The selected consolidated financial data presented below as of and for each of the five years ended December 31, 2002, 2001, 2000, 1999, and 1998 have been derived from our audited consolidated financial statements. However, prior years 2001 and 2000 have been reclassed to reflect the sale of Pyramid Life. See Note F. Discontinued Operations and Subsequent Event for further information. The acquisitions of Provident American Life and Continental General occurred on December 31, 1998 and February 17, 1999, respectively. These acquisitions had no impact on our results of operations in 1998. Results for United Benefit Life are included from August 1, 1998 to July 20, 1999 under a reinsurance agreement and thereafter as an acquired entity. The financial information for the year ended December 31, 1999 includes the operations of Continental General since February 1, 1999 and for Provident American Life and United Benefit Life (through reinsurance) for the entire period. The financial information for the years ended December 31, 2000, 2001, and 2002 includes the operations of all our subsidiaries for the entire year except for Pyramid Life (acquired in July 2000), which is presented separately as discontinued operations, as previously noted. This data should be read in conjunction with the more detailed information contained in the 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.
(1) On December 20, 2002, we entered into a definitive agreement to sell the stock of our subsidiary, Pyramid Life, to a subsidiary of Universal American Financial Corp. The transaction closed on March 31, 2003 for a purchase price of approximately $57.5 million in cash, subject to further adjustment based on Pyramid Life's final statutory capital and surplus as of March 31, 2003. See Note F. Discontinued Operations and Subsequent Event to our consolidated financial statements for further information.
(3) We received proceeds from a December 2001 public offering and private placement offerings in 2000, 1999 and 1998. For more information, see Note B. Equity Transactions to our consolidated financial statements.
This discussion should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this report. Management's discussion and analysis contains forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. However, future performance involves risks and uncertainties which may cause actual results to differ materially from those expressed in the forward-looking statements. See "Forward-Looking Statements."
Management has identified the following items that represent our most sensitive and subjective accounting estimates that have or could have a material impact on our financial statements. These estimates required management to make assumptions about matters that were highly uncertain at the time the estimates were made. Changes to these estimates occur from period to period and may have a material impact on our financial statements. Management has discussed the development, selection and disclosure of these estimates with our Audit Committee.
changes in the timing of claims submission patterns from providers, changes in our speed of processing claims and expected costs to settle unpaid claims.
Management considered the unfavorable claims experience in recent periods when it established its liabilities for unpaid claims at December 31, 2002. Management believes that the recorded liabilities for unpaid claims at December 31, 2002 is within a reasonable range of outcomes. Management closely monitors and evaluates developments and emerging trends in claims costs to determine the reasonableness of judgments made. A retrospective test is performed on prior period claims liabilities and, as adjustments to the liabilities become necessary, the adjustments are reflected in current operations. Management believes that the amount of medical and other benefits payable is adequate to cover our liabilities for unpaid claims as of December 31, 2002.
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, 2002, goodwill was $10.7 million and represented approximately 1.2% 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
Effective January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets issued by the Financial Accounting Standards Board, or FASB, which provides that goodwill and intangibles with indefinite useful lives should not be amortized but instead be tested for impairment annually at the reporting unit level. In accordance with SFAS No. 142, we, together with our independent consultants, completed a transitional goodwill impairment test, which indicated that an impairment loss against our goodwill and other intangible assets was not required. Goodwill and intangibles with indefinite useful lives are tested for impairment on an annual basis and more often if indications of impairment exist. The estimated fair value of goodwill of a reporting unit is determined by applying the appropriate discount rates to estimated future cash flows for the reporting unit. The estimated fair value of licenses was determined by independent appraisals. The results of our analysis and analysis prepared by independent consultants indicated that no reduction of goodwill and licenses was required.
REVENUE RECOGNITION. Life insurance premiums are recognized as revenue when they become due. Health premiums are recognized as revenue over the terms of the policies. Amounts received from interest sensitive contracts, principally universal life and annuity products, 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.
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 six months after
EXTERNAL FACTORS ALSO CONTRIBUTE TO POLICY RENEWAL OR LAPSATION. Economic cycles can influence an insured's ability to continue to pay insurance premiums when due. New government initiatives have raised public awareness of the escalating costs of healthcare, which we believe boosts new sales and promotes renewal payments.
Lapsation and persistency may positively or adversely impact future earnings. Higher persistency generally results in higher renewal premium. However, higher persistency may lead to increased claims in future periods. Additionally, increased lapsation can result in reduced premium collection, accelerated amortization of deferred acquisition cost and anti-selection of higher-risk insureds.
