Our executive offices are located in Rye Brook, New York. Marketing and professional staff for our U.S. insurance subsidiaries occupy space in Lake Mary, Florida. Our Administrative Services operations occupy office space in Pensacola and Weston, Florida and Mississauga, Ontario, Canada. Our Medicare Advantage operations occupy office space in Houston and Beaumont, Texas. We lease all of the
(2) Includes the results of Heritage Health Systems, Inc. since its acquisition on May 28, 2004.
(3) Prior period amounts have been adjusted to reflect the operations of our Canadian subsidiary as discontinued operations.
The following discussion and analysis presents a review of the Company as of December 31, 2006 and its results of operations for the fiscal years ended December 31, 2006, 2005 and 2004.
Policyholder account balances represent the balance that accrues to the benefit of the policyholder, otherwise known as the account value, as of the financial statement date. Account values are increased for additional deposits received and interest credited based on the account value. Account values are reduced by surrenders and other withdrawals, including withdrawals relating to the cost of insurance and expense charges. The interest crediting rates are reviewed periodically and adjusted (with certain minimum levels below which the crediting rate cannot fall).
The liability for future policy benefits represents the present value of future benefits to be paid to or on behalf of policyholders, less the future value of net premiums and is calculated based on actuarially recognized methods using morbidity and mortality tables, which are modified to reflect the Company’s actual experience when appropriate.
A portion of our reserves for long-term care products also reflect our estimates relating to members currently receiving benefits. These reserves are estimated primarily using recovery and mortality rates, as described above.
The Policy and Contract Claims liability for our Accident and Health Policies include a liability for unpaid claims, including claims in the course of settlement, as well as a liability for incurred but not yet reported claims (“IBNR”). Our IBNR, by major product grouping is as follows:
Many factors can affect these reserves and liabilities, such as economic and social conditions, inflation, hospital and pharmaceutical costs, changes in doctrines of legal liability, premium rate increases and extra contractual damage awards. Therefore, the reserves and liabilities we establish are based on extensive estimates, assumptions and prior years’ statistics. When we acquire other insurance companies or blocks of insurance, our assessment of the adequacy of acquired policy liabilities is subject to similar estimates and assumptions. Establishing reserves involves inherent uncertainties, and it is possible that actual claims could materially exceed our reserves and have a material adverse effect on our results of operations and financial condition.
We develop our estimate for IBNR using actuarial methodologies and assumptions, primarily based upon historical claim payment and claim receipt patterns, as well as historical medical cost trends. Depending on the period for which incurred claims are estimated, we apply a different method in determining our estimate. For periods prior to the most recent three months, the key assumption used in estimating our IBNR is that the completion factor pattern remains consistent over a rolling 12-month period after adjusting for known changes in claim inventory levels and known changes in claim payment processes. Completion factors result from the calculation of the percentage of claims incurred during a given period that have historically been adjudicated as of the reporting period. For the most recent three
Our historical assumptions have not varied significantly from the actual amounts experienced to the extent that such variance resulted in a material adverse impact on reserves and net income. Activity in the accident & health policy and contract claim liability is as follows:
During 2006, the claim reserve balances at December 31, 2005 ultimately settled during 2006 for $0.6 million less than originally estimated, representing 0.1% of the incurred claims recorded in 2005. During 2005, the claim reserve balances at December 31, 2004 ultimately settled during 2005 for
Beginning in 2002, we began to increase our retention of new Medicare supplement policies issued. The method used to determine the portion of the claims reserves ceded to our reinsurers was not appropriately reflecting the effect of these increasing retention levels. The method used resulted in the build up of the overstatement from 2002 through the third quarter of 2005.
The dilution to net income and EPS for prior period financial statements as a result of this adjustment is less than 1.6% in any prior year and the understatement is 3.6% in the year of correction. We believe these impacts are not material. In addition, the growth rate before and after the adjustment is substantially the same. Accordingly, we believe that the adjustment did not materially affect the earnings reported or trends in earnings growth for the periods impacted.
The liability for unpaid claims, including IBNR, include estimates of amounts to fully settle known reported claims as well as claims related to insured events that the Company estimates have been incurred, but have not yet been reported to the Company.
