SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
[X] Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934 For the fiscal year ended December 31, 2001
or
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the transition period from _______________ to _____________
Commission file number 0-13972
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PENN TREATY AMERICAN CORPORATION
3440 Lehigh Street, Allentown, PA 18103
(610) 965-2222
Incorporated in Pennsylvania I.R.S. Employer ID No.
23-1664166
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Securities registered pursuant to Section 12(b) of the Act:
Common Stock, $.10 par value
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [ X ] NO [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ X ]
The aggregate market value of the voting stock held by non-affiliates of the
registrant as of March 18, 2002 was $106,909,908.
The number of shares outstanding on the Registrant's common stock, par value
$.10 per share, as of March 18, 2002 was 19,367,737.
Documents Incorporated By Reference:
(1) Proxy Statement for the 2001 Annual Meeting of Shareholders - Part III (2)
Other documents incorporated by reference on this report are listed in the
Exhibit Index
PART I
Item 1. Business
(a) Penn Treaty American Corporation
We are a leading provider of long-term care insurance in the United States.
We market our products primarily to older persons in the states in which we are
licensed through independent insurance agents. Our principal products are
individual, defined benefit accident and health insurance policies covering
long-term skilled, intermediate and custodial nursing home and home health care.
Our policies are designed to make the administration of claims simple, quick and
sensitive to the needs of our policyholders. We also own insurance agencies that
sell senior-market insurance products underwritten by other insurers and us.
We are among the largest writers of individual long-term care insurance in
terms of annualized premiums. We sold 26,474 long-term care policies in 2001,
representing $47 million of annualized premiums. At December 31, 2001, we had
242,644 long-term care insurance policies in-force, representing $351 million of
annualized premiums. Our total premiums were $350 million in 2001, representing
a compound annual growth rate of 22.7% from $102.4 million in 1995. We market
our products primarily through the independent agency channel, which we believe
to be effective in distributing long-term care insurance.
We introduced our first long-term nursing home insurance product in 1972
and our first home health care insurance product in 1983, and we have developed
a record of innovation in long-term care insurance products. Since 1994, we have
introduced several new products designed to meet the changing needs of our
customers, including the following:
o The Independent Living policy, which provides coverage over the full
term of the policy for home care services furnished by unlicensed
homemakers or companions, as well as licensed care providers;
o The Personal Freedom policy, which provides comprehensive coverage for
nursing home and home health care;
o The Assisted Living policy, which is a nursing home plan that provides
enhanced benefits and includes a home health care rider; and
o The Secured Risk Nursing Facility and Post Acute Recovery policies,
which provide limited benefits to higher risk insureds.
In addition, available policy riders include an automatic annual benefit
increase, benefits for adult day-care centers and a return of premium benefit.
Although nursing home and home health care policies accounted for 95.3% of
our total annualized premiums in-force as of December 31, 2001, we also market
and sell life, disability, Medicare supplement, other hospital care insurance
products and a group plan, which offers long-term care coverage to groups on a
guaranteed issue basis.
Effective December 31, 2001, we entered a reinsurance transaction to
reinsure, on a quota share basis, substantially all of our respective long-term
care insurance policies then in-force. The agreement was entered with Centre
Solutions (Bermuda) Limited, which is rated A- by A.M. Best. The agreement,
which is subject to certain coverage limitations, meets the requirements to
qualify as reinsurance for statutory accounting, but not for generally accepted
accounting principles. The initial premium of the treaties is approximately
$619,000,000, comprised of $563,000,000 of debt and equity securities
transferred subsequent to December 31, 2001, and $56,000,000 held as funds due
to the reinsurer. The initial premium and future cash flows from the reinsured
policies, less claims payments, ceding commissions and risk charges, will be
credited to a notional experience account, which is held for our benefit in the
event of commutation and recapture on or after December 31, 2007. The notional
experience account balance will receive an investment credit based upon the
total return of a series of benchmark indices and hedges, which are designed to
closely match the duration of our reserve liabilities.
2
The Long-Term Care Insurance Industry
The long-term care insurance market has grown rapidly in recent years.
According to studies by Conning & Co. and LifePlans, Inc., the long-term care
insurance market experienced a compound average growth rate of 20.1% from 1994
to 1999, rising from approximately $1.7 billion of net written premiums in 1994
to approximately $4.2 billion of net written premiums in 1999. We expect this
growth to continue based on the projected demographics of the United States
population, the rising costs of health care and a regulatory environment that
supports the use of private long-term care insurance.
The population of senior citizens (over age 65) in the U.S. is projected to
grow from the current estimated level of approximately 35 million to
approximately 70 million by 2030, according to a 1996 U.S. Census Bureau report.
Furthermore, health and medical technologies are improving life expectancy and,
by extension, increasing the number of people requiring some form of long-term
care. According to a 1999 report by Conning & Co., market penetration of
long-term care insurance products in the over-65 age group ranges from 5% to 7%.
The size of the target population and the lack of penetration of the existing
market indicate a substantial growth opportunity for companies providing
long-term care insurance products.
We believe that the rising cost of nursing home and home health care
services makes long-term care insurance an attractive means to pay for these
services. According to a 1998 report by the U.S. Healthcare Financing
Administration, the combined cost of home health care and nursing home care was
$20.0 billion in 1980. By 1996, this cost had risen to $108.7 billion. In
addition, recent and proposed tax legislation encourages individuals to use
private insurance for long-term care needs through tax incentives at both the
federal and state levels.
Our Strategy
We seek to enhance shareholder value by strengthening our position as a
leader in providing long-term care insurance. We intend to accomplish this goal
through the following strategies:
Recommencing sales in all states. During 2001, we ceased new sales in the
majority of states in which we are licensed to sell new insurance policies. This
action resulted from a concern that our statutory surplus would continue to
decline from new sales during a period in which we were formulating our
Corrective Action Plan with the Pennsylvania Insurance Department. Since our
Corrective Action Plan was approved in February 2002, we have recommenced sales
in 26 states. We are actively working with all states in order to recommence
sales in all jurisdictions. See "Management's Discussion and Analysis -
Liquidity and Capital Resources."
Refinancing our long-term debt. We have $74,750,000 of convertible debt
that matures in December 2003. We do not expect that our debt will be converted
into shares of common stock at that time. Therefore, we intend to seek
refinancing alternatives that will extend the maturity of the debt and provide
favorable terms to our shareholders.
Developing and qualifying new products with state insurance regulatory
authorities. We have sold long-term care insurance for over 29 years. As an
innovator in nursing home and home health care insurance, we have introduced
many new policies over the years, including four new products in the last five
years. By continually discussing long-term care needs with our agency force and
policyholders, we are able to design new products and to offer what we believe
to be the most complete benefit features in the industry. The development of new
products enables us to generate new business, maintain proper pricing levels and
provide advancements in the benefits we offer. We intend to continue to develop
new insurance products designed to meet the needs of senior citizens and their
families.
Increasing the size and productivity of our network of independent agents.
We have significantly increased the number of agents who sell products for us
and have focused our efforts on states that have larger concentrations of older
individuals. We have successfully increased our number of licensed agents from
approximately 13,000 in 1995 to approximately 49,000 at December 31, 2001. We
intend to continue to recruit agents and we believe that we will be able to
continue to expand our business. Approximately one-third of our agents write new
business for us each year.
3
Utilizing Internet strategies. We have developed a proprietary agent sales
system for long-term care insurance, LTCWorks!, which enables agents to sell
products utilizing downloadable software. We believe that LTCWorks! increases
the potential distribution of our products by enhancing agents' ability to
present the products, assist policyholders in the application process and submit
applications over the Internet. LTCWorks! provides agents who specialize in the
regular sale of long-term care insurance products with a unique and easy to use
sales tool and enables agents who are less familiar with long-term care
insurance to present it when they are discussing other products such as life
insurance or annuities.
Developing third-party administration contracts. We believe that our
surplus and parent company liquidity can be supplemented by providing
administrative services to other long-term care providers and self-funded plans.
We believe that our experience in long-term care affords us opportunities to
develop these relationships.
Introducing group products. In 2000, we began actively marketing our new
group policy, which we anticipate will generate additional premium revenue from
a younger policyholder base. Group products allow us to penetrate an additional
market for the sale of long-term care insurance. We pursue large and small
groups, and offer supplemental coverage on an individually underwritten basis to
group members and their families. We currently market our group products
primarily through agents who market products to individuals. However, we are in
the process of developing a network of agents who generally sell other group
products, and who often have existing relationships with employer groups, to
market our group products. As of December 31, 2001, premiums in-force for our
group products were approximately $4.0 million, covering 3,256 individuals. We
believe our group products present an opportunity to significantly increase the
number of policies in-force without paying significantly increased commissions.
Risk Factors
Certain statements made by us, in this filing, may be considered
forward-looking within the meaning of the Private Securities Litigation Reform
Act of 1995. Although we believe that our expectations are based on reasonable
assumptions within the bounds of our knowledge of our business and operations,
there can be no assurance that our actual results of operations will not differ
materially from our expectations. Factors which could cause actual results to
differ from expectations include:
We may be unable to service and repay our debt obligations if our subsidiaries
cannot pay sufficient dividends or make other cash payments to us and we may be
unable to refinance our debt on favorable terms as necessary.
We are an insurance holding company whose assets principally consist of the
capital stock of our operating subsidiaries. Our ability to redeem, repurchase
or make interest payments on our outstanding debt is dependent upon the ability
of our subsidiaries to pay cash dividends or make other cash payments to us. Our
insurance subsidiaries are subject to state laws and regulations and an order of
the Pennsylvania Insurance Department, which restrict their ability to pay
dividends and make other payments to us. We cannot assure you that we will be
able to service and repay our debt obligations through their maturity in
December 2003. We do not expect our subsidiaries to have sufficient dividend
capability to enable us to repay our 6.25% Convertible Subordinated Notes of
$74,750,000 due December 2003. If these notes are not converted into common
stock, we will have to refinance them. We cannot assure you that we will be able
to refinance the notes on favorable terms.
We could suffer a loss if our premium rates are not adequate and we may be
required to refund or reduce premiums if our premium rates are determined to be
too high.
We set our premiums based on facts and circumstances known at the time and
on assumptions about numerous variables, including the actuarial probability of
a policyholder incurring a claim, the severity and duration of the claim and the
mortality rate of our policyholder base, the persistency or renewal of our
policies in-force and the interest rate which we expect to earn on the
investment of premiums. In setting premiums, we consider historical claims
information, industry statistics and other factors. If our actual experience
proves to be less favorable than we assumed and we are unable to raise our
premium rates, our net income may decrease. We generally cannot raise our
premiums in any state unless we first obtain the approval of the insurance
regulator in that state. We have filed and are preparing to file rate increases
on the majority of our products. We cannot assure you that we will be able to
obtain approval for premium rate increases from existing requests or requests
filed in the future. If we are unable to raise our premium rates because we fail
to obtain approval for a rate increase in one or more states, our net income may
decrease.
4
If we are successful in obtaining regulatory approval to raise premium
rates, the increased premiums may reduce our sales and cause policyholders to
let their policies lapse. Increased lapsation would reduce our premium income
and would require us to expense fully the deferred policy costs relating to
lapsed policies in the period in which those policies lapse, reducing our net
income in that period. Our reinsurance coverage may also be reduced if we fail
to obtain required rate increases.
Insurance regulators also require us to maintain certain minimum statutory
loss ratios on the policies that we sell. We must pay out, on average, a certain
minimum percentage of premiums as benefits to policyholders. State regulations
also mandate the manner in which insurance companies may compute loss ratios and
the manner in which compliance is measured and enforced. If our policies are not
in compliance with state mandated minimum loss ratios, state regulators may
require us to reduce or refund premiums.
Our reserves for future policy benefits and claims may be inadequate, requiring
us to increase liabilities and resulting in reduced net income and book value.
We calculate and maintain reserves for the estimated future payment of
claims to our policyholders using the same actuarial assumptions that we use to
set our premiums. Establishing reserves is an uncertain process, and we cannot
assure you that actual claims expense will not materially exceed our reserves
and have a material adverse effect on our results of operations and financial
condition. Our net income depends significantly upon the extent to which our
actual claims experience is consistent with the assumptions we used in setting
our reserves and pricing our policies. If our assumptions with respect to future
claims are incorrect, and our reserves are insufficient to cover our actual
losses and expenses, we would suffer an increase in liabilities resulting in
reduced net income.
Claims experience can differ from our expectations due to numerous factors,
including mortality rates, duration of care and type of care utilized. Due to
the inherent uncertainty in establishing reserves, it has been necessary in the
past for us to increase the estimated future liabilities reflected in our
reserves for claims and policy expenses. In 1999, we added approximately $4.1
million to our claim reserves for 1998 and prior claim incurrals, in 2000, we
added approximately $6.6 million to our claim reserves for 1999 and prior claim
incurrals, and in 2001, we added approximately $8.8 million to our claim
reserves for 2000 and prior claim incurrals. Our additions to prior year
incurrals in 2001 resulted from a continuance study performed by our consulting
actuary. We also increased claim reserves in 2001 by $1.6 million as a result of
utilizing a lower interest rate for the purpose of discounting our future
liabilities. Over time, it may continue to be necessary for us to increase our
reserves.
New insurance products, such as our Independent Living, Assisted Living and
Personal Freedom policies, entail a greater risk of unanticipated claims than
products which have more extensive historical claims data, such as long-term
nursing home care insurance. We believe that individuals may be more inclined to
use home health care than nursing home care, which is generally only considered
after all other possibilities have been exhausted. Accordingly, we believe that
home health care policies entail a greater risk of wide variations in claims
experience than nursing home insurance. Because we have relatively limited
claims experience with these products, we may incur higher than expected losses
and expenses and may be required to adjust our reserve levels with respect to
these products.
We may recognize a disproportionate amount of policy costs in one financial
reporting period if our estimates with respect to the duration of our policies
are inaccurate.
We recognize policy costs over the life of each policy we sell. These costs
include all expenses that are directly related to, and vary with, the
acquisition of the policy, including commission, underwriting and other policy
issue expenses. We use the same actuarial assumptions used to compute premiums
and reserves to determine the period over which to amortize policy costs.
Upon the occurrence of an unanticipated termination of a policy, we must
fully expense deferred acquisition costs associated with the terminated policy.
If actual experience adversely differs from our actuarial assumptions or if
policies are terminated early by the insured or by us, we would recognize a
disproportionate amount of policy expenses at one time, which would negatively
affect our net income for that period.
5
Annually, we determine if the future profitability of current in-force
policies is sufficient to support our remaining deferred acquisition cost
amount. This determination may include assumptions regarding the current need
and future implementation of premium rate increases. We believe that we need
certain rate increases in order to generate sufficient profitability to offset
our current deferred acquisition costs. In the event that profits are considered
insufficient to fully support the deferred acquisition costs, or if we are
unable to obtain anticipated premium rate increases, we would impair the value
of our deferred acquisition expense asset and would recognize a disproportionate
amount of policy expenses at one time, which would negatively affect our net
income for that period.
We may not be able to compete successfully with insurers who have greater
financial resources or higher financial strength ratings.
We sell our products in highly competitive markets. We compete with large
national insurers, smaller regional insurers and specialty insurers. Many
insurers are larger and have greater resources and higher financial strength
ratings than we do. In addition, we are subject to competition from insurers
with broader product lines. We also may be subject, from time to time, to new
competition resulting from changes in Medicare benefits, as well as from
additional private insurance carriers introducing products similar to those
offered by us. Also, the removal of regulatory barriers (including as a result
of the Gramm-Leach-Bliley Financial Services Modernization Act of 1999) might
result in new competitors entering the long-term care insurance business. These
new competitors may include diversified financial services companies that have
greater financial resources than we do and that have other competitive
advantages, such as large customer bases and extensive branch networks for
distribution.
We may suffer reduced income if governmental authorities change the regulations
applicable to the insurance industry.
We are licensed to do business as an insurance company in a number of
states and are subject to comprehensive regulation by the insurance regulatory
authorities of those states. The primary purpose of such regulation is to
protect policyholders, not shareholders. The laws of the various states
establish insurance departments with broad powers with respect to such things as
licensing companies to transact business, licensing agents, prescribing
accounting principles and practices, admitting statutory assets, mandating
certain insurance benefits, regulating premium rates, approving policy forms,
regulating unfair trade, market conduct and claims practices, establishing
statutory reserve requirements and solvency standards, limiting dividends,
restricting certain transactions between affiliates and regulating the types,
amounts and statutory valuation of investments.
State insurance regulators and the National Association of Insurance
Commissioners ("NAIC") continually reexamine existing laws and regulations, and
may impose changes in the future that materially adversely affect our business,
results of operations and financial condition. In particular, rate rollback
legislation and legislation to control premiums, policy terminations and other
policy terms may affect the amount we may charge for insurance premiums. In
addition, some state legislatures have discussed and implemented proposals to
limit rate increases on long-term care insurance products. Because insurance
premiums are our primary source of income, our net income may be negatively
affected by any of these changes. Many states are now disallowing coverage
exclusions incurred as a result of war or terrorist acts. We have proactively
removed these exclusions in some states, but cannot be certain that our
financial results would not be adversely affected by such acts.
Proposals currently pending in the U.S. Congress may affect our income.
These include the implementation of minimum consumer protection standards for
inclusion in all long-term care policies, including: guaranteed premium rates;
protection against inflation; limitations on waiting periods for pre-existing
conditions; setting standards for sales practices for long-term care insurance;
and guaranteed consumer access to information about insurers, including lapse
and replacement rates for policies and the percentage of claims denied.
Enactment of any of these proposals could adversely affect our net income. In
addition, recent federal financial services legislation requires states to adopt
laws for the protection of consumer privacy. Compliance with various existing
and pending privacy requirements also could result in significant additional
costs to us.
6
We may not be able to compete successfully if we cannot recruit and retain
insurance agents.
We distribute our products principally through independent agents whom we
recruit and train to market and sell our products. We also engage marketing
general agents from time to time to recruit independent agents and develop
networks of agents in various states. We compete vigorously with other insurance
companies for productive independent agents, primarily on the basis of our
financial position, support services, compensation and product features. We may
not be able to continue to attract and retain independent agents to sell our
products, especially if we are unable to restore our capital and surplus and
improve our financial strength ratings. Our business and ability to compete
would suffer if we are unable to recruit and retain insurance agents and if we
lose the services provided by our marketing agents.
Our business is concentrated in a few states.
Historically, our business has been concentrated in a few states. Over the
past four fiscal years, approximately half of our premiums were from sales of
policies in California, Florida and Pennsylvania. Increased competition, changes
in economic conditions, legislation or regulations, rating agency downgrades,
statutory surplus deficiencies or the loss of our ability to write business due
to regulatory intervention in any of these states could significantly affect our
results of operations or prospects. In 2001, we voluntarily ceased new sales in
these states as a result of our subsidiary's statutory surplus position. We
recommenced sales in Pennsylvania in February 2002 and petitioned Florida and
California for reentry. Until the necessary approvals are received, we are
unable to sell new policies in these states. As a result of not selling policies
in these states, or if we fail to recommence sales in other states, our
financial condition may be materially adversely affected.
Declines in the value or the yields on our investment portfolio and significant
defaults in our investment portfolio may adversely affect our net income.
Income from our investment portfolio is a significant element of our
overall net income. If our investments do not perform well, we would have
reduced net income and could suffer a net loss. We are susceptible to changes in
market rates when cash flows from maturing investments are reinvested at
prevailing market rates. Accordingly, a prolonged decrease in interest rates or
in equity security prices or an increase in defaults on our investments could
adversely affect our net income.
Effective December 31, 2001, we entered a reinsurance agreement to
reinsure, on a quota share basis, substantially all of our long-term care
insurance policies in-force. The transaction resulted in the transfer of debt
and equity securities of approximately $563,000,000 to the reinsurer and a funds
withheld balance of $56,000,000. The agreement provides us the opportunity to
commute on or, after December 31, 2007. The reinsurer will maintain a notional
experience account, which reflects the initial premium paid, future premiums
collected net of claims, expenses and accumulated investment earnings. The
notional experience account balance will receive an investment credit based upon
the total return of a series of benchmark indices and hedges, which are designed
to closely match the duration of reserve liabilities. Periodic changes in the
market values of the benchmark indices and hedges will be recorded in our
financial statements as investment gains or losses in the period in which they
occur. As a result, we will likely experience volatility in our future financial
statements.
In addition, we depend in part on income from our investment portfolio to
fund our reserves for future policy claims and benefits. In establishing the
level of our reserves, we make assumptions about the performance of our
investments. If our investment income or the capital gains in our portfolio are
lower than expected, we may have to increase our reserves, which could adversely
affect our net income.
Our new reinsurance eagreement is subject to an aggregate limit of liability,
which is a function of certain factors and which may be reduced as a result of
our inability to obtain certain rate increases.
Our new reinsurance agreement with Centre Solutions (Bermuda) Limited,
effective December 31, 2001, is subject to certain coverage limitations and
aggregate limit of liability, which is a function of certain factors and which
may be reduced as a result of our inability to obtain rate increases. This limit
of liability is subject to certain events such as material breach of the
covenants of the agreement, regulatory risk of changes in regulation or law and
our inability to achieve rate increases deemed necessary by the provisions of
the agreement.
All references to this reinsurance agreement or to Centre Solutions
(Bermuda) Limited throughout this filing and the attached Financial Statements
are intended to contain this statement of risk.
7
Our reinsurers may not satisfy their obligations to us.
We obtain reinsurance from unaffiliated reinsurers on most of our policies
to increase the number and size of the policies we may underwrite and reduce the
risk to which we are exposed. Although reinsurance makes the reinsurer liable to
us to the extent the risk is transferred to the reinsurer, it does not relieve
us of our liability to our policyholders. Accordingly, we bear credit risk with
respect to our reinsurers. We cannot assure you that our reinsurers will pay all
of our reinsurance claims or that they will pay our reinsurance claims on a
timely basis.
Our Corrective Action Plan, as approved by the Pennsylvania Insurance
Department, will result in a strengthening of our statutory reserves. A
component of the Corrective Action Plan is a reinsurance agreement. If the
reinsurer does not honor our agreement, if the limit of liability is reduced as
a result of limitations and / or conditions contained in the reinsurance
agreement, or if the agreement is cancelled, our statutory surplus would be
materially adversely affected.
We may not commute our new reinsurance transaction on December 31, 2007 and may
incur increased expenses by not commuting.
Effective December 31, 2001, we entered a reinsurance transaction with an
unaffiliated reinsurer for substantially all of our long-term care insurance
policies then in-force. This agreement contains commutation provisions and
allows us to recapture the reserve liabilities and the current experience
account balance as of December 31, 2007 or on December 31 of any year
thereafter.
If we choose not to or are unable to commute the agreement as planned, our
financial results would likely suffer a materially adverse impact due to an
escalation of the charges paid to the reinsurer after December 31, 2007.
Additionally, our reinsurance agreement contains significant covenants and
conditions that, if breached, could result in a significant loss, requiring a
payment of $2.5 million per quarter from the period of the breach through
December 31, 2007. Any breach of the reinsurance agreement may also result in
the immediate recapture of the reinsured business, which would have a material
adverse effect on our subsidiaries' statutory surplus. Management has
also completed an assessment of its ability to avoid any breach through 2002 and
believes that it will remain compliant. The reinsurer has been granted warrants
to acquire convertible preferred stock in the event we do not commute the
agreements that, if converted, would represent an additional 20 percent of the
common stock then outstanding.
We may be affected by our financial strength ratings due to highly competitive
markets.
Our ability to expand and to attract new business is affected by the
financial strength ratings assigned to our insurance company subsidiaries by
A.M. Best Company, Inc. and Standard & Poor's Insurance Rating Services, two
independent insurance industry rating agencies. A.M. Best's ratings for the
industry range from "A++ (superior)" to "F (in liquidation)." Standard & Poor's
ratings range from "AAA (extremely strong)" to "CC (extremely weak)." Some
companies are unrated. A.M. Best and Standard & Poor's insurance company ratings
are based upon factors of concern to policyholders and insurance agents and are
not directed toward the protection of investors. Our subsidiaries that are rated
have A.M. Best ratings of "B- (fair)" and Standard & Poor's ratings of "B-
(weak)."
Certain distributors will not sell our group products unless we have a
financial strength rating of at least an "A-." The inability of our subsidiaries
to obtain higher A.M. Best or Standard & Poor's ratings could adversely affect
the sales of our products if customers favor policies of competitors with better
ratings. In addition, the recent downgrades and further downgrades in our
ratings may cause our policyholders to allow their existing policies to lapse.
Increased lapsation would reduce our premium income and would also cause us to
expense fully the deferred policy costs relating to lapsed policies in the
period in which those policies lapsed, thereby reducing our capital and surplus.
Downgrades to our ratings may also lead some independent agents to sell fewer of
our products or to cease selling our policies altogether.
8
We may not have enough capital and surplus to continue to grow.
Our continued growth is dependent upon our ability to continue to fund
expansion of our markets and our network of agents while at the same time
maintaining required minimum statutory levels of capital and surplus to support
such growth. Our new business growth typically results in net losses on a
statutory basis during the early years of a policy, due primarily to differences
in accounting practices between statutory accounting principles and generally
accepted accounting principles. The resultant reduction in statutory surplus, or
surplus strain, can limit our ability to generate new business due to statutory
restrictions on premium to surplus ratios and required statutory surplus
parameters. If we cannot generate sufficient statutory surplus to maintain
minimum statutory requirements through increased statutory profitability,
reinsurance or other capital generating alternatives, we will be limited in our
ability to generate additional premium from new business growth, which would
result in lower net income under generally accepted accounting principles, or,
in the event that our statutory surplus is not sufficient to meet minimum state
premium to surplus and risk based capital ratios, we could be prohibited from
generating additional premium revenue.
Furthermore, the insurance industry may undergo change in the future and,
accordingly, new products and methods of service may also be introduced. In
order to keep pace with any new developments, we may need to expend significant
capital to offer new products and to train our agents and employees to sell and
administer these products and services. We may also need to make significant
capital expenditures for computer systems and other technology needed to market
and administer our policies. We may not be successful in developing new products
and we may not have the funds necessary to make capital expenditures. Any
significant capital expenditures, or the failure to make necessary investments,
may have a material adverse effect on us.
Litigation may result in financial losses, harm to our reputation and divert
management resources.
We are regularly involved in litigation, both as a defendant and as a
plaintiff. The litigation naming us as a defendant ordinarily involves our
activities as an insurer. In recent years, many insurance companies have been
named as defendants in class actions relating to market conduct or sales
practices, and other long-term care insurance companies have been sued when they
sought to implement premium rate increases. We cannot assure you that we will
not be named as a defendant in a similar case. Current and future litigation may
result in financial losses, harm our reputation and require the dedication of
significant management resources.
The Company and certain of its key executive officers are defendants in
consolidated actions that were instituted on April 17, 2001 in the United States
District Court for the Eastern District of Pennsylvania by shareholders of the
Company, on their own behalf and on behalf of a putative class of similarly
situated shareholders who purchased shares of the Company's common stock between
July 23, 2000 through and including March 29, 2001. The consolidated amended
class action complaint seeks damages in an unspecified amount for losses
allegedly incurred as a result of misstatements and omissions allegedly
contained in the Company's periodic reports filed with the SEC, certain press
releases issued by them, and in other statements made by its officials. The
alleged misstatements and omissions relate, among other matters, to the
statutory capital and surplus position of the Company's largest subsidiary, Penn
Treaty Network America Insurance Company. On December 7, 2001, the defendants
filed a motion to dismiss the complaint, which is currently pending. The Company
believes that the complaint is without merit, and it and its executives will
continue to vigorously defend the matter.
We are dependent upon key personnel and our operations could be affected by the
loss of their services.
Our success largely depends upon the efforts of our senior operating
management, including our chairman, chief executive officer, president and
founder, Irving Levit. The loss of the services of Mr. Levit or one or more of
our key personnel could have a material adverse effect on our operations.
Our principal shareholder and other members of our senior management team have
the ability to exert significant influence over our affairs.
Mr. Levit is our principal shareholder and controls, directly or
indirectly, approximately 13% of our common stock. In addition, a majority of
the members of our board of directors are members of our senior management team.
Accordingly, Mr. Levit and other members of our senior management team have the
power to exert significant influence over our policies and affairs.
9
Certain anti-takeover provisions in state law and our Articles of Incorporation
may make it more difficult to acquire us and thus may depress the market price
of our common stock.
Our Restated and Amended Articles of Incorporation, the Pennsylvania
Business Corporation Law of 1988, as amended, and the insurance laws of states
in which our insurance subsidiaries do business contain certain provisions which
could delay or impede the removal of incumbent directors and could make a
merger, tender offer or proxy contest involving us difficult, even if such a
transaction would be beneficial to the interests of our shareholders, or
discourage a third party from attempting to acquire control of us. In
particular, the classification of our board of directors could have the effect
of delaying a change in control. In addition, we have authorized 5,000,000
shares of preferred stock, which we could issue without further shareholder
approval and upon such terms and conditions, and having such rights privileges
and preferences, as the board of directors may determine. We have no current
plans to issue any preferred stock. Insurance laws and regulations of
Pennsylvania and New York prohibit any person from acquiring control of us, and
thus indirect control of our insurance subsidiaries, without the prior approval
of the insurance commissioners of those states.
Reduced liquidity and price volatility could result in a loss to investors.
Although our common stock is listed on the New York Stock Exchange, there
can be no assurance as to the liquidity of investments in our common stock or as
to the price investors may realize upon the sale of our common stock. These
prices are determined in the marketplace and may be influenced by many factors,
including the liquidity of the market for the common stock, the market price of
the common stock, investor perception and general economic and market
conditions.
