The Company owns a building in Strongsville, Ohio, which consists of 121,625 square feet and is occupied by Central. At December 31, 1998, the outstanding principal balance of the mortgage note on the building was approximately $8.3 million. PALHIC leases space in Norristown, Pennsylvania of approximately 20,000 square feet. CGIC owns and occupies a building in Omaha, Nebraska which consists of approximately 61,400 square feet.
In 1996 and 1997, Central experienced substantial losses incurred in connection with newly-issued health plans, greater utilization than anticipated, new state and federal mandates such as guaranteed issue and preventative benefits and overall reductions in profitability arising out of industry-wide pricing competition. In June 1997, in order to address the continued decline in Central's surplus, the Company borrowed $5.2 million from Huntington National Bank, $5 million of which was contributed to the surplus of Central.
In December 1997, Central entered into a reinsurance treaty with Hannover in which Central transferred to Hannover $24.6 million of reserve liability. In return for Hannover's assumption of this liability, Central transferred $14.6 million in assets to Hannover. The reinsurance treaty, which is on a 50/50 quota-share basis, provided Central with a $10 million initial ceding allowance, which increased Central's statutory surplus. The combination of the $14.0 million Surplus Note which was invested in connection with the Bridge Loan and the $10 million ceding allowance provided an additional $24 million to the statutory capital and surplus of Central, increasing statutory levels in excess of regulatory risk-based capital requirements and alleviating the regulatory concerns that were created in 1996 and continued in 1997.
Since January 1, 1998, the Company (1) began a new business plan designed to increase premium rates, reduce costs and emphasize acquisitions; (2) completed the July Equity Financing, in which the Company issued and sold 7,300,000 Common Shares at $5.50 per share and Equity Warrants to purchase an additional 3,650,000 Common Shares at an exercise price of $5.50 per share for an aggregate purchase price of approximately $40.2 million; (3) entered into an agreement with UBL in August 1998 to reinsure 100% of the major medical policies of UBL, covering approximately 100,000 lives with estimated annual premiums of $100 million; (4) acquired PALHIC from PAMCO on December 31, 1998 for $5.5 million in cash; (5) acquired CGIC, from Western and Southern Life Insurance Company of Cincinnati, Ohio, on February 17, 1999 for $84.5 million in cash; (6) completed the February 1999 Financing; and (7) announced, on March 18, 1999, the execution of an agreement with United Benefit to purchase all of the outstanding shares of its subsidiary, UBL, subject to board of directors' approval and approval by the shareholders of United Benefit, and to Central's due diligence, as well as other customary terms and conditions.
Because of the implementation of the Company's new business plan, the July Equity Financing, the February 1999 Financing, the reinsurance agreement with UBL and the acquisitions of PALHIC and CGIC, the Company has undergone numerous changes since January 1, 1998. The acquisitions of PALHIC and CGIC had no impact on the Company's results of operations in 1998, and are therefore not reflected in the "Results of Operations" discussion below. The Company believes that these acquisitions will have a material positive impact on the Company's results in 1999.
force decreased slightly to 103,994 at the end of 1998 compared to 104,687 at the end of 1997. Certificates issued for new group policies were 35,178 in 1998, up 16% from 30,377 in 1997. Total lapses (net of additions/ decreases) in 1998 were 35,871, down 15% from 41,994 in 1997. The increase in new certificates issued in 1998 was related to the infusion of capital into Central, improving the Risk-Based Capital levels above regulatory actions levels in 1997, making Central's marketing position stronger. The larger number of lapses in 1997 was primarily due to a conversion program of older products into newer products, in several states, along with rate increases for all renewal policies.
Interest expense and financing costs increased to $1,841,334, or 71%, from $1,078,198 in 1997. The increase was due primarily to the increase in interest from the $20 million Bridge Loan incurred in December 1997. The Bridge Loan was paid in full in July 1998 from the July Equity Financing.