REINSURANCE. Consistent with the general practice of the insurance industry, we reinsure portions of the coverage by our insurance products to unaffiliated insurance companies under reinsurance agreements. Reinsurance provides a greater diversification of underwriting risk, minimizes our aggregate exposure on major risks and limits our potential losses on reinsured business. Reinsurance involves one or more insurance companies participating in the liabilities or risks of another insurance company in exchange for a portion of the premiums. Although the effect of reinsurance is to lessen our risks, it may lower net income. We have entered into a variety of reinsurance arrangements under which we cede business to other insurance companies to mitigate risk. We also have assumed risk on a "quota share" basis from other insurance companies. Our results of operations are presented net of reinsurance.
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 of occurrence 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.
liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends. Over the past couple of years, the cost and availability of commercial insurance as a result of significant changes in the insurance market have impacted our insurance coverages. We have renewed most of our insurance policies for 2003, although at additional premium cost and with increased exposure to losses. Other policies are up for renewal in mid-2003. We may not be successful in obtaining coverage on terms favorable to us or at all.
- corporate and other -- includes primarily interest income, interest expense and corporate expenses of the holding company.
Immediately prior to the closing of the sale, Continental General acquired Pyramid Life's Kansas City building and personal property and retained most of its employees. Continental General will continue to administer its senior health business out of the Kansas City location, as well as continue to administer Pyramid Life's business during a six to 18 month transition period. Immediately prior to the closing, Continental General also reinsured a small block of certain life insurance policies of Pyramid Life.
At December 31, 2002, Pyramid Life had assets of $157.8 million, net premiums of $98.0 million, net revenues of $104.8 million and net income from operations of $7.1 million.
For the year ended December 31, 2002, total net premiums were $540.1 million, a decrease of 2.8%, from $555.5 million for 2001.
Net investment income was $24.3 million for 2002 compared to $25.3 million for 2001, a decrease of 4.1%, due primarily to lower interest rates.
Fee and other income decreased to $30.7 million for 2002 compared to $36.2 million for 2001, a decrease of 15.1%. This decrease was primarily attributable to a smaller volume of business in force in the medical segment due to the United Benefit Life and Provident American Life termination or replacement program and the cancellation of other medical business in certain states.
The amortization of deferred reinsurance gain of $2.8 million for 2002 represented the recognition of the ceding commission allowances received under our reinsurance agreements. The unamortized amount of $11.0 million at December 31, 2002 was accounted for as a deferred reinsurance gain on the consolidated balance sheet. The amortization of deferred reinsurance gain decreased from $5.0 million for 2001 as a result of lower amortization due to diminishing levels of in force certificates.
Income from continuing operations was $2.1 million, or $0.06 per share, for 2002 compared to a loss of $5.5 million, or $0.31 per share, for 2001. Income from the operations of Pyramid Life (classified as discontinued operations) was $7.1 million, or $0.21 per share, for 2002 compared to $7.9 million, or $0.44 per share, for 2001. Therefore, income including continuing and discontinued operations (excluding loss on sale of Pyramid Life) for 2002 was $9.2 million, or $0.27 per share, compared to $2.3 million, or $0.13 per share, for 2001. The loss on the sale of Pyramid Life recorded in the fourth quarter of 2002 was $11.6 million, or $0.34 per share. As a result of the foregoing, for 2002, net loss attributable to common stockholders was $2.4 million, or $0.07 basic and diluted loss per share of common stock, compared to net income attributable to common stockholders of $5.2 million, or $0.29 basic and diluted income per share of common stock, for 2001.
For the year ended December 31, 2001, total net premiums were $555.5 million, an increase of 15.2%, from $482.4 million for 2000.
Net investment income increased to $25.3 million for 2001 from $24.2 million for 2000, an increase of 4.6%, due primarily to a higher investment base.
Net realized gains (losses) increased to $2.3 million for 2001 from a net realized loss of $0.1 million for 2000 as a result of the sale of 30-year mortgage pass-through securities which reduced prepayment risk, and the sale of callable agency bonds which reduced call risk. Portfolio durations were also shortened to reduce the impact on bond values in a potentially rising interest rate environment. Cash was reinvested in corporate bonds and planned amortization class non-agency mortgage securities, which provide average life protection in a fluctuating interest rate environment. These gains were marginally offset by the write-down for other than temporary impairment of $0.8 million recorded on the two commercial collateralized, mortgage-backed bonds with leasehold interests in the World Trade Center complex, most of which was destroyed by terrorists on September 11, 2001. No default has occurred on contractual payments for these securities.