Corporate Background
We are registered and approved as a holding company under the Pennsylvania
Insurance Code. We were incorporated in Pennsylvania on May 13, 1965 under the
name Greater Keystone Investors, Inc. and changed our name to Penn Treaty
American Corporation on March 25, 1987. Penn Treaty Life Insurance Company
("Penn Treaty Life") was incorporated in Pennsylvania under the name Family
Security Life Insurance Company on June 6, 1962, and its name was changed to
Quaker State Life Insurance Company on December 29, 1969, at which time it was
operating under a limited insurance company charter. We acquired Quaker State
Life Insurance Company on May 4, 1976, and changed its name to Penn Treaty Life
Insurance Company. On July 13, 1989, Penn Treaty Life acquired all of the
outstanding capital stock of AMICARE Insurance Company (formerly Fidelity
Interstate Life Insurance Company), a stock insurance company organized and
existing under the laws of Pennsylvania, and changed its name to Network America
Life Insurance Company on August 1, 1989.
On August 30, 1996, we consummated the acquisition of all of the issued and
outstanding capital stock of Health Insurance of Vermont, Inc., and have since
changed its name to American Network Insurance Company.
Senior Financial Consultants Company, an insurance agency that we own, was
incorporated in Pennsylvania on February 23, 1988 under the name Penn Treaty
Service Company. On February 29, 1988, it acquired, among other assets, the
rights to renewal commissions on a certain block of Penn Treaty Life's existing
in-force policies from Cher-Britt Agency, Inc., and an option to purchase the
rights to renewal commissions on a certain block of Penn Treaty Life's existing
policies from Cher-Britt Insurance Agency, Inc., an affiliated company of
Cher-Britt Agency, Inc. In connection with this acquisition, on March 3, 1988,
we changed the name of the Agency to Cher-Britt Service Company. The option was
exercised on March 3, 1989. Its name was changed to Senior Financial Consultants
Company on August 9, 1994.
On December 31, 1997, Penn Treaty Life dividended to us its common stock
ownership of Penn Treaty Network America Insurance Company. At that time, Penn
Treaty Network America Insurance Company assumed substantially all of the
assets, liabilities and premium in-force of Penn Treaty Life through a purchase
and assumption reinsurance agreement. On December 30, 1998, we sold our common
stock interest in Penn Treaty Life to an unaffiliated insurer. All remaining
policies in-force were assumed by Penn Treaty Network America Insurance Company
through a 100% quota share agreement.
On November 25, 1998, we entered into a purchase agreement to acquire all
of the common stock of United Insurance Group Agency, Inc. ("United Insurance
Group"), a Michigan based consortium of long-term care insurance agencies. The
acquisition was effective January 1, 1999.
10
On December 10, 1999, we incorporated Penn Treaty (Bermuda), Ltd., a
Bermuda based reinsurer, for the purpose of reinsuring affiliated long-term
insurance contracts at a future date.
On January 1, 2000, we acquired Network Insurance Senior Health Division
("NISHD"), a Florida-based insurance agency brokerage company. NISHD was
purchased by Penn Treaty Network America Insurance Company.
(b) Insurance Products
Since 1972, we have developed, marketed and underwritten defined benefit
accident and health insurance policies designed to be responsive to changes in:
o the characteristics and needs of the senior citizen market;
o governmental regulations and governmental benefits available for
senior citizens; and
o the health care and long-term care industries in general.
As of December 31, 2001, 95.3% of our total annualized premiums in-force
were derived from long-term care policies, which include nursing home and home
health care policies. Our other lines of insurance include life, disability,
Medicare supplement and other hospital care policies and riders. We solicit
input from both our independent agents and our policyholders with respect to the
changing needs of insureds. In addition, our representatives regularly attend
seminars to monitor significant trends in the industry.
Our focus on long-term care has enabled us to gain expertise in claims and
underwriting which we have applied to product development. Through the years, we
have continued to build on our brand names by offering the independent agency
channel a series of differentiated products. We have expanded our product line
to offer both tax-qualified and non-qualified plans based on consumer demand for
both.
The following table sets forth, for each of our last three fiscal years our
annualized gross premiums by type of policy.
(annualized premiums in $000's)
Year ended December 31,
-----------------------------------------------------------------
2001 2000 1999
Long-term facility, home and comprehensive coverage:
Annualized premiums $ 351,268 95.3% $ 360,600 95.2% $ 313,222 94.6%
Number of policies 242,644 242,075 208,955
Average premium per policy $ 1,448 $ 1,490 $ 1,499
Disability insurance:
Annualized premiums $ 6,415 1.7% $ 6,634 1.8% $ 7,126 2.2%
Number of policies 13,226 13,502 14,963
Average premium per policy $ 485 $ 491 $ 476
Medicare supplement:
Annualized premiums $ 8,449 2.3% $ 7,314 1.9% $ 6,131 1.9%
Number of policies 8,216 7,696 5,934
Average premium per policy $ 1,028 $ 950 $ 1,033
Life insurance:
Annualized premiums $ 2,185 0.6% $ 3,785 1.0% $ 4,095 1.2%
Number of policies 3,763 6,315 6,677
Average premium per policy $ 581 $ 599 $ 613
Other insurance:
Annualized premiums $ 398 0.1% $ 609 0.2% $ 548 0.2%
Number of policies 2,459 3,900 2,968
Average premium per policy $ 162 $ 156 $ 185
Total annualized premiums in force $ 368,715 100% $ 378,942 100% $ 331,122 100%
Total Policies 270,308 273,488 239,497
11
We received an insurance license in 1972, which permitted us to write
insurance in 12 states. In 1974, we filed a long-term care policy offering a
five-year benefit period. Our policy was the first national plan to equally
cover all levels of care, including skilled, intermediate and custodial care,
with an extended benefit period. We began the sale of home health care riders,
which pay for licensed nurses, certified nurses' aides and home health care
workers who provide care/assistance in the policyholder's home, in 1983. This
plan was the first in the industry to include a limited benefit for homemaker
companion care provided by a friend, neighbor, relative or religious
organization. We began the use of table-based underwriting, which enables higher
risk policyholders to receive coverage at a risk-adjusted premium level, in
1986. Appropriate risk is calculated based upon medical conditions and ability
to perform daily activities. Multiple rate classes enabled us to penetrate an
untapped market in long-term care insurance sales.
We specialize in the sale of long-term care insurance, which is generally
defined as nursing home and home health care insurance coverage.
Long-Term Nursing Home Care. Our long-term nursing home care policies
generally provide a fixed or maximum daily benefit payable during periods of
nursing home confinement prescribed by a physician or necessitated by the
policyholder's cognitive impairment or inability to perform two or more
activities of daily living. These policies include built-in benefits for
alternative plans of care, waivers of premiums after 90 days of benefit payments
on a claim and unlimited restoration of the policy's maximum benefit period. All
levels of nursing care, including skilled, intermediate and custodial (assisted
living) care, are covered and benefits continue even when the policyholder's
required level of care changes. Skilled nursing care refers to professional
nursing care provided by a medical professional (a doctor or registered or
licensed practical nurse) located at a licensed facility that cannot be provided
by a non-medical professional. Assisted living care generally refers to
non-medical care, which does not require professional treatment and can be
provided by a non-medical professional with minimal or no training. Intermediate
nursing care is designed to cover situations that would otherwise fall between
skilled and assisted living care and includes situations in which an individual
may require skilled assistance on a sporadic basis.
Our current long-term nursing home care policies provide benefits that are
payable over periods ranging from one to five years, or the lifetime of the
policyholder. These policies provide for a maximum daily benefit on costs
incurred ranging from $60 to $300 per day. Our Personal Freedom policies also
provide comprehensive coverage for nursing home and home health care, offering
benefit "pools of coverage" ranging from $75,000 to $300,000, as well as
lifetime coverage.
Long-Term Home Health Care. Our home health care policies generally provide
a benefit payable on an expense-incurred basis during periods of home care
prescribed by a physician or necessitated by the policyholder's cognitive
impairment or inability to perform two or more activities of daily living. These
policies cover the services of registered nurses, licensed practical nurses,
home health aides, physical therapists, speech therapists, medical social
workers and other similar home health practitioners. Benefits for our currently
marketed home health care policies are payable over periods ranging from six
months to five years, or the lifetime of the policyholder, and provide from $40
to $160 per day of home benefits. Our home health care policies also include
built-in benefits for waivers of premiums after 90 days of benefit payments, and
unlimited restoration of the policy's maximum benefit period.
We currently offer the following products:
Independent Living Plan. The Independent Living Plan (offered since 1994)
was our first stand-alone home health care plan that covered all levels of care
received at home. Besides covering skilled care and care by home health aides,
this plan pays for care provided by unlicensed, unskilled homemakers. This care
includes assistance with cooking, shopping, housekeeping, laundry,
correspondence, using the telephone and paying bills. Historically, only limited
coverage had been provided under certain of our home health care policies for
homemaker care, typically for a period of up to 30 days per calendar year during
the term of the policy. This benefit is now standard in most long-term care
policies. Family members also may be reimbursed for any training costs incurred
in order to provide in-home care.
The Independent Living policy provides that we will waive the elimination
period, the time at the beginning of the period during which care is provided
for which no benefits are available under the policy (usually twenty days), if
the insured agrees to utilize a care management service referred by us. Newer
policies offer up to 100% of the daily benefit if a care management service is
used, versus 80% if the policyholder does not elect care management services. We
engage the care manager at the time a claim is submitted to prepare a written
assessment of the insured's condition and to establish a written plan of care.
We have subsequently incorporated the use of care management in all of our new
home health care policies.
12
Personal Freedom Plan. Our Personal Freedom Plan (offered since 1996) is a
comprehensive plan which provides a sum of money for long-term care to be used
for either nursing facility or home health care. The plan also provides coverage
for homemaker care for insureds who are unable to perform activities of daily
living such as cooking, shopping, housekeeping, laundry, correspondence, using
the telephone, paying bills and managing medication.
When policyholders purchase this policy, with benefits ranging from $75,000
to $300,000, as well as lifetime coverage, they may then access up to the face
amount of the policy for nursing home or home health care as needed, subject to
maximum daily limits. This plan also includes an optional return of
premium/nonforfeiture benefit.
Assisted Living Plan. The Assisted Living Plan (offered since 1996) is a
stand-alone facility care plan that provides benefits in either a traditional
nursing home setting or in an Assisted Living Facility, the setting preferred by
the majority of policyholders. This policy, coupled with an optional home health
care rider, offers benefits similar to those of the Personal Freedom Plan, but
on an elapsed time, cost incurred basis with a maximum daily benefit, cost
incurred basis, rather than a sum of money basis.
Secured Risk Plan. Our Secured Risk Plan (offered since 1998) offers
facility care benefits to people who would most likely not qualify for long-term
care insurance under traditional policies. Table-based underwriting allows us to
examine these substandard conditions by level of activity and independence of
the applicant. This plan offers protection to such individuals by providing
coverage for care in a nursing facility or in the insured's home if he or she
chooses the limited optional home health care benefits. Features of this plan,
as with many of our other plans, include coverage for pre-existing conditions
after six months, guaranteed renewal for life, premiums that will not increase
with age and no requirement of prior hospitalization.
Post Acute Recovery Plan. The Post Acute Recovery Plan (offered since 1999)
provides facility and home health care benefits for up to one year after
traditional medical insurance, Medicare, Medigap or HMO services stop, thereby
providing a more affordable short-term plan. Coupled with optional home health
care benefits, this product pays for medical recovery in a facility or in the
insured's home when traditional health care coverage stops. Features of this
plan include immediate coverage (no elimination period or deductible), coverage
for pre-existing conditions after six months in most states, guaranteed renewal
and premiums that will not increase with age. We offer a "Care Solutions"
service with this plan, in which a care manager works with the insured to design
a plan of care suited to meet his or her individual needs.
Group Long-Term Care Insurance Plan. Our group long-term care insurance
plan (offered since 2000) provides group long-term care insurance to groups
formed for purposes other than the purchase of insurance, such as an employee
group, an association or a professional organization. A group master policy is
issued to the group and all participating members are issued certificates of
insurance, which describe the benefits available under the policy. Eligibility
for insurance is guaranteed to all members of the group without an underwriting
review on an individual basis. Group members, spouses and parents can generally
purchase supplemental coverage beyond the level paid by the group. This coverage
is offered on an individually underwritten basis.
We are currently seeking to expand our group insurance business and are
enhancing our marketing efforts towards this end. Our management considers this
area to offer significant opportunities for sales growth.
Riders. Our policies generally offer an optional lifetime inflation rider,
which provides for a 5% increase of the selected daily benefit amount on each
anniversary date for the lifetime of the policy. An optional nonforfeiture
shortened benefit rider, which provides the insured with the right to maintain a
portion of his or her benefit period in the event the policy lapses after being
continuously in-force for at least three years, is also available. The return of
premium benefit rider provides for a pro-rata return of premium in the event of
death or surrender beginning in the sixth year. We also offer and encourage the
purchase of home health care riders to supplement our nursing home policies and
nursing home riders to supplement our home health care policies.
Previously, we offered numerous other riders to supplement our long-term
care policies. The need, however, for many of these riders has been eliminated
due to the incorporation of many of the benefits they provided into the basic
coverage included in our newest long-term care policies. Among the built-in
benefits provided under the long-term care policies we currently market are
hospice care, adult day care, survivorship benefits and restoration of benefits.
13
After the enactment of the Health Insurance Portability and Accountability
Act of 1996, issues arose relating to the tax status of long-term care benefits
included as part of non-qualified plans. To permit policyholders to purchase
either the tax-qualified plan or non-qualified plan that best suits their needs,
we introduced the Pledge and Promise. The Pledge and Promise states that, if the
U.S. Congress or the Treasury Department should determine that the benefits
received on a long-term care policy are considered taxable income, we will allow
a policyholder to convert the policy to a tax-qualified policy at any time. The
Pledge and Promise further states that, if the U.S. Congress or Treasury
Department should determine that the benefits received on a non-qualified plan
will not be considered taxable income, we will allow a policyholder to convert
the policy from a tax-qualified plan to a non-qualified plan at any time prior
to its first anniversary.
(c) Marketing
Markets. The following chart shows premium revenues by state for each of
the states where we do business:
($000)
--------------------------------- Current
Year Year Ended December 31, Year %
---------------------------------
State Entered 2001 2000 1999 of Total
-------- ---- ---- ---- --------
Arizona 1988 $15,392 $15,677 $13,715 4.4%
California 1992 51,498 50,165 43,514 14.7%
Colorado 1969 4,701 3,564 2,563 1.3%
Florida 1987 65,067 71,588 63,218 18.6%
Georgia 1990 5,066 4,764 3,350 1.4%
Illinois 1990 19,525 19,748 15,970 5.6%
Iowa 1990 5,361 5,097 4,317 1.5%
Maryland 1987 3,948 3,896 3,427 1.1%
Michigan 1989 6,654 6,357 5,469 1.9%
Missouri 1990 4,061 4,391 4,297 1.2%
Nebraska 1990 4,263 4,358 3,952 1.2%
New Jersey 1996 8,374 7,856 4,707 2.4%
New York 1998 4,103 2,665 676 1.2%
North Carolina 1990 10,399 9,690 8,089 3.0%
Ohio 1989 11,880 11,935 10,149 3.4%
Pennsylvania 1972 43,126 48,692 37,661 12.3%
Texas 1990 17,847 16,105 11,879 5.1%
Virginia 1989 22,638 22,370 19,597 6.5%
Washington 1993 10,670 9,814 7,485 3.0%
All Other States (1) 35,818 38,381 28,481 10.2%
------ ------ ------ -----
All States $350,391 $357,113 $292,516 100.0%
======== ======== ======== ======
________________
(1) Includes all states in which premiums comprised less than one percent of
total premiums in 2001.
Our goal is to strengthen our position as a leader in providing long-term
care insurance to senior citizens by underwriting, marketing and selling our
products throughout the United States. We focus our marketing efforts primarily
in those states where we have successfully developed networks of agents and that
have the highest concentration of individuals whose financial status and
insurance needs are compatible with our products.
Agents. We market our products principally through independent agents. With
the exception of agents employed by our insurance agency subsidiaries, we do not
directly employ agents but instead rely on relationships with independent agents
and their sub-agents. We provide assistance to our agents through seminars,
underwriting training and field representatives who consult with agents on
underwriting matters, assist agents in research and accompany agents on
marketing visits to current and prospective policyholders.
14
Each independent agent must be authorized by contract to sell our products
in each state in which the agent and our companies are licensed. Some of our
independent agents are large general agencies with many sales-persons
(sub-agents), while others are individuals operating as sole proprietors. Some
independent agents sell multiple lines of insurance, while others concentrate
primarily or exclusively on accident and health insurance. We do not have
exclusive agency agreements with any of our independent agents and they are free
to sell policies of other insurance companies, including our competitors.
We generally do not impose production quotas or assign exclusive
territories to agents. The amount of insurance written for us by individual
independent agents varies. We periodically review and terminate our agency
relationships with non-producing or under-producing independent agents and
agents who do not comply with our guidelines and policies with respect to the
sale of our products.
We are actively engaged in recruiting and training new agents. Sub-agents
are recruited by the independent agents and are licensed by us with the
appropriate state regulatory authorities to sell our policies. Independent
agents are generally paid higher commissions than those employed directly by
insurance companies, in part to account for the expenses of operating as an
independent agent. We believe that the commissions we pay to independent agents
are competitive with the commissions paid by other insurance companies selling
similar policies. The independent agent's right to renewal commissions is vested
and commissions are paid as long as the policy remains in-force, provided the
agent continues to abide by the terms of the contract. We generally permit many
of our established independent agents to collect the initial premium with the
application and remit such premium to us less the commission. New independent
agents are required to remit the full amount of initial premium with the
application. We provide assistance to our independent agents in connection with
the processing of paperwork and other administrative services.
We have developed a proprietary agent sales system for long-term care
insurance, LTCWorks!, which enables agents to sell products utilizing
downloadable software. We believe that LTCWorks! increases the potential
distribution of our products by enhancing agents' ability to present the
products, assist policyholders in the application process and submit
applications over the Internet. LTCWorks! provides agents who specialize in the
regular sale of long-term care insurance products with a unique and easy to use
sales tool and enables agents who are less familiar with long-term care
insurance to present it when they are discussing other products such as life
insurance or annuities.
Marketing General Agents and General Agents. We selectively utilize
marketing general agents for the purpose of recruiting independent agents and
developing networks of agents in various states. Marketing general agents
receive an override commission on business written in return for recruiting,
training and motivating the independent agents. In addition, marketing general
agents may function as general agents for us in various states. No single
grouping of agents accounted for more than 10% of our new premiums or renewal
premiums written in 2001 or 2000. One agency accounted for 16% of total premiums
earned in 1999. We acquired a division of this agency during 2000, which reduced
our reliance on this unaffiliated agency. We have not delegated any underwriting
or claims processing authority to any agents.
Group and Franchise Insurance. We have recently begun to sell group
long-term care insurance to groups formed for purposes other than the purchase
of insurance, such as an employee group, an association or a professional
organization. A group master policy is issued to the group and all participating
members are issued certificates of insurance, which describe the benefits
available under the policy. Eligibility for insurance is guaranteed to all
members of the group without an underwriting review on an individual basis.
Group members, spouses and parents can generally purchase supplemental coverage
beyond the level paid by the group. This coverage is offered on an individually
underwritten basis.
We currently market our group products primarily through agents who market
products to individuals. However, we are in the process of developing a network
of agents who generally sell other group products, and who often have existing
relationships with employer groups, to market our group products. As of December
31, 2001, premiums in-force for our group products were approximately $4.0
million, covering 3,256 individuals. We believe our group products present an
opportunity to significantly increase the number of policies in-force without
paying significantly increased commissions.
15
From time to time, we also sell franchise insurance, which is a series of
individually underwritten policies sold to an association or group. While
franchise insurance is generally presented to groups that endorse the insurance,
policies are issued to individual group members. Each application is
underwritten and issuance of policies is not guaranteed to members of the
franchise group.
(d) Administration
Underwriting
We believe that the underwriting process through which we, as an accident
and health insurance company particularly in the long-term care segment, choose
to accept or reject an applicant for insurance is critical to our success. We
have offered long-term care insurance products for nearly 30 years and we
believe we have benefited significantly from our longstanding focus on this
specialized line. Through our experience with and focus on this niche product,
we have been able to establish a system of underwriting designed to permit us to
process our new business and assess the risk presented effectively and
efficiently.
Applicants for insurance must complete detailed medical questionnaires.
Physical examinations are not required for our accident and health insurance
policies, but medical records are frequently requested. All long-term care
applications are reviewed by our in-house underwriting department and all
applicants are also interviewed by members of our underwriting department via
telephone. This "personal history interview" is aimed at not only confirming the
information disclosed on the application, but also at gaining more insight into
the applicant's physical abilities, activity level and cognitive functioning. We
consider age, cognitive status and medical history, among other factors, in
deciding whether to accept an application for coverage and, if accepted, the
appropriate rate class for the applicant. With respect to medical history,
efforts are made to underwrite on the basis of the medical information listed on
the application, but an Attending Physician's Statement is often requested. We
also frequently use face-to-face assessments conducted in the applicant's home
by independent subcontractors (nurse networks). This evaluation is similar to
the personal history interview in terms of obtaining medical information and
information regarding the applicant's functional abilities, and it includes an
expanded cognitive test. We also use the Minnesota Cognitive Acuity Screening
test (formerly known as Cognistat) when a question of cognitive functioning
exists and is not adequately addressed by the other underwriting tools, or when
the possibility of cognitive problems is identified by one of the other
underwriting tools. In addition to age, cognitive status and medical history,
our underwriters are concerned with the applicant's abilities to perform the
activities of daily living. Our underwriting process extends beyond current
conditions, however, and takes into account how existing health conditions are
likely to progress and to what degree the independence of the applicant is
likely to change as the applicant ages.
We use table-based underwriting, or multiple rate classifications, as a
means to accept more business while obtaining the appropriate premiums for
additional risk. Applicants are placed in different risk classes for acceptance
and premium calculation based on medical conditions and level of activity during
the application process. We currently offer Premier, Select, Standard and
Secured risk classifications. If we determine that we cannot offer the requested
coverage, we may suggest an alternative product suitable for coverage for higher
risk applicants. Accepted policies are usually issued within seven working days
from receipt of the information necessary to underwrite the application.
Pre-existing conditions disclosed on an application for new long-term
nursing home care and most home health care policies are covered immediately
upon approval of the policy. Undisclosed pre-existing conditions are covered
after six months in most states and two years in certain other states. In
addition, our Independent Living policies immediately cover all disclosed
pre-existing conditions. In the case of individual Medicare supplement policies,
pre-existing conditions are generally not covered during the six-month period
following the effective date of the policy.
In group long-term care insurance, eligibility is guaranteed to all members
of the group without an underwriting review on an individual basis. However,
supplemental coverage offered to group members and their parents and spouses is
individually underwritten. Franchise insurance is a series of individually
underwritten policies sold to the members of an association or group. The
issuance of policies is not guaranteed to individual members of the franchise
group.
16
In conjunction with the development of our LTCWorks! system, we developed
an underwriting credit-scoring system, which provides consistent underwriting
and rate classification for applicants with similar medical histories and
conditions.
Claims
Claims for policy benefits, except with respect to Medicare supplement and
disability claims, are processed by our claims department, which includes nurses
employed or retained as consultants. We use third party administrators to
process our Medicare supplement claims due to the large number of claims and the
small benefit amount typically paid for each claim. Beginning in 1999, we also
engaged a third party administrator to perform all administration, including
claims processing, for our disability business.
For nursing home claims, upon notification of a claim, a personal claims
assistant is assigned to review all necessary documentation, including
verification of the facility where the claimant resides. A claims examiner
verifies eligibility of the claim under the policy. Every effort is made to
facilitate the processing of the claim, recognizing that this service efficiency
provides substantial value to the policyholder and his or her family. Toward
this end, the personal claims assistant verifies the continued residence of the
policyholder in the facility each month and expedites payment of the claim.
We periodically utilize the services of "care managers" to review certain
claims, particularly those filed under home health care policies. When a claim
is filed, we may engage a care manager to review the claim, including the
specific health problem of the insured and the nature and extent of health care
services being provided. This review may include visiting the claimant to assess
his or her condition. The care manager assists the insured and us by ensuring
that the services provided to the insured, and the corresponding benefits paid,
are appropriate under the circumstances. The care manager then follows the
claimant's progress with periodic contact to ensure that the plan of care
continues to be appropriate and that it is adjusted if warranted by improvement
in the claimant's condition.
Home care claims require the greatest amount of diligent overview and we
have utilized care management techniques for nearly ten years. Under the terms
of our Independent Living policy, we will waive the elimination period if the
insured agrees to utilize a care manager. Newer policies offer 100% claims
coverage if the claimant uses a care manager and provide up to 80% of the daily
benefit if care manager services are not used. The majority of all of our home
health care claims in 2001 were submitted to care management. We anticipate that
this usage will continue as our business grows.
In 1999, we created and staffed an in-house care management unit. This
in-house unit conducts the full range of care management services, which were
previously provided exclusively by subcontractors. We intend to continue to
develop this unit, as we believe it can meet many of our care management needs
more effectively and less expensively than third party vendors can.
Systems Operations
We maintain our own computer system for most aspects of our operations,
including policy issuance, billing, claims processing, commission reports,
premium production by agent (state and product) and general ledger. Critical to
our ongoing success is our ability to continue to provide the quality of service
for which we are known to our policyholders and agents. We believe that our
overall systems are an integral component in delivering that service. If we are
able to generate additional statutory capital, we intend to significantly expand
or enhance our existing system through a replacement project. The extent of the
project has not been determined, but we estimate that it would require a
substantial investment of funds and resources to replace our entire system. One
current proposal would cost approximately $4 million to $8 million over three
years.
In 2000, we entered an outsourcing agreement with a computer services
vendor, which thereby assumed responsibility for the majority of the daily
operations of our system, future program development and business continuity
planning. This vendor provides both in-house and external servicing of all
existing legacy systems and hardware. We believe that this vendor can provide
better expertise in the evolving arena of information technology than we can
provide by running our own operations.
17
(e) Premiums
Our long-term care policies provide for guaranteed renewability at then
current premium rates at the option of the insured. The insured may elect to pay
premiums on a monthly, quarterly, semi-annual or annual basis. In addition, we
offer an automatic payment feature that allows policyholders to have premiums
automatically withdrawn from a checking account.
Premium rates for all lines of insurance are subject to state regulation.
Premium regulations vary greatly among jurisdictions and lines of insurance.
Rates for our insurance policies are established with the assistance of our
independent actuarial consultants and reviewed by the insurance regulatory
authorities. Before a rate change can be made, the proposed change must be filed
with and, with respect to rates for individual policies, approved by the
insurance regulatory authorities in each state in which an increase is sought.
Regulators may not approve the increases we request, may approve them only with
respect to certain types of policies or may approve increases that are smaller
than those we request.
As a result of minimum statutory loss ratio standards imposed to state
regulations, the premiums on our accident and health polices are subject to
reduction and/or corrective measures in the event insurance regulatory agencies
in states where we do business determine that our loss ratios either have not
reached or will not reach required minimum levels. See "Government Regulation."
(f) Future Policy Benefits and Claims Reserves
We are required to maintain reserves equal to our probable ultimate
liability for claims and related claims expenses with respect to all policies
in-force. Reserves, which are computed with the assistance of an independent
firm of actuarial consultants, are established for:
o claims which have been reported but not yet paid;
o claims which have been incurred but not yet reported; and
o the discounted present value of all future policy benefits less the
discounted present value of expected future premiums.
The amount of reserves relating to reported and unreported claims incurred
is determined by periodically evaluating historical claims experience and
statistical information with respect to the probable number and nature of such
claims. We compare actual experience with estimates and adjust reserves on the
basis of such comparisons.
In addition to reserves for incurred claims, reserves are also established
for future policy benefits. The policy reserves represent the discounted present
value of future obligations that are likely to arise from the policies that we
underwrite, less the discounted present value of expected future premiums on
such policies. The reserve component is determined using generally accepted
actuarial assumptions and methods. However, the adequacy of these reserves rests
on the validity of the underlying assumptions that were used to price the
products; the more important of these assumptions relate to policy lapses, loss
ratios and claim incidence rates. We review the adequacy of our deferred
acquisition costs and reserves on an annual basis, utilizing assumptions for
future expected claims and interest rates. If we determine that future gross
profits of our in-force policies are not sufficient to recover our deferred
acquisition costs, we recognize a premium deficiency and "unlock" or change our
original assumptions and reset our reserves to appropriate levels using new
assumptions. The assumptions we use to calculate reserves for claims under our
long-term care products are based on our 29 years of significant claims
experience, primarily with respect to nursing home care products, and on the
experience of the industry as a whole.
We began offering home health care coverage in 1983 and since that time
have realized a significant increase in the number of home health care policies
written. Claims experience with home health care coverage is more limited than
the available nursing home care claims experience. Our experience with respect
to the Independent Living policy, which was first offered in November 1994, and
the Assisted Living and Personal Freedom policies, which were first offered in
late 1996, is more limited than our experience with skilled care facilities. We
believe that individuals may be more inclined to utilize home health care than
nursing home care, which is generally considered only after all other
possibilities have been explored. Accordingly, we believe that wide variations
in claims experience may be more likely in home health care insurance than in
nursing home insurance. Our actuarial consultants utilize both our experience
and other industry data in the computation of reserves for the home health care
product line.
