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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------------
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004
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: 0-11321 [GRAPHIC OMITTED]
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UNIVERSAL AMERICAN FINANCIAL CORP.
(Exact name of registrant as specified in its charter)
NEW YORK 11-2580136
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
SIX INTERNATIONAL DRIVE, SUITE 190, RYE BROOK, NEW YORK 10573
(Address of principal executive offices and zip code)
(914) 934-5200
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
----------------------
NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
- -------------------------------------- ----------------------------------------
Common Stock, par value $.01 per share NASDAQ
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: NONE
----------------------
Indicate by checkmark 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 (the "Act") 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 checkmark 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]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
The aggregate market value of the registrant's voting and non-voting
common stock held by non-affiliates of the registrant on June 30, 2004, the last
business day of the registrant's most recently completed second fiscal quarter,
was approximately $265 million (based on the closing sales price of the
registrant's common stock on that date). As of February 25, 2005, 55,201,151
shares of the registrant's common stock were issued and outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive proxy statement in connection with
its 2005 Annual Meeting of Stockholders (the "Proxy Statement"), scheduled to be
held on May 26, 2005, are incorporated by reference in Part III hereof. Except
with respect to information specifically incorporated by reference in this Form
10-K, the Proxy Statement is not deemed to be filed as part hereof.
TABLE OF CONTENTS
ITEM DESCRIPTION PAGE
PART 1 1 Business 4
2 Properties 48
3 Legal Proceedings 48
4 Submission of Matters to a Vote of Security Holders 48
PART II 5 Market for the Registrant's Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity Securities 49
6 Selected Financial Data 51
7 Management's Discussion and Analysis of Financial
Condition and Results of Operations 52
7A Quantitative and Qualitative Disclosures about Market Risk 81
8 Financial Statements and Supplementary Data 83
9 Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 83
9A Controls and Procedures 83
9B Other Information 85
PART III 10 Directors and Executive Officers of the Registrant 85
11 Executive Compensation 85
12 Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters 85
13 Certain Relationships and Related Transactions 85
14 Principal Accountant Fees and Services 85
Part IV 15 Exhibits and Financial Statement Schedules 86
Signatures 89
As used in this Annual Report on Form 10-K, "Universal American,"
"Company," "we," "our," and "us" refer to Universal American Financial Corp.
and its consolidated subsidiaries, except where the context otherwise requires
or as otherwise indicated.
DISCLOSURE REGARDING FORWARD LOOKING STATEMENTS
Portions of the information in this Annual Report on Form 10-K and certain
oral statements made from time to time by representatives of the Company may be
considered "forward-looking statements" within the meaning of Section 21E of the
Securities Exchange Act of 1934, as amended, and the Private Securities
Litigation Reform Act of 1995. The Company intends such forward-looking
statements to be covered by the safe harbor provisions for forward-looking
statements contained in Section 21E of the Exchange Act and the Private
Securities Litigation Reform Act of 1995. Such forward-looking statements relate
to, without limitation, the Company's future economic performance, plans and
objectives for future operations and projections of revenue and other financial
items. Forward-looking statements can be identified by the use of words such as
"prospects," "outlook," "believes," "estimates," "intends," "may," "will,"
"should," "anticipates," "expects" or "plans," or the negative or other
variation of these or similar words, or by discussion of trends and conditions,
strategy or risks and uncertainties. Forward-looking statements are inherently
subject to risks, trends and uncertainties, many of which are beyond the
Company's ability to control or predict with accuracy and some of which the
Company might not even anticipate. Although the Company believes that the
expectations reflected in such forward-looking statements are based upon
reasonable assumptions at the time made, it can give no assurance that its
expectations will be achieved. Future events and actual results, financial and
otherwise, may differ materially from the results discussed in the
forward-looking statements. Readers are cautioned not to place undue reliance on
these forward-looking statements.
Important factors that may cause actual results to differ materially from
forward-looking statements include, but are not limited to, the risks and
uncertainties set forth in this report in Item 1 "Business" and Item 7
"Management's Discussion and Analysis of Financial Condition and Results of
Operations". The Company assumes no obligation to update and supplement any
forward-looking statements that may become untrue because of subsequent events,
whether as a result of new information, future events or otherwise.
3
Part I
ITEM 1 - BUSINESS
Universal American Financial Corp. ("Company" or "Universal American") is
a specialty health and life insurance holding company, with an emphasis on
providing a broad array of health insurance and managed care products and
services to the growing senior population. Our principal health insurance
products for the senior market are Medicare Supplement and Medicare Advantage.
In addition, we sell specialty health insurance to self-employed individuals in
the United States and Canada, as well as life insurance and fixed annuities. We
distribute these products through a career agency system and an independent
general agency system. We also provide administrative services for senior market
insurance and non-insurance programs to both affiliated and unaffiliated
insurance companies.
Collectively, our insurance subsidiaries are licensed to sell health
insurance, life insurance and annuities in all 50 states, the District of
Columbia, Puerto Rico and all the provinces of Canada. Our managed care
subsidiary operates Medicare Advantage health plans in Texas, New York and
Pennsylvania.
We were incorporated under the laws of the State of New York on August 31,
1981. Our corporate headquarters are located at 6 International Drive, Rye
Brook, New York 10573 and our telephone number is (914) 934-5200. We make
available free of charge on our Internet website (http://www.uafc.com) our
annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K, and amendments to these reports filed or furnished pursuant to Section
13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably
practicable after we electronically file such material with, or furnish it to,
the Securities and Exchange Commission. Copies of any materials we file with the
SEC can be read or copied at the SEC's Public Reference Room at 450 Fifth
Street, NW, Washington, DC 20549. You can obtain information on the operation of
the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also
maintains an Internet site that contains reports, proxy and information
statements, and other information regarding issuers that file electronically
with the SEC. Copies of any materials we have filed electronically with the SEC
may be accessed at the SEC's website: http://www.sec.gov.
SENIOR MARKET OPPORTUNITY
We believe that attractive growth opportunities exist in providing an
array of products, particularly individual health insurance, to the growing
senior market. At present, more than 41 million Americans are eligible for
Medicare. According to the U.S. Census Bureau, more than 2 million Americans
turn 65 in the United States each year, and this number is expected to grow
faster as the so-called baby boomers continue to turn 65. In addition, many
large employers, who traditionally have provided retiree medical coverage, have
begun to curtail their offerings. Finally, the Federal government has embarked
on a program to encourage and incent private insurers to broaden their health
insurance offerings to the senior market. Taken together, these conditions
present significant opportunities for us to increase the sale of our core
products.
In the past ten years, we have become a leading provider of Medicare
Supplement coverage as well as other products designed for the senior market.
The primary elements of our success have been broad and deep distribution,
active risk management and opportunistic acquisitions. We believe that the
market for Medicare Supplement products will continue to be vibrant, especially
since many seniors may lose similar coverage that had previously been offered to
them as retiree benefits by their former employers.
4
The passage of the Medicare Modernization Act of 2003 (the "MMA"), has
created new opportunities for us to use our core skills to expand our business.
The MMA expanded the healthcare options available to Medicare beneficiaries by,
among other things, increasing the reimbursement rates to Medicare managed care
plans ("Medicare Advantage") and making available a subsidized prescription drug
insurance benefit ("Part D"). Beginning in 2006, every Medicare recipient will
be able to buy a prescription drug plan from a private insurer, largely funded
by the federal government. This new prescription drug benefit will be available
to Medicare managed care enrollees as well as Medicare fee-for-service
enrollees. Further, as a result of the increased reimbursement rates to Medicare
managed care plans which generally allows Medicare managed care plans to offer
more attractive benefits and the additional Part D drug benefit offering, we
believe that enrollment in Medicare's managed care programs is likely to
increase in the coming years.
OUR STRATEGY
The principal components of our business strategy are to:
- Build our senior health insurance business by offering a broad array
of products, including:
o Medicare Supplement and Medicare Select
o Medicare Advantage
o Medicare Part D Drug Benefit;
- Build distribution with an emphasis on expanding our Senior
Solutions(R) brand;
- Sell complementary senior market and specialty health products
through our distribution networks;
- Build our senior market administrative services business;
- Continue to complement our internal growth through acquisitions;
- Continue to improve our operating efficiency; and
- Continue to employ conservative risk management techniques,
including maintaining a high quality investment portfolio,
disciplined pricing and prudent use of reinsurance.
OUR OPERATING SEGMENTS
Beginning with this Form 10-K, we have changed the way we report our
business to more accurately reflect the way we manage our business. Previously,
we looked at our business primarily in terms of the type of distribution
channel. Now, we have reorganized our business segments to reflect the products
that we sell and the markets that we serve.
Our business now consists of five principal business segments: Senior
Market Health Insurance, Senior Managed Care - Medicare Advantage, Specialty
Health Insurance - Self-Employed, Life Insurance/Annuities and Senior
Administrative Services. We also report the corporate activities of our holding
company in a separate segment. Information regarding each segment's revenue,
income or loss before taxes and total assets for each of the last three fiscal
years is included in Note 22 - Business Segment Information in our consolidated
financial statements included in this Form 10-K. Information regarding our
foreign operations in Canada (that are included in our Speciality Health
Insurance segment) is included in Note 23 - Foreign Operations in our
consolidated financial statements included in this Form 10-K.
5
SENIOR MARKET HEALTH INSURANCE
Our Senior Market Health Insurance segment focuses on selling health
insurance products designed for the senior market through our Senior
Solutions(R) career agency force and through our network of independent general
agencies. Our primary products are Medicare Supplement and Medicare Select. As
of December 31, 2004, we had $575 million of gross premiums in force in this
segment.
SENIOR MANAGED CARE - MEDICARE ADVANTAGE
This segment includes the operations of Heritage Health Systems, Inc.
("Heritage"), which we acquired in May 2004, and our other initiatives in
managed care for seniors. Heritage operates Medicare Advantage plans in
Southeastern Texas and Medicare Advantage private fee-for-service plans in New
York and Pennsylvania. As of the end of 2004, this segment had $172 million of
premium in force.
SPECIALTY HEALTH INSURANCE - SELF-EMPLOYED
Traditionally, our career agency segment concentrated on selling specialty
health insurance products, primarily fixed benefit accident and sickness
disability insurance, to the middle-income, self-employed market in the United
States and Canada. Even though the primary focus of this field force in the
United States has shifted to the senior market, a significant number of our
United States career agents and all of the Canadian career agents continue to
actively market these products. This segment also includes certain products that
we no longer sell, such as long term care. As of December 31, 2004, we had $167
million of gross premiums in force in this segment.
LIFE INSURANCE/ANNUITIES
The focus of this segment is the sale of life insurance and annuity
products, principally to the senior market. This segment also includes other
traditional life and interest-sensitive life insurance products which are no
longer actively being sold. As of December 31, 2004, we had $67 million of gross
premiums in force for this segment and policy holder account balances for our
annuities and interest-sensitive life insurance products of $478 million.
SENIOR ADMINISTRATIVE SERVICES
Our administrative services subsidiary, CHCS Services, Inc. ("CHCS
Services"), has emerged as a leading, full-service administrator of senior
insurance products and an innovator in geriatric care management. We utilize
state of the art technology and a national network of highly trained health care
professionals to provide the administrative platform for insurance and
insurance-related products and services. Currently, we provide services to over
50 companies as well as to our own insurance company subsidiaries. Our Senior
Administrative Services segment generated revenues of $57 million for the year
ended December 31, 2004.
CORPORATE
Our corporate segment reflects the activities of our holding company
including debt service, certain senior executive compensation and compliance
with regulatory requirements resulting from our status as a public company.
6
SIGNIFICANT TRANSACTIONS - ACQUISITIONS
ACQUISITION OF HERITAGE HEALTH SYSTEMS, INC.
On May 28, 2004, we acquired Heritage, a privately owned managed care
company that operates Medicare Advantage plans in Houston and Beaumont Texas,
for $98 million in cash plus transaction costs of $1.6 million. The acquisition
was financed with $66.5 million of net proceeds derived from the amendment of
our credit facility and $33.1 million of cash on hand. As of the date of
acquisition, Heritage had approximately 16,000 Medicare members and annualized
revenues of approximately $140 million. Operating results generated by Heritage
prior to the date of acquisition are not included in our consolidated financial
statements.
ACQUISITION OF PYRAMID LIFE
On March 31, 2003, we acquired all of the outstanding common stock of
Pyramid Life Insurance Company ("Pyramid Life"). Pyramid Life specializes in
selling health and life insurance products to the senior market, including
Medicare Supplement and Select, long term care, life insurance, and annuities.
With this acquisition, we acquired a $120 million block of in-force business, as
well as a career sales force that is skilled in selling senior market insurance
products. Pyramid Life currently markets its products in 30 states through a
career agency sales force of over 1,000 agents operating out of 39 Senior
Solutions(R) Sales Centers. Following a transition period that took
approximately ten months, the Pyramid Life business was fully transitioned into
our existing operations. Operating results generated by Pyramid Life prior to
the date of acquisition are not included in our consolidated financial
statements.
RECAPTURE OF REINSURANCE CEDED
Effective April 1, 2003, we entered into agreements to recapture
approximately $48 million of Medicare Supplement business that had previously
been reinsured to Transamerica Occidental Life Insurance Company, Reinsurance
Division under two quota share contracts. No ceding allowance was paid in the
recapture and we currently retain 100% of the risks on the $48 million of
Medicare Supplement business. There was no gain or loss reported on these
recapture agreements.
ACQUISITION OF NATIONWIDE BLOCK OF BUSINESS
In November 2002, we entered into an agreement with Nationwide Life
Insurance Company to acquire, through a 100% quota share reinsurance agreement,
Nationwide's individual Medicare Supplement policies. Approximately $22 million
of annualized premium was in force at the date of acquisition.
ACQUISITION OF AMERIPLUS
On August 1, 2003, we acquired 100% of the outstanding common stock of
Ameriplus Preferred Care, Inc. ("Ameriplus"). Ameriplus is engaged in the
business of creating and maintaining a network of hospitals for the purpose of
providing discounts to our Medicare Select policyholders. Ameriplus' network is
utilized in connection with Medicare Select policies written by our subsidiaries
and can be offered to non-affiliated parties as well. Ameriplus receives network
fees when premiums for these Medicare Select policies are collected.
7
ACQUISITION OF GUARANTEE RESERVE MARKETING ORGANIZATION
Effective July 1, 2003, we entered into an agreement with Swiss Re and its
newly acquired subsidiary, Guarantee Reserve Life Insurance Company ("Guarantee
Reserve"), to acquire Guarantee Reserve's marketing organization, including all
rights to do business with its field force. The primary product sold by this
marketing organization is low face amount whole life insurance, primarily for
seniors. Beginning July 1, 2003, the Guarantee Reserve field force continued to
write this business in Guarantee Reserve, with us administering all new business
and assuming 50% of the risk through a quota share reinsurance arrangement. New
business has been written by our subsidiaries with 50% of the risk ceded to
Swiss Re beginning in the second quarter of 2004 as the products were approved
for sale in each state.
SIGNIFICANT TRANSACTIONS - FINANCING
SHELF REGISTRATION
On November 3, 2004, we filed a universal shelf registration statement on
Form S-3 with the SEC, pursuant to which we may issue common stock, warrants
and debt securities from time to time, up to an aggregate offering of $140
million. The registration statement also covers five million shares of common
stock that may be offered for sale by Capital Z Financial Services Fund II, L.P
("Capital Z"), our largest shareholder. In the event that Capital Z sells all
of the five million shares, Capital Z would still own 20.3 million shares or
approximately 37% of our outstanding common stock, before giving effect to any
issuance of shares by us pursuant to the shelf registration. The shelf
registration statement was declared effective in December 2004.
The shelf registration statement enables us to raise funds from the
offering of any individual security covered by the shelf registration statement,
as well as any combination thereof, through one or more methods of distribution,
subject to market conditions and our capital needs. The terms of any offering
pursuant to this shelf will be established at the time of the offering. We plan
to use the proceeds from any future offering under the registration statement
for general corporate purposes, including, but not limited to, working capital,
capital expenditures, investments in subsidiaries, acquisitions and refinancing
of debt. A more detailed description of the use of proceeds will be included in
any specific offering of securities in the prospectus supplement relating to the
offering. A copy of the shelf registration statement as filed with the SEC on
Form S-3 may be obtained at the SEC's website at www.sec.gov, or through the
Investor Relations section of the Universal American website at www.uafc.com.
2003 CREDIT AGREEMENT AND 2004 AMENDMENT
In connection with the acquisition of Pyramid Life on March 31, 2003, we
entered into a new $80 million credit facility consisting of a $65 million term
loan and a $15 million revolving loan facility. We used the proceeds from the
new term loan to repay the $38 million balance outstanding on our then existing
term loan and the balance to fund the purchase of Pyramid Life.
In connection with the acquisition of Heritage on May 28, 2004, we amended
the March 2003 credit facility to increase the term loan to $105 million from
$36.4 million, the balance then outstanding. We used the additional proceeds to
fund the purchase of Heritage. Under the amended credit agreement, the interest
rate was reduced to 225 basis points over the three month London Inter Bank
Offering Rate, the term was extended to March 2009, and the amortization was
reduced in the early years. As of December 31, 2004, the outstanding balance on
our term loan was $101 million. Information regarding our term loan is included
in Note 14 - Loan Payable in our consolidated financial statements included in
this Form 10-K.
8
TRUST PREFERRED ISSUANCES
During 2003, we issued $60 million of fixed and floating rate trust
preferred securities through subsidiary trusts which, combined with the $15
million issued in December 2002, results in a total of $75 million of such
securities outstanding. A portion of the proceeds of the 2003 issuances was used
to pay down our existing debt, and the balance was retained at the parent
company for general corporate purposes. Information regarding our trust
preferred securities is included in Note 15 - Other Long Term Debt in our
consolidated financial statements included in this Form 10-K.
OUR BUSINESS
SENIOR MARKET HEALTH INSURANCE
Medicare Supplement and Medicare Select. Our core senior market health
insurance products are Medicare Supplement and Medicare Select plans. Under
Federal and National Association of Insurance Commissioners ("NAIC") model
regulations adopted in nearly all states, there are currently 12 standard
Medicare Supplement plans (Plans A through J and High Deductible Plans F and J).
These policies provide supplemental coverage for many of the medical expenses
that the basic Medicare program does not cover, such as deductibles, coinsurance
and specified losses that exceed the Federal program's maximum benefits. Plan A
provides the least extensive coverage, while Plan J provides the most extensive
coverage. Under NAIC regulations, Medicare Supplement insurers must offer Plan
A, but may offer any of the other plans at their option. Our insurance company
subsidiaries offer Medicare Supplement policies primarily on plans A, B, C, D,
F, G and High Deductible F. In some areas, we also sell Medicare Select policies
in conjunction with hospitals that contract with us to waive the Medicare Part A
deductible.
These products are guaranteed renewable for the lifetime of the
policyholder, which means that we cannot cancel the policy but we can seek to
increase premium rates on existing and future policies issued based upon our
actual claims experience. We monitor the claims experience and, when necessary,
apply for rate increases in the states in which we sell the products. These rate
increases are subject to state regulatory approval and Federal and state
loss-ratio requirements.
Other Senior Health Products. Our other senior health products include
acute recovery care ("Acute Care"), senior dental and hospital indemnity
products marketed to seniors. Acute Care and senior dental are new products
which we added to our portfolio in 2004. Our Acute Care product provides
benefits for confined care and home health care for short term periods for
individuals recovering from accident or serious illness. Senior dental is a
scheduled benefit indemnity product for seniors that allows policyholders to use
their own dentists.
Medicare Part D. Beginning in 2006, private insurers will be permitted to
offer an insured stand-alone prescription drug benefit ("Part D") pursuant to
the MMA. A portion of the premium for this insurance will be paid by the federal
government, and the balance, if any, will be paid by the individuals who enroll.
The federal government will also provide additional subsidies in the form of
premium support and coverage of the cost-sharing elements of the plan to certain
low income Medicare beneficiaries. We plan to file with appropriate governmental
authorities to offer these programs in several of the regions that have been
established for this program. There is no assurance that our applications will
be accepted or that the program will provide meaningful revenues.
9
New Business Production. The following tables show our total new sales
(issued annualized premiums) of our senior market health insurance products
produced by our independent agency and career agency systems on a gross basis
(before reinsurance) and a net basis (after reinsurance):
GROSS NET
--------------------------------- -------------------------------
YEAR ENDED DECEMBER 31, YEAR ENDED DECEMBER 31,
--------------------------------- -------------------------------
PRODUCTION 2002 2003 2004 2002 2003 2004
- ---------------------------------------- ------- ------- ------- ------- ------- -------
(IN THOUSANDS)
SENIOR MARKET HEALTH INSURANCE
Medicare Supplement/Select.......... $92,059 $86,130 $83,469 $46,932 $74,116 $83,469
Other Senior Health................. -- -- 1,282 -- -- 758
------- ------- ------- ------- ------- -------
TOTAL............................ $92,059 $86,130 $84,751 $46,932 $74,116 $84,227
======= ======= ======= ======= ======= =======
Percentage retained 51% 86% 99%
Annualized Premium In Force. Total senior market insurance product
annualized premium in force on a gross basis and the net amount we retained
after reinsurance, is as follows:
GROSS NET
------------------------------------ ----------------------------------
YEAR ENDED DECEMBER 31, YEAR ENDED DECEMBER 31,
------------------------------------ ----------------------------------
IN FORCE 2002 2003 2004 2002 2003 2004
- ---------------------------------------- -------- -------- -------- -------- -------- --------
(IN THOUSANDS)
SENIOR MARKET HEALTH INSURANCE
Medicare Supplement/Select.......... $424,800 $561,800 $573,600 $102,000 $319,000 $368,800
Other Senior Health................. 1,300 1,100 1,800 1,000 900 1,300
-------- -------- -------- -------- -------- --------
TOTAL............................ $426,100 $562,900 $575,400 $103,000 $319,900 $370,100
======== ======== ======== ======== ======== ========
Percentage retained 24% 57% 64%
SENIOR MANAGED CARE -- MEDICARE ADVANTAGE
With the acquisition of Heritage and internally generated initiatives, we
now offer a line of Medicare Advantage products to complement our Medicare
Supplement business.
Medicare Advantage: HMO Plan. SelectCare of Texas, the health plan
operated by Heritage, offers an HMO product in several counties in Houston and
southeastern Texas. The plan provides all basic Medicare covered benefits with
reduced member cost-sharing as well as additional supplemental benefits,
including a defined prescription drug benefit. This HMO product is built around
contracted networks of providers who, in connection with the health plan,
coordinate an active medical management program. In addition to a monthly
payment per member from CMS, for certain products, the plan may collect a
monthly premium from its members.
This Plan is distributed by Heritage's direct sales force, and our career
agents through Senior Solutions(R) Centers in the coverage areas. As of December
31, 2004, SelectCare had approximately 18,800 members enrolled.
10
Medicare Advantage: Private Fee for Service. In June 2004, we began
enrolling members in Medicare Advantage private fee for service ("PFFS") plans
in certain counties of New York and Pennsylvania. These plans provide enhanced
health care benefits compared to traditional Medicare, including a prescription
drug benefit, subject to cost sharing and other limitations. There are no
provider network restrictions, which allow the members to have more flexibility
in the delivery of their health care services than other Medicare Advantage
plans. In addition to a fixed monthly payment per member from CMS, individuals
in these plans pay a monthly premium. The PFFS products are distributed by our
independent agents in the coverage areas. As of December 31, 2004, 1,405 members
were enrolled in the program generating approximately $9.6 million of annualized
revenue. In early 2005, we filed for expansion of this program into several
additional states.
Membership and Annualized Premium In Force. Membership for our health plan
and private fee for service plans and the related annualized premium in force,
is as follows:
MEMBERSHIP ANNUALIZED PREMIUMS
------------------------ -----------------------
MAY 28, DECEMBER 31, MAY 28, DECEMBER 31,
SENIOR MANAGED CARE 2004 2004 2004 2004
- ----------------------------- -------- ------------ -------- ------------
(IN THOUSANDS)
Health Plan (1) ............. 16,075 18,822 $140,700 $162,800
Private Fee for Service (2).. -- 1,405 -- 9,600
-------- -------- -------- --------
TOTAL .................... 16,075 20,227 $140,700 $172,400
======== ======== ======== ========
(1) The health plan was included in the acquisition of Heritage on May 28,
2004.
(2) We began enrolling members in our private fee for service plan in
June, 2004.
SPECIALTY HEALTH INSURANCE - SELF-EMPLOYED
Products in our Specialty Health Insurance segment include fixed benefit
accident and sickness disability and other health insurance products sold to the
self-employed market in the United States and Canada, as well as certain lines
of business no longer being sold, including long term care and major medical.
This segment's products are distributed primarily by our career agents.
Fixed Benefit Accident and Sickness. Fixed benefit accident and health
products provide three principal types of benefits: disability (fixed periodic
payments to an insured who becomes disabled and unable to work due to an
accident or sickness), hospital (fixed periodic payments to an insured who
becomes hospitalized), and surgical (fixed single payments that vary in amount
for specified surgical or diagnostic procedures). Because the benefits we
provide are fixed in amount at the time of policy issuance and are not intended
to provide full reimbursement for medical and hospital expenses, payment amounts
are not generally affected by inflation or the rising cost of health care
services.
Long Term Care. As of the end of 2004, we no longer distribute new long
term care products. Previously, we had offered several long term care plans
consisting of fully integrated plans and nursing home, and home health care
plans, which remain in force. These products typically are guaranteed renewable
for the lifetime of the policyholder, which means that we cannot cancel the
policy but can seek to increase premium rates on existing policies based upon
our actual claims experience, subject to state regulatory approval and
loss-ratio requirements.
11
New Business Production. The following tables show our total new sales
(issued annualized premiums) of specialty health insurance products produced by
primarily by our career agency systems on a gross basis (before reinsurance) and
a net basis (after reinsurance):
GROSS NET
------------------------------- -------------------------------
YEAR ENDED DECEMBER 31, YEAR ENDED DECEMBER 31,
------------------------------- -------------------------------
PRODUCTION 2002 2003 2004 2002 2003 2004
- --------------------------------- ------- ------- ------- ------- ------- -------
(IN THOUSANDS)
SPECIALTY HEALTH INSURANCE
Accident & Sickness and Other
Specialty Health ......... $ 9,118 $ 8,337 $ 7,494 $ 9,118 $ 8,337 $ 7,494
Canadian Products ........... 7,834 6,334 6,438 7,834 6,334 6,438
Long Term Care .............. 7,756 5,164 1,691 3,878 2,707 948
------- ------- ------- ------- ------- -------
TOTAL .................... $24,708 $19,835 $15,623 $20,830 $17,378 $14,880
======= ======= ======= ======= ======= =======
Percentage retained 84% 88% 95%
Annualized Premium In Force. Total specialty health insurance product
annualized premium in force on a gross basis and the net amount we retained
after reinsurance, is as follows:
GROSS NET
---------------------------------- ----------------------------------
YEAR ENDED DECEMBER 31, YEAR ENDED DECEMBER 31,
---------------------------------- ----------------------------------
IN FORCE 2002 2003 2004 2002 2003 2004
- --------------------------------- -------- -------- -------- -------- -------- --------
(IN THOUSANDS)
SPECIALTY HEALTH INSURANCE
Accident & Sickness and Other
Specialty Health ......... $ 69,100 $ 70,600 $ 63,300 $ 62,300 $ 64,300 $ 61,200
Canadian Products ........... 51,700 57,000 61,300 51,700 57,000 61,300
Long Term Care .............. 36,300 43,900 41,900 22,500 27,200 27,100
-------- -------- -------- -------- -------- --------
TOTAL .................... $157,100 $171,500 $166,500 $136,500 $148,500 $149,600
======== ======== ======== ======== ======== ========
Percentage retained 87% 87% 90%
LIFE INSURANCE/ANNUITIES
This segment includes all of the life insurance and annuity business that
we sell in the United States. The life insurance products that we currently sell
are designed primarily for the senior market. These include "final expense" life
insurance and asset accumulation life insurance. In addition, we sell single and
flexible premium fixed annuities. These products are distributed through both
independent general agents and our career agency distribution systems. This
segment also includes previously produced or acquired term, universal life, and
whole life insurance products that are no longer sold.
