ITEM 1.
BUSINESS
Overview
Ceres, through its insurance subsidiaries, provides a wide array of health and life insurance products through two primary business segments. The Medical segment includes major medical health insurance for individuals, families, associations, and small to mid-size businesses. The Senior segment includes senior health, life and annuity products for Americans age 55 and over. To help control medical costs, we also provide medical cost management services to our insureds. Our nationwide distribution channels include independent and career agents and our electronic distribution platforms.
Ceres (known as Central Reserve Life Corporation prior to December 1998) operated prior to 1998 primarily through its wholly-owned subsidiary, Central Reserve Life Insurance Company. Central Reserve markets and sells major medical health insurance to individuals, families, associations and small to mid-size employer groups and senior products to Americans age 55 and over.
In 1998, we acquired Provident American Life and Health Insurance Company. Provident American Life discontinued new medical sales activities in 2001 and currently has approximately 200 active major medical policyholders (HealthEdge product) and 300 life policyholders. In June 2005, Provident American Life began marketing and selling a new portfolio of senior products.
In 1999, we acquired Continental General Insurance Company which markets and sells both major medical and senior health and life products.
Also, in 1999, we acquired, through foreclosure, United Benefit Life Insurance Company. Since early 2002, United Benefit Life has no active policyholders.
We also have various non-regulated subsidiaries that, through intercompany arrangements, provide a variety of services to our insurance subsidiaries, including personnel, administration, billing and collection, electronic distribution, managed care and sales support services.
Our major medical operations are located in Strongsville (Cleveland), Ohio (as well as our corporate offices) and Omaha, Nebraska, and our senior operations are located in Mission (Kansas City), Kansas.
Our health and life insurance products protect individuals, families, association members, and small to mid-size employer groups during the years up to retirement, while our Medicare supplement, long-term care, other supplemental products, and life and annuity products provide ongoing coverage for senior Americans.
Our strategy is to:
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grow our historically profitable and predictable Senior segment;
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focus on the profitability of our Medical segment; and
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promote electronic distribution for increased efficiency and agent productivity.
Our Medical segment’s pre-tax earnings were $4.1 million in 2005 compared to $5.2 million in 2004 (including a $3.1 million pre-tax charge for litigation settlements). Our Senior segment continued to produce profits for 2005, totaling $17.9 million in pre-tax profits for the year ended 2005 compared to $18.5 million in 2004.
We believe our focus on consistent and selective growth will lead to more predictable earnings, enhanced profitability, and higher financial agency ratings of our insurance subsidiaries. We also believe that our strategies in the Medical and Senior segments have proven effective in balancing our results. Our Senior segment continues to be poised for growth in 2006 and beyond. At the same time, we continue to target market in our Medical segment to maintain stable earnings results.
Our Core Businesses
Senior health, life and annuity products. We continue to concentrate our efforts on the Senior segment because we believe this market has the potential for greater revenue growth and higher profit margins than our Medical segment. Our strategy is to expand this segment by emphasizing competitive markets, working with select distributors, exploring new marketing relationships, and increasing our agent base. The products in this segment are designed specifically for Americans age 55 and over which was estimated at over 65 million in 2004 and is one of the country’s fastest growing age segments that is projected to increase to 103 million people by 2025. In addition, the senior population controls more than 75% of the nation’s financial wealth. Our senior products supplement other programs, such as Medicare, and also include specialty supplemental coverages and life insurance. According to the Centers for Medicare and Medicaid Services (CMS), the number of Medicare enrollees, age 65 and over, more than doubled between 1966 and 2004, growing to 42 million from 19 million. To address this demand, we will continue to concentrate on our primary product, Medicare supplement, and increase our market reach through new plan offerings.
Catastrophic and comprehensive major medical insurance. Historically, major medical insurance has been our core business, accounting for a greater percentage of our revenue than our Senior segment. Our Medical segment includes insurance for individuals (under age 65), families, associations, and small to mid-size businesses. With increasingly stringent federal and state restrictions on small group insurance, we emphasize the sale of individual and association products, which offer greater flexibility in both underwriting and plan design compared to small group products. The associations we market to are groups that are formed for the purpose of providing certain goods, services, and information to individuals who pay dues to be members in the association. Individual and association products, which are individually underwritten for each applicant, offer greater regulatory latitude in adjusting future premium rates, establishing premium rates based on individual risk factors and rejecting applicants with risk factors that exceed our pricing parameters. Beginning in 2006, premium levels are expected to levelize or grow slightly as we continue to concentrate on targeted states, strengthening relationships with selected distributors, emphasizing our most profitable products, adjusting premium rates as necessary to keep pace with medical inflation, and by focusing on increasing profit margins through our medical management and expense management programs.
We market and administer preferred provider organization (PPO) plans and administer our existing traditional indemnity medical plans. We believe that PPO coverage provides greater freedom of choice of doctors and opportunity to seek care from doctors and facilities within networks which deliver healthcare at favorable rates compared to HMOs and traditional indemnity plans. PPO members generally are charged periodic prepaid premiums, co-payments, and deductibles. Traditional indemnity insurance typically allows policyholders substantial freedom of choice in selecting healthcare providers without the financial incentives or cost-control measures typical of managed care plans. We also market health savings accounts (HSA) - qualified products to individuals, families and small businesses. We believe these plans provide insureds with greater flexibility to control their healthcare dollars.
Business Strategy
Principal elements of our business strategy include:
Increasing senior market focus. Because of favorable demographics and higher profit potential in the Senior segment, we intend to continue to focus our sales efforts on this part of our business. We believe the senior market will continue to produce more predictable earnings, particularly since these products are not as sensitive to medical inflation as major medical products. We will be concentrating more on our agent recruiting and a significant amount of our product development efforts on the senior market. We also intend to transition our major medical insureds into our senior products as they age. For the year ended December 31, 2005 our Senior segment comprised 48% of our total net premium revenues compared to 43% for 2004. One of our continuing objectives is to balance our segments’ revenue equally over the next several years. Our Senior segment products are administered at our Kansas facility, which we believe has superior and efficient technology and administration.
Focusing on profitability in the major medical market. While historically the Medical segment has been the largest percentage of our revenue, we, like all health insurance companies, face challenges in this marketplace due
to higher expenses resulting from escalating healthcare and prescription drug costs. However, we believe that the programs that we have in place have lessened the inflationary impact. These programs include:
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target marketing with select distributors in select states with the greatest potential for profitability;
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selective products that shift some of the control over routine, discretionary healthcare costs to the consumer;
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rate adjustments;
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cancellation of unprofitable blocks of business in certain states;
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proactive medical cost management; and
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lowered administrative and sales expenses.
Our selective marketing approach has enabled us to serve the demand for health insurance products while remaining profitable. In mid-2005, we introduced our new Advantage Series of major medical products designed to offer customers a choice of benefit levels and prices. The Advantage Series is built on a new rate manual that we believe allows for pricing consistency for all our individual/association products and distribution channels.
The major medical market requires careful monitoring. We regularly watch our claims inventories and analyze our loss ratios to ensure profitability. As we move forward, we will continue to focus our efforts on strengthening relationships with our best distributors, monitoring our new business activity, and emphasizing our most profitable products. We believe that this approach will allow us to remain competitive in this market.
In 2006, we expect Medical Segment premium revenues to increase by approximately 5%, the first annual increase in premiums since 2001.
Promoting electronic distribution. We promote the use of electronic distribution in both of our business segments to increase efficiency and agent productivity. This electronic platform brings significant benefits to both agents and consumers.
Through electronic submission, our agents have their business processed faster, and have access to pending policy and claims status information. Agents also receive valuable electronic marketing tools which enhance their ability to increase sales. Advance commissions are available to qualifying agents for select senior health and life insurance products and on select major medical products for certain distributors.
Consumers enjoy the advantages of faster policy issue, and personal local service through an agent partner at no additional cost. Our trained call center staff is available for agent support, as well as to answer consumer questions.
Products and Services
We primarily market health, life and annuity insurance products tailored to meet the needs of individuals, families, associations, small to mid-size businesses, and senior Americans. We have specialized teams that focus on new product development for each of our markets. These teams review our current product offerings and compare them with our competitors’ products and changing insured needs. We systematically review our individual and small group major medical plans to help us further develop our product mix.
Major medical. Our major medical products include catastrophic, comprehensive, and basic coverage options from PPO benefit plans to traditional indemnity health insurance plans. Currently, we market primarily PPO plans. We believe our PPO products provide for healthcare delivery at lower premium costs than traditional indemnity plans. We also offer HSA-qualified plans.
Our traditional indemnity health insurance products provide coverage for services from any qualified medical provider. Like our PPO products, most of our indemnity health insurance products offer access to providers at our negotiated network savings. Although our indemnity insureds are not required to use our network providers, we have established programs that reduce claims costs and out-of-pocket expenses for our insureds who do use network providers.
We also have a program that reduces claims costs for prescription drugs on our medical products that include prescription drug coverage. We developed a system with varying levels of co-payment amounts to encourage insureds to use generic drugs and a money-saving mail-order program for maintenance prescription drugs. In addition, our care coordination program has been added to most of our major medical products to provide service enhancements for our insureds.
Our new products are designed with higher profit margins. These products provide higher deductibles and co-payments and are designed to shift to consumers a greater portion of the risk for discretionary medical and brand name pharmaceutical benefits. This benefit structure reduces premium payments for consumers and is designed to lower the level of future premium rate adjustments. We are also emphasizing HSA-qualified plans, which enable insureds to lower their insurance costs and have more control over their healthcare dollars.
Short-term major medical. This product provides major medical coverage for a limited amount of time for people who, for example, are between jobs or are recent graduates.
Small group products. Our Professional Multi-Option (PMO) product is a comprehensive major medical plan offered to our small business customers. We also offer our Partnership Plan, a major medical product in which we share the medical cost risk with the employer, to small to mid-size businesses with 2-100 employees. This alternate funding mechanism allows the employer to limit expense and risk by self-insuring part of the coverage. This product can produce a year-end refund or carryover feature for low claims experience that is attractive to businesses with healthy employees. The savings generated with this plan can be used to provide other employee benefits. We also market an HSA-qualified product to small employer groups. Sales of HSA-qualified plans comprised 73% of new sales to small employer groups in 2005.
Life and annuity. We also market group life insurance and annuity plans. We offer term life insurance as an ancillary product to our major medical insureds. We also offer various single premium deferred annuities.
Senior health insurance products. Our senior market products include a wide range of comprehensive and supplemental major medical benefit products, including Medicare supplement (our cornerstone product), long-term care, and other supplemental products.
Senior life insurance and annuities. Our life insurance and annuity products include lower face amount life insurance policies offering coverages up to $25,000 and annuity plans with first-year bonus interest or interest rate guarantees.
Medical cost management. We focus on reducing medical costs for our insureds by actively managing medical inflation and utilization rate costs. National health expenditures have grown from $1,067 per capita in 1980 to $6,280 per capita in 2004 and are projected to increase to $9,148 per capita in 2010, according to statistics compiled by CMS. Several factors have contributed to the dramatic increase in healthcare expenditures, including increased costs and utilization of high-technology diagnostic testing and treatments, the rising cost of malpractice insurance, higher operating costs for hospitals and physicians, changes in federal and state healthcare regulations, increased utilization and cost of pharmaceuticals, and the aging of the population.
We have numerous programs designed to lower medical costs for our insureds. Some of these programs include:
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shifting to the consumer a greater portion of risk with higher deductible plans and lower premiums;
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focusing our business with national and regional PPOs with superior pricing and management of costs;
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use of a “Centers of Excellence” network providing our insureds access to transplant and other necessary high-risk procedures at approximately 114 renowned medical institutions that have the staff, experience and volume of patients to produce higher recovery rates while offering discounted costs;
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multiple benefit level pharmacy coverage to promote use of lower cost drugs when possible;
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screening techniques to identify and move high-cost and high-risk insureds as early as possible into case management programs to enhance treatment programs and lower the long-term total medical expenses;
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a program to detect fraud and abuse by medical providers, policyholders or agents;
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medical protocol use to avoid claims for unnecessary procedures;
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claims cost negotiation for long-term care expenses;
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product design geared to encourage use of PPOs; and
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enhanced communication to insureds on the features and benefits of these programs, emphasizing how they can reduce their total healthcare costs.
The purpose of these programs is to provide quality care and improve treatment outcomes while reducing total costs for both the company and our insureds. We also offer insureds opportunities to make changes in their benefits to lower their premium payments. Our benefit design department works with our insureds to structure benefit packages to meet their budgets.
Our care coordination program provides our insureds with 24-hour access to medical information, case management early intervention programs and non-network negotiation processes to lower medical expenses, as well as additional services to help them maximize insurance benefits.
Marketing and Sales
Our distribution is critical for our continued growth. We market our products through independent agents with licenses in 48 states, the District of Columbia, and the U.S. Virgin Islands. We have initiated a systematic program to focus our marketing expenses on more productive agents. We compensate our agents for business produced by them on a commission basis at rates that we believe to be competitive with those of other life and health insurance companies.
Distribution Channels. We use a variety of distribution systems in marketing our products. Because product lines vary among many of these distribution systems, we have some overlap of agents between channels. Some of our agents are licensed and contracted with more than one of our distribution channels.
We base our six distribution channels on organization of the agents and specific markets or products:
1.
Senior Brokerage. These agents target Americans age 55 and over with a comprehensive product line. These agents may represent multiple insurance carriers.
2.
Senior Marketing Organizations. This channel is comprised of independent marketing organizations that market our senior products. These agents may represent multiple insurance carriers.
3.
Senior Career. This channel was developed in mid-2005 to focus exclusively on marketing senior products of our Provident American Life and Continental General subsidiaries. These agents give us a “right of first” refusal on our senior products. At December 31, 2005, we had appointed 23 regional sales managers and approximately 256 agents. Our goal is to have a total of 50 regional sales managers and 1,000 agents by year-end 2006.
4.
Medical Marketing Organizations. This channel is comprised of well-established marketing organizations that primarily market health insurance and supplemental health insurance. Some of this business is sold through electronic platforms. These agents may represent multiple insurance carriers.
5.
Medical Brokerage. Our brokerage agents concentrate on sales to individuals, families, associations, and small business owners. The product portfolio includes catastrophic medical coverage, individual medical plans, small group medical plans, HSA-qualified plans, basic medical coverage, short-term major medical, life insurance and annuities. These agents may represent multiple insurance carriers.
6.
Electronic Distribution. QQLink is our fully transactional online platform for Continental General’s major medical products. QQLink, founded in late 2000, combines a traditional agent distribution system with direct online sales of insurance. Consumers are able to review and receive premium quotes and apply for insurance online. QQLink is 99% owned by Ceres with the remaining 1% owned by three of our agents.
Marketing Support. We compete with other insurance companies and other sales operations for our agents. In addition, we compete with other companies that our independent agents represent. Our marketing systems
concentrate on broad product portfolios and sales support to agents. Our strategy is to provide the tools and resources needed by the sales force, so that our agents can devote their time to selling.
We provide comprehensive support programs to attract and retain agents, including:
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competitive products and commission structures;
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advanced commissions on select products for agents who qualify;
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ongoing product development;
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special incentive awards to new agents;
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training seminars to introduce new products and sales material for our agents; and
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consistent agent communication and quality sales materials.
Customer Base
We had approximately 239,000 group certificates and individual policies in force as of December 31, 2005, representing approximately 309,000 insureds. Each group certificate represents an insured and any spouse, children and other dependents. The following table reflects the breakdown by product of the group certificates and individual policies for the years ended December 31, 2005 and 2004.
Because of the Health Insurance Portability and Accountability Act of 1996 (HIPAA) and state regulatory restrictions, we place greater emphasis on the sale of individual and association major medical products. For 2005, 67% of our major medical certificates were individual and association products and 33% were small group products, which were consistent with levels experienced in 2004.
The geographic distribution of direct and assumed premiums, before reinsurance ceded, on a statutory basis of all of our subsidiaries in 2005 and 2004 is presented in the table below. The presentation on a statutory basis differs from U.S. generally accepted accounting principles (GAAP) in that our fee income and annuity considerations are considered premiums for statutory purposes.
Pricing and Underwriting
Effective, consistent and accurate underwriting is a critical element of our profitability and depends on our ability to adequately predict claims liability when determining the prices for our products. Premiums charged on insurance products are based, in part, on assumptions about expected mortality and morbidity experience and competitive factors. Our uniform underwriting procedures are designed to assess and quantify certain insurance risks before issuing life insurance, certain health insurance policies, and certain annuity policies to individuals. These procedures are generally based on industry practices, reinsurer underwriting manuals and our prior underwriting experience. To implement these procedures, we employ an experienced professional underwriting staff.
In most circumstances, our pricing and underwriting decisions follow a prospective rating process. A fixed premium rate is determined at the beginning of the policy period. Unanticipated increases in medical costs may not be able to be recovered in the current policy year. However, prior experience, in the aggregate, is considered in determining premium rates for future periods.
Applications for insurance are reviewed on the basis of answers to application questions. Where appropriate, based on the type and amount of insurance applied for and the applicant’s age and medical history, additional information is required, such as medical examinations, statements from doctors who have treated the applicant in the past, and where indicated, special medical tests. For certain coverages, we may verify information with the applicant by telephone. After reviewing the information collected, we either issue the policy as applied for, issue the policy with an extra premium charge due to unfavorable factors, issue the policy excluding benefits for certain conditions, either permanently or for a period of time, issue the policy excluding a specific individual or dependent, or reject the application. For some of our products, we have adopted simplified policy issue procedures in which the applicant submits an application for coverage typically containing only a few health-related questions instead of a complete medical history.
Our profitability depends on our ability to adequately increase rates for both new business and at renewal. We have implemented procedures that permit us to apply to regulatory authorities for corrective rate actions on a timely basis with respect to both new business rates and the current market rates. This allows us to analyze whether these rates sufficiently cover benefits, expenses and commissions. For renewal business, we analyze our loss ratios and
compare them to our target loss ratios. When this analysis is complete, we implement any necessary corrective action, including rate increases.
Claims
All claims for policy benefits are currently either processed by our claims department or outsourced to third party administrators. We currently outsource to third party vendors:
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claims processing and other administrative services for the Chambers and Provident American Life’s HealthEdge business (until September 30, 2006);
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claims processing for the run-off business of Provident American Life and United Benefit Life;
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prescription drug claims; and
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claims processing for our dental business.
We periodically utilize the services of personnel from our medical cost management subsidiary to review certain claims. When a claim is filed, we may engage medical cost management personnel to review the claim, including the specific health problem of the insured and the nature and extent of healthcare services being provided. Medical cost management personnel often assist the insured by determining that the services provided to the insured, and the corresponding benefits paid, are appropriate under the circumstances.
All of our claims processing, including the claims that are outsourced, must apply the same claims management standards. In addition, we perform random audits of both our internal and outsourced claims processing.
Systems
Our ability to continue providing quality service to our insureds and agents, including policy issuance, billing, claims processing, commission reports, and accounting functions is critical to our ongoing success. We believe that our overall systems are an integral part in delivering that service. We regularly evaluate, upgrade and enhance the information systems that support our operations.
Our business depends significantly on effective information systems. We have many different information systems for our various businesses, including the use of our third party vendors’ systems. Our information systems require an ongoing commitment of significant capital and human resources to maintain and enhance existing systems and develop new systems or relationships with third party vendors in order to keep pace with continuing changes in information processing technology, evolving industry and regulatory standards, and changing customer preferences.
We currently outsource the data center for our Cleveland facility to a third party vendor as well as administration of some blocks of business. We receive regular reports from our third party vendors that enable us to closely monitor our business on their systems.
Investments
We attempt to minimize our business risk through conservative investment policies. Our investment objectives are to maximize yields, preserve principal, and maintain liquidity. Investments for insurance companies must comply with the insurance laws of the state of domicile. These laws prescribe the kind, quality and concentration of investments that may be made. Due to the restrictive nature of these laws, there may be occasions when we may be precluded from making certain otherwise attractive investments. We periodically evaluate these securities. The effective durations of our investments vary from subsidiary to subsidiary with the life insurance subsidiaries between four and five years and the health companies between three and four years.