18
In addition, newer long-term care products, developed as a result of
regulation or market conditions, may incorporate more benefits with fewer
limitations or restrictions. For instance, the Omnibus Budget Reconciliation Act
of 1990 required that Medicare supplement policies provide for guaranteed
renewability and waivers of pre-existing condition coverage limitations under
certain circumstances. In addition, the NAIC has recently adopted model
long-term care policy language providing nonforfeiture benefits and a rate
stabilization standard for long-term care policies, either or both of which may
be adopted by the states in which we write policies. The fluidity in market and
regulatory forces may limit our ability to rely on historical claims experience
for the development of new premium rates and reserve allocations. See
"Government Regulation."
We use an independent firm of actuarial consultants and an in-house actuary
to assist us in pricing insurance products and establishing reserves with
respect to those products. Additionally, actuaries assist us in improving the
documentation of our reserve methodology and in determining the adequacy of our
reserves and their underlying assumptions, a process that has resulted in
certain adjustments to our reserve levels. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Overview." Although
we believe that our reserves are adequate to cover all policy liabilities, we
cannot assure you that reserves are adequate or that future claims experience
will be similar to, or accurately predicted by, our past or current claims
experience.
As of December 31, 2001 and 2000, our reserves for current claims were
$214,466,000 and $164,565,000, respectively. In 2001, we added approximately
$8.8 million to our claim reserves for 2000 and prior claim incurrals, and in
2000 we added approximately $6.6 million to our claim reserves for 1999 and
prior claim incurrals. Our additions to prior year incurrals in 2001 resulted
from a continuance study performed by our consulting actuary. We also increased
reserves in 2001 by $1.6 million as a result of utilizing a lower interest rate
for the purpose of discounting our future liabilities. Over time, it may
continue to be necessary for us to increase our claim reserves.
Policy reserves have been computed principally by the net level premium
method based upon estimated future investment yield, mortality, morbidity,
withdrawals, premium rate increases and other benefits. The following table sets
forth the composition of our policy reserves at December 31, 2001 and 2000 and
the assumptions pertinent thereto:
Amount of Policy Reserves
as of December 31,
2001 2000
---- ----
Accident and health $ 382,660 $ 348,344
Annuities and other 131 118
Ordinary life, individual 13,255 12,947
Years of Issue Discount Rate Discount Rate
-------------- ------------- -------------
Accident and health 1976 to 1986 6.5% 7.0%
1987 6.5% 7.5%
1988 to 1991 6.5% 8.0%
1992 to 1995 6.5% 6.0%
1996 6.5% 7.0%
1997 to 2000 6.5% 6.8%
2001 6.5% 6.5%
Annuities and other 1977 to 1983 6.5% & 7.0% 6.5% & 7.0%
Ordinary life, individual 1962 to 2001 3.0% to 5.5% 3.0% to 5.5%
19
Basis of Assumption
Accident and health...........Morbidity and withdrawals based on actual and
projected experience.
Annuities and other...........Primarily funds on deposit inclusive of accrued
interest.
Ordinary life, individual.....Mortality based on 1955-60 Intercompany Mortality
Table Combined Select and Ultimate.
In 2001, the anticipated future gross profits of our in-force long-term
care business was not sufficient to recover our deferred acquisition costs,
resulting in the recognition of an impairment charge. In connection with this,
we unlocked our prior reserve assumptions due to our determination that certain
elements were insufficient to produce adequate future coverage of claims. These
assumptions include interest rates, premium rates, shock lapses and
anti-selection of policyholder persistence.
(g) Reinsurance
As is common in the insurance industry, we purchase reinsurance to increase
the number and size of the policies we may underwrite. Reinsurance is purchased
by insurance companies to insure their liability under policies written to their
insureds. By transferring, or ceding, certain amounts of premium (and the risk
associated with that premium) to reinsurers, we can limit our exposure to risk.
However, if a reinsurance company becomes insolvent or otherwise fails to honor
its obligations under any reinsurance agreements, we would remain fully liable
to the policyholder.
We reinsure any life insurance policy to the extent the risk on that policy
exceeds $50,000. We currently reinsure our ordinary life policies through
Reassurance Company of Hanover. We also have a reinsurance agreement with
Transamerica Occidental Life Insurance Company to reinsure term life policies
whose risk exceeds $15,000, and with Employer's Reassurance Corporation to
reinsure credit life policies whose risk exceeds $15,000.
We have ceded, through a fronting arrangement, 100% of certain whole life
and deferred annuity policies to Provident Indemnity Life Insurance Company. No
new policies have been ceded under this arrangement since December 31, 1995. We
also entered into a reinsurance agreement to cede 100% of certain life,
accident, health and Medicare supplement insurance policies to Life and Health
of America. These fronting arrangements are used when one insurer wishes to take
advantage of another insurer's ability to procure and issue policies. As the
fronting company, we remain ultimately liable to the policyholder, even though
all of our risk is reinsured. Therefore, the agreements require the maintenance
of securities in escrow for our benefit in the amount equal to our statutory
reserve credit.
We have also entered into a reinsurance agreement with Cologne Life
Reinsurance Company with respect to home health care policies with benefit
periods exceeding 36 months. No new policies have been reinsured under this
agreement since 1998.
We also enter into funds withheld financial reinsurance treaties, which
allow us to temporarily increase statutory surplus. Although these treaties
qualify for statutory accounting treatment as reinsurance, we believe that the
agreements do not qualify as reinsurance according to generally accepted
accounting principles. We commuted all existing financial reinsurance treaties,
effective December 31, 2001, which reduced statutory surplus by approximately
$20,000,000. At December 31, 2001 and 2000, our statutory surplus was increased
by $0 and approximately $20,000,000, respectively, from financial reinsurance.
We have stop-loss reinsurance on our disability business that limits our
liability in aggregate for the life of the policy or above monthly loss amounts.
This coverage is ceded to Employer's Reassurance Corporation, Reassurance
America Life Insurance Company and Lincoln National Life Insurance Company.
Since January 1, 2000, no new policies have been ceded to Employer's Reassurance
Corporation, which has historically provided the majority of our stop-loss
reinsurance.
In 2001, we ceded substantially all of our disability policies to Assurity
Life Insurance Company on a 100% quota share basis. The reinsurer may assume
ownership of the policies as a sale upon various state and policyholder
approvals. We received a ceding allowance of approximately $5,000,000 and ceded
reserves to the reinsurer of approximately $10,300,000.
20
Effective December 31, 2001, we entered a reinsurance transaction to
reinsure, on a quota share basis, substantially all of our respective long-term
care insurance policies then in-force. The agreement was entered with Centre
Solutions (Bermuda) Limited, which is rated A- by A.M. Best. The agreement is
subject to certain coverage limitations, including an aggregate limit of
liability, which is a function of certain factors and which may be reduce in the
event that the rate increases that the reinsurance agreement may require are not
obtained. The agreement meets the requirements to qualify as reinsurance for
statutory accounting, but not for generally accepted accounting principles. The
initial premium of the treaties is approximately $619,000,000, comprised of
$563,000,000 of cash and qualified securities transferred subsequent to December
31, 2001, and $56,000,000 held as funds due to the reinsurer. The initial
premium and future cash flows from the reinsured policies, less claims payments,
ceding commissions and risk charges, will be credited to a notional experience
account, which is held for our benefit in the event of commutation and recapture
on or after December 31, 2007. The notional experience account balance will
receive an investment credit based upon the total return of a series of
benchmark indices and hedges, which are designed to closely match the duration
of our reserve liabilities.
Pennsylvania insurance regulations require that funds ceded for reinsurance
provided by a foreign or "unauthorized" reinsurer must be secured by funds held
in a trust account or by a letter of credit for the protection of policyholders.
We received approximately $648,000,000 in statutory reserve credits from this
transaction as of December 31, 2001, of which $619,000,000 was held by us and
$29,000,000 was backed by letters of credit, which increased our statutory
surplus by $29,000,000 as well.
The agreements contain commutation provisions and allow us to recapture the
reserve liabilities and the current experience account balance as of December
31, 2007 or on December 31 of any year thereafter. We intend to commute the
treaty on December 31, 2007; therefore, we are accounting for the agreements in
anticipation of this commutation. In the event we do not commute the agreements
on December 31, 2007, we will be subject to escalating expenses.
The following table shows our historical use of reinsurance, excluding
financial reinsurance:
Reinsurance Recoverable
-----------------------
Company A.M. Best Rating December 31, 2001 December 31, 2000
- ------- ---------------- ----------------- -----------------
(in thousands)
General and Cologne Life Re of America A+ $10,365 $8,196
Assurity Life Insurance Company A- 8,403 -
Provident Indemnity Life Insurance Company NR3 4,362 4,643
Lincoln National Life Insurance Company (1) A 999 1,142
Employer's Reassurance Corporation (1) A++ 510 662
Reassure America Life Insurance Company (1) A++ 426 400
Life and Health of America B- 388 409
Transamerica Occidental Life Insurance Company A+ 30 1
Reassurance Company of Hanover A 15 11
Swiss Reassurance Life and Health America A++ 7 6
(1) We determine the amount of reinsurance recoverable in accordance with
GAAP on an aggregate basis for multiple companies that provide
reinsurance on our disability business. In order to segregate the risk
by reinsurer, we have listed the amount reported for Reassure
America Life Insurance Company and Lincoln National Life Insurance
Company for reserve credits as calculated under statutory accounting
principles as of December 31, 2001 and 2000. The amounts reported for
Employer's Reassurance Corporation include the net differences between
statutory and GAAP reporting for our disability reinsurance.
(h) Investments
Management has categorized the majority of our investment securities as
available for sale since they may be sold in response to changes in interest
rates, prepayments and similar factors. Investments in this category are
reported at their current market value with net unrealized gains and losses, net
of the applicable deferred income tax effect, being added to or deducted from
the Company's total shareholders' equity on the balance sheet. As of December
31, 2001, shareholders' equity was increased by $10,583,000 due to unrealized
gains of $16,032,000 in the investment portfolio. As of December 31, 2000,
shareholders' equity was decreased by $662,000 due to unrealized losses of
$1,005,000 in the investment portfolio.
21
In 2001, we classified our convertible bond portfolio as trading account
investments. Changes in trading account investment market values are recorded in
our statement of operations during the period in which the change occurs, rather
than as an unrealized gain or loss recorded directly through equity. We recorded
a trading account loss in 2001 of $3,428,000, which reflects the unrealized and
realized loss of our convertible portfolio that arose during the year ended
December 31, 2001. At December 31, 2001, we had liquidated our entire trading
portfolio.
We invest in securities and other investments authorized by applicable
state laws and regulations and follow an investment policy designed to maximize
yield to the extent consistent with liquidity requirements and preservation of
assets. We generally purchase fixed income securities with the expectation of
holding them until maturity. However, we classify these securities as available
for sale and have sold securities prior to their stated maturity, at either a
gain or loss.
We attempt to match the duration and cash flows of our investments to the
liquidity requirements of our liabilities. Although we have generally met our
cash flow requirements from operations, we expect that asset / liability
management will become increasingly important as future claims payments
increase.
Our investments are managed by three external firms: Davidson Capital
Management of Wayne, Pennsylvania, First Union National Bank of Charlotte, North
Carolina and Palisade Capital Management of Fort Lee, New Jersey.
Our investments, other than convertible securities (which were classified
as trading), are recorded at their current market value, with any unrealized
gains or losses recorded through shareholders' equity in the current reporting
period. The following table sets forth the mix of our investment portfolio and
the market value by investment segment for the periods ended December 31, 2001
and 2000.
December 31, 2001 December 31, 2000
----------------- -----------------
Amortized Estimated Amortized Estimated
Cost Market Value Cost Market Value
---- ------------ ---- ------------
(amounts in thousands)
U.S. Treasury securities
and obligations of U.S.
Government authorities
and agencies $ 164,712 $ 172,063 $ 120,691 $ 125,981
Obligations of states and
political sub-divisions 572 612 572 600
Mortgage backed securities 42,587 43,331 26,529 26,720
Debt securities issued by
foreign governments 11,954 12,089 15,817 15,549
Corporate securities 243,793 250,513 186,268 180,638
Equities 8,760 9,802 17,112 16,496
Policy Loans 181 181 142 142
---- ---- ---- ----
Total Investments $ 472,559 $ 488,591 $ 367,131 $ 366,126
========== ========== ========== =========
Net unrealized gain (loss) 16,032 (1,005)
------- -------
$ 488,591 $ 366,126
========= =========
22
As of December 31, 2001, 98% of our total investments were fixed income
debt securities, 40% of which were securities of the United States Government
(or its agencies or instrumentalities). The balance of our total investment
portfolio consisted substantially of publicly traded equity securities.
The following table shows the composition of the debt securities investment
portfolio (at carrying value), excluding short-term investments, by rating as of
December 31, 2001. Ratings are prepared by Moody's Debt Rating Service or
Standard & Poor's Rating Services.
Rating Amount Percent
------ ------ -------
(in thousands)
U.S. Treasury and U.S. Agency Securities..... $192,024 40.1%
Aaa or AAA................................... 34,282 7.2%
Aa or AA..................................... 75,782 15.8%
A............................................ 128,852 26.9%
BBB.......................................... 34,383 7.2%
Other or Not Rated........................... 13,285 2.8%
-------- ------
Total........................................ $478,608 100.0%
======== ======
Our investment policy is to purchase U.S. Treasury securities, U.S. agency
securities and investment-grade municipal and corporate securities with the
highest yield to maturity available, and to have 7% to 10% of our bond
investment portfolio mature each year. Our policy also limits high-yield
investments (those rated below "BBB-") to 5% percent of our total portfolio. We
may only purchase bonds rated "B" or higher. Certain investments may be unrated
or in the process of being rated. At December 31, 2001, our investment portfolio
contained no direct investments in real estate.
During 2001, we recognized impairment losses of approximately $5,800,000,
which we deemed to be other than temporary. During 2000, we recognized
impairment losses of approximately $3,200,000. These losses have been recorded
as realized losses in the consolidated income statement.
We have historically limited our investments in equity securities. At
December 31, 2001, we held common and preferred stock investments that
represented 2% of our total investments. We intend to limit our common and
preferred stock investments to 10% or less of our total investments.
The following table sets forth, for the periods indicated, certain
information concerning investment income, including dividend payments made on
common and preferred stock. The average yield calculation does not reflect the
impact upon market value of investments due to changes in market interest rates.
Year Ended December 31,
-----------------------
2001 2000 1999
---- ---- ----
(in thousands, except percentages)
Average balance of investments, cash
and cash equivalents during the period,
at cost (1).............................. $545,404 $441,300 $392,592
Net investment income.................... 30,613 27,408 22,619
Average yield on investments ............ 5.6% 6.2% 5.8%
- ---------------
(1) Average of average quarterly balances for all investable assets, including
bonds, equity securities, policy loans and cash; average quarterly balances
are averages of amounts at the beginning and end of the quarter.
23
At December 31, 2001, the duration of our bond portfolio was approximately
5.0 years. The following table sets forth the contractual maturity of our bond
portfolio, at amortized cost, by aggregate amount and as a percentage of our
bond portfolio. Actual maturities may differ from contractual maturities because
of the issuer's right to call or repay obligations, with or without call or
prepayment penalties.
Amortized Estimated
Cost Market Value
----------- ------------
Due in one year or less $ 7,969 $ 8,054
Due after one year through five years 145,916 149,582
Due after five years through ten years 234,452 244,114
Due after ten years 75,281 76,858
------------ ------------
$463,618 $478,608
============ ============
As of December 31, 2001, we had purchased approximately $50 million of
corporate owned life insurance ("COLI") from American General Life Insurance
Company of Houston, Texas in order to fund the long-term expense of our employee
benefit programs. COLI is not recorded as an investment but is reported as its
own financial statement category.
Effective December 31, 2001, we entered a reinsurance agreement to
reinsure, on a quota share basis, substantially all of our long-term care
insurance policies in-force. The transaction resulted in the transfer of
approximately $563,000,000 of cash and qualified securities to the reinsurer,
representing approximately 93% of our December 31, 2001 investment and cash
portfolio. The reinsurer will maintain a notional experience account, which
reflects the initial premium paid, future premiums collected net of claims,
expenses and accumulated investment earnings. The notional experience account
balance will receive an investment credit based upon the total return from a
series of benchmark indices and hedges that are intended to match the duration
of our reserve liability. Because we do not have controlling ownership of these
assets, periodic changes in the market values of the benchmark indices and
hedges will be recorded in our financial statements in the period in which they
occur. The investment credit rate represents a total return on a benchmark
portfolio, which subjects us to potential realized losses in our investment
income. As a result, we will likely experience significant increased volatility
in our future financial statements.
i) Selected Financial Information: Statutory Basis
The following table shows certain ratios derived from our insurance
regulatory filings with respect to our accident and health policies presented in
accordance with accounting principles prescribed or permitted by insurance
regulatory authorities ("SAP"), which differ from the presentation under
generally accepted accounting principles ("GAAP") and, which also differ from
the presentation under SAP for purposes of demonstrating compliance with
statutorily mandated loss ratios. See "Government Regulation."
Year ended December 31,
2001 2000 1999
---- ---- ----
Loss Ratio (1) (4) 154.4% 67.1% 70.4%
Expense ratio (2) (4) -201.3% 114.4% 44.1%
------- ------ -----
Combined loss and expense ratio -46.9% 181.5% 114.5%
Persistency (3) 88.0% 86.4% 86.7%
- -----------------
(1) Loss ratio is defined as incurred claims and increases in policy
reserves divided by collected premiums.
(2) Expense ratio is defined as commissions and expenses incurred divided
by collected premiums.
(3) Persistency represents the percentage of premiums renewed, which we
calculate by dividing the total annual premiums in-force at the end of
each year (less first year business for that year) by the total annual
premiums in-force for the prior year. For purposes of this
calculation, a decrease in total annual premiums in-force at the end
of any year would be a result of non-renewal policies, including those
policies that have terminated by reason of death, lapse due to
nonpayment of premiums and/or conversion to other policies offered by
us.
24
(4) The 2001, 2000 and 1999 loss ratios and expense ratios are
significantly affected by the reinsurance of approximately
$408,093,000, $225,741,000 and $90,230,000, respectively, in premium
on a statutory basis under financial and other reinsurance treaties .
reserves are accounted for as offsetting negative benefits and
negative premium, causing substantial deviation in reported ratios.
Statutory accounting practices. As long-term care insurers, our insurance
subsidiaries are required by state insurance regulation to have statutory
surplus, which is calculated differently than under GAAP, at a sufficient level
to support existing policies as well as new business growth. Under SAP, costs
associated with sales of new policies must be charged to earnings as incurred.
Because these costs, together with required reserves, generally exceed first
year premiums, statutory surplus may be reduced during periods of increasing
first year sales. The commissions paid to agents on new business production are
generally higher for new business than for renewing policies. Because statutory
accounting requires commissions to be expensed as paid, rapid growth in first
year business generally results in higher expense ratios.
Effective December 31, 2001, we entered a reinsurance transaction that,
according to Pennsylvania insurance regulation, required the reinsurer to
provide us with letters of credit in order for us to receive statutory reserve
and surplus credit from the reinsurance. The letters of credit were dated
subsequent to December 31, 2001, as a result of the final closing of the
agreement. In addition, the initial premium paid for the reinsurance included
investment securities carried at amortized cost but valued at market price for
purposes of the premium transfer and the experience account. The Pennsylvania
Insurance Department permitted us to receive credit of $29,000,000 for the
letters of credit, and to accrue the anticipated, yet unknown, gain of
$18,000,000 from the sale of securities at market value, in our statutory
financial results for December 31, 2001. The impact of this permitted practice
served to increase the statutory surplus of our insurance subsidiaries by
approximately $47,000,000 at December 31, 2001. Had we not been granted a
permitted practice, our statutory surplus would have been negative until the
first quarter 2002 reporting period, when a permitted practice would no longer
be required due to our receipt of the letters of credit prior to March 31, 2002.
Minimum loss ratios. Mandated loss ratios are calculated in a manner
intended to provide adequate reserving for the long-term care insurance risks,
using statutory lapse rates and certain assumed interest rates. The statutorily
assumed interest rates differ from those used in developing reserves under GAAP.
For this reason, statutory loss ratios differ from loss ratios reported under
GAAP. Mandatory statutory loss ratios also differ from loss ratios reported on a
current basis under SAP for purposes of our annual and quarterly state insurance
filings. The states in which we are licensed have the authority to change these
minimum ratios and to change the manner in which these ratios are computed and
the manner in which compliance with these ratios is measured and enforced. We
are unable to predict the impact of (1) the imposition of any changes in the
mandatory statutory loss ratios for individual or group long-term care policies
to which we may become subject, (2) any changes in the minimum loss ratios for
individual or group long-term care or Medicare supplement policies, or (3) any
change in the manner in which these minimums are computed or enforced in the
future. We have not been informed by any state that our subsidiaries do not meet
mandated minimums, and we believe we are in compliance with all such minimum
ratios. In the event the we are not in compliance with minimum statutory loss
ratios mandated by regulatory authorities with respect to certain policies, we
may be required to reduce or refund our premiums on such policies.
(j) Insurance Industry Rating Agencies
Our subsidiaries have A.M. Best ratings of "B- (fair)" and Standard &
Poor's ratings of "B- (weak)." A.M. Best and Standard & Poor's ratings are based
on a comparative analysis of the financial condition and operating performance
for the prior year of the companies rated, as determined by their publicly
available reports. A.M. Best's classifications range from "A++ (superior)" to "F
(in liquidation)." Standard & Poor's ratings range from "AAA (extremely strong)"
to "CC (extremely weak)." A.M. Best and Standard & Poor's ratings are based upon
factors of concern to policyholders and insurance agents and are not directed
toward the protection of investors and are not recommendations to buy, hold or
sell a security. In evaluating a company's financial and operating performance,
the rating agencies review profitability, leverage and liquidity, as well as
book of business, the adequacy and soundness of reinsurance, the quality and
estimated market value of assets, the adequacy of reserves and the experience
and competence of management.
Certain distributors will not sell our group products unless we have a
financial strength rating of at least an "A-." The inability of our subsidiaries
to obtain higher A.M. Best or Standard & Poor's ratings could adversely affect
the sales of our products if customers favor policies of competitors with better
ratings. In addition, a downgrade in our ratings may cause our policyholders to
allow their existing policies to lapse. Increased lapsation would reduce our
premium income and would also cause us to expense fully the deferred policy
costs relating to lapsed policies in the period in which those policies lapsed.
Recent downgrades or further downgrades in our ratings also may lead some
independent agents to sell less of our products or to cease selling our policies
altogether.
25
(k) Competition
We operate in a highly competitive industry. We believe that competition is
based on a number of factors, including service, products, premiums, commission
structure, financial strength, industry ratings and name recognition. We compete
with a large number of national insurers, smaller regional insurers and
specialty insurers, many of whom have considerably greater financial resources,
higher ratings from A.M. Best and Standard and Poor's and larger networks of
agents than we do. Many insurers offer long-term care policies similar to those
we offer and utilize similar marketing techniques. In addition, we are subject
to competition from insurers with broader product lines. We also may be subject,
from time to time, to new competition resulting from changes in Medicare
benefits, as well as from additional private insurance carriers introducing
products similar to those offered by us.
We also actively compete with other insurers in attracting and retaining
agents to distribute our products. Competition for agents is based on quality of
products, commission rates, underwriting, claims service and policyholder
service. We continuously recruit and train independent agents to market and sell
our products. We also engage marketing general agents from time to time to
recruit independent agents and develop networks of agents in various states. Our
business and ability to compete may suffer if we are unable to recruit and
retain insurance agents and if we lose the services provided by our marketing
general agents.
We also compete with non-insurance financial services companies such as
banks, securities brokerage firms, investment advisors, mutual fund companies
and other financial intermediaries marketing insurance products, annuities,
mutual funds and other retirement-oriented investments. The Gramm-Leach-Bliley
Financial Services Modernization Act of 1999 ("Gramm-Leach-Bliley Act")
implemented fundamental changes in the regulation of the financial services
industry, permitting mergers that combine commercial banks, insurers and
securities firms under one holding company. The ability of banks to affiliate
with insurers may adversely affect our ability to remain competitive.
The insurance industry may undergo further change in the future and,
accordingly, new products and methods of service may also be introduced. In
order to keep pace with any new developments, we may need to expend significant
capital to offer new products and to train our agents and employees to sell and
administer these products and services. Our ability to compete with other
insurers depends on our success in developing new products.
(l) Government Regulation
Insurance companies are subject to supervision and regulation in all states
in which they transact business. We are registered and approved as a holding
company under the Pennsylvania Insurance Code. Our insurance company
subsidiaries are chartered in the states of Pennsylvania and New York. We are
currently licensed in all states and the District of Columbia.
The extent of regulation of insurance companies varies, but generally
derives from state statutes which delegate regulatory, supervisory and
administrative authority to state insurance departments. Although many states'
insurance laws and regulations are based on models developed by the National
Association of Insurance Commissioners, 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 states, and variation from the model laws within states is common.
The Pennsylvania Insurance Department, the New York Insurance Department
and the insurance regulators in other jurisdictions have broad administrative
and enforcement powers relating to the granting, suspending and revoking of
licenses to transact insurance business, the licensing of agents, the regulation
of premium rates and trade practices, the content of advertising material, the
form and content of insurance policies and financial statements and the nature
of permitted investments. In addition, regulators have the power to require
insurance companies to maintain certain deposits, capital, surplus and reserve
levels calculated in accordance with prescribed statutory standards. The NAIC
has developed minimum capital and surplus requirements utilizing certain
risk-based factors associated with various types of assets, credit, underwriting
and other business risks. This calculation, commonly referred to as RBC, serves
as a benchmark for the regulation of insurance company solvency by state
insurance regulators. The primary purpose of such supervision and regulation is
the protection of policyholders, not investors. See "Selected Financial
Information - Statutory Basis."
26
Most states mandate minimum benefit standards and loss ratios for long-term
care insurance policies and for other accident and health insurance policies.
Most states have adopted the NAIC's proposed standard minimum loss ratios of 65%
for individual Medicare supplement policies and 75% for group Medicare
supplement policies. A significant number of states, including Pennsylvania and
Florida, also have adopted the NAIC's proposed minimum loss ratio of 60% for
both individual and group long-term care insurance policies. Certain states,
including New Jersey and New York, have adopted a minimum loss ratio of 65% for
long-term care. The states in which we are licensed have the authority to change
these minimum ratios, the manner in which these ratios are computed and the
manner in which compliance with these ratios is measured and enforced.
On an annual basis, the Pennsylvania Insurance Department and the New York
Insurance Department are provided with a calculation prepared by our consulting
actuaries regarding compliance with required minimum loss ratios for Medicare
supplement and credit policies. This report is made available to all states.
Although certain other policies (e.g., nursing home and hospital care policies)
also have specific mandated loss ratio standards, there presently are no similar
reporting requirements in the states in which we do business for such other
policies.
In December 1986, the NAIC adopted the Long-Term Care Insurance Model Act
("Model Act"), which was adopted to promote the availability of long-term care
insurance policies, to protect applicants for such insurance and to facilitate
flexibility and innovation in the development of long-term care coverage. The
Model Act establishes standards for long-term care insurance, including
provisions relating to disclosure and performance standards for long-term care
insurers, incontestability periods, nonforfeiture benefits, severability,
penalties and administrative procedures. Model regulations were also developed
by the NAIC to implement the Model Act. Some states have also adopted standards
relating to agent compensation for long-term care insurance. In addition, from
time to time, the federal government has considered adopting standards for
long-term care insurance policies, but it has not enacted any such legislation
to date.
Some state legislatures have adopted proposals to limit rate increases on
long-term care insurance products. In the past, we have been generally
successful in obtaining rate increases when necessary. We currently have rate
increases on file with various state insurance departments and anticipate that
increases on other products may be required in the future. If we are unable in
the future to obtain rate increases, or in the event of legislation limiting
rate increases, we believe it would have a negative impact on our future
earnings.
In September 1996, Congress enacted the Health Insurance Portability and
Accountability Act ("HIPAA"), which permits premiums paid for eligible long-term
care insurance policies after December 31, 1996 to be treated as deductible
medical expenses for federal income tax purposes. The deduction is limited to a
specified dollar amount ranging from $200 to $2,500, with the amount of the
deduction increasing with the age of the taxpayer. In order to qualify for the
deduction, the insurance contract must, among other things, provide for
limitations on pre-existing condition exclusions, prohibitions on excluding
individuals from coverage based on health status and guaranteed renewability of
health insurance coverage. Although we offer tax-deductible policies, we will
continue to offer a variety of non-deductible policies as well. We have
long-term care policies that qualify for tax exemption under HIPAA in all states
in which we are licensed.
In 1998, the NAIC adopted the Codification of Statutory Accounting
Principles ("Codification") guidance, which replaced the current Accounting
Practices and Procedures manual as the NAIC's primary guidance on statutory
accounting as of January 1, 2001. The Codification provides guidance for areas
where statutory accounting has been silent and changes current statutory
accounting in some areas, including the recognition of deferred income taxes.
The Pennsylvania and New York Insurance Departments have adopted the
Codification guidance, effective January 1, 2001. The Codification guidance
serves to reduce the insurance subsidiaries' surplus, primarily due to certain
limitations on the recognition of goodwill and EDP equipment and the recognition
of other than temporary declines in investments. In 2001, our statutory surplus
was reduced by approximately $2,000 as a result of the Codification guidance.
These reductions are partially offset by certain other items, including the
recognition of deferred tax assets subject to certain limitations.
27
We are also subject to the insurance holding company laws of Pennsylvania
and of the other states in which we are licensed to do business. These laws
generally require insurance holding companies and their subsidiary insurers to
register and file certain reports, including information concerning their
capital structure, ownership, financial condition and general business
operations. Further, states often require prior regulatory approval of changes
in control of an insurer and of intercompany transfers of assets within the
holding company structure. The Pennsylvania Insurance Department and the New
York Insurance Department must approve the purchase of more than 10% of the
outstanding shares of our common stock by one or more parties acting in concert,
and may subject such party or parties to the reporting requirements of the
insurance laws and regulations of Pennsylvania and New York and to the prior
approval and/or reporting requirements of other jurisdictions in which we are
licensed. In addition, our officers, directors and 10% shareholders and those of
our insurance subsidiaries are subject to the reporting requirements of the
insurance laws and regulations of Pennsylvania and New York, as the case may be,
and may be subject to the prior approval and/or reporting requirements of other
jurisdictions in which they are licensed.