Senior Life. We offer a line of low-face amount, simplified issue whole
life products that are sold by our senior market independent agency and our
career agency systems.
Asset Enhancer Life Insurance. We market a line of interest sensitive
whole life products that are designed for efficient asset transfer to
beneficiaries. These products also offer acceleration of benefit features that
cover certain long term care expenses.
12
New Business Production. The following tables show our total new sales
(issued annualized premiums) of our life insurance products produced by our
independent agency and career agency systems on a gross basis (before
reinsurance) and a net basis (after reinsurance):
GROSS NET
---------------------------- ----------------------------
YEAR ENDED DECEMBER 31, YEAR ENDED DECEMBER 31,
---------------------------- ----------------------------
PRODUCTION 2002 2003 2004 2002 2003 2004
- ---------------------------------- ------ ------- ------- ------ ------- -------
(IN THOUSANDS)
LIFE INSURANCE.................... $6,729 $25,264 $38,469 $5,187 $16,109 $23,951
====== ======= ======= ====== ======= =======
Percentage retained 77% 64% 62%
Annuities. We market single and flexible premium deferred annuities
primarily focusing on the senior and retirement markets. The base rates on the
annuity products currently marketed by us range from 3% to 3.6%. We offer sales
inducements in the form of first year only bonus interest rates, which range
from 1% to 4%, on certain of our annuity products. Including the bonus interest
rates, our current credited rates on our annuity products range from 3% to 7.3%.
Our currently marketed annuity products have minimum guaranteed interest rates
ranging from 1.5% to 3%. We have the right to change the crediting rates at any
time, subject to the minimums, and generally adjust them quarterly.
Annuity deposits are not reported as revenue in accordance with generally
accepted accounting principles. The following table shows our annuity deposits
by distribution channel:
YEAR ENDED DECEMBER 31,
--------------------------------
2002 2003 2004
------- -------- -------
(IN THOUSANDS)
Senior Market Independent Agents $17,561 $ 62,294 $19,495
Career Agency .................. 33,018 63,564 56,944
------- -------- -------
TOTAL ANNUITY DEPOSITS .. $50,579 $125,858 $76,439
======= ======== =======
The decline in annuity deposits is as a result of a reduction in the
current interest rates that we credit and the minimum interest rates that we
guarantee on our annuity products.
SENIOR ADMINISTRATIVE SERVICES
We have built our administrative services capabilities through internal
development and acquisition. Through our wholly owned subsidiary, CHCS Services,
we provide outsourcing services that support insurance and non-insurance
products, primarily for the senior market.
We perform a full range of administrative services for senior market
insurance products, primarily Medicare Supplement and Select, senior life and
long term care, for both affiliated and unaffiliated companies. The services
include policy underwriting and issuance, policy billing and collection,
telephone verification, policyholder services, claims adjudication and payment,
clinical case management, care assessment and referral to health care
facilities.
We also perform similar services, particularly in the long term care area,
for non-insurance products offered both by insurance and non-insurance
companies, including our Nurse Navigator(SM) product, a non-insurance elder care
service product that includes health related information and referrals and
access to nationwide networks of geriatric care nurses and long term care
providers available on a discounted basis.
13
We utilize state of the art technology and a national network of highly
trained health care professionals to provide the administrative platform for
these insurance and insurance-related products and services. The information
technology includes electronic claims processing, imaging and workflow processes
to ensure maximum efficiency in policy issue, policy administration and claims
processing. Our proprietary network of registered nurses and social workers
provides personalized support and care for our senior programs nationwide. In
addition, our proprietary network of discount providers is an integral part of
our geriatric care management services. We have a customer contact center that
provides around the clock access to our nurses on staff and can handle calls in
several different languages.
The following table shows the sources of our service fee revenue by type
of product:
YEAR ENDED DECEMBER 31,
-------------------------------
2002 2003 2004
------- ------- -------
(IN THOUSANDS)
Affiliated Revenue
Medicare Supplement ..................... $18,604 $22,478 $29,376
Long term care .......................... 2,635 2,589 2,752
Life Insurance .......................... 347 2,480 3,942
Other ................................... 1,245 1,797 2,819
------- ------- -------
Total Affiliated Revenue ............. 22,831 29,344 38,889
------- ------- -------
Unaffiliated Revenue
Medicare Supplement ..................... 9,022 9,469 8,557
Long term care .......................... 8,205 7,065 6,331
Non-insurance products .................. 1,270 1,563 1,552
Other ................................... 1,420 1,042 1,330
------- ------- -------
Total Unaffiliated Revenue ........... 19,917 19,139 17,770
------- ------- -------
Total Administrative Services Revenue........ $42,748 $48,483 $56,659
======= ======= =======
Included in unaffiliated revenue are fees received to administer certain
business of our insurance subsidiaries that is 100% reinsured to an unaffiliated
reinsurer which amounted to $5.3 million for the year ended December 31, 2004,
$7.4 million for 2003 and $6.9 million for 2002. These fees, together with the
affiliated revenue, were eliminated in consolidation.
14
MARKETING AND DISTRIBUTION
We distribute our insurance and managed care products through both our
career agency system and a traditional independent general agency system. We
measure new sales of our products based on issued annualized premiums,
representing the total annual premium expected to be received by us on policies
that were issued during the year. The following tables show our new sales,
excluding annuity deposits, (issued annualized premiums) by distribution channel
and by major product line on a gross basis (before reinsurance) and a net basis
(after reinsurance):
SENIOR SENIOR LIFE
MARKET MANAGED SPECIALTY INSURANCE
PRODUCT HEALTH CARE HEALTH /ANNUITIES TOTAL
- ------------------------------------- -------- -------- --------- ---------- --------
(IN THOUSANDS)
TOTAL DISTRIBUTION - GROSS
2004............................. $ 84,752 $ 21,574 $ 15,623 $ 38,469 $160,418
2003............................. 86,130 -- 19,836 25,264 131,230
2002............................. 92,059 -- 24,707 6,730 123,496
TOTAL DISTRIBUTION - NET
2004............................. $ 84,227 $ 21,574 $ 14,879 $ 23,951 $144,631
2003............................. 74,116 -- 17,379 16,109 107,604
2002............................. 46,932 -- 20,829 5,187 72,948
We have continued to expand geographically, and we have increased our
recruiting efforts to augment our production. Additionally, based on the
increased financial strength of our Company, we have increased our retention on
new Medicare Supplement business, in order to continue growing our net premium.
One marketing organization produced 8.5% in 2004 and 7.6% in 2003 of our
total annualized new sales, primarily senior life business. In 2002, two
marketing organizations produced 6.4% and 5.8%, respectively, of our total
annualized new sales, primarily Medicare Supplement business. No other marketing
organization or single agent produced more than 5.0% of our total annualized new
sales in 2004, 2003 or 2002.
CAREER AGENCY
In order to maximize production from our career agency sales force, we
focus on the sale of senior market insured and non-insured products through our
Senior Solutions(R) program. Senior Solutions(R) is our trademarked brand for
our portfolio of supplemental health and life insurance, asset protection and
senior care service products we offer the senior market, exclusively through our
career companies of Pennsylvania Life and Pyramid Life. In 2004, our career
agents also began distributing our Medicare Advantage products. As of December
31, 2004, our career field force had 84 Senior Solutions(R) branch offices
throughout the United States with approximately 1,800 agents. In contrast to
independent agents, career agents have an exclusive arrangement with us, and
only sell products that we provide or authorize.
Immediately after we acquired Heritage, our Senior Solutions(R) offices in
Southeastern Texas began to sell our SelectCare health plan product. By the end
of 2004, our Senior Solutions(R) agents represented approximately 35% of the new
sales of this product.
15
In addition, our career agency sales force distributes specialty health
insurance products, primarily fixed benefit accident and sickness disability
insurance, to the self-employed market in the United States and Canada. We have
13 branch offices in Canada, with approximately 300 agents that focus primarily
on this market.
The following tables show our new sales, excluding annuity deposits,
(issued annualized premiums) by our career agency systems by major product line
on a gross basis (before reinsurance) and a net basis (after reinsurance):
SENIOR SENIOR LIFE
MARKET MANAGED SPECIALTY INSURANCE
PRODUCT HEALTH CARE HEALTH /ANNUITIES TOTAL
- --------------------------------------- -------- -------- -------- ---------- --------
(IN THOUSANDS)
CAREER AGENCY - GROSS
2004............................... $ 26,614 $ 11,284 $ 15,408 $ 5,466 $ 58,772
2003............................... 20,242 -- 17,588 5,014 42,844
2002............................... 1,826 -- 20,561 2,872 25,259
CAREER AGENCY - NET
2004............................... 26,277 $ 11,284 $ 14,771 $ 5,466 $ 57,798
2003............................... 19,658 -- 16,255 5,014 40,927
2002............................... 913 -- 18,756 2,872 22,541
SENIOR MARKET INDEPENDENT AGENTS
This field force focuses on the sale of senior market products, including
Medicare Supplement and Medicare Select, senior life insurance, Acute Care and
senior dental products and annuities. These marketing organizations and general
agencies typically recruit and train their own agents, bearing all of the costs
incurred in connection with developing their organization. We now sell our
products through approximately 28,000 independent licensed agents in 35 states
and have plans to recruit more agents and expand into additional states.
In 2004, we began offering our Medicare Advantage private fee for service
products in New York and Pennsylvania through our senior market independent
agents.
The following tables show our new sales, excluding annuity deposits,
(issued annualized premiums) by our independent general agency system by major
product line on a gross basis (before reinsurance) and a net basis (after
reinsurance):
SENIOR SENIOR LIFE
MARKET MANAGED SPECIALTY INSURANCE
PRODUCT HEALTH CARE HEALTH /ANNUITIES TOTAL
- --------------------------------------- -------- -------- --------- ---------- --------
(IN THOUSANDS)
SENIOR MARKET INDEPENDENT AGENTS -
GROSS
2004............................... $ 58,137 $ 10,291 $ 215 $ 33,003 $101,646
2003............................... 65,888 -- 2,247 20,250 88,384
2002............................... 90,233 -- 4,146 3,858 98,237
SENIOR MARKET INDEPENDENT AGENTS - NET
2004............................... $ 57,951 $ 10,291 $ 107 $ 18,485 $ 86,834
2003............................... 54,458 -- 1,124 11,095 66,677
2002............................... 46,019 -- 2,073 2,315 50,407
16
DIRECT DISTRIBUTION
The Medicare Advantage HMO products offered by Heritage in the Texas
market are also distributed directly to consumers through a full-time employee
sales force. If we expand the geographical areas in which we market Medicare
Advantage HMO plans, we intend to build this aspect of our distribution.
GEOGRAPHICAL DISTRIBUTION OF PREMIUM
Through our insurance subsidiaries, we are licensed to market our products
in all fifty states, the District of Columbia, Puerto Rico and in all the
provinces of Canada. Our managed care subsidiary operates Medicare Advantage
health plans in Texas, New York and Pennsylvania. The following table shows the
geographical distribution of the direct cash premium and annuity deposits
collected (in thousands), as reported on a statutory basis to the regulatory
authorities for the full year of 2004:
REPETITIVE
% OF DIRECT CASH % OF ANNUITY % OF
STATE/REGION TOTAL TOTAL PREMIUM PREMIUM DEPOSITS ANNUITY
- -------------- -------- --------- ----------- --------- -------- ---------
Texas ........ $184,754 19.5% $182,251 20.9% $ 2,503 3.3%
Florida ...... 133,745 14.1% 126,011 14.5% 7,734 10.2%
Canada ....... 60,400 6.4% 60,400 6.9% -- -- %
New York ..... 58,257 6.1% 46,086 5.3% 12,171 16.1%
Indiana ...... 48,976 5.2% 44,088 5.1% 4,888 6.4%
Pennsylvania.. 48,933 5.2% 47,158 5.4% 1,775 2.3%
Wisconsin .... 48,955 5.2% 32,034 3.7% 16,921 22.3%
-------- -------- -------- -------- -------- --------
Subtotal.. 584,020 61.6% 538,028 61.7% 45,992 60.7%
All other .... 363,498 38.4% 333,695 38.3% 29,803 39.3%
-------- -------- -------- -------- -------- --------
Total ........ $947,518 100.0% $871,723 100.0% $ 75,795 100.0%
======== ======== ======== ======== ======== ========
TOTAL BUSINESS IN FORCE
Our direct, acquired and assumed annualized premium in force (including
only the portion of premiums on interest-sensitive products that is applied to
the cost of insurance) and related policy counts are shown in the following
tables:
GROSS ANNUALIZED PREMIUM IN FORCE
DECEMBER 31, 2004
-----------------
(IN MILLIONS, POLICIES IN THOUSANDS)
---------------------------------------------------------------------------------------------
SENIOR MARKET
INDEPENDENT AGENTS CAREER AGENCY DIRECT TOTAL
------------------ ------------- --------- ------ ----------------------------
$ % $ % $ % $ % POLICIES
----- ----- ----- ----- ----- ----- ----- ----- --------
SENIOR MARKET HEALTH INSURANCE
Medicare Supplement/Select .. 447.4 83.2% 126.2 43.5% -- -% 573.6 58.4% 310.1
Other Senior Health ......... 1.2 0.2% 0.6 0.2% -- -% 1.8 0.2% 4.3
----- ----- ----- ----- ----- ----- ----- ----- -----
SUB TOTAL ....................... 448.6 83.5% 126.8 43.7% -- -% 575.4 58.6% 314.4
----- ----- ----- ----- ----- ----- ----- ----- -----
SENIOR MANAGED CARE - MEDICARE
ADVANTAGE
Health Plan ................. -- -% 8.7 3.0% 154.1 100.0% 162.8 16.7% 18.8
Private Fee for Service ..... 9.6 1.7% - -% -- -% 9.6 1.0% 1.4
----- ----- ----- ----- ----- ----- ----- ----- -----
SUB TOTAL ....................... 9.6 1.7% 8.7 3.0% 154.1 100.0% 172.4 17.6% 20.2
----- ----- ----- ----- ----- ----- ----- ----- -----
SPECIALTY HEALTH INSURANCE
Accident & Sickness and Other 4.4 0.8% 58.9 20.3% -- -% 63.3 6.4% 200.5
Canadian Products ........... -- -% 61.3 21.1% -- -% 61.3 6.2% 131.9
Long Term Care .............. 24.0 4.5% 17.9 6.2% -- -% 41.9 4.3% 24.7
----- ----- ----- ----- ----- ----- ----- ----- -----
SUB TOTAL ....................... 28.4 5.3% 138.1 47.6% -- -% 166.5 16.9% 357.1
----- ----- ----- ----- ----- ----- ----- ----- -----
LIFE INSURANCE/ANNUITY .......... 50.9 9.5% 16.5 5.7% -- -% 67.4 6.9% 182.4
----- ----- ----- ----- ----- ----- ----- ----- -----
TOTAL ........................... 537.5 100.0% 290.1 100.0% 154.1 100.0% 981.7 100.0% 874.2
===== ===== ===== ===== ===== ===== ===== ===== =====
17
GROSS ANNUALIZED PREMIUM IN FORCE
DECEMBER 31, 2003
(IN MILLIONS, POLICIES IN THOUSANDS)
SENIOR MARKET
INDEPENDENT AGENTS CAREER AGENCY DIRECT TOTAL
$ % $ % $ % $ % POLICIES
----- ----- ----- ----- ----- ----- ----- ----- --------
SENIOR MARKET HEALTH INSURANCE
Medicare Supplement/Select .. 449.9 85.6% 111.9 42.0% -- -% 561.8 70.9% 309.5
Other Senior Health ......... 1.1 0.2% -- 0.0% -- -% 1.1 0.1% 1.9
----- ----- ----- ----- ----- ----- ----- ----- -----
SUB TOTAL ....................... 451.0 85.8% 111.9 42.0% -- -% 562.9 71.1% 311.5
----- ----- ----- ----- ----- ----- ----- ----- -----
SPECIALTY HEALTH INSURANCE
Accident & Sickness and other 9.3 1.8% 61.3 23.0% -- -% 70.6 8.9% 196.7
Canadian Products ........... -- 0.0% 57.0 21.4% -- -% 57.0 7.2% 135.9
Long Term Care .............. 25.5 4.9% 18.4 6.9% -- -% 43.9 5.5% 26.1
----- ----- ----- ----- ----- ----- ----- ----- -----
SUB TOTAL ....................... 34.8 6.6% 136.7 51.3% -- -% 171.5 21.6% 358.6
----- ----- ----- ----- ----- ----- ----- ----- -----
LIFE INSURANCE/ANNUITY .......... 39.7 7.6% 18.0 6.7% -- -% 57.7 7.3% 135.0
----- ----- ----- ----- ----- ----- ----- ----- -----
TOTAL ........................... 525.5 100.0% 266.6 100.0% -- -% 792.1 100.0% 805.0
===== ===== ===== ===== ===== ===== ===== ===== =====
ACCOUNT VALUES ON INTEREST-SENSITIVE PRODUCTS
The following table shows the account values and policy counts for our
interest-sensitive products before reinsurance. For these products, we earn
income on the difference between investment income that we earn on our invested
assets and interest credited to these account balances.
AS OF DECEMBER 31,
2002 2003 2004
-------- -------- --------
(IN THOUSANDS)
Annuities .............................. $134,860 $256,521 $317,085
Interest-sensitive Life................ 136,718 163,164 161,288
-------- -------- --------
Grand Total .................... $271,578 $419,685 $478,373
======== ======== ========
Policies .............................. 33.6 46.1 46.1
======== ======== ========
INVESTMENTS
Our investment policy is to balance the portfolio duration to achieve
investment returns consistent with the preservation of capital and maintenance
of liquidity adequate to meet payment of policy benefits and claims. We invest
in assets permitted under the insurance laws of the various states in which we
operate. Such laws generally prescribe the nature, quality of and limitations on
various types of investments that may be made. However, we do not currently have
investments in partnerships, special purpose entities, real estate, commodity
contracts, or other derivative securities. We currently engage the services of
three investment advisors under the direction of the management of our insurance
company subsidiaries and in accordance with guidelines adopted by the Investment
Committees of their respective boards of directors. Conning Asset Management
Company manages the portfolio of all of our United States subsidiaries, except
for the portfolio of Pyramid Life and certain floating rate portfolios, which
are managed by Hyperion Capital. MFC Global Investment Management manages our
Canadian portfolio. We invest primarily in fixed maturity securities of the U.S.
Government and its agencies and in corporate fixed maturity securities with
investment grade ratings of "BBB-" (Standard & Poor's Corporation), "Baa3"
(Moody's Investor Service), or higher. Our current policy is not to invest in
derivative programs
18
or other hybrid securities, except for GNMA's, FNMA's and investment grade
corporate collateralized mortgage obligations.
The following table summarizes the composition of our investment portfolio
by carrying value (which represents fair value):
DECEMBER 31, 2003 DECEMBER 31, 2004
-------------------------------- -------------------------------
PERCENT OF PERCENT OF
TOTAL TOTAL
CARRYING VALUE CARRYING CARRYING VALUE CARRYING
(FAIR VALUE) VALUE (FAIR VALUE) VALUE
------------ ----- ------------ -----
(IN THOUSANDS)
Fixed Maturity Securities:
U.S. Government and
Government agencies (1) .......... $ 226,738 17.6% $ 199,572 14.5%
Mortgage-backed (1) .............. 52,992 4.1% 133,596 9.7%
Asset-backed ..................... 48,080 3.70% 87,529 6.4%
Foreign securities (2) ........... 236,934 18.4% 238,347 17.2%
Investment grade corporates ...... 568,288 44.2% 504,775 36.6%
Non-investment grade corporates .. 8,360 0.6% 7,003 0.5%
---------- ---------- ---------- ----------
Total fixed maturity securities 1,141,392 88.7% 1,170,822 84.9%
Cash and cash equivalents ............ 116,524 9.1% 181,257 13.1%
Other Investments:
Policy loans ..................... 25,502 2.0% 24,318 1.8%
Equity securities ................ 1,507 0.1% 755 0.1%
Other invested assets ............ 1,583 0.1% 1,187 0.1%
---------- ---------- ---------- ----------
Total cash and invested assets ....... $1,286,508 100.0% 1,378,339 100.0%
========== ========== ========== ==========
(1) U.S. Government and government agencies include GNMA and FMNA
mortgage-backed securities.
(2) Primarily Canadian dollar denominated bonds supporting our Canadian
insurance reserves.
The following table shows the distribution of the contractual maturities
of our portfolio of fixed maturity securities by carrying value as of December
31, 2004. Expected maturities will differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without call
or prepayment penalties:
PERCENT OF TOTAL
AVAILABLE FOR SALE CARRYING VALUE FIXED MATURITIES
------------------ -------------- ----------------
(IN THOUSANDS)
Due in 1 year or less .............................. $ 35,118 3.0%
Due after 1 year through 5 years ................... 208,709 17.8%
Due after 5 years through 10 years.................. 326,983 27.9%
Due after 10 years ................................. 267,259 22.8%
Asset-backed securities ............................ 87,529 7.5%
Mortgage-backed securities ......................... 245,224 21.0%
---------- -----
Total ....................................... $1,170,822 100.0%
========== =====
19
The following table shows the distribution of the ratings assigned by
Standard & Poor's Corporation to the securities in our portfolio of fixed
maturity securities:
DECEMBER 31, 2003 DECEMBER 31, 2004
------------------------------ ----------------------------------
(IN THOUSANDS)
CARRYING VALUE CARRYING VALUE
STANDARD & POOR'S (ESTIMATED FAIR % OF TOTAL FIXED (ESTIMATED FAIR % OF TOTAL FIXED
RATING VALUE) INVESTMENT VALUE) INVESTMENT
------ ------ ---------- ------ ----------
AAA.......................... $ 380,683 33.4% $ 425,504 36.3%
AA........................... 123,752 10.8% 136,396 11.7%
A 475,056 41.6% 434,710 37.1%
BBB.......................... 153,540 13.5% 167,209 14.3%
BB........................... 7,768 0.6% 7,003 0.6%
B............................ 593 0.1% -- --%
---------- ----- ---------- -----
Total................ $1,141,392 100.0% $1,170,822 100.0%
========== ===== ========== =====
At December 31, 2004, 99.4% of our fixed maturity investments were rated
"investment grade" compared to 99.3% as of December 31, 2003. "Investment grade"
securities are those rated "BBB-" or higher by Standard & Poor's Corporation or
"Baa3" or higher by Moody's Investors Service. We owned approximately $332.8
million of collateralized mortgage obligations secured by residential mortgages
and asset-backed securities, as of December 31, 2004 compared to $253.1 million,
as of December 31, 2003, representing approximately 28.4% of our fixed maturity
portfolio as of December 31, 2004 and 22.2% of our fixed maturity portfolio as
of December 31, 2003. Some classes of mortgage backed securities are subject to
significant prepayment risk, because in periods of declining interest rates,
mortgages may be repaid more rapidly than scheduled, as individuals refinance
higher rate mortgages to take advantage of the lower rates. As a result, holders
of mortgage backed securities may receive higher prepayments on their
investments, which they may not be able to reinvest at an interest rate
comparable to the rate paid on such mortgage backed securities.
Fixed maturity securities with less than investment grade ratings had
aggregate carrying values of $7.0 million as of December 31, 2004 and $8.4
million as of December 31, 2003, amounting to 0.6% of total investments as of
December 31, 2004 and 0.7% of total investments as of December 31, 2003. These
securities represented less than 0.4% of total assets as of December 31, 2004
and 0.5% of total assets as of December 31, 2003. Our holdings of less than
investment grade fixed maturity securities are diversified and the largest
investment in any one such security as of December 31, 2004 was $3.0 million,
which was less than 0.2% of total assets. During the year ended December 31,
2004, we did not write down the value of any fixed maturity securities. We wrote
down the value of certain of our fixed maturity portfolio's securities
considered to have been subject to an other-than-temporary decline in value by
$1.3 million in 2003 and $10.6 million in 2002 (primarily as a result of the
impairment of our WorldCom bonds, which were disposed of in the third quarter of
2002 at a price approximating their carrying value after the
other-than-temporary decline was recognized). The other-than-temporary
impairments were included in net realized gains (losses) on investments in our
consolidated statements of operations.
20
INVESTMENT INCOME
Investment income is an important part of our total revenues and
profitability. We cannot predict the impact that changes in future interest
rates will have on our financial statements. The following table presents the
investment results of our total invested asset portfolio:
YEARS ENDED DECEMBER 31,
---------------------------------------------
2002 2003 2004
---------- ---------- ----------
(IN THOUSANDS)
Total cash and invested assets,
end of period ...................... $ 999,902 $1,286,508 $1,378,339
========== ========== ==========
Net investment income ................ $ 57,716 $ 61,075 $ 65,191
========== ========== ==========
Yield on average cash and
investments ........................ 6.1% 5.3% 4.9%
========== ========== ==========
Net realized investment gains
(losses) on the sale of
securities (including
other-than-temporary declines
in market value) ................... $ (5,083) $ 2,057 $ 10,647
========== ========== ==========
The decrease in our yield is a result of a decline in overall economic
interest rates and our decision to maintain higher cash balances in anticipation
of an increase in the economic interest rates.
REINSURANCE
In the normal course of business, we reinsure portions of certain policies
that we underwrite. We enter into reinsurance arrangements with unaffiliated
reinsurance companies to limit our exposure on individual claims and to limit or
eliminate risk on our non-core or under-performing blocks of business.
Accordingly, we are party to several reinsurance agreements on our life and
accident & health insurance risks. Our senior market accident & health insurance
products are generally reinsured under quota share coinsurance treaties, while
our life insurance risks are generally reinsured under either quota share
coinsurance or yearly-renewable term treaties. Under quota share coinsurance
treaties, we pay the reinsurer an agreed upon percentage of all premiums and the
reinsurer reimburses us that same percentage of any losses. In addition, the
reinsurer pays us allowances to cover commissions, cost of administering the
policies and premium taxes. Under yearly-renewable term treaties, the reinsurer
receives premiums at an agreed upon rate for its share of the risk on a
yearly-renewable term basis. We also use excess of loss reinsurance agreements
for certain policies whereby we limit our loss in excess of specified
thresholds.
The table below details our gross annualized premium in force, the portion
that we ceded to reinsurers and the net amount that we retained:
DECEMBER 31, 2003 DECEMBER 31, 2004
------------------------------------------ -------------------------------------------
GROSS CEDED NET RETAINED GROSS CEDED NET RETAINED
----- ----- --- -------- ----- ----- --- --------
(In millions)
SENIOR MARKET HEALTH INSURANCE
Medicare Supplement/Select .. $561.8 $242.8 $319.0 57% $573.6 $204.8 $368.8 64%
Other Senior Health ......... 1.1 0.2 0.9 82% 1.8 0.5 1.3 72%
------ ------ ------ --- ------ ------ ------ ---
SUB TOTAL ..................... 562.9 243.0 319.9 57% 575.4 205.3 370.1 64%
------ ------ ------ --- ------ ------ ------ ---
SPECIALTY HEALTH INSURANCE
Accident & Sickness and other 70.6 6.3 64.3 91% 63.3 2.1 61.2 97%
Canadian Products ........... 57.0 -- 57.0 100% 61.3 -- 61.3 100%
Long Term Care .............. 43.9 16.7 27.2 62% 41.9 14.8 27.1 65%
------ ------ ------ --- ------ ------ ------ ---
SUB TOTAL ..................... 171.5 23.0 148.5 87% 166.5 16.9 149.6 90%
------ ------ ------ --- ------ ------ ------ ---
LIFE INSURANCE/ANNUITIES ...... 57.7 12.6 45.1 78% 67.4 19.5 47.9 71%
------ ------ ------ --- ------ ------ ------ ---
TOTAL ......................... $792.1 $278.6 $513.5 65% $809.3 $241.7 $567.6 70%
====== ====== ====== == ====== ====== ====== ==
21
We have several quota share coinsurance agreements (as described above) in
place with General Re Life Corporation ("General Re") and Hannover Life Re of
America ("Hannover"). General Re is rated "A+" and Hannover is rated "A" by A.M.