At December 31, 2005, approximately $447.5 million or 91.5% of our invested assets were fixed maturity securities. At December 31, 2005, 95.2% of our fixed maturity securities available-for-sale were of investment grade quality with 83.5% in securities rated A or better (typically National Association of Insurance Commissioners (NAIC) I) and 11.7% in securities rated BBB (typically NAIC II). We do not invest in derivatives, such as futures, forwards, swaps, option contracts or other financial instruments with similar characteristics.
At December 31, 2005, the fair value of our investments in mortgage-backed securities totaled $166.1 million, or 34.0% of total invested assets. We minimize the credit risk of our mortgage-backed securities by holding primarily issues of U.S. Government agencies or high-quality non-agency issuers rated AA or better. Among the agency mortgage-backed securities, which comprises 19.5% of total invested assets, the securities are comprised of pass-through securities and planned amortization class collateralized mortgage obligations. The pass-through securities primarily are invested in current market coupons that should exhibit only moderate prepayments in a declining interest rate environment, while the planned amortization class collateralized mortgage obligations provide strong average life protection over a wide range of interest rates. The non-agency mortgage-backed securities, which represent 14.4% of total invested assets, consist of commercial and jumbo residential mortgage securities. The commercial mortgage-backed securities provide very strong prepayment protection through lockout and yield maintenance provisions, while the residential mortgage-backed securities are concentrated in non-accelerating securities that have several years of principal lockout provisions.
The amortized cost and estimated fair value of available-for-sale securities as of December 31, 2005, were as follows:
For more information, see Note B. Cash and Investments to our audited consolidated financial statements.
Reserves
We establish and report liabilities or reserves on our balance sheet for unpaid healthcare costs by estimating the ultimate cost of incurred claims that have not yet been reported to us by our policyholders or their providers and reported claims that we have not yet paid. Since these reserves represent our estimates, the process requires a degree of judgment. Reserves are established according to Actuarial Standards of Practice and generally accepted actuarial principles and are based on a number of factors, including experience derived from historical claims payments and actuarial assumptions to arrive at loss development factors.
Such assumptions and other factors include:
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healthcare cost trends;
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the incidence of incurred claims;
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the extent to which all claims have been reported; and
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internal claims processing changes.
Due to the variability inherent in these estimates, reserves are sensitive to changes in medical claims payment patterns and changes in medical cost trends. A deterioration or improvement of the medical cost trend or changes in claims payment patterns from the trends and patterns assumed in estimating reserves would trigger a change.
The majority of Central Reserve’s and Provident American Life’s reserves and liabilities for claims are for the health insurance business. The majority of Continental General’s reserves and liabilities for claims are for the life and annuity and long-term care business due to the long duration nature of these productions. For our individual and
group accident and health business, we establish an active life reserve plus a liability for due and unpaid claims, claims in course of settlement and incurred but not yet reported claims, as well as a reserve for the present value of amounts not yet due on claims. These reserves and liabilities are also impacted by many factors, such as economic and social conditions, inflation, hospital and pharmaceutical costs, changes in doctrines of legal liability and damage awards for pain and suffering. Therefore, the reserves and liabilities established are necessarily based on estimates and prior years’ experience.
Liabilities for future policy reserves on traditional life insurance have generally been provided on a net level premium method based upon estimates of future investment yield, mortality, and withdrawals using our experience and actuarial judgment with an allowance for possible unfavorable deviation from the expected experience. The various actuarial factors are determined from mortality tables and interest rates in effect when the policy is issued.
Liabilities for interest sensitive contracts such as deferred annuities and universal life-type contracts are based on the retrospective deposit method. This is the full account value before any surrender charges are applied.
We may from time to time need to increase or decrease our claims reserves significantly above or below our initial estimates and any adjustments would be reflected in our earnings. An inadequate estimate in reserves could have a material adverse impact on our business, financial condition and results of operations. For more information, please see “Critical Accounting Policies” section under Item 7. - Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Reinsurance
General. Consistent with the general practice of the insurance industry, we reinsure portions of the coverage provided 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.
Under quota share reinsurance, the reinsurer assumes or cedes an agreed percentage of certain risks insured by the ceding insurer and shares premium revenue and losses proportionately. When we cede business to others, reinsurance does not discharge us from our primary liability to our insureds. However, the reinsurance company that provides the reinsurance coverage agrees to become the ultimate source of payment for the portion of the liability it is reinsuring and indemnifies us for that portion. However, we remain liable to our insureds with respect to ceded reinsurance if any reinsurer fails to meet its obligations to us.
Existing Arrangements. In the ordinary course of business, we maintain reinsurance arrangements designed to limit the maximum amount of exposure that we retain on a given policy.
A significant portion of our risks are reinsured with a single reinsurance company, Hannover Life Reassurance Company of America, a health and life reinsurance company. In 2005, Hannover accounted for 94.1% of the total premiums ceded by our subsidiaries. Hannover has entered into reinsurance agreements with several of our subsidiaries, including Central Reserve, Provident American Life, United Benefit Life and Continental General. Our reinsurance agreements with Hannover are not cancelable or terminable by Hannover. In recent years, we have reduced our reliance on reinsurance. Our arrangements are generally for closed blocks of business, which means that Hannover is not reinsuring any new sales or business of any of our subsidiaries under these reinsurance agreements.
In July 2001, we implemented a program to terminate or replace the United Benefit Life and Provident American Life medical policies. Some policyholders in some states were offered a replacement product, HealthEdge, underwritten by Provident American Life. Through June 30, 2002, Hannover reinsured the HealthEdge product on the same basis as the reinsurance under the prior reinsurance agreements. Beginning July 1, 2002, Provident American Life retained 100% of the business and risk on the remaining HealthEdge policies in force. At
the end of 2001, substantially all other health policies of United Benefit Life and Provident American Life were terminated.
To evaluate the claims paying ability and financial strength of Hannover, we review financial information provided to us by Hannover, and hold meetings with its management to review operations, marketing, reinsurance and financial issues. Hannover suffered significant losses as a result of our reinsurance agreements with respect to United Benefit Life and Provident American Life. We believe our relations with Hannover are good.
The total premiums ceded by our subsidiaries in 2005 to unaffiliated reinsurers amounted to $68.4 million, of which Hannover represented approximately 94.1%. Our gross reinsurance receivables from unaffiliated reinsurers amounted to $131.2 million as of December 31, 2005, of which approximately 99.2% was attributable to Hannover, and of which approximately $127.2 million represented reserves held by our reinsurers under our various reinsurance treaties in place. Cash settlements are made quarterly with Hannover and timely paid.
Hannover is a subsidiary of Hannover Rueckversicherungs, a German corporation, which had assets of $47.9 billion and total stockholders’ equity of $3.5 billion at December 31, 2004. Moody’s has assigned Hannover Rueckversicherungs a financial strength rating of Baa1 (adequate). Hannover and Hannover Rueckversicherungs each have an A (excellent) rating from A.M. Best Company, Inc. In addition, Hannover Rueckversicherungs has a financial strength rating of AA- (very strong) from Standard & Poor’s. Hannover’s failure to pay our claims in full or on a timely basis could have a material adverse effect on our business, financial condition and results of operations.
For ordinary and group life claims, Continental General’s maximum retention is $125,000 and, at December 31, 2005, Central Reserve’s maximum retention was $50,000 with no retention maintained over age 70. As of 2006, Central Reserve did not cede its group life claims due to a substantial reduction in its exposure. For accident and health claims, maximum retention on individual claims is $500,000. For a complete discussion of our material reinsurance agreements, including recent reinsurance agreements, see Note K. Reinsurance Arrangements to our audited consolidated financial statements.
Our future growth may be dependent on our ability to obtain reinsurance in the future. While we expect to continue our relationship with Hannover in the future, we will continue to identify new companies with respect to new reinsurance agreements. The amount and cost of reinsurance available to us would be subject, in large part, to prevailing market conditions beyond our control. We may be unable to obtain reinsurance in the future, if necessary, at competitive rates or at all.
Competition
The insurance business is highly competitive. In our major medical business, we compete with large national, regional and specialty health insurers, including Golden Rule Resources Ltd., Assurant, World Insurance/American Republic, various Blue Cross/Blue Shield companies, and United Healthcare Corporation. In our senior business, we compete with other national, regional and specialty insurers, including Universal American Financial Corp., Banker’s Life and Casualty, United Teachers Associates Insurance Company, Torchmark, Pacificare, United Healthcare, Mutual of Omaha, Conseco, Inc., Blue Cross organizations, and Medicare HMOs. Many of our competitors have substantially greater financial resources, broader product lines, or greater experience than we do. In addition to claims paying ratings, we compete on the basis of price, reputation, diversity of product offerings and flexibility of coverage, ability to attract and retain agents, and the quality and level of services provided to agents and insureds.
We face additional competition due to a trend among healthcare providers and insurance companies to combine and form networks in order to contract directly with small businesses and other prospective customers to provide healthcare services. In addition, because many of our products are marketed through independent agents, most of which represent more than one company, we compete with other companies for the marketing focus of each agent.
Ratings
Our ratings assigned by A.M. Best Company, Inc. and other nationally recognized rating agencies are important in evaluating our competitive position. A.M. Best ratings are based on an analysis of the financial
condition of the companies rated. A.M. Best ratings are primarily based upon factors of concern to policyholders and insurance agents. Central Reserve’s current rating is a B+ (very good). Continental General’s current rating is a B+ (very good). Provident American Life’s and United Benefit Life’s ratings are NR-3 (rating procedure inapplicable). This rating is defined by A.M. Best to mean that normal rating procedures do not apply due to unique or unusual business features. Provident American Life and United Benefit Life fall into this category because, due to reinsurance, they both retain only a small portion of their gross premiums.
In October 2005, Fitch affirmed Central Reserve’s and Continental General’s financial strength ratings of BBB (good credit quality).
Government Regulation
Government regulation of health and life insurance, annuities and healthcare coverage and health plans is a changing area of law and varies from state to state. We strive to maintain compliance with the various federal and state regulations applicable to our operations. To maintain compliance with these constantly evolving regulations, we may need to make changes occasionally to our services, products, structure or operations. We are unable to predict what additional government regulations affecting our business may be enacted in the future or how existing or future regulations might be interpreted. Additional governmental regulation or future interpretation of existing regulations could increase the cost of our compliance or materially affect our operations, products or profitability. We carefully monitor state and federal legislative and regulatory activity as it affects our business. We believe that we are compliant in all material respects with all applicable federal and state regulations.
Insurance Regulation. We are subject to regulation and supervision by state insurance regulatory agencies. This regulation is primarily intended to protect insureds rather than investors. These regulatory bodies have broad administrative powers relating to standards of solvency, which must be met on a continuing basis, granting and revoking of licenses, licensing of agents, approval of policy forms, approval of rate increases, maintenance of adequate reserves, claims payment practices, form and content of financial statements, types of investments permitted, issuance and sale of stock, payment of dividends, and other matters pertaining to insurance. We are required to file detailed annual statements with the state insurance regulatory bodies and are subject to periodic examination. The most recent completed regulatory examination for Central Reserve, Provident American Life and United Benefit Life was performed by the State of Ohio as of December 31, 2004. For Continental General, the most recent examination was performed by the State of Nebraska as of December 31, 2004. State insurance departments also periodically conduct market conduct examinations of our insurance subsidiaries.
Although many states’ insurance laws and regulations are based on models developed by the National Association of Insurance Commissioners (NAIC) and are therefore similar, variations among the laws and regulations of different states are common. The NAIC is a voluntary association of all of the state insurance commissioners in the United States. The primary function of the NAIC is to develop model laws on key insurance regulatory issues that can be used as guidelines for individual states in adopting or enacting insurance legislation. While the NAIC model laws are accorded substantial deference within the insurance industry, these laws are not binding on insurance companies unless adopted by a state, and variation from the model laws within the state is common.
The NAIC has risk-based capital (RBC) requirements for life and health insurers to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks associated with asset quality, mortality and morbidity, asset and liability matching and other business factors. The RBC formula is used by state insurance regulators to monitor trends in statutory capital and surplus for the purpose of initiating regulatory action. 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 require increasing degrees of regulatory oversight and intervention as an insurance company’s RBC declines. The level of regulatory oversight ranges from requiring the insurance company to inform and obtain approval from the domiciliary insurance commissioner of a comprehensive financial plan for increasing its RBC, to mandatory regulatory intervention requiring an insurance company to be placed under regulatory control in a rehabilitation or liquidation proceeding.
The RBC Model Act provides for four different levels of regulatory attention depending on the ratio of a company’s total adjusted capital, defined as the total of its statutory capital, surplus and asset valuation reserve, to its risk-based capital.
•
The “Company Action Level” is triggered if a company’s total adjusted capital is less than 200%, but greater than or equal to 150% of its RBC. At the “Company Action Level,” a company must submit a comprehensive plan to the regulatory authority that discusses proposed corrective actions to improve its capital position. A company whose total adjusted capital is between 250% and 200% of its RBC is subject to a trend test. The trend test calculates the greater of any decrease in the margin (i.e., the amount in dollars by which a company’s adjusted capital exceeds its RBC) between the current year and the prior year and between the current year and the average of the past three years, and assumes that the decrease could occur again in the coming year. If a similar decrease in margin in the coming year would result in a RBC ratio of less than 190%, then “Company Action Level” regulatory action would be triggered.
•
The “Regulatory Action Level” is triggered if a company’s total adjusted capital is less than 150%, but greater than or equal to 100% of its RBC. At the “Regulatory Action Level,” the regulatory authority will perform a special examination of the company and issue an order specifying corrective actions that must be followed.
•
The “Authorized Control Level” is triggered if a company’s total adjusted capital is less than 100%, but greater than or equal to 70% of its RBC, at which level the regulatory authority may take any action it deems necessary, including placing the company under regulatory control.
•
The “Mandatory Control Level” is triggered if a company’s total adjusted capital is less than 70% of its RBC, at which level the regulatory authority is mandated to place the company under its control.
We calculated the risk-based capital for our insurance subsidiaries as of December 31, 2005, using the applicable RBC formula. Based on these calculations, the risk-based capital levels for each of our subsidiaries exceeded the levels required by regulatory authorities.
Dividends paid by our insurance subsidiaries to Ceres are limited by state insurance regulations. The insurance regulator in the insurer’s state of domicile may disapprove any dividend which, together with other dividends paid by an insurance company in the prior 12 months, exceeds the regulatory maximum as computed for the insurance company based on its statutory surplus and net income. On February 24, 2005, Central Reserve received approval from the Ohio Department of Insurance to pay an extraordinary dividend of up to $12.0 million to Ceres Group, its parent company. A dividend of $10.0 million was subsequently paid on May 4, 2005 and was used for the stock repurchase program. On December 30, 2005, Continental General paid Ceres a dividend of $7.0 million. In 2006, Continental General could pay a dividend to Ceres of up to $6.2 million without prior approval of its state regulator. However, in 2006, Central Reserve would be prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus.
Many states have also enacted insurance holding company laws, which require registration and periodic reporting by insurance companies controlled by other corporations. These laws vary from state to state, but typically require periodic disclosure concerning the corporation which controls the insurer, and prior notice to, or approval by, the applicable regulator of inter-company transfers of assets and other transactions, including payments of dividends in excess of specified amounts by the insurer, within the holding company system. These laws often also require the prior approval for the acquisition of a significant direct or indirect ownership interest (for example, 10% or more) in an insurance company. Our insurance subsidiaries are subject to these laws and we believe they are in compliance in all material respects with all applicable insurance holding company laws and regulations.
Additional regulatory initiatives may be undertaken in the future, either at the federal or state level, to engage in structural reform of the insurance industry in order to reduce the escalation of insurance costs or to make insurance more accessible. These future regulatory initiatives could have a material adverse effect on our business, financial condition and results of operations.
Healthcare Regulation and Reform. Government regulation and reform of the healthcare industry also affects the manner in which we conduct our business. There continues to be diverse legislative and regulatory
initiatives at both the federal and state levels to affect aspects of the nation’s health care system. The Gramm-Leach-Bliley Act mandated restrictions on the disclosure and safeguarding of our insureds’ financial information. The USA Patriot Act placed new federal compliance requirements relating to anti-money laundering, customer identification and information sharing. The Department of Labor regulations affected the timeframes for making a decision on claims submitted by those insured by an employer sponsored plan. In addition, recent legislation is being proposed regarding associations and the way we market our products (the Enzi bill).
HIPAA requires certain guaranteed issuance and renewability of health insurance coverage for individuals and small employer groups and limits exclusions on pre-existing conditions. HIPAA has also mandated the adoption of extensive standards for the use and disclosure of health information. HIPAA also mandated the adoption of standards for the exchange of electronic health information in an effort to encourage overall administrative simplification and enhance the effectiveness and the efficiency of the healthcare industry. We have developed, and continue to enhance, electronic data interface (EDI) systems and relationships, relating to our claim adjudication operations. These electronic processes increase the efficiencies in the service provided to our customers.
HIPAA’s Security standards became effective April 20, 2005 and further mandated that specific requirements be met relating to maintaining the confidentiality and integrity of electronic health information and protecting it from anticipated hazards or uses and disclosures that are not permitted.
The Medicare Prescription Drug Improvement and Modernization Act of 2003, or DIMA, made many significant changes to the Medicare fee-for-service and Medicare+Choice programs, as well as other changes to the commercial health insurance marketplace. Most significantly, DIMA created a prescription drug benefit for Medicare beneficiaries, established a new Medicare Advantage program to replace the Medicare+Choice program, and enacted health savings accounts (HSAs) for non-Medicare eligible individuals and groups. We will continue to assess the impact, if any, of DIMA and any other new or proposed Medicare legislation.
In addition to federal regulation and reform, many states have enacted, or are considering, various healthcare reform statutes. These reforms relate to, among other things, managed care practices, prompt pay payment practices, health insurer liability and mandated benefits. Most states have also enacted patient confidentiality laws that prohibit the disclosure of confidential information. As with all areas of legislation, the federal regulations establish minimum standards and preempt conflicting state laws that are less restrictive but will allow state laws that are more restrictive. We expect that this trend of increased legislation will continue. These laws or regulations may limit our operations and hinder our ability to effectively manage utilization and costs. We are unable to predict what state reforms will be enacted or how they would affect our business.
Most states have also enacted small group insurance and rating reforms, which generally limit the ability of insurers and health plans to use risk selection as a method of controlling costs for small group businesses. These laws may generally limit or eliminate use of pre-existing condition exclusions, experience rating, and industry class rating and limit the amount of rate increases from year to year. We have discontinued selling certain policies in states where, due to these healthcare reform measures, we cannot operate profitably. We may discontinue sales in other states in the future. Our operations also may be subject to PPO or managed care laws and regulations in certain states. PPO and managed care regulations generally contain requirements pertaining to provider networks, provider contracting, and reporting requirements that vary from state to state.
One of the significant techniques we use to manage healthcare costs and facilitate care delivery is contracting with networks to give our insureds access to physicians, hospitals and other providers, who accept negotiated reimbursement and do not balance bill our insured. A number of organizations are advocating for legislation that would exempt some providers from federal and state antitrust laws. In any particular market, providers could refuse to contract, demand higher payments or take actions that could result in higher healthcare costs, less desirable products for insureds or difficulty meeting regulatory or accreditation requirements. In some markets, some providers, particularly hospitals, physician/hospital organizations or multi-specialty physician groups, may have significant market positions or near monopolies. In addition, physician or practice management companies, that aggregate physician practices for administrative efficiency and marketing leverage, continue to expand. These providers may compete directly with us. If these providers refuse to contract with the network we use, use their market position to negotiate less favorable contracts or place us at a competitive disadvantage, those activities could adversely affect our ability to market products or to be profitable in those areas.
Statutory and regulatory changes may also significantly alter our ability to manage pharmaceutical costs through restricted formularies of products available to our insureds.
E-Commerce Regulation. We may be subject to additional federal and state statutes and regulations in connection with our changing product strategy, which includes Internet services and products. On an increasingly frequent basis, federal and state legislators are proposing laws and regulations that apply to Internet based commerce and communications. Areas being affected by this regulation include user privacy, pricing, content, taxation, copyright protection, distribution and quality of products, and services. To the extent that our products and services would be subject to these laws and regulations, the sale of our products and our business could be harmed.