In 1997 premiums, before reinsurance, increased slightly to $262,161,343 from $260,076,097. The group life and health segment accounted for 99% of the premiums in 1997. The group certificates in force decreased about 10% to 104,687 in 1997 compared to 116,304 at the end of 1996. Certificates issued for new group policies were 30,377 in 1997, down 17% from 36,574 in 1996. Total lapses (net of additions/decreases) in 1997 were 41,994, up 24% from 33,990 in 1996. Overall the major reason for the flat growth in premiums, decrease in certificates and increase in lapses can be attributed to the financial condition of Central in 1997 and 1996. The large losses and related decrease in statutory surplus discouraged new business and required large rate increases. Although unprofitable business did terminate, it terminated faster than new profitable business was being issued. The lowering of Central's A.M. Best rating, to B from B+, also had a negative effect on the sale of ordinary life and annuity policies during 1997.
Benefits and claims incurred expenses increased 3% in 1997 to $210,776,366 in 1997 from $203,677,232 in 1996. The incurred loss ratio was 81.4% for 1997 compared to 78.9% for 1996. The major reasons for the increase in the claims loss ratio and the level of claims incurred were (a) the continued effect of an underpriced product sold heavily in 1995, (b) a larger number of unexpected and unanticipated prior year claims (1996) paid in 1997, resulting in a 1996 reserve deficiency of approximately $7 million, (c) larger number of annuity policies lapsed than anticipated, (d) a run off in claims due to rate renewal actions and (e) a reserve strengthening in the fourth quarter of 1997.
Operating expenses increased 6% to $39,242,350, or 15.2%, of premiums in 1997 compared to $36,874,665, or 14.3%, of premiums in 1996. Although salaries, benefits and premium taxes remained the largest portions of the total operating expenses, other operating expenses increased due to the costs incurred relative to seeking additional funds for capital and surplus during 1997 for Central.
Interest expense increased 33% to $1,078,198 from $812,833 in 1996. The increase was due to the $5.2 million loan in June 1997 and the $20 million loan in December 1997. The $5.2 million loan was paid off in December 1997.
The net loss for 1997 was $20,956,356, or $5.01 per share, compared to $9,288,365, or $2.25 per share, in 1996. The Company's revenues increased approximately $647,000, however claims and expenses increased over $7 million, the majority being in claims. Central's group accident and health business represented 98% of the revenues and a higher loss ratio from this segment has a negative effect on earnings. The statutory loss ratio for the group accident and health segment increased to 81.7% in 1997 compared to 77.9% in 1996. Although the losses were higher in 1997, Central received $14 million from the Company and issued a surplus note for the $14 million and received a $10 million ceding allowance from a reinsurance treaty, both of which increased Central's statutory capital and surplus. At December 31, 1997, Central's statutory capital and surplus was $24,650,804, which was above any regulatory action levels.
For information concerning the provision for income taxes, as well information regarding differences between effective tax rates and statutory tax rates, see Note G of the Notes to Consolidated Financial Statements.
Products included in the life and annuity segment include term insurance, single premium deferred annuities, flexible premium deferred annuities, and single premium immediate annuities. These products are not marketed aggressively by the Company, and are underwritten as an accommodation product. Such products are segregated from the group life and health segment based upon significant differences in the sales and administration of such policies, including the underwriting and claims adjudication processes.
The corporate and other segment encompasses all other activities of the organization, including interest income and expense of the parent company.
The group life and health segment had net revenues of $168,000,000 for 1998, compared to $263,000,000 for 1997. The primary reason for the decrease in net revenue is due to the quota share reinsurance treaties with Hannover and UBL, which reduced net premium by $101,000,000 ($147,000,000 in ceded premium, offset by an increase in assumed premium of $46,000,000). The remaining differences were related to an increase in direct premium of $2,700,000, an increase in other income of approximately $1,700,000, and an increase in investment income of approximately $700,000.
