account and the aggregate limit of liability. Accordingly, the contract is being accounted for in accordance with deposit accounting for reinsurance contracts.
The Company's current modeling and actuarial projections suggest that it is likely to be able to commute the agreement, as planned, on December 31, 2007. In order to commute the agreement, PTNA's and ANIC's statutory surplus following commutation must be sufficient to support the reacquired business in compliance with all statutory requirements. Upon commutation, the Company will receive cash or other liquid assets equaling the value of our experience account from the reinsurer. The Company would also record the necessary reserves for the business in its statutory financial statements. Accordingly, the Company's ability to commute the agreement is highly dependent upon the value of the experience account exceeding the level of required statutory reserves to be established. As of December 31, 2002, the statutory basis reserve liabilities of $905,330 exceed the experience account value of $708,982. Management expects the growth in the experience account will exceed the growth in the reserve liabilities such that the experience account value will exceed the reserve liabilities at December 31, 2007. In addition to the performance of the reinsured policies from now through 2007, the experience account value is susceptible to market interest rate changes. A market interest rate increase of 100 basis points could reduce the value of the current experience account by approximately $70,000 and jeopardize the Company's ability to commute as planned. As the intended commutation date approaches, the sensitivity of the experience account to market interest rate movement will decline as the duration of the benchmark indices becomes shorter, however the amount of assets susceptible to such interest sensitivity will continue to grow as additional net cash flows are added to the experience account balance prior to commutation.
The warrants are part of the consideration for the reinsurance contract and are recognized as reinsurance premiums over the anticipated life of the contract, which is six years. The warrants were valued at the issuance date using a Black-Scholes model with the following assumptions: 6.0 years expected life, volatility of 70.9% and a risk free rate of 4.74%. The $15,855 value of the warrants was recorded as a deferred premium as of December 31, 2001. Of the original $15,855 value, $2,643 of deferred premium was amortized during 2002.
As a result of the Company's intention to commute, it considered only the expense and risk charges anticipated prior to the commutation date in its most recent DAC recoverability analyses and has not recorded the potential of future escalating charges in its current financial statements. In addition, the Company is recognizing the additional condiseration of entering into the agreement, represented by the fair value of the warrants granted to the reinsurer, over the period of time to the expected commutation date.
The 2001 Centre Agreement granted the reinsurer an option to participate in reinsuring new business sales on a quota share basis. In August 2002, the reinsurer exercised its option to reinsure up to 50% of future sales, subject to a limitation of the reinsurer's risk. The reinsurer may continue this level of participation on the first $100 million in new policy premium issued after January 1, 2002. The final agreement, which was entered into in December 2002, further provides the reinsurer the option to reinsure a portion of the next $1 billion in newly issued long-term care annual insurance premium, subject to maximum quota share amounts of up to 40% as additional policies are written.
This agreement does not qualify for reinsurance treatment in accordance with GAAP because, based on the Company's analysis, the agreement does not result in the reasonable possibility that the reinsurer may realize a significant loss. This is due to an aggregate limit of liability that reduces the likelihood of the reinsurer realizing a significant loss on the agreement.
Effective January 1994, PTNA entered into a reinsurance agreement to cede 100% of certain life, accident and health and Medicare supplement insurance to a third party insurer. Total reserve credits taken related to this agreement as of December 31, 2002, 2001 and were approximately $401, $388 and $409 respectively.
PTNA is a party to a reinsurance agreement to cede certain home health care claims beyond 36 months. Reinsurance recoverables related to this treaty were $10,175 and $7,726 at December 31, 2002 and 2001, respectively. The reinsurer has notified PTNA that they believe the Company is in breach of its current agreement as a result of entering the 2001 Centre Agreement without the prior written approval of the reinsurer. PTNA has contested this assertion of breach and is continuing discussions with the reinsurer to reach an equitable resolution, including, but not limited to, the recapture of the excess home health care coverage and reserves, premium rate increases, or additional reinsurance business in the future. The ultimate resolution of this dispute cannot be determined at this time.