The cost of acquiring new business, principally non-level commissions, agency production, policy underwriting, policy issuance, and associated costs, all of which vary with, and are primarily related to the production of new and renewal business, are deferred. For interest-sensitive life and annuity products, these costs are amortized in relation to the present value of expected gross profits on the policies arising principally from investment, mortality and expense margins in accordance with FAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments”. The determination of expected gross profits for interest-sensitive products is an inherently uncertain process that relies on assumptions including projected interest rates, the persistency of the policies issued as well as anticipated benefits, commissions and expenses. It is possible that the actual profits from the business may vary materially from the assumptions used in the determination and amortization of deferred acquisition costs (“DAC”).
determination of DAC. Actual experience may vary from assumed trends, however these assumptions are not changed unless prospective unlocking is triggered. Prospective unlocking revised the assumptions to bring them in line with emerging experience. Annually, during its third fiscal quarter, the Company performs an analysis to determine whether unlocking as a result of significant changes in the actual premium rate increase experience. At the point when unlocking is triggered, the DAC model is modified prospectively with assumptions for all components, including rate increases, persistency, benefit design and expenses updated based on actual experience. If and when unlocking of assumptions is triggered, there is not immediate impact on the DAC balance. Rather, the unlocking impacts the pattern of the future amortization of the DAC balance. The reserves for future policy benefits for Medicare supplement business also are impacted prospectively by unlocking and according, similar assumption revisions would occur.
During the third quarter of 2006, the annual test for unlocking was performed and we determined that there were no significant changes in the actual premium rate increase experience. Accordingly, there was no prospective unlocking of assumptions for DAC for the Company’s Medicare supplement business during 2006. However, based on current premium rate trends, we believe that it is likely that unlocking will be triggered during 2007. The balance of DAC for Medicare Supplement business as of December 1, 2006 was approximately $121 million. Should the unlocking be triggered in 2007, we anticipate that it is reasonably likely that the amortization subsequent to the unlocking will be slower in the initial quarters subsequent to unlocking by between $0.3 million and $0.8 million per quarter and then it will increase.
Other amortizing assets include acquired life and accident & health policy bases, managed care membership bases, provider contracts, customer contracts and hospital network contracts. Below is a table reflecting our amortization policies for each of these items:
At least annually, management reviews the unamortized balances of present value of future profits, goodwill and other identified intangibles to determine whether events or circumstances indicate the carrying value of such assets is not recoverable, in which case an impairment charge would be recognized. Management believes that no impairments of present value of future profits, goodwill or other identified intangibles existed as of December 31, 2006.
Fair value of investments is based upon quoted market prices, where available, or on values obtained from independent pricing services. For certain mortgage-backed and asset-backed securities, the determination of fair value is based primarily upon the amount and timing of expected future cash flows of the security. Estimates of these cash flows are based upon current economic conditions, past credit loss experience and other circumstances.
security until recovery. The cost basis for securities determined to be impaired are reduced to their fair value, with the excess of the cost basis over the fair value recognized as a realized investment loss.
We entered the Medicare Advantage business in 2004 with the acquisition of Heritage Health Systems, Inc. which operates Medicare Advantage coordinated care plans in Southeastern Texas and began offering new PFFS plans in 2 states. During 2006, we increased the marketing of PFFS plans to a total of 15 states.
commercial managed care plan in Oklahoma City, OK for $17.5 million in cash. Harmony was a majority-owned subsidiary of the Oklahoma City Clinic. Founded in 2002, GlobalHealth currently has approximately 3,200 Medicare Advantage members with annualized revenue of approximately $30 million. Under the terms of the agreement, the Oklahoma City Clinic has entered into a long-term agreement with Universal American to provide healthcare services to GlobalHealth members. In addition, Oklahoma City Clinic will retain the risk for commercial business under a global capitation arrangement.
Through our strategic alliance with PharmaCare, we retain 50% of the Medicare Part D business of our PDPs. The remainder is reinsured PharmaCare Re on a 50% quota share basis. Additionally, as part of the strategic alliance, we created PDMS, which is 50% owned by us and 50% owned by PharmaCare. PDMS principally performs marketing and risk management services on behalf of our PDPs and PharmaCare Re.
(1) We evaluate the results of operations of our segments based on income before realized gains and income taxes. Management believes that realized gains and losses are not indicative of overall operating trends. This differs from generally accepted accounting principles, which includes the effect of realized gains in the determination of net income. The schedule above reconciles our segment income to net income in accordance with generally accepted accounting principles.
Net income for 2006 increased to $119.3 million, or $1.99 per diluted share, compared to $53.9 million, or $0.91 per diluted share for 2005. Income from continuing operations, after taxes, was $61.1 million, or $1.02 per diluted share for 2006 compared income from continuing operations, after taxes, of $43.8 million, or $0.74 per diluted share for 2005. Income from continuing operations for 2006 includes realized investment gains, net of tax, of $5.0 million, which reflects a benefit from a $1.9 million release of a tax valuation allowance relating to net capital loss carryforwards. Realized investment gains, net of tax, included in income from continuing operations for 2005 was $4.9 million, which reflects a benefit from a $1.7 million release of a tax valuation allowance relating to net capital loss carryforwards. Our effective tax rate for continuing operations was 34.8% for 2006, and 34.1% for 2005, reflecting the release of the valuation allowance noted above.