Under Pennsylvania law, public utilities and their affiliates,
subsidiaries, officers and employees may not be licensed or admitted as
insurers. If any public utility or affiliate, subsidiary, officer or employee of
any public utility acquires 5% or more of the outstanding shares of our common
stock, such party may be deemed to be an affiliate, in which event our
Certificate of Authority to do business in Pennsylvania may be revoked upon a
determination by the Pennsylvania Insurance Department that such party exercises
effective control over us. Although several entities own more than 5% of our
common stock, no public utility or affiliate, subsidiary, officer or employer of
any public utility holds sufficient voting authority to exercise effective
control over us.
States also restrict the dividends our insurance subsidiaries are permitted
to pay. Dividend payments will depend on profits arising from the business of
our insurance company subsidiaries, computed according to statutory formulae.
Under the insurance laws of Pennsylvania and New York, insurance companies can
pay dividends only out of surplus. In addition, Pennsylvania law requires each
insurance company to give 30 days advance notice to the Pennsylvania Insurance
Department of any planned extraordinary dividend (any dividend paid within any
twelve-month period which exceeds the greater of (1) 10% of an insurer's surplus
as shown in its most recent annual statement filed with the Insurance Department
or (2) its net gain from operations, after policyholder dividends and federal
income taxes and before realized gains or losses, shown in such statement) and
the Insurance Department may refuse to allow it to pay such extraordinary
dividends. Our Corrective Action Plan also requires the approval of the
Pennsylvania Insurance Department of all dividends. Under New York law, our New
York insurance subsidiary must give the New York Insurance Department 30 days'
advance notice of any proposed etraordinary dividend and cannot pay any dividend
if the regulator disapproves the payment during that 30-day period.
In addition, our New York insurance company must obtain the prior approval
of the New York Insurance Department before paying any dividend that, together
with all other dividends paid during the preceding twelve months, exceeds the
lesser of 10% of the insurance company's surplus as of the preceding December 31
or its adjusted net investment income for the year ended the preceding December
31. In 2002, we received a dividend from our New York subsidiary of $651,000.
The dividend proceeds were used for parent company liquidity needs.
We believe that, other than our New York subsidiary, none of our insurance
subsidiaries are eligible to make dividend payments to the parent company in
2002.
Periodically, the federal government has considered adopting a national
health insurance program. Although it does not appear that the federal
government will enact an omnibus health care reform law in the near future, the
passage of such a program could have a material impact upon our operations. In
addition, legislation enacted by Congress could impact our business. Among the
proposals are the implementation of certain minimum consumer protection
standards for inclusion in all long-term care policies, including guaranteed
renewability, protection against inflation and limitations on waiting periods
for pre-existing conditions. These proposals would also prohibit "high pressure"
sales tactics in connection with long-term care insurance and would guarantee
consumers access to information regarding insurers, including lapse and
replacement rates for policies and the percentage of claims denied. As with any
pending legislation, it is possible that any laws finally enacted will be
substantially different from the current proposals. Accordingly, we are unable
to predict the impact of any such legislation on our business and operations.
28
Compliance with multiple federal and state privacy laws may affect our
profits. Congress enacted the Gramm-Leach-Bliley Financial Services
Modernization Act in November 1999. Federal agencies have adopted regulations to
implement this legislation. The Gramm-Leach-Bliley Act empowers states to adopt
their own measures to protect the privacy of consumers and customers of insurers
that are covered by the Gramm-Leach-Bliley Act, so long as those protections are
at least as stringent as those required by the Gramm-Leach-Bliley Act. If states
do not enact their own insurance privacy laws or adopt regulations, the privacy
requirements of the Gramm-Leach-Bliley Act will apply to insurers, although no
enforcement mechanism has yet been adopted for insurers. The Department of
Health and Human Services has adopted privacy rules, which will also apply to at
least some of our products. The NAIC has adopted the Insurance Information and
Privacy Model Act, but no state has yet adopted this model act. Individual state
insurance regulators have indicated that their states may adopt privacy laws or
regulations that are more stringent than the NAIC's model act and those provided
for under federal law. Compliance with different laws in states where we are
licensed could prove extremely costly.
We monitor economic and regulatory developments that have the potential to
impact our business. Recently enacted federal legislation will allow banks and
other financial organizations to have greater participation in securities and
insurance businesses. This legislation may present an increased level of
competition for sales of our products. Furthermore, the market for our products
is enhanced by the tax incentives available under current law. Any legislative
changes that lessen these incentives could negatively impact the demand for
these products.
(m) Employees
As of December 31, 2001, we had 303 full-time employees (not including
independent agents). We are not a party to any collective bargaining agreements.
Item 2. Properties
Our principal offices in Allentown, Pennsylvania occupy two buildings,
totaling approximately 30,000 square feet of office space in a 40,000 square
foot building and all of an 8,000 square foot building. We own both buildings
and a 2.42 acre undeveloped parcel of land located across the street from our
home offices. We also lease additional office space in Michigan and New York.
Item 3. Legal Proceedings
Our subsidiaries are parties to various lawsuits generally arising in the
normal course of their business. We do not believe that the eventual outcome of
any of the suits to which we are party will have a material adverse effect on
our financial condition or results of operations. However, the outcome of any
single event could have a material impact upon the quarterly or annual financial
results of the period in which it occurs.
The Company and certain of our key executive officers are defendants in
consolidated actions that were instituted on April 17, 2001 in the United States
District Court for the Eastern District of Pennsylvania by shareholders of the
Company, on their own behalf and on behalf of a putative class of similarly
situated shareholders who purchased shares of the Company's common stock between
July 23, 2000 through and including March 29, 2001. The consolidated amended
class action complaint seeks damages in an unspecified amount for losses
allegedly incurred as a result of misstatements and omissions allegedly
contained in our periodic reports filed with the SEC, certain press releases
issued by us, and in other statements made by our officials. The alleged
misstatements and omissions relate, among other matters, to the statutory
capital and surplus position of our largest subsidiary, Penn Treaty Network
America Insurance Company. On December 7, 2001, the defendants filed a motion to
dismiss the complaint, which is currently pending. We believe that the complaint
is without merit, and we will continue to vigorously defend the matter.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted during the fourth quarter of the fiscal year
ended December 31, 2001 to a vote of security holders.
29
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Our common stock is traded on the New York Stock Exchange under the symbol
"PTA." The following table indicates the high and low closing prices of our
common stock as reported on the New York Stock Exchange during the periods
indicated.
High Low
---- ---
2001
1st Quarter $ 19.56 $ 10.17
2nd Quarter $ 8.85 $ 2.20
3rd Quarter $ 4.18 $ 2.21
4th Quarter $ 6.35 $ 2.70
2000
1st Quarter $ 17.69 $ 12.31
2nd Quarter $ 19.94 $ 13.13
3rd Quarter $ 18.56 $ 14.94
4th Quarter $ 21.25 $ 15.88
We have never paid any cash dividends on our common stock and do not intend
to do so in the foreseeable future. It is our present intention to retain any
future earnings to support the continued growth of our business. Any future
payment of dividends is subject to the discretion of the board of directors and
is dependency, in part, on any dividends we may receive from our subsidiaries.
The payment of dividends by our subsidiaries is dependent on a number of
factors, including their respective earnings and financial condition, business
needs and capital and surplus requirements, and is also subject to certain
regulatory restrictions and the effect that such payment would have on their
financial strength ratings. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity and Capital Resources,"
"Business--Insurance Industry Rating Agencies" and "Business--Government
Regulation."
30
Item 6. Selected Financial Data
The following selected consolidated statement of operations data and
balance sheet data as of and for the years ended December 31, 2001, 2000, 1999,
1998 and 1997, have been derived from our Consolidated GAAP Financial
Statements.
2001 2000 1999 1998 1997
--------- --------- --------- --------- ---------
(in thousands, except per share data and ratio)
Statement of Operations Data:
Revenues:
Total premiums $ 350,391 $ 357,113 $ 292,516 $ 223,692 $ 167,680
Net investment income 30,613 27,408 22,619 20,376 17,009
Net realized (losses) gains (7,795) 652 5,393 9,209 1,417
Other income 9,208 8,096 6,297 885 417
--------- --------- --------- --------- ---------
Total revenues 382,417 393,269 326,825 254,162 186,523
--------- --------- --------- --------- ---------
Benefits and expenses:
Benefits to policyholders (1) 239,155 243,571 200,328 154,300 123,865
Commissions 76,805 102,313 96,752 80,273 55,240
Net acquisition costs amortized (deferred) (2) 9,860 (43,192) (51,134) (46,915) (28,294)
Impairment of net unamortized policy
acquisition costs (3) 61,800 -- -- -- --
General and administrative expenses 49,282 49,973 40,736 26,069 20,614
Excise tax expense (4) 5,635 -- -- -- --
Loss due to impairment of property
and equipment (5) -- -- 2,799 -- --
Change in reserve for claim litigation (250) 1,000 -- -- --
Interest expense 4,999 5,134 5,187 4,809 4,804
--------- --------- --------- --------- ---------
Total benefits and expenses 447,286 358,799 294,668 218,536 176,229
--------- --------- --------- --------- ---------
(Loss) income before federal income taxes (64,869) 34,470 32,157 35,626 10,294
(Benefit) provision for federal income taxes (16,280) 11,720 10,837 11,578 2,695
--------- --------- --------- --------- ---------
Net (loss) income $ (48,589) $ 22,750 $ 21,320 $ 24,048 $ 7,599
========= ========= ========= ========= =========
Basic earnings per share $ (3.41) $ 3.13 $ 2.83 $ 3.17 $ 1.01
========= ========= ========= ========= =========
Diluted earnings per share $ (3.41) $ 2.61 $ 2.40 $ 2.64 $ 0.98
========= ========= ========= ========= =========
Weighted average shares outstanding (6) 14,248 7,279 7,533 7,577 7,540
Weighted average diluted shares outstanding (7) 14,248 9,976 10,293 10,402 7,758
Balance Sheet Data:
Total investments $ 488,591 $ 366,126 $ 373,001 $ 338,889 $ 301,787
Total assets 940,367 856,131 697,639 580,552 465,772
Total debt (8) 79,190 81,968 82,861 76,550 76,752
Shareholders' equity 192,796 188,062 158,685 157,670 132,756
Book value per share $ 10.24 $ 25.81 $ 21.81 $ 20.79 $ 17.53
Other Supplemental Data:
Net operating income (9) $ 6,838 $ 23,180 $ 19,600 $ 17,832 $ 6,553
Net operating income excluding
goodwill amortization (10) $ 7,691 $ 24,034 $ 20,259 $ 18,043 $ 6,784
GAAP Ratios:
Loss ratio 68.3% 68.2% 68.5% 69.0% 73.9%
Expense ratio (11) 59.0% 32.0% 31.3% 28.7% 31.2%
--------- --------- --------- --------- ---------
Total 127.3% 100.2% 99.8% 97.7% 105.1%
========= ========= ========= ========= =========
Return on average equity (12) (25.5%) 13.1% 13.5% 16.6% 6.0%
Selected Statutory Data:
Net premiums written (13) $ (64,689) $ 130,676 $ 208,655 $ 143,806 $ 167,403
Statutory surplus (beginning of
period) $ 30,137 $ 67,070 $ 76,022 $ 67,249 $ 81,795
Ratio of net premiums written to
statutory surplus (2.2)x 1.9x 2.7x 2.1x 2.0x
31
Notes to Selected Financial Data (in thousands)
(1) In 1997, we added approximately $12,000 to our reserves as a result of our
reassessment of assumptions utilized in the actuarial determination of our
claims reserves. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
(2) Effective September 10, 2001, we discontinued the sale, nationally, of all
new long-term care insurance policies until our Corrective Action Plan was
completed and approved by the Pennsylvania Insurance Department. As a
result, we did not defer the costs associated with new policy issuance and
recognized only the amortization of existing deferred acquisition costs. In
addition, we recognized approximately $10,000 in additional amortization
expense when we unlocked our factors during the second quarter of 2001. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
(3) Effective December 31, 2001, we entered a reinsurance agreement for
substantially all of our long-term care insurance policies. The agreement
requires us to pay an annual expense and risk charge to the reinsurer in
the event we later commute the agreement. As a result of these anticipated
charges, we determined to impair the value of our net unamortized policy
acquisition costs by $61,500.
(4) As a result of our December 31, 2001 reinsurance agreement with a foreign
reinsurer, we must pay federal excise tax of 1% on all ceded premium. The
2001 expense represents excise taxes due for premiums transferred at the
inception of the contract.
(5) During 1999, we discontinued the implementation of a new computer system,
for which we had previously capitalized $2,799 of licensing, consulting and
software costs. When we decided not to use this system, its value became
fully impaired. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
(6) On May 25, 2001, we issued approximately 11,047 new common shares of our
common stock, for net proceeds of $25,726, through an investor rights
offering.
(7) Diluted shares outstanding includes shares issuable upon the conversion of
our convertible debt and exercise of options outstanding, except in 2001,
for which the inclusion of such shares would be anti-dilutive.
(8) In 1996, we issued $74,750 in convertible debt, due December 2003. In 1999,
we purchased an agency for cash and a note for $7,167 payable in
installments through January 2002. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Liquidity and
Capital Resources."
(9) Net operating income excludes the effect, net of taxes, of (1) net realized
gains and losses from the sale of our investments in debt and equity
securities in all years and trading account losses, (2) our 1999 property
and equipment impairment charge, (3) our 2001 DAC impairment charge and
excise tax expense and (4) our tax valuation allowance in 2001. Net
operating income is not calculated in accordance with GAAP. It should not
be considered in isolation or as a substitute for net income calculated in
accordance with GAAP. Different companies calculate net operating income
differently and therefore net operating income as presented for us may not
be comparable to net operating income reported by other companies.
(10) Net operating income excluding goodwill amortization excludes the effect,
net of taxes, of amortization of goodwill. This amount is not calculated in
accordance with GAAP. It should not be considered in isolation or as a
substitute for net income calculated in accordance with GAAP. Different
companies calculate net operating income differently and therefore net
operating income as presented for us may not be comparable to net operating
income reported by other companies.
(11) Expense ratios exclude the impact of reduced commissions and increased
general and administrative expenses resulting from the 1999 and 2000
acquisitions of our agency subsidiaries. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
(12) Return on average equity is calculated by dividing net income by the
average of equity at the beginning and end of each period.
(13) Under statutory accounting principles, ceded reserves are accounted for as
offsetting negative benefits and negative premium. Our 2001, 2000 and 1999
premium is reduced by $408,093, $225,741 and $90,230, respectively from
reinsurance transactions.
32
Quarterly Data
Our unaudited quarterly data for each quarter of 2001 and 2000 has been
derived from unaudited financial statements and include all adjustments,
consisting only of normal recurring accruals, which we consider necessary for a
fair presentation of the results of operations for these periods. Such quarterly
operating results are not necessarily indicative of our future results of
operations.
The following table presents unaudited quarterly data for each quarter of
2001 and 2000.
2001
---------------------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
--------- --------- --------- ---------
(in thousands, except per share data and ratios)
Total premiums $ 96,019 $ 90,039 $ 80,588 $ 83,745
Net investment income 6,725 7,185 8,571 8,132
Net realized capital gains and losses and
other income (889) 3,476 728 (1,902)
--------- --------- --------- ---------
Total revenues 101,855 100,700 89,887 89,975
--------- --------- --------- ---------
Benefits to policyholders 72,137 60,235 47,220 59,563
Commissions and expenses 37,372 33,793 27,999 32,308
Net acquisition costs amortized (deferred) (5,397) 1,750 7,255 68,052
--------- --------- --------- ---------
Net (loss) income $ (2,336) $ 2,430 $ 4,075 $ (52,759)
========= ========= ========= =========
GAAP loss ratio 75.1% 66.9% 58.6% 71.1%
GAAP expense ratio (excluding interest) 33.3% 39.5% 43.7% 119.8%
--------- --------- --------- ---------
Total 108.4% 106.4% 102.3% 191.0%
========= ========= ========= =========
2000
---------------------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
--------- --------- --------- ---------
(in thousands, except per share data and ratios)
Total premiums $ 86,038 $ 86,825 $ 91,963 $ 92,287
Net investment income 6,161 6,636 6,874 7,737
Net realized capital gains and losses and
other income 4,293 808 2,886 761
--------- --------- --------- ---------
Total revenues 96,492 94,269 95,352 94,401
--------- --------- --------- ---------
Benefits to policyholders 59,911 59,488 61,120 63,052
Commissions and expenses 37,859 38,347 38,167 38,913
Net acquisition costs deferred (10,890) (12,090) (9,111) (11,101)
--------- --------- --------- ---------
Net income $ 5,491 $ 4,788 $ 6,776 $ 5,696
========= ========= ========= =========
GAAP loss ratio 69.6% 68.5% 66.5% 68.3%
GAAP expense ratio (excluding interest) 31.3% 30.2% 31.6% 30.1%
--------- --------- --------- ---------
Total 101.0% 98.8% 98.1% 98.5%
========= ========= ========= =========
33
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following table sets forth the components of our condensed statements
of operations for the years ended December 31, 2001, 2000 and 1999, expressed as
a percentage of total revenues.
Year Ended December 31,
----------------------------
2001 2000 1999
---- ---- ----
Statement of Operations Data:
Revenues:
Total premiums 91.6% 90.8% 89.5%
Net investment income 8.0% 6.9% 6.9%
Net realized (losses) gains -2.0% 0.2% 1.7%
Other income 2.4% 2.1% 1.9%
---- ---- ----
Total revenues 100.0% 100.0% 100.0%
------ ------ ------
Benefits and expenses:
Benefits to policyholders 62.5% 61.9% 61.3%
Commissions 20.1% 26.0% 29.6%
Net policy acquisition costs
amortized (deferred) 18.7% -11.0% -15.6%
General and administrative expense 14.3% 13.0% 13.3%
Interest expense 1.4% 1.3% 1.6%
---- ---- ----
Total benefits and expenses 117.0% 91.2% 90.2%
------ ----- -----
(Loss) income before federal income taxes -17.0% 8.8% 9.8%
(Benefit) provision for federal income taxes -4.3% 3.0% 3.3%
----- ---- ----
Net (loss) income -12.7% 5.8% 6.5%
====== ==== ====
34
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview (amounts in thousands)
Our principal products are individual, defined benefit accident and health
insurance policies that consist of nursing home care, home health care, Medicare
supplement and long-term disability insurance. We experienced significant
reductions in new premium sales during 2001 due to the cessation of new business
generation in all states and as a result of market concerns regarding our
insurance subsidiaries' statutory surplus. Under our Corrective Action Plan,
which was recently approved by the Pennsylvania Insurance Department (the
"Department"), we intend to limit new business growth to levels that will allow
us to maintain sufficient statutory surplus. Our underwriting practices rely
upon the base of experience that we have developed in over 29 years of providing
nursing home care insurance, as well as upon available industry and actuarial
information. As the home health care market has developed, we have encouraged
our customers to purchase both nursing home and home health care coverage, thus
providing our insureds with enhanced protection and broadening our policy base.
Our insurance subsidiaries are subject to the insurance laws and
regulations of the states in which they are licensed to write insurance. These
laws and regulations govern matters such as payment of dividends, settlement of
claims and loss ratios. State regulatory authorities must approve premiums
charged for insurance products. In addition, our insurance subsidiaries are
required to establish and maintain reserves with respect to reported and
incurred but not reported losses, as well as estimated future benefits payable
under our insurance policies. These reserves must, at a minimum, comply with
mandated standards. For a description of current regulatory matters affecting
our insurance subsidiaries, see "Liquidity and Capital Resources - Subsidiary
Operations."
Our results of operations are affected significantly by the following other
factors:
Level of required reserves for policies in-force. The amount of reserves
relating to reported and unreported claims incurred is determined by
periodically evaluating historical claims experience and statistical information
with respect to the probable number and nature of such claims. Claim reserves
reflect actual experience through the most recent time period. We compare actual
experience with estimates and adjust our reserves on the basis of such
comparisons. Revisions to reserves are reflected in our current results of
operations through benefits to policyholders.
We also maintain reserves for policies that are not currently on claim
based upon actuarial expectations that a policy may go on claim in the future.
These reserves are calculated based on factors that include estimates for
mortality, morbidity, interest rates and persistency. Factor components
generally include assumptions that are consistent with both our experience and
industry practices.
Policy premium levels. We attempt to set premium levels to maximize
profitability. Premium levels on new products, as well as rate increases on
existing products, are subject to government review and regulation.
Deferred policy acquisition costs. In connection with the sale of our
insurance policies, we defer and amortize a portion of the policy acquisition
costs over the related premium paying periods of the life of the policy. These
costs include all expenses that are directly related to, and vary with, the
acquisition of the policy, including commissions, underwriting and other policy
issue expenses. The amortization of deferred policy acquisition costs ("DAC") is
determined using the same projected actuarial assumptions used in computing
policy reserves. DAC can be affected by unanticipated terminations of policies
because, upon such terminations, we are required to expense fully the DAC
associated with the terminated policies.
With the assistance of our consulting actuary, we reviewed the
appropriateness and recoverability of DAC. We determined that we require premium
rate increases on a majority of our existing products in order to fully recover
our present DAC from future profits. We recognized a DAC impairment loss of
$61,800 during 2001 primarily as a result of the additional cost projected for
our new reinsurance agreement, including investment management fees, excise
taxes and expense and risk charges. In the event that premium rate increases
cannot be obtained as needed, our DAC would be further impaired and we would
incur an expense in the amount of the impairment. See "Net Policy Acquisition
Costs Deferred."
35
The number of years a policy has been in in-force. Claims costs tend to be
higher on policies that have been in-force for a longer period of time. As the
insured ages, it is more likely that the insured will need services covered by
the policy. However, the longer the policy is in effect, the more premium we
receive.
Investment income. Our investment portfolio consisted primarily of
investment grade fixed income securities. Income generated from this portfolio
is largely dependent upon prevailing levels of interest rates. Due to the
duration of our investments (approximately 5.0 years), investment interest
income does not immediately reflect changes in market interest rates. Subsequent
to December 31, 2001 and in connection with a reinsurance agreement, we
transferred a significant portion of our investment portfolio to our reinsurer.
Under our new reinsurance agreement, substantially all of our investable assets
were transferred to the reinsurer. The reinsurer will maintain a notional
experience account for our benefit that includes these assets and all future
cash flows from the reinsured business. We will record an investment credit on
this experience account based upon the total return of a series of benchmark
indices and hedges, which are designed to closely match the duration of reserve
liabilities.
Lapsation and persistency. Factors that affect our results of operations
include lapsation and persistency, both of which relate to the renewal of
insurance policies. Lapsation is the termination of a policy by non-renewal.
Lapsation is automatic if and when premiums become more than 31 days overdue
although, in some cases, a lapsed policy may be reinstated within six months.
Persistency represents the percentage of premiums renewed, which we calculate by
dividing the total annual premiums at the end of each year (less first year
premiums for that year) by the total annual premiums in-force for the prior
year. For purposes of this calculation, a decrease in total annual premiums
in-force at the end of any year would be the result of non-renewal of policies,
including policies that have terminated by reason of death, lapsed due to
nonpayment of premiums and/or been converted to other policies we offered. First
year premiums are premiums covering the first twelve months a policy is
in-force. Renewal premiums are premiums covering all subsequent periods.
Policies renew or lapse for a variety of reasons, both internal and
external. We believe that our efforts to address policyholder concerns or
questions help to ensure policy renewals. We also believe that we enjoy a
favorable reputation among policyholders for providing desirable policy benefits
and efficient claims processing. We work closely with our licensed agents, who
play an integral role in policy conservation and policyholder communication.
External factors also contribute to policy renewal or lapsation. Economic
cycles can influence a policyholder's ability to continue the payment of
insurance premiums when due. We believe that tax relief for certain long-term
care insurance premiums and other governmental initiatives, which have raised
public awareness of the escalating costs of long-term care, increase new sales
and renewal payments. The ratings assigned to our insurance subsidiaries by
independent rating agencies also influence consumer decisions.
Lapsation and persistency can both positively and adversely impact future
earnings. Reduced lapses and higher persistency generally result in higher
renewal premiums and lower amortization of deferred acquisition costs, but may
lead to increased claims in future periods. Higher lapsation can result in
reduced premium collection and a greater percentage of higher-risk
policyholders, but requires us to fully expense deferred acquisition costs
relating to lapsed policies in the period in which policies lapse.
Results of Operations
Twelve Months Ended December 31, 2001 and 2000
(dollars in thousands)
Premiums. Total premium revenue earned in the twelve month period ended
December 31, 2001, including long-term care, disability, life and Medicare
supplement, decreased 1.9% to $350,391, compared to $357,113 in the twelve month
period ended December 31, 2000. Total premium in the 2001 period was reduced by
$10,009 as a result of premium ceded for the reinsurance of our disability
product line.
Total first year premiums earned in 2001 decreased 54.5% to $44,539,
compared to $97,888 in 2000. First year long-term care premiums earned in 2001
decreased 56.0% to $42,135, compared to $95,693 in 2000. We experienced
significant reductions in new premium sales due to the cessation of new business
generation in all states during the third and fourth quarters and as a result of
the market's concerns regarding our insurance subsidiaries' statutory surplus.
36
Effective September 10, 2001, we discontinued the sale, nationally, of all
new long-term care insurance policies until our Corrective Action Plan was
completed and approved by the Department. This decision resulted from our
concern about further depletion of statutory surplus from new sales prior to the
completion and approval of the Corrective Action Plan and from increasing
concern regarding our financial status expressed by many states in which we are
licensed to conduct business. Under our Corrective Action Plan, we intend to
limit future new business growth to levels that will allow us to maintain
sufficient statutory surplus. See "Liquidity and Capital Resources." Since the
approval of our Corrective Action Plan on February 12, 2002, we have recommenced
sales in 26 states and are continuing efforts to recommence in all states upon
individual state approvals.
Total renewal premiums earned in 2001 increased 18.0% to $305,852, compared
to $259,225 in 2000. Renewal long-term care premiums earned in 2001 increased
18.7% to $290,632, compared to $244,945 in 2000. This increase reflects renewals
of a larger base of in-force policies, as well as a continued increase in
policyholder persistency.
Net Investment Income. Net investment income earned during 2001 increased
11.7% to $30,613, from $27,408 for 2000. Management attributes this growth to an
increase in invested assets, which resulted from premium receipts and from the
investment of additional funds generated from our rights offering. Our average
yield on invested assets at cost, including cash and cash equivalents, was 5.6%
in 2001, compared to 6.2% in 2000. The average yield is lower due to reduced
market rates for reinvesting of maturing investments and due to higher cash
balances held during 2001.
Net Realized Capital Gains and Trading Account Activity. During 2001, we
recognized capital losses of $4,367, compared to capital gains of $652 in 2000.
The results of both years were recorded due to realized gains and losses from
our normal investment management operations and from impairment losses of
approximately $5,800 in 2001 and $3,200 in 2000 on equity and debt securities,
which we deemed to be other than temporary. At December 31, 2001, we entered a
reinsurance agreement for which a substantial portion of our investment
portfolio was later ceded as the initial premium for this agreement. As a result
of this intended transfer or sale of assets, we determined that all gross
unrealized losses on our debt and equities securities would not be recovered and
therefore were deemed other than temporary impairments. We recognized a loss of
$3,867 from this determination.
We classified our convertible bond portfolio as trading account investments
as a result of Statement of Financial Accounting Standards No. 133 "Accounting
for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). Changes in
trading account investment market values are recorded in our statement of
operations during the period in which the change occurs, rather than as an
unrealized gain or loss recorded directly through equity. Therefore, we recorded
a trading account loss in 2001 of $3,428, which reflects the unrealized and
realized loss of our convertible portfolio that arose during the year ended
December 31, 2001. We sold all of our convertible bond investments during 2001.
Other Income. We recorded $9,208 in other income during 2001, up from
$8,096 in 2000. The increase is attributable to an increase of commissions
earned by United Insurance Group on sales of insurance products underwritten by
unaffiliated insurers and to income generated from corporate owned life
insurance policies.
Benefits to Policyholders. Total benefits to policyholders in 2001
decreased 1.8% to $239,115, compared to $243,571 in 2000. Our loss ratio, or
policyholder benefits to premiums, was 68.3% in 2001, compared to 68.2% in 2000.
We review the adequacy of our deferred acquisition costs on an annual
basis, utilizing assumptions for future expected claims and interest rates. If
we determine that the future gross profits of our in-force policies are not
sufficient to recover our deferred acquisition costs, we recognize a premium
deficiency and "unlock" (or change) our original assumptions and reset our
reserves to appropriate levels using new asumptions. In 2001, we recognized a
premium deficiency and we unlocked our prior reserve assumptions. These
assumptions include interest rates, premium rates, shock lapses and
anti-selection of policyholder persistence. As a result, reserves for benefits
to policyholders was decreased by approximately $7,600 in 2001, due to
anticipated premium rate increases, which were only partially offset by changes
in discounts rates, lapse assumptions and future claims assumptions.