Legislative Developments. Numerous proposals to reform the current health care system have been introduced in the U.S. Congress and in various state legislatures. Proposals have included, among other things, modifications to the existing employer-based insurance system, a quasi-regulated system of “managed competition” among health insurers, and a single-payer, public program. Changes in health care policy could significantly affect our business. Legislation has been introduced from time to time in the U.S. Congress that could result in the Federal government assuming a more direct role in regulating insurance companies.
We are unable to evaluate new legislation that may be proposed and when or whether any such legislation will be enacted and implemented. However, many of the proposals, if adopted, could have a material adverse effect on our business, financial condition or results of operations; while others, if adopted, could potentially benefit our business.
Employees
We had approximately 607 employees at December 31, 2005. We consider our employee relations to be good. All our agents are independent contractors and not employees.
Available Information
Ceres Group, Inc. is a Delaware corporation. Our principal executive offices are located at 17800 Royalton Road, Cleveland, Ohio 44136 and our telephone number at that address is (440) 572-2400.
Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge through the Company’s website at http://www.ceresgp.com as soon as reasonably practicable after we electronically file such reports with the Securities and Exchange Commission.
We have adopted a code of corporate conduct for our directors, officers and employees, known as the Code of Conduct and Ethics. The Code is available on our website at http://www.ceresgp.com or you may request a free copy of the Code of Conduct and Ethics from:
Ceres Group, Inc.
Attention: Investor Relations
17800 Royalton Road
Cleveland, Ohio 44136
(440) 572-2400
ITEM 1A.
ITEM 1A.
RISK FACTORS
The following factors could impact our business, financial condition and results of operations:
Failure to accurately predict health care costs when pricing our products and establishing our liabilities for future policy benefits and claim liabilities could have a significant impact on our business and results of operations.
If actual claims experience is less favorable than our underlying assumptions used in setting the prices for our products and establishing our liabilities, the required change in our claims reserves could have a material adverse effect on our business, financial condition and results of operations. Reserves represent our estimates, require a
degree of judgment, and are sensitive to changes in medical claims payment patterns and changes in medical cost trends. To mitigate this risk, we employ actuaries and consultants who have developed, refined and used the same set of reserve models over the past several years.
In addition, the premium charged for our products may be insufficient to cover the costs associated with the distribution of such products, including benefits, claims and losses, settlement expenses, acquisition expenses, and other corporate expenses. We utilize a variety of actuarial and qualitative methods to set our pricing levels. Any negative fluctuation in our estimates of the effect of continued medical inflation and high benefit utilization could have a material adverse impact on our results of operations.
In connection with the sale of our insurance policies, we defer and amortize a portion of the policy acquisition costs over the related premium paying periods of the life of the policy. Deferred acquisition costs are affected by unanticipated termination of policies because, upon termination, we expense fully the unamortized deferred acquisition costs associated with the terminated policies. Therefore, the unanticipated termination of a significant number of policies or the determination that deferred acquisition costs are unrecoverable could have a material adverse effect on our financial condition and results of operations.
Increased policy termination by our policyholders, or lapsation, will also result in reduced premium collection and a greater percentage of higher-risk insureds. Increased claims in future periods and unfavorable loss ratios are usually associated with blocks of business that have greater percentages of higher-risk insureds and, therefore, lapsation could adversely impact our future earnings.
We may lose business to competitors offering products similar to ours at lower prices.
We operate in highly competitive markets (senior and major medical) where we compete with large national, regional and specialty health and life insurers, many of whom have substantially greater financial resources, broader product lines and greater experience than we do. We compete, and will continue to compete with these companies, for customers and agents. We compete not only for individual and group customers, but also for agents and marketing relationships. Increased competition may exert strong pressures upon our profitability and impair our ability to successfully grow.
Our profitability depends in large part on our ability to accurately predict and effectively manage rising health care costs, and accurately predict loss ratios, persistency, and the performance of and improvements in our business, as well as implement necessary increases in premium rates.
Health care costs, increased use of medical services, the aging population, advances in medical technology, increased use of pharmaceutical products and services, and government imposed limitations on Medicare reimbursements are some of the factors which could adversely affect our ability to accurately predict and manage rising health care costs and accurately predict the performance of our business, which could result in a material adverse effect on our business, financial condition and results of operations.
In addition, we face pressure to contain premium prices. Our insureds may select our more restricted benefit packages to lower their premium costs. Alternatively, our customers may move to a competitor to obtain more favorable premiums. Our ability to raise premiums is subject to regulatory constraints. Limitations on our ability to increase or maintain our premium rates could adversely affect our business, financial condition and results of operations.
Changes in government regulation may affect our profitability, increase our costs of compliance or cause us to discontinue marketing certain products or marketing in certain states.
We conduct business in a highly regulated industry. Changes in government regulation may affect our profitability by increasing our costs of compliance or by causing us to discontinue marketing certain products or marketing our products in certain states. We are subject to extensive federal and state regulation and compliance with these regulations could increase our insurance companies’ operating costs. Most insurance regulations are designed to protect the interests of policyholders rather than stockholders and other investors. 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, including revocation of our license. Our failure to comply with new or existing regulations could subject us to significant fines and penalties. As government regulation changes, the costs of compliance may cause us to change our operations significantly, which may adversely affect our business and results of operations. Also, changes in the level of regulation of the insurance industry (whether federal or state) or changes in laws or regulations (or interpretations of these laws) could have a material adverse effect on our business.
We are subject to a variety of legal actions relating to our business operations, including claims related to the denial of benefits, which may result in financial losses or harm our reputation.
Current and future litigation may result in financial losses, harm our reputation and require the dedication of significant resources. We are regularly involved in litigation. This litigation typically involves our activities as an insurer and often includes claims for punitive damages. In recent years, many insurance companies, including us, have been named as defendants in class action lawsuits relating to market conduct or sales activities. Based on current information, including consultation with outside counsel, we believe that any ultimate liability that may arise from our current litigation would not materially affect our results of operations. However, we cannot predict with certainty, given the inherent unpredictability of litigation, the outcome of any actions against us or the potential costs involved. Our evaluation of the likely impact of any of these actions could change in the future and an unfavorable outcome in any case could have a material adverse effect on our financial condition and results of operations.
Changes in the relationship with the associations that make available our health insurance products to their members and/or changes in laws and regulations governing “association group” insurance could have a material adverse effect on our business, financial condition and results of operations.
A substantial portion of our major medical insurance products is issued to members of various independent membership associations that act as the master policyholder for these products. The associations provide their members access to a number of benefits and products, including health insurance underwritten by us. Subject to applicable state law, individuals generally may not obtain insurance under an association’s master policy unless they are also members of the association. The agreements with these associations are terminable by us or the association upon not less than 90 days’ advance notice to the other party.
Our agents act as representatives for these associations by enrolling new association members. For such services, some agents may receive compensation from the association. In addition to the health insurance premium derived from the sale of health insurance, we receive fee income from the associations, including fees associated with enrollment services, fees for association marketing and administrative services.
While we believe that we are providing association group coverage in full compliance with applicable law, changes in our relationship with the associations and/or changes in laws and regulations governing “association group” insurance, particularly changes that would subject the issuance of policies to prior premium rate approval and/or require the issuance of policies on a “guaranteed issue” basis, could have a material adverse effect on our business, financial condition and results of operations.
Our profitability may be adversely affected if we are unable to maintain our current preferred provider organization (PPO) arrangements and to enter into other appropriate arrangements.
Our profitability is dependent upon our ability to reach favorable arrangements with PPO networks that contract with hospitals, physicians and other health benefits providers. The failure to maintain network arrangements or to secure new cost-effective PPO network contracts may result in a loss of policyholders or higher medical costs that could adversely affect our business.
Our success depends on our ability to develop, market, distribute and administer profitable and competitive products and services in a timely, cost-effective manner.
Our success depends, in part, on our ability to develop, market, distribute and administer profitable and competitive products and services that meet consumers’ changing health insurance needs and changes in
government requirements. In recent years, the health insurance industry has experienced substantial changes, primarily caused by healthcare legislation. Our future success will depend, in part, on our ability to effectively enhance our current products, claims processing capabilities, and develop new products on a timely and cost-effective basis.
A failure of our information systems to provide timely and accurate information could adversely affect our business and results of operations.
Information processing is critical to our business, and a failure of our information systems to provide timely and accurate information could adversely affect our business and results of operations. The failure to maintain effective and efficient information systems or disruptions to our information systems could cause disruptions in our business operations, including the failure to comply with prompt pay laws, loss of existing insureds, difficulty in attracting new customers, disputes with insureds, providers and agents, regulatory issues, increases in administrative expense and other adverse consequences.
Failure by our reinsurers to timely and fully meet their obligations under our reinsurance agreements could have an adverse effect on our profitability and financial conditions.
We reinsure a portion of the health and life insurance policies we write. However, reinsurance does not discharge us from our primary liability to our insureds. Failure by reinsurers to pay in full and in a timely manner the claims made against them in accordance with the terms of our reinsurance agreements could expose our insurance subsidiaries to liabilities in excess of their reserves and surplus and could subject them to insolvency proceedings. In 2005, Hannover accounted for approximately 94% of total premiums ceded by our insurance subsidiaries. The inability of Hannover and other reinsurers to satisfy their obligations could have a material adverse effect on our business, financial condition and results of operations.
Our insurance subsidiaries are subject to risk-based or statutory capital requirements. Our failure to meet these standards could subject us to regulatory actions.
Our insurance subsidiaries are subject to risk-based capital (RBC) standards imposed by their states of domicile. These laws, based on the RBC Model Act adopted by the NAIC, require our regulated insurance subsidiaries to report their results of risk-based capital calculations to the departments of insurance and the NAIC. Failure to meet the minimum RBC requirements or statutory capital requirements could subject our insurance subsidiaries to further examination or corrective action, including state supervision or liquidation, which could have a material adverse effect on our business, financial condition and results of operations.
A decline in our financial agency ratings could adversely affect our operations.
Our principal insurance subsidiaries are currently rated by A.M. Best Company and Fitch. Decreases in operating performance and other financial measures may result in a downgrade in the ratings of our insurance subsidiaries. A downgrade in these current ratings could have a material adverse effect on our business, financial condition and results of operations.
Our investment portfolio involves risks, including risks inherent with ownership of bonds and risks associated with rising interest rates.
Our investment portfolio primarily consists of fixed maturity securities. There exists a risk that all amounts due (both principal and interest) on our fixed maturity investments will not be collected according to the security’s contractual terms. We attempt to minimize this risk by adhering to a conservative investment strategy. With the exception of short-term investments and securities on deposit with various state regulators, investment responsibilities have been delegated to external investment managers within the investment parameters established by us.
Our external investment managers prepare a monthly investment surveillance list to analyze our fixed maturity portfolio for potential other-than-temporary impairment. All of our fixed maturity investments are reported at fair market value at December 31, 2005. The amortized cost and estimated fair value of fixed maturities on our investment surveillance list at December 31, 2005 were $2.5 million and $2.4 million, respectively
In addition, interest rates could 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 $12.6 million after-tax at December 31, 2005. This amount represents approximately 6.2% of our stockholders’ equity at such date.
Applicable laws restrict the acquisition of more than 10% of our outstanding voting securities.
Ceres is a regulated holding company by the jurisdictions in which our insurance company subsidiaries are domiciled. These laws require prior approval by the state insurance regulators of changes in control of an insurer. Generally these laws require notice to the insurer and prior written approval by the state insurance regulator of the jurisdiction in which the insurance company is domiciled. Under these laws, anyone acquiring more than 10% of our outstanding voting securities would be presumed to have acquired control of Ceres, unless such presumption is rebutted.
Our Company faces additional risks, such as:
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changing regulations of corporate governance and public disclosure that has increased both our costs and the risk of non-compliance, including Section 404 of the Sarbanes-Oxley Act of 2002;
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our dependence on senior management and key personnel;
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our ability to continue to meet the terms of our debt obligations under our credit agreement, as amended, which contains a number of significant financial and other covenants;
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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;
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the performance of others on whom we rely for administrative and operations services;
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changes in accounting and reporting practices;
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payments to state assessment funds;
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changes in tax laws; and
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our ability to fully collect all agent advances.
The risks listed above should not be construed as exhaustive.
Forward-Looking Statements
This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are necessarily based on estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, us.
In particular, forward-looking statements can be identified by the use of words such as “may,” “will,” “should,” “expect,” “anticipate,” “estimate,” “continue” or similar words. In light of the risks and uncertainties inherent in all future projections, the inclusion of forward-looking statements in this report should not be considered as a representation by us or any other person that our objectives or plans will be achieved. Numerous factors could cause our actual results to differ materially and adversely from those in the forward-looking statements, including those risks outlined above in “Risk Factors.” We undertake no obligation to publicly release the results of any future
revisions we may make to forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2.
PROPERTIES
Owned Properties (office space)
Leased Properties (office space)
(1)
The lease on the Dallas sales office expired on January 31, 2006.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
The nature of our business subjects us to a variety of legal actions (including class actions) and claims relating to such things as denial of healthcare benefits, premium rate increases, termination of coverage, claims administration, our relationship with the associations that market our products, and alleged violations of state and federal statutes.
We are involved in various legal and regulatory actions occurring in the normal course of business that could result in significant liabilities and costs. Based on current information, including consultation with outside counsel, we believe that any ultimate liability that may arise from any of these actions would not materially affect our audited consolidated financial position or results of operations. However, we cannot predict with certainty the outcome of any of these actions against us or the potential costs involved. Our evaluation of the likely impact of any of these actions could change in the future and an unfavorable outcome in any case could have a material adverse effect on our consolidated financial position, results of operations or cash flows of a future period.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
(a) Market Information. Our common stock trades on the NASDAQ National Market under the symbol CERG. The following table shows the high and low closing prices of our common stock for the quarters listed. These prices were taken from the NASDAQ Monthly Statistical Reports. On March 1, 2006, our common stock closed at $5.46 per share.
(b) Holders. As of March 1, 2006, we had an estimated 2,418 record holders.
(c) Dividends. We have not paid any cash dividends on our common stock since the end of 1996, and we do not anticipate paying any dividends in the foreseeable future. Our credit agreement, as amended, contains financial and other covenants that, among other matters, limit the payment of cash dividends on our common stock. For more information on our credit agreement, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.”
Dividends paid by our insurance subsidiaries to us are limited by state insurance regulations. The insurance regulator in the insurer’s state of domicile may disapprove any dividend which, together with other dividends paid by an insurance company in the prior 12 months, exceeds the regulatory maximum as computed for the insurance company based on its statutory surplus and net income. On February 24, 2005, Central Reserve received approval from the Ohio Department of Insurance to pay an extraordinary dividend of up to $12.0 million to Ceres, its parent company. A dividend of $10.0 million was subsequently paid on May 4, 2005 and was used for the stock repurchase program. On December 30, 2005, Continental General paid Ceres a dividend of $7.0 million. In 2006, Continental General could pay a dividend to Ceres of up to $6.2 million without prior approval of its state regulator. However, in 2006, Central Reserve would be prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus.
(d) Issuer Purchases of Equity Securities. The following is a summary of stock repurchases, pursuant to our previously-announced stock repurchase program, for the fourth quarter of 2005. See Note N. Treasury Stock, to our audited consolidated financial statements for further information.
(1)
On May 4, 2005, our Board of Directors authorized the repurchase of up to $10 million of our outstanding common stock in the open market or in private transactions. During the fourth quarter of 2005, we completed the authorized $10 million stock repurchase program and repurchased 45,938 shares in open market transactions at an average price per share of $5.97.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The selected audited consolidated financial data presented below as of and for each of the five years ended December 31, 2005, 2004, 2003, 2002 and 2001 have been derived from our audited consolidated financial statements. However, financial data for 2001 was reclassified to reflect the sale of Pyramid Life Insurance Company on March 31, 2003. For further information, see Note D. Discontinued Operations to our audited consolidated financial statements. The financial information for the years ended December 31, 2005, 2004, 2003, 2002 and 2001 includes the operations of all our subsidiaries for the entire year except for Pyramid Life. Pyramid Life, which is presented separately as discontinued operations, was acquired on July 26, 2000 and sold on March 31, 2003. The data for 2005, 2004 and 2003 should be read in conjunction with the more detailed information contained in the audited consolidated financial statements and accompanying notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this filing.
(1)
Effective March 31, 2003, Continental General sold its subsidiary, Pyramid Life Insurance Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. See Note D. Discontinued Operations to our audited consolidated financial statements for further information.
(2)
The exercise of options and warrants is not assumed when a loss from operations is reported and the result would be antidilutive.
(3)
In 2001, we received net proceeds of $46.5 million from a public offering of 16.1 million shares of our common stock, at $3.20 per share.
(4)
“Accumulated other comprehensive income” relates primarily to the net unrealized gain (loss) on available-for-sale securities.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
This discussion should be read in conjunction with the audited 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.”
Overview
Ceres Group, through its insurance subsidiaries, provides a wide array of health and life insurance products through two primary business segments. The Medical segment includes major medical health insurance for individuals, families, associations, and small to mid-size businesses. The Senior segment includes senior health, life and annuity products for Americans age 55 and over. To help control medical costs, Ceres also provides medical cost management services to its insureds.
Our insurance subsidiaries include Central Reserve Life Insurance Company, Provident American Life & Health Insurance Company, United Benefit Life Insurance Company and Continental General Insurance Company. Central Reserve markets and sells both major medical health insurance to individuals, families, associations, and small employer groups and senior products to Americans age 55 and over. Continental General markets and sells both major medical and senior health and life products to individuals, families, associations and Americans age 55 and over. Provident American Life discontinued new medical sales activities and currently has approximately 200 active major medical certificate holders and 300 life policyholders. In June 2005, Provident American Life began marketing and selling a new portfolio of senior products. United Benefit Life has no active policyholders.
Effective March 31, 2003, Ceres sold its subsidiary, Pyramid Life Insurance Company to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash, before transaction costs of $2.2 million. For more information on the Pyramid Life sale, see Note D. Discontinued Operations to our audited consolidated financial statements.
Critical Accounting Policies
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 consolidated financial statements in the period in which they are made. Management has discussed the development, selection and disclosure of these estimates with our Audit Committee.
Liabilities for Other Policy Claims and Benefits Payable. The most significant accounting estimate in our audited consolidated financial statements is our liability for other policy claims and benefits payable.
Major Medical, Medicare Supplement & Other Health. The liability for other policy claims and benefits payable (except for long-term care disabled life reserves which represented approximately 40% of the total liabilities for other policy claims and benefits payable at December 31, 2005) consists of actual claims reported but not paid and estimates of claims incurred but not reported (IBNR). Liability estimates are developed using actuarial principles and assumptions that consider, among other things, historical claims payment patterns, claims inventory levels, network reimbursement changes, historical utilization trends, current levels of authorized inpatient days, other medical cost inflation factors, in-force levels, benefit design changes, seasonality, demographic mix change and expected costs to settle unpaid claims.
We employ actuaries and consultants that have developed, refined and used the same set of reserve models over the past several years. These reserve models make use of both historical claim payment patterns as well as emerging medical cost trends to project our best estimate of claim liabilities. Within these models, historical data of paid claims is formatted into claim triangles which compare claim incurred dates to the claim payment dates. This information is analyzed to create “completion factors” that represent the average percentage of total incurred claims
that have been paid through a given date after being incurred. Completion factors are applied to claims paid through the financial statement date to estimate the ultimate claim expense incurred for the current period. Actuarial estimates of claim liabilities are then determined by subtracting the actual paid claims from the estimate of the ultimate incurred claims.
For the more recent incurred months, the percentage of claims paid to claims incurred in those months is generally low. As a result, the completion factor methodology is less reliable for such months. For that reason, incurred claims for recent months are not projected solely from historical completion and payment patterns. Instead, they are projected by estimating the claim expense for those months based upon recent claim expense levels and claim trend levels, or “trend factors.” As these months mature over time, the two estimates (completion factor and trend) are blended with completion factors being used exclusively for older months.
A substantial portion of liability estimates relates to the most recent four incurred months. Changes in the completion and trend factors can have a significant effect on the liability estimates. A hypothetical 2% increase in claim trend coupled with a 1% decrease in completion factors for the prior twelve months could cause an 8% increase in our liability for other policy claims and benefits payable.