The life and annuity segment had revenues of $1,900,000 in 1998, compared to $2,100,000 in 1997. The decrease was due to a reduction in life premiums earned in 1998 and investment income due to a decrease in investments. Expenses were $2,200,000 in 1998, compared to $2,400,000 in 1997. The primary reason for the decrease was due to a release of reserves applicable to annuities that were surrendered for cash.
Liquidity is the ability of an enterprise to generate adequate amounts of cash to meet its financial commitments. The major needs for cash are to enable Central to pay claims and expenses as they come due. Central's primary sources of cash are premiums and investment income. Central's payments consist of current claim payments to insureds, managed care expenses, operating expenses such as salaries, employee benefits, commissions, taxes, and shareholder dividends payable to the Company. The Company has, in the past, relied on the dividend from Central to enable it to pay dividends to shareholders. Central and the Company discontinued paying dividends at the end of 1996. By statute, the state regulatory authorities set minimum liquidity standards to protect both policyholders and shareholders and limit the dividends payable by Central to the Company.
$8,899,659 at amortized cost (held to maturity) and fixed maturities of $80,832,097 at estimated fair value (available for sale) at December 31, 1998. The Company does not hold any so-called "junk" bonds or what are generally considered high-yield type securities, and 100% of the bonds are of investment grade quality. In addition to the fixed maturities, the Company also had $15,031,058 in cash and cash equivalents at December 31, 1998 and a $15 million line of credit with a major bank. There was no amount outstanding on the line of credit at December 31, 1998. Effective February 17, 1999, this line of credit was replaced with a $10 million line of credit as described below.
Assets increased 33% to $180,233,135 at December 31, 1998 from $135,803,577 at December 31, 1997. The increase was primarily due to the July Equity Financing and reinsurance transactions in 1998.
The total policy liabilities and accruals increased to $97,113,067 at December 31, 1998, or approximately 20%, from $81,090,299 at December 31, 1997. The increase was primarily due to an increase in reserves for the UBL block of policies reinsured in the third quarter of 1998. The Company's shareholders' equity was $35,835,714 at December 31, 1998 compared to $1,511,842 at December 31, 1997. The increase was primarily due to the July Equity Financing.
To provide funds for the acquisition of CGIC, the Company incurred a debt of $40 million under a Credit Agreement. Under the terms of the Credit Agreement, dated as of February 17, 1999, among the Company, various lending institutions and The Chase Manhattan Bank ("Chase"), as Administrative Agent (the "Credit Agreement"), the first principal payment of $3.0 million is due February 17, 2000. Quarterly payments are due thereafter starting with $1.0 million through February 17, 2001; $1.5 million thereafter through February 17, 2002; and $2.25 million every three months thereafter to February 17, 2005. Interest on the outstanding balance will be determined based on whether the Company selects 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(x) the rate which is 1/2 of 1% in excess of a federal funds rate and (y) 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 Credit Agreement also provides for a $10 million line of credit which bears interest at the same rate as the $40 million loan. There is currently no amount outstanding under the line of credit.
Interest Rate Risk is the risk that interests 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 Central attempts to mitigate this risk by charging fees for non-conformance with certain policy provisions and/or by attempting to match the maturity schedule of its assets with the expected payouts of its liabilities To the extent that liabilities come due more quickly than assets mature, an insurer would have to sell assets prior to maturity and recognize a gain or loss.
The Company has undertaken a plan to resolve the Y2K issue which involves the following phases: assessment, strategy, implementation and testing/certification.
to modify or replace significant portions of Central's hardware and software so that those systems will properly utilize dates beyond December 31, 1999.