Best. These agreements cover various accident & health insurance products,
primarily Medicare Supplement and long term care policies, written or acquired
by us and contain ceding percentages ranging from 25% to 100%. Effective January
1, 2004, we increased our retention on all new Medicare Supplement sales to
100%. During 2004, we ceded premiums of $109.0 million to General Re and $105.3
million to Hannover, each representing approximately 12% of our total direct and
assumed premiums. During 2003, we ceded premiums of $123.5 million to General Re
and $116.3 million to Hannover, representing 17% and 16%, respectively, of our
total direct and assumed premiums.
Our quota share coinsurance agreements are generally subject to cancellation
on 90 days notice as to future business, but policies reinsured prior to such
cancellation remain reinsured as long as they remain in force. There is no
assurance that if any of our reinsurance agreements were canceled we would be
able to obtain other reinsurance arrangements on satisfactory terms.
We evaluate the financial condition of our reinsurers and monitor
concentrations of credit risk to minimize our exposure to significant losses
from reinsurer insolvencies. We are obligated to pay claims in the event that a
reinsurer to whom we have ceded an insured claim fails to meet its obligations
under the reinsurance agreement. As of December 31, 2004, all of our primary
reinsurers were rated "A" or better by A.M. Best. We do not know of any
instances where any of our reinsurers have been unable to pay any policy claims
on any reinsured business.
ADMINISTRATION OF REINSURED BLOCKS OF BUSINESS
We retain the administration for reinsured blocks of business, including
underwriting, issue, policy maintenance, rate management and claims adjudication
and payment. In addition to reimbursement for commissions and premium taxes on
the reinsured business, we also receive allowances from the reinsurers as
compensation for our administration.
SENIOR MARKET HEALTH INSURANCE
Historically, we reinsured much of our Senior Market Health Insurance
business to unaffiliated reinsurers under quota share coinsurance agreements.
Beginning in 2001, we gradually reduced the amount of premium that we ceded to
reinsurers on new business, and all new Medicare Supplement business written
after January 1, 2004 has been 100% retained by the Company. Under the existing
coinsurance agreements, which remain in effect for the life of each policy
reinsured, we reinsure a portion of the premiums, claims and commissions on a
pro rata basis and receive additional expense allowances for policy issue and
administration and premium taxes. The amounts reinsured under these agreements
range from 25% to 100%. As older, reinsured business lapses and new business
that has no reinsurance is written, the overall percentage of business we retain
will increase. As of December 31, 2004, the percentage of Medicare Supplement
business we retained increased to 64%, as compared to 57% at the end of 2003.
SENIOR MANAGED CARE - MEDICARE ADVANTAGE
We reinsure our Medicare Advantage and private fee for service products on an
excess of loss basis, which limits our risk to amounts ranging from $100,000 to
$200,000.
22
SPECIALTY HEALTH INSURANCE
We retain 100% of the fixed benefit accident & sickness disability and
hospital business issued in our Specialty Health Insurance segment. Long term
care business is reinsured on a 50% quota share basis, except for the acquired
long term care business written in Pennsylvania Life and Union Bankers which is
100% retained. We have excess of loss reinsurance agreements to reduce our
liability on individual risks for home health care policies to $250,000. For
other long term care policies issued in the U.S. we have reinsurance agreements
which cover 90% of the benefits on claims after two years and 100% of the
benefits on claims after the third or fourth years depending upon the plan. We
also have excess of loss reinsurance agreements with unaffiliated reinsurance
companies on most of our medical insurance policies to reduce the liability on
individual risks to $325,000 per year.
LIFE INSURANCE/ANNUITIES
Senior life insurance products currently being issued are reinsured under 50%
quota share coinsurance agreements, except for certain states where our
retention is 100%. Our whole life products currently being issued are reinsured
on a yearly renewable term basis for amounts in excess of $100,000.
UNDERWRITING PROCEDURES
Premiums charged on insurance products are based, in part, on assumptions
about expected mortality and morbidity experience. We have adopted and follow
detailed uniform underwriting procedures designed to assess and quantify various
insurance risks before issuing individual life insurance, health insurance
policies and annuity policies to individuals. These procedures are generally
based on industry practices, reinsurer underwriting manuals and our prior
underwriting experience. To implement these procedures, our insurance company
subsidiaries employ an experienced professional underwriting staff.
Applications for insurance are reviewed on the basis of the answers that the
customer provides to the application questions. Where appropriate to the type
and amount of insurance applied for and the applicant's age and medical history,
additional information is required, such as medical examinations, statements
from doctors who have treated the applicant in the past and, where indicated,
special medical tests. If deemed necessary, we use investigative services to
supplement and substantiate information. For certain coverages, we may verify
information with the applicant by telephone. After reviewing the information
collected, we either issue the policy as applied for on a standard basis, issue
the policy with an extra premium charge due to unfavorable factors, issue the
policy excluding benefits for certain conditions, either permanently or for a
period of time, or reject the application. For some of our coverages, we have
adopted simplified policy issue procedures in which the applicant submits an
application for coverage typically containing only a few health-related
questions instead of a complete medical history. Under regulations promulgated
by the National Association of Insurance Commissioners ("NAIC") and adopted as a
result of the Omnibus Budget Reconciliation Act of 1990, we are prohibited from
using medical underwriting criteria for our Medicare Supplement policies for
certain first-time purchasers and for dis-enrollees from health maintenance
organizations (HMOs). If a person applies for insurance within six months after
becoming eligible by reason of age, or disability in some circumstances, the
application may not be rejected due to medical conditions. For other prospective
Medicare Supplement policyholders, such as senior citizens who are purchasing
our products, the underwriting procedures are limited based upon standard
industry practices.
In New York and some other states, some of our products, including Medicare
Supplement, are subject to guaranteed issue "Community Rating" laws that
severely limit or prevent underwriting of individual applications. See the
"Regulation" section of this document. Additionally, we are not permitted to
underwrite for new members for our Medicare Advantage HMO Plan or our private
fee for service plans.
23
RESERVES
In accordance with applicable insurance regulations, we have established, and
carry as liabilities in our statutory financial statements, actuarially
determined reserves that are calculated to satisfy our policy and contract
obligations. Reserves, together with premiums to be received on outstanding
policies and contracts and interest at assumed rates on such amounts, are
calculated to be sufficient to satisfy policy and contract obligations. The
actuarial factors used in determining reserves for life insurance policies are
based on statutorily prescribed mortality tables and interest rates. In
addition, reserves for accident and health insurance policies use prescribed or
permitted morbidity tables. Reserves are also maintained for unearned premiums,
for premium deposits, for claims that have been reported and are in the process
of being paid or contested and for our estimate for claims that have been
incurred but have not yet been reported.
The reserves reflected in our consolidated financial statements are
calculated in accordance with generally accepted accounting principles ("GAAP").
These reserves are determined based on our best estimates of mortality and
morbidity, persistency, expenses and investment income. We use the net level
premium method for all non-interest-sensitive products and the retrospective
deposit method for interest-sensitive products. GAAP reserves differ from
statutory reserves due to the use of different assumptions regarding mortality
and morbidity, interest rates and the introduction of lapse assumptions into the
GAAP reserve calculation.
When we acquire blocks of insurance policies or insurers owning blocks of
policies, our assessment of the adequacy of the transferred policy liabilities
is subject to risks and uncertainties. With acquired and existing businesses, we
may from time to time need to increase our claims reserves significantly in
excess of those estimated. An inadequate estimate in reserves could have a
material adverse impact on our results of operations or financial condition.
COMPETITION
The life and accident and health insurance industry in North America is
highly competitive. There are approximately 2,000 life and accident and health
insurance companies operating in the United States. We compete with numerous
other insurance companies on a national basis plus other regional insurance
companies and financial services companies, including health maintenance
organizations, preferred provider organizations, and other health care-related
institutions which provide medical benefits based on contractual agreements. We
may be at a disadvantage because many of these organizations have been in
business for a longer period of time and have substantially greater capital,
larger and more diversified portfolios of life and health insurance policies,
larger agency sales operations and higher ratings than we do. In addition, it
has become increasingly difficult for smaller and mid-size companies to compete
effectively with their larger competitors for insurance product sales in part as
a result of heightened consumer and agent awareness of the ratings and financial
size of companies.
We believe we can meet these competitive pressures by offering a high level
of service and accessibility to our field force and by developing specialized
products and marketing approaches. We also believe that our policies and premium
rates, as well as the commissions paid to our sales agents, are generally
competitive with those offered by other companies selling similar types of
products in the same jurisdictions. In addition, our insurance subsidiaries
operate at lower policy acquisition and administrative expense levels than some
other insurance companies, allowing us to offer competitive rates while
maintaining underwriting margins. In the case of our Medicare Supplement
business, low expense levels are necessary in order to meet state mandated loss
ratios and achieve the desired underwriting margins. Also, we believe our
disciplined underwriting procedures, pricing practices, effective rate
management and related staff, our quality customer service, our significant
market position in certain
24
geographic areas, the quality of our distribution network and our appropriate
financial strength, provide additional strength to compete effectively.
In addition, we compete with other managed care organizations for government
healthcare program contracts, renewals of those government contracts, members
and providers. Many of our competitors are large companies that have greater
financial, technological and marketing resources than we do. In the Medicare
managed care market, our primary competitors for contracts, members and
providers are national and regional commercial managed care organizations that
serve Medicare recipients and provider-sponsored organizations. The MMA may
cause a number of commercial managed care organizations already in our service
areas to decide to enter the Medicare market. In addition, beginning in 2006, a
new regional Medicare Preferred Provider Organization, or Medicare PPO, program
will be implemented pursuant to the MMA. Medicare PPOs would allow their members
more flexibility to select physicians than the current Medicare Advantage plans,
such as HMOs, which often require members to coordinate with a primary care
physician. Regional Medicare PPO plans will compete with local Medicare
Advantage HMO plans, including the plans we offer.
RATINGS
Increased public and regulatory concerns regarding the financial stability
of insurance companies have resulted in policyholders placing greater emphasis
upon company ratings and have created some measure of competitive advantage for
insurance carriers with higher ratings. A.M. Best is considered to be a leading
insurance company rating agency. In evaluating a company's financial and
operating performance, A.M. Best reviews profitability, leverage and liquidity
as well as the quality of the book of business, the adequacy and soundness of
reinsurance programs, the quality and estimated market value of assets, reserve
adequacy and the experience and competence of management. A.M. Best's ratings
are based upon factors relevant to policyholders, agents, insurance brokers and
intermediaries and are not directed to the protection of investors. Currently,
A.M. Best maintains ratings of "B++" on American Pioneer, American Progressive,
Constitution Life, Penncorp Life (Canada), Pennsylvania Life, and Pyramid Life
and B+ on Union Bankers. These B++ and B+ ratings mean that, in A.M. Best's
opinion, these companies have demonstrated "very good" overall performance when
compared to standards it has established and have a "good" ability to meet their
obligations to policyholders and are in the "Secure" category of all companies
rated by A.M. Best. A.M. Best does not rate our other insurance company
subsidiaries.
Standard & Poor's currently assigns its "BBB+ (stable outlook)" counterparty
credit and financial strength ratings to our American Pioneer, American
Progressive, Pennsylvania Life and Penncorp Life (Canada) subsidiaries. This
rating means that in Standard & Poor's opinion, these companies have good
financial security characteristics, but are more likely to be affected by
adverse business conditions than are insurers that are rated higher by Standard
& Poor's. A plus (+) or minus (-) shows Standard & Poor's opinion of the
relative standing of the insurer within a rating category. In connection with
our acquisition of Heritage Health Systems, Inc., Standard & Poor's placed its
"BBB- (stable outlook)" credit rating on our Amended Credit Facility. This
investment grade rating means the obligation exhibits adequate protection
parameters.
Our insurance company subsidiaries are not currently rated by Moody's
Investors Service or Fitch Ratings. Although a higher rating by A.M. Best,
Standard & Poor's or another insurance rating organization could have a
favorable effect on our business, we believe that our competitive pricing,
effective rate management, quality customer service and effective marketing has
enabled, and will continue to enable, our insurance company subsidiaries to
compete effectively.
25
REGULATION
General
Our insurance company subsidiaries, like other insurance companies, are
subject to the laws, regulations and supervision of the jurisdictions in which
they are domiciled. The purpose of those laws and regulations is primarily to
provide safeguards for policyholders rather than to protect the interest of
shareholders. The following table sets forth the domiciles of our insurance
company subsidiaries.
Florida:
American Pioneer Life Insurance Company ("American Pioneer")
Peninsular Life Insurance Company ("Peninsular")
New York:
American Progressive Life & Health Insurance Company of New York
("American Progressive")
Kansas:
The Pyramid Life Insurance Company ("Pyramid Life")
Oklahoma:
Eagle Life Insurance Company ("Eagle")
Pennsylvania:
Pennsylvania Life Insurance Company ("Pennsylvania Life")
Texas:
American Exchange Life Insurance Company ("American Exchange")
Constitution Life Insurance Company ("Constitution")
Marquette National Life Insurance Company ("Marquette")
SelectCare of Texas ("SelectCare")
Union Bankers Insurance Company ("Union Bankers")
Canada:
Penncorp Life Insurance Company ("Penncorp Life (Canada)")
Pennsylvania Life, Constitution Life, Union Bankers, American Pioneer and
American Progressive are subsidiaries of American Exchange. Pyramid Life is a
subsidiary of Pennsylvania Life. Marquette is a subsidiary of Constitution.
Peninsular Life is a subsidiary of American Pioneer. SelectCare is a subsidiary
of Heritage.
Each of our insurance company subsidiaries is also subject to the regulations
and supervision by the insurance department of each of the jurisdictions in
which they are admitted and authorized to transact business. Such regulations
cover, among other things, the declaration and payment of dividends by our
insurance company subsidiaries, the setting of rates to be charged for some
types of insurance, the granting and revocation of licenses to transact
business, the licensing of agents, the regulation and monitoring of market
conduct and claims practices, the approval of forms, the establishment of
reserve requirements, investment restrictions, the regulation of maximum
allowable commission rates, the mandating of some insurance benefits, minimum
capital and surplus levels, and the form and accounting practices used to
prepare financial statements required by statute. A failure to comply with legal
or regulatory restrictions may subject the insurance company subsidiary to a
26
loss of a right to engage in some businesses or an obligation to pay fines or
make restitution, which may affect our profitability.
Most jurisdictions mandate minimum benefit standards and loss ratios for
accident and health insurance policies. Generally we are required to maintain,
with respect to our individual long term care policies, minimum anticipated loss
ratios over the entire period of coverage. With respect to our Medicare
Supplement policies, we are generally required to attain and maintain an actual
loss ratio, after three years, of not less than 65 percent of earned premium. We
provide, to the insurance departments of all states in which we conduct
business, annual calculations that demonstrate compliance with required loss
ratio standards for both long term care and Medicare Supplement insurance. We
prepare these calculations utilizing statutory lapse and interest rate
assumptions. In the event we fail to maintain minimum mandated loss ratios, our
insurance company subsidiaries could be required to provide retrospective
premium refunds or prospective premium rate reductions. We believe that our
insurance company subsidiaries currently comply with all applicable mandated
minimum loss ratios. In addition, we actively review the loss ratio experience
of our products and request approval for rate increases from the respective
insurance departments when we determine they are needed. We cannot guarantee
that we will receive the rate increases we request.
Under Federal and NAIC model regulations, adopted in substantially all
states, there are currently 12 standard Medicare Supplement plans (Plans A
through J and High Deductible Plans F and J). Plan A provides the least
extensive coverage, while Plan J provides the most extensive coverage. Under
NAIC regulations, Medicare Supplement insurers must offer Plan A, but may offer
any of the other plans at their option. The Medicare Prescription Drug,
Improvement and Modernization Act of 2003 ("MMA") prohibits the sale of the
former H, I and J plans and authorizes two additional plans after December 2005
(Plans K and L).
Every insurance company that is a member of an "insurance holding company
system" generally is required to register with the insurance regulatory
authorities in its domicile state and file periodic reports concerning its
relationships with its insurance holding company and with its affiliates.
Material transactions between registered insurance companies and members of the
holding company system are required to be "fair and reasonable" and in some
cases are subject to administrative approval. The books, accounts and records of
each party are required to be maintained so as to clearly and accurately
disclose the precise nature and details of any such transactions.
Each of our U.S. insurance company subsidiaries is required to file detailed
reports with the insurance department of each jurisdiction in which it is
licensed to conduct business and its books and records are subject to
examination by each such insurance department. In accordance with the insurance
codes of their domiciliary states and the rules and practices of the NAIC, our
insurance company subsidiaries are examined periodically by examiners of each
company's domiciliary state with elective participation by representatives of
the other states in which they are licensed to do business. Regularly scheduled
regulatory financial examinations are near completion for American Progressive,
Pyramid, and Marquette as of and for the period ended December 31, 2003. We have
not been informed of any significant findings or adjustments to statutory
surplus from these examinations, except for a finding for American Progressive
regarding annuity sales practices. During the fourth quarter of 2004, we
recorded approximately $0.3 million in additional benefits on certain
replacement annuity policies that we determined contained inappropriate
disclosure information to the insured. There is no additional liability to these
policyholders. There were no other regulatory financial examinations of our
insurance subsidiaries during 2004.
Many states require deposits of assets by insurance companies for the
protection of policyholders either in those states or for all policyholders.
These deposited assets remain part of the total assets of the
-27-
company. As of December 31, 2004, securities totaling $41.8 million,
representing approximately 3.8% of the carrying value of our total investments,
were on deposit with various state treasurers or custodians. As of December 31,
2003, securities totaling $44.1 million, representing approximately 3.8% of
total investments, were on deposit. These deposits must consist of securities
that comply with the standards established by the particular state.
Penncorp Life (Canada), our Canadian domiciled subsidiary, is subject to
provincial regulation and supervision in each of the provinces of Canada in
which it conducts business. Provincial insurance regulation is concerned
primarily with the form of insurance contracts and the sale and marketing of
insurance and annuity products, including the licensing and supervision of
insurance marketing personnel.
Other Insurance Regulatory Changes
The NAIC and state insurance regulators in the United States are involved in
a process of re-examining existing laws and regulations and their application to
insurance companies. This re-examination has focused on insurance company
investment and solvency issues, risk-based capital guidelines, assumption
reinsurance, interpretations of existing laws, the development of new laws, the
interpretation of non-statutory guidelines, and the circumstances under which
dividends may be paid. The NAIC has encouraged states to adopt model laws on
specific topics as follows: investment reserve requirements; risk-based capital
standards; additional investment restrictions; restrictions on an insurance
company's ability to pay dividends; product illustrations; suitability of
annuity sales to seniors; and producer compensation disclosures.
The NAIC is currently developing new model laws or regulations, including
product design standards and reserve requirements. While the Federal government
currently does not regulate the insurance business directly, Federal legislation
and administrative policies in a number of areas, such as Medicare, employee
benefits regulation, age, sex and disability-based discrimination, financial
services regulation and Federal taxation, can significantly affect the insurance
business. It is not possible to predict the future impact of changing regulation
on our operations or the operations of our insurance company subsidiaries.
Since 1993, New York State has required that all health insurance sold to
individuals and groups with less than 50 employees be offered on an open
enrollment and community rated basis. The community rating aspect of the law
prohibits the use of age, sex, health or occupational factors in rating and
requires that the same average rate be used for all persons with the same policy
residing in the same location. Such insurance may continue to be sold to groups
with more than 50 employees on an underwritten basis, with premium set to
reflect expected or actual results. The Medicare Supplement policies actively
marketed by American Progressive in New York State and some of its in force
business are subject to the community rating rules. Similar legislation is in
effect for certain products in other states. The extension of such legislation
to other states where we offer significant medically underwritten health
insurance might cause us to reconsider our health care coverage offerings in any
such state.
Producer Compensation Disclosure
State regulators and attorney generals have initiated investigations into
producer compensation and product pricing. While the initial investigations have
focused on commercial lines insurers and brokers, it remains to be seen whether
the investigations will broaden and potentially change how our products are
sold. We have responded to inquiries regarding our sales practices, and we do
not anticipate that our responses will require any change in our compensation
practices or any other adverse result. The NAIC appointed a task force to
consider appropriate regulatory action. In late December 2004, the NAIC adopted
an amendment to the Producer Licensing Model Act. The amendment, while not a
state law, is expected to be considered by state legislators during 2005. The
amendment to the model law would require our producers to disclose to
prospective purchasers of our products the fact that the producer will
28
receive compensation from the insurance company that issues an insurance product
to the consumer. It is possible that some states will adopt laws that are
broader than the NAIC model amendment.
Long Term Care Rate Stabilization
In 2000, the NAIC adopted a model law intended to address the issue of the
rising cost of long term care insurance and other matters. The model law
includes provisions intended to assure that rates on long term care insurance
policies, under which the insurer reserves the right to increase premiums, are
initially set high enough to make such increases unlikely. These rate
stabilization laws have been adopted in a number of states. Although we no
longer market long term care insurance, we are complying with the laws as they
are adopted by filing new policy forms and rates. Insurers are now required to
certify that rates will not be increased in moderately adverse circumstances.
Annuity Suitability
In September 2003, the National Association of Insurance Commissioners
adopted the Senior Protection in Annuity Transaction Model Regulation. It is
expected that most states will adopt the regulation swiftly. The model
regulation imposes additional obligations on insurance producers and their
supervisors relating to annuity sales to customers age 65 and over. The burden
of demonstrating suitability of the recommended annuity is that of the producer
with oversight responsibilities imposed on the producer's supervisor and the
insurer. We are developing guidelines to distribute to our sales forces to
assist in complying with the regulations.
Recent Medicare Reform Legislation
Medicare is a federal program that provides eligible persons age 65 and over
and some disabled persons a variety of hospital and medical insurance benefits.
Medicare beneficiaries have the option to enroll in a Medicare Advantage plan as
an HMO benefit in areas where such a plan is offered. Under Medicare Advantage,
managed care plans contract with CMS to provide comparable Medicare benefits as
a traditional fee-for-service Medicare in exchange for a fixed monthly payment
per member that varies based on the county in which a member resides.
On December 8, 2003, President Bush signed MMA, which made numerous changes
to the Medicare program, including expanding the Medicare program to include a
prescription drug benefit beginning in 2006, a transitional drug discount card
that as of June 2004 enables Medicare beneficiaries to obtain discounts on drugs
prior to receiving drug coverage in 2006, and expanding the Medicare+Choice
program and renaming it "Medicare Advantage." Medicare Advantage plans are
eligible to sponsor the drug discount card and transitional assistance program
as well as the new prescription drug plan. CMS, however, may limit the number of
prescription drug plan sponsors and endorsed drug card sponsors that are
selected in a particular area. We offer an approved drug discount card in
certain markets.
MMA creates the drug discount card and transitional assistance program as an
interim program until the new drug benefit goes into effect January 1, 2006. The
voluntary drug discount card program will enable Medicare beneficiaries to pay a
fixed fee to access discounts on drugs. Certain low income beneficiaries may
enroll in the transitional assistance program and receive a subsidy of up to
$600 per year for certain covered drugs that are purchased using the drug
discount card. A Medicare Advantage plan may apply to be an endorsed sponsor of
the drug card as a stand alone product or may apply to offer the drug discount
card exclusively to its enrollees. The drug discount card program went into
effect in June 2004 and sponsors may continue to enroll eligible individuals
through December 31, 2005. In 2006, endorsed card sponsors must honor the drug
card until the end of a transition period which runs until the date of the
individual's enrollment in a new drug benefit or the end of the drug benefit
enrollment period.
-29-
Under MMA, commencing in 2006, a new voluntary prescription drug benefit will
be available under Medicare. Medicare beneficiaries will pay a monthly premium
for the covered outpatient drug benefit offered through a private drug plan. The
drug benefit is subject to certain cost sharing. Under the standard drug
coverage, for 2006, the cost sharing is a $250 deductible, 25% coinsurance for
annual drug costs reimbursed by Medicare, up to $2,250, and no reimbursement for
drug costs above $2,250, until the beneficiary has paid $3,600. After that, MMA
provides catastrophic stop loss coverage for annual incurred drug costs in
excess of $3,600, subject to nominal cost-sharing. Plans are not required to
mirror these limits; instead, drug plans are required to provide coverage that
is at least actuarially equivalent to the standard drug coverage delineated in
the MMA. These numbers will be adjusted on an annual basis. MMA provides
subsidies and the reduction or elimination of cost sharing for certain
low-income beneficiaries, including dual-eligible individuals who receive
benefits under both Medicare and Medicaid. This new drug benefit will be offered
by new regional prescription drug plans. Medicare Advantage organizations must
offer a plan with the drug benefit. In addition, Medicare Advantage plans may
bid to offer a stand-alone prescription drug plan that beneficiaries who have
fee for service Medicare may elect.
MMA also revises payment methodologies for Medicare Advantage organizations
beginning in 2004, and in 2006 MMA expands the Medicare Advantage program to
include, in addition to the traditional HMO and fee-for-service plans
established by county, new regional plans which will provide out-of-network
benefits in addition to in-network benefits. The Secretary of Health and Human
Services, or HHS, created 26 regions, each of which may include more than one
state or portions of a particular state. MMA creates a new competitive bidding
process beginning in 2006 for both the local HMO plan and the new regional plan
for setting the payment to the Medicare Advantage plan and the beneficiary
premium and benefits. The bidding process does not limit the number of plans
that may participate in the Medicare Advantage program.
MMA shifts coverage responsibility for the drug benefit for dual-eligible
individuals. Starting January 1, 2006, dual-eligibles will receive their drug
coverage from the Medicare program and not the Medicaid program.
Dividend Restrictions
American Progressive is a New York insurance company. New York State
insurance law provides that the declaration or payment of a dividend by American
Progressive requires the approval of the New York Superintendent of Insurance.
Management expects that no dividend would be approved until American Progressive
had generated sufficient statutory profits to offset its negative unassigned
surplus.
Pennsylvania Life is a Pennsylvania insurance company, Pyramid Life is a
Kansas insurance company and American Exchange, Constitution, Marquette and
Union Bankers are Texas insurance companies. SelectCare is licensed in Texas as
a Provider Sponsored Organization ("PSO"). Pennsylvania, Kansas and Texas
insurance laws provide that a life insurer may pay dividends or make
distributions from accumulated earnings without the prior approval of the
Insurance Department, provided they do not exceed the greater of (i) 10% of the
insurer's surplus as to policyholders as of the preceding December 31; or (ii)
the insurer's net gain from operations for the immediately preceding calendar
year with 30 days advance notification to the insurance department. Accordingly,
Pennsylvania Life would be able to pay ordinary dividends of up to $6.3 million
to American Exchange (its direct parent) without the prior approval from the
Pennsylvania Insurance Department in 2005. Pyramid Life would be able to pay
ordinary dividends of up to $2.5 million to Pennsylvania Life (its direct
parent) without the prior approval from the Kansas Insurance Department and
Marquette would be able to pay ordinary dividends of up to $0.3 million to
Constitution (its direct parent) without the prior approval from the Texas
Insurance Department in 2005. American Exchange, Constitution and Union Bankers
had negative earned surplus at December 31, 2004 and would not be able to pay
dividends in 2005 without
30
special approval. Texas insurance companies are also required to have positive
"earned surplus", as defined by Texas regulations, which differs from statutory
unassigned surplus. SelectCare would not be able to pay dividends in 2005 with
out special approval.
American Pioneer and Peninsular are Florida insurance companies. Florida
insurance law provides that a life insurer may pay a dividend or make a
distribution without the prior written approval of the department when certain
conditions are met. American Pioneer had negative unassigned surplus at December
31, 2004 and would not be able to pay dividends in 2005 without special
approval.