Long-Term Care Disabled Life Reserves. With respect to long-term care disabled life reserves, the tabular method is used for all open claims where the eligibility for benefits has been established. The ability to accurately perform a disabled life reserve calculation is dependent upon the appropriateness of the continuance tables used. The long-term care continuance tables are based on a third party actuarial firm’s long-term care guidelines. The continuance factors are adjusted based on emerging actual-to-expected claim cost data by benefit type and cause of impairment. A hypothetical 1% annual increase in the assumed termination rate in the continuance tables would result in an approximately 2% increase in the case reserve, or $700,000 at December 31, 2005.
The claim liability model develops estimates of 1) claims in the course of settlement, 2) case reserves, and 3) IBNR. The calculation methodologies for the three specific reserves are as follows:
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Claims in the Course of Settlement
For each open claim, a claim in the course of settlement amount is calculated, representing the amount of payments expected to be owed on existing claims for services received prior to the valuation date but for which benefits have not yet been paid. This amount is calculated by multiplying the number of days between the valuation date and the last service date for which benefits have been paid by the daily benefit of the policy, where the daily benefit is adjusted by the expected salvage factor. This salvage factor represents the average portion of the full daily benefit expected to be paid.
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Case Reserves
For each open claim, a case reserve is calculated, representing the present value of future benefits expected to be incurred for services subsequent to the valuation date. Each open claim is valued based on the duration and payments since the claim has been opened, the age and sex of the claimant, and the specific benefits of the policy (daily benefit, benefit period, presence of inflation protection, etc.). Continuance tables varying by age, sex and claim type are used to calculate the expected future length of claim given the individual policy’s benefit history and maximum benefit amount. This expected future length of claim along with the salvage-adjusted daily benefit determines the total expected future payments. These payments are discounted at the GAAP valuation rate (6.125% at December 31, 2005 and 2004) to determine the case reserve.
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IBNR
An IBNR reserve is calculated to represent the liability for claims incurred but not yet reported as of the valuation date. This would include a case reserve portion for ongoing claims as well as nonrecurring claims for both known and unknown cases. Historical information is used to establish the amount of IBNR that develops after various points in time. This information is used to calculate an average IBNR per policy in-force. Adjustments are made to account for changes in durational mix and trend. These factors are then applied to the current in-force.
Adequacy of Liability for Other Policy Claims and Benefits Payable. Claims liabilities are recorded at amounts we estimate to be appropriate. Adjustments of prior year estimates may result from higher-than-expected medical costs or, as we have experienced during the last two years, a reduction in projected medical costs in the period an adjustment was made. Our reserve models in the aggregate have developed favorably in recent years, suggesting that the accrued liabilities calculated from the models were more than adequate to cover our ultimate liability for unpaid claims.
The following table reflects the activity in the liability for other policy claims and benefits payable, including the claims adjustment expenses, net of reinsurance recoverables:
The above table indicates a net redundancy in reserves (“Incurred claims and claims adjustment expenses, net of reinsurance for prior years” divided by “Adjusted net beginning balance”) of 0.5% in 2004, 19.0% in 2003, and 10.9% in 2002.
The following is a breakdown of the estimated redundancy (deficiency) by segment:
Claim reserve estimates are continually monitored and reviewed, and, as estimates are adjusted, differences are reflected in current operations. We develop best estimate reserves for all lines of business and do not develop ranges of possible outcomes. Based on historical deviations from our best estimate, we have generally been within 5% to 15% of the recorded reserve estimates.
As discussed above, liability estimates are developed using actuarial principles and assumptions that consider a variety of issues. Changes in the completion and trend factors can have a significant effect on these liability
estimates. For example, in the Medical Segment, a $10.1 million redundancy in the 2002 reserves emerged in 2003 due to the moderation of the higher than expected claim trend (including severity and frequency) experienced in 2002 related to December 31, 2001 reserves. This ultimate claim trend with the benefit of hindsight and payment of the underlying claims was significantly lower than the historical claim trends that were used to establish the reserves. The $14.2 million redundancy in the 2003 reserves (which emerged in 2004) reflects the successful cancellation of unprofitable business in 2002 and the subsequent improvement in actual claims experience, as well as the improving claim trend. The $3.1 million redundancy in the 2004 reserves (which emerged in 2005) reflects the lower level of severity on fourth quarter 2004 incurreds.
In the Senior segment, we adjusted the continuance tables in 2002 to reflect the higher level of cognitive claims in our long-term care block. The redundancy, which emerged in 2003 and 2004, reflected the improvement in actual claim experience and the reduction in expected length of stay. The $2.6 million deficiency, which emerged in 2005, reflects an extension in the length of stay on our long-term care block coupled with an increase of policies on claim with inflation rider benefit protection.
Future Policy Benefits, Losses and Claims. Liabilities for future policy reserves for accident and health and traditional life business are based on the net level premium basis and estimates of future claims, investment yield, lapses using our experience and actuarial judgment with an allowance for possible future adverse deviations from expected experience. Interest rates used range from 4.5% to 6.125%. Original assumptions will continue to be used in subsequent accounting periods to determine changes in the liability for future policy benefits (often referred to as the “lock-in” concept) unless a premium deficiency exists. We review actual experience with respect to investment yields, mortality, morbidity, and lapses to help insure that existing liabilities, together with the present value of future premiums, will be sufficient to cover the present value of future benefits and maintenance costs and to recover unamortized acquisition costs.
Liabilities for interest sensitive products such as deferred annuities and universal life are based on the retrospective deposit method. This is the policyholder fund balance before adjusting for any surrender charges. Guaranteed minimum rates for universal life contracts are 4.0% to 5.5%. At December 31, 2005, credited rates for universal life contracts ranged from 4.0% to 5.5%. Guaranteed base minimum rates for deferred annuities ranged from 3.0% to 5.5% depending on the duration of the contract. At December 31, 2005, credited rates for deferred annuities ranged from 3.0% to 6.0%.
Deferred Acquisition Costs. In connection with the sale of our insurance policies, we defer and amortize a portion of the policy acquisition costs over the related premium paying periods of the life of the policy. These costs include certain excess policy acquisition costs associated with issuing an insurance policy, including commissions and underwriting, all of which vary with and are primarily related to the production of new business. The amortization of deferred acquisition costs is determined using the same projected actuarial assumptions used in computing policy reserves. Deferred acquisition costs associated with traditional life and accident and health contracts are charged to expense over the premium-paying period or as premiums are earned over the life of the contract. Deferred acquisition costs associated with interest-sensitive life and annuity products are charged to expense over the estimated duration of the policies in relation to the present value of the estimated gross profits from surrender charges and investments, mortality, and expense margins.
We evaluate the recoverability of our deferred acquisition costs on an annual basis. The recoverability of our deferred acquisition costs is sensitive to judgments and assumptions made in projecting future cash flows on our various blocks of business. The most significant assumptions are claim cost trends, magnitude of rate increases, lapsation and persistency, and mortality.
Management believes the amount of deferred acquisition costs as of December 31, 2005 is recoverable.
Other Accounting Policies and Insurance Business Factors
Our results of operations are affected by the following accounting and insurance business factors:
Goodwill and Other Intangible Assets. Goodwill represents the excess of purchase price over the fair value of tangible and identifiable intangible net assets acquired. At December 31, 2005, goodwill was $10.7 million and represented approximately 1.4% of our total assets. Additionally, other intangible assets represent purchased assets
that also lack physical substance but can be distinguished from goodwill because of other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract asset or liability. At December 31, 2005, our other intangible assets consisted of $3.4 million in licenses, or 0.4% of our total assets.
Effective January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets issued by the Financial Accounting Standards Board (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 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 indicated that no reduction of goodwill or licenses was required in 2005 or 2004. A slight reduction of $0.1 million was made to the carrying value of licenses in 2003 due to the cancellation of business in certain unprofitable states.
Long-lived Assets. Property and intangible assets are reviewed for possible impairment when events indicate that the carrying amount of an asset may not be recoverable. Assumptions and estimates used in the evaluation of impairment may affect the carrying value of long-lived assets, which could result in impairment charges in future periods. Depreciation and amortization policies reflect judgments on the estimated useful lives of assets.
Premium 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. Revenue from interest sensitive contracts, principally universal life and annuity products, consist of mortality charges for the cost of insurance, contract administration charges, and surrender charges assessed against policyholder account balances during the period. Amounts received from interest sensitive contacts 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.
Value of business acquired. A portion of the purchase price paid for Continental General Corporation was allocated to the value of business acquired based on the actuarially determined present value of the expected pre-tax future profits from the business assuming a discount rate of 15.0%. Interest is accrued on the balance annually at a rate consistent with the rate credited on the acquired policies on the acquisition date, which ranges from 4.0% to 8.75%. Recoverability of the value of business acquired is evaluated periodically by comparing the current estimate of the present value of expected pre-tax future profits to the unamortized asset balance. If the current estimate is less than the existing asset balance, the difference would be charged to expense, and if the current estimate is higher than the existing asset balance, the difference will emerge into profits as earned.
For accident and health and ordinary life business, the value of business acquired is amortized over the estimated life of the in force business using assumptions consistent with those in computing reserves. Interest of 6.5% for Continental General is credited to the unamortized balance. For interest sensitive products such as universal life and deferred annuities, the value of business acquired is amortized over the expected profit stream of the in force business. The expected profit stream is based upon actuarial assumptions as to mortality, lapses and expenses. Earned interest was assumed to be 6.0% for Continental General, the market rate at the time of acquisition.
The number of years a policy has been in effect. Claims costs tend to be higher on policies that have been in force for a longer period of time. As the policy ages, it is more likely that the insured will need services covered by the policy. However, generally, the longer the policy is in effect, the more premium we will receive for major medical and Medicare supplement policies. For other health, life and annuity policies/contracts, reserve liabilities are established for policy benefits expected to be paid for in future years.
Lapsation and persistency. Other factors that affect our results of operations are lapsation and persistency, both of which relate to the renewal of insurance policies and certificates in force. Lapsation is the termination of a policy for nonrenewal and, pursuant to our practice, is automatic if and when premiums become more than 31 days overdue. However, policies may be reinstated, if approved, within 90 days after the policy lapses. Persistency
represents the percentage of total certificates in force at the end of a period less any newly-issued certificates divided by the total certificates in force at the beginning of the period.
Policies renew or lapse for a variety of reasons, due both to internal and external causes. We believe that our efforts to address any concerns or questions of our insureds in an expedient fashion help to ensure ongoing policy renewal. We work closely with our licensed agents, who play an integral role in obtaining policy renewals and communicating with our insureds. In 2005, we continued to experience high lapse rates on our renewal major medical business.
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.
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 antiselection 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. A significant portion of our risks are reinsured with a single reinsurance company, Hannover Life Reassurance Company of America. For more information on Hannover, see “Business-Reinsurance-Existing Arrangements.” We also have assumed risk on a “quota share” basis from other insurance companies. Our results of operations are presented net of reinsurance.
Liabilities for Litigation. We are involved in various litigation and regulatory actions. Such actions typically involve disputes over policy coverage and benefits, but may also relate to premium rates, agent and employment related issues, regulatory compliance and market conduct, contractual relationships, and other matters. These disputes are resolved by settlement, dismissal or upon a decision rendered by a judge, jury or regulatory official.
In determining the amount to be recorded as a litigation reserve, judgments are generally made by management, in consultation with legal counsel and other experts both within and outside the Company, on a case-by-case basis based on the facts and the merits of the case, the general litigation and regulatory environment of the originating state, our past experience with outcomes of cases in particular jurisdictions, historical results of similar cases and other relevant factors. We closely monitor and evaluate developments and emerging facts of each case to determine the reasonableness of judgments and assumptions on which litigation reserves are based. Such assumptions relate to matters that are highly uncertain. Estimates could be made based on other reasonable assumptions or judgments that would differ materially from those estimates recorded. We will accrue a liability if the likelihood of an adverse outcome is probable and the amount is estimable. We will not accrue a liability if either the likelihood of an adverse outcome is only reasonably possible or an estimate is not determinable. Our evaluation of the likely outcome of these actions and the resulting estimate of the potential liability are subject to periodic adjustments that may have a material impact on our financial condition and results of operations of a future period.
Inherent uncertainties surround legal proceedings and actual results could differ materially from those assumed in estimating the liabilities. The possibility exists that a decision could be rendered against us, and, in some circumstances, include punitive or other damage awards in excess of amounts reserved, that may have a material impact on our financial condition, results of operations or cash flows of a future period.
Insurance. We use a combination of insurance and self-insurance for a number of our risks including property, general liability, directors’ and officers’ liability, workers’ compensation, vehicle liability, and employee-related healthcare benefits. Liabilities associated with the risks that are retained are estimated by considering various historical trends and forward-looking assumptions. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends. Over the past couple of years, increases in 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
2006. Other policies are up for renewal in mid-2006. We may not be successful in obtaining coverage on terms favorable to us or at all.
Results of Operations
We have three reportable segments:
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Medical - includes catastrophic and comprehensive major medical plans;
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Senior and Other - includes Medicare supplement, long-term care, dental, life insurance and annuities; and
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Corporate and Other - includes primarily interest income, interest expense, and corporate expenses of the holding company.
The financial information for the years ended December 31, 2005, 2004 and 2003, includes the operations of all our subsidiaries for the entire period with the exception of Pyramid Life.
Discontinued Operations. On March 31, 2003, we sold our indirect subsidiary, Pyramid Life Insurance Company, to the Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash before transaction costs of $2.2 million. Consistent with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, Pyramid Life was classified as held for sale as of December 31, 2002, and was measured at its fair value less costs to sell. A total loss from the sale of $13.8 million was recorded in 2002 and 2003 ($11.6 million in 2002 and $2.2 million in 2003.) The financial information for the year ended December 31, 2003 excludes the operations of Pyramid Life and the $2.2 million loss from the sale, net of taxes except where specifically noted. The results of operations and cash flows of Pyramid Life have been reported separately as discontinued operations of a subsidiary in our audited consolidated financial statements for 2003. See Note D. Discontinued Operations to our audited consolidated financial statements for further information.
Overview and Outlook for 2006. Net income for 2005 was $15.0 million or $0.44 per diluted share, compared to net income for 2004 of $19.1 million or $0.55 per diluted share.
Pre-tax income for our Medical segment was $4.1 million for 2005, compared to $5.2 million for 2004, including a $3.1 million pre-tax charge for the California litigation settlements. Premiums in the Medical segment decreased approximately 10.5% in 2005 due to the decline in major medical certificates in force as well as high lapse rates. Premiums increased 1.6% from the third quarter to the fourth quarter of 2005. In 2006, we expect premiums to increase by approximately 5.0%, the first annual increase in premiums since 2001. The loss ratio in the Medical segment was 73.4% in 2005, compared to 71.3% for 2004. The loss ratio was impacted by an increased severity of large claims and unfavorable experience on our partially self-funded small group (Partnership) plan. In 2006, we expect the loss ratio to remain consistent with 2005.
Pre-tax income from our Senior and Other segment was $17.9 million for 2005 compared to $18.5 million in 2004. Premiums in the Senior and Other segment increased 12.9% in 2005 due primarily to Medicare supplement new business production as well as rate increases that were filed in 2004 and implemented in 2005. In addition, we introduced new Medicare supplement products through our Provident American Life subsidiary and began selling new senior life insurance plans. We expect premiums in this segment to increase approximately 15% in 2006 due to the 2006 rate increases on our Medicare supplement blocks and new sales. The loss ratio in the Senior and Other segment was 78.7% in 2005, compared to 75.6% for 2004. The Medicare supplement loss ratio was 73.8% in 2005 compared to 71.9% in 2004. The 2005 segment results were impacted by a higher than expected loss ratio for our Medicare supplement business and unfavorable long-term care experience. In 2006, we expect the Senior and Other loss ratio to decrease to approximately 76.0% and the Medicare supplement loss ratio to decrease to approximately 72.0% due to the approval and implementation of an average 15% rate increase on this block of business (assuming a claim trend of 10%).
2005 Compared to 2004
Net Premiums (net of reinsurance ceded)
For the year ended December 31, 2005, total net premiums decreased 0.6% to $427.9 million, compared to $430.2 million for 2004.
Medical
Medical premiums for 2005 were $221.0 million, compared to $247.0 million for 2004, a decrease of 10.5%. The decrease in medical premiums was primarily the result of a 10.0% decrease in major medical certificates in force from 66,724 at December 31, 2004 to 60,080 at December 31, 2005 due to continued high lapsation rates on both first year and renewal business.
Medical premiums increased 1.6% from the third quarter to the fourth quarter of 2005 primarily due to new business production. In mid-2005, we introduced our new Advantage Series of major medical products designed to offer customers a choice of benefit levels and prices. We now expect medical premiums to increase by approximately 5% on an annualized basis in 2006, the first annual increase in premiums since 2001.
Senior and Other
Senior and other premiums increased $23.6 million, or 12.9%, to $206.8 million for the year ended December 31, 2005, compared to $183.2 million for 2004. The increase in senior and other premiums was primarily the result of a $23.4 million increase in Medicare supplement premium due to new business production as well as rate increases that were filed in 2004 and implemented in the first quarter of 2005. We expect premiums in this segment to increase approximately 15% in 2006.
In June 2005, we introduced new Medicare supplement products through our Provident American Life subsidiary and began selling new senior life insurance plans. We also developed a career distribution channel to focus on marketing senior products of our Provident American Life and Continental General subsidiaries. These agents give us a right of first refusal on all senior products. At December 31, 2005, we had appointed 23 regional sales managers and approximately 256 agents to focus specifically on marketing our senior product portfolio.
In addition, we have begun marketing Medicare Part D prescription drug plans through our relationship with Coventry Health Care, Inc. and its affiliates. At January 31, 2006, we had approximately 10,000 insureds enrolled in these plans. We will participate in 25% of the risk on all Part D policies sold by our agents. Part D policies are effective January 1, 2006 and after.
Other Revenues
Net investment income was $26.9 million for 2005, compared to $25.4 million for 2004, an increase of 5.9%. The increase was attributable to an increase in the overall book yield of our investment portfolio caused by the increased interest rate environment and the shift out of our convertible bond trading portfolios in 2005. The book yield of our available-for-sale investment portfolio at December 31, 2005 was 5.50% compared to a book yield of 5.34% at December 31, 2004.
Net realized gains decreased to $0.7 million for 2005, compared to $1.2 million for 2004. The $0.5 million decrease was primarily attributable to $0.7 million in realized losses on our trading portfolios in 2005 compared to $0.8 million in realized gains in 2004 partially offset by a $1.0 million increase in realized gains on our available-for-sale portfolios. The trading portfolios were liquidated in 2005.
Fee and other income decreased to $17.1 million for 2005, compared to $19.5 million for 2004, a decrease of 12.3%. This decrease was attributable to the decline in major medical policies and the associated policy fee income.
Benefits, Claims, Losses and Settlement Expenses
Total benefits, claims, losses and settlement expenses increased to $325.0 million for 2005, compared to $314.6 million for 2004, an increase of 3.3%.
Medical
Medical benefits, claims, losses and settlement expenses were $162.2 million for 2005, compared to $176.1 million for 2004, a decrease of 7.9%. The decrease was primarily the result of a smaller volume of business in force partially offset by an increase in claims severity. In addition, the medical loss ratio was 73.4% for 2005, compared to 71.3% for 2004. The loss ratio was impacted in 2005 by increased severity of large claims on certain renewal blocks of business in our Central Reserve subsidiary and unfavorable experience on our partially self-funded small group (Partnership) plan. We expect the 2006 loss ratio in the Medical segment to remain consistent with 2005.
Senior and Other
Senior and other benefits, claims, losses and settlement expenses were $162.7 million for 2005, compared to $138.5 million for 2004, an increase of 17.5%. The senior and other loss ratio was 78.7% for 2005, compared to 75.6% for 2004. This increase was primarily due to an increase in the Medicare supplement loss ratio from 71.9% in 2004 to 73.8% in 2005, unfavorable long-term care experience in the third quarter of 2005 and an increase in long-term care benefit reserves in the fourth quarter of 2005 related to revisions to our long-term care model. Our long-term care model was adjusted to reflect the higher 2005 rate levels and persistency. The Medicare supplement loss ratio is expected to decrease to approximately 72.0% in 2006 compared to 73.8% in 2005 due to the approval and implementation of an average 15% rate increase on this block of business. The overall loss ratio in this segment is expected to be approximately 76% in 2006.