Our Senior Managed Care-Medicare Advantage segment generated segment income of $10.5 million during 2006, a decrease of $17.0 million, compared to $27.8 million for 2005, primarily due to expenses of approximately $24.9 million relating to expansion initiatives for our Medicare Advantage plans, offset in part by the continued growth in membership in our Medicare Advantage plans.
Our Specialty Health Insurance segment income decreased by $1.9 million, or 16%, compared to 2005, primarily as a result of worsening morbidity in our long-term care lines.
Net income for 2005 declined 16% to $53.9 million, or $0.91 per diluted share, compared to $63.9 million, or $1.13 per diluted share in 2004. Income from continuing operations, after taxes, was $43.8 million, or $0.74 per diluted share for 2005 compared income from continuing operations, after taxes, of $51.8 million, or $0.92 per diluted share for 2004. Income from continuing operations for 2005 was affected by higher claim costs and reserve adjustments in our Medicare supplement business, which reduced net income by $6.3 million, or $0.11 per diluted share, and increased lapsation of our Medicare supplement in force business, which resulted in an acceleration of the amortization of deferred acquisition costs and present value of future profits which reduced net income by $1.7 million, or $0.03 per diluted share. Additionally, income from continuing operations for 2005 was reduced by after-tax expenses of $8.1 million, or $0.14 per diluted share, relating to the implementation of our Part D program and Medicare Advantage growth initiatives. These items are offset, in part, by the growth in our Senior Managed Care business, which added $11.5 million, or $0.21 per diluted share, in 2005.
Income from continuing operations for 2005 includes realized investment gains, net of tax, of $4.9 million, which reflects the benefit from a $1.7 million release of a tax valuation allowance relating to capital loss carryforwards. The realized investment gains during 2005 were generated as we took advantage of the tightening of the yield curve and sold longer duration investments. Income from continuing operations for 2004 includes realized investment gains, net of tax, of $3.7 million. Our effective tax rate for continuing operations was 34.1% for 2005, reflecting the release of the valuation allowance noted above, and 33.1% for 2004.
Our Senior Managed Care-Medicare Advantage segment generated segment income of $27.8 million during 2005, an increase of $17.7 million, compared to $10.1 million in 2004, primarily due to the inclusion of the results of Heritage for the full year in 2005 compared to only seven months in 2004 and the continued growth in membership in our Medicare Advantage plans. This segment includes the results of Heritage and our other initiatives in Medicare managed care, including our Medicare Advantage private fee-for-service plans, since our acquisition or inception during the second quarter of 2004.
Our Specialty Health Insurance segment income decreased by $0.2 million, or 2%, to $12.1 million for 2005 compared to $12.3 million for 2004, primarily due to higher claim costs, partially offset by the allowances earned on the new reinsurance arrangement with PharmaCare Re.
The loss from our Corporate segment increased by $1.4 million, or 12%, compared to 2004. The increase was due primarily to higher interest cost as a result of an increase in the amount of the debt outstanding during the year, relating to the amendment of our credit facility in connection with our acquisition of Heritage, and an increase in the weighted average interest rates, as compared to 2004.
Our Senior Managed Care-Medicare Advantage segment includes the operations of our initiatives in managed care for seniors. We operate various health plans that offer coverage to Medicare beneficiaries, under contracts with CMS, in Southeastern Texas, Oklahoma and Florida. The health plans are sold by our
career and independent agents and directly by employee representatives. In connection with the health plans, we operate separate MSO’s that manage that business and affiliated IPA’s. We participate in the net results derived from these affiliated IPA’s. Our Medicare Advantage PFFS plans, also under a contract with CMS, are sold by our career and independent agents through American Progressive and Pyramid Life.
Revenues. Net premiums for the Senior Managed Care segment increased by $206.8 million, or 87%, compared to 2005. Approximately $192.4 million of the increase was due to growth in membership. Pursuant to the MMA, we began to receive incremental revenue from CMS for the Part D prescription drug benefit in 2006. For 2006, our health plans received $28.0 million from CMS for the Part D prescription drug benefit. Those increases were partially offset by $13.8 million related to the reduction in the average premium PMPM due to an increase in the percentage of members in our PFFS plans which have a lower PMPM than our health plans. Net investment income increased by $3.1 million, due primarily to growth in invested assets as a result of growth in business, as well as increased yields.