Total benefits, claims, losses and settlement expenses increased to $443.8 million for 2001 compared to $370.6 million for 2000, an increase of 19.8%.
Medical benefits, claims, losses and settlement expenses were $328.8 million for 2001 compared to $286.4 million for 2000, an increase of 14.8%. The increase was a result of higher than anticipated benefit utilization in 2001 versus 2000 in the medical segment related to increased costs of services, greater utilization of medical services and greatly increased expenditures on prescription drugs, and a larger volume of business in force. Additionally, for these same reasons, a $17.0 million deficiency in 2000 reserves emerged in 2001. The medical loss ratio was 81.7% for 2001 compared to 76.8% for 2000. The increase was due to the above mentioned items.
Interest expense and financing costs decreased to $4.7 million in 2001 compared to $5.6 million in 2000 as a result of lower interest rates and lower debt outstanding.
Assets decreased 6.4% to $887.5 million (including $157.8 million for Pyramid Life) at December 31, 2002 from $947.7 million at December 31, 2001. Assets of $397.1 million, or 44.7% of the total assets, were in investments at December 31, 2002. Fixed maturities, our primary investment, were $388.1 million, or 97.7% of total investments, at December 31, 2002. Other investments consist of surplus notes, policy loans and mortgage loans. We have classified all of our fixed maturities as "available-for-sale" and accordingly have reported them at estimated fair value at December 31, 2002.
Approximately 94.0% of our bonds were of investment grade quality at December 31, 2002. In addition to the fixed maturities, we also had $32.1 million in cash and cash equivalents of which, $7.7 million was restricted at December 31, 2002.
CREDIT AGREEMENT. To provide funds for the acquisition of Continental General, on February 17, 1999, we entered into a credit agreement among Ceres, various lending institutions, and JPMorgan Chase (formerly the Chase Manhattan Bank) as Administrative Agent. Under the agreement, we borrowed $40.0 million under a tranche A term loan and secured a $10.0 million revolver. The credit agreement was amended on July 25, 2000 to increase the revolver from $10.0 million to $15.0 million in connection with the acquisition of Pyramid Life. Any amount outstanding on the revolver had to be repaid on February 17, 2002. The revolver bore interest at the same rate choices as the tranche A term loan. On February 17, 2002, the balance of the revolver was permanently repaid from proceeds of our December 2001 public offering.
On March 30, 2001, this credit agreement was amended to enter into a new $10.0 million term loan with CIT Equipment Financing, Inc. The proceeds of this term loan, the tranche B term loan, were used to permanently pay down $10.0 million of our then fully-drawn $15.0 million revolver agreement. The terms of this amendment provide for CIT Group to participate equally with the syndicate of banks and Chase under the credit agreement.
- requires us to repay the term loans with 25% of the net cash proceeds from any future sale or issuance of our equity, excluding warrants and compensation awards or plans; and
- a leverage ratio (consolidated debt to consolidated total capital) of 0.30 to 1.00;
The following schedule summarizes current and future contractual obligations as of December 31, 2002 after giving effect to the March 31, 2003 $10.0 million partial pay down of our long-term debt:
medical business. As that business declines, fee income declines. Dividends from our regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. In 2003, none of our insurance subsidiaries (Central Reserve and Continental General) can pay a dividend to Ceres Group, the parent company, without prior approval of their respective state regulators as a result of their respective statutory levels of unassigned surplus. If our non-regulated subsidiaries do not generate sufficient fee income to service all of our debt obligations, there may be a material adverse effect on our business, financial condition and results of operations, and a significant adverse effect on the market value of our common stock. In addition, if necessary, additional financing may not be available on terms favorable to us or at all.