37
Claims experience can differ from our expectations due to numerous factors,
including mortality rates, duration of care and type of care utilized. When we
experience adverse deviation from our estimates, we typically seek premium rate
increases that are sufficient to offset future deviation. During 2001, we filed
premium rate increases on the majority of our policy forms in a majority of
states. These rate increases were sought as a result of higher claims
expectations and policyholder persistency than existed at the time of the
original form filings. The assumptions used in requesting and supporting the
premium rate increase filings are consistent with those incorporated in our
newest policy form offerings. We have been generally successful in the past in
obtaining state insurance department approvals for increases. If we are
unsuccessful in obtaining rate increases when deemed necessary, or if we do not
pursue rate increases when actual claims experience exceeds our expectations, we
could suffer a financial loss.
Due to the inherent uncertainty in establishing reserves, it has been
necessary in the past for us to increase the estimated future liabilities
reflected in our reserves for claims and policy expenses. In the year in which a
claim is first incurred, we establish policy and contract claims reserves that
are actuarially determined to be the present value of all future payments
required for that claim. We assume that our current reserve amount and interest
income earned on invested assets will be sufficient to make all future payments.
We evaluate our prior year assumptions by reviewing the development of reserves
for the prior period. This amount, $17,477 and $13,427, in 2001 and 2000,
respectively, includes imputed interest from prior year-end reserve balances
plus adjustments to reflect actual versus estimated claims experience. These
adjustments (particularly when calculated as a percentage of the prior year-end
reserve balance) provide a relative measure of deviation in actual performance
as compared to our initial assumptions.
In 2000, excluding the effect of imputed interest, we added approximately
$6,600 to our claim reserves for 1999 and prior claim incurrals, and in 2001, we
added approximately $8,800 to our claim reserves for 2000 and prior claim
incurrals. Our additions to prior year incurrals in 2001 resulted from a
continuance study performed by our consulting actuary. In 2001, we also
increased claim reserves by an additional $1,600 as a result of utilizing a
lower interest rate for the purpose of discounting our future liabilities. We
also inreased our claim reserves approximately $5,600 during 2001 by increasing
our loss adjustment expense reserve, which is established for the funding of
administrative costs associated with the payment of current claims. Over time,
it may continue to be necessary for us to increase our reserves.
Commissions. Commissions to agents decreased 24.9% to $76,805 in 2001,
compared to $102,313 in 2000.
First year commissions on accident and health business in 2001 decreased
54.9% to $29,371, compared to $65,117 in 2000, due to the decrease in first year
accident and health premiums. The mix of policyholder issue ages for new
business affects the percentage of commissions paid for new business due to our
age-scaled commission rates. Generally, sales to younger policyholders result in
a higher commission percentage. The ratio of first year accident and health
commissions to first year accident and health premiums was 67.4% in 2001 and
67.1% in 2000.
Renewal commissions on accident and health business in 2001 increased 25.8%
to $49,536, compared to $39,390 in 2000, consistent with the increase in renewal
premiums discussed above. The ratio of renewal accident and health commissions
to renewal accident and health premiums was 16.3% in 2001 and 15.7% in 2000,
which varies as a result of the weighting of policies written by agents with
differing contracts.
During 2001 and 2000, we reduced commission expense by netting $3,706 and
$4,923, respectively, from override commissions that affiliated insurers paid to
our subsidiary agencies. The reduction in commission overrides earned by these
agencies in 2001 resulted from our suspension of new sales in all states at
varying times throughout 2001.
Net Policy Acquisition Costs Amortized (Deferred) and Impairment of DAC.
The net deferred policy acquisition costs in 2001 decreased 22.8% to a net
amortization of $9,860, compared to net deferrals of $43,192 in 2000.
Deferred costs typically include all costs that are directly related to,
and vary with, the acquisition of policies. These costs include the variable
portion of commissions, which are defined as the first year commission rate less
ultimate renewal commission rates, and variable general and administrative
expenses related to policy underwriting. Deferred costs are amortized over the
life of the policy based upon actuarial assumptions, including persistency of
policies in-force. In the event a policy lapses prematurely due to death or
termination of coverage, the remaining unamortized portion of the deferred
amount is immediately recognized as expense in the current period.
38
The amortization of deferred costs is generally offset largely by the
deferral of costs associated with new premiums generation. Lower new premium
sales during 2001 produced significantly less expense deferral to offset
amortized costs.
During 2001, with the assistance of our consulting actuary, we completed an
analysis to determine if existing policy reserves and policy and contract claim
reserves, together with the present value of future gross premiums, would be
sufficient to (1) cover the present value of future benefits to be paid to
policyholders and settlement and maintenance costs and (2) recover unamortized
deferred policy acquisition costs, referred to as recoverability analysis. We
determined that we would require premium rate increases on certain of our
existing products in order to fully recover our present deferred acquisition
cost asset from future profits. We perform the recoverability analysis each
quarter. During the second quarter we recognized an impairment charge of $300 as
a result of this analysis. Effective December 31, 2001, we entered a reinsurance
agreement for substantially all of our long-term care insurance policies. The
reinsurance agreement includes an annual expense and risk charges. These
additional expense and risk charges reduced our anticipated future gross profits
and resulted in a further impairment of our deferred policy acquisition cost
asset of $61,500. We also amortized approximately $10,000 more of deferred
acquisition cost asset during 2001 due to changing our future assumptions. "See
Premiums."
When an impairment occurs, the historical assumptions utilized is the
establishment of the reserves and DAC are "unlocked" and based on current
assumptions. Changes in policy reserves and unamortized deferred policy
acquisition costs will be based on these revised assumptions in future periods.
In determining the impairment, we evaluated future claims expectations, premium
rates and our ability to obtain future rate increases, persistency and expense
projections.
General and Administrative Expenses. General and administrative expenses in
2001 decreased 1.4% to $49,282, compared to $49,973 in 2000. The amounts for the
years ended 2001 and 2000, respectively, include $6,591 and $8,138 related to
United Insurance Group. The ratio of total general and administrative expenses,
excluding United Insurance Group expense, to premium revenues was 12.2% in 2001,
compared to 11.7% in 2000.
General and administrative expenses were increased during 2001 as a result
of supplemental accounting and actuarial fees, legal fees, depreciation expenses
and the recognition of $434 of compensation expense related to the variable
treatment of options granted to employees. The compensation expense represents
the December 31, 2001 market value of our common stock in excess of the grant
price of the options. Throughout 2001 we took certain actions to reduce costs,
including staff eliminations, marketing reductions and overhead eliminations. We
believe that if we remain unable to write new business in states where we have
ceased new production, we will need to decrease production expenses further.
As a result of our December 31, 2001 reinsurance agreement with a foreign
reinsurer, we must pay federal excise tax of 1% on all ceded premium. At
December 31, 2001, we accrued $5,635 of excise tax, which represents the total
amount due for the transfer of premium at the inception of the agreement. This
amount was paid in the first quarter 2002.
Reserve for Claim Litigation. In the second quarter 2000, a jury awarded
compensatory damages of $24 and punitive damages of $2,000 in favor of the
plaintiff in a disputed claim case against one of our subsidiaries, for which we
had maintained a $1,000 reserve. During the second quarter 2001, we agreed to
settle the claim, and reversed the remaining reserve balance.
Provision for Federal Income Taxes. Our provision for federal income taxes
for 2001 decreased 276.8% to a tax benefit of $16,280, compared to a tax
provision of $11,720 for 2000 as a result of net losses in 2001. During 2001, we
determined that the net operating loss carryforward attributable to our non-life
parent may be impaired due to the life subsidiary's inability to utilize these
losses within the allowed future periods. As a result, we recognized a valuation
allowance of $5,775 to our deferred tax asset in 2001.
Comprehensive Income. During 2001, our investment portfolio generated
pre-tax, unrealized gains of $11,606, compared to $10,350 in 2000. After
accounting for deferred taxes from these gains, shareholders' equity decreased
by $37,345 from comprehensive losses during 2001, compared to comprehensive
income of $29,151 in 2000.
39
Twelve Months Ended December 31, 2000 and 1999
(dollars in thousands)
Premiums. Total premiums earned in the twelve month period ended December
31, 2000, including long-term care, disability, life and Medicare supplement,
increased 22.1% to $357,113, compared to $292,516 in the twelve month period
ended December 31, 1999.
First year long-term care premiums earned in 2000 increased 1.8% to
$95,693, compared to $93,957 in 1999. We attribute our growth to continued
improvements in product offerings, which competitively meet the needs of the
long-term care marketplace, and growth from recent expansion into new states,
such as New Jersey, Connecticut and New York. In addition, we introduced our
group plan, which offers long-term care insurance to group members on a
guaranteed acceptance basis. Group plan sales accounted for approximately $4,000
in 2000 first year premium. We believe that our growth was otherwise hampered
during 2000 as a result of the introduction of higher priced products in many
states and unfavorable press reports regarding the long-term care industry and
our company as a market leader.
Renewal premiums earned in 2000 increased 33.5% to $259,225, compared to
$194,243 in 1999. Renewal long-term care premiums earned in 2000 increased 35.3%
to $244,945, compared to $181,010 in 1999. This increase reflects renewals of a
larger base of in-force policies and policyholder persistency, which remained
constant at approximately 87%, as well as rate increases.
Net Investment Income. Net investment income earned for 2000 increased
21.2% to $27,408, from $22,619 for 1999. Management attributes this growth to an
increase in invested assets as a result of higher established reserves.
Investment income was reduced, however, by our use of $6,000 of invested cash
for the acquisition of Network Insurance Senior Health Division on January 1,
2000. Our average yield on invested assets at cost, including cash and cash
equivalents, was 6.2% in 2000, compared to 5.8% in 1999. Average yields
generally increased due to cash from maturing bonds invested at higher rates.
These yields are reduced as a result of investments in equity securities, which
generate low or no dividend yields.
Net Realized Capital Gains. During 2000, we recognized capital gains of
$652, compared to gains of $5,393 in 1999. Capital gains and losses are
generally recorded as a result of our normal investment management operations.
At December 31, 2000, however, we realized a capital loss of $3,200 by marking
the cost basis of one of our bonds to its current market value. The issuer of
this bond declared bankruptcy, which prompted the bond's impairment. In 1999, we
recognized capital gains to offset expenses of approximately $2,800 as a result
of the impairment of certain of our fixed assets as discussed below.
Other Income. We recorded $8,096 in other income during 2000, up from
$6,297 in 1999. The increase is attributable to the partial settlement of a
previously disclosed lawsuit, the details of which are confidential in
accordance with the settlement agreement, and to income generated from corporate
owned life insurance policies.
Benefits to Policyholders. Total benefits to policyholders in 2000
increased 21.6% to $243,571, compared to $200,328 in 1999. Our loss ratio, or
policyholder benefits to premiums, was 68.2% in 2000, compared to 68.5% in 1999.
This ratio is expected to grow as new business premiums as a percentage of total
premiums decreases.
Claims experience can differ from our expectations due to numerous factors,
including mortality rates, duration of care and type of care utilized. When we
experience adverse deviation from our estimates, we typically seek premium rate
increases that we estimate will be sufficient to offset future deviation. We
have been generally successful in the past in obtaining state insurance
department approvals for increases.
Policyholder benefits include additions to reserves and claims payments for
policyholders' incurring claims in the current and prior years. In 2000, we paid
$37,864 related to current year incurrals and $85,153 related to claims incurred
in 1999 and prior years. In 1999, we paid $25,145 for current year claims and
$69,887 related to prior year incurrals. Paid claims as a percentage of premiums
were 34.4% in 2000, compared to 32.5% in 1999. This ratio increased as a result
of aging policies and a reduction in new premium as a percentage of total
premium reduction.
40
In the year in which a claim is first incurred, we establish reserves that
are actuarially determined to be the present value of all future payments
required for that claim. We assume that our current reserve amount and interest
income earned on invested reserves will be sufficient to make all future
payments. We measure the validity of our prior year assumptions by reviewing the
development of reserves for the prior period (i.e., incurred from prior years).
This amount, $13,427 and $9,231 in 2000 and 1999, respectively, includes imputed
interest from prior year-end reserve balances of $6,863 and $5,085,
respectively, plus adjustments to reflect actual versus estimated claims
experience. These adjustments, particularly as a percentage of the prior
year-end reserve balance, yield a relative measure of deviation in actual
performance to our initial assumptions. In 2000, we added approximately $6,600
or 4.8% of prior year-end reserves to our claim reserves for 1999 and prior
claim incurrals. In 1999, we added approximately $4,100 or 3.9% of prior
year-end reserves to our claim reserves for 1998 and prior claim incurrals.
Commissions. Commissions to agents increased 5.7% to $102,313 in 2000,
compared to $96,752 in 1999.
First year commissions on accident and health business in 2000 decreased
.6% to $65,117, compared to $65,538 in 1999, due primarily to the lack of
commissions paid for our new group policies. The ratio of first year accident
and health commissions to first year accident and health premiums was 67.1% in
2000 and 69.4% in 1999, which also reflects the lack of group product
commissions. The mix of policyholder issue ages for new business affects the
overall percentage of commissions paid for new business due to our age-scaled
commission rates. Generally, sales to younger policyholder have a higher
commission percentage.
Renewal commissions on accident and health business in 2000 increased 32.5%
to $39,390 compared to $29,736 in 1999, consistent with the increase in renewal
premiums discussed above. The ratio of renewal accident and health commissions
to renewal accident and health premiums was 15.7% in 2000 and 16.0% in 1999.
This ratio fluctuates in relation to the age of the policies in-force and the
rates of commissions paid to the producing agents.
Commission expense during 2000 was reduced by the netting of $4,923 from
override commissions paid to our insurance agency subsidiaries by affiliated
insurers. During 1999, commissions were reduced by $2,593. In 2000, override
commission reductions included approximately $1,991 from the insurance agency
that we purchased in January 2000.
Net Policy Acquisition Costs Deferred. The net deferred policy acquisition
costs in 2000 decreased 15.5% to $43,192, compared to $51,134 in 1999.
Although new premiums increased in 2000, lower first year commissions from
our group product line resulted in lower deferred acquisition costs. In
addition, amortization of previously deferred costs offsets a greater portion of
the current period deferral, especially when new premium growth slows, as has
been the case in 2000.
General and Administrative Expenses. General and administrative expenses in
2000 increased 22.7% to $49,973, compared to $40,736 in 1999. In 2000 and 1999
general and administrative expenses included $8,138 and $7,748, respectively,
related to United Insurance Group. Generally, costs such as premium taxes and
salaries related to business processing increase proportionately to premium
growth. Management believes that current cost savings initiatives, such as
remote office consolidation and outsourcing of certain administrative functions,
has helped to contain the level of our expenses. 2000 expenses increased due to
the depreciation of capitalized costs for new internal software development,
legal expenses and sales promotion expense. General and administrative expenses
as a percentage of premiums (excluding United Insurance Group and goodwill
amortization related to its purchase) were 11.8% in 2000, compared to 11.3% in
1999.
Loss Due to Impairment of Property and Equipment. During 1999, we
discontinued the implementation of a new computer system. At June 30, 1999, we
had capitalized $2,799 of expenditures related to this project, including
licensing costs and fees paid to outside parties for system development and
implementation. As the system was not yet in service, none of these costs had
previously been depreciated. When we decided not to use these fixed assets,
their value became fully impaired and we recognized the entire amount as current
period expense.
In conjunction with our decision to discontinue our implementation of this
computer system, we filed suit against the software manufacturer and several
consultants, alleging misrepresentations regarding the system's capabilities and
ability to meet our expectations. We have settled a portion of the lawsuit in
exchange for payment of an undisclosed amount. However, we continue to seek a
judgment against two additional parties who acted as consultants on the project.
41
Reserve for Claim Litigation. In April 2000, a jury awarded compensatory
damages of $24 and punitive damages of $2,000 in favor of the plaintiff in a
disputed claim case against one of our subsidiaries. The trial judge granted our
motion for a new trial or a remitter of the award to $1,000. The plaintiff
appealed the judge's order. The result of the plaintiff's appeal could be, among
other things, a reinstatement of the jury verdict or confirmation of the judge's
order granting us a new trial. We have established a $1,000 reserve pending the
outcome of this case.
Provision for Federal Income Taxes. Our provision for federal income taxes
for 2000 increased 8.1% to $11,720, compared to $10,837 for 1999. The effective
tax rates of 34.0% and 33.7% in 2000 and 1999, respectively, are at or below the
normal federal corporate rate as a result of credits from our investments in
tax-exempt bonds and corporate owned life insurance and dividends we receive
that are partially exempt from taxation and are partially offset by
non-deductible goodwill amortization and other non-deductible expenses.
Comprehensive Income. During 2000, our investment portfolio generated
pre-tax unrealized gains of $10,350, compared to 1999 unrealized losses of
$18,009. After accounting for deferred taxes from these gains, shareholders'
equity increased by $29,151 from comprehensive income during 2000, compared to
comprehensive income of $5,875 in 1999.
Liquidity and Capital Resources
(dollars in thousands)
Our consolidated liquidity requirements have historically been created and
met from the operations of our insurance subsidiaries, from our agency
subsidiaries and from funds raised in the capital markets. Our primary sources
of cash are premiums, investment income and maturities of investments. We have
obtained, and may in the future obtain, cash through public offerings of our
common stock, other capital markets activities or debt instruments. Our primary
uses of cash are policy acquisition costs (principally commissions), payments to
policyholders, investment purchases and general and administrative expenses.
Our 2000 Report of Independent Accountants contained a going concern
opinion resulting from doubt regarding our parent company liquidity and
insurance subsidiary statutory surplus. Our 2001 Report of Independent
Accountants no longer contains a going concern opinion given the steps that we
have been able to accomplish. However, we cannot make assurances that our future
statutory surplus and parent liquidity will not again produce doubt as to our
ability to continue as a going concern without additional resources in the
future. See "Parent Company Operations."
In 2001, our cash decreased by $1,996, primarily from funds used to
purchase bonds and equity securities of $263,388. Our cash was primarily
increased by proceeds from the sale and maturity of investment securities of
$128,881. These sources of funds were supplemented with $111,277 from operations
and $25,726 generated from the issuance of common stock in our Rights Offering.
In 2000, our cash increased by $99,249, primarily due to the maturity and
sale of $250,765 of our bond and equity securities portfolio. These sources of
funds were supplemented with $92,415 from operations. The major source of cash
from operations was premium revenue used to fund reserve additions of $116,227.
The primary uses of cash during 2000 were the purchase of $233,539 in bonds and
equity securities, $102,313 paid as agent commissions and $6,000 used to
purchase Network Insurance Senior Health Division.
In 1999, our cash decreased $21,055, primarily due to $192,990 used to
purchase bonds and equity securities, $4,999 used to purchase our common stock,
which is held as treasury stock, and $9,194 used to purchase United Insurance
Group. Cash was provided primarily from the maturity and sale of $140,892 in
bonds and equity securities. These sources of funds were supplemented with
$50,533 from operations. The major provider of cash from operations was premium
revenue used to fund reserve additions of $104,610.
We invest in securities and other investments authorized by applicable
state laws and regulations and follow an investment policy designed to maximize
yield to the extent consistent with liquidity requirements and preservation of
assets. At December 31, 2001, the market value of our bond portfolio represented
103.2% of our cost, compared to 99.9% at December 31, 2000, with a current
unrealized gain of $14,990 at December 31, 2001, compared to an unrealized loss
of $389 at December 31, 2000. The market value of our equity portfolio exceeded
cost by $1,042 at December 31, 2001, but was below cost by $616 at December 31,
2000.
42
At December 31, 2001 and December 31, 2000, the average maturity of our
bond portfolio was 7.1 and 7.2 years, respectively.
Subsidiary Operations
(in thousands)
Our insurance subsidiaries are regulated by various state insurance
departments. In its ongoing effort to improve solvency regulation, the NAIC has
adopted Risk-Based Capital ("RBC") requirements for insurance companies to
evaluate the adequacy of statutory capital and surplus in relation to investment
and insurance risks, such as asset quality, mortality and morbidity, asset and
liability matching, benefit and loss reserve adequacy, and other business
factors. The RBC formula is used by state insurance regulators as an early
warning tool to identify, for the purpose of initiating regulatory action,
insurance companies that potentially are inadequately capitalized. In addition,
the formula defines minimum capital standards that an insurer must maintain.
Regulatory compliance is determined by a ratio of the enterprise's regulatory
Total Adjusted Capital, to its Authorized Control Level RBC, as defined by the
NAIC. Companies below specific trigger points or ratios are classified within
certain levels, each of which may require specific corrective action depending
upon the insurer's state of domicile.
Our subsidiaries are required to hold statutory surplus that is, at a
minimum, above a calculated mandatory control level at which the Pennsylvania
Insurance Department (the "Department") would be required to place our
subsidiary under regulatory control, leading to rehabilitation or liquidation.
Insurers are obligated to hold additional statutory surplus above the mandatory
control level. At December 31, 2000, our primary insurance subsidiary,
representing 94% of our direct premium, had Total Adjusted Capital at the
regulatory action level. As a result, it was required to file a Corrective
Action Plan (the "Plan") with the insurance commissioner.
Subsequent to December 31, 2001, the Department approved the Plan. As a
primary component of the Plan, effective December 31, 2001, we entered a
reinsurance transaction to reinsure, on a quota share basis, substantially all
of our respective long-term care insurance policies then in-force. The agreement
was entered with Centre Solutions (Bermuda) Limited, which is rated A- by A.M.
Best. The agreement, which is subject to certain coverage limitations, meets the
requirements to qualify as reinsurance for statutory accounting, but not for
generally accepted accounting principles. The initial premium of the treaties is
approximately $619,000, comprised of $563,000 of cash and qualified securities
transferred subsequent to December 31, 2001, and $56,000 as funds heldo due to
the reinsurer. The initial premium and future cash flows from the reinsured
policies, less claims payments, ceding commissions and risk charges, will be
credited to a notional experience account, which is held for our benefit in the
event of commutation and recapture on or after December 31, 2007. The notional
experience account balance will receive an investment credit based upon the
total return of a series of benchmark indices and hedges that are intended to
match the duration of our reserve liability.
The agreement contains commutation provisions and allows us to recapture
the reserve liabilities and the current experience account balance as of
December 31, 2007 or on December 31 of any year thereafter. If we choose not to
or are unable to commute the agreement as planned, our financial results would
likely suffer a materially adverse impact due to an escalation of the charges
paid to the reinsurer. Additionally, our reinsurance provisions contain
significant covenants and conditions that, if breached, could result in a
significant loss, requiring a payment of $2.5 million per quarter from the
period of the breach through December 31, 2007. Any breach of the reinsurance
agreement may also result in the immediate recapture of the reinsured business,
which would have a material adverse effect on our subsidiaries' statutory
surplus. Management has completed an assessment of its ability to avoid any
breach through 2002 and believes that it will remain compliant. In addition,
the reinsurer has been granted warrants to acquire convertible preferred stock
in the event we do not commute the agreements that, if converted, would
represent an additional 20 percent of the common stock then outstanding.
Pennsylvania insurance regulations require that funds ceded for reinsurance
provided by a foreign or "unauthorized" reinsurer must be secured by funds held
in a trust account or by a letter of credit for the protection of policyholders.
We received approximately $648,000 in statutory reserve credits from this
transaction as of December 31, 2001, of which $619,000 was held by us and
$29,000 was backed by letters of credit, which increased our statutory surplus
by $29,000 as well. As a result, our subsidiary's RBC ratio at December 31,
2001 was substantially above the required statutory minimum, as well as above
recommended or trigger levels.
43
The initial premium paid for the reinsurance (in February 2002) included
investment securities carried at amortized cost but valued at market price for
purposes of the premium transfer and the experience account. The Pennsylvania
Insurance Department permitted us to receive credit of $29,000 for the letters
of credit, and to accrue the anticipated, yet unknown, gain of $18,000 from the
sale of securities at market value, in our statutory financial results for
December 31, 2001. The impact of this permitted practice served to increase the
statutory surplus of our insurance subsidiaries by approximately $47,000 at
December 31, 2001. Had we not been granted a permitted practice, our statutory
surplus would have been negative. Upon finalization of the reinsurance
agreement, transfer of funds and establishment of appropriate letters of credit
in the first quarter of 2002, the permitted practices are not expected to be
required.
The Plan requires our subsidiary to comply with certain other agreements at
the direction of the Department, including, but not limited to:
o new investments are limited to NAIC 1 or 2 rated securities.
o affiliated transactions are limited and require Department approval.
o an agreement to increase statutory reserves (which is the
responsibility of the reinsurer) by an additional $100,000 throughout
2002-2004, such that our policy reserves will be based on new, current
claims assumptions and will not include any rate increases. These
claim assumptions are applied to all policies, regardless of issue
year and are assumed to have been present since the policy was first
issued.
Our subsidiary insurers will be subject to continued surplus strain as a
result of new business as well as a reduced level of premium to support our
general and administrative expenses. We believe that our surplus will continue
to be sufficient and that our RBC ratio at December 31, 2002 will be above the
NAIC Company Action Level. We expect to seek other sources of additional capital
to supplement our statutory surplus.
Effective September 10, 2001, we determined to discontinue the sale
nationally of all new long-term care insurance policies until the Plan was
approved by the Department. The decision resulted from our concern about further
depletion of statutory surplus from new sales prior to the completion and
approval of the Plan and from increasing concern regarding our status by many
states in which we are licensed to conduct business. The form of our cessation
varied by state, ranging from no action to certificate suspensions.
Upon the approval by the Department of the Plan in February 2002, we
recommenced new sales in 23 states. We have since recommenced sales in 3
additional states. We are actively working with all states in order to
recommence sales in all remaining jurisdictions.
The majority of our insurance subsidiaries' cash flow results from our
existing long-term care policies, which will be ceded to the reinsurer under
this agreement. Our subsidiaries' ability to meet additional liquidity needs and
fixed expenses in the future is highly dependent upon our ability to issue new
policies and to control expense growth.
We have historically utilized financial reinsurance arrangements to
mitigate the surplus strain caused by the new business growth. As a result of
these arrangements, Penn Treaty Network America's ("PTNA") 2000 statutory
surplus was increased by $19,841. These arrangements are designed to be paid
over a relatively short period of time. As a result of these repayment
provisions and our commutation of all existing treaties during 2001, all of the
surplus benefit derived from the financial reinsurance treaties reversed during
fiscal 2001.
Our new reinsurance agreement meets the requirements necessary to qualify
as reinsurance for statutory accounting. Since it does not have an accelerated
repayment provision, we do not consider it to be financial reinsurance. The
agreement does not create a material probability of loss for the reinsurer, and
accordingly does not qualify for reinsurance under generally accepted accounting
principles and is not reflected as such in our financial statements.
The agreement contains commutation provisions and allows us to recapture
the reserve liabilities and the current experience account balance as of
December 31, 2007 or on December 31 of each any thereafter. We have an intent
and desire to commute the treaty on December 31, 2007 and we are accounting for
the agreement in anticipation of this commutation. In the event we do not
commute the agreement on December 31, 2007, we will be subject to escalating
expenses.
44
Our future growth is dependent upon our ability to continue to expand our
historical markets, retain and expand our network of agents and effectively
market our products and our ability to fund our marketing and expansion while
maintaining minimum statutory levels of capital and surplus required to support
such growth. Under the insurance laws of Pennsylvania and New York, where our
insurance subsidiaries are domiciled, insurance companies can pay dividends only
out of earned surplus. In addition, under Pennsylvania law, our Pennsylvania
insurance subsidiaries (including our primary insurance subsidiary) must give
the Pennsylvania Insurance Department at least 30 days' advance notice of any
proposed "extraordinary dividend" and cannot pay such a dividend if the
Insurance Department disapproves the payment during that 30-day period. For
purposes of that provision, an extraordinary dividend is a dividend that,
together with all other dividends paid during the preceding twelve months,
exceeds the greater of 10% of the insurance company's surplus as shown on the
company's last annual statement filed with the Insurance Department or its
statutory net income as shown on that annual statement. Statutory earnings are
generally lower than earnings reported in accordance with generally accepted
accounting principles due to the immediate or accelerated recognition of all
costs associated with premium growth and benefit reserves. Additionally, the
Plan requires the Department to approve all dividend requests, regardless of
statutory allowances.
Under New York law, our New York insurance subsidiary must give the New
York Insurance Department 30 days' advance notice of any proposed dividend and
cannot pay any dividend if the regulator disapproves the payment during that
30-day period. In addition, our New York insurance company must obtain the prior
approval of the Insurance Department before paying any dividend that, together
with all other dividends paid during the preceding twelve months, exceeds the
lesser of 10% of the insurance company's surplus as of the preceding December 31
or its adjusted net investment income for the year ended the preceding December
31. During 2002, we received a dividend from our New York subsidiary of $651.
Our subsidiaries' debt currently consists primarily of a mortgage note in
the amount of approximately $1,581 that was issued by a former subsidiary and
assumed by us when that subsidiary was sold. The mortgage note is currently
amortized over 15 years, and has a balloon payment due on the remaining
outstanding balance in December 2003. Although the note carries a variable
interest rate, we have entered into an amortizing swap agreement with the same
bank with a nominal amount equal to the outstanding debt, which has the effect
of converting the note to a fixed rate of interest of 6.85%.
Parent Company Operations
(in thousands)
We are a non-insurer that directly controls 100% of the voting stock of our
insurance company subsidiaries. If we are unable to meet our financial
obligations, become insolvent or discontinue operations, the financial condition
and results of operations of our insurance company subsidiaries could be
materially affected.
On April 27, 2001, we distributed rights to our shareholders and holders of
our 6.25% convertible subordinated notes due 2003 ("Rights Offering") for the
purpose of raising new equity capital. Pursuant to the Rights Offering, holders
of our common stock and holders of our convertible subordinated notes received
rights to purchase 11,547 newly issued shares of common stock at a set price of
$2.40 per share. The Rights Offering was completed on May 25, 2001 and generated
net proceeds of $25,726 in additional equity capital. We contributed $18,000 of
the net proceeds to the statutory capital of our subsidiaries.