Penncorp Life (Canada) is a Canadian insurance company. Canadian law provides
that a life insurer may pay a dividend after such dividend declaration has been
approved by its board of directors and upon at least 10 days prior notification
to the Superintendent of Financial Institutions. Such a dividend is limited to
retained net income (based on Canadian GAAP) for the preceding two years, plus
net income earned for the current year. In considering approval of a dividend,
the board of directors must consider whether the payment of such dividend would
be in contravention of the Insurance Companies Act of Canada. During 2004,
Penncorp Life (Canada) paid dividends of C$33.9 million (approximately US$25.5
million) to Universal American in 2004. We anticipate that Penncorp (Canada)
will be able to pay dividends equal to its net income earned during 2005, less
$2.5 million.
Risk-Based Capital and Minimum Capital Requirements
The NAIC's risk-based capital requirements for insurance companies adopted by
state regulators take into account asset risks, interest rate risks, mortality
and morbidity risks and other relevant risks with respect to the insurer's
business and specify varying degrees of regulatory action to occur to the extent
that an insurer does not meet the specified risk-based capital thresholds, with
increasing degrees of regulatory scrutiny or intervention provided for companies
in categories of lesser risk-based capital compliance. Penncorp Life (Canada),
is subject to minimum continuing capital and surplus requirements, which
Canadian regulators use to assess financial strength and to determine when
regulatory intervention is needed. As of December 31, 2004 all of our U.S.
insurance company subsidiaries maintained ratios of total adjusted capital to
risk-based capital in excess of the authorized control level and Penncorp Life
(Canada) maintained minimum continuing capital and surplus requirement ratios in
excess of minimum requirements. However, should our insurance company
subsidiaries' risk-based capital position decline in the future, their ability
to pay dividends, required capital contributions from Universal American and the
degree of regulatory supervision or control to which they are subjected might be
affected.
Guaranty Association Assessments
Our insurance company subsidiaries can be required, under solvency or
guaranty laws of most jurisdictions in which they do business, to pay
assessments to fund policyholder losses or liabilities of unaffiliated insurance
companies that become insolvent. These assessments may be deferred or forgiven
under most solvency or guaranty laws if they would threaten an insurer's
financial strength and, in most instances, may be offset against future premium
taxes. The insurance company subsidiaries provide for known and expected
insolvency assessments based on information provided by the National
Organization of Life & Health Guaranty Associations. Our insurance company
subsidiaries have not incurred any significant costs of this nature. The
likelihood and amount of any future assessments is unknown and is beyond our
control.
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The Health Insurance Portability and Accountability Act of 1996
The Health Insurance Portability and Accountability Act of 1996 ("HIPAA")
mandates guaranteed availability and renewability of health insurance for
certain employees and individuals; limits on termination options and on the use
of preexisting condition exclusions; prohibitions against discriminating on the
basis of health status; and requirements which make it easier to continue
coverage in cases where an employee is terminated or changes employers. HIPAA
also calls for the adoption of standards for the exchange of electronic health
information and privacy requirements that govern the handling, use and
disclosure of protected customer health information. We anticipate that we will
meet the HIPAA Security Rule changes that will become effective on April 21,
2005, many of which have been implemented with the privacy portion of HIPAA.
However, HIPAA is far-reaching and complex and proper interpretation and
practice under the law continue to evolve. Consequently, our efforts to measure,
monitor and adjust our business practices to comply with HIPAA are ongoing. We
do not believe that compliance with those aspects of HIPAA currently in effect
and those in the process of regulatory completion, if adopted as currently
proposed, will have a material adverse effect on our financial condition or
results of operations.
"Do Not Call" Regulations
Effective October 1, 2003, the Federal government removed the exemption for
insurance companies as it relates to "Do Not Call" regulations. Insurance
companies are now required to develop their own "Do Not Call" lists and
reference state and Federal Do Not Call Registries, before making calls to
market insurance products. Approximately two thirds of the country's residential
telephone numbers are on the Federal registry, which could limit the marketing
calls made and potentially negatively impact sales.
Patriot Act
The portion of the USA PATRIOT Act that applies to insurance companies became
effective in mid 2004. Insurance companies will have to impose tighter processes
and procedures to more thoroughly verify its applicants, insureds, claimants and
premium payers in an effort to prevent money laundering. Our insurance companies
have implemented measures to comply with the Office of Federal Asset Control
requirements, whereby the names of customers and potential customers must be
reviewed against a listing of known terrorists and money launderers.
OUTSOURCING ARRANGEMENTS
Mainframe Processing - Data Center Outsourcing. We outsource our mainframe
processing to Alicomp ("Alicomp"), a division of Alicare, Inc. The data center
is located in Leonia, New Jersey. Our core application software programs are run
in Alicomp's data center facility to obtain the necessary mainframe computer
capacity and other computer support services without making the substantial
capital and infrastructure investments that would be necessary for us to provide
these services internally.
Our current agreement with Alicomp obligates Alicomp to provide us with
comprehensive data processing services and obligates us to utilize Alicomp's
services for substantially all of our mainframe data processing requirements. We
are billed monthly for these services on an as-used basis in accordance with a
predetermined pricing schedule for specific services. Our agreement with
Alicomp, as amended, expires on December 31, 2008, and is terminable by us with
or without cause. Our current agreement with Alicomp is renewable automatically
for consecutive one year terms unless and until either party has provided the
other with six months prior written notice of nonrenewal. In the event we elect
to terminate the contract, we would be subject to termination fees equal to six
months of current fees should we terminate the contract in 2005, four months of
current fees should we terminate the contract in 2006, two
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months of current fees should we terminate the contract in 2007 and one month of
current fees should we terminate the contract in 2008. Alicomp also provides us
with mainframe disaster recovery services. During 2004, we paid an average of
$0.4 million per month.
Medicare Advantage Administration. Heritage outsources certain administrative
services, including member services and billing and enrollment to an
unaffiliated heath care services company. Under this agreement, which expires in
January 2010, Heritage pays a percentage of monthly revenues for the contracted
services. During 2004, we paid an average of $0.4 million per month.
EMPLOYEES
As of February 25, 2005, we employed approximately 1,200 employees, none of
whom is represented by a labor union in such employment. We consider our
relations with our employees to be good.
RISK FACTORS
The following risks may have a material impact on our results of operations
or financial condition:
RISKS RELATED TO OUR BUSINESS
Our net income may decline if our premium rates are not adequate.
We set the premium rates on our insurance policies based on facts and
circumstances known at the time we issue the policies and on assumptions about
numerous variables, including the actuarial probability of a policyholder
incurring a claim, the severity and duration of the claim, the mortality rate of
our policyholder base, the persistency or renewal rate of our policies in force,
our commission and policy administration expenses, and the interest rate earned
on our investment of premiums. In setting premium rates, we consider historical
claims information, industry statistics and other factors. If our actual claims
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 review the adequacy of our accident & health premium
rates regularly and file rate increases on our products when we believe
permitted premium rates are too low. When determining whether to approve or
disapprove our rate increase filings, the various state insurance departments
take into consideration our actual claim experience compared to expected claim
experience, policy persistency (which means the percentage of policies that are
in-force at certain intervals from the issue date compared to the total amount
originally issued), investment income and medical cost inflation. If the
regulators do not believe these factors warrant a rate increase, it is possible
that we will not be able to obtain approval for premium rate increases from
currently pending requests or requests filed in the future. If we are unable to
raise our premium rates because we fail to obtain approval for rate increases in
one or more states, our net income may decrease. If we are successful in
obtaining regulatory approval to raise premium rates, the increased premium
rates may reduce the volume of our new sales and cause existing policyholders to
let their policies lapse. This would reduce our premium income in future
periods. Increased lapse rates also could require us to expense all or a portion
of the deferred policy costs relating to lapsed policies in the period in which
those policies lapse, reducing our net income in that period.
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Our reserves for future policy benefits and claims may prove to be
inadequate, requiring us to increase liabilities and resulting in reduced net
income and shareholders' equity.
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. For our accident and health insurance business, we establish active
life reserves for expected future policy benefits (including for certain of our
policies, provisions for return of premiums ("ROP")), plus a liability for due
and unpaid claims, claims in the course of settlement, and incurred but not
reported claims. Many factors can affect these reserves and liabilities, such as
economic and social conditions, taxability of ROP benefits, inflation, hospital
and medical costs, changes in doctrines of legal liability and extra-contractual
damage awards. Therefore, the reserves and liabilities we establish are
necessarily based on extensive estimates, assumptions and prior years'
statistics. When we acquire other insurance companies or blocks of insurance,
our assessment of the adequacy of acquired policy liabilities is subject to
similar estimates and assumptions. Establishing reserves involves inherent
uncertainties, and it is possible that actual claims could materially exceed our
reserves and have a material adverse effect on our results of operations and
financial condition. 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 be required to increase our liabilities
resulting in reduced net income, statutory surplus and shareholders' equity.
We incurred additional debt obligations in connection with our acquisition of
Heritage that could restrict our operations.
We have a significant amount of outstanding indebtedness. As of December 31,
2004, we had $101 million in borrowings outstanding under our amended credit
agreement and $75 million in trust preferred securities. We have available
borrowing capacity under our new senior secured revolving credit facility of
approximately $15 million. We may also incur additional indebtedness in the
future. Our substantial indebtedness could have adverse consequences, including:
- increasing our vulnerability to adverse economic, regulatory and industry
conditions, and placing us at a disadvantage compared to our competitors
that are less leveraged;
- limiting our ability to compete and our flexibility in planning for, or
reacting to, changes in our business and the industry in which we operate;
- limiting our ability to borrow additional funds for working capital,
capital expenditures, acquisitions and general corporate or other
purposes; and
- exposing us to greater interest rate risk since the interest rate on
borrowings under our senior credit facilities is variable.
Our debt service obligations will require us to use a portion of our
operating cash flow to pay interest and principal on indebtedness instead of for
other corporate purposes, including funding future expansion of our business and
ongoing capital expenditures. If our operating cash flow and capital resources
are insufficient to service our debt obligations, we may be forced to sell
assets, seek additional equity or debt capital or restructure our debt. However,
these measures might be unsuccessful or inadequate in permitting us to meet
scheduled debt service obligations.
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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.
We are an insurance holding company whose assets principally consist of the
capital stock of our operating subsidiaries, substantially all of which is
pledged to our bank lenders. Because our principal outstanding indebtedness has
been incurred by our parent company, our ability to make interest and principal
payments on our outstanding debt is dependent upon the ability of our
subsidiaries to pay cash dividends or make other cash payments to our parent
company. Our subsidiaries will be able to pay dividends to our parent company
only if they earn sufficient profits and, in the case of our insurance company
subsidiaries, they satisfy the requirements of the state insurance laws relating
to dividend payments and the maintenance of required surplus, to which they are
subject.
Capital constraints could restrict our ability to support our premium growth
Our continued growth is dependent upon our ability to support premium growth
through the expansion of our markets and our network of agents while at the same
time maintaining sufficient levels of capital and surplus to support that
growth. Our new business growth typically results in reduced income, or net
losses, on some products during the early years of a policy (statutory surplus
strain), due primarily to differences in accounting practices between statutory
accounting principles and generally accepted accounting principles in the United
States and Canada. The resulting statutory surplus strain can limit our ability
to generate new business due to statutory restrictions on premium to surplus
ratios and other required statutory surplus parameters. In addition, some
states, such as Florida and Texas, limit an insurer's ability to write certain
lines of business if gross and/or net premiums written would exceed a specified
percentage of surplus. In addition, we are required to maintain adequate risk
based capital ratios as prescribed by the National Association of Insurance
Commissioners ("NAIC"). Moreover, substantially more capital than the statutory
minimums are needed to support our level of premium growth and to finance
acquisitions. If we cannot generate sufficient capital and statutory surplus to
maintain minimum statutory requirements and support our growth, we could be
restricted in our ability to generate new premium revenue.
The availability of reinsurance on acceptable terms and the financial
stability of our reinsurers could impact our ability to manage risk and
increase the volume of insurance that we sell.
We utilize reinsurance agreements with larger, financially sound reinsurers
to mitigate insurance risks that we underwrite. We enter into reinsurance
arrangements with unaffiliated reinsurance companies to limit our exposure on
individual claims and to limit or eliminate risk on our non-core or
under-performing blocks of business. As of December 31, 2004, we ceded to
reinsurers approximately 25% of our gross annualized insurance premium in force.
Reinsurance arrangements leave us exposed to two risks: credit risk and
replacement risk. Credit risk exists because reinsurance does not relieve us of
our liability to our insureds for the portion of the risks ceded to reinsurers.
We are exposed to the risk of a reinsurer's failure to pay in full and in a
timely manner the claims we make against them in accordance with the terms of
our reinsurance agreements, which could expose our insurance company
subsidiaries to liabilities in excess of their reserves and surplus and could
expose them to insolvency proceedings. The failure of a reinsurer to make claims
payments to us could materially and adversely affect our results of operations
and financial condition and our ability to make payments to our policyholders.
Replacement risk exists because a reinsurer may cancel its participation on new
business issued on advance notice. As a result, we would need to find
reinsurance from another source to support our level of new business. The amount
and cost of reinsurance available to us is subject, in large part, to prevailing
market conditions beyond our control. Because our current reinsurance agreements
are non-cancelable for business in force, non-renewal or cancellation of a
reinsurance arrangement affects only new business and the reinsurer remains
liable on business reinsured prior to non-renewal or cancellation. In the event
that current reinsurers cancel their
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participation on new business, we would seek to replace them, possibly at higher
rates. If we are not able to reinsure our life insurance products on acceptable
terms, we would consider limiting the amount of such new business issued. A
failure to obtain reinsurance on acceptable terms would allow us to underwrite
new business only to the extent that we are willing and able to bear the
exposure to the new business on our own.
Our financial strength rating is lower than several distributors' minimum
acceptable rating and could affect our competitiveness and results of
operations.
Increased public and regulatory concerns regarding the financial stability of
insurance companies have resulted in policyholders placing greater emphasis upon
financial strength ratings and have created some measure of competitive
advantage for insurance companies with higher ratings. Our ability to expand and
to attract new business is affected by the financial strength ratings assigned
to our insurance company subsidiaries by independent insurance industry rating
agencies, such as A.M. Best Company, Inc. Some distributors such as financial
institutions, unions, associations and affinity groups may not sell our products
to these groups unless the rating of our insurance company subsidiary writing
the business improves to at least an "A-" from their current "B++." The lack of
higher A.M. Best ratings for our insurance company subsidiaries could adversely
affect sales of our products. In addition, any future downgrade in our ratings
may cause our policyholders to allow their existing policies to lapse. Increased
lapse rates 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, reducing net income in that period. Any future
downgrade in our ratings could also cause some of our agents to sell less of our
products or to cease selling our policies altogether.
Failure to maintain our information systems could adversely affect our
business.
Our business depends significantly on efficient, effective and well
controlled information systems. We have various information systems which
support our operating segments. Our information systems require an ongoing
commitment of significant resources to maintain and enhance existing systems and
develop new systems in order to keep pace with continuing changes in information
processing technology, evolving industry and regulatory standards, and changing
customer preferences. We have outsourced the operation of our data center to an
independent third party and may from time to time obtain additional services or
facilities from other independent third parties. Dependence on third parties for
these services and facilities may make our operations vulnerable to their
failure to perform as agreed.
There is no assurance that we will continue to be successful in managing our
growing operations or in integrating acquired companies into our operations.
As part of our strategy, we have experienced, and expect to continue to
experience, considerable growth through acquisitions and our internal efforts.
The rapid growth in the size and complexity of our operations has placed, and
will continue to place, significant demands on our management, operations
systems, accounting systems, internal controls systems and financial resources.
Acquisitions involve numerous additional risks, some of which we have
experienced in the past, including: (i) difficulties in integrating operations,
technologies, products, systems and personnel of the acquired company; (ii)
diversion of financial and management resources from existing operations; (iii)
potential increases in policy lapses; (iv) potential losses from unanticipated
litigation or levels of claims; and (v) inability to generate sufficient revenue
to offset acquisition costs. Our ability to manage our growth and compete
effectively will depend, in part, on our success in addressing these demands and
risks. Any failure by us to effectively manage our growth could have a material
adverse effect on our business, financial condition or results of operations.
36
We may not be able to find suitable acquisition candidates.
Part of our business strategy is to make acquisitions that will be accretive
to income and will advance our strategic mission. Since 1990, we have acquired
ten insurance companies, three administrative companies and four blocks of
insurance business. Additionally, in May 2004, we acquired Heritage Health
Systems, Inc., a privately owned managed care company that operates Medicare
Advantage plans in Southeastern Texas. We continue to evaluate possible
acquisition transactions on an ongoing basis, and at any given time, we may be
engaged in discussions with respect to possible acquisitions. We cannot be sure
that we will be able to find suitable acquisition candidates and close the
transactions. Factors that might preclude closing transactions include the
inability to reach a definitive agreement with the seller, the inability to
obtain financing on acceptable terms, and the discovery of material issues with
the acquisition candidate as a result of our due diligence investigation. If we
cannot find suitable acquisition candidates or are not successful in completing
acquisitions, we may not be able to sustain our recent historical growth rates.
Changes in the exchange rate between the U.S. dollar and the Canadian dollar
may impact our results.
We publish our consolidated financial statements in U.S. dollars. However,
portions of our operations are transacted using the Canadian dollar as the
functional currency. As of and for the year ended December 31, 2004,
approximately 12% of our assets, 9% of our revenues, excluding realized gains,
and 16% of our income before realized gains and taxes were derived from our
Canadian operations. Accordingly, our earnings and shareholders' equity are
affected by fluctuations in the value of the U.S. dollar as compared to the
Canadian dollar. Although this risk is somewhat mitigated by the fact that both
the assets and liabilities for our Canadian operations are denominated in
Canadian dollars, we are still subject to losses resulting from currency
translation that will impact our reported consolidated financial condition,
results of operations and cash flows from year to year.
A significant amount of our assets is invested in fixed income securities and
is subject to market fluctuations.
Our investment portfolio consists almost entirely of fixed income securities.
The fair market value of these assets and the investment income from these
assets fluctuate depending on general economic and market conditions. The fair
market value of our investments in fixed income securities generally increases
or decreases in an inverse relationship with fluctuations in interest rates,
while net investment income realized by us from future investments in fixed
income securities will generally increase or decrease with interest rates. In
addition, actual net investment income and/or cash flows from investments that
carry prepayment risk (such as mortgage-backed and other asset-backed
securities) may differ from those anticipated at the time of investment as a
result of interest rate fluctuations. Because substantially all of our fixed
income securities are classified as available for sale, changes in the market
value of our securities are reflected in our balance sheet. Similar treatment is
not available for liabilities. Therefore, interest rate fluctuations could
adversely affect our results of operations and financial condition.
Compliance with recently enacted laws and regulations is complex and
expensive
Several laws and regulations adopted by the Federal government including
Sarbanes-Oxley, HIPPA, the Patriot Act, and "Do Not Call" regulations, have
created additional administrative and compliance requirements on the Company.
The requirements of these laws and regulations are still evolving and the cost
of compliance may have an adverse effect on our profitability. In addition, if
we do not comply adequately, we may be faced with administrative penalties.
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Future changes in legislation may adversely affect our business
Since insurance and managed care are regulated businesses with high public
profiles, it is always possible that future legislation may be enacted which
would have an adverse effect on our business.
Proposals for further federal reforms have included, among other things,
restricting coverage of deductible and co-payments on Medicare Supplement
policies, coverage to persons under age 65 and employer-based insurance systems,
subsidizing premiums for lower income people and programs, regulating policy
availability, affordability of public and private programs standardization of
major medical or long term care coverages, imposing mandated or target loss
ratios or rate regulation, and requiring the use of community rating or other
means that further limit the ability of insurers to differentiate among risks,
or mandating utilization review or other managed care concepts to determine what
benefits would be paid by insurers.
In addition to federal regulation, many states have enacted, or are
considering, various health care reform statutes. These proposed reforms relate
to, among other things, managed care practices, such as waiting period
restrictions on pre-existing conditions, credit for certain prior coverage, and
limitations on rate increases and guaranteed renewability for small business
plans and policies for individuals. Most states have also enacted patient
confidentiality laws that prohibit the disclosure of confidential medical
information, some of which, as permitted by HIPAA, are more restrictive than
HIPAA's rules protecting health information privacy. These or other reform
proposals could necessitate revisions in our Medicare Supplement products could
increase or decrease the level of competition among health care insurers and
could significantly affect our health insurance business, although it is not
possible to predict which proposals will be adopted and what their effect will
be.
A portion of our insurance business is the sale of deferred annuities and
life insurance products, which are attractive to purchasers in part because
policyholders generally are not subject to Federal income tax on increases in
the value of an annuity or life and health insurance contract until some form of
distribution is made from the contract. From time to time, Congress has
considered proposals to reduce or eliminate the tax advantages of annuities and
life insurance, which, if enacted, might have an adverse effect on our ability
to sell the affected products in the future.
We may be responsible for the actions of our independent and career agents
In litigation against our subsidiaries, claims are sometimes made that agents
failed to comply with applicable laws, regulations and rules, or acted
improperly in other ways, and that we are responsible for such failure. Although
we require our agents to comply with applicable laws, regulations, and our rules
and standards, and maintain monitoring and supervisory procedures to enforce
this requirement, we may be held liable for contractual or extra-contractual
damages on such claims. While no such claim has resulted in material liability
to any of our insurance subsidiaries in the past, no assurance can be given that
no material liability will result in the future.
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RISKS RELATED TO OUR MEDICARE ADVANTAGE BUSINESS
If our government contracts are not renewed or are terminated, our business
could be substantially impaired.
We provide our Medicare and other services through a limited number of
contracts with federal government agencies. These contracts generally have terms
of one or two years and are subject to nonrenewal by the applicable agency. All
of our government contracts are terminable for cause if we breach a material
provision of the contract or violate relevant laws or regulations. In addition,
our right to add new members may be suspended by a government agency if it finds
deficiencies in our provider network or operations. If we are unable to renew,
or to successfully rebid or compete for any of our government contracts, or if
any of our contracts are terminated, our business could be substantially
impaired. If any of those circumstances were to occur, we would likely pursue
one or more alternatives, including seeking to enter into contracts in other
geographic markets, seeking to enter into contracts for other services in our
existing markets, or seeking to acquire other businesses with existing
government contracts. If we were unable to do so, we could be forced to cease
conducting business. In any such event, our revenues and profits would decrease
materially.
If we are unable to manage medical benefits expense effectively, our
profitability will likely be reduced or we could cease to be profitable.
The profitability of our Medicare Advantage business depends, to a
significant degree, on our ability to predict and effectively manage our costs
related to the provision of healthcare services. Relatively small changes in the
ratio of our expenses related to healthcare services to the premiums we receive,
or medical loss ratio, can create significant changes in our financial results.
Factors that may cause medical benefits expense to exceed our estimates include:
- an increase in the cost of healthcare services and supplies, including
pharmaceuticals, whether as a result of inflation or otherwise;
- higher than expected utilization of healthcare services;
- periodic renegotiation of hospital, physician and other provider
contracts;
- the occurrence of catastrophes, major epidemics, terrorism or
bio-terrorism;
- changes in the demographics of our members and medical trends affecting
them; and
- new mandated benefits or other changes in healthcare laws, regulations
and/or practices.
Because of the relatively high average age of the Medicare population, medical
benefits expense for our Medicare plans may be particularly difficult to
control. Although we have been able to manage our medical benefits expense
through a variety of techniques, we may not be able to continue to manage these
expenses effectively in the future. If our medical benefits expense increases,
our profits could be reduced or we may not remain profitable. We maintain
reinsurance to protect us against severe or catastrophic medical claims, but we
cannot assure you that such reinsurance coverage currently is or will be
adequate or available to us in the future or that the cost of such reinsurance
will not limit our ability to obtain it.
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Because our Medicare Advantage premiums, which generate most of our Medicare
Advantage revenues, are fixed by contract, we are unable to increase our
Medicare Advantage premiums during the contract term if our corresponding
medical benefits expense exceeds our estimates.
Most of our Medicare Advantage revenues are generated by premiums consisting
of fixed monthly payments per member. These payments are fixed on an annual
basis by contract, and we are obligated during the contract period, which is
generally one or two years, to provide or arrange for the provision of
healthcare services as established by state and federal governments. We have
less control over costs related to the provision of healthcare services than we
do over our selling, general and administrative expense. Medical benefits
expense as a percentage of premium revenue tends to fluctuate. If our medical
benefits expense exceeds our estimates, we will be unable to adjust the premiums
we receive under our current contracts, and our profits may decline.
Reductions in funding for government healthcare programs could substantially
reduce our profitability.
All of our Medicare Advantage programs we offer are through
government-sponsored programs, such as Medicare. As a result, our profitability
is dependent, in large part, on continued funding for government healthcare
programs at or above current levels. For example, the premium rates paid to
health plans like ours by the Federal government differ depending on a
combination of factors such as upper payment limits established by the Federal
government, a member's health status, age, gender, county or region, and member
eligibility categories. In addition, CMS has adopted a payment program, whereby
in 2004, 30% of the premium rates paid to health plans related to specific
disease classification of members. This will increase to 50% in 2005, to 75% in
2006 and to 100% in 2007. Reductions in payments under Medicare or the other
programs under which we offer health plans could likewise reduce our
profitability. Federal budgetary constraints also may limit premiums payable
under our Medicare plans.
We are subject to extensive government regulation, and any violation of the
laws and regulations applicable to us could reduce our revenues and
profitability and otherwise adversely affect our operating results.
Our Medicare Advantage business is extensively regulated by the federal
government and the states in which we operate. The laws and regulations
governing our Medicare Advantage operations are generally intended to benefit
and protect health plan members and providers rather than stockholders. The
government agencies administering these laws and regulations have broad latitude
to enforce them. These laws and regulations, along with the terms of our
government contracts, regulate how we do business, what services we offer, and
how we interact with our members, providers and the public. We are subject, on
an ongoing basis, to various governmental reviews, audits and investigations to
verify our compliance with our contracts and applicable laws and regulations.
Any adverse review, audit or investigation could result in:
- forfeiture of amounts we have been paid pursuant to our government
contracts;
- imposition of civil or criminal penalties, fines or other sanctions on us;
- loss of our right to participate in government-sponsored programs,
including Medicare;
- damage to our reputation in various markets;
- increased difficulty in marketing our products and services; and
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- loss of one or more of our licenses to act as an insurer or health
maintenance organization or to otherwise provide a service.
Any of these events could reduce our revenues and profitability and otherwise
adversely affect our operating results.
We derive a substantial portion of our Medicare Advantage revenues and
profits from Medicare Advantage operations in Texas, and legislative
actions, economic conditions or other factors that adversely affect those
operations could materially reduce our revenues and profits.
If we are unable to continue to operate in Texas, or if our current
operations in any portion of Texas are significantly curtailed, our revenues
will decrease materially. Our reliance on our operations in Texas could cause
our revenues and profitability to change suddenly and unexpectedly, depending on
legislative actions, economic conditions and similar factors. In addition, our
market share in Texas may make it more difficult for us to expand our membership
in existing markets in Texas. Our inability to continue to operate in Texas, or
a decrease in the revenues of our Texas operations, would harm our overall
operating results.
We may be unable to expand into some geographic areas without incurring
significant additional costs.
We are likely to incur additional costs if we enter states or counties
where we do not currently operate. Our rate of expansion into other geographic
areas may also be inhibited by:
- the time and costs associated with obtaining a health maintenance
organization license to operate in the new area or the expansion of
our licensed service area, if necessary;
- our inability to develop a network of physicians, hospitals and
other healthcare providers that meets our requirements and those of
government regulators;
- competition, which increases the costs of recruiting members;
- the cost of providing healthcare services in those areas; and
- demographics and population density.
Accordingly, we may be unsuccessful in entering other metropolitan areas,
counties or states.
A failure to estimate incurred but not reported medical benefits expense
accurately will affect our profitability.
Our medical benefits expense includes estimates of medical claims incurred
but not reported, or IBNR. We, together with our internal and consulting
actuaries, estimate our medical cost liabilities using actuarial methods based
on historical data adjusted for payment patterns, cost trends, product mix,
seasonality, utilization of healthcare services and other relevant factors.