Benefits, Claims and Expenses. Medical expenses increased by $161.3 million, or 94%, compared to 2005. Growth in membership added approximately $120.5 million. The enhanced prescription drug benefit increased pharmacy benefit costs by $12.0 million to $22.4 million. The balance of $28.8 million was due to an increase in the loss ratio. Overall loss ratios for the segment increased by 290 basis points to 74.7% for 2006 from 71.8% for 2005. Commissions and general expenses increased by $64.7 million compared to 2005, due primarily to the growth in business, including $24.9 million for marketing costs for new service areas and other development activities, as well as an increase in commissions, as more of the Medicare Advantage product is being sold by our agents.
Revenues. Net premiums for the Senior Managed Care segment increased by $144.9 million, for the full year of 2005 compared to the seven months since acquisition in 2004. Approximately $123.6 million of the increase was due an increase in member months due to the inclusion of a full year for 2005 as well as growth in membership. The balance of $21.3 million was related to an increase in the average premium PMPM of 9.1%. Net investment income increased by $2.3 million, due primarily to growth in invested assets as a result of growth in business.
Benefits, Claims and Expenses. Medical expenses increased by $104.4 million, for the full year of 2005 compared to the seven months since acquisition in 2004. Approximately $103.5 million of the increase was due an increase in member months due to the inclusion of a full year for 2005 as well as growth in membership. The balance of $0.9 million was due to an increase in the loss ratio. Overall loss ratios for the segment increased by 40 basis points to 71.8% for 2005 from 71.4% for 2004. Commissions and general expenses increased by $24.7 million for the full year of 2005 compared to the seven months since acquisition in 2004, due primarily to growth in business,
During 2005, the IPA’s earned $12.0 million on $118.2 million in revenues received from our health plans. For the seven months since the acquisition of Heritage in 2004, the IPA’s earned $5.6 million on $58.5 million in revenues received from our health plans.
Benefits, Claims and Expenses. Policyholder benefits incurred declined by $24.8 million, or 9%, compared to 2005. The reduction in business, as noted above, resulted in a reduction in benefits of $15.9 million. The decrease in the loss ratio further reduced benefits by $8.9 million to benefits during 2006. Overall loss ratios for 2006 decreased 230 basis points to 72.4% compared to 74.7% for 2005. The decrease in our Medicare supplement loss ratio was primarily as a result of the adjustment in the fourth quarter of 2005 to increase incurred claims by $9.9 million (see further discussion below) that increased the loss ratio for 2005.
The increase in deferred acquisition costs was $22.7 million less for 2006 than the increase for 2005. Two factors contributed to the decrease. First, we incurred lower commissions and other acquisition costs as a result of lower production, resulting in a decrease in the costs capitalized of $9.3 million. Second, amortization increased by approximately $13.4 million, primarily as a result of higher lapsation of our Medicare supplement business, compared to 2005. We began to experience higher than expected lapsation in our Medicare supplement business in the third quarter of 2005 that continued and worsened in the first quarter of 2006. This excess lapsation moderated somewhat in the second and third quarters of 2006, but not as much as we anticipated, and increased again in the fourth quarter. We believe that there are a number of factors contributing to the increased lapsation, including competitive pressure from new Medicare Advantage products and increased competition from other Medicare supplement carriers. This increase in lapsation has accelerated the amortization of the deferred acquisition costs and present value of future profits assets associated with the business that lapsed.
Commissions and general expenses, net of reinsurance allowances, decreased by $8.2 million, or 7%, compared to 2005. The following table details the components of commission and other operating expenses:
The ratio of commissions to gross premiums decreased to 13.2% for 2006, from 14.3% for 2005, as a result of lower overall commission rates associated with the continued growth of our in force renewal premium and less new business production that has higher commission rates. Other operating costs as a percentage of gross premiums were 13.1% for 2006, compared to 12.7% for 2005 as a result of lower acquisition expenses due to lower new business production and lower fixed costs. Commission and expense allowances received from reinsurers as a percentage of the premiums ceded decreased to 18.2% for 2006 from 20.6% for 2005, primarily due to the reduction in new business ceded and the effects of normal lower commission allowances on our aging base of ceded renewal business.
Revenues. Net premiums for the Senior Market Health Insurance segment increased by $35.2 million, or 10%, compared to 2004, due to increased retention of our Medicare supplement business, rate increases and new sales.