Other Expenses and Net Income
Selling, general and administrative expenses decreased to $131.6 million in 2005, compared to $134.6 million in 2004, a decrease of 2.2%. Included in selling, general and administrative expenses for 2004, is a $3.1 million pre-tax charge ($2.0 million after-tax or $0.06 per share) relating to the settlement of two California lawsuits against the Company and its subsidiaries. These lawsuits related primarily to challenges to premium increases for California holders of major medical policies issued by United Benefit Life and Provident American Life. For more information, see Note L. Contingencies and Commitments to our audited consolidated financial statements. Excluding this charge, selling, general and administrative expenses were $131.6 million in 2005 compared to $131.5 million in 2004, an increase of $0.1 million. The increase was primarily due to a $2.0 million increase in commissions attributable to a higher overall commissions rate due to an increase in first year premium, reduced reinsurance allowances of $3.2 million due to expected lapsation of closed blocks of reinsured business, and an increase in regulatory fees due to routine regulatory exams in 2005 at both of our major insurance companies. The increases were partially offset by the following:
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a decrease in salaries and benefits of approximately $1.0 million due to a reduced workforce;
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a decrease in consulting expenses of approximately $1.0 million related to bringing our Cleveland data processing and programming back in-house from a third party vendor in the first half of 2004;
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a decrease in legal fees;
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a decrease in actuarial consulting fees due to the appointment of a chief actuary in 2005; and
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a decrease in fees charged by third party administrators for claims processing and other administrative services due to a decline in medical business in force.
As a percentage of premium, selling, general and administrative expenses were 30.8% in 2005 compared to 31.3% in 2004, including the California litigation settlements.
The net (deferral) amortization and change in deferred acquisition costs (DAC) and value of business acquired (VOBA) resulted in a net deferral of $5.2 million for 2005, compared to net amortization of $4.6 million for 2004. In the Senior segment, the DAC asset increased by $9.0 million in 2005 compared to $5.4 million in 2004. The increase was primarily due to a higher level of costs capitalized due to an increase in Medicare supplement business and a decrease in DAC amortization on our long-term care business due to higher 2005 rate levels and persistency. In addition, the amortization of VOBA decreased $1.4 million for 2005 compared to 2004 related to a slowdown in
amortization on our universal life block of business due to improving mortality and an increase in expected future gross profits. The decline in the DAC asset in the Medical segment was $3.1 million in 2005 compared to $7.7 million in 2004. Higher lapse rates on new and existing medical business caused a higher-than-expected increase in the level of DAC amortization in 2004. In addition, new sales in the Medical segment increased 35% over 2004 levels.
Interest expense and financing costs were $0.7 million in 2005, which was comparable to 2004. The higher effective interest rate in 2005 was offset by the reduction in debt outstanding.
Income before federal income taxes was $20.4 million for 2005, compared to $21.9 million for the same period in 2004, including a $3.1 million pre-tax charge related to the settlement of the California lawsuits.
A federal income tax expense of $5.4 million was recorded for 2005, which included a $1.8 million ($0.05 per share) federal income tax benefit related to the reduction of federal income tax reserves associated with the elimination of our untaxed policyholder surplus account exposure and recently closed tax years. In 2004, a federal income tax expense of $2.8 million was recorded, which included a $5.0 million reduction in the deferred tax valuation allowance. As a result of our continued profitability, a projection of continued taxable income in future periods, and the corresponding utilization of the net operating loss (NOL) carryforwards against 2004 taxable income, the deferred tax valuation allowance was reduced by $5.0 million, or $0.14 per share, in 2004. The effective tax rate, including the $1.8 million reduction of federal income tax reserves, was 26.2% of the income before federal income taxes for 2005. The effective tax rate for 2004, including the $5.0 million reduction to the deferred tax valuation allowance, was 12.6% of the income before federal income taxes. See Note I. Federal Income Taxes for a detailed reconciliation of our effective tax rate. We expect our effective tax rate will be 35% in 2006.
Net income was $15.0 million, or $0.44 per diluted share, for 2005, compared to $19.1 million, or $0.55 per diluted share, for 2004.
Compared to 2003
Net Premiums (net of reinsurance ceded)
For the year ended December 31, 2004, total net premiums decreased 10.1% to $430.2 million, compared to $478.3 million for 2003.
Medical
Medical premiums for 2004 were $247.0 million, compared to $305.4 million for 2003, a decrease of 19.1%. The decrease in medical premiums was primarily the result of a 20.7% decrease in major medical certificates in force from 84,167 at December 31, 2003 to 66,724 at December 31, 2004 due to higher lapsation rates. We believed that necessary rate increases implemented in excess of claim trends on certain blocks caused higher lapsation rates in 2003 and 2004. In addition, in 2004, we experienced higher than anticipated lapse rates on new business.
However, new business production increased in 2004, compared to the same period in 2003, partially offsetting the higher than anticipated lapse rates. We had planned to continue to focus sales in a select number of geographic locations which had historically produced favorable underwriting results. From the third quarter to the fourth quarter of 2004, the decline in major medical premium moderated to approximately 1.8% (or approximately 7% on an annualized basis), as the increased level of new business production approached the level of renewal business which was lapsing. The decline in major medical premium was expected to moderate to approximately 5% on an annualized basis in 2005.
Senior and Other
Senior and other premiums increased $10.3 million, or 6.0%, to $183.2 million for the year ended December 31, 2004, compared to $172.9 million for 2003. The increase in senior and other premiums was primarily the result of an increase in new business production of our Medicare supplement policies and growth of our senior life product. New business production of Medicare supplement policies increased in 2004 compared to 2003 due primarily to the introduction of new standardized Medicare supplement plans at Central Reserve and a new standardized plan at Continental General.
Other Revenues
Net investment income was $25.4 million for 2004, compared to $25.1 million for 2003, an increase of 1.3%. This increase was the result of an increase in average invested assets due to the investment of most of the proceeds from the sale of Pyramid Life on March 31, 2003 and the assumption of a related block of life business with approximately $12.1 million in invested assets. The book yield of our available-for-sale investment portfolio at December 31, 2004 was 5.34% compared to a book yield of 5.39% at December 31, 2003.
Net realized gains decreased to $1.2 million for 2004, compared to $1.9 million for 2003. The decrease was primarily attributable to gains generated on the sale of mortgage-backed securities and corporate bonds in 2003, which were partially offset by $0.8 million in realized gains on our trading portfolios in 2004.
Fee and other income decreased to $19.5 million for 2004, compared to $28.9 million for 2003, a decrease of 32.6%. This decrease was attributable to the decline in major medical policies and the associated policy fee income as well as $5.7 million of fees in 2003 related to the transition processing of senior business for Pyramid Life. This transition agreement terminated on December 31, 2003.
Benefits, Claims, Losses and Settlement Expenses
Total benefits, claims, losses and settlement expenses decreased to $314.6 million for 2004, compared to $353.7 million for 2003, a decrease of 11.1%.
Medical
Medical benefits, claims, losses and settlement expenses were $176.1 million for 2004, compared to $226.2 million for 2003, a decrease of 22.1%. The decrease was primarily the result of a smaller volume of business in force due to the reduction in medical business as a result of higher than anticipated lapse rates. In
addition, the medical loss ratio was 71.3% for 2004, compared to 74.1% for 2003. The improvement in the loss ratio was due primarily to favorable run-off of prior year claim reserves.
Senior and Other
Senior and other benefits, claims, losses and settlement expenses were $138.5 million for 2004, compared to $127.5 million for 2003. The senior and other loss ratio was 75.6% for 2004, compared to 73.7% for 2003. The Medicare supplement loss ratio was higher than expected in 2004. The Medicare supplement loss ratio for 2004 was 71.9%, compared to 67.1% in 2003. The increase in the Medicare supplement loss ratio was caused by an increase in claim frequency on Medicare Part B physician claims. For 2004, rate increases on this block were approximately 5% based on the Company’s estimate of claims trends when the 2004 rate increases were filed. However, the 2004 claims trend was approximately 10%, resulting in the higher than expected loss ratio for the full year.
Other Expenses and Net Income
Selling, general and administrative expenses decreased to $134.6 million in 2004, compared to $146.9 million in 2003, a decrease of 8.4%. Included in selling, general and administrative expenses for 2004, is a $3.1 million pre-tax charge ($2.0 million after-tax or $0.06 per share) relating to the settlement of two California lawsuits against the Company and its subsidiaries. These lawsuits related primarily to challenges to premium increases for California holders of major medical policies issued by United Benefit Life and Provident American Life. For more information, see Note L. Contingencies and Commitments to our audited consolidated financial statements. Excluding this charge, other operating expenses decreased $14.3 million and commissions decreased $4.4 million as a direct result of the decline in medical premiums offset by reduced reinsurance allowances of $3.3 million resulting from a lower volume of ceded premium. As a percentage of premium, selling, general and administrative expenses, including the California litigation settlements, were 31.3% in 2004, compared to 30.7% in 2003. The increase in the selling, general and administrative expense ratio was primarily due to the $3.1 million pre-tax charge from the California litigation settlements and an increase in consulting expenses and salaries of approximately $1.0 million due to bringing our Cleveland data processing and programming back in-house from a third party vendor.
The net amortization and change in acquisition costs (DAC) and value of business acquired (VOBA) resulted in net amortization of $4.6 million for 2004, compared to net amortization of $6.0 million for 2003. In the Senior segment, a net deferral of $3.3 million was recorded for 2004 compared to net amortization of $1.2 million for 2003. In 2004, the level of costs capitalized increased due to higher levels of Medicare supplement new business production. In the Medical segment, net amortization was $7.9 million for 2004 compared to $4.8 million in 2003. The $3.1 million increase in the net amortization was due to higher assumed lapsed rates on existing business which caused an increase in the level of DAC amortization in the first quarter of 2004. The rate of decline on the DAC asset in the Medical segment moderated in the balance of the year.
Interest expense and financing costs decreased to $0.7 million in 2004, compared to $1.6 million in 2003, as a result of a decrease in outstanding debt and a decrease in the amortization of deferred debt costs in 2004 as compared to 2003. The early pay-off of our former credit agreement resulted in the immediate amortization of the capitalized loan fees relating to that debt, causing additional interest expense of $0.3 million in 2003.
Income from continuing operations before federal income taxes, including the $3.1 million pre-tax charge from the California litigation settlements, was $21.9 million for 2004, compared to $26.0 million for 2003.
A federal income tax expense of $2.8 million was recorded for 2004, which included a $5.0 million reduction to the deferred tax valuation allowance. As a result of our continued profitability, a projection of continued taxable income in future periods, and the corresponding utilization of a portion of the net operating loss (NOL) carryforwards against 2004 taxable income, the deferred tax valuation allowance was reduced by $5.0 million, or $0.14 per share, to $0 in 2004. At December 31, 2004, we had a deferred tax asset of approximately $4.8 million established related to the remaining NOLs. The effective tax rate, including the $5.0 million reduction to the deferred tax valuation allowance, was 12.6% of the income from continuing operations before federal income taxes. In 2003, a federal income tax expense of $6.6 million was recorded, which included a $2.7 million reduction to the deferred tax valuation allowance, or $0.08 per share, as a result of the improved profitability of certain subsidiaries
in the Medical segment. The effective tax rate for 2003, including the $2.7 million reduction to the deferred tax valuation allowance, was 25.6% of the income from continuing operations before federal income taxes. See Note I. Federal Income Taxes for a detailed reconciliation of our effective tax rate.
Income from continuing operations was $19.1 million, or $0.55 per share, for 2004, compared to $19.4 million, or $0.56 per share for 2003. Income from the discontinued operations of Pyramid Life for 2003 was $3.6 million, or $0.11 per share (which included $3.9 million of net realized investment gains, $1.9 million of operating income and an additional loss on the sale of $2.2 million). For 2004, net income was $19.1 million, or $0.55 per share, compared to $22.9 million, or $0.67 per share, for 2003, which included $3.6 million, or $0.11 per share, from Pyramid Life.
Liquidity and Capital Resources
Liquidity is our ability to generate adequate amounts of cash to meet our financial commitments. Our major needs for cash are to enable our insurance subsidiaries to pay claims and expenses as they come due and for Ceres to pay interest on, and to repay principal of, its indebtedness. The primary sources of cash are premiums, investment income, fee income, equity and debt financings, and reimbursements from reinsurers. Payments consist of current claim payments to insureds, medical cost management expenses, and operating expenses such as salaries, employee benefits, commissions, taxes, and interest on debts. Net cash provided by operating activities in 2005 was $40.5 million compared to net cash used in operating activities of $15.4 million in 2004. The increase was primarily the result of the following:
•
2004 included a significant reduction in our major medical claim reserves due to our declining block of major medical business in force and the decline in our claim inventory; and
•
an increase in 2005 operating cash flows of approximately $22.8 million due to the liquidation of the trading investment portfolios in September 2005. The trading portfolios were purchased in the fourth quarter of 2004 which resulted in a decrease in 2004 operating cash flows of approximately $22.7 million.
The increases previously mentioned were partially offset by the payment of the California litigation settlements in the first quarter of 2005.
Assets increased 0.7% to $771.0 million at December 31, 2005 from $766.0 million at December 31, 2004. Assets of $488.9 million, or 63.4% of the total assets, were in investments at December 31, 2005. Fixed maturities, our primary investment, were $447.5 million, or 91.5% of total investments, at December 31, 2005. Other investments consist of equity securities, an investment in a limited partnership, policy loans, and mortgage loans. During the second quarter of 2005, we invested approximately $20.0 million in a collateralized securities fund which invests in asset-backed and mortgage-backed securities. This fund invests a minimum of 80% of its total assets in investment-grade securities. The shares in the fund are classified as equity securities available-for-sale at December 31, 2005.
Approximately 95.2% of our fixed maturities available-for-sale were of investment grade quality at December 31, 2005. In addition to the fixed maturities, we also had $26.8 million in cash and cash equivalents of which $6.1 million was restricted at December 31, 2005.
The total reinsurance receivable was $131.2 million at December 31, 2005. Of this amount, $127.2 million represents reserves held by our reinsurers under our various reinsurance treaties in place. Hannover holds substantially all of these reserves.
The total policy liabilities and benefits accrued were 89.5% of the total liabilities at December 31, 2005 compared to 87.3% at December 31, 2004.
Credit Agreement. At December 31, 2004, our credit facility consisted of a $4.0 million term loan A with National City Bank and a $9.0 million term loan B with CIT Group. The term loan A had quarterly principal payments of $250,000 through December 2005, $375,000 through December 2006, and a payment of $500,000 on March 1, 2007. The term loan B had quarterly principal payments of $312,500 through December 2004, $375,000 through December 2006, $562,500 through December 2007, and $1,250,000 through June 2008.
Effective May 2, 2005, we entered into an amendment to the credit facility in order to permit the stock repurchase program and to allow National City to assume the term loan B. The amendment:
•
Acknowledged that CIT Group had assigned to National City all of its rights, and National City had assumed all of the obligations of CIT Group, under the credit agreement and the term loan B;
•
Changed the term loan B maturity date to March 1, 2008 from June 1, 2008;
•
Revised the amortization of term loan B so that term loan B has quarterly payments of $687,500 (previously $375,000) from June 2005 through March 2006, $375,000 from June 2006 through December 2006, $562,500 from March 2007 through December 2007, and $1,250,000 in March 2008;
•
Modified the “Minimum Consolidated Fixed Charge Coverage Ratio” to 1.50 to 1.00 from 1.15 to 1.00; and
•
Permitted the $10 million stock repurchase program (announced on May 4, 2005).
At December 31, 2005, the interest rate on our term loan A balance of $2.0 million was 7.69% per annum and on our $5.3 million term loan B was 8.19% per annum. Both term loans bear interest at floating rates, based on either Prime or LIBOR, plus applicable spreads. Under Prime rate borrowings, the interest rate for term loan A and term loan B will be the Prime interest rate plus 0.50% and 1.0%, respectively. Under Eurodollar borrowings, the interest rate for term loan A and term loan B will be LIBOR plus 3.25% and 3.75%, respectively.
Our obligations under the credit agreement, as amended, are guaranteed by four of our non-regulated subsidiaries and are secured by pledges of the capital stock of Central Reserve, Continental General, and our non-regulated subsidiaries, as well as security interests in certain equipment and other tangible property of Ceres and the non-regulated subsidiaries.
The credit agreement contains various covenants including financial covenants relating to leverage, fixed charge coverage, risk-based capital of the regulated insurance subsidiaries, and tangible net worth. It also has a number of affirmative and negative covenants, including limitations relating to indebtedness, liens, mergers, purchases and sales of assets, investments, dividends, and stock repurchases. At December 31, 2005, we were in compliance with these covenants.
Off-Balance Sheet Arrangements. We do not have transactions or relationships with variable interest entities, and we do not have any off-balance sheet financing other than normal operating leases.
Contractual Obligations. The following schedule summarizes current and future contractual obligations as of December 31, 2005:
(1)
The interest associated with our variable-rate term loans is based upon interest rates in effect at December 31, 2005. The contractual amounts to be paid on variable-rate obligations are affected by changes in market interest rates. Future changes in market interest rates could materially affect the contractual amounts to be paid.
(2)
Represents estimated timing for fulfilling unfunded and callable capital commitments for investments in a limited partnership and two commercial mortgage loan trusts. Outstanding commitments are included in payments due in less than one year since the timing of funding these commitments cannot be reasonably estimated.
(3)
Estimated payments required under interest sensitive life and annuity contracts. The actual payments could vary based on changes in assumed crediting rates, persistency, and mortality levels.
(4)
Includes claims and benefits payable on our major medical, Medicare supplement, long-term care and other health care products.
In 2003, we committed to invest $5.0 million in a limited partnership, NYLIM-GCR Fund I-2002, L.P. Investments by this partnership consisted primarily of a diversified pool of subordinated real estate mezzanine debt and sub-tranche loans with a concentration in office assets located in major metropolitan areas. These capital commitments could be called by the partnership at any time during the commitment period to fund working capital needs or to purchase new investments. During 2005, the partnership made capital calls on our limited partnership commitment of $1.6 million and made returns of capital totaling $1.3 million from the proceeds received from partial debt repayments. At December 31, 2005, we had outstanding unfunded capital commitments totaling $0.4 million related to this limited partnership. The commitment period on this limited partnership expired on December 31, 2005. Accordingly, we are under no obligation to fund the remaining unfunded commitment.
In 2005, we committed to invest $10.0 million in a limited partnership, NYLIM Real Estate Mezzanine Fund II, L.P. Like the first fund, investments by this partnership are expected to consist primarily of a diversified pool of subordinated real estate mezzanine debt and sub-tranche loans with an expected concentration in office assets located in major metropolitan areas. The capital commitments can be called by the partnership at any time during the commitment period to fund working capital needs or to purchase new investments. Once the commitment period expires, we are under no obligation to fund the remaining unfunded commitment, but may elect to do so. The partnership has not made any capital calls on our $10.0 million commitment. Therefore, at December 31, 2005, we had outstanding unfunded and callable capital commitments totaling $10.0 million related to this limited partnership.
In addition, we committed to invest $5.0 million in the aggregate, in two commercial mortgage loan trusts in 2005. At December 31, 2005, we had outstanding unfunded commitments totaling $2.0 million related to these commercial mortgage loan trusts.
We believe that cash flow from operating activities will be sufficient to meet the currently anticipated operating and capital expenditure requirements of our subsidiaries over the next 12 months. Funds to meet our debt obligations are generated from fee income from our non-regulated subsidiaries. Our ability to make scheduled payments of the principal and interest on our indebtedness depends on our future performance and the future performance of our non-regulated subsidiaries, which are subject to economic, financial, competitive and other factors beyond our control. Fee income is derived from fees charged primarily on our major medical business. As that business continues to decline, fee income will decline.
Dividends from our regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. On February 24, 2005, Central Reserve received approval from the Ohio Department of Insurance to pay an extraordinary dividend of up to $12.0 million to Ceres Group, the parent company. On May 4, 2005, Central Reserve paid Ceres a dividend of $10.0 million, which was used for the stock repurchase program. On December 30, 2005, Continental General paid Ceres a dividend of $7.0 million. In 2006, Continental General could pay a dividend to Ceres of up to $6.2 million without prior approval of its state regulator. However, in 2006, Central Reserve would be prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus.