Parent company debt currently consists of $74,750 of 6.25% Convertible
Subordinated Notes due 2003, as well as an installment note in the amount of
$2,858 issued in connection with the purchase of United Insurance Group. The
convertible subordinated notes, issued in November 1996, are convertible into
common stock at $28.44 per share until maturity in December 2003. At maturity,
to the extent that the convertible subordinated notes have not been converted
into common stock, we will have to repay their entire principal amount in cash.
The convertible subordinated notes carry a fixed interest coupon of 6.25%,
payable semi-annually. Because we do not have sufficient cash flow to retire the
debt upon maturity, and the conversion price of $28.44 per share is not likely
to be met, we expect that we will need to refinance our 6.25% Convertible
Subordinate Notes on or before maturity in 2003. The terms of any such
refinancing are not yet known, or if refinancing is achievable. We cannot give
assurance that these terms will not be materially adverse to our existing
shareholders' interests.
On January 1, 1999, we purchased all of the common stock of United
Insurance Group, a Michigan based consortium of long-term care insurance
agencies, for $18,192. As part of the purchase, we issued a note payable for
$8,078, which was in the form of a three-year zero-coupon installment note. The
installment note, after discounting for imputed interest, was recorded as a note
payable of $7,167, and had an outstanding balance of $2,858 at December 31,
2001. The remainder of the purchase was paid in cash. The total outstanding
balance of the note was repaid in January 2002.
45
Our total debt and financing obligations through 2006 are as follows:
Lease
Debt Commitments Total
----
2002 $ 2,978 $ 547 $ 3,525
2003 76,212 433 76,645
2004 - 344 344
2005 - 252 252
2006 - 18 18
-------- ------- --------
Total $ 79,190 $ 1,594 $ 80,784
======== ======= ========
Amounts subsequent to 2006 are immaterial.
In December 1999, we contributed $1,000 to initially capitalize another
subsidiary, which concurrently lent us $750 in exchange for a demand note, which
is still outstanding.
At December 31, 1999, we had a $3,000 line of credit from a bank, which was
unused. The line of credit was not renewed by the bank at December 31, 2000.
As part of our reinsurance agreement, effective December 31, 2001, the
reinsurer was granted four tranches of warrants to purchase non-voting shares of
convertible preferred stock. The first three tranches of convertible preferred
stock are exercisable through December 31, 2007 at common stock equivalent
prices ranging from $4.00 to $12.00 per share if converted. If exercised for
cash, at the reinsurer's option, the warrants could yield additional capital and
liquidity of approximately $20,000 and would represent, if converted, of
approximately 15% of the outstanding shares of our common stock. If the
agreement is not commuted on or after December 31, 2007, the reinsurer may
exercise the fourth tranche of warrants for common stock equivalent prices of
$2.00 per share if converted, potentially generating additional capital of
$12,000, representing an additional 20% of the then outstanding common stock. No
assurance can be given that the reinsurer will exercise any or all of the
warrants granted.
Cash flow needs of the parent company primarily include interest payments
on outstanding debt and limited operating expenses. The funding is primarily
derived from the operating cash flow of our agency subsidiary operations and
dividends from the insurance subsidiaries. However, as noted above, the dividend
capabilities of the insurance subsidiaries are limited and the only insurance
company that can pay dividends is American Independent Network Insurance Company
of New York. While we intend to sell this insurance subsidiary in order to
generate additional parent company liquidity, we cannot assure that this will be
accomplished during 2002. In the event the sale is not completed, we may need to
rely upon the dividend capabilities of our agency subsidiaries to meet current
liquidity needs. These sources of funds, however, are expected to be
insufficient to meet our future needs beyond June 30, 2003, including the
repayment of $74.8 million of long-term debt in December 2003.
In March 2002, we completed an equity placement of 500 shares of
unregistered common stock for net proceeds of approximately $2,400. The equity
placement included current and new institutional investors, with shares offered
at $4.65. The offering price was a 10 percent discount to the 30-day average
price prior to the issuance. We have agreed to file a registration statement
with the Securities and Exchange Commission on or before June 5, 2002 to
register these shares for resale. The proceeds of the equity placement are
expected to provide sufficient additional liquidity to the parent company to
meet our debt obligations prior to the maturity of the convertible debt in 2003.
The proceeds, together with currently available cash sources, are not sufficient
to meet the December 2003 final interest requirement of the debt or to retire
the debt upon maturity.
Our liquidity projections, while based upon our best estimates and
containing excess margin for our estimated needs, may not be sufficient to meet
our obligations throughout 2003. We cannot assure that we will not need
additional funding in the event that our liquidity projections are insufficient
to meet our future cash needs.
46
New Accounting Principles
(in thousands)
Effective January 1, 2001, we adopted SFAS No. 133, which establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts (collectively referred to as
"derivatives") and for hedging activities. SFAS No. 133 requires an entity to
recognize all derivatives as either assets or liabilities in the statement of
financial position and measure those instruments at fair value.
In accordance with SFAS No. 133, which we transferred its convertible bond
portfolio from the available for sale category to the trading category. Theses
bonds were sold during December 2001.
We are party to an interest rate swap agreement, which converts its
mortgage loan from a variable rate to a fixed rate instrument. We determined
that the swap qualifies as a cash-flow hedge. The notional amount of the swap is
approximately $1,600. The effects have been determined to be immaterial to the
financial statements.
Our involvement with derivative instruments and transactions is primarily
to mitigate its own risk and is not considered speculative in nature.
In June 2001, the Financial Accounting Standards Board ("FASB") issued two
Statements of Financial Accounting Standards ("SFAS"). SFAS No. 141, "Business
Combinations" requires usage of the purchase method for all business
combinations initiated after June 30, 2001, and prohibits the use of the pooling
of interests method of accounting for business combinations. The provisions of
SFAS No. 141 relating to the application of the purchase method are generally
effective for business combinations completed after June 30, 2001. Such
provisions include guidance on the identification of the acquiring entity, the
recognition of intangible assets other than goodwill acquired in a business
combination and the accounting for negative goodwill. The transition provisions
of SFAS No. 141 require an analysis of goodwill, acquired in purchase business
combinations prior to July 1, 2001, to identify and reclassify separately
identifiable intangible assets currently recorded as goodwill.
SFAS No. 142, "Goodwill and Other Intangible Assets," primarily addresses
the accounting for goodwill and intangible assets subsequent to their
acquisition. We will adopt SFAS No. 142 on January 1, 2002 and will cease
amortizing goodwill at that time. All goodwill recognized in our consolidated
balance sheet at January 1, 2002 will be assigned to one or more reporting
units. Goodwill in each reporting unit will be tested for impairment by June 30,
2002. Any impairment loss recognized as a result of this transitional impairment
test of goodwill will be reported as the cumulative effect of a change in
accounting principle. Our book value is currently in excess of our market value,
which will require an analysis of the goodwill at the reporting unit level.
Management has not yet completed this analysis to determine the extent of
impairment, if any.
Item 7a. Quantitative and Qualitative Disclosures About Market Risk
(dollars in thousands)
We invest in securities and other investments authorized by applicable
state laws and regulations and follow an investment policy designed to maximize
yield to the extent consistent with liquidity requirements and preservation of
assets.
A significant portion of assets and liabilities are financial instruments,
which are subject to the market risk of potential losses from adverse changes in
market rates and prices. Our primary market risk exposures relate to interest
rate risk on fixed rate domestic medium-term instruments and, to a lesser
extent, domestic short-term and long-term instruments. We have established
strategies, asset quality standards, asset allocations and other relevant
criteria for our portfolio to manage our exposure to market risk.
We currently have an interest rate swap on our mortgage, which is used as a
hedge to convert the mortgage to a fixed interest rate. We believe that, since
the notional amount of the swap is amortized at the same rate as the underlying
mortgage and both financial instruments are with the same bank, no credit or
financial risk is carried with the swap.
Our financial instruments are held for purposes other than trading. Our
portfolio does not contain any significant concentrations in single issuers
(other than U.S. treasury and agency obligations), industry segments or
geographic regions.
47
We urge caution in evaluating overall market risk from the information
below. Actual results could differ materially because the information was
developed using estimates and assumptions as described below, and because
insurance liabilities and reinsurance receivables are excluded in the
hypothetical effects (insurance liabilities represent 81.6% of total liabilities
and reinsurance receivables on unpaid losses represent 2.7% of total assets).
Long-term debt, although not carried at fair value, is included in the
hypothetical effect calculation.
The hypothetical effects of changes in market rates or prices on the fair
values of financial instruments as of December 31, 2001, excluding insurance
liabilities and reinsurance receivables on unpaid losses because such insurance
related assets and liabilities are not carried at fair value, would have been as
follows:
If interest rates had increased by 100 basis points at December 31, 2001,
there would have been a decrease of approximately $17,408 in the net fair value
of our investment portfolio less our long-term debt and the related swap
agreement. A 200 basis point increase in market rates at December 31, 2001 would
have resulted in a decrease of approximately $33,472 in the net fair value. If
interest rates had decreased by 100 and 200 basis points, there would have been
a net increase of approximately $18,887 and $39,406, respectively, in the net
fair value of our total investments and debt.
If interest rates had increased by 100 basis points at December
31, 2000, there would have been a decrease of approximately $15,674 in the net
fair value of our investment portfolio less our long-term debt and the related
swap agreement. The change in fair value was determined by estimating the
present value of future cash flows using models that measure the change in net
present values arising from selected hypothetical changes in market interest
rate. A 200 basis point increase in market rates at December 31, 2000 would have
resulted in a decrease of approximately $30,035 in the net fair value. If
interest rates had decreased by 100 and 200 basis points, there would have been
a net increase of approximately $17,123 and $35,847, respectively, in the net
fair value of our total investments and debt.
We hold certain mortgage and asset backed securities as part of our
investment portfolio. The fair value of these instruments may react in a convex
or non-linear fashion when subjected to interest rate increases or decreases.
The anticipated cash flows of these instruments may differ from expectations in
changing interest rate environments, resulting in duration drift or a varying
nature of predicted time-weighted present values of cash flows. The result of
unpredicted cash flows from these investments could cause the above hypothetical
estimates to change. However, we believe that the minimal amount we have
invested in these instruments and their broadly defined payment parameters
sufficiently outweigh the cost of computer models necessary to accurately
predict the possible impact on our investment income of hypothetical effects of
changes in market rates or prices on the fair values of financial instruments as
of December 31, 2001.
Effective December 31, 2001, we entered a reinsurance agreement to
reinsure, on a quota share basis, substantially all of our long-term care
insurance policies in-force. The transaction resulted in the transfer of debt
and equity securities of approximately $563,000 to the reinsurer. The agreements
provide us the opportunity to commute and recapture after December 31, 2007. To
that end, the reinsurer will maintain a notional experience account for our
benefit only in the event of commutation and recapture, which reflects the
initial premium paid, future premiums collected net of claims, expenses and
accumulated investment earnings. The notional experience account balance will
receive an investment credit based upon the total return of a series of
benchmark ndices and hedges that are designed to closely match the duration of
reserve liabilities. Because we do not have controlling ownership of these
assets, periodic changes in the market values of the benchmark indices and
hedges will be recorded in our financial statements as gains or losses in the
period in which they occur. As a result, we will likely experience significant
volatility in our future financial statements.
Item 8. Financial Statements and Supplementary Data
Refer to Consolidated Financial Statements and notes thereto attached to
this report.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
Not Applicable.
48
PART III
Item 10. Directors and Executive Officers of the Registrant
Incorporated by reference from our Definitive Proxy Statement for the
Annual Meeting of Shareholders to be held in May 2002.
Item 11. Executive Compensation
Incorporated by reference from our Definitive Proxy Statement for the
Annual Meeting of Shareholders to be held in May 2002. See Exhibits
10.1, 10.2, 10.11 and 10.17.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Incorporated by reference from our Definitive Proxy Statement for the
Annual Meeting of Shareholders to be held in May 2002.
Item 13. Certain Relationship and Related Transactions
Incorporated by reference from our Definitive Proxy Statement for the
Annual Meeting of Shareholders to be held in May 2002.
PART IV
Item 14. Exhibits, Financial Statements, Schedule and Reports
(a) The following documents are filed as a part of this report.
(1) Financial Statements.
49
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Pages
-----
Report of Independent Accountants F-2
Financial Statements:
Consolidated Balance Sheets as of December 31,
2001 and 2000 F-3
Consolidated Statements of Income and Comprehensive Income
for the Years Ended December 31, 2001, 2000 and 1999 F-4
Consolidated Statements of Shareholders' Equity
for the Years Ended December 31, 2001,
2000 and 1999 F-5
Consolidated Statements of Cash Flows for the
Years Ended December 31, 2001, 2000 and 1999 F-6
Notes to Consolidated Financial Statements F-7
Financial Pages (F) 1
Report of Independent Accountants
To the Board of Directors and Shareholders of Penn Treaty American Corporation
Allentown, Pennsylvania
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of income and comprehensive income, of shareholders'
equity and of cash flows present fairly, in all material respects, the financial
position of Penn Treaty American Corporation and Subsidiaries (the "Company") at
December 31, 2001 and 2000, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2001 in
conformity with accounting principles generally accepted in the United States of
America. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements in
accordance with auditing standards generally accepted in the United States of
America, which 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, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
- ------------------------------
PricewaterhouseCoopers LLP
Philadelphia, Pennsylvania
April 1, 2002
Financial Pages (F) 2
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
as of December 31, 2001 and 2000
(amounts in thousands)
ASSETS 2001 2000
--------- ---------
Investments:
Bonds, available for sale at market (amortized cost of
$463,618 and $349,877, respectively) $ 478,608 $ 349,488
Equity securities at market (cost of $8,760 and $17,112, respectively) 9,802 16,496
Policy loans 181 142
--------- ---------
Total investments 488,591 366,126
Cash and cash equivalents 114,600 116,596
Property and equipment, at cost, less accumulated depreciation of
$6,594 and $5,162, respectively 12,783 12,467
Unamortized deferred policy acquisition costs 180,052 251,711
Receivables from agents, less allowance for
uncollectable amounts of $199 2,190 3,333
Accrued investment income 7,907 6,214
Federal income tax recoverable 4,406 3,671
Goodwill less accumulated amortization of $4,607 and $3,314, respectively 25,771 27,064
Present value of future profits acquired 1,937 2,352
Receivable from reinsurers 25,594 16,131
Corporate owned life insurance 54,478 41,628
Other assets 22,058 8,838
--------- ---------
Total assets $ 940,367 $ 856,131
========= =========
LIABILITIES
Policy reserves:
Accident and health $ 382,660 $ 348,344
Life 13,386 13,065
Policy and contract claims 214,466 164,565
Accounts payable and other liabilities 19,422 14,706
Long-term debt 79,190 81,968
Deferred income tax liability 38,447 45,421
--------- ---------
Total liabilities 747,571 668,069
--------- ---------
Commitments and contingencies (Note 11)
SHAREHOLDERS' EQUITY
Preferred stock, par value $1.00; 5,000 shares authorized, none outstanding -- --
Common stock, par value $.10; 40,000 and 25,000 shares authorized,
19,750 and 8,202 shares issued and outstanding at December 31, 2001
and 2000, respectively 1,975 820
Additional paid-in capital 94,802 53,879
Accumulated other comprehensive income (loss) 10,583 (662)
Retained earnings 92,141 140,730
--------- ---------
199,501 194,767
Less 915 common shares held in treasury, at cost (6,705) (6,705)
--------- ---------
192,796 188,062
--------- ---------
Total liabilities and shareholders' equity $ 940,367 $ 856,131
========= =========
See accompanying notes to consolidated financial statements
Financial Pages (F) 3
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Income and Comprehensive Income
for the Years Ended December 31, 2001, 2000 and 1999
(amounts in thousands)
2001 2000 1999
--------- --------- ---------
Revenues:
Premium revenue $ 350,391 $ 357,113 $ 292,516
Net investment income 30,613 27,408 22,619
Net realized capital (losses) gains (4,367) 652 5,393
Trading account losses (3,428) -- --
Other income 9,208 8,096 6,297
--------- --------- ---------
382,417 393,269 326,825
Benefits and expenses:
Benefits to policyholders 239,155 243,571 200,328
Commissions 76,805 102,313 96,752
Net policy acquisition costs amortized (deferred) 9,860 (43,192) (51,134)
Impairment of unamortized policy acquisition costs 61,800 -- --
General and administrative expenses 49,282 49,973 40,736
Excise tax expense 5,635 -- --
Loss due to impairment of property and equipment -- -- 2,799
Loss due to change in reserve for claim litigation (250) 1,000 --
Interest expense 4,999 5,134 5,187
--------- --------- ---------
447,286 358,799 294,668
--------- --------- ---------
(Loss) income before federal income taxes (64,869) 34,470 32,157
(Benefit) provision for federal income taxes (16,280) 11,720 10,837
--------- --------- ---------
Net (loss) income $ (48,589) $ 22,750 $ 21,320
========= ========= =========
Other comprehensive income:
Unrealized holding gain (loss) arising during period 11,606 10,350 (18,009)
Income tax (expense) benefit from unrealized holdings (3,946) (3,519) 6,123
Reclassification of gain (loss) included in net income 5,432 (652) (5,393)
Income tax (expense) benefit from reclassification (1,847) 222 1,834
--------- --------- ---------
Comprehensive (loss) income $ (37,344) $ 29,151 $ 5,875
========= ========= =========
Basic earnings per share $ (3.41) $ 3.13 $ 2.83
Diluted earnings per share $ (3.41) $ 2.61 $ 2.40
Weighted average number of shares outstanding 14,248 7,279 7,533
Weighted average number of shares outstanding
(Diluted) 14,248 9,976 10,293
See accompanying notes to consolidated financial statements
Financial Pages (F) 4
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
for the Years Ended December 31, 2001, 2000 and 1999
(amounts in thousands)
Accumulated
Additional Other Total
Common Stock Paid-In Comprehensive Retained Treasury Shareholders'
-------------------
Shares Amount Capital Income (Loss) Earnings Stock Equity
------ ------ ------- ------------- -------- ----- ------
Balance, December 31, 1998 8,189 $ 819 $ 53,516 $ 8,381 $ 96,660 $ (1,706) $ 157,670
Net income 21,320 21,320
Other comprehensive loss (15,445) (15,445)
Treasury stock purchase (4,999) (4,999)
Option-based compensation 108 108
Exercised options proceeds 2 31 31
-----------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------
Balance, December 31, 1999 8,191 819 53,655 (7,064) 117,980 (6,705) 158,685
Net income 22,750 22,750
Other comprehensive income 6,402 6,402
Option-based compensation 86 86
Exercised options proceeds 11 1 138 139
-----------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------
Balance, December 31, 2000 8,202 820 53,879 (662) 140,730 (6,705) 188,062
Net loss (48,589) (48,589)
Other comprehensive income 11,245 11,245
Option-based compensation 485 485
Rights offering proceeds 11,547 1,155 24,571 25,726
Warrants issued 15,855 15,855
Exercised options proceeds 1 12 12
-----------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------
Balance, December 31, 2001 19,750 $1,975 $ 94,802 $ 10,583 $ 92,141 $ (6,705) $ 192,796
=========================================================================================
See accompanying notes to consolidated financial statements.
Financial Pages (F) 5
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
for the Years Ended December 31,
(amounts in thousands)
2001 2000 1999
--------- --------- ---------
Net cash flow from operating activities:
Net (loss) income $ (48,589) $ 22,750 $ 21,320
Adjustments to reconcile net (loss) income to cash
provided by operations:
Amortization of intangible assets 2,068 2,068 1,765
Policy acquisition costs, net 71,660 (43,192) (51,134)
Deferred income tax (benefit) provision (12,767) 8,675 8,860
Depreciation expense 1,409 1,275 996
Net realized capital gains (losses) 7,795 (652) (5,393)
Loss on disposal of property and equipment -- 137 2,799
Increase (decrease) due to change in:
Receivables from agents 1,143 (620) (347)
Receivable from reinsurers (9,463) (1,061) (2,782)
Policy and contract claims 49,901 27,031 31,867
Policy reserves 34,637 89,196 72,743
Accounts payable and other liabilities 4,716 1,819 2,959
Federal income taxes recoverable (735) (2,055) 178
Accrued investment income (1,693) (296) (1,029)
Net proceeds from purchases and sales of trading account 21,285 -- --
Other, net (10,090) (12,660) (32,269)
--------- --------- ---------
Cash provided by operations 111,277 92,415 50,533
--------- --------- ---------
Cash flow from investing activities:
Net cash from purchase of subsidiary -- (6,000) (9,194)
Proceeds from sales of bonds 107,296 207,906 108,003
Proceeds from sales of equity securities 2,699 30,163 25,572
Maturities of investments 18,886 12,696 7,317
Purchase of bonds (258,343) (205,213) (168,430)
Purchase of equity securities (5,045) (28,326) (24,560)
Acquisition of property and equipment (1,726) (3,637) (4,472)
--------- --------- ---------
Cash (used in) provided by investing (136,233) 7,589 (65,764)
--------- --------- ---------
Cash flow from financing activities:
Purchase of treasury stock -- -- (4,999)
Net proceeds from stock offering 25,726 -- --
Proceeds from exercise of stock options 12 138 31
Repayments of long-term debt (2,778) (893) (856)
--------- --------- ---------
Cash provided by (used in) financing 22,960 (755) (5,824)
--------- --------- ---------
(Decrease) increase in cash and cash equivalents (1,996) 99,249 (21,055)
Cash balances:
Beginning of period 116,596 17,347 38,402
--------- --------- ---------
End of period $ 114,600 $ 116,596 $ 17,347
========= ========= =========
Acquisition of subsidiary with note payable $ -- $ -- $ 7,167
========= ========= =========
See accompanying notes to consolidated financial statements
Financial Pages (F) 6
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(amounts in thousands, except per share information)
1. Basis of Presentation:
The accompanying consolidated financial statements of Penn Treaty
American Corporation and its Subsidiaries (the "Company") have been
prepared in accordance with accounting principles generally accepted in
the United States of America ("GAAP") and include Penn Treaty Network
America Insurance Company ("PTNA"), American Network Insurance Company
("ANIC"), American Independent Network Insurance Company of New York
("AIN"), Penn Treaty (Bermuda), Ltd. ("PTB"), United Insurance Group
Agency, Inc. ("UIG"), Network Insurance Senior Health Division
("NISHD") and Senior Financial Consultants Company ("SFCC").
Significant intercompany transactions and balances have been eliminated
in consolidation. Certain prior year amounts have been reclassified to
conform to the current year presentation.
The preparation of financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent
liabilities and the reported amounts of revenues and expenses. Actual
results could differ from those estimates.
Nature of Operations:
The Company sells accident and health, life and disability insurance
through its wholly owned subsidiaries. The Company's principal lines of
business are long-term care products and home health care products. The
Company distributes its products principally through independent agents
and managing general agents. The Company operates its home office in
Allentown, Pennsylvania, and has satellite offices in Michigan and New
York, whose principal functions are to market and underwrite new
business. The Company is licensed in all states. Sales in Florida,
California and Pennsylvania accounted for 19%, 15% and 12%,
respectively, of the Company's premiums for the year ended December 31,
2001. No other state sales accounted for more than 10% of the Company's
premiums for the year ended December 31, 2001.
2. Summary of Significant Accounting Policies:
Investments:
Management categorizes the majority of its investment securities as
available for sale since they may be sold in response to changes in
interest rates, prepayments and similar factors. Investments in this
classification are reported at the current market value with net
unrealized gains or losses, net of the applicable deferred income tax
effect, being added to or deducted from the Company's total
shareholders' equity on the balance sheet.
Effective January 1, 2001, in accordance with Statement of Financial
Accounting Standard No. 133 "Accounting for Derivative Instruments and
Hedging Activities" ("SFAS No. 133"), the Company transferred its
convertible bond portfolio, which contained embedded derivatives, from
the available for sale category of investments to the trading category.
Realized gains and losses and changes in unrealized gains and losses
for the trading portfolio are recorded in current operations. The
unrealized loss at the time of the transfer was $1,064. During 2001, we
sold our entire convertible bond portfolio.
Realized investment gains and losses, including provisions for market
declines considered to be other than temporary, are included in income.
Gains and losses on sales of investment securities are computed on the
specific identification method.
Debt and equity securities are regularly evaluated to determine if
market values below amortized cost are as a result of credit quality,
performance or general market decline. If market value declines are
determined to be other than temporary, the amortized cost is adjusted
to the market value of the security, with the loss recognized in the
current period.
Financial Pages (F) 7
Purchases and sales of securities are recorded on a trade-date basis.
Interest income is recorded on the accrual basis. Dividends are
recorded on the ex-dividend date.
The Company is subject to interest rate risk to the extent that its
investment portfolio cash flows are not matched to its insurance
liabilities. Management believes it manages this risk through
monitoring cash flows and actuarial assumptions regarding the timing of
future insurance liabilities.
Policy loans are stated at the aggregate unpaid principal balance.
Unamortized Deferred Policy Acquisition Costs:
The costs primarily related to and varying with the acquisition of new
business, principally commissions, underwriting and policy issue
expenses, have been deferred. These deferred costs are amortized over
the related premium-paying periods utilizing the same projected
premium assumptions used in computing reserves for future policy
benefits. Net policy acquisition costs deferred, on the consolidated
statements of operations, are net of amortization of $55,812, $37,681
and $26,956 for the years ended December 31, 2001, 2000 and 1999,
respectively. Recoverability of deferred acquisition costs is
dependent upon the Company's ability to obtain future rate increases
and certain other factors. The ability to obtain these increases is
subject to regulatory approval, and is not guaranteed.
The Company regularly assesses the recoverability of deferred
acquisition costs through actuarial analysis. To determine
recoverability, the present value of future premiums less future costs
and claims are added to current reserve balances. If this amount is
greater than current unamortized deferred acquisition costs, the
unamortized amount is deemed recoverable. In the event recoverability
is not demonstrated, the Company reassesses the calculation using
justifiable premium rate increases. If rate increases are not received
or are deemed unjustified, the Company will expense, as impaired, the
attributable portion of the deferred asset in the current period. If
the Company concludes that the deferred acquisition costs are impaired,
the Company will record impairment loss and a reduction in the deferred
acquisition cost asset. In the event of an impairment, the Company will
also evaluate its historical assumptions utilized in establishing the
policy reserves and deferred acquisition costs and may update those
assumptions to reflect current experience (referred to as "unlocking").
The primary assumptions include persistency, claims expectations,
interest rates and rate increases.
During 2001, the Company recognized an impairment of its deferred
acquisition costs of approximately $61,800. Effective December 31,
2001, the Company entered into a reinsurance agreement covering
substantially all of its long-term care policies (see Note 12). The
reinsurance agreement requires the Company to pay annual expense and
risk charges to the reinsurer. The reduction in the anticipated future
gross profits resulting from the expenses and risk charges was the
primary factor causing the 2001 impairment of the deferred acquisition
costs.
In performing the impairment analyses, the Company included anticipated
premium rate increases. The Company has determined that it will require
premium rate increases on a majority of its existing products in order
to fully recover its present deferred policy acquisition cost asset
from future profits.
Property and Equipment:
Property and equipment are stated at cost, less accumulated
depreciation and amortization. Expenditures for improvements, which
materially increase the estimated useful life of the asset, are
capitalized. Expenditures for repairs and maintenance are charged to
operations as incurred. Depreciation is provided principally on a
straight-line basis over the related asset's estimated life. Upon sale
or retirement, the cost of the asset and the related accumulated
depreciation are removed from the accounts and the resulting gain or
loss, if any, is included in operations.
Financial Pages (F) 8
The following table lists the range of lives, cost and accumulated
depreciation for various asset classes:
Accumulated
Class Years Cost Depreciation
- ----- ----------- ---- ------------
Automobiles 5 $ 370 $ 229
Equipment and Software 3 - 12 10,877 3,862
Furniture 7 - 12 1,864 1,183
Buildings 10 - 40 6,266 1,320
------- -------
$19,377 $ 6,594
======= =======
Depreciation expense was $1,409, $1,275 and $996 for the years ended
December 31, 2001, 2000 and 1999, respectively.
Cash and Cash Equivalents:
Cash and cash equivalents include highly liquid debt instruments
purchased with a maturity of three months or less.
Goodwill:
Goodwill is being amortized to expense on a straight-line basis over a
10- to 40-year range. During 2001, 2000 and 1999, $1,293, $1,293 and
$993 were amortized to expense, respectively.
Present Value of Future Profits Acquired:
The present value of future profits of ANIC's acquired business is
being amortized over the life of the insurance business acquired.
During each of the years ended 2001, 2000 and 1999, $415 was amortized
to expense.
At the time of purchase, the acquired ANIC premium in-force was deemed
to have a remaining average life of approximately ten years. Although
amortization of future profits will normally occur in accordance with
actuarial assumptions over the life of the policies, the Company
determined to amortize this on a straight-line basis over ten years and
regularly monitors the emerging profitability of the acquired business.
The Company believes that this approach is not materially different
than if an actuarial methodology had been employed.
Impairment of Long-Lived Assets:
Long-lived assets and certain identifiable intangible assets held and
used by the Company are reviewed for impairment whenever events or
circumstances indicate that the carrying amount may not be recoverable.
During 1999, the Company determined to discontinue its planned
implementation of a new computer system. The Company expensed as fully
impaired the remaining carrying value of $2,799 for this asset.
Other Assets:
Other assets consist primarily of due and unpaid insurance premiums
and unamortized debt offering costs.
Corporate Owned Life Insurance:
During 1999, the Company purchased approximately $30,000 of corporate
owned life insurance to fund the future payment of employee benefit
expenses. The Company purchased an additional $10,000 in each of 2001
and 2000. The Company includes the cash value of these policies, which
is invested in investment grade corporate bonds, as a separate
financial statement caption. Increases in the cash surrender value are
recorded as other income.