A discussion of the accounting for Part D is included in Notes 2 and 19 of the notes to the consolidated financial statements in this Annual Report on Form 10-K. For the year ended December 31, 2006, we based our membership for Part D on enrollment information provided by CMS which indicated
that, as of December 31, 2006, approximately 456,000 members were enrolled in our PDPs for which we were paid by CMS. This includes approximately 432,000 members in our PDPs that we participate in on a 50% basis and 24,000 members in an unaffiliated PDP that we participate in on a 33% basis. Our revenues and claims expenses are based on premium earned and incurred pharmacy benefits for the reported enrolled membership. The membership information continues to be reconciled and refined by CMS with respect to the allocation among all plans participating in the Part D program. As a result, it is likely that the membership data upon which we based our results for 2006 will change, with a corresponding change in the financial results for the segment. We are unable to precisely quantify the impact of any potential change until the membership data is fully reconciled with CMS, however, we do not believe that the effect of any change from the amounts reported as of December 31, 2006 is likely to be material. Other Part D revenue represents our equity in the earnings or loss of PDMS. We report this as revenue for segment reporting purposes in analyzing the ratio of net pharmacy benefits incurred because the amount is incorporated in the calculation of the risk corridor adjustment. For consolidated reporting, this amount is included as a separate line following income from continuing operations. See reconciliation of segment revenues in Note 21 of the notes to the consolidated financial statements in this Annual Report on Form 10-K.
The ratio of incurred prescription durg benefits to net premiums for 2006 was 87.4%. The ratio of incurred prescription drug benefits to total Part D revenue for 2006 was 73.5%. Our PDP designs generally result in us sharing in a greater portion of the responsibility for total pharmacy costs in the early stages of a member’s plan period and less in the later stages. Based on the coverage provided by our PDPs, we anticipate that results for our Part D business will be seasonal, with higher benefit ratios in the first and second quarters, decreasing in the third and fourth quarters. Changes in the benefit ratios are partially offset as a result of the risk corridor adjustments.
Revenues. Both direct and ceded premium for the Specialty Health Insurance segment increased approximately $160.5 million, compared to 2005, as a result of the premiums relating to the PharmaCare Re reinsurance agreement discussed above. Net premiums declined by approximately $5.3 million, or 6%,
The increase in deferred acquisition costs was $2.2 million less during 2006, as compared to the increase during 2005. This was primarily due to lower production of new fixed benefit accident and sickness business during 2006, resulting in a lower level of acquisition costs to capitalize.
Commissions and general expenses decreased by $6.6 million, or 23%, compared to 2005, primarily as a result of the $3.2 million increase in the reinsurance allowance earned on the reinsurance arrangement with PharmaCare Re, as compared to 2005, due to the arrangement beginning on July 1, 2005. Commissions declined by $0.8 million and general expenses declined by approximately $2.6 million, primarily as a result of the reduction in new business and renewal premium.
Commissions and general expenses decreased by $6.2 million, or 18%, compared to 2004, primarily as a result of the $2.6 million increase in the reinsurance allowance earned on the reinsurance arrangement with PharmaCare Re that began on July 1, 2005. Commissions declined by $3.8 million and general expenses declined by approximately $0.7 million, primarily as a result of the reduction in new business and renewal premium.
Revenues. Net premiums for the segment increased by $1.8 million, or 3%, compared to 2005, as a result of the growth in renewal premiums for our senior life product of approximately $2.6 million, offset by declines in our traditional life insurance and interest sensitive products of approximately $0.8 million.
Revenues. Net premiums for the segment increased by $9.7 million, or 19%, compared to 2004. Approximately $9.3 million of the increase relates to the growth in renewal premiums for our senior life product. Ceded premiums increased by approximately $5.3 million, primarily as a result of the increase in our senior life premiums.
Benefits, Claims and Expenses. Policyholder benefits incurred increased by $2.7 million, or 8%, compared to 2004. The increase in business and related reserves added approximately $6.9 million to policyholder benefits during 2005, however this was offset by approximately $4.1 million as a result of favorable mortality, including a larger amount of reinsurance to offset claims, as compared to 2004. Interest credited increased by $0.5 million, due to the increase in policyholder account balances as a result of continued annuity sales, offset by a reduction in our overall credited rates. The increase in deferred acquisition costs was $7.4 million less during 2005, as compared to the increase in 2004. This was primarily due to lower production of new senior life insurance and annuity business during 2005, resulting in a lower level of acquisition costs to capitalize, as well as increased levels of amortization corresponding to the increased level of insurance in force. Commissions and general expenses decreased by $0.6 million, or 2%, compared to 2004, due to the lower levels of new senior life insurance an annuity business, as noted above.