Phase 2 -- Strategy. This phase involves the development of appropriate strategies for both IT and non-IT systems. The selection of an appropriate strategy is based upon such factors as the assessments made in Phase 1, the type of system, the availability of a Y2K-compliant replacement and cost. The strategy phase has been completed for all IT systems. The Company outsourced IT systems to an outside vendor as of March 31, 1998 for Central and transitioned processing of certain critical business applications to the outside vendor later in 1998. The vendor has represented that the IT systems utilized for processing certain transactions of Central are Y2K compliant as of December 31, 1998. Central, in conjunction with the outside vendor, has identified other business application software that is critical to Central's operations and is in the process of executing remediation plans relative to such applications. For those applications the Company and the outside vendor anticipate the systems will be Y2K compliant by July 31, 1999.
As indicated in Phase 1, above, the strategy, implementation and testing and certification phases for PALHIC and CGIC have started and are on schedule for completion in 1999.
Contingency Plans -- As a precautionary measure, the Company is currently developing contingency plans for all systems by department and business function which are expected to be in place by the end of the third quarter of 1999. These plans include information systems recovery, remote site processing and manual procedures to ensure that critical business functions continue without effecting customers and business partners. The Company's subsidiaries can process business on other systems within the group. A special team will create a plan that will document how business may be transferred between the companies for processing.
Cost -- The total cost of the Y2K project is estimated at $5.5 million of which approximately 50% consists of costs related to employees of the Company and is being funded through operating cash flows. To date, the Company has incurred approximately $2.6 million related to all phases of the Y2K project. The estimated additional costs are currently expected to be $2.9 million, which includes PALHIC and CGIC.
Based upon its efforts to date, the Company believes that the vast majority of both its IT and its non-IT systems, including all critical and important systems will remain up and running after January 1, 2000. Accordingly, the Company does not currently anticipate that internal systems failures will result in any material adverse effect to its operations or financial condition. During 1999, the Company will also continue and expand its efforts to ensure that major third-party businesses and public and private providers of infrastructure services, such as utilities, communications services and transportation, will also be prepared for Y2K, and to develop contingency plans to address any failures on their part to become Y2K compliant. At this time, the Company believes that the most likely "worst-case" scenario involves potential disruptions in areas in which the Company's operations must rely on the outside vendor. While such failures could affect important operations of the Company and its subsidiaries, either directly or indirectly, in a significant manner, the Company cannot at present estimate either the likelihood or the potential cost of such failures.
Inflation has had an impact on claim costs and overall operating costs and although it has been lower in the last few years, hospital and medical costs have still increased at a higher rate than general inflation, especially in prescription drug costs. New, more-expensive and wider use of pharmaceuticals is inflating health care costs. The Office of Personnel Management reported the costs of prescription drugs increased by 22% in 1998. While to a certain extent these increased costs are offset by interest rates (investment income), hospital charges increased, while the rate of income from investments has not increased proportionately. The Company will continue to establish premium rates in accordance with trends in hospital and medical costs along with concentrating on various cost containment programs. However, there can be no assurance that these efforts by the Company will fully offset the impact of inflation or that premiums will equal or exceed increasing health care costs.
In December 1997, the AICPA issued SOP 97-3, Accounting by Insurance and Other Enterprises for Insurance-Related Assessments, which provides guidance for determining when an insurance or other enterprise should recognize a liability for guaranty-fund and other insurance-related assessments and guidance for measuring the liability. This statement is effective for the Company's 1999 financial statements with early adoption permitted. The Company does not expect adoption of this statement to have a material effect on its financial position or results of operations.
This report on Form 10-K contains both historical and forward-looking statements. Forward-looking statements are statements other than historical information or statements of current condition. The forward-looking statements relate to the plans and objectives of the Company for future operations. In light of the risks and uncertainties inherent in all future projections, the inclusion of the forward-looking statements should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved. Many factors could cause the Company's actual results to differ materially from those in the forward-looking statements, including the following:
- the failure to successfully integrate the businesses of PALHIC, CGIC or UBL into the Company, including the failure to achieve cost consolidations;
- unforeseen losses with respect to loss and settlement expense reserves for unreported and reported claims;
- the Company's visibility in the market place and its financial and claims paying ratings;
- the risk that issuers of securities owned by the Company will default or that other parties will not pay or perform;
- the failure to complete the Y2K conversion, including the success of the outside vendor of Central in being Y2K compliant; and
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Central Reserve Life Corporation and subsidiaries as of December 31, 1997, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 1997, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
Columbus, Ohio KPMG LLP February 20, 1998, except for Notes B and C, as to which the date is March 30, 1998.