Actual conditions, however, could differ from those assumed in the estimation
process. Due to the uncertainties associated with the factors used in these
assumptions, materially different amounts could be reported in our financial
statements for a particular period under different conditions or using different
assumptions. Adjustments, if necessary, are made to medical benefits expense
when the criteria used to determine IBNR change and when actual claim costs are
ultimately determined. Although our estimates of IBNR have historically been
adequate, they may be inadequate in the future, which would adversely affect our
results of
41
operations. Further, our inability to estimate IBNR accurately may also affect
our ability to take timely corrective actions, further exacerbating the extent
of any adverse effect on our results.
The new Medicare legislation makes changes to the Medicare program that
could reduce our profitability and increase competition for our existing
and prospective members.
On December 8, 2003, President Bush signed the Medicare Modernization Act
of 2003 (the "MMA"). The new rate methodologies, expanded benefits and shifts in
certain coverage responsibilities pursuant to the Act may increase competition
and create uncertainties, including the following:
- The Act increases reimbursement for Medicare Advantage plans. Higher
reimbursement rates may increase the number of plans that
participate in the program, creating new competition that could
adversely affect our profitability.
- Beginning in 2006, a new regional Medicare Preferred Provider
Organization, or Medicare PPO, program will be implemented pursuant
to the Act. Medicare PPOs would allow their members more flexibility
to select physicians than the current plans, which are HMOs that
require members to coordinate with a primary care physician. The
regional Medicare PPO program will compete with local Medicare
Advantage HMO programs and may affect our Medicare Advantage HMO
business. We do not know how the creation of the regional Medicare
PPO program, which is intended to provide further choice to
beneficiaries, will affect our Medicare Advantage HMO business.
- Beginning in 2006, the payments for the local Medicare Advantage HMO
and regional Medicare Advantage PPO programs will be based on a
competitive bidding process that may decrease the amount of premiums
paid to us or cause us to increase the benefits we offer.
- Beginning in 2006, organizations that offer Medicare Advantage plans
of the type we currently offer will be required to offer a
prescription drug benefit, as defined by Medicare, and Medicare
Advantage enrollees will be required to obtain their drug benefit
from their Medicare Advantage plan. It is not known at this time
whether the governmental payments will be adequate to cover the
actual costs for this benefit. Current enrollees may prefer a
stand-alone drug plan and may dis-enroll from the Medicare Advantage
plan altogether in order to participate in another drug plan.
Accordingly, the new prescription drug benefit could reduce our
profitability and membership enrollment following its implementation
in 2006.
- Some enrollees may have chosen our Medicare Advantage plan in the
past rather than a Medicare fee-for-service program because of the
added drug benefit that we offer with our Medicare Advantage plan.
Following the implementation of the new prescription drug benefit,
Medicare beneficiaries will have the opportunity to obtain a drug
benefit without joining a managed care plan. As a result, our
membership enrollment may decline.
42
Future changes in healthcare law may reduce our profitability or
liquidity.
Healthcare laws and regulations, and their interpretations, are subject to
frequent change. Changes in existing laws or regulations, or their
interpretations, or the enactment of new laws or regulations could reduce our
profitability by:
- imposing additional capital requirements;
- increasing our administrative and other costs;
- increasing mandated benefits;
- forcing us to restructure our relationships with providers; or
- requiring us to implement additional or different programs and
systems.
Changes in state law also may adversely affect our profitability. Laws relating
to managed care consumer protection standards, including increased plan
information disclosure, limits to premium increases, expedited appeals and
grievance procedures, third party review of certain medical decisions, health
plan liability, access to specialists, clean claim payment timing, physician
collective bargaining rights and confidentiality of medical records either have
been enacted or continue to be under discussion. New healthcare reform
legislation may require us to change the way we operate our business, which may
be costly. Further, although we have exercised care in structuring our
operations to attempt to comply in all material respects with the laws and
regulations applicable to us, government officials charged with responsibility
for enforcing such laws may assert that we or certain transactions in which we
are involved are in violation of these laws, or courts may ultimately interpret
such laws in a manner inconsistent with our interpretation. Therefore, it is
possible that future legislation and regulation and the interpretation of laws
and regulations could have a material adverse effect on our ability to operate
under the Medicare program and to continue to serve our members and attract new
members.
Restrictions on our ability to market would adversely affect our revenue.
We rely on our marketing and sales efforts for a significant portion of
our membership growth. The federal and state governments in which we currently
operate permit marketing but impose strict requirements and limitations as to
the types of marketing activities that are permitted. If our marketing efforts
were to be prohibited or curtailed, our ability to increase or sustain
membership would be significantly harmed, which would adversely affect our
revenue.
If we are unable to maintain satisfactory relationships with our
providers, our profitability could decline and we may be precluded from
operating in some markets.
Our profitability depends, in large part, upon our ability to enter into
cost-effective contracts with hospitals, physicians and other healthcare
providers in appropriate numbers in our geographic markets and at convenient
locations for our members. In any particular market, however, providers could
refuse to contract, demand higher payments or take other actions that could
result in higher medical benefits expense. In some markets, certain providers,
particularly hospitals, physician/hospital organizations or multi-specialty
physician groups, may have significant market positions or near monopolies. If
such a provider or any of our other providers refuse to contract with us, use
their market position to negotiate contracts that might not be cost-effective or
otherwise place us at a competitive disadvantage, those activities could
adversely affect our operating results in that market area. In the long term,
our ability to contract successfully with a sufficiently large number of
providers in a particular geographic market will
43
affect the relative attractiveness of our managed care products in that market
and could preclude us from renewing our Medicare contracts in those markets or
from entering into new markets. Our provider contracts with network primary care
physicians and specialists generally have terms of one year, with automatic
renewal for successive one-year terms. We may terminate these contracts for
cause, based on provider conduct or other appropriate reasons, subject to laws
giving providers due process rights. The contracts generally may be cancelled by
either party without cause upon 60 or 90 days prior written notice. Our
contracts with hospitals generally have terms of one to two years, with
automatic renewal for successive one-year terms. We may terminate these
contracts for cause, based on provider misconduct or other appropriate reasons.
Our hospital contracts generally may be cancelled by either party without cause
upon 120 days prior written notice. We may be unable to continue to renew such
contracts or enter into new contracts enabling us to serve our members
profitably. We will be required to establish acceptable provider networks prior
to entering new markets. Although we have established long-term relationships
with many of our network providers, we may be unable to maintain those
relationships or enter into agreements with providers in new markets on a timely
basis or under favorable terms. If we are unable to retain our current provider
contracts or enter into new provider contracts timely or on favorable terms, our
profitability could decline.
We may not have adequate intellectual property rights in our brand names
for our health plans, and we may be unable to adequately enforce such
rights.
Our success depends, in part, upon our ability to market our health plans
under our brand names, including our "Texan Plus" family of products. While we
hold federal trademark registrations for the "Texan Plus" trademark, we have not
taken enforcement action to prevent infringement of our federal trademark and
have not secured registrations of our other marks. Other businesses may have
prior rights in the brand names that we market under or in similar names, which
could limit or prevent our ability to use these marks, or to prevent others from
using similar marks. If we are unable to prevent others from using our brand
names, or if others prohibit us from using them, our revenues could be adversely
affected. Even if we are able to protect our intellectual property rights in
such brands, we could incur significant costs in doing so.
Ineffective management of our growth may adversely affect our results of
operations, financial condition and business.
Depending on acquisition and other opportunities, we expect to continue to
increase our membership and to expand into other markets. Continued rapid growth
could place a significant strain on our management and on other resources. Our
ability to manage our growth may depend on our ability to strengthen our
management team and attract, train and retain skilled associates, and our
ability to implement and improve operational, financial and management
information systems on a timely basis. If we are unable to manage our growth
effectively, our financial condition and results of operations could be
materially and adversely affected.
We are subject to competition that may limit our ability to increase or
maintain membership in the markets we serve.
We operate in a highly competitive environment and in an industry that is
currently subject to significant changes due to business consolidations, new
strategic alliances and aggressive marketing practices by other managed care
organizations. We compete for members principally on the basis of size, location
and quality of provider network, benefits provided, quality of service and
reputation. A number of these competitive elements are partially dependent upon
and can be positively affected by financial resources available to a health
plan. Many other organizations with which we compete have substantially greater
financial and other resources than we do. In addition, changes resulting from
the new Medicare
44
legislation may bring additional competitors into our market area. As a result,
we may be unable to increase or maintain our membership.
Claims relating to medical malpractice and other litigation could cause us
to incur significant expenses.
The providers with whom we contract who are involved in medical care
decisions may be exposed to the risk of medical malpractice claims. A small
percentage of these providers do not have malpractice insurance. Although our
network providers are independent contractors, claimants sometimes allege that a
managed care organization such as us should be held responsible for alleged
provider malpractice, and some courts have permitted that theory of liability.
In addition, managed care organizations may be sued directly for alleged
negligence, such as in connection with the credentialing of network providers or
for improper denials or delay of care. In addition, Congress and several states
are considering legislation that would expressly permit managed care
organizations to be held liable for negligent treatment decisions or benefits
coverage determinations. From time to time, we are party to various other
litigation matters, some of which seek monetary damages. We cannot predict with
certainty the eventual outcome of any pending litigation or potential future
litigation, and we might incur substantial expense in defending these or future
lawsuits or indemnifying third parties with respect to the results of such
litigation. We maintain errors and omissions insurance with a policy limit of
$10 million and other insurance coverage and, in some cases, indemnification
rights that we believe are adequate based on industry standards. However,
potential liabilities may not be covered by insurance or indemnity, our insurers
or indemnifying parties may dispute coverage or may be unable to meet their
obligations or the amount of our insurance or indemnification coverage may be
inadequate. We cannot assure you that we will be able to obtain insurance
coverage in the future, or that insurance will continue to be available on a
cost-effective basis, if at all. Moreover, even if claims brought against us are
unsuccessful or without merit, we would have to defend ourselves against such
claims. The defense of any such actions may be time-consuming and costly, and
may distract our management's attention. As a result, we may incur significant
expenses and may be unable to effectively operate our business.
Negative publicity regarding the managed care industry may harm our
business and operating results.
In the past, the managed care industry has received negative publicity.
This publicity has led to increased legislation, regulation, review of industry
practices and private litigation in the commercial sector. These factors may
adversely affect our ability to market our services, require us to change our
services and increase the regulatory burdens under which we operate, further
increasing the costs of doing business and adversely affecting our operating
results.
RISKS RELATED TO THE INSURANCE BUSINESS
We may not be able to compete successfully with competitors that have
greater resources than we do.
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. Our future success will depend, in part, on our ability to
effectively enhance our current products and claims processing capabilities and
to develop new products in the changing health care environment on a timely and
cost-effective basis.
45
We may not be able to compete successfully if we cannot recruit and retain
insurance agents.
We distribute our products principally through career agents and
independent agents who we recruit and train to market and sell our products. We
also engage managing general agents from time to time to recruit agents and
develop networks of agents in various states. We compete with other insurance
companies for productive agents, primarily on the basis of our financial
position, support services, compensation and product features. It can be
difficult to successfully compete with larger insurance companies that have
higher financial strength ratings than we do for productive agents. Our business
and ability to compete will suffer if we are unable to recruit and retain
insurance agents or if we lose the services provided by our managing general
agents.
Governmental regulation could affect our profitability.
Our insurance company subsidiaries are subject to regulation and
supervision by the insurance departments of their domiciliary jurisdictions.
Each is also subject to regulation and supervision by the insurance department
of each of the other states in which they are admitted to do business. Such
supervision and regulation are largely for the benefit and protection of
policyholders and not shareholders. Such regulation and supervision by the
insurance departments extend, among other things, to the declaration and payment
of dividends by our insurance company subsidiaries, the setting of rates to be
charged for some types of insurance, the granting and revocation of licenses to
transact business, the licensing of agents, monitoring market conduct, approval
of forms, establishment of reserve requirements, regulation of maximum
commissions payable, mandating some insurance benefits, claims practices,
maintenance of minimum surplus requirements, and the form and content of
financial statements required by statute. Our failure to comply with legal or
regulatory restrictions could result in our inability to engage in some
businesses or an obligation to pay fines or make restitution, which could affect
our profitability. 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. Some states currently limit rate increases on long term
care insurance products and other states have considered doing so. Because
insurance premiums are our primary source of income, our net income may be
reduced by any of these changes.
We may be required to refund or reduce premiums if our premium rates are
determined to be too high.
Insurance regulators require that we maintain minimum statutory loss
ratios on some of the insurance products that we sell. We must therefore pay
out, on average, a specified 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 insurance products are not in compliance with state
mandated minimum loss ratios, state regulators may require us to refund or
reduce premiums.
Recently enacted and pending or future legislation could affect our
income.
During recent years, the health insurance industry has experienced
substantial changes, primarily caused by healthcare legislation. Recent Federal
and state legislation and legislative proposals relating to healthcare reform
contain features that could severely limit or eliminate our ability to vary our
pricing terms or apply medical underwriting standards with respect to
individuals, which could increase our loss ratios and decrease our
profitability. In 2003, Congress passed the Medicare Modernization Act of 2003.
Although there are several components to this Medicare reform bill that may have
an impact on our
46
Medicare Supplement business, two fundamental components will be most relevant.
First, the bill establishes a prescription drug benefit under Medicare and a
mechanism for private insurers to offer this program. Second, the bill contains
significant incentives designed to improve current Medicare + Choice (now known
as Medicare Advantage) plans, and to encourage new Medicare Advantage plans to
enter the market on a favorable basis. The legislation may create some downward
pressure on our Medicare Supplement sales, largely because the increased
government reimbursements for managed care plans will encourage HMOs to add
benefits to existing plans or add new plans, in more jurisdictions. In addition,
an increase in the market acceptance of Medicare Advantage plans may adversely
affect our persistency. If the legislation leads to a significant increase in
the number of Medicare beneficiaries enrolled in health maintenance
organizations, sales of our Medicare Supplement products may decrease since the
product provides benefits that supplement the coverage provided by traditional
Medicare. This could have a material adverse effect on our business, financial
condition and results of operations.
We have stopped selling new long term care insurance and the premiums that
we charge for the policies that remain in force may not be adequate to
cover the claims expenses that we incur.
We have concluded that the sale of long term care insurance does not fit
within our strategic or financial goals. We began to curtail the sale of new
business in 2003, and stopped all new sales at the end of 2004. Approximately,
$42 million of premium remains in force, of which we retain approximately $27
million. Although the entire block of business was slightly profitable in 2004,
we have incurred substantial losses from a block of home health care business
that we stopped selling in 1999. There can be no assurance that current premiums
we charge will be adequate to cover the claims expenses that we will incur in
the future. There is also no assurance that rate increases that we may seek will
be approved by the applicable state regulators or, if approved, will be adequate
to fully mitigate adverse loss experience.
Tax law changes could adversely affect our sales and profitability.
We sell deferred annuities and some forms of life insurance products,
which are attractive to purchasers in part because policyholders generally are
not subject to Federal income tax on increases in policy values until some form
of distribution is made. From time to time, Congress has considered proposals to
reduce or eliminate the tax advantages of annuities and life insurance which, if
enacted, could make these products less attractive to consumers. We do not
believe that Congress is now actively considering any legislation that would
reduce or eliminate the tax advantages of annuities or life insurance. However,
it is possible that the tax treatment of annuities or life insurance could
change as a result of legislation, Internal Revenue Service regulations, or
judicial decisions. The reduction or loss of these tax advantages could reduce
our sales of life and annuity products and their profitability.
Insurance companies are frequently the targets of litigation, including
class action litigation that could result in substantial judgments.
A number of civil jury verdicts have been returned against insurers in the
jurisdictions in which we do business involving insurers' sales practices,
alleged agent misconduct, discrimination and other matters. Increasingly these
lawsuits have resulted in the award of substantial judgments against the insurer
that are disproportionate to the actual damages, including material amounts of
punitive damages. In some states, juries have substantial discretion in awarding
punitive and non-economic compensatory damages which creates the potential for
unpredictable material adverse judgments in any given lawsuit. In addition, in
some class action and other lawsuits involving insurers' sales practices,
insurers have made material settlement payments. We may also face lawsuits from
insureds who dispute our refusal to pay claims made by them. From time to time
we are involved in such litigation or, alternatively, in arbitration. We cannot
predict the outcome of any such litigation or arbitration. Because litigation
and jury trials are
47
inherently unpredictable and some amounts sought by plaintiffs are large, there
can be no assurance that any litigation involving us will not have a material
adverse effect on our business, financial condition or results of operations.
ITEM 2 - PROPERTIES
Our executive offices are located in Rye Brook, New York. Marketing and
professional staff for our U.S. insurance subsidiaries occupy space in Lake
Mary, Florida. Our Canadian operations are located in Mississauga, Ontario,
Canada. Our Administrative Services operations occupy office space in Pensacola
and Weston, Florida. Our Medicare Advantage operations occupy office space in
Houston and Beaumont, Texas and Nashville, Tennessee. We lease all of the
approximately 285,000 square feet of office space that we occupy. Management
considers its office facilities suitable and adequate for the current level of
operations. In addition to the above, Pennsylvania Life or Penncorp Life
(Canada) is the named lessee on approximately 71 properties occupied by career
agents for use as field offices. Rent for these field offices is reimbursed by
the agents. Additional information regarding our lease obligations is included
in Note 17 - Commitments and Contingencies in our consolidated financial
statements included in this Form 10-K.
ITEM 3 - LEGAL PROCEEDINGS
We have litigation in the ordinary course of our business, including
claims for medical, disability and life insurance benefits, and in some cases,
seeking punitive damages. Management and counsel believe that after reserves and
liability insurance recoveries, none of these will have a material adverse
effect on us.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted by us to a vote of stockholders, through
the solicitation of proxies or otherwise, during the fourth quarter of 2004.
48
PART II
ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF COMMON SECURITIES
MARKET INFORMATION
Our common stock is traded in the over-the-counter market and quoted on
the Nasdaq National Market tier of The Nasdaq Stock Market ("Nasdaq") under the
symbol "UHCO". The following table sets forth the high and low sales prices for
our common stock on the Nasdaq National Market, as reported by Nasdaq for the
periods indicated.
PERIOD COMMON STOCK
- ------------------------------------------------------ -------------------
HIGH LOW
- ------------------------------------------------------ ------ ------
Year Ended December 31, 2003
First Quarter .................................... $ 6.06 $ 5.20
Second Quarter ................................... 6.99 5.60
Third Quarter .................................... 9.40 5.95
Fourth Quarter ................................... 12.45 8.50
Year Ended December 31, 2004
First Quarter .................................... 12.82 9.36
Second Quarter ................................... 12.50 10.00
Third Quarter .................................... 12.95 10.29
Fourth Quarter ................................... 16.01 11.07
Year Ending December 31, 2005
First Quarter (through March 1, 2005) ............ 16.35 14.16
On March 1, 2005, the closing sale price of our common stock as reported
by Nasdaq was $16.10 per share.
STOCKHOLDERS
As of the close of business on March 1, 2005, there were approximately
1,300 holders of record of our common stock. We estimate that there are
approximately 15,000 beneficial owners of our common stock.
DIVIDENDS
We have never declared cash dividends on our common stock, and have no
present intention to declare any cash dividends in the foreseeable future.
49
ISSUER PURCHASES OF EQUITY SECURITIES
Total Number of Maximum Number
Shares Purchased as of Shares That May
Total Number Average Part of Publicly Yet Be Purchased
of Shares Price Paid Announced Plans or Under the Plans or
Period Purchased (1) Per Share Programs Programs
------ ------------- --------- -------- --------
October 1, 2004 - October 31, 2004.............. -- $ -- -- 709,362
November 1, 2004 - November 30, 2004 ........... 406 $12.50 406 708,956
December 1, 2004 - December 31, 2004............ 75 $12.58 75 708,881
----------- -----------------
Total........................................ 481 481
=========== =================
(1) All shares were purchased in private transactions.
During 2000, our Board of Directors approved a plan for us to repurchase
up to 0.5 million shares of our common stock in the open market. The primary
purpose of the plan is to fund employee stock bonuses. Our Board approved an
amendment to the plan to increase the total shares authorized for repurchase to
1.0 million in March 2002 and during December 2003 approved a second amendment
to increase the shares authorized for repurchase to 1.5 million. Additional
repurchases may be made from time to time at prevailing prices, subject to
restrictions on volume and timing.
RECENT SALES OF UNREGISTERED SECURITIES
During the Company's fiscal quarter ended September 30, 2004 in connection
with the acquisition of Heritage Health Systems, Inc., an employee acquired
14,500 shares of the Company's Common Stock pursuant to the Company's 1998
Incentive Compensation Plan. These shares were reissued from the Company's
treasury stock on September 10, 2004. The Company received proceeds of $10.35
per share, or $150,000, equal to the market value for the ten days trailing the
date the award was approved, in connection with the issuance of such shares. The
issuance was exempt from registration under the Securities Act pursuant to
Section 4(2) thereof. The issuance did not involve any public offering and the
employee received shares which contained a legend to indicate that such shares
are not registered under the Securities Act and cannot be transferred in the
absence of such a registration or an exemption from registration. The employee
who acquired such shares is a member of the Company's management.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The information regarding securities authorized for issuance under our
equity compensation plans is disclosed in Item 12 "Security Ownership of Certain
Beneficial Owners and Management and Related Stockholder Matters."
50
ITEM 6 - SELECTED FINANCIAL DATA
The table below provides selected financial data and other operating
information as of and for the five fiscal years ended December 31, 2004. We
derived the selected financial data presented below for the five fiscal years
ended December 31, 2004 from our audited financial statements, which were
audited by Ernst & Young LLP, our independent auditors. We have prepared the
following data, other than statutory data, in conformity with generally accepted
accounting principles. You should read this selected financial data together
with our financial statements and the notes to those financial statements as
well as the discussion under the caption "Management's Discussion and Analysis
of Financial Condition and Results of Operations."
AS OF OR FOR THE YEAR ENDED DECEMBER 31,
-----------------------------------------------------------------
2000 (1) 2001 2002 2003 (2) 2004 (3)
--------- --------- --------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE AND OTHER DATA)
INCOME STATEMENT DATA:
Direct premium and policyholder fees ...... $ 451,323 $ 513,575 $ 586,686 $ 700,415 $ 858,921
Reinsurance premium assumed ............... 3,055 2,549 5,075 27,042 35,682
Reinsurance premium ceded ................. (234,625) (286,918) (325,184) (280,489) (249,419)
Net premium and other policyholder fees ... 219,753 229,206 266,577 446,968 645,184
Net investment income ..................... 56,945 57,812 57,716 61,075 65,191
Realized gains ............................ 146 3,078 (5,083) 2,057 10,647
Fee and other income ...................... 7,247 10,847 12,313 12,648 14,323
Total revenues ............................ 284,091 300,943 331,523 522,748 735,345
Total benefits, claims and other deductions 251,025 257,580 287,493 456,269 638,877
Income before taxes ....................... 33,066 43,363 44,030 66,479 96,468
Net income ................................ 22,885 28,925 30,127 43,052 63,871
PER SHARE DATA:
Earnings per share:
Basic ............................... 0.49 0.58 0.57 0.80 1.17
Diluted ............................. 0.49 0.57 0.56 0.78 1.13
Book value per share:
Basic ............................... $ 3.72 $ 4.38 $ 5.42 $ 6.41 $ 7.60
AS AT
DECEMBER 31, DECEMBER 31,
2003 2004
---------- ----------
BALANCE SHEET DATA:
Total cash and investments ................. $1,286,508 $1,378,339
Total assets ............................... 1,780,948 2,017,088
Policyholder related liabilities ........... 1,251,055 1,343,026
Outstanding bank debt ...................... 38,172 101,063
Trust preferred securities ................. 75,000 75,000
Shareholders' equity ....................... 345,738 419,421
DATA REPORTED TO REGULATORS (4):
Statutory capital and surplus .............. $ 179,028 $ 183,136
Asset valuation reserve .................... 1,542 2,423
Adjusted capital and surplus ............... 180,570 185,559
- ----------
(1) Includes the results of American Insurance Administration Group, Inc.
since its acquisition on January 6, 2000, and Capitated Health Care
Services, Inc. since its acquisition on August 10, 2000.
(2) Includes the results of Pyramid Life since its acquisition on March 31,
2003.
(3) Includes the results of Heritage Health Systems, Inc. since its
acquisition on May 28, 2004.
(4) Includes capital and surplus of Penncorp Life (Canada) of C$82,907 as of
December 31, 2003 and C$57,398 as of December 31, 2004, as reported to the
Office of the Superintendent of Financial Institutions Canada, converted
at the related exchange rates of C$0.7654 per U.S. $1.00 as of December
31, 2003 and C$0.8320 per U.S. $1.00 as of December 31, 2004.
51
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
INTRODUCTION
The following analysis of our consolidated results of operations and
financial condition should be read in conjunction with the consolidated
financial statements and related consolidated footnotes included in this Annual
Report on Form 10-K.
The following discussion and analysis presents a review of the Company as
of December 31, 2004 and its results of operations for the fiscal years ended
December 31, 2004, 2003 and 2002.
OVERVIEW
Our principal business segments are based on product and include: Senior
Market Health Insurance, Senior Managed Care - Medicare Advantage, Specialty
Health Insurance, Life Insurance/Annuities and Senior Administrative Services.
We also report the activities of our holding company in a separate segment.
Previously, we reported our segments based on distribution channel. Our former
Senior Market Brokerage and Career Agency segments have been replaced with the
three new segments: Senior Market Health Insurance, Life Insurance/Annuity and
Specialty Health Insurance. Our Senior Managed Care - Medicare Advantage and
Senior Administrative Services segments will be unchanged. We believe that this
new segmentation will provide even greater clarity to our results.
Reclassifications have been made to conform prior year amounts to the current
year presentation. A description of these segments follows:
SENIOR MARKET HEALTH INSURANCE - This segment consists primarily of our Medicare
Supplement business and other senior market health products distributed through
our career agency sales force and through our network of independent general
agencies.
SENIOR MANAGED CARE - MEDICARE ADVANTAGE - Our Senior Managed Care - Medicare
Advantage segment includes the operations of Heritage and our other initiatives
in managed care for Seniors. Heritage operates Medicare Advantage plans in
Houston and Beaumont Texas, and our Medicare Advantage private fee-for-service
plan in the New York and Pennsylvania.
SPECIALTY HEALTH INSURANCE - Our Specialty Health Insurance segment includes
specialty health insurance products, primarily fixed benefit accident and
sickness disability insurance, sold to the middle-income self-employed market in
the United States and Canada. This segment also includes certain products that
we no longer sell, such as long term care and major medical. This segment's
products are distributed primarily by our career agents.
LIFE INSURANCE/ANNUITIES - This segment includes all of the life insurance and
annuity business sold in the United States. This segment's products include
senior, traditional and universal life insurance and fixed annuities and are
distributed through both independent general agents and our career agency
distribution systems.
SENIOR ADMINISTRATIVE SERVICES - Our administrative services subsidiary, CHCS
Services, acts as a third party administrator and service provider of senior
market insurance products and geriatric care management for both affiliated and
unaffiliated insurance companies. The services provided include policy
underwriting and issuance, telephone and face-to-face verification, policyholder
services, claims adjudication, case management, care assessment and referral to
health care facilities.
CORPORATE - Our Corporate segment reflects the activities of our holding
company, including debt service, certain senior executive compensation, and
compliance with regulatory requirements resulting from our status as a public
company.
52
Intersegment revenues and expenses are reported on a gross basis in each
of the operating segments but eliminated in the consolidated results. These
intersegment revenues and expenses affect the amounts reported on the individual
financial statement line items, but are eliminated in consolidation and do not
change income before taxes. The significant items eliminated include
intersegment revenue and expense relating to services performed by the Senior
Administrative Services segment for our other segments and interest on notes
payable or receivable between the Corporate segment and the other operating
segments.