Included in unaffiliated revenue are fees received to administer certain business of our insurance subsidiaries that is 100% reinsured to an unaffiliated reinsurer, which amounted to $3.2 million in the year ended December 31, 2006, $4.1 million for 2005 and $5.3 million for 2004. These fees, together with the affiliated revenue, were eliminated in consolidation.
The loss from our Corporate segment increased by $1.4 million, or 12%, in 2005 compared to 2004. The increase was due primarily to higher interest cost as a result of an increase in the amount of the debt outstanding during the year, relating to the amendment of our credit facility in connection with our acquisition of Heritage, and an increase in the weighted average interest rates, as compared to 2004. During the fourth quarter of 2005, $1.8 million of the liability for the terminated plans was released, compared to a release of $0.6 million in 2004.
(1) These obligations include contractual interest and the table reflects scheduled maturities for contractual obligations existing as of December 31, 2006 and does not include any obligations arising as a result of our shelf registration.
(3) Includes scheduled amortization through final maturity in 2009. The loan payable is floating rate debt. We did not project future changes in the base interest rates. For the purpose of this schedule, we applied the rate in effect at December 31, 2006 to all future periods.
(4) Includes minimum obligations on our data center outsourcing contract, as well as our outsourced administrative service contracts for certain portions of our HMO plan business (See Outsourcing Arrangements in Part 1, Item 1 of this Annual Report on Form 10-K). Our actual monthly payments are affected by the amount of service provided under the contract and the levels of business
administered and currently the actual payments exceed the minimums stated in the contracts. Therefore our actual payments will exceed the amounts presented in the above schedule based upon future usage and premium amounts.
(5) The obligations on policy related liabilities represent those payments we expect to make on death, disability and health insurance claims and policy surrenders. These projected values contain assumptions for future policy persistency, mortality and morbidity comparable with our historical experience. The distribution of payments for policy and contract claims includes assumptions as to the timing of policyholders reporting claims for prior periods and the amounts of those claims. Actual amounts and timing of both future policy benefits and policy and contract claims may differ significantly from the estimates above. We anticipate that our liabilities for policyholder account balances and reserves for future policy benefits totaling $1.1 billion, along with future net premiums, investment income and recoveries from our reinsurers, will be sufficient to fund future policy benefit payments. In addition, we anticipate that our policy and contract claims liability totaling $214.7 million, along with recoveries from our reinsurers, will be sufficient to fund these claim liability payments.
To provide the cash and capital for our insurance company subsidiaries to support our growth and expansion initiatives in Medicare Advantage, we have used the proceeds from the sale of our Canadian operations and, in March of 2007, we drew down all $50 million of our new short-term revolving credit facility. Additionally, we signed a letter of intent to issue up to an additional $100 million of trust preferred securities through a separate subsidiary trust. The trust preferred securities will not be and have not been registrered under the Securities Act of 1933, as amended, and may not be offered or sold in the United States absent registration on an applicable exemption from registration requirements. This reference to the trust preferred securities shall not constitute an offer of any sale of the security. The closing issuance $50 million of the trust preferred securities is expected to occur in late March 2007. There can be no assurance as to our continued ability to access funds though the capital markets to support our growth and expansion intitiatives.
In connection with the acquisition of Heritage on May 28, 2004, the Company amended the Credit Agreement by increasing the facility to $120 million from $80 million (the “Amended Credit Agreement”), including an increase in the term loan portion to $105 million from $36.4 million (the balance outstanding at May 28, 2004) and maintaining the $15 million revolving loan facility. None of the revolving loan facility
The Company incurred additional loan origination fees of approximately $2.1 million, which were capitalized and are being amortized on a straight-line basis over the life of the Amended Credit Agreement along with the continued amortization of the origination fees incurred in connection with the Credit Agreement. The Company pays an annual commitment fee of 50 basis points on the unutilized revolving loan facility.
The obligations of the Company under the Amended Credit Facility are guaranteed by our subsidiaries, CHCS Services Inc., WorldNet Services Corp., Quincy Coverage Corporation, Universal American Financial Services, Inc., Heritage, HHS-HPN Network, Inc., Heritage Health Systems of Texas, Inc., PSO Management of Texas, LLC, HHS Texas Management, Inc. and HHS Texas Management LP (collectively the “Guarantors”) and secured by substantially all of the assets of each of the Guarantors. In addition, as security for the performance by the Company of its obligations under the Amended Credit Facility, the Company, CHCS Services Inc., Heritage and HHS Texas Management, Inc., have each pledged and assigned substantially all of their respective securities (but not more than 65% of the issued and outstanding shares of voting stock of any foreign subsidiary), all of their respective limited liability company and partnership interests, all of their respective rights, title and interest under any service or management contract entered into between or among any of their respective subsidiaries and all proceeds of any and all of the foregoing.