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
Ceres Group, Inc. (the "Company"), known as Central Reserve Life Corporation prior to December 8, 1998, operated in 1998 and prior periods primarily through its wholly-owned subsidiary, Central Reserve Life Insurance Company ("Central"). Central is a life and accident and health insurer, domiciled in Ohio, offering a full range of life, health, and annuity products distributed through general agents and independent writing agents. While Central is licensed in 36 states, approximately 67% of premium volume is generated from seven states: Ohio, Indiana, North Carolina, Arizona, Michigan, South Carolina, and Tennessee. As described more fully in Notes D and I, in the latter half of 1998 and early 1999, the Company completed a quota share reinsurance transaction and two acquisitions, which management anticipates will expand the business of the Company.
Investments in equity securities and non-redeemable preferred stocks are reported at fair value.
Property and equipment are carried at cost less allowances for depreciation and amortization. The home office building is depreciated on the straight-line method over 31.5 years, except for certain components which are depreciated over 15 years. Depreciation for other property and equipment is computed on the straight-line basis over the estimated useful lives of the equipment, principally five and seven years.
Liabilities for unpaid life and accident and health claims, which include a provision for estimated costs to investigate and settle claims, are estimated based upon past experience for pending, incurred but not reported, and reopened claims. Accident and health claims incurred but not reported are computed using actuarially-determined factors based on a combination of claim completion and projected claim cost methods, utilizing durational experience, seasonal cycle, changes in health care practice, changes in inflation rates, and the claims backlog. 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; such adjustments are included in current operations.
Deferred reinsurance gain consists of initial ceding allowances received from reinsurers. Such amounts are amortized into income over the estimated remaining life of the underlying policies reinsured.
As of January 1, 1998, the Company adopted FASB Statement No. 130, Reporting Comprehensive Income ("FAS 130"). FAS 130 establishes new rules for the reporting and display of comprehensive income and its components; however, the adoption of this Statement had no impact on the Company's net income or shareholders' equity. FAS 130 requires unrealized gains or losses on the Company's available-for-sale securities, which prior to adoption were reported separately in shareholders' equity, to be included in other comprehensive income. Prior year financial statements have been reclassified to conform to the requirements of FAS 130.
The consolidated financial statements reflect estimates and judgments made by management that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and revenues and expenses for the reporting period. Actual results could differ significantly from those estimates.
In June 1997, the FASB issued Statement No. 131, Disclosures About Segments of an Enterprise and Related Information ("FAS 131"). FAS 131 requires that a public business enterprise report a measure of segment profit or loss, certain specific revenue and expense items, and segment assets. It requires reconciliations of total segment revenues, total segment profit or loss, total segment assets, and other amounts disclosed for segments to corresponding amounts in the enterprise's general-purpose financial statements. FAS 131 also requires that a public business enterprise report descriptive information about the way that the operating segments were determined, the products and services provided by the operating segments, differences between the measurements used in reporting segment information and those used in the enterprise's general-purpose financial statements, and changes in the measurement of segment amounts from period to period.
In November 1997, the Company entered into a Stock Purchase Agreement ("Original Stock Purchase Agreement") with Strategic Acquisition Partners, LLC ("Strategic"), wherein the Company agreed to issue and sell 5,000,000 common shares and warrants to purchase an additional 2,500,000 common shares at an exercise price of $6.50 per share, for an aggregate purchase price of $27,500,000. On March 30, 1998, the Company entered into an amended and restated Stock Purchase Agreement ("New Stock Purchase Agreement") with Strategic and two additional investors: Insurance Partners, L.P. and Insurance Partners Offshore (Bermuda), L.P. (collectively, "Insurance Partners"). The New Stock Purchase Agreement was subsequently approved by shareholders, and accordingly, in July 1998 the Company issued and sold 7,300,000 common shares at $5.50 per share and warrants to purchase an additional 3,650,000 common shares at an exercise price of $5.50 per share, which expire July 2, 2005, and received proceeds of $37,675,000, which are net of transaction expenses.