In addition, insurance companies are subject to extensive federal and state regulation and compliance with these regulations could increase the insurance companies' operating costs. In some circumstances, failure to comply with certain insurance regulations could subject an insurance company to regulatory actions by such insurance company's state of domicile. For example, states have statutory risk-based capital, or RBC, requirements for health and other insurance companies based on the RBC Model Act. These RBC requirements are intended to assess the capital adequacy of life and health insurers, taking into account the risk characteristics of an issuer's investments and products. In general, under these laws, an insurance company must submit a report of its RBC level to the insurance department of its state of domicile as of the end of the previous calendar year. These laws provide for four different levels of regulatory attention depending on the ratio of an insurance company's total adjusted capital (defined as the total of its statutory capital, surplus and asset valuation reserve) to its risk-based capital. As of December 31, 2002, our risk-based capital levels for each of our insurance subsidiaries, except for Continental General, exceeded the levels required by regulatory authorities. Continental General's statutory capital level was below "Company Action Level" at December 31, 2002. However, after the addition of the capital generated from the sale of Pyramid Life, Continental General's risk-based capital level exceeded the levels required by regulatory authorities.
- negative economic factors and conditions specific to the issuers industry;
Interest Rate Risk is the risk that interest rates will change and cause a decrease in the value of an insurer's investments. This change in rates may cause certain interest-sensitive products to become uncompetitive or may cause disintermediation if we attempt to mitigate this risk by charging fees for non-conformance with certain policy provisions and/or by attempting to match the maturity schedule of our assets with the expected payouts of its liabilities. To the extent that liabilities come due more quickly than assets mature, we would have to sell assets prior to maturity and recognize a gain or loss. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical decline in fair value of stockholders' equity is estimated to be $13.6 million after-tax at December 31, 2002. This amount represents approximately 8.1% of our stockholders' equity at such date.
Seasonality is the risk of fluctuations of revenues and operating results. Historically, our revenues and operating results have varied from quarter to quarter and are expected to continue to fluctuate in the future. These fluctuations have been due to a number of factors, including higher benefit utilization by our insureds during the winter months and the use of deductibles. More specifically, our senior segment's seasonality is the opposite of our medical segment's, meaning that earnings in the senior segment are generally lower in the first quarter and higher later in the year. This is mainly a factor of our Medicare Supplement products that pay the Medicare deductible for our insureds generally during the early months of the year.
- unforeseen losses with respect to loss and settlement expense reserves for unreported and reported claims or adverse changes in persistency or profitability of insurance contracts that would accelerate the amortization of our deferred acquisition costs;
- rising healthcare costs, especially the rising costs of prescription drug costs that are rising faster than other medical costs, and rising utilization rates;
- developments in healthcare reform and other regulatory issues, including the Health Insurance Portability and Accountability Act of 1996 and increased privacy regulation, and changes in laws and regulations in key states in which we operate;
- our ability to meet risk-based or statutory capital requirements and the outcome of our efforts to meet these capital requirements;
- the adequacy of funds, including fee income, received from our non-regulated subsidiaries, and the restrictions on our insurance subsidiaries' ability to pay dividends to Ceres, to meet our debt obligations;
- the failure to successfully manage our operations and integrate future acquisitions, if any, including the failure to achieve cost savings;
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which supercedes Emerging Issues Task Force, or EITF, Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring). The provisions of this Statement are effective for exit or disposal activities initiated after December 31, 2002. SFAS No. 146 requires recognition of a liability for costs associated with an exit or disposal activity when the liability is incurred, rather than when the entity commits to an exit plan under EITF Issue No. 94-3. This Statement applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a disposal activity covered by SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Additionally, this Statement does not apply to costs associated with the retirement of a long-lived asset covered by SFAS No. 143, Accounting for Asset Retirement Obligations. We anticipate that the adoption of this standard will not have a material effect on our results of operations, financial position or liquidity.
In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. This Statement rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, SFAS No. 44, Accounting for Intangible Assets of Motor Carriers, and SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This Statement amends SFAS No. 13, Accounting for Leases, to eliminate an inconsistency between the
We have audited the accompanying consolidated balance sheets of Ceres Group, Inc. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2002. We have also audited the information presented in the financial statement schedules listed in the Index at Item 15(a). These financial statements and financial statement schedules are the responsibility of Ceres Group's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Ceres Group, Inc. and subsidiaries at December 31, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States. 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.
As described in Notes A, F and J, Ceres Group adopted Statements of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets,and No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, as of January 1, 2002.
Cleveland, Ohio March 4, 2003, except for Notes A, F, and O as to which the date is March 31, 2003
We provide, through our insurance subsidiaries, a wide array of health and life insurance products to over 358,000 insureds. While we, through our subsidiaries, are licensed in 49 states, the District of Columbia and the U.S. Virgin Islands, approximately 61.3% of our total premium volume is generated from ten states: Ohio, Florida, Texas, Pennsylvania, Indiana, Georgia, Missouri, Illinois, Kansas and Nebraska.