If our non-regulated subsidiaries do not generate sufficient fee income or we are unable to take dividends from our insurance subsidiaries 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 needed, additional financing may not be available on terms favorable to us or at all.
Net Operating Loss Carryforward
At December 31, 2005, we had a tax net operating loss, or NOL, carryforward of approximately $1.6 million for federal income tax purposes, which expires through 2021.
We determine whether a valuation allowance for our deferred tax asset is necessary based on an analysis of amounts recoverable in the statutory carryback period and available tax planning strategies. At December 31, 2005, we had a deferred tax asset of approximately $0.6 million established relating to the remaining NOL carryforwards of $1.6 million. We have determined that no valuation allowance is required due to our continued profitability and the projection of a continued pattern of taxable income sufficient to utilize these NOLs. During 2004, we evaluated and reduced our valuation allowance for deferred taxes by $5.0 million, or $0.14 per share, as a result of our continued profitability and the projection of a continued pattern of taxable income in future periods sufficient to utilize these net operating losses.
Financial Information about Industry Segments from Continuing Operations
The following table presents the revenues, expenses, and profit (loss) from continuing operations before federal income taxes, for the last three years attributable to our industry segments. Investment income is allocated by segment based on the level of policy liabilities and benefits accrued and allocated capital. We assume that the longer duration, higher yielding investments support the life, annuity and long-term care blocks of business. The remaining investments, which tend to be shorter in duration, support the major medical and Medicare supplement blocks of business. We do not separately allocate assets or income tax expenses (benefits) by industry segment. Revenues from each segment are primarily generated from premiums charged to external policyholders and interest earned on cash and investments.
The following table presents net premiums by major product line for the years ended December 31, 2005, 2004 and 2003:
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See Item 1A. - “Risk Factors.”
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CERES GROUP, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND
FINANCIAL STATEMENT SCHEDULES
Report of Independent Registered Public Accounting Firm
Stockholders and Board of Directors
Ceres Group, Inc.
We have audited the accompanying consolidated balance sheets of Ceres Group, Inc. (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three year period ended December 31, 2005. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2005 and 2004, and the results of its operations and its cash flows for each of the years in the three year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on criteria established in “Internal Control - Integrated Framework‘ issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
KPMG LLP
Columbus, Ohio
March 16, 2006
Report of Independent Registered Public Accounting Firm
Stockholders and Board of Directors
Ceres Group, Inc.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting contained in Item 9A, “Controls and Procedures” of Ceres Group, Inc.’s (the “Company”) 2005 Annual Report on Form 10-K, that the Company maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Ceres Group, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also, in our opinion, Ceres Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Ceres Group, Inc. as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three year period ended December 31, 2005, and our report dated March 16, 2006 expressed an unqualified opinion on those consolidated financial statements.
KPMG LLP
Columbus, Ohio
March 16, 2006
CERES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2005 and 2004
(dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
CERES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended December 31, 2005, 2004 and 2003
(dollars in thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
CERES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
For the Years Ended December 31, 2005, 2004 and 2003
(dollars in thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
CERES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2005, 2004 and 2003
(dollars in thousands)
*
For further information, see Note D. Discontinued Operations to our audited consolidated financial statements.
The accompanying notes are an integral part of these consolidated financial statements.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
A.
Summary of Business and Significant Accounting Policies
Summary of Business
Ceres Group, Inc. (formerly known as Central Reserve Life Corporation) operated in 1998 and prior periods primarily through its wholly-owned subsidiary, Central Reserve Life Insurance Company. As of December 31, 2005, 2004 and 2003, the Company’s consolidated statements also include the continuing operations of Provident American Life & Health Insurance Company acquired on December 31, 1998, Continental General Corporation and its wholly-owned subsidiary, Continental General Insurance Company, acquired on February 17, 1999, United Benefit Life Insurance Company under a reinsurance arrangement effective August 1, 1998 and acquired on July 21, 1999 (through foreclosure), and the discontinued operations of Pyramid Life Insurance Company acquired on July 26, 2000. Effective March 31, 2003, Ceres sold its subsidiary, Pyramid Life Insurance Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash before transaction costs of $2.2 million. See Note D. Discontinued Operations for further information.
We provide, through our insurance subsidiaries, a wide array of health and life insurance products. While our insurance subsidiaries are licensed in 49 states, the District of Columbia, and the U.S. Virgin Islands, approximately 62.5% of our total premium volume is generated from ten states: Ohio, Florida, Pennsylvania, Texas, Indiana, Illinois, Virginia, Kansas, Nebraska, and Michigan.
Unless the context indicates otherwise, “we,” “our,” and “us” refers to Ceres Group, Inc. and its subsidiaries on a consolidated basis.
Significant Accounting Policies
Principles of Consolidation
The accompanying audited consolidated financial statements include the continuing operations of Ceres and its wholly-owned subsidiaries, except for Pyramid Life, which is included in discontinued operations. All intercompany transactions have been eliminated in consolidation.
The accompanying audited consolidated financial statements have been prepared in accordance with U.S generally accepted accounting principles, which differ from accounting practices prescribed or permitted by the various state departments of insurance in which the insurance subsidiaries are domiciled. See Note Q. Statutory Financial Information for further information.
Business Combinations
All of our acquisitions were accounted for using the purchase method of accounting. Additionally, since the issuance of SFAS No. 141, Business Combinations (SFAS 141), by the 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 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.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
Accordingly, following the guidance of both SFAS 141 and EITF D-100 and upon adoption in 2002 of SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142), we reclassified licenses of $3.6 million as a separate indefinite-lived intangible asset from goodwill.
Goodwill and Other Intangible Assets
Goodwill represents the excess of purchase price over the fair value of tangible and identifiable net assets acquired. Other intangible assets, such as licenses, are defined as purchased assets that also lack physical substance, but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset or liability.
On January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets. Under the provisions of SFAS 142, goodwill is no longer ratably amortized into the income statement over an estimated life, but rather is tested at least annually for impairment. Intangible assets which have finite lives continue to be amortized over their estimated useful lives and also continue to be subject to impairment testing. Prior to the adoption of SFAS 142, goodwill was amortized on a straight-line basis over periods of 25 years or less. See Note H. Goodwill and Other Intangible Assets for a summary of our goodwill and other intangible assets.
Use of Estimates
The preparation of the audited consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Cash and Cash Equivalents
Cash and cash equivalents include cash and all liquid securities with maturities of 90 days or less when purchased. See Note B. Cash and Investments for further information.
Investments
Investments in fixed maturities and equity securities are designated at purchase as held-to-maturity, available-for-sale or trading. Fixed maturities include bonds and mortgage-backed securities. Equity securities include non-redeemable preferred stock and a collateralized securities fund which invests in asset-backed and mortgage-backed securities. Held-to-maturity investments are securities, which management has the positive intent and ability to hold until maturity, and are reported at amortized cost. Available-for-sale investments are stated at fair value, with unrealized holding gains and losses reported in accumulated other comprehensive income (loss), net of deferred federal income taxes. Trading securities are stated at fair value and are bought and held principally for the purpose of selling them in the near term. Unrealized holding gains and losses related to trading securities are included in our Consolidated Statements of Operations as part of net realized gains.
The investment in the limited partnership is carried on the equity method of accounting. Investments in policy notes and mortgage loans are reported at cost, which approximates fair value. There is no allowance for losses based on the current status of mortgage loans.
Premiums and discounts arising from the purchase of mortgage-backed securities are amortized using the interest method over the estimated remaining term of the securities, adjusted for anticipated prepayments. The majority of our mortgage-backed securities are of high credit quality and therefore, the retrospective method is used to adjust the effective yield. Premiums and discounts on other debt instruments are amortized using the effective interest method over the remaining term of the security.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
Realized gains and losses on the sale of investments are determined using the specific-identification method, and are credited or charged to income. Also charged to income are unrealized losses on investment securities for which a decline in fair market value is deemed to be other-than-temporary, and unrealized holding gains and losses on trading securities.
The estimated fair value of investments is based upon quoted market prices, where available, or on values obtained from independent pricing services.
Other-Than-Temporary Declines in 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:
•
the nature of the investment and cause of the impairment;
•
our ability and intent to retain the investment for a period of time to allow for a recovery in value;
•
the duration and extent to which the fair value has been less than cost; and
•
the financial condition and prospects of the issuer.
Deferred Acquisition Costs (DAC)
Certain excess policy acquisition costs associated with issuing an insurance policy, including commissions and underwriting, all of which vary with and are primarily related to the production of new business, have been deferred and reported as deferred acquisition costs. Deferred acquisition costs associated with traditional life and accident and health contracts are charged to expense over the premium-paying period or as premiums are earned over the life of the contract. Deferred acquisition costs associated with interest-sensitive life and annuity products are charged to expense over the estimated duration of the policies in relation to the present value of the estimated gross profits from surrender charges and investments, mortality, and expense margins. The assumptions used to amortize acquisition costs with regard to interest, mortality, morbidity, and persistency are consistent with those used to estimate the liability for future policy benefits. For interest-sensitive and annuity products, these assumptions are reviewed on a regular basis and are revised if actual experience differs significantly from original expectations. Deferred acquisition costs are subject to periodic recoverability and loss recognition testing. These tests ensure that the present value of future contract-related cash flows will support the capitalized deferred acquisition cost asset. These cash flows consist primarily of premium income, less benefits and expenses. The present value of these cash flows, less the benefit reserve, is then compared with the unamortized deferred acquisition cost balance. In the event the estimated present value of net cash flows is less, this deficiency would be charged to expense as a component of amortization and the asset balance is reduced by a like amount. Different assumptions with regard to deferred acquisition costs could produce materially different amounts of amortization.
Value of Business Acquired (VOBA)
A portion of the purchase price paid for Continental General Corporation was allocated to the value of business acquired for all long duration insurance contracts, including guaranteed renewable Medicare supplement and long-term care, based on the actuarially-determined present value of the expected pre-tax future profits from the business assuming a discount rate of 15.0%. In addition to the initial value of business acquired assigned to Continental General’s health business, certain of the Medicare supplement plans contained higher commission rates in the first six policy years as compared to the ultimate renewal commission rate. The initial deferral of these higher commission costs subsequent to the purchase date resulted in net additions to the original value of business acquired
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
from 1999 to 2001. The net amortization of these costs began in 2002 and will continue over the remaining life of the Medicare supplement policies. Interest is accrued on the balance annually at a rate consistent with the rate credited on the acquired policies on the acquisition date, which ranges from 4.0% to 8.75%. Recoverability of the value of business acquired is evaluated periodically by comparing the current estimate of the present value of expected pre-tax future profits to the unamortized asset balance. If the current estimate is less than the existing asset balance, the difference would be charged to expense, and if the current estimate is higher than the existing asset balance, the difference will emerge into profits as earned.
For accident and health and ordinary life business, the value of business acquired is amortized over the estimated life of the in force business using assumptions consistent with those in computing reserves. Interest of 6.5% is credited to the unamortized balance for Continental General Corporation. For interest sensitive products such as universal life and deferred annuities, the value of business acquired is amortized over the expected profit stream of the in force business. The expected profit stream is based upon actuarial assumptions as to mortality, lapses, and expenses. Earned interest was assumed to be 6.0% for Continental General Corporation, which was the market rate at the time of acquisition. If estimated gross profits, gross margins or premiums differ from expectations, the amortization of VOBA is adjusted on a retrospective or prospective basis, as appropriate. Changes in assumptions can have a significant impact on the amount of VOBA reported for all products and their related amortization patterns.
Shadow DAC/VOBA
As certain fixed maturities available-for-sale related to our interest-sensitive life insurance products are carried at fair value, an adjustment is made to deferred acquisition costs and the value of business acquired equal to the change in amortization that would have occurred if such securities had been sold at their stated fair value and the proceeds reinvested at current yields. The change in this adjustment is included with the change in fair value of fixed maturity securities available-for-sale, net of tax, that is credited or charged directly to stockholders’ equity and is a component of other comprehensive income. At December 31, 2005, the remaining adjustment to deferred acquisition costs and value of business acquired was minimal. At December 31, 2004, deferred acquisition costs were decreased by $1.0 million and the value of business acquired was also decreased by $1.0 million related to this adjustment.
Property and Equipment
Property and equipment are carried at cost less allowances for depreciation and amortization. Office buildings are depreciated on the straight-line method over 35 years, except for certain components, which are depreciated over 15 years. Depreciation for other property and equipment is computed on the straight-line basis over the estimated useful life of the equipment, principally three to seven years.
Future Policy Benefits, Losses and Claims
Liabilities for future policy reserves for accident and health and traditional life business are based on the net level premium basis and estimates of future claims, investment yield, lapses using our experience and actuarial judgment with an allowance for possible future adverse deviations from expected experience. Interest rates used range from 4.5% to 6.125%. We review actual experience with respect to investment yields, mortality, morbidity, and lapses to help insure that existing liabilities, together with the present value of future premiums, will be sufficient to cover the present value of future benefits and maintenance costs and to recover unamortized acquisition costs.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
Liabilities for interest sensitive products such as deferred annuities and universal life are based on the retrospective deposit method. This is the policyholder fund balance before adjusting for any surrender charges. Guaranteed minimum rates for universal life contracts are 4.0% to 5.5%. At December 31, 2005, credited rates ranged from 4.0% to 5.5%. Guaranteed base minimum rates for deferred annuities range from 3.0% to 5.5% depending on the duration of the contract. At December 31, 2005, credited rates for deferred annuities ranged from 3.0% to 6.0%.
Other Policy Claims and Benefits Payable
Liabilities for unpaid life and accident and health claims (except long-term care disabled life reserves) consist of actual claims reported but not paid and estimates of claims incurred but not reported (IBNR). Liability estimates are developed using actuarial principles and assumptions that consider, among other things, historical claim payment patterns, claim inventory levels, network reimbursement changes, historical utilization trends, current levels of authorized inpatient days, other medical cost inflation factors, in-force levels, benefit design changes, seasonality, demographic mix change and expected costs to settle unpaid claims.
Liabilities for long-term care disabled life reserves consist of estimates of claims in the course of settlement, case reserves, and IBNR. Claims in the course of settlement represent the amount of payments expected to be owed on existing claims for services received prior to the valuation date but for which benefits have not been paid. Case reserves are calculated for each open case and represent the present value of future benefits expected to be incurred for services subsequent to the valuation date. At December 31, 2005, a discount rate of 6.125% was used to determine the case reserves. Finally, an IBNR reserve is calculated to represent the liability for claims incurred but not reported as of the valuation date.
Although considerable variability is inherent in the computation of claim liabilities, 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.
Other Policyholders’ Funds
Other policyholders’ funds consist of supplementary contracts without life contingencies, premiums and annuity considerations received in advance and remittance and items not allocated.
Insurance Related Assessments
Statement of Position No. 97-3, Accounting by Insurance and Other Enterprises for Insurance-Related Assessments, 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. At December 31, 2005 and 2004, the liability for guaranty-fund and other insurance-related assessments was $0.8 million and $1.0 million, respectively, and was included in other liabilities in our Consolidated Balance Sheets.
Comprehensive Income
Comprehensive income in 2005, 2004 and 2003 includes a change in unrealized gains or losses on available-for-sale securities, in addition to reported net income as prescribed by SFAS No. 130, Reporting Comprehensive Income. See Note R. Comprehensive Income for further information.
Premium Revenue
Life premiums are recognized as revenue when they become due. Accident and health premiums are recognized as revenue over the terms of the policies. Revenues from interest sensitive contracts, principally
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
universal life and annuity products, consist of mortality charges for the cost of insurance, contract administration charges, and surrender charges assessed against policyholder account balances during the period. Amounts received from interest sensitive contracts are not reflected in premium revenue; rather, such amounts are accounted for as deposits with the related liabilities included in future policy benefits, losses, and claims.
Fee and Other Income
Fee and other income consists of monthly collection, management, and administrative fees, and are recognized when the services are performed.
Deferred Reinsurance Gain
Deferred reinsurance gain consists of initial ceding allowances received from reinsurers, less amounts amortized into income over the estimated remaining life of the underlying policies reinsured, except for interest sensitive products that are amortized over the expected profit stream of the in force business.
Federal Income Taxes
Federal income taxes are accounted for 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. See Note I. Federal Income Taxes for further information.
Stock-Based Compensation
We account for our stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB Opinion No. 25), as amended. Accordingly, no compensation expense has been recognized for our stock option plans in our Consolidated Statements of Operations.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
The following table illustrates the effect on net income and net income per share if we had applied the fair-value-based method and recognition provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS No. 123), to stock-based compensation.
(1)
For the year ended December 31, 2003, there was a positive pro forma impact on net income and basic and diluted earnings per share due to the forfeiture of options resulting from employee terminations.
New Accounting Pronouncements
On February 16, 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 155, Accounting for Certain Hybrid Financial Instruments (SFAS 155). SFAS 155 amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 140). SFAS 155 also resolves issues addressed in SFAS No. 133 Implementation Issue No. D1, Application of Statement 133 to Beneficial Interests in Securitized Financial Assets. The following is a summary of SFAS 155: (1) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; (2) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133; (3) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; (4) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; (5) amends SFAS 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective on January 1, 2007, although earlier adoption is permitted as of the beginning of an entity’s fiscal year. We are currently evaluating the impact of the adoption of SFAS 155 on our consolidated results of operations, cash flows and financial position.
In November 2005, the FASB issued Staff Position (FSP) No. FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” (FSP 115-1). FSP 115-1 addresses the determination as to when an investment is considered impaired, whether that impairment is other-than-temporary, and the measurement of the impairment loss. It also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in FSP 115-1 amends SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and was effective January 1, 2006. We do not
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
expect the adoption of this staff position to have a significant impact on our consolidated results of operations, cash flows or financial position.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (SOP 05-1). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, issued by the FASB. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of a feature or coverage within a contract. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. Retrospective application of SOP 05-1 to previously issued financial statements is not permitted. Initial application of SOP 05-1 should be as of the beginning of an entity’s fiscal year. We are currently evaluating the impact of SOP 05-1 on our consolidated results of operations, cash flows and financial position.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS 154), which replaces Accounting Principles Board (APB) Opinion No. 20, Accounting Changes (APB 20), and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, with earlier adoption permitted. We will apply the provisions of SFAS 154 when applicable in future reporting periods.
In December 2004, the FASB issued SFAS No. 123R (Revised 2004), Share-Based Payment (SFAS 123R), which amends SFAS 123 and supersedes APB 25. SFAS 123R requires that all share-based payment transactions, including grants of employee stock options, be recognized in the Consolidated Statement of Operations based on their fair values. In addition, SFAS 123R amends SFAS No. 95, Statement of Cash Flows, to require that excess tax benefits be reported as a financing cash flow rather than as a reduction to taxes paid, which is included within operating cash flows. Upon adoption, pro forma disclosures are no longer an alternative. The provisions of SFAS 123R, as amended by the Securities and Exchange Commission, are effective on January 1, 2006 for calendar year companies. We plan to adopt SFAS 123R using the modified prospective transition method effective January 1, 2006. Under the modified prospective transition method, fair value accounting and recognition provisions of SFAS 123R are applied to share-based awards granted or modified subsequent to the date of adoption and prior periods are not restated. In addition, for awards granted prior to the effective date, the unvested portion of the awards shall be recognized in periods subsequent to the adoption based on the grant date fair value determined for recognition or pro forma disclosure purposes under SFAS 123. We do not expect the adoption of SFAS 123R to have a significant impact on our consolidated results of operations, cash flows or financial position.
In July 2003, the AICPA issued SOP 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (SOP 03-1). SOP 03-1 addresses a number of topics, the most significant of which is the accounting for contracts with guaranteed minimum death benefits. SOP 03-1 requires companies to evaluate the significance of guaranteed minimum death benefits to determine whether the contract should be accounted for as an investment or insurance contract. If the contract is determined to be an insurance contract, companies are required to establish a reserve to recognize a portion of the assessment (revenue) that compensates the insurance company for benefits to be provided in future periods. SOP 03-1 also provides guidance on separate account presentation, interest in separate accounts, gains and losses on the transfer of
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
assets from the general account to a separate account, liability valuation, return based on a contractually referenced pool of assets or index, annuitization options and sales inducements to contract holders. The effective date of SOP 03-1 was for fiscal years beginning after December 15, 2003, with earlier adoption encouraged. We adopted SOP 03-1 on January 1, 2004. The adoption of SOP 03-1 did not have a significant impact on our consolidated results of operations, cash flows or financial position.