In connection with the Original Stock Purchase Agreement, Strategic arranged an interim loan (the "Bridge Loan") of $20,000,000 to the Company. The bridge loan was due June 30, 1998, and bore interest at the prime rate of a major commercial bank. As consideration for the arrangement, the Company issued Strategic warrants to purchase 800,000 common shares at $6.00 per share in December 1997, which expire December 2002, and additional warrants to purchase 200,000 common shares at $6.00 per share in July 1998, which expire on July 2, 2003. Proceeds from the Bridge Loan were used as follows: (i) $5,200,000 was used to repay outstanding bank debt, (ii) $14,000,000 was used by the Company to invest in the statutory surplus of Central, and was evidenced by a surplus note in favor of the Company from Central, and (iii) $800,000 was used to establish an interest reserve at the Company and to pay transaction expenses. The Bridge Loan was repaid in full by the Company in July 1998 from the proceeds received in accordance with the New Stock Purchase Agreement.
which raised substantial doubt about the Company's ability to continue as a going concern at December 31, 1997 have been alleviated.
On December 31, 1998, Central acquired 100% of the outstanding common stock of Provident American Life and Health Insurance Company ("PALHIC") from Provident American Corporation ("PAMCO") for $5,505,000. PALHIC is a life and accident and health insurer, domiciled in Pennsylvania, licensed in 40 states and the District of Columbia, that markets managed care health insurance products to individuals and small businesses, and critical illness coverage. Funds for the acquisition were provided from Central's working capital. This transaction has been accounted for in the accompanying consolidated financial statements in accordance with the purchase method and accordingly, the purchase price was allocated to assets and liabilities acquired based upon estimates of their fair values. There is no impact on the accompanying consolidated statement of operations for 1998 as a result of this transaction. Revenues of PALHIC are not material to the consolidated revenues of the Company.
Immediately prior to the completion of this transaction, PALHIC ceded 100% of its insurance in force to Provident Indemnity Life Insurance Company ("PILIC"), a subsidiary of PAMCO.
On February 17, 1999, the Company entered into a $40,000,000 credit facility with a syndicate of major commercial banks. In accordance with the terms of the loan, the first principal payment of $3,000,000 is due February 17, 2000. Quarterly payments are due thereafter as follows: $1,000,000 through February 17, 2001; $1,500,000 thereafter through February 17, 2002; and $2,250,000 every three months thereafter to Febru-
ary 17, 2005. The loan bears interest at a variable rate (approximately 8.75% at February 17, 1999). The Company has pledged the common stock of Continental and Central as security for the loan. The credit facility prohibits the payment of dividends upon the Company's Common Shares, except upon compliance with certain conditions.
The amortized cost and estimated fair value of fixed maturities at December 31, 1998, by contractual maturity, are as follows:
Proceeds, gross realized gains and gross realized losses from the sale (excluding calls, maturities and pay downs) of fixed maturities available-for-sale during each year were as follows:
At December 31, 1998, cash includes $4,345,322 held for self-funded accident and health accounts, which is restricted to use. Central is entitled to investment income from these funds. A corresponding liability is included in the accompanying consolidated financial statements.
At December 31, 1998, the Company held no unrated or less-than-investment grade bonds. The Company performs periodic evaluations of the relative credit standings of the issuers of the bonds held in the Company's portfolio. These evaluations are considered by the Company in its overall investment strategy.