The Company made regularly scheduled principal payments of $5.3 million during the year ended December 31, 2006, $5.3 million during 2005 and $5.7 million during 2004 in connection with its credit facilities. The Company paid interest of $6.9 million during 2006, $5.5 million during 2005 and $3.1 million during 2004 in connection with its credit facilities. Due to the variable interest rate for this Credit Agreement, the Company would be subject to higher interest costs if short-term interest rates rise.
The Trusts have the right to call the Capital Securities at par after five years from the date of issuance (which ranged from December 2002 to October 2003). The proceeds from the sale of the Capital Securities, together with proceeds from the sale by the Trusts of their common securities to our parent holding company, were invested in thirty-year floating rate Junior Subordinated Debt of our parent holding company. From the proceeds of the trust preferred securities, $26.0 million was used to pay down debt during 2003. The balance of the proceeds has been used, in part to fund acquisitions, to provide capital to our insurance subsidiaries to support growth and to be held for general corporate purposes.
date of issuance, and payable quarterly in arrears at a floating rate equal to the three-month LIBOR plus a spread. The floating rate resets quarterly and is limited to a maximum of 12.5% during the first sixty months. Due to the variable interest rate for these securities, we may be subject to higher interest costs if short-term interest rates rise. The Capital Securities are subject to mandatory redemption upon repayment of the Junior Subordinated Debt at maturity or upon earlier redemption. The Junior Subordinated Debt is unsecured and ranks junior and subordinate in right of payment to all present and future senior debt of our parent holding company and is effectively subordinated to all existing and future obligations of the Company’s subsidiaries. Our parent holding company has the right to redeem the Junior Subordinated Debt after five years from the date of issuance.
The shelf registration statement enables us to raise funds from the offering of any individual security covered by the shelf registration statement, as well as any combination thereof, through one or more methods of distribution, subject to market conditions and our capital needs. The terms of any offering pursuant to this shelf will be established at the time of the offering. We plan to use the proceeds from any future offering under the registration statement for general corporate purposes, including, but not limited to, working capital, capital expenditures, investments in subsidiaries, acquisitions and refinancing of debt. A more detailed description of the use of proceeds will be included in any specific offering of securities in the prospectus supplement relating to the offering.
Senior Administrative Services Company. Liquidity for our Senior Administrative Services subsidiary is measured by its ability to pay operating expenses and pay dividends to our parent company. The primary source of liquidity is fees collected from clients. We believe that the sources of cash for our Senior Administrative Services company exceed scheduled uses of cash and results in amounts available to dividend to our parent holding company.
Senior Managed Care Company. Liquidity for our managed care company is measured by its ability to pay operating expenses and pay dividends to our parent company. The primary source of liquidity is management fees for administration of our healthplan affiliates and services provided to the IPA’s. Dividend payments by our healthplan affiliates to Heritage are subject to the approval of the insurance regulatory authorities of our healthplan affiliates’s respective state of domicile. SCOT is not able to pay dividends during 2006 without prior approval. However, we believe that the sources of cash to our managed care holding company exceed scheduled uses of cash which will result in funds available to dividend to our parent holding company.
significantly from state to state. Pennsylvania Life is able to pay ordinary dividends of up to $21.9 million and Pyramid Life is be able to pay dividends of $2.7 million to American Exchange (their direct parent) in 2007 without the prior approval from the insurance department for their respective states of domicile..
Some of our life insurance and annuity policies are interest-sensitive in nature. The amount of surrenders and withdrawals is affected by a variety of factors such as credited interest rates for similar products, general economic conditions and events in the industry that affect policyholders’ confidence. Although the contractual terms of substantially all of our in force life insurance policies and annuities give the holders the right to surrender the policies and annuities, we impose penalties for early surrenders. As of December 31, 2006 we held reserves that exceeded the underlying cash surrender values of our net retained in force life insurance and annuities by $32.8 million. Our insurance subsidiaries, in our view, have not experienced any material changes in surrender and withdrawal activity in recent years.
determined by us based upon factors such as portfolio rates of return and prevailing market rates and typically follow the pattern of yields on the assets supporting these liabilities.