Effective December 31, 2000 and 1999, PTNA entered separate funds withheld financial reinsurance agreements with unaffiliated reinsurers. Under the agreements, PTNA ceded the claims risk of a material portion of its long-term care policies. The agreements did not qualify for reinsurance treatment in accordance with SFAS No. 113 because, based on the Company's analysis, the agreements did not result in the reasonable possibility that the reinsurer could realize a significant loss in the event of adverse development. As a result, the Company was applying deposit accounting for these agreements and results of operations reflected only the non-refundable annual fee owed to the reinsurer. Since the contracts were executed as funds withheld, there was no reinsurance recoverable or payable on a GAAP basis on the balance sheet. The agreements met the requirements to qualify for reinsurance treatment under statutory accounting rules. As a result of these agreements, 2000 statutory surplus was increased by $19,841. During 2001, both agreements were commuted, resulting in a reduction of statutory surplus of approximately $20,000.
In 2001, ANIC ceded substantially all of its disability policies to an unaffiliated insurer on a quota share basis. The insurer may assume ownership of the policies as a sale upon various state and policyholder approvals. At December 31, 2002 and 2001, reinsurance recoverables related to this treaty were $5,828 and $10,338, respectively.
The Company remains liable in the event that the reinsuring companies are unable to meet their obligations.
A member of the Company's board of directors is a principal in Davidson Capital Management, which provides investment management services to the Company. The Company paid this firm $99, $462 and $300 during the years ended December 31, 2002, 2001 and 2000, respectively.
A member of the Company's board of directors and the chairman of its audit committee is a senior executive with Advest, Inc., an investment banking firm, which has provided investment banking services in the past and that the Company has engaged as a financial advisor in the offering of its 2008 Subordinated Convertible Notes. This firm received $2 and $475 in fees during 2002 and 2001, respectively. No fees were paid to this firm in 2000.
A member of the Company's board of directors is a principal in U.S. Care, Inc., a marketing organization to which the Company paid $128, $159 and $23 in 2002, 2001 and 2000, respectively. The Company also made a loan of $100, with interest applied at 9%, to U.S. Care, Inc. in 2001, which is guaranteed by renewal commissions payable to the Company in future periods.
Fair values are based on estimates using present value or other valuation techniques where quoted market prices are not available. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The fair value amounts presented do not purport to represent and should not be considered representative of the underlying value of the Company.
The methods and assumptions used to estimate the fair values of each class of the financial instruments described below are as follows:
In March 2002, the Company completed a private placement of 510 shares of common stock for net proceeds of $2,352. The common stock was sold to several current and new institutional investors, at $4.65 per share. The offering price was a 10 percent discount to the 30-day average price of our common stock prior to the issuance of the new shares. Pursuant to registration rights granted in the private placement, the Company filed a registration statement registering the shares granted in the private placement for resale. The Securities and Exchange Commission declared the registration statement effective on June 20, 2002. The proceeds of the private placement provided additional liquidity to the parent company to meet its debt service obligations.
In June 2002, the Company completed a private placement of 60 shares of common stock as compensation to its financial advisor in conjunction with the private placement of 510 shares and as consideration for future services. Thirty of these shares were included in the resale registration statement, which was declared effective by the Securities and Exchange Commission on June 20, 2002. The Company recorded $325 as an expense in 2002 related to this item. In November, 2002, the Company completed a private placement of an additional 20 shares of common stock to its financial advisor in conjunction with the exchange of its 2003 convertible subordinated notes. The Company recorded $68 as an expense related to this item.
After adjusting for the further exchange of 2003 Notes for Exchange Notes in March 2003, and the issuance of 2008 Notes in February and March, 2003, the Company's total debt and financing obligations through 2008 will be as follows: Lease Debt Obligations Total ---- ----------- ----- 2003 10,451 344 10,795 2004 - 252 252 2005 - 18 18 2006 - 18 18 2007 - 18 18 2008 98,065 18 98,083 -------- ----- -------- Total $108,516 $ 668 $109,184 ======== ===== ========
The following lists the condensed financial information for the parent company as of December 31, 2002 and 2001 and for the years ended December 31, 2002, 2001 and 2000.
Equity in undistributed net (losses) earnings of subsidiaries* (21,544) (42,745) 27,855 -------- -------- --------
Retained earnings, beginning of year 92,141 140,730 117,980 -------- -------- --------
The condensed financial information should be read in conjunction with the Penn Treaty American Corporation and Subsidiaries consolidated statements and notes thereto.