Net Income per Share
Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted net income per share reflects the potential dilution that could occur if common stock equivalents were exercised and shared in the earnings of the Company. Only those potential common shares, which are dilutive, are included in the computation of diluted net income per share. See Note S. Computation of Net Income Per Common Share for further information.
Reclassification
Certain amounts presented in the prior years’ financial statements have been reclassified to conform to the current year’s method of presentation.
B.
Cash and Investments
The amortized cost and estimated fair value of available-for-sale securities as of December 31, 2005 were as follows:
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
The amortized cost and estimated fair value of available-for-sale securities as of December 31, 2004 were as follows:
No investment of the Company exceeded 10% of total stockholders’ equity at December 31, 2005. Except for bonds and notes of the U.S. Government or of a non-government agency or authority, no investment of the Company exceeded 10% of total stockholders’ equity at December 31, 2004.
The amortized cost and estimated fair value of available-for-sale securities as of December 31, 2005 by contractual maturity were as follows:
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalties.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
Proceeds, gross realized gains and gross realized losses from the sales (excluding calls, maturities and pay downs) of fixed maturities available-for-sale during each year were as follows:
The following is a summary of net investment income by category of investment:
At December 31, 2005 and 2004, our insurance subsidiaries had certificates of deposit, money market funds and fixed maturity securities with a carrying value of $25.4 million and $25.8 million, respectively, on deposit with various state insurance departments to satisfy regulatory requirements.
At December 31, 2005 and 2004, $5.6 million and $6.5 million, respectively, of cash was held for fully insured employer shared risk plans, which is restricted to use. We are entitled to investment income from these funds.
In 2003, we committed to invest $5.0 million in a limited partnership, NYLIM-GCR Fund I-2002, L.P. Investments by this partnership consisted primarily of a diversified pool of subordinated real estate mezzanine debt and sub-tranche loans with a concentration in office assets located in major metropolitan areas. These capital commitments could be called by the partnership at any time during the commitment period to fund working capital needs or to purchase new investments. During 2005, the partnership made capital calls on our limited partnership commitment of $1.6 million and made returns of capital totaling $1.3 million from the proceeds received from partial debt repayments. At December 31, 2005, we had outstanding unfunded capital commitments totaling $0.4 million related to this limited partnership. The commitment period on this limited partnership expired on December 31, 2005. Accordingly, we are under no obligation to fund the remaining unfunded commitment.
In 2005, we committed to invest $10.0 million in a limited partnership, NYLIM Real Estate Mezzanine Fund II, L.P. Like the first fund, investments by this partnership are expected to consist primarily of a diversified pool of subordinated real estate mezzanine debt and sub-tranche loans with an expected concentration in office assets located in major metropolitan areas. The capital commitments can be called by the partnership at any time
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
during the commitment period to fund working capital needs or to purchase new investments. Once the commitment period expires, we are under no obligation to fund the remaining unfunded commitment, but may elect to do so. The partnership has not made any capital calls on our $10.0 million commitment. Therefore, at December 31, 2005, we had outstanding unfunded and callable capital commitments totaling $10.0 million related to this limited partnership.
In addition, we committed to invest $5.0 million in the aggregate, in two commercial mortgage loan trusts in 2005. These investments are classified as mortgage loans as they represent investments where return is based solely on the mortgage loans and there are no other assets of the trusts. At December 31, 2005, we had outstanding unfunded commitments totaling $2.0 million related to these commercial mortgage loan trusts.
At December 31, 2005, we held no unrated bonds and approximately 4.8% of fixed maturity investments classified as available-for-sale were in less-than-investment grade securities. Approximately 4.2% of the fixed maturities available-for-sale were invested in BB rated subordinated non-agency residential and commercial mortgage-backed securities. These securities include jumbo residential mortgages and commercial mortgages with strong prepayment protection. We perform periodic evaluations of the relative credit standings of the issuers of the bonds held in our portfolio. We consider these evaluations in our overall investment strategy.
The following is a summary of available-for-sale securities that have been in a continuous unrealized loss position as of December 31, 2005:
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
The following is a summary of available-for-sale securities that have been in a continuous unrealized loss position as of December 31, 2004:
We evaluate our investment policies consistent with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Trading securities are carried at fair value with unrealized gains and losses reported in our Consolidated Statements of Operations as part of net realized gains. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported in accumulated other comprehensive income, net of deferred federal income taxes. Investments in fixed and equity securities are designated at purchase as held-to-maturity, available-for-sale, or trading. The investment in the limited partnership is accounted for under the equity method of accounting and accordingly, the partnership earnings are included in net investment income. Investments in policy notes and mortgage loans are reported at cost which approximates fair value.
If management believes a decline in the value of a particular investment is temporary, the decline is reported as an unrealized capital loss, net of deferred federal income taxes, in Stockholders’ Equity. If the decline is expected to be other-than-temporary, the carrying value of the investment is written down and a realized capital loss is reported in our Consolidated Statements of Operations. In June 2003, we wrote down our holdings in American Airlines and Coastal Corp. to their then fair market value, recording a total realized pre-tax loss of $0.3 million. None of the investments above are delinquent or in default and there are no conditions present that indicate a high probability that all amounts will not be collected. Based on evaluation by both internal management along with external investment managers, including our ability to sell or hold the investments and the length of time and magnitude of the unrealized loss, management has determined that at December 31, 2005, none of the above investment values represent an other-than-temporary impairment.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
C.
Property and Equipment
Property and equipment are stated at cost and are summarized by category as follows:
Other property and equipment consists principally of software, leasehold improvements, and office equipment. Depreciation expense for the years ended December 31, 2005, 2004 and 2003 was $1.0 million, $1.2 million, and $1.5 million, respectively.
D.
Discontinued Operations
On March 31, 2003, Continental General sold the stock of its subsidiary, Pyramid Life, which was primarily included in our Senior and Other segment, to the Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash, before transaction costs of $2.2 million. Net proceeds from the sale were used to strengthen Continental General’s statutory capital and repay $10.0 million of our bank debt. The total loss from the sale (net of taxes and expenses incurred) was $13.8 million. Additionally, we continued to process Pyramid Life’s business through an administrative services agreement, which terminated on December 31, 2003. At December 31, 2002, we adjusted the carrying value of Pyramid Life’s assets held for sale to fair market value to reflect the purchase price of $57.5 million (before transaction costs of $2.2 million), which resulted in a charge of $11.6 million in 2002. In addition, Pyramid Life’s book value increased in the first quarter of 2003 due to net income and unrealized investment gains. Pursuant to the stock purchase agreement, the final purchase price was adjusted based on the statutory book value at March 31, 2003, and an additional loss of $2.2 million was recorded in 2003 to reflect the final purchase price. As a result of the sale, Pyramid Life’s operations were classified as discontinued operations for 2003.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
Summarized financial data for Pyramid Life’s operations are as follows:
Statements of Operations
We have revised the 2003 Consolidated Statement of Cash Flows to separately disclose the operating, investing and financing portions of the cash flows attributable to discontinued operations, which in prior years were reported on a combined basis as a single amount.
E.
Leases
On May 25, 2001, we entered into an agreement with Royalton Investors, LLC and Big T Investments, LLC, unaffiliated third parties, to sell our Cleveland headquarters. The transaction was effective July 31, 2001. The building was sold to Royalton Investors, LLC and Big T Investments, LLC for $16.0 million and concurrently we leased it back for a term of 15 years with four optional five-year extensions. A deferred gain of $7.2 million was recorded at the time of the sale. On October 19, 2004, Royalton Investors, LLC and Big T Investments, LLC sold the building and assigned its interest as lessor under the lease agreement dated July 31, 2001, to Strongsville Corporate Center Acquisitions, LLC, an unaffiliated third party. At December 31, 2005 and 2004, the unamortized deferred gain related to the sale of the building was $5.3 million and $5.8 million, respectively, and was included with other liabilities in our Consolidated Balance Sheets. The amortization of the deferred gain was included in net realized
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
gains in our Consolidated Statements of Operations and was $0.5 million for the year ended December 31, 2005 and $0.4 million for each of the years ended December 31, 2004 and 2003.
Rent expense for our Cleveland headquarters was approximately $1.8 million for each of the years ended December 31, 2005, 2004 and 2003. Future rent payments for the Cleveland headquarters and all other operating leases are as follows:
F.
Deferred Acquisition Costs
Unamortized deferred policy acquisition costs are summarized as follows:
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
G.
Value of Business Acquired
The value of business acquired is summarized as follows:
The increased expense reserve is primarily a result of the higher commission rates paid in the initial policy years of the Medicare supplement business acquired. Under the current assumptions, amortization for the next five years is expected to be as follows (dollars in thousands):
H.
Goodwill and Other Intangible Assets
Goodwill represents the excess of purchase price over the fair value of tangible and identifiable intangible net assets acquired. At December 31, 2005, goodwill was $10.7 million, all of which related to the Senior and Other segment which, is identified as the reporting unit, and represented approximately 1.4% of our total assets. Additionally, other intangible assets represent purchased assets that also lack physical substance, but can be distinguished from goodwill because of other legal rights or because the assets are capable of being sold or exchanged either on its own or in combination with a related contract asset or liability. At December 31, 2005, our other intangible assets consisted of $3.4 million in licenses, which represented 0.4% of our total assets.
Goodwill and intangibles with indefinite useful lives are tested for impairment on an annual basis as of September 30 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 indicated that no reduction of goodwill or licenses was required in 2005 or 2004. A slight reduction of $0.1 million was made to the carrying value of licenses in 2003 due to the cancellation of business in certain unprofitable states.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
I.
Federal Income Taxes
We file a consolidated federal income tax return with our subsidiaries. In 2005, Continental General will be included in the consolidated filing for the first time since its acquisition on February 17, 1999.
Federal income tax expense (benefit) from continuing operations was composed of the following:
Income tax expense (benefit) is recorded in various places in our consolidated financial statements. A summary of the amounts and places are as follows:
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
Income tax expense 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 tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2005 and 2004 are presented below:
At December 31, 2005 and 2004, we had a federal income tax receivable, which is included in other assets on our Consolidated Balance Sheets, of $1.0 million and $3.7 million, respectively.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
At December 31, 2005, we had a tax net operating loss carryforward, or NOL, of approximately $1.6 million for federal income tax purposes, which expires through 2021.
In 2004, we determined a valuation allowance based on an analysis of amounts recoverable in the statutory carryback period and available tax planning strategies. During 2004, we evaluated our valuation allowance for deferred taxes and determined that no valuation allowance was required on the remaining NOL carryforwards of $13.6 million due to our continued profitability and the projection of a continued pattern of taxable income in future periods sufficient to utilize these NOLs. Accordingly, our net change in the deferred tax valuation allowance during 2004 was $5.0 million. In 2003, the deferred tax valuation allowance was reduced by $2.7 million as a result of the utilization of NOL carryforwards of certain subsidiaries of the Medical segment.
Prior to 1984, the Life Insurance Company Income Tax Act of 1959, as amended by the Deficit Reduction Act of 1984 (DRA), permitted the deferral from taxation of a portion of statutory income under certain circumstances. In these situations, the deferred income was accumulated in the Policyholders’ Surplus Account (PSA). On January 1, 1984 the balance of the PSA was fixed and only subject to taxation in the event amounts in the PSA were distributed to shareholders, or if the balance of the account exceeded certain limitations prescribed by the IRS. On October 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004. Included among the various provisions of the Act was a two-year suspension of the taxation on distributions of amounts from a company’s PSA and reordering rules for current distributions. At December 31, 2004, the accumulated untaxed PSA balance at Central Reserve was $2.9 million.
At December 31, 2004, management was evaluating any actions that would enable us to provide current distributions, thus reducing or eliminating the PSA balance. At the close of the suspension period, the previous ordering rules will be reinstated. We previously established a general tax contingency reserve for the untaxed PSA balance exposure because distribution prior to the end of the suspension period was not certain.
On February 24, 2005, Central Reserve received approval from the Ohio Department of Insurance to pay an extraordinary dividend to Ceres Group. Accordingly, we made a $2.9 million tax free distribution from the PSA and reduced the corresponding tax contingency reserve by $1.0 million in 2005.
During the third quarter of 2005, the IRS concluded the 2003 audit for all companies except Continental General. Accordingly, we reduced our tax reserves due to elimination of tax contingencies associated with the closed tax years and recognized a federal income tax benefit of $0.8 million in 2005.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
J.
Liability for Other Policy Claims and Benefits Payable
The following table reflects the activity in the liability for other policy claims and benefits payable, including the claims adjustment expenses, net of reinsurance recoverables, as follows:
The above table indicates a net redundancy in reserves (“Incurred claims and claims adjustment expenses, net of reinsurance for prior years” divided by “Adjusted net beginning balance”) of 0.5% in 2004, 19.0% in 2003 and 10.9% in 2002.
The foregoing indicates that a $0.4 million redundancy in the 2004 reserves emerged in 2005 primarily due to a lower level of severity on fourth quarter 2004 major medical incurreds partially offset by a deficiency in long-term care reserves. In 2004, a $19.6 million redundancy in the 2003 reserves emerged primarily as a result of favorable development of prior year major medical and long-term care claim reserves. In 2003, a $13.0 million redundancy in the 2002 reserves emerged as a result of the moderation of the higher than expected medical claim trend experienced in 2002 related to 2001 reserves and improvement in long-term care actual claim experience.
K.
Reinsurance Arrangements
Central Reserve Life Insurance Company
In December 2000, Central Reserve entered into a reinsurance transaction with Lincoln National Reassurance Company, or Lincoln, for a ceding allowance of $4,000,000. The policies reinsured, on a combined coinsurance and modified coinsurance basis, were 80% of all group term life insurance and 35% of all individual deferred annuities in force on and after December 31, 2000. The ceding allowance was accounted for as a deferred reinsurance gain in the accompanying audited consolidated financial statements and was amortized into income based upon the
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
emerging profit stream of the in force business. This reinsurance agreement was terminated effective June 30, 2005 by mutual consent of the parties.
In December 1997, Central Reserve 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 Reserve ceded 50% of the premiums of the eligible policies, and in return received reimbursement for 50% of the claims paid, plus a commission and expense allowance. In connection with the 1997 Treaty, Central Reserve transferred $24.5 million of reserves to Hannover, and received an initial ceding allowance of $10.0 million, resulting in a net cash transfer of $14.5 million to Hannover. The initial ceding allowance was reported as a deferred reinsurance gain, and is being amortized into income over the duration of the underlying block of business.
Continental General Insurance Company
In February 1999, Continental General entered into a reinsurance agreement with Hannover, under which Hannover reinsured 50% of all insurance business in force at Continental General for a ceding allowance of $13.0 million. The ceding allowance is being accounted for as a deferred reinsurance gain in the accompanying audited consolidated financial statements and is being amortized into income over the duration of the underlying block of business. Various assets, primarily comprised of fixed income securities with a market value of $188.4 million, were transferred from Continental General to Hannover for the policy liabilities assumed by Hannover.
Effective March 31, 2003, Continental General entered into a reinsurance agreement with Pyramid Life under which Continental General reinsured on a 100% coinsurance basis and, to the extent policyholders consent or are deemed to consent thereto, on an assumption reinsurance basis, certain interest sensitive whole-life policies. Cash of $12.1 million was transferred from Pyramid Life to Continental General for the policy liabilities assumed by Continental General.
Provident American Life & Health Insurance Company
Prior to the acquisition of Provident American Life, all of the insurance business of Provident American Life in force at December 31, 1998 was ceded to Provident Indemnity. Hannover reinsured all the individual and small group health insurance in force at December 31, 1998, of Provident Indemnity for a ceding allowance of approximately $10.0 million. On January 1, 1999, Hannover ceded 10% of this insurance in force to Central Reserve and Central Reserve paid a $1.0 million ceding commission.
Effective January 1, 1999, Provident American Life entered into a reinsurance agreement with Provident Indemnity, whereby Provident American Life reinsured 100% of Provident Indemnity’s business written after December 31, 1998. In a separate reinsurance agreement, Provident American Life ceded to Hannover 50% of its direct business written after December 31, 1998 and 50% of the business reinsured from Provident Indemnity.
On December 31, 2002, Provident American Life and Hannover entered into an agreement, which amended the reinsurance arrangement relative to the policies of Provident American Life and Provident Indemnity. For claims incurred June 30, 2002 and prior, Hannover continues to be responsible for its quota share percentage. For premiums earned and claims incurred July 1, 2002 and subsequent, Provident American Life retains 100% of the business and risk on the remaining closed block of policies.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
United Benefit Life Insurance Company
Effective August 1, 1998, Central Reserve entered into a reinsurance treaty with United Benefit Life, a life and accident and health insurer in Texas. Under the terms of the treaty, Central Reserve agreed to assume 100% of United Benefit Life’s block of business, until such time as profits earned by Central Reserve on the assumed block reached a contractual threshold, which approximated $20.0 million of pre-tax income. Central Reserve paid to United Benefit Life a $20.0 million ceding allowance in connection with this transaction.
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 audited 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.
On December 31, 2002, United Benefit Life and Hannover entered into an agreement, which amended these reinsurance arrangements. For claims incurred June 30, 2002 and prior, Hannover continues to be responsible for its quota share percentage. For claims incurred July 1, 2002 and subsequent, Central Reserve retains 100% of the risk.
Other
In the ordinary course of business, the Company maintains other reinsurance arrangements with other insurers. These arrangements are designed to limit the maximum amount of exposure that the Company retains on a given policy. At December 31, 2005, for ordinary and group life claims, Continental General’s maximum retention is $125,000 and Central Reserve’s maximum retention is $50,000 with no retention maintained over age 70. For accident and health claims, maximum retention on individual claims is $500,000.
The following table summarizes the net impact of reinsurance arrangements on premiums and benefits, claims, losses and settlement expenses, and selling, general and administrative expenses:
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
Our insurance companies remain obligated for amounts ceded in the event that the reinsurers do not meet their obligations. Initial ceding allowances received from reinsurers are accounted for as deferred reinsurance gain and are amortized into income over the estimated remaining life of the underlying policies reinsured, except for interest sensitive products that are amortized over the expected profit stream of the in force business. The above table does not include the amortization of initial ceding allowances received from reinsurers. Amortization of deferred reinsurance gain for the years ended December 31, 2005, 2004 and 2003 was $1.0 million, $1.5 million, and $1.7 million, respectively.
L.
Contingencies and Commitments
The nature of our business subjects us to a variety of legal actions (including class actions) and claims relating to such things as denial of healthcare benefits, premium rate increases, termination of coverage, claims administration, our relationship with the associations that market our products, and alleged violations of state and federal statutes.
A California lawsuit was filed against United Benefit Life, Central Reserve, Ceres, the American Association for Consumer Benefits (AACB), and Does 1 through 100 inclusive in the Superior Court for San Luis Obispo County, California (Case No.: CV 020275, filed April 2002) by Annelie and Joseph Purdy, on behalf of themselves and all others similarly situated, seeking class action certification on behalf of individuals in California who purchased group health insurance from United Benefit Life through the AACB. Plaintiffs alleged causes of action for breach of contract, bad faith, violations of California’s Unfair Competition Law and fraud in the inception. Plaintiffs sought unspecified damages, including the return of premium rate increases during the relevant period of time. Plaintiffs’ motion for statewide class certification was granted in November 2003 and the case was scheduled to go to trial in January 2005. The plaintiffs also filed an action against Provident American Life containing somewhat similar allegations. On September 15, 2004, we announced that we had agreed to settle these lawsuits. The settlements contemplated payments to class members and others, as well as certain attorneys’ fees and costs. In 2004, we recorded (in selling, general and administrative expenses) a pre-tax charge of $3.1 million ($2.0 million after-tax). All of the settlements were paid in 2005 and did not materially exceed that amount. These California litigation settlements did not involve any admission of wrongdoing by the Company or any subsidiary.