Other property and equipment consists principally of furniture, fixtures, and data processing equipment. Depreciation expense for the years ended December 31, 1998, 1997 and 1996 was $874,918, $1,104,230, and $1,136,390, respectively.
If the IRS were to prevail in its position that Central no longer qualified as a life company for tax purposes, approximately $2,600,000 of tax and interest would be payable and federal income taxes would increase in the future. Presently, as a small life company having less than $500,000,000 in total assets, Central is permitted, among other things, a deduction from the first $3,000,000 of income of 60% or $1,800,000. As Central's income increases above $3,000,000, the special deduction is reduced proportionately.
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1998 and 1997 are presented below:
Reserve liabilities assumed by Central under the UBL agreement on August 1, 1998 exceeded the cash transferred to Central by UBL as reimbursement for this assumption by $3,000,000, which is reflected in a note receivable. Subsequent to August 1, 1998, the balance of the note receivable was increased to $7,367,556 as a result of adverse developments in the assumed policy liabilities, net of amounts ceded to Hannover, and net of an allowance for uncollectability. The note receivable is secured by the outstanding common stock and assets of UBL, which assets include real estate, bonds and reinsurance receivables from an unrelated party, and commissions due to IAA. Effective March 17, 1999, the Company and UBL executed an agreement for Central to assume ownership of UBL in satisfaction of the note receivable. The Company anticipates that such transaction will be completed during the second quarter of 1999.
In connection with the UBL reinsurance treaty, Central ceded to Hannover 80% of the book of business assumed from UBL. This treaty provided Central an initial ceding allowance of $20,000,000, which is being accounted for as a deferred reinsurance gain in the accompanying consolidated financial statements, and will be amortized into income over the duration of the underlying block of business.
In December 1997, Central entered into a retroactive reinsurance treaty (the "1997 Treaty") with Hannover. The quota share treaty was effective January 1, 1997, and covered certain group accident and health policies in force and written during 1997. Under the provisions of the 1997 Treaty, Central cedes 50% of the premiums of the eligible policies, and in return receives reimbursement for 50% of the claims paid, plus a commission and expense allowance. In connection with the 1997 Treaty, Central transferred $24,550,000 of reserves to Hannover, and received an initial ceding allowance of $10,000,000, resulting in a net cash transfer of $14,550,000 to Hannover. The initial ceding allowance is reported as a deferred reinsurance gain, in the accompanying consolidated financial statements.
In the ordinary course of business, Central maintains other reinsurance arrangements with other insurers. These arrangements are designed to limit the maximum amount of exposure that Central retains on a given policy. For ordinary and group life claims, Central's maximum retention is $50,000, with no retention maintained over age 70. Maximum retention on substandard risks is $10,000. For accident and health claims, maximum retention on individual claims is $500,000.
Central remains obligated for amounts ceded in the event that the reinsurers do not meet their obligations.
Other reinsurance arrangements in conjunction with other business combinations are described in Note D.
On December 16, 1997, Central issued to the Company a $14,000,000 surplus note with interest on the unpaid balance payable quarterly at a fixed rate of 8 1/2%. Central reported the $14,000,000 as surplus rather than a liability in accordance with statutory accounting practices. In June 1998, the Company converted the surplus note into a capital contribution to Central.
At December 31, 1998, the Company maintained a $15,000,000 line of credit arrangement with a major commercial bank for short-term borrowings. There was no amount outstanding on the line of credit at December 31, 1998. Effective February 17, 1999, this line of credit was replaced with a $10,000,000 line of credit with a syndicate of major commercial banks.
On March 5, 1983, the Company adopted an Incentive Stock Option Plan (the "1983 Plan"). The 1983 Plan, which expired in May 1993, provided that key full-time employees of the Company and its subsidiaries were eligible for participation. The following table summarizes data regarding the 1983 Plan.