Unless the context indicates otherwise, "we," "our," and "us" refers to Ceres Group, Inc. and its subsidiaries on a consolidated basis.
All of our acquisitions were accounted for using the purchase method of accounting. Additionally, since the issuance of Statement of Financial Accounting Standards, or SFAS, No. 141, Business Combinations, by the Financial Accounting Standards Board, or FASB, business combinations initiated after June 30, 2001, are required to be accounted for by the purchase method. Results of operations of the acquired business are included in the income statement from the date of acquisition. Additionally, SFAS No. 141 expanded the criteria for recording intangible assets separate from goodwill.
The FASB staff also issued Emerging Issues Task Force, or EITF, D-100: Clarification of Paragraph 61(b) of FASB Statement No. 141 and Paragraph 49(b) of FASB No. 142, which further clarified what the FASB staff believed was the Board's intent for reclassifying an intangible asset out of goodwill of a previously acquired intangible asset.
Investments in policy notes and mortgage loans are reported at cost which approximates fair value.
We regularly review our investment portfolio for factors that may indicate that a decline in fair value of an investment is other-than-temporary. Some factors considered in evaluating whether or not a decline in fair value is other than temporary include:
Effective January 1, 2002, we adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. This Statement superseded SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, and the accounting and reporting provisions of Accounting Principles Board Opinion, or APB Opinion, 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, for the disposal of a segment of a business. This Statement also amended Accounting Research Bulletin No. 51, Consolidated Financial Statements.
This Statement requires that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and broadens the presentation of discontinued operations to include more disposal transactions. The adoption of SFAS No. 144 on January 1, 2002 did not have a material effect on our results of operations, financial position or liquidity. See Note F. Discontinued Operations for further detail related to the adoption of SFAS No. 144.
Liabilities for future policy reserves for accident and health and ordinary life business are based on the net level premium basis and estimates of future claims, investment yield, lapses using the Company's experience and actuarial judgment with an allowance for possible future adverse deviations from expected experience. Interest rates used range from 4.5% to 6.0%. Liabilities for interest sensitive products such as deferred annuities and universal life are based on the retrospective deposit method. This is the policyholder fund balance before adjusting for any surrender charges. Guaranteed minimum rates for universal life contracts are 4.0% to 5.0%. At December 31, 2002, credited rates ranged from 4.0% to 4.5%. Guaranteed base minimum rates for deferred annuities range from 3.0% to 5.0% depending on the duration of the contract. Current rates credited range from 3.0% to 5.8%.
Claim liabilities with a long pay out period, such as long-term care and disability income claims, are discounted at an interest rate of 4.5%. Although considerable variability is inherent in such computations, management believes that the liabilities for unpaid life and accident and health claims are adequate. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known with such adjustments included in current operations.
Fee and other income consist of collection, management, and administrative fees, and are recognized when earned.
Federal income taxes have been provided using the liability method in accordance with SFAS No. 109, Accounting for Income Taxes issued by the FASB. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reviewed for recoverability and a valuation allowance is established, if necessary.
Stock-based compensation plans are accounted for using the intrinsic value method prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees. In accordance with the intrinsic value method, compensation cost is measured as the excess, if any, of the quoted market price of the equity instrument awarded at the measurement date over the amount an employee must pay to acquire the equity instrument. Stock-based compensation costs are recognized over the period in which employees render services associated with the awards.
We adopted SFAS No. 123, Accounting for Stock-Based Compensation, which permits entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants as if the fair-value-based method, as defined in SFAS No. 123, had been applied. Additionally, in December 2002, the FASB issued SFAS No. 148, Accounting For Stock-Based Compensation-Transition and Disclosure. SFAS No. 148 amends SFAS No. 123, to provide alternative methods of transition to SFAS No. 123's fair value method of accounting for stock-based employee compensation, but does not require companies to account for employee stock options using the fair value method. SFAS No. 148 also amends the disclosure provisions of SFAS No. 123 and APB Opinion, No. 28, Interim Financial Reporting. We elected to continue to apply provisions of APB Opinion No. 25 and provide the pro forma disclosure required by SFAS No. 123 and the amended disclosures required by SFAS No. 148. See Note Q. Stock Plans for further information.