We are involved in various other legal and regulatory actions occurring in the normal course of business that could result in significant liabilities and costs. Based on current information, including consultation with outside counsel, we believe that any ultimate liability that may arise from any of these other actions would not materially affect our audited consolidated financial position or results of operations. However, we cannot predict with certainty
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
the outcome of any of these actions against us or the potential costs involved. Our evaluation of the likely impact of any of these actions could change in the future and an unfavorable outcome in any case could have a material adverse effect on our consolidated financial position, results of operations or cash flows of a future period.
M.
Debt
At December 31, 2004, our credit facility consisted of a $4.0 million term loan A with National City Bank and a $9.0 million term loan B with CIT Group. The term loan A had quarterly principal payments of $250,000 through December 2005, $375,000 through December 2006, and a payment of $500,000 on March 1, 2007. The $9.0 million term loan B with CIT Group had quarterly principal payments of $312,500 through December 2004, $375,000 through December 2006, $562,500 through December 2007, and $1,250,000 through June 2008.
Effective May 2, 2005, we entered into an amendment to the credit facility in order to permit the stock repurchase program and to allow National City to assume the term loan B. The amendment:
•
Acknowledged that CIT Group had assigned to National City all of its rights, and National City had assumed all of the obligations of CIT Group, under the credit agreement and the term loan B;
•
Changed the term loan B maturity date to March 1, 2008 from June 1, 2008;
•
Revised the amortization of term loan B so that term loan B has quarterly payments of $687,500 (previously $375,000) from June 2005 through March 2006, $375,000 from June 2006 through December 2006, $562,500 from March 2007 through December 2007, and $1,250,000 in March 2008;
•
Modified the “Minimum Consolidated Fixed Charge Coverage Ratio” to 1.50 to 1.00 from 1.15 to 1.00; and
•
Permitted the $10 million stock repurchase program (announced on May 4, 2005).
At December 31, 2005, the interest rate on our term loan A balance of $2.0 million was 7.69% per annum and on our $5.3 million term loan B was 8.19% per annum. Both term loans bear interest at floating rates, based on either Prime or LIBOR, plus applicable spreads. Under Prime rate borrowings, the interest rate for term loan A and term loan B will be the Prime interest rate plus 0.50% and 1.0%, respectively. Under Eurodollar borrowings, the interest rate for term loan A and term loan B will be LIBOR plus 3.25% and 3.75%, respectively.
Our obligations under the credit agreement, as amended, are guaranteed by four of our non-regulated subsidiaries and are secured by pledges of the capital stock of Central Reserve, Continental General, and our non-regulated subsidiaries, as well as security interests in certain equipment and other tangible property of Ceres and the non-regulated subsidiaries.
The credit agreement contains various covenants including financial covenants relating to leverage, fixed charge coverage, risk-based capital of regulated insurance subsidiaries and tangible net worth. It also has a number of affirmative and negative covenants, including limitations relating to indebtedness, liens, mergers, purchases and sales of assets, investments, dividends and stock repurchases. At December 31, 2005, we were in compliance with these covenants.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
N.
Treasury Stock
On May 4, 2005, our Board of Directors authorized the repurchase of up to $10 million of our outstanding common stock in the open market or in private transactions utilizing a $10 million extraordinary dividend from our Central Reserve subsidiary.
In 2005, we repurchased 703,703 shares of our common stock, or approximately $4.1 million, in open market transactions at an average price per share of $5.82.
On September 8, 2005, we purchased, in a private transaction, 1,000,000 shares of our common stock for $5.9 million from International Managed Care funds (IMC). Two of our directors, Robert A. Spass and Bradley E. Cooper, are affiliated with the IMC funds. The purchase price of $5.92 per share represented a discount of 3% to the average closing price of Ceres’ stock for the five trading days ended August 31, 2005 and a discount of 5% from the closing price of the common stock on August 31, 2005. There were no commissions paid on this transaction. We completed the authorized $10 million stock repurchase program in October 2005.
O.
Stock Plans
Stock Option Plans
In 1999, 372 employees each received 1,000 common stock options under the 1998 Employee Stock Option Plan. A second grant was made for new employees hired from January 1, 1999 through September 30, 1999, and still employed as of December 31, 1999. Under this second grant in 2000, 75 employees each received 1,000 common stock options. Each grant vests after three years and expires ten years from the date of the grant, with accelerated vesting upon an event of a change in control. We terminated this plan in December 2000. At December 31, 2005, there were options outstanding under the plan to purchase 285,000 shares.
In 1998, pursuant to the 1998 Key Employee Share Incentive Plan, we granted common stock options to certain key employees. In 1999 through 2004, we 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. On May 19, 2004, our shareholders adopted an amendment to the plan, to increase the total number of shares of our common stock reserved for issuance under the plan by an additional 1,000,000 shares to a total of 3,000,000 shares of our common stock. The adopted amendments to the plan also allowed for the grant of stock and restricted stock awards in addition to stock options and stock appreciation rights to officers, non-employee directors, consultants and advisors. At December 31, 2005, there were options outstanding under the plan to purchase 1,204,267 shares.
In 1998 and 1999, pursuant to various individual employment agreements, we granted non-qualified options to purchase 815,000 shares of our common stock to certain key employees. Such grants generally vest over three years and expire ten years from the date of grant. At December 31, 2005, there were options outstanding pursuant to these grants to purchase 315,000 shares.
In 1999, pursuant to the 1999 Special Agents’ Stock Option Plan, we granted 78,706 common stock options to certain regional sales directors and managing general agents. Each grant vested immediately and expires ten years from the date of grant. We terminated this plan at the end of 2000. At December 31, 2005, there were options outstanding under the plan to purchase 78,706 shares.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
A summary of our stock option activity is presented below:
Exercise prices for options outstanding at December 31, 2005 ranged from $1.95 to $9.50. A summary of the options by range of exercise price is as follows:
Warrants
In 2005 and 2004, we issued 285,166 and 61,931 shares of our common stock, respectively, to various investors upon the cashless exercise of certain warrants that were issued in July 1998. These warrants, which expired in 2005, were fully exercisable for 3,335,575 and 287,960 shares of our common stock in 2005 and 2004, respectively. On December 23, 2003, we issued a warrant to purchase 25,000 shares of our common stock at an exercise price of $5.27 per share to a current marketing agency of the Company which exchanged its QQLink stock for cash and the warrant. All of these warrants, which expire in 2008, were outstanding at December 31, 2005.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
Stock Purchase Plan
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. In 2005 and 2004, 13,343 and 9,027 shares, respectively, had been issued under the employee plan.
Agent Stock Purchase Plan
We also have a 2000 Agent Stock Purchase Plan similar to the employee plan under which certain of our agents may purchase shares of our common stock at the same discount from fair value. The agent stock purchase plan does not qualify as an employee stock purchase plan within the meaning of Section 423 of the Code. In 2005 and 2004, 20,850 and 22,265 shares, respectively, had been issued under the agent plan. There are 1,000,000 shares of common stock reserved for issuance in the aggregate under both plans. Both of the plans will terminate when all of the shares reserved for issuance under the plans have been purchased unless sooner terminated by our Board.
Stock Awards
Pursuant to the 1998 Key Employee Share Incentive Plan, as amended on May 19, 2004, 55,000 shares of restricted stock awards were granted to executive officers in 2004. The awards vest 25% over four years. We recognized stock compensation expense related to these awards of $0.1 million in each of the years ended December 31, 2005 and 2004. In addition, 41,850 and 27,996 shares of our common stock were granted to non-employee directors of our Board in 2005 and 2004, respectively. We recognized stock compensation expense related to these awards of $0.2 million in 2005, which was comparable to the stock compensation expense recognized in 2004.
Stock-Based Compensation
As required by SFAS No. 123, Accounting for Stock-Based Compensation, we have estimated the pro forma impact on net income and earnings per share of stock-based compensation under the fair value method, using the Black-Scholes option valuation model.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our employee stock options.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
Significant underlying assumptions made are summarized as follows:
Based on the methodology and assumptions delineated above, the weighted average fair value of options was $1.51, $1.50, and $1.51 per share for 2005, 2004 and 2003, respectively. There was no significant pro forma impact on net income and net income per share of stock-based compensation under the fair value method for the years ended December 31, 2005 and 2004. The pro forma impact for the year ended December 31, 2003 would be to increase net income by $0.8 million or $0.02 per share due to the forfeiture of options resulting from employee terminations.
P.
Preferred Shares
We have authorized 1,900,000 Non-Voting Preferred Shares, $.001 par value. We have never issued any Non-Voting Preferred Shares. However, our Board is authorized at any time to provide for the issuance of such shares in one or more series, and to determine the designations, preferences, limitations and other rights of the shares issued, including but not limited to the dividend rate, liquidation preference, redemption rights and price, sinking fund requirements, conversion rights and restrictions on the issuance of such shares. However, our credit agreement prohibits the payment of dividends on preferred stock. Holders of non-voting preferred shares shall have no voting rights except as required by law.
We also have authorized 100,000 Convertible Voting Preferred Shares, $.001 par value, of which none were outstanding at December 31, 2005.
Q.
Statutory Financial Information
State insurance laws and regulations prescribe accounting practices for determining statutory net income and equity for insurance companies. In addition, state regulators may permit statutory accounting practices that differ from prescribed practices.
Statutory accounting practices prescribed or permitted by regulatory authorities for our insurance subsidiaries differ from generally accepted accounting principles. Shareholders’ equity and net income, as determined in accordance with statutory accounting practices (as filed with respective state insurance departments), for our consolidated insurance subsidiaries are summarized as follows:
(1)
The consolidated statutory net gain for the year ended December 31, 2003 includes $31.0 million from the sale of Pyramid Life and $0.7 million in statutory earnings from Pyramid Life through March 31, 2003. On March 31, 2003, we sold Pyramid Life to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp. See Note D. Discontinued Operations for further information.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
Generally, the capital and surplus of our insurance subsidiaries available for transfer to the parent company are limited to the amounts that the insurance subsidiaries’ capital and surplus, as determined in accordance with statutory accounting practices, exceed minimum statutory capital requirements. However, payments of the amounts as dividends may be subject to approval by regulatory authorities. On February 24, 2005, Central Reserve received approval from the Ohio Department of Insurance to pay an extraordinary dividend of up to $12.0 million to Ceres Group, the parent company. On May 4, 2005, Central Reserve paid Ceres a dividend of $10.0 million, which was used for the stock repurchase program. On December 30, 2005, Continental General paid Ceres a dividend of $7.0 million. In 2006, Continental General could pay a dividend to Ceres of up to $6.2 million without prior approval of its state regulator. However, in 2006, Central Reserve would be prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus.
The NAIC also has risk-based capital (RBC) requirements for life and health insurers to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks associated with asset quality, mortality and morbidity, asset and liability matching and other business factors. The RBC formula is used by state insurance regulators to monitor trends in statutory capital and surplus for the purpose of initiating regulatory action. We calculated the risk-based capital for its insurance subsidiaries as of December 31, 2005 using the applicable RBC formula. Based on these calculations, the RBC levels of each of our insurance subsidiaries at December 31, 2005 exceeded the levels required by regulatory authorities.
R.
Comprehensive Income
Comprehensive income is as follows:
S.
Computation of Net Income Per Common Share
Basic and diluted net income per share is calculated in accordance with SFAS No. 128, Earnings per Share. Basic net income per common share is computed by dividing net income by the weighted average number of shares outstanding during the period. Diluted net income per common share is computed by dividing net income by the weighted average number of shares outstanding during the period including the effect of the assumed exercise of dilutive stock options and warrants under the treasury stock method.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
Basic and diluted weighted average shares of common stock are as follows:
T.
Employee Benefit Plan
We sponsor 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 participant’s contributions subject to a maximum of 6% of the participant’s salary.
Effective June 1, 2002, the Plan was amended so that participants can elect to make pre-tax contributions from 1% to 25% of their compensation and after-tax contributions were no longer permitted. In addition to the Company Match Contribution, we match 100% of each participant’s contributions (Stock Match Contribution) to the Ceres Group, Inc. Stock Fund, up to a maximum of $1,000 per year provided the participant agrees that the pre-tax contributions will not be transferred out of the fund for a minimum of one year.
In addition, we may contribute a Profit Sharing Contribution to the Plan, as determined by our Board. All eligible, active employees who have worked over 1,000 hours during the plan year and who are employed on the last day of the plan year share in this contribution. Participants who leave employment during the plan year due to retirement, death or disability will also share in the contribution. There were no Profit Sharing Contributions made for the 2005, 2004 and 2003 plan years, respectively.
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. Our total matching contributions were approximately $520,000 for 2005, $506,000 for 2004, and $504,000 for 2003.
U.
Operating Segments
We apply SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, which requires us to report information about our operating segments according to the management approach for determining reportable segments. This approach is based on the way management organizes segments within a company for making operating decisions and assessing performance. We have three distinct operating segments based upon product types: Medical, Senior and Other, and Corporate and Other. Products included in the Medical segment include catastrophic and comprehensive medical plans. Significant products in the Senior and Other segment include Medicare supplement, long-term care, dental, life insurance, and annuities. The Corporate and Other segment encompasses all other activities, including investment income, interest expense, and corporate expenses of the parent company.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
The following table presents the revenues, expenses and profit (loss) from continuing operations before federal income taxes, for the last three years attributable to our industry segments. Investment income is allocated by segment based on the level of policy liabilities and benefits accrued and allocated capital. We assume that the longer duration, higher yielding investments support the life, annuity and long-term care blocks of business. The remaining investments, which tend to be shorter in duration, support the major medical and Medicare supplement blocks of business. We do not separately allocate assets or income tax expenses (benefits) by industry segment. Revenues from each segment are primarily generated from premiums charged to external policyholders and interest earned on cash and investments.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
The following table presents net premiums by major product line for the years ended December 31, 2005, 2004 and 2003:
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
V.
Fair Values of Financial Instruments
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.
The tax ramifications of the related unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.
We used the following methods and assumptions in estimating our fair value disclosures:
Investment securities - Fair value for fixed maturity and equity securities is based on quoted market prices, where available. For fixed maturity securities not actively traded, fair value is estimated using values obtained from independent pricing services.
Cash and cash equivalents, accrued investment income, premiums receivable, mortgage loans and policy notes - The carrying amounts reported in the consolidated balance sheets for these instruments approximate their fair value.
Annuity contracts - The fair value for the annuity reserves included in the liability for future policy benefits, losses, and claims is the amount payable on demand.
Other policyholders’ funds - The carrying amount reported in the consolidated balance sheets for these instruments approximate their fair value.
Debt - The carrying amounts reported in the consolidated balance sheets for the long-term debt approximates their fair value.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
Carrying amounts and estimated fair values of financial instruments at December 31, 2005 and 2004 are summarized as follows:
W.
Concentrations of Credit Risk
Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of fixed maturity investments, cash, cash equivalents, and reinsurance receivable.
We maintain cash and cash equivalent investments with various financial institutions, and perform periodic evaluations of the relative credit standings of those financial institutions.
Substantially all of our reinsurance recoverable is due from a single reinsurer, Hannover. At December 31, 2005, Hannover has an “A” rating from the A.M. Best Company. We perform periodic evaluations of this reinsurer’s credit standing.
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
December 31, 2005, 2004 and 2003
X.
Quarterly Results of Operations - (Unaudited)
The following is a summary of quarterly results of operations for the years ended December 31, 2005 and 2004.
Schedule II
CERES GROUP, INC. AND SUBSIDIARIES
Condensed Financial Information of Registrant
Ceres Group, Inc. (Parent Only)
Balance Sheets
December 31, 2005 and 2004
(dollars in thousands)
(1)
Eliminated in consolidation.
See accompanying report of independent registered public accounting firm.
Schedule II (continued)
CERES GROUP, INC. AND SUBSIDIARIES
Condensed Financial Information of Registrant
Ceres Group, Inc. (Parent Only)
Statements of Operations
For the Years Ended December 31, 2005, 2004 and 2003
(dollars in thousands)
(1)
Represents dividend income from subsidiaries, which is eliminated in consolidation.
(2)
Eliminated in consolidation.
(3)
Includes the parent company’s equity of regulated and non-regulated subsidiaries, which is eliminated in consolidation.
See accompanying report of independent registered public accounting firm.
Schedule II (continued)
CERES GROUP, INC. AND SUBSIDIARIES
Condensed Financial Information of Registrant
Ceres Group, Inc. (Parent Only)
Statements of Cash Flows
For the Years Ended December 31, 2005, 2004 and 2003
(dollars in thousands)
(1)
Eliminated in consolidation.
See accompanying report of independent registered public accounting firm.
Schedule III
CERES GROUP, INC. AND SUBSIDIARIES
SUPPLEMENTAL INSURANCE INFORMATION
(dollars in thousands)
See accompanying report of independent registered public accounting firm.
Schedule IV
CERES GROUP, INC. AND SUBSIDIARIES
REINSURANCE
(dollars in thousands)
N/M = not meaningful
See accompanying report of independent registered public accounting firm.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. We carried out an evaluation, under the supervision and with the participation of our President and Chief Executive Officer along with our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)) as of December 31, 2005. Based upon that evaluation, our President and Chief Executive Officer along with our Chief Financial Officer concluded that our disclosure controls and procedures are effective and designed to ensure that material information relating to us and our consolidated subsidiaries in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
Management’s Report on Internal Control over Financial Reporting. Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)). Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2005. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Our management has concluded that, as of December 31, 2005, our internal control over financial reporting is effective based on these criteria. Our independent auditors, KPMG LLP, have audited our assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005, as stated in their report which is included herein.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Changes in internal control. There have been no changes in our internal control over financial reporting that occurred during the last fiscal quarter that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 regarding directors and executive officers is incorporated by reference to our Proxy Statement in connection with our 2006 Annual Meeting of Stockholders to be held on May 16, 2006. We expect to file the Proxy Statement on or after April 1, 2006.
Section 16(a) Beneficial Ownership Reporting Compliance
Information regarding Section 16(a) beneficial ownership reporting compliance is set forth in “Section 16(a) Beneficial Ownership Reporting Compliance” in our Proxy Statement, which information is incorporated herein by reference.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated by reference to our Proxy Statement in connection with our 2006 Annual Meeting of Stockholders to be held on May 16, 2006.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Equity Compensation Plan Information
As of December 31, 2005, the following table presents information regarding all of the Company’s option plans or awards with respect to Equity Compensation Plans approved by our stockholders:
*
The plan was amended on May 19, 2004 to increase the number of shares reserved for issuance under the plan by an additional 1,000,000 shares to a total of 3,000,000 shares and allow for the grant of stock and restricted stock awards to officers, non-employee directors, consultants and advisors. In 2005 and 2004, 41,850 and 82,996 shares, respectively, of stock and restricted stock awards were granted under this plan to officers and non-employee directors.
As of December 31, 2005, the following table presents information regarding all of the Company’s option plans or awards with respect to Equity Compensation Plans not previously approved by our stockholders:
*
The plan was terminated by our Board of Directors and no future grants will be made. The outstanding grants under the plan were not affected by the termination.
For additional information regarding our equity compensation plans, see Note O. Stock Plans in the accompanying audited consolidated financial statements in this Form 10-K.
Additional information required by Item 12 is incorporated by reference to our Proxy Statement in connection with our 2006 Annual Meeting of Stockholders to be held on May 16, 2006.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated by reference to our Proxy Statement in connection with our 2006 Annual Meeting of Stockholders to be held on May 16, 2006.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by Item 14 is incorporated by reference to our Proxy Statement in connection with our 2006 Annual Meeting of Stockholders to be held on May 16, 2006.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Filed documents. The following documents are filed as part of this report:
1. Financial Statements.
Ceres Group, Inc. and Subsidiaries: Audit Reports.
Consolidated Balance Sheets - December 31, 2005 and 2004.
Consolidated Statements of Operations - Years ended December 31, 2005, 2004 and 2003.
Consolidated Statements of Stockholders’ Equity - Years ended December 31, 2005, 2004 and 2003.
Consolidated Statements of Cash Flows - Years ended December 31, 2005, 2004 and 2003.
Notes to Audited Consolidated Financial Statements.
2. Financial Statement Schedules.
Ceres Group, Inc.:
II. Condensed Financial Information of Registrant - Ceres Group, Inc. (parent only).
III. Supplementary Insurance Information.
IV. Reinsurance.
Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the audited consolidated financial statements or notes thereto.
(b) Exhibits.
* Filed herewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated.
EXHIBIT INDEX