In 1998, pursuant to various individual employment agreements with certain key officers, and pursuant to the 1998 Key Employee Share Incentive Plan, the Company granted common stock options to certain employees. Such grants generally vest over three years, and expire ten years from the date of the grant. Also in 1998, pursuant to an employment contract, the Company provided an award of common shares to a key employee. The number of shares awarded is contingent upon the weighted average fair value of the common shares over specified periods, but is based on a fixed dollar amount. The award vests on July 1, 2001, and management currently estimates that 395,669 shares will be issued at that date, based upon the fair value of the Company's shares at December 31, 1998.
As required by FASB Statement No. 123, Accounting for Stock-Based Compensation,the Company has estimated the pro forma impact on net income and earnings per share of stock-based compensation under the fair value method, using the Black-Scholes option valuation model.
The statutory capital and surplus of PALHIC as reported in its Annual Statement filed with regulatory authorities at December 31, 1998 was $5,392,945.
At December 31, 1998, total statutory capital and surplus of Central and PALHIC are approximately $27,900,000 and $3,900,000 in excess of minimum regulatory requirements, respectively.
Central and PALHIC are subject to certain Risk-Based Capital ("RBC") requirements as specified by the NAIC. The RBC model serves as a benchmark for the regulation of life and accident and health insurance companies by state insurance regulators. At December 31, 1998, both Central and PALHIC exceeded the minimum RBC requirements.
The amount of dividends which Central and PALHIC can pay is subject to certain regulatory restrictions. In 1999, Central can pay approximately $1,056,000 in dividends without the prior approval by the Ohio Insurance Commissioner. In 1999, PALHIC cannot pay any dividends without the prior approval of the Pennsylvania Insurance Commissioner as a result of its statutory unassigned deficit at December 31, 1998.
The following table sets forth the computation of basic and diluted loss per share:
In 1998, 1997 and 1996, there were no differences between basic and diluted loss per share because the Company reported net losses in those years, and the exercise of potential shares would therefore have been antidilutive.
The Company has identified three distinct operating segments based upon product types, as follows: group life and health, life insurance and annuities, and corporate and other.
Products included in the group life and health segment include short-term major medical insurance products and comprehensive major medical plans. Group life policies are included in this segment because such policies are issued only in conjunction with health insurance policies, and the costs of administering those policies are incidental to the administration of the related health policies.
Products included in the life and annuity segment include term insurance, single premium deferred annuities, flexible premium deferred annuities, and single premium immediate annuities. These products are not marketed aggressively by the Company, and are underwritten as an accommodation product. Such products are segregated from the group life and health segment based upon significant differences in the sales and administration of such policies, including the underwriting and claims adjudication process.
Revenues from each segment are primarily generated from premiums charged to external policyholders and interest earned on cash and investments, and are summarized in the following tables:
The Company does not separately allocate investment or other identifiable assets by industry segment, nor are income tax (benefits) expenses allocated by industry segment. The Company also expanded the detail of its disclosures for 1998, 1997 and 1996, which included certain reclassifications.
CASH, CASH EQUIVALENTS, PREMIUMS RECEIVABLE, NOTE RECEIVABLE, REINSURANCE RECEIVABLE, AND POLICY LOANS -- The carrying amounts reported in the consolidated balance sheets for these instruments approximate their fair value.
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of fixed maturity investments, cash, cash equivalents and reinsurance receivable.
Substantially all of the Company's reinsurance recoverable is due from a single reinsurer, Hannover. At December 31, 1998, Hannover maintains an "A" rating from the A.M. Best Company. The Company performs periodic evaluation of this reinsurer's credit standing.
The following is a summary of quarterly results of operations for the years ended December 31, 1998 and 1997:
(b) Includes $3,700,000 related to policy administration fees expensed to Hannover in 1998.
(c) The sum of basic and diluted income (loss) per share by quarter does not agree with the amounts reported on the statement of operations due to the issuance of 7,300,000 Company Common Shares in July 1998.
CERES GROUP, INC. (PARENT ONLY) STATEMENTS OF OPERATIONS - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------