CRITICAL ACCOUNTING POLICIES
Our consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States ("GAAP"). The
preparation of our financial statements in conformity with GAAP requires us to
make estimates and assumptions that affect the amounts of assets and liabilities
and disclosures of assets and liabilities reported by us at the date of the
financial statements and the revenues and expenses reported during the reporting
period. As additional information becomes available or actual amounts become
determinable, the recorded estimates may be revised and reflected in operating
results. Actual results could differ from those estimates. Accounts that, in our
judgment, are most critical to the preparation of our financial statements
include policy liabilities and accruals, deferred policy acquisition costs,
intangible assets, valuation of certain investments and deferred income taxes.
There have been no changes in our critical accounting policies during the
current quarter.
POLICY RELATED LIABILITIES
We calculate and maintain reserves for the estimated future payment of
claims to our policyholders using the same actuarial assumptions that we use in
the pricing of our products. For our accident and health insurance business, we
establish an active life reserve for expected future policy benefits, plus a
liability for due and unpaid claims, claims in the course of settlement and
incurred but not reported claims. Many factors can affect these reserves and
liabilities, such as economic and social conditions, inflation, hospital and
pharmaceutical costs, changes in doctrines of legal liability and extra
contractual damage awards. Therefore, the reserves and liabilities we establish
are based on extensive estimates, assumptions and prior years' statistics. When
we acquire other insurance companies or blocks of insurance, our assessment of
the adequacy of acquired policy liabilities is subject to similar estimates and
assumptions. Establishing reserves involves inherent uncertainties, and it is
possible that actual claims could materially exceed our reserves and have a
material adverse effect on our results of operations and financial condition.
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 be required to increase our liabilities resulting in reduced
net income and shareholders' equity.
DEFERRED POLICY ACQUISITION COSTS
The cost of acquiring new business, principally non-level commissions and
agency production, underwriting, policy issuance, and associated costs, all of
which vary with, and are primarily related to the production of new and renewal
business, are deferred. For interest-sensitive life and annuity products, these
costs are amortized in relation to the present value of expected gross profits
on the policies arising principally from investment, mortality and expense
margins in accordance with SFAS No. 97, "Accounting and Reporting by Insurance
Enterprises for Certain Long-Duration Contracts and for Realized Gains and
Losses from the Sale of Investments". For other life and health products, these
costs are amortized in proportion to premium revenue using the same assumptions
used in estimating the
53
liabilities for future policy benefits in accordance with SFAS No. 60,
"Accounting and Reporting by Insurance Enterprises."
The determination of expected gross profits for interest-sensitive
products is an inherently uncertain process that relies on assumptions including
projected interest rates, the persistency of the policies issued as well as
anticipated benefits, commissions and expenses. It is possible that the actual
profits from the business may vary materially from the assumptions used in the
determination and amortization of deferred acquisition costs. Deferred policy
acquisition costs are written off to the extent that it is determined that
future policy premiums and investment income or gross profits would not be
adequate to cover related losses and expenses.
PRESENT VALUE OF FUTURE PROFITS AND OTHER INTANGIBLES
Business combinations accounted for as a purchase result in the allocation
of the purchase consideration to the fair values of the assets and liabilities
acquired, including the present value of future profits, establishing such fair
values as the new accounting basis. The present value of future profits is based
on an estimate of the cash flows of the in force business acquired, discounted
to reflect the present value of those cash flows. The discount rate selected
depends upon the general market conditions at the time of the acquisition and
the inherent risk in the transaction. Purchase consideration in excess of the
fair value of net assets acquired, including the present value of future profits
and other identified intangibles, for a specific acquisition, is allocated to
goodwill. Allocation of purchase price is performed in the period in which the
purchase is consummated. Adjustments, if any, in subsequent periods relate to
resolution of pre-acquisition contingencies and refinements made to estimates of
fair value in connection with the preliminary allocation.
Amortization of present value of future profits is based upon the pattern
of the projected cash flows of the in-force business acquired, over weighted
average lives ranging from six to forty years. Other identified intangibles are
amortized over their estimated lives.
On a periodic basis, management reviews the unamortized balances of
present value of future profits, goodwill and other identified intangibles to
determine whether events or circumstances indicate the carrying value of such
assets is not recoverable, in which case an impairment charge would be
recognized. Management believes that no impairments of present value of future
profits, goodwill or other identified intangibles existed as of December 31,
2004.
INVESTMENT VALUATION
Fair value of investments is based upon quoted market prices, where
available, or on values obtained from independent pricing services. For certain
mortgage and asset-backed securities, the determination of fair value is based
primarily upon the amount and timing of expected future cash flows of the
security. Estimates of these cash flows are based upon current economic
conditions, past credit loss experience and other circumstances.
We regularly evaluate the amortized cost of our investments compared to
the fair value of those investments. Impairments of securities generally are
recognized when a decline in fair value below the amortized cost basis is
considered to be other-than-temporary. Generally, we consider a decline in fair
value to be other-than-temporary when the fair value of an individual security
is below amortized cost for an extended period and we do not believe that
recovery in fair value is probable. Impairment losses for certain mortgage and
asset-backed securities are recognized when an adverse change in the amount or
timing of estimated cash flows occurs, unless the adverse change is solely a
result of changes in estimated market interest rates and we intend to hold the
security until maturity. The cost basis for securities
54
determined to be impaired are reduced to their fair value, with the excess of
the cost basis over the fair value recognized as a realized investment loss.
INCOME TAXES
We use the liability method to account for deferred income taxes. Under
the liability method, deferred tax assets and liabilities are recognized for the
future tax consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date of a change in tax rates.
We establish valuation allowances on our deferred tax assets for amounts
that we determine will not be recoverable based upon our analysis of projected
taxable income and our ability to implement prudent and feasible tax planning
strategies. Increases in these valuation allowances are recognized as deferred
tax expense. Subsequent determinations that portions of the valuation allowances
are no longer necessary are reflected as deferred tax benefits. To the extent
that valuation allowances were established in conjunction with acquisitions,
changes in those allowances are first applied to increasing or decreasing the
goodwill (but not below zero) or other intangibles related to the acquisition
and then applied as an increase or decrease in income tax expense.
SIGNIFICANT TRANSACTIONS - ACQUISITIONS
Acquisition of Heritage Health Systems, Inc.
On May 28, 2004, we acquired Heritage, a privately owned managed
care company that operates Medicare Advantage plans in Houston and Beaumont
Texas, for $98 million in cash plus transaction costs of $1.6 million. The
acquisition was financed with $66.5 million of net proceeds derived from the
amendment of our credit facility and $33.1 million of cash on hand. As
of the date of acquisition, Heritage had approximately 16,000 Medicare members
and annualized revenues of approximately $140 million. Operating results
generated by Heritage prior to the date of acquisition are not included in our
consolidated financial statements.
ACQUISITION OF PYRAMID LIFE
On March 31, 2003, we acquired all of the outstanding common stock of
Pyramid Life Insurance Company ("Pyramid Life"). Pyramid Life specializes in
selling health and life insurance products to the senior market, including
Medicare Supplement and Select, long term care, life insurance, and annuities.
With this acquisition, we acquired a $120 million block of in-force business, as
well as a career sales force that is skilled in selling senior market insurance
products. Pyramid Life markets its products in 30 states through a career agency
sales force of over 1,000 agents operating out of 39 Senior Solutions(R) Sales
Centers. Following a transition period that took approximately ten months, the
Pyramid Life business was fully transitioned into our existing operations.
Operating results generated by Pyramid Life prior to the date of acquisition are
not included in our consolidated financial statements.
55
RECAPTURE OF REINSURANCE CEDED
Effective April 1, 2003, we entered into agreements to recapture
approximately $48 million of Medicare Supplement business that had previously
been reinsured to Transamerica Occidental Life Insurance Company, Reinsurance
Division ("Transamerica") under two quota share contracts. No ceding allowance
was paid in the recapture and we currently retain 100% of the risks on the $48
million of Medicare Supplement business. There was no gain or loss reported on
these recapture agreements.
ACQUISITION OF NATIONWIDE BLOCK OF BUSINESS
In November 2002 we entered into an agreement with Nationwide Life
Insurance Company ("Nationwide") to acquire, through a 100% quota share
reinsurance agreement, Nationwide's individual Medicare Supplement policies.
Approximately $22 million of annualized premium was in force at the date of
acquisition.
ACQUISITION OF AMERIPLUS
On August 1, 2003, we acquired 100% of the outstanding common stock of
Ameriplus Preferred Care, Inc. ("Ameriplus"). Ameriplus is engaged in the
business of creating and maintaining a network of hospitals for the purpose of
providing discounts to our Medicare Select policyholders. Ameriplus' network is
utilized in connection with Medicare Select policies written by our subsidiaries
and can be offered to non-affiliated parties as well. Ameriplus receives network
fees when premiums for these Medicare Select policies are collected.
ACQUISITION OF GUARANTEE RESERVE MARKETING ORGANIZATION
Effective July 1, 2003, we entered into an agreement with Swiss Re and its
newly acquired subsidiary, Guarantee Reserve Life Insurance Company ("Guarantee
Reserve"), to acquire Guarantee Reserve's marketing organization, including all
rights to do business with its field force. The primary product sold by this
marketing organization is low face amount whole life insurance, primarily for
seniors. Beginning July 1, 2003, the Guarantee Reserve field force continued to
write this business in Guarantee Reserve, with us administering all new business
and assuming 50% of the risk through a quota share reinsurance arrangement. New
business has been written by our subsidiaries with 50% of the risk ceded to
Swiss Re beginning in the second quarter of 2004 as the products were approved
for sale in each state.
56
RESULTS OF OPERATIONS -- CONSOLIDATED OVERVIEW
The following table reflects income from each of our segments (1) and
contains a reconciliation to reported net income:
FOR THE YEAR ENDED DECEMBER 31,
----------------------------------
2002 2003 2004
-------- -------- --------
(IN THOUSANDS)
Senior Market Health Insurance (1) ............... $ 8,564 $ 27,734 $ 35,407
Senior Managed Care - Medicare Advantage (1) ..... -- -- 10,136
Specialty Health Insurance (1) ................... 25,603 24,435 26,316
Life Insurance/Annuities (1) ..................... 14,207 11,981 13,370
Senior Administrative Services (1) ............... 7,632 11,018 13,090
Corporate (1) .................................... (6,893) (10,746) (12,498)
Realized gains (losses) .......................... (5,083) 2,057 10,647
-------- -------- --------
Income before income taxes (1) ................... 44,030 66,479 96,468
Income taxes, excluding capital gains ............ 15,682 23,325 28,871
Income taxes on capital gains (losses) ........... (1,779) 720 3,726
Income tax benefit on early extinguishment of debt -- (618) --
-------- -------- --------
Total income taxes ........................... 13,903 23,427 32,597
-------- -------- --------
Net income ............................... $ 30,127 $ 43,052 $ 63,871
======== ======== ========
Per Share Data (Diluted):
Net income ............................... $ 0.56 $ 0.78 $ 1.13
======== ======== ========
- ----------
(1) We evaluate the results of operations of our segments based on income
before realized gains and income taxes. Management believes that realized
gains and losses are not indicative of overall operating trends. This
differs from generally accepted accounting principles, which includes the
effect of realized gains in the determination of net income. The schedule
above reconciles our segment income to net income in accordance with
generally accepted accounting principles.
Years ended December 31, 2004 and 2003
Net income for 2004 increased 48% to $63.9 million, or $1.13 per share,
compared to $43.1 million, or $0.78 per share in 2003. During 2004, we
recognized realized gains, net of tax, of $6.9 million, or $0.12 per share,
compared to realized gains, net of tax, of $1.3 million, or $0.02 per share in
2003. The realized gains in 2004 were generated at Penncorp Life (Canada) as a
result of the sale of investments to fund the dividend of approximately $19.6
million paid to the parent company during the first quarter of 2004 and the tax
payments made during the first quarter of 2004 relating to 2003 taxable income.
See "Liquidity and Capital Resources -- Obligations of the Parent Company to
Affiliates" for additional information regarding the dividend. Additionally,
during the third quarter of 2004, we took the opportunity to realize investment
gains as interest rates dropped during the year to make efficient use of our tax
capital loss carryforwards. We believe that further opportunity for generating
realized investment gains is limited. Our overall effective tax rate was 33.8%
for 2004 and 35.2% for 2003.
Our Senior Market Health Insurance segment results improved by $7.7
million, or 28%, to $35.4 million in 2004 compared to 2003, primarily as a
result of the Pyramid Life business being included for a full year in 2004
compared to nine months in 2003 and increased retention of the Medicare
Supplement business. We have increased our retention to 100% for all Medicare
Supplement business sold beginning January 1, 2004.
Our Senior Managed Care - Medicare Advantage segment includes the results
of Heritage and our other initiatives in Medicare managed care, including our
Medicare Advantage private fee for service plans, for the seven months since
acquisition or inception.
57
Our Specialty Health Insurance segment results improved by $1.9 million,
or 8%, to $26.3 million in 2004 compared to 2003, primarily as a result of
improvement in loss ratios, as well as the strengthening of the Canadian dollar,
relative to the U.S. dollar.
Results for our Life Insurance/Annuities segment improved by $1.4 million,
or 12%, to $13.4 million in 2004 compared to 2003, primarily as a result of an
increase in business and more favorable morbidity.
Our Senior Administrative Services segment income improved by $2.1
million, or 19%, compared to 2003. This improvement was primarily a result of
the growth in premiums managed.
The loss from our Corporate segment increased by $1.8 million, or 16%,
compared to the 2003. The increase was due to higher interest cost as a result
of an increase in the amount of the debt outstanding during the year, relating
to the amendment of our credit facility in connection with our acquisition of
Heritage, offset in part, by a reduction in the weighted average interest rates,
as compared to the same period of 2003.
Years Ended December 31, 2003 and 2002
Net income for 2003 increased 43%, to $43.1 million, or $0.78 per share,
compared to $30.1 million, or $0.56 per share in 2002. During 2003, we
recognized realized gains, net of tax of $1.3 million, or $0.02 per share,
compared to realized losses, net of tax of $3.3 million, or $0.06 per share in
2002. The losses in 2002 were primarily a result of the recognition of an
impairment of our WorldCom holdings. In connection with the acquisition of
Pyramid Life on March 31, 2003, we refinanced our credit facility. As a result
of the repayment of our existing debt, we were required to write off the
unamortized portion of the fees we incurred for that debt. This resulted in a
pre-tax, non-cash charge of $1.8 million (the "financing charge"), which is
included in the operating loss of the Corporate segment. Our overall effective
tax rate was 35.2% for 2003 as compared to 31.6% for 2002. Our 2002 results
benefited from the release of a portion of a tax valuation reserve that added
$0.03 per share. Excluding the release of the tax valuation allowance, the
effective tax rate was 35.2% in 2002.
Our Senior Market Health Insurance segment results increased by $19.2
million, or 224%, to $27.7 million in 2003 compared to 2002, primarily due to
the addition of the Pyramid Life business since its acquisition on March 31,
2003 and growth and increased retention of the Medicare Supplement business. We
had increased our retention, on average, to 75% for all Medicare Supplement
business sold beginning January 1, 2003, from 50% in 2002.
Our Specialty Health Insurance segment results decreased by $1.2 million,
or 5%, to $24.4 million in 2003 compared to 2002, primarily as a result of an
increase in loss ratios, offset by strengthening of the Canadian dollar.
Results for our Life Insurance/Annuities segment declined by $2.2 million,
or 16%, to $12.0 million in 2003 compared to 2002, primarily as a result of less
favorable mortality.
Our Senior Administrative Services segment income improved by $3.4
million, or 44%, compared to 2002. This improvement was primarily a result of
the growth in premiums managed and the scheduled reduction in the amortization
of intangible assets.
58
The loss from our Corporate segment increased by $3.9 million, or 56%,
compared to 2002, due primarily to the charge associated with the refinancing of
our debt and the increase in financing costs and other parent company expenses.
In connection with the acquisition of Pyramid Life, we refinanced our debt. The
early extinguishment of the existing debt resulted in the immediate amortization
of the related capitalized loan origination fees, resulting in a pre-tax expense
of approximately $1.8 million. The increase in financing cost was due to an
increase in the amount of the debt outstanding during the year, offset in part,
by a reduction in the weighted average interest rates for the year, compared to
2002.
SEGMENT RESULTS -- SENIOR MARKET HEALTH INSURANCE
FOR THE YEAR ENDED DECEMBER 31,
-------------------------------------
2002 2003 2004
--------- --------- ---------
(IN THOUSANDS)
PREMIUMS :
Direct and assumed ............................ $ 394,047 $ 511,272 $ 576,345
Ceded ......................................... (289,121) (243,215) (221,022)
--------- --------- ---------
Net premiums .............................. 104,926 268,057 355,323
Net investment income ............................. 1,853 3,341 4,167
Other income ...................................... 123 221 859
--------- --------- ---------
Total revenue ............................. 106,902 271,619 360,349
--------- --------- ---------
Policyholder benefits ............................. 73,482 184,493 246,019
Change in deferred acquisition costs .............. (10,201) (21,914) (32,878)
Amortization of intangible assets ................. 112 1,823 1,973
Commissions and general expenses, net of allowances 34,945 79,483 109,828
--------- --------- ---------
Total benefits, claims and other deductions 98,338 243,885 324,942
--------- --------- ---------
Segment income .................................... $ 8,564 $ 27,734 $ 35,407
========= ========= =========
Years ended December 31, 2004 and 2003
Our Senior Market Health Insurance segment results improved by $7.7
million, or 28%, to $35.4 million in 2004 compared to 2003, primarily as a
result of the inclusion of the results of operations of the Pyramid Life
business for a full year in 2004 compared to only nine months in 2003 and
increased retention of the Medicare Supplement business. We have increased our
retention to 100% for all Medicare Supplement business sold beginning January 1,
2004.
REVENUES. Net premiums for the Senior Market Health Insurance segment
increased by $87.3 million, or 33%, compared to 2003. Approximately $28.2
million, or 11%, relates to additional premiums from the Pyramid Life business
as a result of the inclusion of the results of operations of the Pyramid Life
business for a full year in 2004 compared to only nine months in 2003. $59.1
million, or 22%, is due to growth and increased retention of the Medicare
Supplement business
Net investment income increased by approximately $0.8 million, or 25%,
compared to 2003. The increase is due primarily to growth in invested assets due
to growth in business.
BENEFITS, CLAIMS AND EXPENSES. Policyholder benefits, including the change
in reserves, increased by $61.5 million, or 33%, during 2004 compared to 2003,
primarily as a result of the increased retention of the Medicare Supplement
business noted above, the effect of a full year of the Pyramid Life operations
and a modest increase in loss ratios. Overall loss ratios for the segment
increased to 69.2% in 2004 compared to 68.8% in 2003, which accounted for $1.3
million of the increase in benefits. The additional quarter of the Pyramid Life
business contributed $19.6 million and the growth and increased retention rate
added the balance of $40.6 million to the increase.
59
The change in deferred acquisition costs was $11.0 million more in 2004,
compared to the amount in 2003. $3.7 million of this change is due to the
Pyramid Life business being included for a full year in 2004 compared to nine
months in 2003. The balance of $7.3 million is a result of growth and the
increased retention of the Medicare Supplement business.
The amortization of intangibles relates primarily to intangibles relating
to the acquisition of Pyramid Life.
Commissions and general expenses increased by $30.3 million, or 38%, in
2004 compared to 2003. $7.8 million of this increase is due to the inclusion of
an additional quarter of the results of operations of the Pyramid Life business
and the balance of $22.5 million is due to higher net commission expense due to
the growth and increased retention of the Medicare Supplement business. The
following table details the components of commission and other operating
expenses:
2003 2004
--------- ---------
(IN THOUSANDS)
Commissions ....................................... $ 78,014 $ 84,977
Other operating costs ............................. 61,236 72,269
Reinsurance allowances ............................ (59,767) (47,418)
--------- ---------
Commissions and general expenses, net of allowances $ 79,483 $ 109,828
========= =========
The ratio of commissions to gross premiums decreased to 14.7% during 2004,
from 15.3% in 2003, as a result of the growth in the in force renewal premium
from better persistency and rate increases. Other operating costs as a
percentage of gross premiums increased to 12.5% during 2004 from 12.0% in 2003.
Commission and expense allowances received from reinsurers as a percentage of
the premiums ceded also decreased to 21.5% during 2004 from 24.6% in 2003,
primarily due to the reduction in new business ceded and the affects of normal
lower commission allowances on an aging base of renewal ceded business.
Years ended December 31, 2003 and 2002
Our Senior Market Health Insurance segment results increased by $19.2
million, or 224%, to $27.7 million in 2003 compared to 2002, primarily due to
the inclusion of the results of operations of the Pyramid Life business since
its acquisition on March 31, 2003 and growth and increased retention of the
Medicare Supplement business. We had increased our retention, on average, to 75%
for all Medicare Supplement business sold beginning January 1, 2003, from 50% in
2002.
REVENUES. Net premiums for the Senior Market Health Insurance segment
increased by $163.1 million, or 156%, compared to 2002. Approximately $77.1
million, or 47% of the increase, related to additional premiums from the Pyramid
Life business since its acquisition. $86.0 million, or 53% of the increase, is
due to growth and increased retention of the Medicare Supplement business
Net investment income increased by approximately $1.5 million, or 80%,
compared to 2003. The increase is due primarily to growth in invested assets due
to growth in business.
BENEFITS, CLAIMS AND EXPENSES. Policyholder benefits, including the change
in reserves, increased by $111.0 million, or 151%, during 2003 compared to 2002,
primarily as a result of increased retention of the Medicare Supplement business
noted above and the inclusion of the results of operations of the Pyramid Life
business, since its acquisition. This was partially offset by a decrease in loss
ratios. Overall loss ratios for the segment decreased to 68.8% in 2003 compared
to 70.0% in 2002, which decreased benefits by $1.1 million. The additional
Pyramid Life business contributed $51.8 million of additional benefits expense
and growth in business and the increased retention rate added the balance of
$60.3 million to the increase.
60
The change in deferred acquisition costs was $11.7 million more in 2003,
compared to the amount in 2002. $7.5 million of this change was due to the
addition of Pyramid Life business, since its acquisition. The balance of $4.2
million was a result of growth and the increased retention of the Medicare
Supplement business.
The amortization of intangibles relates primarily to intangibles relating
to the acquisition of Pyramid Life.
Commissions and general expenses increased by $44.5 million, or 127%, in
2003 compared to 2002. $24.2 million of this increase is due to the additional
Pyramid business, since its acquisition on March 31, 2003 and the balance of
$20.3 million is due to higher net commission expense due to the growth and
increased retention of the Medicare Supplement business. The following table
details the components of commission and other operating expenses:
2002 2003
-------- --------
(IN THOUSANDS)
Commissions ....................................... $ 66,400 $ 78,014
Other operating costs ............................. 49,717 61,236
Reinsurance allowances ............................ (81,172) (59,767)
-------- --------
Commissions and general expenses, net of allowances $ 34,945 $ 79,483
======== ========
The ratio of commissions to gross premiums decreased to 15.3% during 2003,
from 16.9% in 2002, as a result of the growth in the in force renewal premium
from better persistency and rate increases. Other operating costs as a
percentage of gross premiums decreased to 12.0% during 2003 from 12.6% in 2002.
Commission and expense allowances received from reinsurers as a percentage of
the premiums ceded also decreased to 24.6% during 2003 from 28.1% in 2002,
primarily due to the reduction in new business ceded, the recapture of the
Transamerica treaties, and the affects of normal lower commission allowances on
an aging base of renewal ceded business.
SEGMENT RESULTS -- SENIOR MANAGED CARE - MEDICARE ADVANTAGE
YEARS ENDED DECEMBER 31,
------------------------------
2002 2003 2004(2)
----- ------ -------
(IN THOUSANDS)
Net premiums ........................................................ $ -- $ -- $93,011
Net and other investment income ..................................... -- -- 517
----- ------ -------
Total revenue ..................................................... -- -- 93,528
----- ------ -------
Medical expenses .................................................... -- -- 66,449
Amortization of intangible assets ................................... -- -- 1,901
Commissions and general expenses .................................... -- -- 15,042
----- ------ -------
Total benefits, claims and other
deductions ...................................................... -- -- 83,392
----- ------ -------
Segment income ...................................................... -- -- 10,136
Depreciation, amortization and interest ............................. -- -- 2,104
----- ------ -------
Earnings before interest, taxes,
depreciation and amortization
("EBITDA") (1) .................................................... $ -- $ -- $12,240
===== ===== =======
- ---------------------------
(1) In addition to segment income, we also evaluate the results of our
Medicare Advantage segment based on earnings before interest, taxes,
depreciation and amortization ("EBITDA"). EBITDA is a common alternative
measure of performance used by investors, financial analysts and rating
agencies. It is also a measure that is included in the fixed charge ratio
required by the covenants for our outstanding bank debt. Accordingly,
these groups use EBITDA, along with other measures, to estimate the value
of a company and evaluate the Company's ability to meet its debt service
requirements. While we consider EBITDA to be an important measure of
comparative operating performance, it should not be construed as an
alternative to segment income or cash flows from operating activities (as
determined in accordance with generally accepted accounting principles).
(2) Includes results for the seven months since acquisition or inception.
61
Our Senior Managed Care - Medicare Advantage segment includes the
operations of Heritage and our other initiatives in Medicare managed care,
including our Medicare Advantage private fee-for-service plans. Heritage
generates its revenues and profits from three sources. First, Heritage owns an
interest in SelectCare, a health plan that offers coverage to Medicare
beneficiaries under a contract with CMS. Next, Heritage operates three separate
Management Service Organizations ("MSO's") that manage the business of
SelectCare and two affiliated Independent Physician Associations ("IPA's").
Lastly, Heritage participates in the profits derived from these IPA's. The
components of the revenues and results within the segment are as follows:
YEAR ENDED DECEMBER 31, 2004 (3)
--------------------------------
REVENUES SEGMENT INCOME
-------- --------------
(IN THOUSANDS)
Health Plan ........... $ 90,497 $ 3,722
Affiliated IPA's ...... 58,517 5,619
MSO's and Corporate ... 15,843 1,124
Private Fee-for Service 3,333 (329)
Eliminations .......... (74,662) --
-------- --------
Total ............. $ 93,528 $ 10,136
======== ========
- ---------------------------
(3) Includes results for the seven months since acquisition or inception.
Intrasegment revenues are reported on a gross basis in each of the above
components of the Medicare Advantage segment. These intrasegment revenues are
eliminated in the consolidation for the segment totals. The eliminations include
premiums received by the IPA's from the Health Plan amounting to $59.1 million
and management fees received by the MSO's from the Health Plan and the IPA's
amounting to $15.6 million for the seven months since its acquisition.
Heritage operates a health plan through SelectCare, a provider sponsored
organization ("PSO"). SelectCare is a Medicare Advantage coordinated care plan
operating in Beaumont and Houston, Texas, which had 16,100 members as of May 28,
2004 (the date of acquisition) and receives its premiums primarily from CMS.
SelectCare makes capitated risk payments to four IPA's or medical groups in the
Houston and Beaumont regions, two of which are affiliated IPA's. In addition,
SelectCare retains the risk for certain other types of care, primarily out of
area emergency and transplants. As of December 31, 2004, SelectCare had
approximately 18,800 members enrolled. For the seven months since its
acquisition, SelectCare had revenues of $90.5 million and had a medical loss
ratio of 83.3%.
Heritage participates in the profits from the two affiliated IPA's that
receive capitated payments from SelectCare. As of December 31, 2004, the
affiliated IPA's managed the care for approximately 14,200 SelectCare members.
For the seven months since its acquisition, Heritage earned $5.6 million on
$58.5 million in fees received from SelectCare.
Heritage owns three MSO's that provide comprehensive management services
to SelectCare and its affiliated IPA's as part of long-term management
agreements. Services provided include strategic planning, provider network
services, marketing, finance and accounting, enrollment, claims processing,
information systems, utilization review, credentialing and quality management.