Financial Pages (F) 9
Income Taxes:
Income taxes consist of amounts currently due plus deferred tax expense
or benefits. Deferred income tax liabilities, net of assets, have been
recorded for temporary differences between the reported amounts of
assets and liabilities in the accompanying financial statements and
those in the Company's income tax return.
Revenue Recognition:
Premiums on long duration accident and health insurance, the majority
of which is guaranteed renewable, and life insurance are recognized
when due. Estimates of premiums due but not yet collected are accrued.
Commission override revenue from unaffiliated insurers is included in
other income when its underlying premium is due, net of an allowance
for unissued or cancelled policies.
Policy Reserves and Policy and Contract Claims:
The Company establishes policy reserve liabilities to reflect the
impact of level renewal premiums and the increasing risks of claims
losses as policyholders age. The Company also establishes claim
reserves to reflect the liability for incurred claims.
A policy reserve liability is determined using the present value of
estimated future policy benefits to be paid to or on behalf of
policyholders less the present value of estimated future premiums to be
collected from policyholders. This liability is accrued as policy
reserves and is recognized concurrent with premium revenue. Those
estimates are based on assumptions, including estimates of expected
investment yield, mortality, morbidity, withdrawals and expenses,
applicable at the time insurance contracts are effective. These
reserves differ from policy and contract claims, which are recognized
when insured events occur.
Policy and contract claims include amounts comprising: (1) an estimate,
based upon prior experience, for accident and health claims reported,
and incurred but unreported losses; (2) the actual in-force amounts for
reported life claims and an estimate of incurred but unreported claims;
and (3) an estimate of future administrative expenses, which would be
incurred to adjudicate existing claims. The methods for making such
estimates and establishing the resulting liabilities are periodically
reviewed and updated and any resulting adjustments are reflected in
earnings currently.
The establishment of appropriate reserves is an inherently uncertain
process and includes estimates for amounts of benefits and length of
benefit period for each claim, and there can be no assurance that the
ultimate liability will not materially exceed the Company's claim and
policy reserves and have a material adverse effect on the Company's
results of operations and financial condition. Due to the inherent
uncertainty of estimating reserves, it has been necessary, and may
over time continue to be necessary, to revise estimated future
liabilities as reflected in the Company's policy reserves and policy
and contract claims.
The Company reviews the adequacy of its deferred acquisition costs on
an annual basis, utilizing assumptions for future expected claims and
interest rates. If the Company determines that the future gross
profits of its in-force policies are not sufficient to recover its
deferred acquisition costs, the Company recognizes a premium
deficiency and "unlocks" (or changes) our historical assumptions to
match current expectations. In 2001, the Company recognized a premium
deficiency and unlocked its prior reserve assumptions. These
assumptions include interest rates, premium rates, shock lapses and
anti-selection of policyholder persistence. As a result, reserves for
benefits to policyholders was decreased by approximately $7,600 in
2001, due to anticipated premium rate increases, which were partially
offset by changes in doscount rates, lapse assumptions and future
claims assumptions.
In late 1994, the Company began marketing its Independent Living
policy, a home health care insurance product, which provides coverage
over the full term of the policy for services furnished by a homemaker
or companion who is not a qualified or licensed care provider. In late
1996, the Company began marketing its Personal Freedom policy, a
comprehensive nursing home and home health care product, and its
Assisted Living policy, a revised nursing home with attached home
health care rider policy. In 1998, the Company introduced its Secured
Risk policy, a limited benefit plan made available to higher risk
applicants. Because of the Company's relatively limited claims
experience with these products, the Company may incur higher than
expected loss ratios and may be required to adjust further its reserve
levels with respect to these products.
Financial Pages (F) 10
The Company discounts all policy and contract claims, which involve
fixed periodic payments extending beyond one year. This is consistent
with the method allowed for statutory reporting, the long duration of
claims, and industry practice for long-term care policies. Benefits are
payable over periods ranging from six months to five years, and are
also available for lifetime coverage.
Reinsurance:
The Company reports all reserve amounts gross of reinsurance. The
amounts receivable from unaffiliated reinsurers are reported as
receivable from reinsurers.
Accounts Payable and Other Liabilities:
Accounts payable and other liabilities consist primarily of amounts
payable to agents and vendors and deferred income items. During 2001,
the Company reinsured its disability policies with an unaffiliated
insurer, for which it received a ceding commission of approximately
$5,000. This deferred ceding commission will be recognized as income
over the remaining life of the policies. As a result the Company
recognized $319 of income in 2001.
Earnings Per Share:
A reconciliation of the numerator and denominator of the basic earnings
per share computation to the numerator and denominator of the diluted
earnings per share computation follows. Basic earnings per share
excludes dilution and is computed by dividing income available to
common stockholders by the weighted-average number of common shares
outstanding for the period. Diluted earnings per share reflects the
potential dilution that could occur if securities or other contracts to
issue common stock were exercised or converted into common stock.
Anti-dilutive effects are not included.
For the Periods Ended December 31,
----------------------------------------
2001 2000 1999
---- ---- ----
Net (loss) income $ (48,589) $ 22,750 $ 21,320
Weighted average common shares outstanding 14,248 7,279 7,533
---------------------------------------
Basic earnings per share $ (3.41) $ 3.13 $ 2.83
=======================================
Net (loss) income $ (48,589) $ 22,750 $ 21,320
Adjustments net of tax:
Interest expense on convertible debt - 3,084 3,098
Amortization of debt offering costs - 240 241
---------------------------------------
Diluted net (loss) income $ (48,589) $ 26,074 $ 24,659
---------------------------------------
Weighted average common shares outstanding 14,248 7,279 7,533
Common stock equivalents due to dilutive
effect of stock options - 69 132
Shares converted from convertible debt - 2,628 2,628
---------------------------------------
Total outstanding shares for fully diluted earnings
per share computation 14,248 9,976 10,293
---------------------------------------
Diluted earnings per share $ (3.41) $ 2.61 $ 2.40
=======================================
New Accounting Principles:
Effective January 1, 2001, the Company adopted Statement of Financial
Accounting Standards No. 133, which establishes accounting and
reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts (collectively
referred to as "derivatives") and for hedging activities. SFAS No. 133
requires an entity to recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those
instruments at fair value.
Financial Pages (F) 11
In accordance with SFAS No. 133, the Company transferred its
convertible bond portfolio from the available for sale category to the
trading category. All of its convertible bonds were sold during 2001.
The Company is party to an interest rate swap agreement, which converts
its mortgage loan from a variable rate to a fixed rate instrument. The
Company determined that the swap qualifies as a cash-flow hedge. The
notional amount of the swap is approximately $1,600. The effects have
been determined to be immaterial to the financial statements.
The Company's involvement with derivative instruments and transactions
is primarily to mitigate its own risk and is not considered speculative
in nature.
In June 2001, the Financial Accounting Standards Board ("FASB") issued
two Statements of Financial Accounting Standards ("SFAS"). SFAS No.
141, "Business Combinations," requires usage of the purchase method for
all business combinations initiated after June 30, 2001, and prohibits
the usage of the pooling of interests method of accounting for business
combinations. The provisions of SFAS No. 141 relating to the
application of the purchase method are generally effective for business
combinations completed after June 30, 2001. Such provisions include
guidance on the identification of the acquiring entity, the recognition
of intangible assets other than goodwill acquired in a business
combination and the accounting for negative goodwill. The transition
provisions of SFAS No. 141 require an analysis of goodwill acquired in
purchase business combinations prior to July 1, 2001 to identify and
reclassify separately identifiable intangible assets currently recorded
as goodwill.
SFAS No. 142, "Goodwill and Other Intangible Assets," primarily
addresses the accounting for goodwill and intangible assets subsequent
to their acquisition. The Company will adopt SFAS No. 142 on January
1, 2002 and will cease amortizing goodwill at that time. All goodwill
recognized in the Company's consolidated balance sheet at January 1,
2002 should be assigned to one or more reporting units. Goodwill in
each reporting unit should be tested for impairment by June 30, 2002.
An impairment loss recognized as a result of a transitional impairment
test of goodwill should be reported as the cumulative effect of a
change in accounting principle.
Our book value is currently in excess of our market value, which will
require an analysis of the goodwill at the reporting unit level.
Management has not yet completed this analysis to determine the extent
of impairment, if any. In 2001, the Company amortized $1,293 of
goodwill.
3. Acquisition of Businesses:
The Company purchased all of the common stock of UIG, a Michigan based
consortium of long-term care insurance agencies, for the amount of
$18,192, of which $8,078 was in the form of a three-year installment
note, with the remainder paid in cash. The acquisition was effective
January 1, 1999. The Company accounted for the acquisition as a
purchase, and established $17,000 of goodwill, which is being amortized
over 25 years.
On January 10, 2000, PTNA entered a purchase agreement to acquire all
of the common stock of NISHD, a Florida brokerage insurance agency for
cash of $6,000. The acquisition was effective January 1, 2000. The
Company accounted for the acquisition as a purchase and recorded $6,000
of goodwill, which is being amortized over 20 years. The proforma
effect of consolidating the financial results of NISHD prior to 2000 is
immaterial to the Company's financial condition or results of
operations.
Financial Pages (F) 12
4. Investments and Financial Instruments:
December 31, 2001
---------------------------------------------------------
Amortized Gross Unrealized Gross Unrealized Estimated
Cost Gains Losses Market Value
-------- ---------------- ---------------- ------------
U.S. Treasury securities
and obligations of U.S
Government authorities
and agencies $ 164,712 $ 7,351 $ - $ 172,063
Mortgage backed securities 42,587 744 - 43,331
Obligations of states and
political sub-divisions 572 40 - 612
Debt securities issued by
foreign governments 11,954 135 - 12,089
Corporate securities 243,793 6,720 - 250,513
--------- -------- --------- ---------
$ 463,618 $ 14,990 $ - $ 478,608
========= ======== ========= =========
December 31, 2000
---------------------------------------------------------
Amortized Gross Unrealized Gross Unrealized Estimated
Cost Gains Losses Market Value
--------- ---------------- ---------------- ------------
U.S. Treasury securities
and obligations of U.S
Government authorities
and agencies $ 120,691 $ 5,654 $ (364) $ 125,981
Mortgage backed securities 26,529 343 (152) 26,720
Obligations of states and
political sub-divisions 572 28 - 600
Debt securities issued by
foreign governments 15,817 44 (312) 15,549
Corporate securities 186,268 2,291 (7,921) 180,638
--------- ------- --------- ---------
$ 349,877 $ 8,360 $ (8,749) $ 349,488
========= ======= ========= =========
The amortized cost and estimated market values of debt securities at
December 31, 2001 by contractual maturity are shown below. Expected
maturities may differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without call
or prepayment penalties.
Amortized Estimated
Cost Market Value
---------- ------------
Due in one year or less $ 7,969 $ 8,054
Due after one year through five years 145,916 149,582
Due after five years through ten years 234,452 244,114
Due after ten years 75,281 76,858
--------- ----------
$ 463,618 $ 478,608
========= ==========
Financial Pages (F) 13
Gross proceeds and realized gains and losses on the sales of debt
securities, excluding calls, were as follows:
Gross Gross
Realized Realized
Proceeds Gains Losses
-------- -------- --------
2001 $158,182 $ 4,970 $ 7,697
2000 $209,229 $ 8,613 $ 9,114
1999 $108,003 $ 3,133 $ 1,492
Gross proceeds and realized gains and losses on the sales of equity
securities were as follows:
Gross Gross
Realized Realized
Proceeds Gains Losses
-------- -------- --------
2001 $ 20,026 $ 1,055 $ 6,123
2000 $ 30,163 $ 4,241 $ 3,088
1999 $ 25,572 $ 4,848 $ 1,073
At December 31, 2000, the Company reduced its cost basis on a bond,
whose issuer had declared bankruptcy, to its market value, realizing
an impairment charge of approximately $3,200. In 2001, the Company
reduced its cost basis of equity securities by approximately $5,800 as
a result of differences deemed other than temporary. During 2001, we
recognized capital losses of $4,367, compared to capital gains of $652
in 2000. The results in both years were recorded as a result of
realized gains and losses from our normal investment management
operations and impairment losses.
At December 31, 2001, the Company entered a reinsurance agreement for
which substantially all of its investment portfolio was later ceded as
the initial premium for this agreement. As a result of this intended
transfer or sale of assets, the Company determined that all gross
unrealized losses on its debt and equities securities likely would not
be recovered and were therefore deemed other than temporary
impairments. The Company recognized a loss of $3,867 from this
determination.
Gross unrealized gains and losses pertaining to equity securities were
as follows:
Gross Gross
Original Unrealized Unrealized Estimated
Cost Gains Losses Market Value
-------- ---------- ---------- ------------
2001 $ 8,760 $ 1,042 $ -- $ 9,802
2000 $17,112 $ 1,758 $(2,374) $16,496
1999 $17,853 $ 2,579 $(1,269) $19,163
Net investment income is applicable to the following investments:
2001 2000 1999
-------- -------- --------
Bonds $ 28,157 $ 25,777 $ 21,460
Equity securities 519 665 482
Cash and short-term investments 3,167 1,751 1,432
--------
Investment income 31,843 28,193 23,374
Investment expense (1,230) (785) (755)
-------- -------- --------
Net investment income $ 30,613 $ 27,408 $ 22,619
======== ======== ========
Pursuant to certain statutory licensing requirements, as of December
31, 2001, the Company had on deposit bonds aggregating $8,453 (fair
value) in insurance department safekeeping accounts. The Company is not
permitted to remove the bonds from these accounts without approval of
the regulatory authority.
Financial Pages (F) 14
5. Policy Reserves and Claims:
Policy reserves have been computed principally by the net level premium
method based upon estimated future investment yield, mortality,
morbidity, withdrawals and other benefits. The composition of the
policy reserves at December 31, 2001 and 2000 and the assumptions
pertinent thereto are presented below:
Amount of Policy Reserves
as of December 31,
---------------------------
2001 2000
--- ----
Accident and health $ 382,660 $ 348,344
Annuities and other 131 118
Ordinary life, individual 13,255 12,947
Years of Issue Discount Rate Discount Rate
Accident and health 1976 to 1986 6.5% 7.0%
1987 6.5% 7.5%
1988 to 1991 6.5% 8.0%
1992 to 1995 6.5% 6.0%
1996 6.5% 7.0%
1997 to 2000 6.5% 6.8%
2001 6.5% 6.5%
Annuities and other 1977 to 1983 6.5% & 7.0% 6.5% & 7.0%
Ordinary life, individual 1962 to 2001 3.0% to 5.5% 3.0% to 5.5%
Basis of Assumption
Accidentand health Morbidity and withdrawals based on actual
and projected experience.
Annuities and other Primarily funds on deposit inclusive of
accrued interest.
Ordinary life, individual Mortality based on 1955-60 Intercompany
Mortality Table Combined Select and
Ultimate.
Financial Pages (F) 15
Activity in policy and contract claims is summarized as follows:
2001 2000
---- ----
Balance at January 1 $ 164,565 $ 137,534
less reinsurance recoverable 5,454 3,917
------ -----
Net balance at January 1 159,111 133,617
Incurred related to:
Current year 193,552 135,084
Prior years 17,477 13,427
------- ------
Total incurred 211,029 148,511
Paid related to:
Current year 73,726 37,864
Prior years 90,836 85,153
------- ------
Total paid 164,562 123,017
Net balance at December 31 205,578 159,111
plus reinsurance recoverable 8,888 5,454
------ -----
Balance at December 31 $ 214,466 $ 164,565
========== =========
In the year in which a claim is first incurred, the Company
establishes reserves that are actuarially determined to be the present
value of all future payments required for that claim. It assumes that
its current reserve amount and interest income earned on invested
assets will be sufficient to make all future payments. The Company
evaluates its prior year assumptions by reviewing the development of
reserves for the prior period (i.e. incurred from prior years). This
amount includes imputed interest from prior year-end reserve balances
plus adjustments to reflect actual versus estimated claims experience.
These adjustments (particularly when calculated as a percentage of the
prior year-end reserve balance) provide a relative measure of
deviation in actual performance as compared to its initial
assumptions.
In 2001, excluding the effect of imputed interest, the Company added
approximately $8,800 to its claim reserves for 2000 and prior claim
incurrals, and in 2000, it added approximately $6,600 to its claim
reserves for 1999 and prior claim incurrals. The additions to prior
year incurrals in 2001 resulted from a continuance study performed by
its consulting actuary. In 2001, the Company also increased claim
reserves by an additional $1,600 as a result of utilizing a lower
interest rate for the purpose of discounting its future liabilities.
The Company also increased its claim reserves approximately $5,600
during 2001 by increasing its loss adjustment expense reserve, which
is established for the funding of administrative costs associated with
the payment of current claims. Over time, it may continue to be
necessary for the Company to increase its reserves.
6. Long-Term Debt:
Long-term debt at December 31, 2001 and 2000 is as follows:
2001 2000
---- ----
Convertible, subordinated debt issued
in November 1996, with a semi-annual
coupon of 6.25% annual percentage rate.
Debt is callable after December 2, 1999
at declining redemption values and matures
in December 2003. Prior to maturity, the
debt is convertible to shares of the
Company's common stock at $28.44 per share. $74,750 $74,750
Mortgage loan with interest rate fixed
for five years at 6.85% effective September
1998, which was repriced from 7.3% in 1997.
Although carrying a variable rate of LIBOR
+ 90 basis points, the loan has an effective
fixed rate due to an offsetting swap with the
same institution. Current monthly payment
of $16 based on a fifteen year amortization
schedule with a balloon payment due September
2003; collateralized by property with
depreciated cost of $2,361 and $2,352 as
of December 31, 2001 and 2000, respectively. 1,582 1,664
Financial Pages (F) 16
Installment note for purchase of UIG,
due January 2002, payable in annual
installments at 0% interest. (imputed at 6%) 2,858 5,554
------ -------
$79,190 $81,968
======= =======
Principal repayment of mortgage and other debt are due as follows:
2002 $ 2,978
2003 76,212
--------
$ 79,190
========
7. Federal Income Taxes:
The (benefit) provision for federal income taxes for the years ended
December 31 consisted of:
2001 2000 1999
---- ---- ----
Current $ (3,503) $ 3,045 $ 1,974
Deferred (12,777) 8,675 8,863
-------- -------- -----
$(16,280) $ 11,720 $ 10,837
========= ======== ========
Deferred income tax assets and liabilities have been recorded for
temporary differences between the reported amounts of assets and
liabilities in the accompanying financial statements and those in the
Company's income tax return. Management believes the existing net
deductible temporary differences are realizable on a more likely than
not basis. The sources of these differences and the approximate tax
effect are as follows for the years ended December 31:
2001 2000
---- ----
Net operating loss carryforward $ 22,102 $ 3,080
Excise tax 1,972 -
Policy reserves - 18,841
Unrealized losses on investments - 352
Other than temporary decline
in market value 3,187 1,150
Other - 612
Valuation allowance (5,775) -
------- -
Total deferred tax assets $ 21,486 $ 24,035
========= ========
Deferred policy acquisition costs $ (36,822) $(67,533)
Present value of future profits acquired (678) (823)
Premiums due and unpaid (767) (1,100)
Unrealized gains on investments (5,451) -
Policy reserves (13,830) -
Other (2,385) -
------- -
Total deferred income liabilities $ (59,933) $(69,456)
========== =========
Net deferred income tax $ (38,447) $(45,421)
========== =========
Financial Pages (F) 17
The Company has net operating loss carryforwards of approximately
$16,300, which have been generated by taxable losses at the parent
company, and if unused will expire between 2018 and 2021. The parent
company's net operating loss carryforwards can be utilized by the
Company's insurance subsidiaries subject to the lesser of subsidiary
taxable income or 34% of the current aggregate carryforward amount.
During 2001, the Company established a valuation allowance of $5,775
against these parent company net operating loss carryforwards. In
addition, the Company has net operating loss carryforwards of
approximately $48,000, which have been generated by taxable losses at
the Company's life subsidiaries, and if unused, will expire on 2016.
A reconciliation of the income tax (benefit) provision computed using
the federal income tax rate to the (benefit) provision for federal
income taxes is as follows:
2001 2000 1999
-------- -------- --------
Computed federal income tax (benefit)
provision at statutory rate $(22,704) $ 12,065 $ 10,933
Valuation allowance 5,775 -- --
Small life insurance company
deduction (363) -- (120)
Tax-exempt income (1,147) (585) (96)
Other 2,159 240 120
-------- -------- --------
$(16,280) $ 11,720 $ 10,837
======== ======== ========
At December 31, 2001, the accumulated earnings of the Company for
Federal income tax purposes included $1,451 of "Policyholders'
Surplus", a special memorandum tax account. This memorandum account
balance has not been currently taxed, but income taxes computed at
then-current rates will become payable if surplus is distributed.
Provisions of the Deficit Reduction Act of 1984 do not permit further
additions to the "Policyholders' Surplus" account.
8. Statutory Information:
The insurance subsidiaries prepare their statutory financial statements
in accordance with accounting practices prescribed or permitted by the
insurance department of the state of domicile. Net income and capital
and surplus as reported in accordance with statutory accounting
principles for the Company's insurance subsidiaries are as follows:
2001 2000 1999
---- ---- ----
Net loss ($32,222) ($28,984) ($ 6,826)
Capital and surplus $17,807 $ 29,137 $ 66,872
Total reserves, including policy and contract claims, reported to
regulatory authorities were approximately $584,949 and $212,082 less
than those recorded for GAAP as of December 31, 2001 and 2000,
respectively. This difference is primarily attributable to reinsurance
agreements in force as of December 31, 2001 and 2000. For further
discussion see Note 12, "Reinsurance".
The differences in statutory net loss compared to GAAP net (loss)
income are primarily due to the immediate expensing of acquisition
costs, as well as differing reserving methodologies and treatment of
reinsurance and deferred income taxes. Due to the differences in
expensing of acquisition costs and reserving methodologies, under
statutory accounting there is generally a net loss and a corresponding
decrease in surplus, referred to as surplus strain, during periods of
growth.
Effective December 31, 2001, the Company entered a reinsurance
transaction that, according to Pennsylvania insurance regulation,
required the reinsurer to provide it with letters of credit in order
for the Company to receive statutory reserve and surplus credit from
the reinsurance. The letters of credit were dated subsequent to
December 31, 2001, as a result of the final closing of the agreement.
In addition, the initial premium paid for the reinsurance included
investment securities carried at amortized cost on the statutory
financial statements, but valued at market value for purposes of the
premium transfer. The Pennsylvania Insurance Department permitted the
Company to receive credit of $29,000 for the letters of credit, and to
accrue the anticipated, yet unknown, gain of $18,000 from the sale of
securities at market value, in its statutory financial results for
December 31, 2001. The impact of this permitted practice served to
increase the statutory surplus of the Company's insurance subsidiaries
by approximately $47,000 at December 31, 2001. Had the Company not
been granted a permitted practice, its statutory surplus would have
been negative. Upon finalization of the reinsurance agreement,
transfer of funds and establishment of appropriate Letters of Credit,
in the first quarter of 2002 the permitted practices are not expected
to be required.
Financial Pages (F) 18
The Company's insurance subsidiaries are regulated by various state
insurance departments. In its ongoing effort to improve solvency
regulation, the National Association of Insurance Commissioners
("NAIC") has adopted Risk-Based Capital ("RBC") requirements for
insurance companies to evaluate the adequacy of statutory capital and
surplus in relation to investment and insurance risks, such as asset
quality, mortality and morbidity, asset and liability matching,
benefit and loss reserve adequacy and other business factors. The RBC
formula is used by state insurance regulators as an early warning tool
to identify, for the purpose of initiating regulatory action,
insurance companies that potentially are inadequately capitalized. In
addition, the formula defines minimum capital standards, which an
insurer must maintain. Regulatory compliance is determined by a ratio
of the enterprise's regulatory Total Adjusted Capital, to its
Authorized Control Level RBC, as defined by the NAIC. Companies below
specific trigger points or ratios are classified within certain
levels, each of which may require specific corrective action depending
upon the insurer's state of domicile.
The Company's subsidiaries are required to hold statutory surplus that
is, at a minimum, above a calculated authorized control level at which
the Pennsylvania Insurance Department (the "Department") may required
to place its subsidiary under regulatory control, leading to
rehabilitation or liquidation. Insurers are obligated to hold
additional statutory surplus above the authorized control level. At
December 31, 2000, the Company's primary insurance subsidiary,
representing 94% of our direct premium, had Total Adjusted Capital at
the regulatory action level. As a result, it was required to file a
Corrective Action Plan (the "Plan") with insuran commissioner.
Subsequent to December 31, 2001, the Department approved the Plan. As
a primary component of the Plan, effective December 31, 2001, the
Company entered a reinsurance transaction to reinsure, on a quota
share basis, substantially all of its respective long-term care
insurance policies then in-force. The agreement, which is subject to
certain coverage limitations, including an aggregate limit of
liability, which is a function of certain factors and which may be
reduced in the event that rate increases are not obtained. The
agreement meets the requirements to qualify as reinsurance for
statutory accounting, but not for generally accepted accounting
principles.
Pennsylvania insurance regulations require that funds ceded for
reinsurance provided by a foreign or "unauthorized" reinsurer must be
secured by funds held in a trust account or by a letter of credit for
the protection of policyholders. The Company received approximately
$648,000 in reserve credits from this transaction as of December 31,
2001, of which the Company held $619,000 and $29,000 was backed by
letters of credit, which increased the Company's statutory surplus by
$29,000 as well. As a result, its subsidiary's RBC ratio at December
31, 2001 was substantially above the required statutory minimum, as
well as above recommended or trigger levels.
The Plan requires the Company's subsidiary to comply with certain other
agreements at the direction of the Department, including, but not
limited to:
o new investments are limited to NAIC 1 or 2 rated securities.
o affiliated transactions are limited and require Department
approval.
o an agreement to increase statutory reserves the reinsurance
agreement has the capacity to accomodate this increase by an
additional $100,000 throughout 2002-2004, such that its policy
reserves will be based on new, current claims assumptions and
will not include any rate increases. These claim assumptions are
applied to all policies, regardless of issue year and are assumed
to have been present since the policy was first issued.
Financial Pages (F) 19
States restrict the dividends the Company's insurance subsidiaries are
permitted to pay. Dividend payments will depend on profits arising
from the business of its insurance company subsidiaries, computed
according to statutory formulae. Under the insurance laws of
Pennsylvania and New York, insurance companies can pay dividends only
out of surplus. In addition, Pennsylvania law requires each insurance
company to give 30 days advance notice to the Pennsylvania Insurance
Department of any planned extraordinary dividend (any dividend paid
within any twelve-month period which exceeds the greater of (1) 10% of
an insurer's surplus as shown in its most recent annual statement
filed with the Insurance Department or (2) its net gain from
operations, after policyholder dividends and federal income taxes and
before realized gains or losses, shown in such statement) and the
Insurance Department may refuse to allow it to pay such extraordinary
dividends. The Company's Corrective Action Plan also requires the
approval of the Pennsylvania Insurance Department of all dividends.
Under New York law, the Company's New York insurance subsidiary must
give the New York Insurance Department 30 days' advance notice of any
proposed extraordinary dividend and cannot pay any dividend if the
regulator disapproves the payment during that 30-day period.
In addition, the Company's New York insurance company must obtain the
prior approval of the New York Insurance Department before paying any
dividend that, together with all other dividends paid during the
preceding twelve months, exceeds the lesser of 10% of the insurance
company's surplus as of the preceding December 31 or its adjusted net
investment income for the year ended the preceding December 31. In
2002, the Company received a dividend from our New York subsidiary of
$651,000. The dividend proceeds were used for parent company liquidity
needs.
In 1998, the NAIC adopted the Codification of Statutory Accounting
Principles ("Codification") guidance, which replaced the current
Accounting Practices and Procedures manual as the NAIC's primary
guidance on statutory accounting as of January 1, 2001. The
Codification provides guidance for areas where statutory accounting has
been silent and changes current statutory accounting in some areas,
including the recognition of deferred income taxes.
The Pennsylvania and New York Insurance Departments have adopted the
Codification guidance, effective January 1, 2001. The Codification
guidance serves to reduce the insurance subsidiaries' surplus,
primarily due to certain limitations on the recognition of goodwill and
EDP equipment and the recognition of other than temporary declines in
investments. In 2001, the Company's statutory surplus was reduced by
approximately $2,000 as a result of the Codification guidance. These
reductions are partially offset by certain other items, including the
recognition of deferred tax assets subject to certain limitations.
9. 401(k) Retirement Plan:
The Company has a 401(k) retirement plan, covering substantially all
employees with at least one year of service. Under the plan,
participating employees may contribute up to 15% of their annual salary
on a pre-tax basis. The Company, under the plan, equally matches
employee contributions up to the first 3% of the employee's salary. The
Company and employee portion of the plan is vested immediately. The
Company's expense related to this 401(k) plan was $167, $147 and $129
for the years ended December 31, 2001, 2000 and 1999, respectively. The
Company may elect to make a discretionary contribution to the plan,
which will be contributed proportionately to each eligible employee.
The Company did not make a discretionary contribution in 2001, 2000 or
1999.
10. Stock Option Plans:
At December 31, 2001, the Company had three stock-based compensation
plans, which are described below. For 2000 and 1999, and for certain
options granted in 2001, the Company has adopted the disclosure-only
provisions of Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("SFAS No. 123"), and
applies APB Opinion No. 25 "Accounting for Stock Issued to Employees,"
("APB Opinion No. 25") and related Interpretations in accounting for
its plans. Accordingly, the Company is not required to recognize
compensation expense when the exercise price is equal to, or greater
than, the fair market value at the date of grant.