No stock-based employee compensation cost is reflected in net income, as all options granted under our plan generally had an exercise price equal to or higher than the fair value of the underlying common stock on
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which supercedes EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring). The provisions of this Statement are effective for exit or disposal activities initiated after December 31, 2002. SFAS No. 146 requires recognition of a liability for costs associated with an exit or disposal activity when the liability is incurred, rather than when the entity commits to an exit plan under EITF Issue No. 94-3. This Statement applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a disposal activity covered by SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Additionally, this Statement does not apply to costs associated with the retirement of a long-lived asset covered by SFAS No. 143, Accounting for Asset Retirement Obligations. We
- repay the remaining balance of $2.5 million of our revolver on February 17, 2002;
- repurchase our convertible voting preferred stock for $5.0 million (See Note R. Preferred Shares for further information);
- contribute $28.0 million to the capital of our insurance subsidiaries; and
On July 25, 2000, we sold 3,333,334 shares of our common stock at $6.00 per share in a private placement offering, and, on July 26, 2000, we sold 75,000 shares of our convertible voting preferred stock at $100.00 per share to United Insurance Company of America in a private placement offering. The $27.5 million proceeds from these sales were used for the purchase of Pyramid Life from United Insurance, a subsidiary of Unitrin, Inc. See Note C. Business Combinations and Note R. Preferred Shares for further information.
The acquisition described below was accounted for using the purchase method of accounting, with the excess of the purchase price over the estimated fair-value of the identifiable net assets recorded as goodwill.
On July 26, 2000, the Company, through Continental General Insurance Company, completed the purchase of Pyramid Life from United Insurance. Pyramid Life, based in Mission, Kansas, provides health and life insurance primarily for the senior market, including Medicare supplement, long-term care, home health care, and senior life insurance products. Pyramid Life markets senior insurance products through approximately 2,500 independent agents in 40 states.
- $7.5 million from the sale to United of 75,000 newly-issued shares of convertible voting preferred stock;
- $15.0 million from a combination of funds from Continental General and financing provided by the Chase Manhattan Bank and associated banks.
Pyramid Life's results of operations had been previously included in our consolidated results of operations since the date of acquisition. However, due to the planned sale of Pyramid Life, its operations have been classified as discontinued operations and prior years' financial information has been reclassified. See Note F. Discontinued Operations and Subsequent Event for further information.
Other property and equipment consists principally of software, leasehold improvements and office equipment. Depreciation expense for the years ended December 31, 2002, 2001 and 2000 was $1.2 million, $1.6 million, and $1.4 million, respectively.
We entered into a definitive agreement dated as of December 20, 2002 to sell the stock of our subsidiary, Pyramid Life, which was primarily included in our senior segment, to a subsidiary of Universal American Financial Corp. Additionally, we will continue to process Pyramid Life's business for a period of six to 18 months after the sale through an administrative services agreement. The loss from the sale (net of taxes and expenses incurred) is expected to be $11.6 million. The sale was completed March 31, 2003 for $57.5 million in cash, subject to further adjustment based on Pyramid Life's statutory capital and surplus as of March 31. Proceeds from the sale were used to strengthen Continental General's statutory capital and repay $10.0 million of our bank debt. As a result of the planned sale, Pyramid Life's operations were classified as discontinued operations and prior years' financial information has been reclassified. Accordingly, we adjusted the carrying value of Pyramid Life's assets held for sale to fair market value at December 31, 2002, which resulted in an $11.6 million charge in the fourth quarter of 2002.
The changes in the carrying amount of goodwill for the year ended December 31, 2002, were as follows:
The changes in the carrying amount of licenses, for the year ended December 31, 2002, were as follows:
Income tax expense (benefit) attributable to income from continuing operations differs from the amounts computed by applying the U.S. federal income tax rate of 35%. Those effects are summarized as follows:
The Company determines a valuation allowance based on an analysis of amounts recoverable in the statutory carryback period and available tax planning strategies. In assessing the valuation allowance established at December 31, 2002 and 2001, estimates were made as to the potential financial impact on the Company of recent NOLs and our financial condition.
In accordance with federal tax law, a portion of insurance companies' net income, prior to 1984, is not subject to federal income taxes (within certain limitations) until it is distributed to policyholders, at which time it is taxed at regular corporate rates. For federal income tax purposes this untaxed income is accumulated in a memorandum account designated "policyholders' surplus." At December 31, 2002, the accumulated untaxed policyholders' surplus for the Company, all of which relates to Central Reserve, was $2.9 million.