Our domestic insurance subsidiaries are required to maintain minimum amounts of statutory capital and surplus as required by regulatory authorities. However, substantially more than the statutory minimum amounts are needed to meet statutory and administrative requirements of adequate capital and surplus to support the current level of our insurance subsidiaries’ operations. Each of our insurance subsidiaries’ statutory capital and surplus exceeds its respective minimum statutory requirement at levels we believe are sufficient to support their current levels of operation. Additionally, the National Association of Insurance Commissioners (“NAIC”) imposes regulatory risk-based capital (“RBC”) requirements on life insurance enterprises. At December 31, 2006, all of our insurance subsidiaries maintained ratios of total adjusted capital to RBC in excess of the “authorized control level”. The combined statutory capital and surplus, including asset valuation reserve, of our U.S. insurance subsidiaries totaled $242.9 million at December 31, 2006 and $158.4 million at December 31, 2005. For the year ended December 31, 2006, our U.S. insurance subsidiaries generated a statutory net income of $29.3 million. For the year ended December 31, 2005, our U.S. insurance subsidiaries generated a statutory net loss of $1.8 million. Our U.S. insurance companies generated statutory net income of $5.4 million for the year ended December 31, 2004.
Our health plan affiliates are also required to maintain minimum amounts of capital and surplus, as required by regulatory authorities and is also subject to RBC requirements. At December 31, 2006, the statutory capital and surplus of each of our health plan affiliates exceeds its minimum requirement and its RBC is in excess of the “authorized control level”. The statutory capital and surplus for our health plan affiliates was $44.0 million at December 31, 2006 and $25.3 million at December 31, 2005. Statutory net income for our health plan affiliates was $17.3 million for the year ended December 31, 2006, $9.6 million for 2005 and $5.5 million for 2004.
Our investment policy is to balance the portfolio duration to achieve investment returns consistent with the preservation of capital and maintenance of liquidity adequate to meet payment of policy benefits and claims. We invest in assets permitted under the insurance laws of the various states in which we operate. Such laws generally prescribe the nature, quality of and limitations on various types of investments that may be made. We do not currently have investments in partnerships, special purpose entities, real estate, commodity contracts, or other derivative securities. We currently engage the services of three investment advisors under the direction of the management of our insurance company subsidiaries and in accordance with guidelines adopted by the Investment Committees of their respective boards of directors. Conning Asset Management Company manages the portfolio of all of our United States subsidiaries, except for the portfolio of Pyramid Life, and certain floating rate portfolios, which are managed by Hyperion Capital. MFC Global Investment Management manages our Canadian portfolio. We invest primarily in fixed maturity securities of the U.S. Government and its agencies and in corporate fixed maturity securities with investment grade ratings of “BBB-” (Standard & Poor’s Corporation), “Baa3” (Moody’s Investor Service) or higher.
We file a consolidated return for Federal income tax purposes that includes all of the non-life insurance company subsidiaries, as well as Heritage and its subsidiaries. American Exchange and its subsidiaries and Penncorp Life (Canada) are not currently included. American Exchange and its subsidiaries file a separate consolidated Federal return. Penncorp Life (Canada) files a separate return with the Canada Revenue Agency.
As a result of uncertainty regarding the ability to generate taxable capital gains to utilize capital loss carryforwards, the Company established a valuation allowance in the amount of $3.2 million during 2004 that was reported as a deferred income tax expense to bring the total allowance for capital loss carryforwards to $3.7 million. Portions of the valuation allowance were released and reported as a deferred income tax benefit as capital gains were generated and the Company was able to realize the benefit from the capital loss carryforwards. Approximately $1.6 million was released during 2005 and $1.9 million was released during 2006.
In 2003, the Company established a reserve for pre-acquisition tax years of certain life insurance subsidiaries that were being examined by the Internal Revenue Service in the amount of $4.4 million. During 2004, the Company released the reserve based on the completion of the exams.
Beginning January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123-Revised, “Share-Based Payment” (“FAS 123-R”) using the modified prospective method, and began recognizing compensation cost for share-based payments to employees and non-employee directors based on the grant date fair value of the award, which is amortized over the grantees’ service period. The Company has elected to use the Black-Scholes valuation model to value employee stock options, as it had done for its previous pro forma stock compensation disclosures. The adoption of FAS 123-R did not have a material effect on the Company’s method of computing compensation costs for options as compared to that used to prepare the pro forma disclosures in prior periods. The impact of the adoption of FAS 123-R on our consolidated financial condition and results of operations is detailed in Note 7 to the consolidated financial statements in the Annual Report on Form 10-K. A summary of other recent and pending accounting pronouncements is provided in Note 2 of the consolidated financial statements in the Annual Report on Form 10-K under the caption “Future Adoption of Accounting Standards.” We do not anticipate any material impact from the future adoption of the pending accounting pronouncements discussed in that note.