The Company's 1987 Employee Incentive Stock Option Plan provided for
the granting of options to purchase up to 1,200 shares of common
stock. This plan expired in 1997 and was subsequently replaced by the
1998 Employee Non-Qualified Incentive Stock Option Plan ("1998 Plan").
The 1998 Plan allows for the grant of options to purchase up to 600
shares of common stock. No new options may be granted under the 1987
Plan. The term of each option granted in 2001 is ten years.
Financial Pages (F) 20
Effective May 1995, the Company adopted a Participating Agent Stock
Option Plan which provides for the granting of options to purchase up
to 300 shares of common stock. The exercise price of all options
granted under the plan may not be less than the fair market value of
the shares on the date of grant. The term of each option is ten years,
and the options become exercisable in four equal, annual installments
commencing one year from the option grant date. SFAS No. 123 requires
that the fair value of options granted to non-employees (agents) be
recognized as compensation expense over the estimated life of the
option. Options were granted to agents in 1997, 1996 and 1995. No
agent options were granted in 2001, 2000, 1999 or 1998. The Company
recognized $51, $86 and $108 of compensation expense in 2001, 2000 and
1999, respectively as a result of these grants.
During 2001, the Company granted 566 replacement options to its
employees for all existing options granted under its existing fixed
option plans. As a result, these options are now subject to the
variable accounting provisions of APB Opinion No. 25 until exercised,
forfeited or cancelled. The Company recorded compensation expense of
$434 in 2001 related to these variable options, representing the
intrinsic value of the stock options at the reporting date to the
extent the fair value exceeded the exercise price of the employee
options at the grant date. In addition, 30 options were granted to a
new senior executive in 2001.
Had compensation cost for the Company's employee stock-based
compensation plans been determined based on the fair value at the
grant dates for awards under those plans consistent with the method of
SFAS No. 123, the Company's net (loss) income and earnings per share
would have been reduced to the pro forma amounts indicated below.
Compensation cost is estimated using an option-pricing model with the
following assumptions for new options granted to employees in 2001,
2000 and 1999. In 2001, options were valued with an expected life of
5.3 years, volatility of 70.9% and a risk free rate of 4.9%. The
weighted average fair value of options granted in 2001 was $1.71. In
2000, options were valued with an expected life of 5.3 years,
volatility of 28.3% and a risk free rate of 4.8%. The weighted average
fair value of options granted in 2000 was $6.80. No options were
granted in 1999. The Company's net income and earnings per share
results would have been reduced to the pro forma amounts indicated
below for the years ended December 31, 2001, 2000 and 1999,
respectively.
2001 2000 1999
---- ---- ----
Net Income As reported $ (48,589) $ 22,750 $ 21,320
Pro forma $ (49,133) $ 22,325 $ 21,030
Basic Earnings Per Share As reported $ (3.41) $ 3.13 $ 2.83
Pro forma $ (3.41) $ 3.07 $ 2.79
Diluted Earnings Per Share As reported $ (3.41) $ 2.61 $ 2.40
Pro forma $ (3.41) $ 2.57 $ 2.37
Financial Pages (F) 21
The following is a summary of the Company's option activity, including
grants, exercises, forfeitures and weighted average price information:
2001 2000 1999
-------------------------- -------------------------- ------------------------
Exercise Exercise Exercise
Price Price Price
Options Per Option Options Per Option Options Per Option
--------- ----------- ---------- ------------- ---------- -----------
Outstanding at beginning of year 685 $ 19.59 552 $ 19.64 554 $ 19.62
Granted 596 $ 6.96 155 $ 19.25 0 $ -
Exercised 1 $ 12.45 11 $ 12.56 2 $ 13.38
Forfeitures 632 $ 18.79 11 $ 24.44 0 $ -
----------- ---------- --------- ------------- --------- -----------
Outstanding at end of year 648 $ 8.48 685 $ 19.59 552 $ 19.64
=========== --------- ========= ============= ========== ===========
Exercisable at end of year 88 $ 17.99 457 $ 18.15 404 $ 16.20
=========== ========== ========= ============= ========== ===========
Outstanding Remaining Exercisable
at December Contractual at December
Range of Exercise Prices 31, 2001 Life (Yrs) 31, 2001
------------------------ ---------------------------------------------------------
3.40 -- 4.72 206 10 13
5.19 -- 7.82 258 10 18
8.60 -- 12.38 103 10 4
12.63 -- 32.25 81 7 53
-------------------------------------------------------
-------------------------------------------------------
648 10 88
=======================================================
11. Commitments and Contingencies:
Operating Lease Commitments:
The total net rental expenses under all leases amounted to
approximately $561, $688 and $629 for the years ended December 31,
2001, 2000 and 1999, respectively.
The Company's required payments due under non-cancelable leases in
each of the next five years are as follows:
Years Amounts
----- -------
2002 $ 433
2003 344
2004 252
2005 18
2006 18
-------
$ 1,065
Amounts after 2006 are immaterial.
During May 1987, the Company assigned its rights and interests in a
land lease to a third party for $175. The agreement indemnifies the
Company against any further liability with respect to future lease
payments. The Company remains contingently liable to the lessor under
the original deed of lease for rental payments of $16 per year, the
amount being adjustable based upon changes in the consumer price index
since 1987, through the year 2063.
Financial Pages (F) 22
Letters of Credit:
At December 31, 2001, the Company received letters of credit of
$29,000 to receive statutory reserve credit and statutory surplus
credit for its new quota share reinsurance agreement. As part of the
Company's financial reinsurance agreements in effect at December 31,
2000 and 1999, it received an unsecured letter of credit from a bank
for $5,000 and $20,000, respectively, which served to allow the
Company to receive statutory reserve credit for its financial
reinsurance with state insurance departments at each of those dates.
Litigation:
The Company's subsidiaries are parties to various lawsuits generally
arising in the normal course of their business. The Company does not
believe that the eventual outcome of any of the suits to which it is
party will have a material adverse effect on its financial condition or
results of operations. However, the outcome of any single event could
have a material impact upon the quarterly or annual financial results
of the period in which it occurs.
The Company and certain of its key executive officers are defendants in
consolidated actions that were instituted on April 17, 2001 in the
United States District Court for the Eastern District of Pennsylvania
by shareholders of the Company, on their own behalf and on behalf of a
putative class of similarly situated shareholders who purchased shares
of the Company's common stock between July 23, 2000 through and
including March 29, 2001. The consolidated amended class action
complaint seeks damages in an unspecified amount for losses allegedly
incurred as a result of misstatements and omissions allegedly contained
in the Company's periodic reports filed with the SEC, certain press
releases issued by the Company, and in other statements made by its
officials. The alleged misstatements and omissions relate, among other
matters, to the statutory capital and surplus position of the Company's
largest subsidiary, PTNA. On December 7, 2001, the defendants filed a
motion to dismiss the complaint, which is currently pending. The
Company believes that the complaint is without merit, and it and its
executives will continue to vigorously defend the matter.
12. Reinsurance:
The Company currently reinsures with unaffiliated companies any life
insurance policy to the extent the risk on that policy exceeds $50.
Effective January 1994, PTNA entered into a reinsurance agreement to
cede 100% of certain life, accident and health and Medicare supplement
insurance to a third party insurer. Total reserve credits taken related
to this agreement as of December 31, 2001, 2000 and 1999 were
approximately $388, $409 and $456 respectively.
PTNA is party to a reinsurance agreement to cede 100% of certain whole
life and deferred annuity policies issued by PTNA to a third party
insurer. These policies are intended for the funeral arrangement or
"pre-need" market. Total reinsurance recoverables taken related to
this agreement as of December 31, 2001 and 2000 were approximately
$4,362 and $4,643, respectively. The third party reinsurer is required
to maintain securities at least equal to the statutory reserve credit
in escrow with a bank. Effective January 1, 1996, this agreement was
modified, and as a result, no new business is reinsured under this
facility.
PTNA is a party to a reinsurance agreement to cede certain home health
care claims beyond 36 months. Reinsurance recoverables related to this
treaty were $7,726 and $6,054 at December 31, 2001 and 2000,
respectively.
PTNA is party to a coinsurance agreement on a previously acquired block
of long- term care business whereby 66% is ceded to a third party. At
December 31, 2001 and 2000 reinsurance recoverables taken related to
this treaty were approximately $2,639 and $2,142, respectively.
Effective December 31, 2000 and 1999, PTNA entered separate funds
withheld financial reinsurance agreements with unaffiliated reinsurers.
Under the agreements, PTNA ceded the claims risk of a material portion
of its long-term care policies. This transference of risk qualifies the
agreements for statutory treatment as reinsurance. The agreements are
not considered reinsurance under SFAS No. 113 "Accounting and Reporting
for Reinsurance of Short-Duration and Long-Duration Contracts". As a
result of these agreements, 2000 statutory surplus was increased by
$19,841. During 2001, both agreements were commuted, resulting in a
reduction of statutory surplus of approximately $20,000.
Financial Pages (F) 23
Effective December 31, 2001, the Company entered a reinsurance
transaction to reinsure, on a quota share basis, substantially all of
its long-term care insurance policies then in force. The initial
premium of the treaty resulted in the transfer of approximately
$563,000 in cash and marketable securities subsequent to December 31,
2001, and $56,000 as funds held due to the reinsurer. The initial
premium and future cash flows of the reinsured policies, less claims
payments, ceding commissions and risk charges, will be credited to a
notional experience account, which is held for the Company's benefit
in the event of commutation and recapture following December 31, 2007.
The Company will also receive an investment credit on the experience
account balance, which is based upon the total return from a series of
benchmark indices and hedges that are intended to match the duration
of the reserve liability.
The agreement contains commutation provisions and allows the Company
to recapture the reserve liabilities and the current experience
account balance as of December 31, 2007, or on December 31 of any year
thereafter. The Company intends to commute the treaty on December 31,
2007; therefore, it is accounting for the agreements in anticipation
of this commutation. In the event the Company does not commute the
agreements on December 31, 2007, it will be subject to escalating
expenses. Additionally, the reinsurance provisions contain covenants
and conditions that, if breached, may result in the immediate
commutation of the agreement and the payment of $2.5 million per
quarter from the period of the breach through December 31, 2007. These
covenants include, but are not limited to, material breach and
insolvency.
As part of the agreement, the reinsurer was granted four tranches of
warrants to purchase non-voting shares of convertible preferred stock.
The first three tranches of convertible preferred stock are exercisable
through December 31, 2007 at common stock equivalent prices ranging
from $4.00 to $12.00 per share if converted. If exercised for cash, at
the reinsurer's option, the warrants could yield additional capital and
liquidity of approximately $20,000 and would represent ownership of
approximately 15% of the outstanding shares of our common stock. If the
agreement is not commuted following December 31, 2007, the reinsurer
may exercise the fourth tranche of warrants for common stock equivalent
prices of $2.00 per share if converted, potentially generating
additional capital of $12,000, representing an additional 20% of the
then outstanding common stock. The reinsurer is under no obligation to
exercise any of the warrants.
The warrants are part of the consideration and will be recognized as
premium over the anticipated life of the contract. The warrants are
valued using a Black-Scholes model with the following assumptions: 6.0
years expected life, volatility of 70.9% and a risk free rate of
4.74%. The $15,855 value of the warrants is recorded as a deferred
premium and will be amortized to expense over the anticipated six
years of the agreement.
In 2001, ANIC ceded substantially all of its disability policies to an
unaffiliated insurer on a quota share basis. The insurer may assume
ownership of the policies as a sale upon various state and policyholder
approvals. At December 31, 2001, reinsurance recoverables related to
this treaty were $10,338.
The Company remains liable in the event that the reinsuring companies
are unable to meet their obligations.
Financial Pages (F) 24
The Company has assumed and ceded reinsurance on certain life and
accident and health contracts under various agreements. The tables
below highlight the amounts shown in the accompanying consolidated
statements of income and comprehensive income, which are net of
reinsurance activity:
Ceded to Assumed
Gross Other from Other Net
Amount Companies Companies Amount
------ --------- ----------- ------
December 31, 2001
Ordinary life insurance
In-force $52,322 $10,543 $0 $ 41,779
Premiums:
Accident and health 355,574 13,760 5,749 347,563
Life 3,586 759 1 2,828
Benefits to policyholders:
Accident and health 211,849 3,935 1,153 209,067
Life 2,356 394 0 1,962
Inc in policy reserves:
Accident and health 32,019 7,244 2,656 27,431
Life 1,515 820 0 695
Commissions $76,095 $1,178 $1,888 $76,805
December 31, 2000
Ordinary life insurance
In-force $58,907 $12,675 $0 $46,232
Premiums:
Accident and health 352,534 3,010 4,512 354,036
Life 3,304 228 1 3,077
Benefits to policyholders:
Accident and health 164,728 2,346 713 163,095
Life 2,469 441 0 2,028
Inc (dec) in policy reserves:
Accident and health 76,514 77 1,053 77,490
Life 931 (27) 0 958
Commissions $100,681 $255 $1,887 $102,313
December 31, 1999
Ordinary life insurance
In-force $61,522 $14,009 $0 $47,513
Premiums:
Accident and health 289,396 2,935 2,738 289,199
Life 3,664 348 1 3,317
Benefits to policyholders:
Accident and health 133,188 2,265 161 131,084
Life 2,117 14 0 2,103
Inc (dec) in policy reserves:
Accident and health 65,725 360 (14) 65,351
Life 2,733 943 0 1,790
Commissions $95,376 $621 $1,997 $96,752
13. Transactions with Related Parties:
Irv Levit Insurance Management Corporation, an insurance agency which
is owned by our Chairman, Chief Executive Officer and President,
produced approximately $10, $43 and $34 of renewal premiums for some of
our subsidiaries for the years ended December 31, 2001, 2000 and 1999,
respectively, for which it received commissions of approximately $2,
$10 and $8, respectively. Irv Levit Insurance Management Corporation
also received commission overrides on business written for some of our
subsidiaries by certain agents, principally general agents who were its
agents prior to January 1979 and any of their sub-agents hired prior
and subsequent to January 1979. These commission overrides totaled
approximately $544, $551 and $543 for the years ended December 31,
2001, 2000 and 1999, respectively.
Financial Pages (F) 25
As of December 31, 2001, Palisade Capital Management owned
approximately less than 1% of our common stock. Palisade Capital
Management also manages a portion of our investment portfolio for
which it received fees of $224, $231 and $170 for the years ended
December 31, 2001, 2000 and 1999, respectively.
A member of the Company's board of directors is a principal in Davidson
Capital Management, which provides investment management services to
the Company. The Company paid this firm $462, $300 and $242 during the
years ended December 31, 2001, 2000 and 1999, respectively.
A member of the Company's board of directors and the chairman of its
audit committee is a senior executive with Advest, Inc., an investment
banking firm, which has provided investment banking services in the
past and that the Company has engaged to explore financial
alternatives. This firm received $475 in fees during 2001. No fees were
paid to this firm in 2000 or 1999.
A member of the Company's board of directors is a principal in U.S.
Care, Inc., a marketing organization to which the Company paid $159
and $23 in 2001 and 2000, respectively. The Company also made a loan
of $100, with interest applied at 9%, to U.S. Care, Inc. in 2001,
which is guaranteed by renewal commissions payable to the Company in
future periods.
14. Major Agency:
A managing general agent accounted for approximately 16% of total
premiums in 1999. In 2000, the Company purchased a division of this
managing agent, which served to reduce the Company's dependence upon
this agency. In 2001 and 2000, the total premiums from this managing
general agent accounted for less than 10% of the Company's total
premiums.
15. Concentrations of Credit Risk:
Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash and cash
equivalents and investments. The Company places its cash and cash
equivalents and investments with high quality financial institutions,
and attempts to limit the amount of credit exposure to any one
institution. However, at December 31, 2001, and at other times during
the year, amounts in any one institution exceeded the Federal Deposit
Insurance Corporation limits. The Company is also party to certain
reinsurance transactions whereby the Company remains ultimately liable
for claims exposure under ceded policies in the event the assuming
reinsurer is unable to meet its commitments due to default or
insolvency.
16. Fair Value of Financial Instruments:
Fair values are based on estimates using present value or other
valuation techniques where quoted market prices are not available.
Those techniques are significantly affected by the assumptions used,
including the discount rate and estimates of future cash flows. The
fair value amounts presented do not purport to represent and should not
be considered representative of the underlying value of the Company.
The methods and assumptions used to estimate the fair values of each
class of the financial instruments described below are as follows:
Investments -- The fair value of fixed maturities and equity securities
are based on quoted market prices. It is not practicable to determine
the fair value of policy loans since such loans are not separately
transferable and are often repaid by reductions to benefits and
surrenders.
Cash and cash equivalents -- The statement value approximates fair
value.
Financial Pages (F) 26
Long-term debt -- The statement value approximates the fair value of
mortgage debt and capitalized leases, since the instruments carry
interest rates, which approximate market value. The convertible,
subordinated debt, as a publicly traded instrument, has a readily
accessible fair market value, and, as such is reported at that value.
December 31, 2001 December 31, 2000
--------------------- ----------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
-------- ----- -------- ------
Financial assets:
Investments
Bonds, available for sale $478,608 $478,608 $349,488 $349,488
Equity securities 9,802 9,802 16,496 16,496
Policy loans 181 181 142 142
Cash and cash equivalents 114,600 114,600 116,596 116,596
Financial liabilities:
Convertible debt $ 74,750 $ 52,325 $ 74,750 $ 60,828
Mortgage and other debt 4,440 4,440 7,218 7,218
17. Subsequent Event:
In March 2002, the Company completed an equity placement of 510 shares
of unregistered common stock for net proceeds of approximately $2,400.
The equity placement was with several current and new institutional
investors, with shares offered at $4.65. The offering price was a 10
percent discount to the 30-day average price prior to the issuance. The
Company intends to file a registration statement with the Securities
and Exchange Commission on or before June 5, 2002. The proceeds of the
equity placement provided additional liquidity to the parent company to
meet its debt service obligations. The proceeds, together with
currently available cash sources, are not sufficient to meet the
December 2003 final interest requirement of the debt or to retire the
debt upon maturity.
18. Condensed Financial Statements:
The following lists the condensed financial information for the parent
company as of December 31, 2001 and 2000 and for the years ended
December 31, 2001, 2000 and 1999.
Financial Pages (F) 27
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
(PARENT COMPANY)
Balance Sheets
as of December 31, 2001 and 2000
(amounts in thousands)
ASSETS 2001 2000
--------- ---------
Bonds, available for sale at market (amortized cost $0) $ -- $ --
Equity securities at market (cost $0) -- --
Cash and cash equivalents 3,126 1,163
Investment in subsidiaries* 273,370 272,453
Other assets 1,245 1,412
--------- ---------
Total assets $ 277,741 $ 275,028
========= =========
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Long-term debt $ 77,608 $ 80,304
Accrued interest payable 651 768
Accounts payable 58 88
Due to subsidiaries* 6,628 5,806
--------- ---------
Total liabilities 84,945 86,966
--------- ---------
Shareholders' equity
Preferred stock, par value $1.00; 5,000 shares
authorized, none outstanding -- --
Common stock, par value $.10; 25,000 shares
authorized, 19,750 and 8,202 shares
issued, respectively 1,975 820
Additional paid-in capital 94,802 53,879
Accumulated other comprehensive income (loss) 10,583 (662)
Retained earnings 92,141 140,730
--------- ---------
199,501 194,767
Less 915 of common shares held in treasury, at cost (6,705) (6,705)
--------- ---------
Total shareholders' equity 192,796 188,062
--------- ---------
Total liabilities and shareholders' equity $ 277,741 $ 275,028
========= =========
* Eliminated in consolidation
The condensed financial information should be read in
conjunction with the Penn Treaty American Corporation and
Subsidiaries consolidated statements and notes thereto
Financial Pages (F) 28
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
(PARENT COMPANY)
Statements of Operations
for the Years Ended December 31, 2001, 2000 and 1999
(amounts in thousands)
2001 2000 1999
--------- --------- ---------
Investment and other income $ 209 $ 771 $ 300
General and administrative expense 1,165 1,159 1,379
Loss due to impairment of property
and equipment -- -- 2,799
Interest expense 4,888 4,717 4,672
--------- --------- ---------
--------- --------- ---------
Loss before equity in undistributed net
earnings of subsidiaries* (5,844) (5,105) (8,550)
Equity in undistributed net (losses)
earnings of subsidiaries* (42,745) 27,855 29,870
--------- --------- ---------
--------- --------- ---------
Net (loss) income (48,589) 22,750 21,320
Retained earnings, beginning of year 140,730 117,980 96,660
--------- --------- ---------
--------- --------- ---------
Retained earnings, end of year $ 92,141 $ 140,730 $ 117,980
========= ========= =========
========= ========= =========
*Eliminated in consolidation
The condensed financial information should be read in
conjunction with the Penn Treaty American Corporation and
Subsidiaries consolidated statements and notes thereto
Financial Pages (F) 29
PENN TREATY AMERICAN CORPORATION AND SUBSIDIARIES
(PARENT COMPANY)
Statements of Cash Flows
for the Years Ended December 31, 2001, 2000 and 1999
(amounts in thousands)
2001 2000 1999
-------- -------- --------
Cash flows from operating activities:
Net (loss) income $(48,589) $ 22,750 $ 21,320
Adjustments to reconcile net (loss) income
to cash used in operations:
Equity in undistributed earnings of subsidiaries 42,745 (27,855) (29,870)
Depreciation and amortization 437 491 397
Net realized losses -- 130 48
Loss due to impairment of property and equipment -- -- 2,799
Increase (decrease) due to change in:
Due to/from subsidiaries 822 575 2,672
Other, net (469) 99 (515)
-------- -------- --------
-------- -------- --------
Net cash used in operations (5,054) (3,810) (3,149)
-------- -------- --------
-------- -------- --------
Cash flows from investing activities:
Cash purchase of subsidiary -- -- (10,113)
Sales and maturities of investments -- 5,494 4,063
Purchase of investments -- (874) (3,406)
Acquisition of property and equipment (25) (50) (1,614)
-------- -------- --------
Net cash (used in) provided by investing activities (25) 4,570 (11,070)
-------- -------- --------
-------- -------- --------
Cash flows from financing activities:
Contribution to subsidiary (18,000) -- (1,000)
Dividend from subsidiary 2,000 -- 1,039
Proceeds from exercise of stock options 12 139 31
Proceeds from note payable to subsidiary -- -- 750
Repayment of mortgages and other borrowings (2,696) (818) (794)
Proceeds from rights offering 25,726 -- --
-------- -------- --------
-------- -------- --------
Net cash provided by (used in) financing activities 7,042 (679) 26
-------- -------- --------
-------- -------- --------
Increase (decrease) in cash and cash equivalents 1,963 81 (14,193)
Cash and cash equivalents balances:
Beginning of year 1,163 1,082 15,275
-------- -------- --------
-------- -------- --------
End of year $ 3,126 $ 1,163 $ 1,082
======== ======== ========
======== ======== ========
Supplemental disclosures of cash flow information:
Cash paid during the year for interest $ 4,843 $ 4,863 $ 4,887
======== ======== ========
======== ======== ========
Acquisition of subsidiary with note payable $ -- $ -- $ 7,167
======== ======== ========
======== ======== ========
The condensed financial information should be read in
conjunction with the Penn Treaty American Corporation and
Subsidiaries consolidated statements and notes thereto
Financial Pages (F) 30
(2) Exhibits.
3.1 Restated and Amended Articles of Incorporation of Penn
Treaty American Corporation. ****
3.1(b) Amendment to Restated and Amended Articles of
Incorporation of Penn Treaty American Corporation.
*****
3.2 Amended and Restated By-laws of Penn Treaty American
Corporation, as amended. *****
4. Form of Penn Treaty American Corporation Common Stock
Certificate. *
4.1 Indenture dated as of November 26, 1996 between Penn
Treaty American Corporation and First Union National
Bank, as trustee (including forms of Notes)
(incorporated by reference to Exhibit 4.1 to Penn
Treaty American Corporation's current report on Form
8-K filed on December 6, 1996).
10.1 Penn Treaty American Corporation 1987 Employee
Incentive Stock Option Plan (incorporated by reference
to Exhibit 99.1 to Registrant's Registration Statement
on Form S-8, No. 333-89927, filed on October 29, 1999.
10.2 Penn Treaty American Corporation 1995 Participating
Agent Stock Option Plan. (incorporated by reference to
Exhibit 10.2 to Registrant's Annual Report on Form 10-K
for the year ended December 31, 1997.
10.3 Penn Treaty American Corporation Employees' Pension
Plan. *
10.4 Penn Treaty American Corporation 1998 Employee
Incentive Stock Option Plan (incorporated by reference
to Exhibit 99.1 to Registrant's Registration Statement
on Form S-8, No. 333-89927, filed on October 29, 1999.
10.5 Form of General Agent's Contract of Network America
Life Insurance Company. ****
10.6 Form of Managing General Agency Agreement. ****
10.7 Regional General Agents' Contract dated August 1, 1971
between Penn Treaty Life Insurance Company and Irving
Levit of the Irv Levit Insurance Management
Corporation, as amended on August 15, 1971, May 26,
1976 and June 16, 1987, and by an undated override
commissions schedule. ***
10.8 Commission Supplement to General Agent's Contract dated
December 7, 1993 between Network America Life Insurance
Company and Network Insurance. ****
10.9 Mortgage in the amount of $2,450,000 dated September
13, 1988 between Penn Treaty Life Insurance Company and
Merchants Bank, N.A. **
10.10 Amendments to Mortgage dated September 24, 1991,
October 13, 1992 and September 2, 1993. ****
10.11 Loan and Security Agreement by and between Penn Treaty
American Corporation and CoreStates Bank, N.A. dated
December 28, 1994.****
50
10.12 Form of Investment Counseling Agreement dated May 3,
1995 between Penn Treaty American Corporation and James
M. Davidson & Company. ****
10.13 Form of Assumption and Reinsurance Agreement dated
December 22, 1997, between Penn Treaty Life Insurance
Company and Network America Life Insurance Company. ***
10.14 Quota Share Reinsurance Agreement between Penn Treaty
Network America and London Life International.
10.15 Form of Change of Control Agreements with Executives.
***
10.16 Penn Treaty American Corporation 1998 Incentive Stock
Option Plan. ***
10.17 Employment Contract with Executive Vice President. ***
11. Earnings Per Share. See Notes to Consolidated Financial
Statements, "Note 1."
21. Subsidiaries of the Registrant. ****
23. Consent of PricewaterhouseCoopers, LLP
(b) Reports on Form 8-K:
We filed no reports on Form 8-K during the quarter ended December 31, 2001.
* Incorporated by reference to the Registrant's Registration Statement on Form
S-1 dated May 12, 1987, as amended.
** Incorporated by reference to the Registrant's Registration Statement on Form
S-1 dated November 17, 1989, as amended.
*** Incorporated by reference to the Registrant's Annual Report on Form 10-K for
the year ended December 31, 1998.
**** Incorporated by reference to the Registrant's Registration Statement on
Form S-1 dated June 30, 1995, as amended.
***** Incorporated by reference to the Registrant's Registration Statement on
Form S-3 dated February 19, 1999.
Executive Compensation Plans - see Exhibits 10.1, 10.2, 10.11 and 10.17.
51
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
PENN TREATY AMERICAN CORPORATION
Date: April 1, 2002 By: /s/ Irving Levit
----------------------------------------------------
Irving Levit, Chairman of the Board, Chief Executive
Officer and President (principal executive officer)
Date: April 1, 2002 By: /s/ Cameron B. Waite
----------------------------------------------------
Cameron B. Waite, Chief Financial Officer
(principal financial officer)
Date: April 1, 2002 By: /s/ Michael F. Grill
----------------------------------------------------
Michael F. Grill, Treasurer
(principal accounting officer)
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
registrant and in the capacities and on the dates indicated.
Date: April 1, 2002 By: /s/ Irving Levit
------------------------------------------------
Irving Levit, Chairman of the Board, Chief
Executive Officer and President
Date: April 1, 2002 By: /s/ A.J. Carden
------------------------------------------------
A.J. Carden, Executive Vice President and
Director
Date: April 1, 2002 By: /s/ Michael F. Grill
------------------------------------------------
Michael F. Grill, Treasurer and Director
Date: April 1, 2002 By: /s/ Domenic P. Stangherlin
-----------------------------------------------
Domenic P. Stangherlin, Director
Date: April 1, 2002 By: /s/ Jack D. Baum
-----------------------------------------------
Jack D. Baum, Vice President, and Director
Date: April 1, 2002 By: /s/ Francis R. Grebe
-----------------------------------------------
Francis R. Grebe, Director
Date: April 1, 2002 By: /s/ Alexander M. Clark
-----------------------------------------------
Alexander M. Clark, Director
Date: April 1, 2002 By: /s/ Matthew Kaplan
-----------------------------------------------
Matthew Kaplan, Director
Date: April 1, 2002 By: /s/ James Heyer
-----------------------------------------------
James Heyer, Director
52
Date: April 1, 2002 By: /s/ Cameron B. Waite
----------------------------------------------------
Cameron B. Waite, Chief Financial Officer
(principal financial officer)
Date: April 1, 2002 By: /s/ Michael F. Grill
----------------------------------------------------
Michael F. Grill, Treasurer
(principal accounting officer)
53
Exhibit 23
Consent of Independent Accountants
We hereby consent to the incorporation by reference in the Registration
Statements on Form S-8 (No. 333-89927 and No. 333-89929) and the Registration
Statements on Form S-3 (No. 333-72649 and No. 333-50016) of Penn Treaty American
Corporation of our report dated April 1, 2002 relating to the financial
statements, which appears in this Form 10-K.
/s/ PricewaterhouseCoopers LLP
- ------------------------------
PricewaterhouseCoopers LLP
Philadelphia, Pennsylvania
April 1, 2002
54