The foregoing indicates that a $8.4 million deficiency in the 2001 reserves emerged in 2002 as a result of higher-than-anticipated claims cost associated with a reduction in pending claims inventory in the medical segment. In 2001, a $17.0 million deficiency in the 2000 reserves emerged as a result of higher utilization in the medical segment related to increased costs of services, a greater utilization of medical services and greatly increased expenditures on prescription drugs. In 2000, a $7.9 million deficiency in the 1999 reserves emerged as a result of higher utilization in all segments.
In December 2001, Continental General entered into a reinsurance transaction with London Life International Reinsurance Corporation, or London, for a 75% quota share of certain health policies issued after February 1, 1999. Under the provisions of the treaty, effective January 1, 2001, Continental General cedes 75% of the premiums of the eligible policies, and in return receives reimbursement for 75% of the claims paid, plus a commission and expense allowance. If the combined loss ratio (defined as benefits plus expense allowances divided by premium) is less than 100%, an experience refund will be paid from London to Continental General. The expense and profit charge is 200 basis points and 85 basis points of reinsurance premium for 2002 and 2001, respectively. Beginning January 1, 2002, London retroceded any losses on these policies in excess of a combined ratio of 110% to Central Reserve. In exchange for coverage on this business, Central Reserve received 100 basis points of reinsurance premium in 2002 from London. On June 2, 2002, these reinsurance agreements were terminated. The Company has determined that this contract does not transfer risk in accordance with generally accepted accounting principles and has reflected this agreement as a deposit.
In connection with the United Benefit Life reinsurance treaty, Central Reserve ceded 80% of the business in force on August 1, 1998 to Hannover, thereby retaining a net risk of 20%. Additionally, Central Reserve ceded 50% of the policies written by United Benefit Life subsequent to August 1, 1998 and reinsured by Central Reserve to Hannover. This treaty provided Central Reserve an initial ceding allowance of $20.0 million, which was being accounted for as a deferred reinsurance gain in the accompanying consolidated financial statements, and was amortized into income over the duration of the underlying block of business. In 1999, Central Reserve acquired through foreclosure the stock of United Benefit Life.
Interest on the outstanding balance of the term loans is determined based on our selection each quarter of either a Base Rate Loan or a Eurodollar Loan. Under the Base Rate Loan, the interest rate will be 2.5% per annum plus the higher of (a) the rate which is 0.50% of 1.0% in excess of a federal funds rate or (b) Chase's prime rate as in effect from time to time. Under the Eurodollar Loan, the interest rate will be 3.5% per annum plus a Eurodollar rate, which is the arithmetic average of the offered quotation to first-class banks in the interbank Eurodollar market by Chase, adjusted for certain reserve requirements. The interest rate of the tranche B term loan is 0.5% per annum higher than the above rates. At December 31, 2002, the interest rate on our tranche A term loan balance of $16.0 million was 4.9% per annum and our $9.0 million CIT tranche B term loan was 5.4% per annum.
- prohibit the payment of cash dividends on, or the repurchase of, shares of our common stock;
We do not have transactions or relationships with "special purpose" entities, and we do not have any off balance sheet financing other than normal operating leases.
On April 15, 2002, Peter W. Nauert announced his retirement from his position as our Chief Executive Officer effective June 1, 2002. He will remain as Chairman of the Board of Directors through June 2003. In the first quarter of 2002, we reported a pre-tax non-recurring special charge to operations of approximately $2.7 million ($2.4 million in continuing operations and $0.3 million in discontinued operations) related to the early termination of his employment agreement and the payment of certain benefits through June 2003.
In 1998, pursuant to the 1998 Key Employee Share Incentive Plan, the Company granted common stock options to certain key employees. In 1999 through 2002, the Company granted additional common stock options to certain employees under the 1998 Key Employee Share Incentive Plan. In general, such grants vest over three years and expire ten years from the date of the grant. In the event of a change in control, all options granted immediately vest and become exercisable in full. There are 2,000,000 shares of our common stock reserved for issuance under this plan. At December 31, 2002, there were options outstanding under the plan to purchase 1,483,628 shares.
In 1999, pursuant to the 1999 Special Agents' Stocks Option Plan, the Company 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. The Company terminated this plan at the end of 2000. At December 31, 2002, there were options outstanding under the plan to purchase 78,706 shares.
Exercise prices for options outstanding at December 31, 2002 ranged from $3.90 to $10.50. While some options have no expiration date, management estimates the remaining average contractual life of options awarded is 5 years. A summary of the options by range of exercise price is as follows:
The Company also had outstanding at December 31, 2002, 3,657,743 warrants at $5.41, expiring in 2005.