For the seven months since its acquisition, these MSO's earned $1.1 million of
income on $15.8 million of fees collected.
Starting in the month of June, American Progressive, an insurance
subsidiary of Universal American, began enrolling members in its private fee for
service product, a Medicare Advantage program that allows its member to have
more flexibility in the delivery of their health care services than other
Medicare Advantage plans. In addition to premium received from CMS, American
Progressive receives modest premium payments from the members as well. As of
December 31, 2004, American Progressive had 1,405 members enrolled. For the
seven months since inception, American Progressive collected $3.3 million of
premium from CMS and the members, and reported a medical loss ratio of 75.4%. In
addition,
62
American Progressive expensed approximately $0.4 million in start-up expenses,
primarily during the second quarter of 2004.
SEGMENT RESULTS -- SPECIALTY HEALTH INSURANCE
FOR THE YEAR ENDED DECEMBER 31,
------------------------------------------
2002 2003 2004
--------- ---------- ----------
(IN THOUSANDS)
PREMIUMS:
Direct and assumed ...................................... $ 164,034 $ 173,746 $ 174,343
Ceded ................................................... (29,815) (29,131) (26,561)
--------- --------- ---------
Net premiums .......................................... 134,219 144,615 147,782
Net investment income ..................................... 27,737 26,970 26,351
Other income .............................................. 369 546 516
--------- --------- ---------
Total revenue ......................................... 162,325 172,131 174,649
--------- --------- ---------
Policyholder benefits ..................................... 88,371 97,204 96,836
Change in deferred acquisition
costs ................................................... (11,838) (10,553) (8,292)
Commissions and general expenses,
net of allowances ....................................... 60,189 61,045 59,789
--------- --------- ---------
Total benefits, claims and
other deductions .................................... 136,722 147,696 148,333
--------- --------- ---------
Segment income ............................................ $ 25,603 $ 24,435 $ 26,316
========= ========= =========
Years ended December 31, 2004 and 2003
Our Specialty Health Insurance segment results improved by $1.9 million,
or 8%, to $26.3 million in 2004 compared to 2003, primarily as a result of
improvement in loss ratios, as well as the strengthening of the Canadian dollar.
The operations of Penncorp Life (Canada), which are included in our Specialty
Health segment results, are transacted using the Canadian dollar as the
functional currency. The Canadian dollar strengthened relative to the U.S.
dollar in 2004. The average conversion rate increased 8%, to C$0.7689 per
U.S.$1.00 for 2004, from C$0.7141 per U.S.$1.00 for 2003. This strengthening
added approximately $1.0 million of pre-tax income to the Specialty Health
segment results for 2004, compared to 2003. See discussion below under the
heading "Quantitative and Qualitative Disclosures about Market Risk" for
additional information.
REVENUES. Net premiums for the Specialty Health Insurance segment
increased by $3.2 million, or 2%, compared to 2003. Approximately, $1.9 million
of the increase relates to additional long term care and major medical premiums
from the inclusion of the results of operations of Pyramid Life business for a
full year in 2004 compared to only nine months in 2003. The balance of the
increase is due to rate increases, offset by a reduction in long term care
premium as a result of our decision to discontinue marketing that product,
beginning in late 2003. Canadian business accounted for approximately 40% of the
net premiums of this segment in 2004 and 38% of the net premiums in 2003, the
increase attributed to the stronger Canadian dollar.
Net investment income decreased by approximately $0.6 million, or 2%,
compared to 2003. The decrease is due primarily to a combination of lower yields
and a decrease in invested assets, due to the dividend paid by Penncorp Life
(Canada) to our parent holding company in early 2004.
BENEFITS, CLAIMS AND EXPENSES. Policyholder benefits, including the change
in reserves, decreased by $0.4 million, or less than 1%, during 2004 compared to
2003, primarily as a result of improved loss ratios. Overall loss ratios for the
segment declined to 65.5% in 2004 compared to 67.2% in 2003. During 2004 we
recorded a non-recurring reduction in reserves in the amount of U.S. $1.3
million (C$1.8 million) which was identified during a review in connection with
a conversion of the actuarial system used to determine reserves on our Canadian
policies. Additionally, during 2004, we increased reserves on the runoff block
of Florida home healthcare business by $1.4 million as a result of an actuarial
study performed on this block.
63
The increase in deferred acquisition costs was $2.3 million less in 2004,
compared to the increase in 2003. This is as a result of a lower level of new
business being written relative to the amortization of amounts previously
capitalized.
Commissions and general expenses decreased by $1.3 million, or 2%, in 2004
compared to 2003. Approximately $0.6 million of the decrease relates to
reductions in general expenses and the balance relates to lower commission
expense as a result of the reduction in new business sold.
Years ended December 31, 2003 and 2002
Our Specialty Health Insurance segment results decreased by $1.2 million,
or 5%, to $24.4 million in 2003 compared to 2002, primarily as a result of an
increase in loss ratios, offset by strengthening of the Canadian dollar. The
operations of Penncorp Life (Canada), which are included in our Specialty Health
segment results, are transacted using the Canadian dollar as the functional
currency. The Canadian dollar strengthened relative to the U.S. dollar in 2003.
The average conversion rate increased 12%, to C$0.7141 per U.S. $1.00 for 2003,
from C$0.6370 per U.S. $1.00 for 2002. This strengthening added approximately
$1.5 million of pre-tax income to the Specialty Health segment results for 2003,
compared to 2002. See discussion below under the heading "Quantitative and
Qualitative Disclosures about Market Risk" for additional information.
REVENUES. Net premiums for the Specialty Health Insurance segment
increased by $10.4 million, or 8%, compared to 2002. Approximately, $6.7 million
of the increase was related to premiums from the Pyramid Life business since its
acquisition. The remainder of the increase was primarily due to rate increases.
Canadian business accounted for approximately 38% of the net premiums of this
segment in 2003 and 43% of the net premiums in 2002.
Net investment income decreased by approximately $0.8 million, or 3%,
compared to 2002. The decrease was due primarily to lower yields on invested
assets.
BENEFITS, CLAIMS AND EXPENSES. Policyholder benefits, including the change
in reserves, increased by $8.8 million, or 10%, during 2003 compared to 2002.
Approximately $6.4 million of the increase was related to benefits from the
Pyramid Life business since its acquisition. The balance was primarily a result
of higher loss ratios. Overall loss ratios for the segment increased to 67.2% in
2003 compared to 65.8% in 2002. The increase in deferred acquisition costs was
$1.3 million less in 2003, compared to the increase in 2002. This was the result
of lower levels of new business being written relative to the amortization of
amounts previously capitalized.
Commissions and general expenses increased by $0.9 million, or 1%, in 2003
compared to 2002. The increase was due primarily to the additional Pyramid Life
business, since its acquisition.
64
SEGMENT RESULTS -- LIFE INSURANCE/ANNUITIES
FOR THE YEAR ENDED DECEMBER 31,
--------------------------------------
2002 2003 2004
-------- -------- --------
(IN THOUSANDS)
PREMIUMS:
Direct and assumed ...................................... $ 36,091 $ 43,933 $ 61,543
Ceded ................................................... (7,342) (7,793) (11,506)
-------- -------- --------
Net premiums .......................................... 28,749 36,140 50,037
Net investment income ..................................... 27,865 30,742 34,207
Other income .............................................. 203 208 279
-------- -------- --------
Total revenue ......................................... 56,817 67,090 84,523
-------- -------- --------
Policyholder benefits ..................................... 20,572 26,411 34,844
Interest credited to policyholders ........................ 10,964 14,900 18,617
Change in deferred acquisition
costs ................................................... (5,844) (18,637) (24,337)
Amortization of intangible assets ......................... -- 817 925
Commissions and general expenses,
net of allowances ....................................... 16,917 31,618 41,104
-------- -------- --------
Total benefits, claims and
other deductions .................................... 42,610 55,109 71,153
-------- -------- --------
Segment income ............................................ $ 14,207 $ 11,981 $ 13,370
======== ======== ========
Years ended December 31, 2004 and 2003
Results for our Life Insurance/Annuities segment improved by $1.4 million,
or 12%, to $13.4 million in 2004 compared to 2003, primarily as a result of an
increase in business and more favorable morbidity.
REVENUES. Net premiums for the segment increased by $13.9 million, or 39%,
compared to 2003. Approximately, $7.1 million of the increase relates to the net
business produced by the former Guarantee Reserve field force acquired in mid
2003. Approximately $2.5 million of the increase relates to additional premiums
from the Pyramid Life business as a result of inclusion of the results of
operations of the Pyramid business for a full year in 2004 compared to only nine
months in 2003. The balance relates to increased sales of our senior life
product and an increase in policy fees on our interest sensitive life and
annuity business as a result of the growth in the level of deposits for those
products. Ceded premiums increased by approximately $2.3 million as a result of
the Guarantee Reserve business. During 2003, prior to receiving approval to
write the business through the insurance subsidiaries of Universal American, 50%
of the business was assumed from Swiss Re. As we received the regulatory
approvals, we wrote the business through our insurance subsidiaries and ceded
50% back to Swiss Re. The balance of the increase in the ceded premiums relates
to the increase in our senior life business.
Our agents sold $72.0 million of fixed annuities during 2004 and $120.7
million in 2003. Annuity deposits are not considered premiums for reporting in
accordance with generally accepted accounting principles. The reduction in
annuity sales was the result of lower interest crediting rates on policy account
balances and a decrease in minimum guaranteed crediting rates on our policies
from the rates existing in 2003.
Net investment income increased by approximately $3.5 million, or 11%,
compared to 2003. Approximately $4.9 million relates to the increase in
policyholder account balances as a result of the additional deposits received as
noted above. This was offset by a decline in yields on the portfolio.
BENEFITS, CLAIMS AND EXPENSES. Policyholder benefits, including the change
in reserves, increased by $8.4 million, or 32%, during 2004 compared to 2003,
consistent with the increase in premiums. Claims benefits incurred for the
segment declined in 2004 compared to 2003, as a result of more favorable
mortality. Interest credited increased by $3.7 million, due to the increase in
policyholder account balances as a result of continued annuity sales, offset by
a reduction in credited rates. In addition, during the fourth quarter of 2004,
we recorded approximately $0.3 million in additional benefits on
65
certain replacement annuity policies that we determined contained inappropriate
disclosure information to the insured. There is no additional liability to these
policyholders.
The increase in deferred acquisition costs was approximately $5.7 million
more in 2004, compared to the increase in 2003. This is directly related to the
increase in commissions and other acquisition costs related to the new life and
annuity business produced during the year. The amortization of intangible assets
relates to the present value of the future profits of the life business acquired
with Pyramid Life. Commissions and general expenses increased by $9.5 million,
or 30%, in 2004 compared to 2003, consistent with the increase in premium.
Years ended December 31, 2003 and 2002
Results for our Life Insurance/Annuities segment declined by $2.2 million,
or 16%, to $12.0 million in 2003 compared to 2002, primarily as a result of less
favorable mortality.
REVENUES. Net premiums for the segment increased by $7.4 million, or 26%,
compared to 2002. Approximately $3.6 million of the increase was related to
additional premiums from the Pyramid business since its acquisition on March 31,
2003. Approximately, $1.7 million of the increase was related to the net
business produced by the former Guarantee Reserve field force acquired in mid
2003. The balance was related to increased sales of our senior life product and
an increase in policy fees on our interest sensitive life and annuity business
as a result of the growth in the level of deposits for those products. Ceded
premiums increased by approximately $0.5 million as a result of the increase in
our senior life business.
Our agents sold $120.7 million of fixed annuities during 2003 and $46.1
million in 2002. Annuity deposits are not considered premiums for reporting in
accordance with generally accepted accounting principles.
Net investment income increased by approximately $2.9 million, or 10%,
compared to 2002. Approximately $4.3 million was related to the increase in
policyholder account balances as a result of the additional deposits received as
noted above. This was offset by a decline in yields.
BENEFITS, CLAIMS AND EXPENSES. Policyholder benefits, including the change
in reserves, increased by $5.8 million, or 28%, during 2003 compared to 2002,
consistent with the increase in premiums. Approximately $3.7 million of the
increase relates to benefits from the Pyramid Life business since its
acquisition. The balance was primarily a result of less favorable mortality in
2003 compared to 2002. Interest credited increased by $3.9 million, due to the
increase in policyholder account balances as a result of the continued sales and
the Pyramid Life business added since its acquisition on March 31, 2003.
The increase in deferred acquisition costs was approximately $12.8 million
more in 2003, compared to the increase in 2002. This was directly related to the
increase in commissions and other acquisition costs related to the new life and
annuity business produced during the year. The amortization of intangible assets
was related to the present value of the future profits of the life business
acquired with Pyramid Life. Commissions and general expenses increased by
$14.7 million, or 87%, in 2003 compared to 2002. Approximately $5.9 million was
related to commissions and expenses relating to the Guarantee Reserve business,
approximately $4.3 million was related to commissions and expenses relating to
the annuity business and approximately $2.1 million of the increase was related
to commissions and expenses for the Pyramid Life business since its acquisition.
66
SEGMENT RESULTS -- SENIOR ADMINISTRATIVE SERVICES
FOR THE YEAR ENDED DECEMBER 31,
----------------------------------
2002 2003 2004
------- ------- -------
(IN THOUSANDS)
Affiliated Fee Revenue
Medicare Supplement ................................................. $18,604 $22,478 $29,376
Long term care ...................................................... 2,635 2,589 2,752
Life insurance ...................................................... 347 2,480 3,942
Other ............................................................... 1,245 1,797 2,819
------- ------- -------
Total Affiliated Revenue .......................................... 22,831 29,344 38,889
------- ------- -------
Unaffiliated Fee Revenue
Medicare Supplement ................................................. 9,022 9,469 8,557
Long term care ...................................................... 8,205 7,065 6,331
Non-insurance products .............................................. 1,270 1,563 1,552
Other ............................................................... 1,420 1,042 1,330
------- ------- -------
Total Unaffiliated Revenue ........................................ 19,917 19,139 17,770
------- ------- -------
Service fee and other income .......................................... 42,748 48,483 56,659
Net investment income ................................................. 470 48 9
------- ------- -------
Total revenue ..................................................... 43,218 48,531 56,668
------- ------- -------
Amortization of present value of future profits ....................... 1,514 370 418
General expenses ...................................................... 34,072 37,143 43,160
------- ------- -------
Total expenses .................................................... 35,586 37,513 43,578
------- ------- -------
Segment income .................................................... 7,632 11,018 13,090
Depreciation, amortization and interest ............................... 2,846 2,038 2,199
------- ------- -------
Earnings before interest, taxes, depreciation
and amortization ("EBITDA")(1) ...................................... $10,478 $13,056 $15,289
======= ======= =======
- ---------------------------
(1) In addition to segment income, we also evaluate the results of our Senior
Administrative Services segment based on earnings before interest, taxes,
depreciation and amortization ("EBITDA"). EBITDA is a common alternative
measure of performance used by investors, financial analysts and rating
agencies. It is also a measure that is included in the fixed charge ratio
required by the covenants for our outstanding bank debt. Accordingly,
these groups use EBITDA, along with other measures, to estimate the value
of a company and evaluate the Company's ability to meet its debt service
requirements. While we consider EBITDA to be an important measure of
comparative operating performance, it should not be construed as an
alternative to segment income or cash flows from operating activities (as
determined in accordance with generally accepted accounting principles).
Included in unaffiliated revenue are fees received to administer certain
business of our insurance subsidiaries that is 100% reinsured to an unaffiliated
reinsurer, which amounted to $5.3 million in the year ended December 31, 2004,
$7.4 million for 2003 and $6.9 million for 2002. These fees, together with the
affiliated revenue, were eliminated in consolidation.
Years ended December 31, 2004 and 2003
Our Senior Administrative Services segment income improved by $2.1
million, or 19%, compared to 2003. This improvement was primarily a result of
the growth in premiums managed. EBITDA for this segment increased $2.2 million,
or 17%, compared to 2003.
Service fee revenue increased by $8.2 million, or 17%, compared to 2003.
Affiliated service fee revenue increased by $9.5 million compared to 2003 as a
result of the increase in Medicare Supplement/Select business in force at our
insurance subsidiaries, including Pyramid, for which CHCS Services began
providing service effective January 1, 2004, and fees from the administration of
the life insurance products sold by the Guarantee Reserve marketing organization
that was acquired in July 2003. Unaffiliated service fee revenue decreased by
approximately $1.4 million primarily due to the reduction in the fees from the
underwriting work we performed for the consortium that is offering long term
care to employees of the federal government and their families. The initial
enrollment period for this program, for which we performed underwriting, began
in the third quarter of 2002 and ended during the first
67
quarter of 2003. General expenses for the segment increased by $6.0 million, or
16%, due primarily to the increase in business.
Years Ended December 31, 2003 and 2002
Our Senior Administrative Services segment income improved by $3.4
million, or 44%, compared to 2002. This improvement was primarily a result of
the growth in premiums managed and the scheduled reduction in the amortization
of intangible assets. EBITDA for this segment increased $2.6 million, or 25%,
compared to 2002.
Service fee revenue increased by $5.7 million, or 13%, compared to 2002.
Affiliated service fee revenue increased by $6.5 million compared to 2002 as a
result of the increase in Medicare Supplement/Select business in force at our
insurance subsidiaries, as well as the fees from the administration of the life
insurance products sold by the recently acquired Guarantee Reserve marketing
organization. Unaffiliated service fee revenue decreased by approximately $0.8
million primarily due to the reduction in the fees from the underwriting work we
performed for the consortium that is offering long term care to employees of the
federal government and their families. The initial enrollment period for this
program, for which we performed underwriting, began in the third quarter of 2002
and ended during the first quarter of 2003.
General expenses for the segment increased by $3.1 million, or 9%,
primarily due to the increase in business and the cost of bringing new clients
on line.
The amortization of intangible assets relates primarily to the acquisition
of CHCS Services, Inc. (formerly American Insurance Administration Group, Inc,
"AIAG"). Approximately $7.7 million of the present value of future profits
("PVFP") was established when AIAG was acquired in January 2000. It is being
amortized in proportion to the expected profits from the contracts in force on
the date of acquisition. During 2003, the amortization of PVFP was approximately
$0.4 compared to $1.5 million in 2002.
SEGMENT RESULTS -- CORPORATE
The following table presents the primary components comprising the loss
from the segment:
FOR THE YEAR ENDED DECEMBER 31,
---------------------------------
2002 2003 2004
------ ------ -----
(IN THOUSANDS)
Interest ................................................ $3,095 $4,894 $7,903
Early extinguishment of debt ............................ -- 1,766 --
Amortization of capitalized loan origination fees ....... 539 492 727
Stock-based compensation expense ........................ 641 367 92
Other parent company expenses, net ...................... 2,618 3,227 3,776
------ ------ -----
Segment loss ........................................ $6,893 $10,746 $12,498
====== ======= =======
Years Ended December 31, 2004 and 2003
The loss from our Corporate segment increased by $1.8 million, or 16%,
compared to the 2003. The increase was due to higher interest cost as a result
of an increase in the amount of the debt outstanding during the year, relating
to the amendment of our credit facility in connection with our acquisition of
Heritage, offset in part, by a reduction in the weighted average interest rates,
as compared to the same period of 2003. Our combined outstanding debt was $176.1
million at December 31, 2004 compared to $113.2 million at December 31, 2003.
The weighted average interest rate on our loan payable decreased to 4.06% in
2004 from 4.5% in 2003. The weighted average interest rate on our other long
term debt
68
increased slightly to 6.3% for 2004 from 5.9% for 2003. See "Liquidity and
Capital Resources" for additional information regarding our loan payable and
other long term debt. As noted below, in 2003, we reported a $1.8 million charge
relating to the early extinguishment of debt that was incurred during the first
quarter of 2003 that did not recur in 2004. Other parent company expenses
increased as a result of additional expenses from an increase in corporate
governance related activities, as well as management bonuses.
Certain of the companies acquired in July 1999 had post-retirement benefit
plans in place prior to their acquisition and Universal American maintained the
liability for the expected cost of such plans. In October 2000, participants
were notified of the termination of the plans in accordance with their terms.
The liability will continue to be reduced as, and to the extent, it becomes
certain that we will incur no liabilities for the plans as a result of the
termination. During the fourth quarter of 2004, $0.6 million of the liability
was released and during the fourth quarter of 2003, $0.4 million of the
liability was released. Future projected releases of the liability are
anticipated to be $1.9 million in 2005, $0.7 million in 2006, and $0.1 million
in 2007.
Years Ended December 31, 2003 and 2002
The loss from our Corporate segment increased by $3.9 million, or 56%,
compared to 2002, due primarily to the charge associated with the refinancing of
our debt and the increase in financing costs and other parent company expenses.
In connection with the acquisition of Pyramid Life, we refinanced our debt. The
early extinguishment of the existing debt resulted in the immediate amortization
of the related capitalized loan origination fees, resulting in a pre-tax expense
of approximately $1.8 million. The increase in financing cost was due to an
increase in the amount of the debt outstanding during the year, offset in part,
by a reduction in the weighted average interest rates for the year, compared to
2002. We issued $60.0 million of trust preferred securities during 2003, of
which $21.0 million was used to pay down the new term loan. Our combined
outstanding debt was $113.2 million at December 31, 2003 compared to $65.8
million at December 31, 2002. The weighted average interest rate on our long
term debt decreased to 4.5% in 2003 from 5.4% in 2002. Other parent company
expenses increased as a result of additional expenses from an increase in
acquisition related activities.
69
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
Our contractual obligations as of December 31, 2004, are shown below.
PAYMENTS DUE BY PERIOD
-----------------------------------------------------------------------------
LESS THAN 1 MORE THAN 5
CONTRACTUAL OBLIGATIONS TOTAL YEAR 1-3 YEARS 3-5 YEARS YEARS
- ------------------------------- ----------- ---------- ------------ ----------- ------------
(IN THOUSANDS)
Long Term Debt Obligations (1):
Trust preferred securities(2) $ 221,486 $ 5,150 $ 10,306 $ 10,329 $ 195,701
Loan payable (3) ............ 118,386 9,564 18,444 90,378 --
Capital Lease Obligations ..... -- -- -- -- --
Operating Lease Obligations ... 19,281 2,526 5,192 4,276 7,287
Purchase Obligations (4) ...... 42,868 9,498 19,195 13,800 375
Policy Related Liabilities (5)
Policyholder account balances 702,532 47,857 87,963 78,553 488,159
Reserves for future policy
benefits .................... 1,083,436 59,099 111,096 102,259 810,982
Policy and contract claims .. 102,435 76,568 24,119 1,630 118
Other Long -- Term
Liabilities ................. -- -- -- -- --
---------- ---------- ---------- ---------- ----------
Total ..................... $2,290,424 $ 210,262 $ 276,315 $ 301,225 $1,502,622
========== ========== ========== ========== ==========
- --------
(1) These obligations include contractual interest and reflects scheduled
maturities for contractual obligations existing as of December 31, 2004
and does not include any obligations arising as a result of our shelf
registration.
(2) Trust preferred securities all have scheduled maturities of 30 years from
the date of issue, however they are all callable by us after five years.
For the purpose of this schedule, we have assumed that the securities will
be redeemed at their scheduled maturities, not the call date. Accordingly,
the obligation for repayment of principal relating to these is included in
the more than 5 Years column. The trust preferred securities all have
floating rate coupons, except for $15 million which has a fixed rate
through its no call period and then converts to a floating rate.
Additionally, we have entered into separate swap agreements whereby we pay
fixed rates on $35 million of the trust preferred securities through the
no call period. We did not project future changes in the base interest
rates. For the purpose of this schedule, we applied the base rate in
effect at December 31, 2004 to all future periods. Additionally, we
assumed that, upon the expiration of the swap agreements and the fixed
rate, the rate for the respective trust preferred securities adjusted to a
variable rate using the current base rate.
(3) Includes scheduled amortization through final maturity in 2009. The loan
payable is floating rate debt. We did not project future changes in the
base interest rates. For the purpose of this schedule, we applied the rate
in effect at December 31, 2004 to all future periods.
(4) Includes minimum obligations on our data center outsourcing contract, as
well as payments required under our outsourced administration service
contract for our HMO product (See Outsourcing Arrangements above). Our
actual monthly payments are affected by the amount of service provided
under the contract and the HMO product's premium levels in force and
currently exceed the minimums stated in the contracts. Therefore our
actual payments will exceed the amounts presented in the above schedule
based upon future usage and premium amounts.
(5) The obligations on policy related liabilities represent those payments we
expect to make on death, disability and health insurance claims and policy
surrenders. These projected values contain assumptions for future policy
persistency, mortality and morbidity comparable with our historical
experience. The distribution of payments for policy and contract claims
includes assumptions as to the timing of policyholders reporting claims
for prior periods and the amounts of those claims. Actual amounts and
timing of both future policy benefits and policy and contract claims may
differ significantly from the estimates above. We anticipate that the
liabilities for policyholder account balances and reserves for future
policy benefits totaling $1.8 billion, along with future net premiums,
investment income and recoveries from our reinsurers, will be sufficient
to fund future policy benefit payments. In addition, we anticipate that
the policy and contract claims liability totaling $ 102.4 million, along
with recoveries from our reinsurers, will be sufficient to fund these
claim liability payments.
70
LIQUIDITY AND CAPITAL RESOURCES
Our capital is used primarily to support the retained risks and growth of
our insurance company subsidiaries and health plan and to support our parent
company as an insurance holding company. In addition, we use capital to fund our
growth through acquisitions of other companies, blocks of insurance or
administrative service business.
We require cash at our parent company to meet our obligations under our
credit facility and our outstanding debenture held by our subsidiary,
Pennsylvania Life. In January 2002, our parent company issued a debenture to
Pennsylvania Life in conjunction with the transfer of the business of
Pennsylvania Life's Canadian Branch to Penncorp Life (Canada). The outstanding
balance on the debenture was $3.4 million at December 31, 2004. We anticipate
funding the repayment of the debenture from dividends of Penncorp Life (Canada).
We also require cash to pay the operating expenses necessary to function as a
holding company (applicable insurance department regulations require us to bear
our own expenses), and to meet the costs of being a public company.
We believe that our current cash position, the availability of our $15.0
million revolving credit facility, the expected cash flows of our administrative
service company and management service organizations (acquired in the
acquisition of Heritage) and the surplus note interest payments from American
Exchange (as explained below) can support our parent company obligations for the
foreseeable future. However, there can be no assurance as to our actual future
cash flows or to the continued availability of dividends from our insurance
company subsidiaries.
Credit Facility, as Amended in May 2004
In connection with the acquisition of Pyramid Life, we obtained an $80
million credit facility (the "Credit Agreement") on March 31, 2003 to repay our
then existing loan and provide funds for the acquisition of Pyramid Life. The
Credit Agreement consisted of a $65 million term loan which was drawn to fund
the acquisition and a $15 million revolving loan facility. The Credit Agreement
initially called for interest at the London Interbank Offering Rate ("LIBOR")
for one, two or three months, at the option of the Company, plus 300 basis
points. Effective March 31, 2004, the spread over LIBOR was reduced to 275 basis
points in accordance with the terms of the Credit Agreement. Principal
repayments were scheduled over a five-year period with a final maturity date of
March 31, 2008. We incurred loan origination fees of approximately $2.1 million,
which were capitalized and are being amortized on a straight-line basis over the
life of the Credit Agreement.
In connection with the acquisition of Heritage on May 28, 2004, the
Company amended the Credit Agreement by increasing the facility to $120 million
from $80 million (the "Amended Credit Agreement"), including an increase in the
term loan portion to $105 million from $36.4 million (the balance outstanding at
May 28, 2004) and maintaining the $15 million revolving loan facility. None of
the revolving loan facility has been drawn as of December 31, 2004. Under the
Amended Credit Agreement, the spread over LIBOR was reduced to 225 basis points.