Our 2000 Employee Stock Purchase Plan was adopted by our stockholders on June 27, 2000. Under the plan, employees may purchase shares of our common stock at a 15% discount from fair value. All of our full time employees, including officers, are eligible to participate in the employee stock purchase plan, subject to limited exceptions. Eligible employees participate voluntarily, and may withdraw from an offering at any time before the stock is purchased. Participation terminates automatically upon termination of employment other than for death, disability or retirement. Six-month offerings are made available beginning May 1 and November 1 of each year. The purchase price per share in an offering will not be less than 85% of the lesser of
the stock's fair value at the beginning of the offering period or on the applicable exercise date and may be paid through payroll deductions. As of December 31, 2002 and 2001, 63,954 and 62,761 shares, respectively, had been issued under the employee plan.
Based on the methodology and assumptions delineated above, the weighted average fair value of options was $1.39, $1.18 and $1.25 per share for 2002, 2001 and 2000, respectively. The pro forma impact would be to decrease net income by $0.4 million, $0.8 million and $0.7 million and decrease net income per share by $0.01, $0.05 and $0.04 for basic and for diluted for the years ended December 31, 2002, 2001 and 2000, respectively.
The Company has authorized 100,000 Convertible Voting Preferred Shares, $.001 par value, of which none are outstanding at December 31, 2002. On December 27, 2001, the Company repurchased its convertible voting preferred stock for $5.0 million from the proceeds of the public offering. The carrying value of the convertible voting preferred stock was $8.2 million and the related dividends distributable was $0.4 million. The resulting gain from repurchase of the convertible voting preferred stock was $3.6 million. The gain was recorded in retained earnings and was reflected as a component of net income attributable to common stockholders. For more information regarding our convertible voting preferred stock, see Note B. Equity Transactions and Note C. Business Combinations for further information.
Statutory accounting practices prescribed or permitted by regulatory authorities for Ceres' insurance subsidiaries differ from generally accepted accounting principles. Shareholders' equity and net income, unaudited, as determined in accordance with statutory accounting practices, for Ceres and its subsidiaries are summarized as follows:
The Company sponsors the Ceres Group, Inc. 401(k) Plan, a defined contribution 401(k) savings plan (the Plan). Effective January 1, 2001, the Plan was amended to increase the employer match (Company Match Contribution) to 50% of the first 6% of each participant's salary deferrals.
A participant's interest in the Company Match Contribution, Stock Match Contribution and Profit Sharing Contribution allocated to the participant's account becomes vested over a five-year graded vesting schedule with 100% vesting over five years. Total matching contributions by the Company were approximately $642,000 for 2002, $768,000 for 2001, and $376,000 for 2000.
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. We do not separately allocate investments or other identifiable assets by industry segment, nor are income tax expenses (benefits)
allocated by industry segment. Revenues from each segment are primarily generated from premiums charged to external policyholders and interest earned on cash and investments.
We do not separately allocate investments or other identifiable assets by industry segment, nor are income tax expenses (benefits) allocated by industry segment. The Company also expanded the detail of its disclosures for 2002, 2001 and 2000, which included certain reclassifications.
Fair values of financial instruments are based upon quoted market prices, where available, or on values obtained from independent pricing services. In cases where quoted market prices are not available, fair value is based on estimates using present value or other valuation techniques. These techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Although fair value estimates are calculated using assumptions that management believes are appropriate, differences between estimated and actual outcomes or changes in the underlying assumptions could cause these values to vary materially. Consequently, calculated fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized by the immediate settlement of the instruments.
CASH, CASH EQUIVALENTS, PREMIUMS RECEIVABLE, REINSURANCE RECEIVABLE, SURPLUS NOTES, MORTGAGE LOANS AND POLICY NOTES -- The carrying amounts reported in the consolidated balance sheets for these instruments approximate their fair value.
Carrying amounts and estimated fair values of financial instruments at December 31, 2002 and 2001, are summarized as follows:
Substantially all of the Company's reinsurance recoverable is due from a single reinsurer, Hannover. At December 31, 2002, Hannover maintained an "A" rating from the A.M. Best Company. The Company performs periodic evaluations of this reinsurer's credit standing.
(2) Includes $9.5 million and $8.0 million in advances from non-regulated subsidiaries in 2002 and 2001, respectively.
(3) Includes the parent company's equity of regulated and non-regulated subsidiaries, which is eliminated in consolidation.