Effective January 1, 2005, the interest rate on the term loan is 4.8%. Principal
repayments are scheduled at $5.3 million per year over a five-year period with a
final payment of $80.1 million due upon maturity on March 31, 2009. The Company
incurred additional loan origination fees of approximately $2.1 million, which
were capitalized and are being amortized on a straight-line basis over the life
of the Amended Credit Agreement along with the continued amortization of the
origination fees incurred in connection with the Credit Agreement. The Company
pays an annual commitment fee of 50 basis points on the unutilized revolving
loan facility.
71
The obligations of the Company under the Amended Credit Facility are
guaranteed by our subsidiaries, WorldNet Services Corp., CHCS Services Inc.,
CHCS Inc., Quincy Coverage Corporation, Universal American Financial Services,
Inc., Heritage, HHS-HPN Network, Inc., Heritage Health Systems of Texas, Inc.,
PSO Management of Texas, LLC, HHS Texas Management, Inc. and HHS Texas
Management LP (collectively the "Guarantors") and secured by substantially all
of the assets of each of the Guarantors. In addition, as security for the
performance by the Company of its obligations under the Amended Credit Facility,
the Company, WorldNet Services Corp., CHCS Services Inc., Heritage and HHS Texas
Management, Inc., have each pledged and assigned substantially all of their
respective securities (but not more than 65% of the issued and outstanding
shares of voting stock of any foreign subsidiary), all of their respective
limited liability company and partnership interests, all of their respective
rights, title and interest under any service or management contract entered into
between or among any of their respective subsidiaries and all proceeds of any
and all of the foregoing.
The Amended Credit Facility requires the Company and its subsidiaries to
meet certain financial tests, including a minimum fixed charge coverage ratio, a
minimum risk based capital test and a minimum consolidated net worth test. The
Amended Credit Facility also contains covenants, which among other things, limit
the incurrence of additional indebtedness, dividends, capital expenditures,
transactions with affiliates, asset sales, acquisitions, mergers, prepayments of
other indebtedness, liens and encumbrances and other matters customarily
restricted in such agreements.
The Amended Credit Facility contains customary events of default,
including, among other things, payment defaults, breach of representations and
warranties, covenant defaults, cross-acceleration, cross-defaults to certain
other indebtedness, certain events of bankruptcy and insolvency and judgment
defaults.
Due to the variable interest rate for this Credit Agreement, the Company
would be subject to higher interest costs if short-term interest rates rise.
We made regularly scheduled principal payments of $5.7 million and paid
$3.1 million in interest in connection with our credit facilities during the
year ended December 31, 2004. During 2003, we made regularly scheduled principal
payments of $8.7 million and paid $2.7 million in interest in connection with
our credit facilities.
The following table shows the schedule of principal payments (in
thousands) remaining on our Amended Credit Agreement, with the final payment in
March 2009:
2005............................................................. $ 5,250
2006............................................................. 5,250
2007............................................................. 5,250
2008............................................................. 5,250
2009............................................................. 80,063
--------
$101,063
========
2003 Refinancing of Debt
In January 2003, we made a scheduled principal payment of $2.8 million on
our then current credit facility, and in March, 2003 made an additional
principal payment of $5.0 million from a portion of the proceeds from the
issuance of Trust Preferred securities. These payments reduced the outstanding
balance on our then current credit facility to $42.9 million, which was repaid
on March 31, 2003 from the proceeds of the Credit Agreement obtained in
connection with the acquisition of Pyramid Life. The early extinguishment of the
then existing debt resulted in the immediate amortization of the related
capitalized loan origination fees, resulting in a pre-tax expense of
approximately $1.8 million.
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Other Long Term Debt
We formed statutory business trusts, which exist for the exclusive purpose
of issuing trust preferred securities representing undivided beneficial
interests in the assets of the trust, investing the gross proceeds of the trust
preferred securities in junior subordinated deferrable interest debentures of
our parent holding company (the "Junior Subordinated Debt") and engaging in only
those activities necessary or incidental thereto. In accordance with the
adoption of FIN 46R, we have deconsolidated the trusts.
Separate subsidiary trusts of our parent holding company (the "Trusts")
have issued a combined $75.0 million in thirty year trust preferred securities
(the "Capital Securities") as of December 31, 2004, as detailed in the following
table:
RATE AS OF
MATURITY DATE AMOUNT ISSUED TERM SPREAD OVER LIBOR DECEMBER 31, 2004
------------- ------------- ---- ----------------- -----------------
(IN THOUSANDS) (BASIS POINTS)
December 2032 $15,000 Fixed/Floating 400 (1) 6.7%
March 2033 10,000 Floating 400 6.1%
May 2033 15,000 Floating 420 6.6%
May 2033 15,000 Fixed/Floating 410 (2) 7.4%
October 2033 20,000 Fixed/Floating 395 (3) 7.0%
-------
$75,000
=======
- --------
(1) Effective September, 2003, we entered into a swap agreement whereby it
will pay a fixed rate of 6.7% in exchange for a floating rate of LIBOR
plus 400 basis points. The swap contract expires in December 2007.
(2) The rate on this issue is fixed at 7.4% for the first five years, after
which it is converted to a floating rate equal to LIBOR plus 410 basis
points.
(3) Effective April 29, 2004, we entered into a swap agreement whereby it will
pay a fixed rate of 6.98% in exchange for a floating rate of LIBOR plus
395 basis points. The swap contract expires in October 2008.
The Trusts have the right to call the Capital Securities at par after five
years from the date of issuance. The proceeds from the sale of the Capital
Securities, together with proceeds from the sale by the Trusts of their common
securities to our parent holding company, were invested in thirty-year floating
rate Junior Subordinated Debt of our parent holding company. From the proceeds
of the trust preferred securities, $26.0 million was used to pay down debt
during 2003. The balance of the proceeds has been used, in part to fund
acquisitions, to provide capital to our insurance subsidiaries to support growth
and to be held for general corporate purposes.
The Capital Securities represent an undivided beneficial interest in the
Trusts' assets, which consist solely of the Junior Subordinated Debt. Holders of
the Capital Securities have no voting rights. Our parent holding company owns
all of the common securities of the Trusts. Holders of both the Capital
Securities and the Junior Subordinated Debt are entitled to receive cumulative
cash distributions accruing from the date of issuance, and payable quarterly in
arrears at a floating rate equal to the three-month LIBOR plus a spread. The
floating rate resets quarterly and is limited to a maximum of 12.5% during the
first sixty months. Due to the variable interest rate for these securities, we
are be subject to higher interest costs if short-term interest rates rise. The
Capital Securities are subject to mandatory redemption upon repayment of the
Junior Subordinated Debt at maturity or upon earlier redemption. The Junior
Subordinated Debt is unsecured and ranks junior and subordinate in right of
payment to all present and future senior debt of our parent holding company and
is effectively subordinated to all existing and future obligations of the
Company's subsidiaries. Our parent holding company has the right to redeem the
Junior Subordinated Debt after five years from the date of issuance.
73
Our parent holding company has the right at any time, and from time to
time, to defer payments of interest on the Junior Subordinated Debt for a period
not exceeding 20 consecutive quarters up to each debenture's maturity date.
During any such period, interest will continue to accrue and our parent holding
company may not declare or pay any cash dividends or distributions on, or
purchase, our common stock nor make any principal, interest or premium payments
on or repurchase any debt securities that rank equally with or junior to the
Junior Subordinated Debt. Our parent holding company has the right at any time
to dissolve the Trusts and cause the Junior Subordinated Debt to be distributed
to the holders of the Capital Securities. We have guaranteed, on a subordinated
basis, all of the Trusts' obligations under the Capital Securities including
payment of the redemption price and any accumulated and unpaid distributions to
the extent of available funds and upon dissolution, winding up or liquidation
but only to the extent the Trusts have funds available to make such payments.
The Capital Securities have not been and will not be registered under the
Securities Act of 1933, as amended (the "Securities Act"), and will only be
offered and sold under an applicable exemption from registration requirements
under the Securities Act.
We paid $4.7 million in interest in connection with the Junior
Subordinated Debt during the year ended December 31, 2004, and paid $2.1 million
during 2003.
Lease Obligations
We are obligated under certain lease arrangements for our executive and
administrative offices in New York, Florida, Indiana, Tennessee, Texas, and
Ontario, Canada. Rent expense was $2.6 million for the year ended December 31,
2004, $1.9 million for 2003 and $1.7 million for 2002. Annual minimum rental
commitments, subject to escalation, under non-cancelable operating leases (in
thousands) are as follows:
2005............................................................. $ 2,526
2006............................................................. 2,605
2007............................................................. 2,588
2008............................................................. 2,328
2009 and thereafter.............................................. 9,236
-------
Totals....................................................... $19,283
=======
In addition to the above, Pennsylvania Life and Penncorp Life (Canada) are
the named lessees on 71 properties occupied by Career Agents for use as field
offices. The Career Agents reimburse Pennsylvania Life and Penncorp Life
(Canada) the actual rent for these field offices. The total annual rent paid by
the Company and reimbursed by the Career Agents for these field offices during
2004 was approximately $1.1 million.
Shelf Registration
On November 3, 2004, we filed a universal shelf registration statement on
Form S-3 with the U.S. Securities and Exchange Commission ("SEC"), pursuant to
which we may issue common stock, warrants and debt securities from time to time,
up to an aggregate offering of $140 million. The registration statement also
covers five million shares of common stock that may be offered for sale by
Capital Z Financial Services Fund II, L.P ("Capital Z"), our largest
shareholder. In the event that Capital Z sells all of the five million shares,
Capital Z would still own 20.3 million shares or approximately 37% of our
outstanding common stock, before giving effect to any issuance of shares by us
pursuant to the shelf registration. The shelf registration statement was
declared effective in December 2004.
74
The shelf registration statement enables us to raise funds from the
offering of any individual security covered by the shelf registration statement,
as well as any combination thereof, through one or more methods of distribution,
subject to market conditions and our capital needs. The terms of any offering
pursuant to this shelf will be established at the time of the offering. We plan
to use the proceeds from any future offering under the registration statement
for general corporate purposes, including, but not limited to, working capital,
capital expenditures, investments in subsidiaries, acquisitions and refinancing
of debt. A more detailed description of the use of proceeds will be included in
any specific offering of securities in the prospectus supplement relating to the
offering. A copy of the shelf registration statement as filed with the SEC on
Form S-3 may be obtained at the SEC's website at www.sec.gov, or through the
Investor Relations section of the Universal American website at www.uafc.com.
Obligations of the Parent Company to Affiliates
In January 2002, our parent company issued an $18.5 million 8.5% debenture
to Pennsylvania Life in connection with the transfer of the business of
Pennsylvania Life's Canadian Branch to Penncorp Life (Canada). The debenture is
scheduled to be repaid in full during 2005. Our parent company repaid principal
of $4.5 million in 2002, $7.1 million in 2003 and $3.5 million in 2004, reducing
the outstanding balance to $3.4 million. Our parent holding company paid $0.5
million in interest on these debentures during 2004, $1.0 million in 2003 and
$1.5 million in 2002. The interest on these debentures is eliminated in
consolidation. Dividends from Penncorp Life (Canada) funded the interest and
principal paid on the debenture to date and it is anticipated that they will
fund all future payments made on this debenture.
Sources of Liquidity to the Parent Company
We anticipate funding the obligations of the parent company and the
capital required to grow our business from the four distinct and uncorrelated
sources of cash flow within the organization as follows:
- the expected cash flows of our senior administrative services
company,
- the expected cash flows of our senior managed care company (acquired
in the acquisition of Heritage),
- dividend payments received from Penncorp Life (Canada), and -
- surplus note principal and interest payments from American Exchange.
In addition, we maintain a large cash position and have access to our
unutilized $15.0 million revolving credit facility. However, there can be no
assurance as to our actual future cash flows or to the continued availability of
dividends from our insurance company subsidiaries.
Senior Administrative Services Company. Liquidity for our senior
administrative services subsidiary is measured by its ability to pay operating
expenses and pay dividends to our parent company. The primary source of
liquidity is fees collected from clients. We believe that the sources of cash
for our senior administrative services company exceed scheduled uses of cash and
results in amounts available to dividend to our parent holding company. We
measure the ability of the senior administrative services company to pay
dividends based on its earnings before interest, taxes, depreciation and
amortization ("EBITDA"). EBITDA for our Senior Administrative Services segment
was $15.3 million for the year ended December 31, 2004, and was $13.1 million
for 2003 and $10.5 million for 2002.
75
Senior Managed Care Company. Liquidity for our managed care company is
measured by its ability to pay operating expenses and pay dividends to our
parent company. The primary source of liquidity is management fees for
administration of SelectCare and services provided to the IPA's. Dividend
payments by SelectCare to Heritage are subject to the approval of the insurance
regulatory authorities of the state of Texas, SelectCare's state of domicile.
SelectCare is not able to pay dividends during 2005 without prior approval. We
believe that the sources of cash to our managed care holding company exceed
scheduled uses of cash which will result in funds available to dividend to our
parent holding company. We measure the ability of the senior managed care
holding company to pay dividends based on its EBITDA. EBITDA for our senior
managed care holding company was $12.2 million for the seven months since its
acquisition on May 28, 2004.
Penncorp Life (Canada) Dividends. Penncorp Life (Canada) is a Canadian
insurance company. Canadian law provides that a life insurer may pay a dividend
after such dividend declaration has been approved by its board of directors and
upon at least 10 days prior notification to the Superintendent of Financial
Institutions. Such a dividend is limited to retained net income (based on
Canadian GAAP) for the preceding two years, plus net income earned for the
current year. In considering approval of a dividend, the board of directors must
consider whether the payment of such dividend would be in contravention of the
Insurance Companies Act of Canada. During the first quarter of 2004, Penncorp
Life (Canada) paid dividends of C$26.7 million (approximately US$20.0 million)
to Universal American, relating to 2003 net income. The amount of the dividend
was larger than normal due to a benefit received by Penncorp Life (Canada) from
an actuarial experience study that allowed Penncorp Life (Canada) to reduce its
policy benefit reserves at December 31, 2003 on a Canadian GAAP basis. The
actuarial experience study did not have an impact on Penncorp Life (Canada)'s
policy benefit reserves on a U.S. GAAP basis. During the remainder of 2004,
Penncorp Life (Canada) paid dividends totaling C$7.2 million (US$5.6 million)
relating to net income for 2004. Penncorp Life (Canada) paid dividends to
Universal American totaling C$11.2 million (US $8.1 million) during 2003 and
C$9.3 million (US $5.9 million) during 2002. We anticipate that Penncorp Life
(Canada) will be able to pay dividends equal to its net income earned during
2005, less $2.5 million.
Insurance Subsidiaries -- Surplus Note, Dividends and Capital
Contributions. Cash generated by our insurance company subsidiaries will be made
available to our holding company, principally through periodic payments of
principal and interest on the surplus note owed to our holding company by our
subsidiary, American Exchange Life. As of December 31, 2004, the principal
amount of the surplus note was $48.5 million. The note bears interest to our
parent holding company at LIBOR plus 325 basis points. We anticipate that the
surplus note will be primarily serviced by dividends from Pennsylvania Life, a
wholly owned subsidiary of American Exchange, and by tax-sharing payments among
the insurance companies that are wholly owned by American Exchange and file a
consolidated Federal income tax return. American Exchange made principal
payments totaling $11.6 million during the year ended December 31, 2004. No
principal payments were made during 2003. During 2002, the surplus note was
reduced by $10.0 million in the form of a capital contribution to American
Exchange by our holding company. American Exchange paid interest on the surplus
note of $2.4 million during the year ended December 31, 2004, $2.8 million in
2003, and $3.8 million in 2002.
Our parent holding company made capital contributions to American Exchange
amounting to $17.8 million during 2004. In March 2004, Pennsylvania Life
declared and paid a dividend in the amount of $10.6 million to American
Exchange. American Exchange made capital contributions of $12.0 million to Union
Bankers, $8.2 million to American Pioneer and $7.0 million to American
Progressive during the year ended December 31, 2004.
76
During the year ended December 31, 2003, no dividends were declared or
paid by the U.S. insurance company subsidiaries to American Exchange. During
2003, American Exchange received capital contributions from its parent totaling
$35.5 million. American Exchange made capital contributions of $27.0 million to
Pennsylvania Life, primarily relating to the acquisition of Pyramid Life, $2.5
million to American Pioneer, $2.5 million to American Progressive and $3.5
million to Union Bankers. Pennsylvania Life contributed $1.0 million to Pyramid
Life in 2003.
During 2002, Pennsylvania Life paid dividends amounting to $3.0 million to
American Exchange. Universal American contributed 100% of the common stock of
American Pioneer and American Progressive to American Exchange during 2002.
American Exchange also received capital contributions from its parent totaling
$4.2 million during the year. American Exchange made capital contributions of
$3.0 million to American Pioneer and $1.2 million to American Progressive during
2002.
Dividend payments by our U.S. insurance companies to our holding company
or to intermediate subsidiaries are limited by, or subject to the approval of
the insurance regulatory authorities of each insurance company's state of
domicile. Such dividend requirements and approval processes vary significantly
from state to state. Pennsylvania Life is able to pay ordinary dividends of up
to $6.3 million to American Exchange during 2005, without prior approval.
Pyramid Life is able to pay ordinary dividends of up to $2.5 million to
Pennsylvania Life (its direct parent) with prior notice to the Kansas Insurance
Department and Marquette would be able to pay ordinary dividends of up to $0.3
million to Constitution (its direct parent) without the prior approval from the
Texas Insurance Department during 2005. American Exchange, American Pioneer,
American Progressive, Constitution and Union Bankers had negative earned surplus
at December 31, 2004 and are not be able to pay dividends in 2005 without
special approval.
Insurance Subsidiaries - Liquidity
Liquidity for our insurance company subsidiaries is measured by their
ability to pay scheduled contractual benefits, pay operating expenses, fund
investment commitments, and pay dividends to their parent company. The principal
sources of cash for our insurance operations include scheduled and unscheduled
principal and interest payments on investments, premium payments, annuity
deposits, and the sale or maturity of investments. Both the sources and uses of
cash are reasonably predictable and we believe that these sources of cash for
our insurance company subsidiaries exceed scheduled uses of cash.
Liquidity is also affected by unscheduled benefit payments including
benefits under accident and health insurance policies, death benefits and
interest-sensitive policy surrenders and withdrawals.
Our accident and health insurance policies generally provide for
fixed-benefit amounts and, in the case of Medicare Supplement policies, for
supplemental payments to Medicare provider rates. Some of these benefits are
subject to medical-cost inflation and we have the capability to file for premium
rate increases to mitigate rising medical costs. Our health insurance business
is widely dispersed in the United States and Canada, which mitigates the risk of
unexpected increases in claim payments due to epidemics and events of a
catastrophic nature. These accident and health polices are not
interest-sensitive and therefore are not subject to unexpected policyholder
redemptions due to investment yield changes.
Some of our life insurance and annuity policies are interest-sensitive in
nature. The amount of surrenders and withdrawals is affected by a variety of
factors such as credited interest rates for similar products, general economic
conditions and events in the industry that affect policyholders' confidence.
Although the contractual terms of substantially all of our in force life
insurance policies and annuities give the holders the right to surrender the
policies and annuities, we impose penalties for early surrenders. As of December
31, 2004 we held reserves that exceeded the underlying cash surrender values of
our net
77
retained in force life insurance and annuities by $34.3 million. Our insurance
subsidiaries, in our view, have not experienced any material changes in
surrender and withdrawal activity in recent years.
Changes in interest rates may affect the incidence of policy surrenders
and withdrawals. In addition to the potential impact on liquidity, unanticipated
surrenders and withdrawals in a changed interest rate environment could
adversely affect earnings if we were required to sell investments at reduced
values in order to meet liquidity demands. We manage our asset and liability
portfolios in order to minimize the adverse earnings impact of changing market
rates. We have segregated a portion of our investment portfolio in order to
match liabilities that are sensitive to interest rate movements with fixed
income securities containing similar characteristics to the related liabilities,
most notably the expected duration and required interest spread. We believe that
this asset/liability management process adequately covers the expected payment
of benefits related to these liabilities.
As of December 31, 2004, our insurance company subsidiaries held cash and
cash equivalents totaling $129.4 million, as well as fixed maturity securities
that could readily be converted to cash with carrying values (and fair values)
of $1.2 billion.
The net yields on our cash and invested assets decreased to 4.9% for the
year ended December 31, 2004, from 5.3% for 2002 and 6.4% for 2003. A portion of
these securities are held to support the liabilities for policyholder account
balances, which liabilities are subject to periodic adjustments to their
credited interest rates. The credited interest rates of the interest-sensitive
policyholder account balances are determined by us based upon factors such as
portfolio rates of return and prevailing market rates and typically follow the
pattern of yields on the assets supporting these liabilities.
Our insurance subsidiaries are required to maintain minimum amounts of
statutory capital and surplus as required by regulatory authorities. However,
substantially more than the statutory minimum amounts are needed to meet
statutory and administrative requirements of adequate capital and surplus to
support the current level of our insurance subsidiaries' operations. Each of our
insurance subsidiaries' statutory capital and surplus exceeds its respective
minimum statutory requirement at levels we believe are sufficient to support
their current levels of operation. Additionally, the National Association of
Insurance Commissioners ("NAIC") imposes regulatory risk-based capital ("RBC")
requirements on life insurance enterprises. At December 31, 2004, all of our
insurance subsidiaries maintained ratios of total adjusted capital to RBC in
excess of the "authorized control level". The combined statutory capital and
surplus, including asset valuation reserve, of our U.S. insurance subsidiaries
totaled $127.9 million at December 31, 2004 and $117.1 million at December 31,
2003. Statutory net income for the year ended December 31, 2004 was $5.4
million, which included after tax net realized gains of $0.9 million, and for
the year ended December 31, 2003 was $6.0 million, which included after tax net
realized losses of $0.3 million. The net statutory loss for the year ended
December 31, 2002 was $9.1 million, which included after tax net realized losses
of $16.8 million.
Penncorp Life (Canada) reports to Canadian regulatory authorities based
upon Canadian statutory accounting principles that vary in some respects from
U.S. statutory accounting principles. Penncorp Life (Canada)'s net assets based
upon Canadian statutory accounting principles were C$57.4 million (US$47.8
million) as of December 31, 2004 and were C$82.9 million (US$63.5 million) as of
December 31, 2003. Net income based on Canadian generally accepted accounting
principles was C$8.4 million (US$6.5 million) for the year ended December 31,
2004, C$34.4 million (US$24.6 million) for 2003 and C$12.8 million (US$8.2
million) for 2002. Penncorp Life (Canada) maintained a Minimum Continuing
Capital and Surplus Requirement Ratio ("MCCSR") in excess of the minimum
requirement at December 31, 2004.
78
Investments
Our investment policy is to balance the portfolio duration to achieve
investment returns consistent with the preservation of capital and maintenance
of liquidity adequate to meet payment of policy benefits and claims. We invest
in assets permitted under the insurance laws of the various states in which we
operate. Such laws generally prescribe the nature, quality of and limitations on
various types of investments that may be made. We do not currently have
investments in partnerships, special purpose entities, real estate, commodity
contracts, or other derivative securities. We currently engage the services of
three investment advisors under the direction of the management of our insurance
company subsidiaries and in accordance with guidelines adopted by the Investment
Committees of their respective boards of directors. Conning Asset Management
Company manages the portfolio of all of our United States subsidiaries, except
for the portfolio of Pyramid Life, and certain floating rate portfolios, which
are managed by Hyperion Capital. MFC Global Investment Management manages our
Canadian portfolio. We invest primarily in fixed maturity securities of the U.S.
Government and its agencies and in corporate fixed maturity securities with
investment grade ratings of "BBB-" (Standard & Poor's Corporation), "Baa3"
(Moody's Investor Service) or higher. Our current policy is not to invest in
derivative programs or other hybrid securities, except for GNMA's, FNMA's and
investment grade corporate collateralized mortgage obligations.
As of December 31, 2004, 99.4% of our fixed maturity investments had
investment grade ratings from Standard & Poor's Corporation or Moody's Investor
Service. There were no non-income producing fixed maturities as of December 31,
2004. During the year ended December 31, 2004, we did not write down the value
of any fixed maturity securities. We wrote down the value of certain fixed
maturity securities, considered to have been subject to an other-than-temporary
decline in value, by $1.3 million during 2003, and by $10.6 million during 2002
(primarily as a result of the impairment of our World Com holdings). In each
case, these write-downs represent our estimate of other than temporary declines
in value and were included in net realized gains (losses) on investments in our
consolidated statements of operations.
As of December 31, 2004, our insurance company subsidiaries held cash and
cash equivalents totaling $129.4 million, as well as fixed maturity securities
that could readily be converted to cash with carrying values (and fair values)
of $1.2 billion.
FEDERAL INCOME TAXATION OF THE COMPANY
We file a consolidated return for Federal income tax purposes that
includes all of the non-life insurance company subsidiaries, including Heritage.
American Progressive was included in the consolidated return through March 31,
2002 and American Pioneer was included through June 30, 2002. American Exchange
and its subsidiaries and Penncorp Life (Canada) are not current included.
American Exchange and its subsidiaries, including American Progressive since
April 1, 2002 and American Pioneer since July 1, 2002, file a separate
consolidated Federal return. Penncorp Life (Canada) files a separate return with
the Canada Revenue Agency.
As of December 31, 2004 we (exclusive of American Exchange and its
subsidiaries and Penncorp Life (Canada)) had net operating tax loss
carryforwards of approximately $7.9 million (including $6.9 million from
Heritage) that expire in 2015 and 2024 and capital loss carryforwards of $1.3
million that expire in 2007. As of December 31, 2004, we also had an Alternative
Minimum Tax ("AMT") credit carryforward for Federal income tax purposes of
approximately $0.5 million that can be carried forward indefinitely. As a result
of our acquisitions of CHCS and Heritage, use of most of our loss carryforwards
is subject to annual limitations.
79
As of December 31, 2004, American Exchange and its subsidiaries had net
operating loss carryforwards, most of which relate to the companies acquired in
1999 (and were incurred prior to their acquisition by us), of approximately $6.9
million that expire between 2009 and 2017. At December 31, 2004, American
Exchange and its subsidiaries also had capital loss carryforwards of $7.9
million that expire in 2007. As of December 31, 2004, American Exchange and its
subsidiaries also had an AMT credit carryforward for Federal income tax purposes
of approximately $0.7 million that can be carried forward indefinitely As a
result of the change in the ownership of the companies acquired in 1999, use of
most of these loss carryforwards is subject to annual limitations.
At December 31, 2004 and 2003, the Company carried valuation allowances of
$3.8 million and $0.6 million, respectively, with respect to its deferred tax
assets. The Company establishes a valuation allowance based upon an analysis of
projected taxable income and its ability to implement prudent and feasible tax
planning strategies. As a result of uncertainty regarding the ability to
generate taxable capital gains, the Company established a valuation allowance in
the amount of $3.2 million for its capital loss carryforwards during 2004 that
was recorded as a deferred income tax expense. Additionally, the Company
released $3.8 million relating to a portion of reserve amounts established for
pre-acquisition tax years of certain life insurance subsidiaries that were being
examined by the Internal Revenue Service. At December 31, 2003, the valuation
allowance for certain of the life tax operating loss carryforwards no longer was
considered necessary. The amount of the valuation allowance released during 2003
was $4.5 million and was recorded as a deferred income tax benefit. In 2003, the
Company established a reserve for pre-acquisition tax years of certain life
insurance subsidiaries that were being examined by the Internal Revenue Service.
As a result of the increased profitability of the Administrative Services
segment, valuation allowances for certain of the non-life tax loss carryforwards
no longer were considered necessary as of December 31, 2003. The amount of the
valuation allowance released during 2003 was $0.1 million and was also recorded
as a deferred income tax benefit. Management believes it is more likely than not
that the Company will realize the value of the recorded net deferred tax assets.
Our U.S. insurance company subsidiaries, other than Peninsular Life
Insurance Company, are taxed as life insurance companies as provided in the
Internal Revenue Code. The Omnibus Budget Reconciliation Act of 1990 amended the
Internal Revenue Code to require a portion of the expenses incurred in selling
insurance products to be capitalized and amortized over a period of years, as
opposed to an immediate deduction in the year incurred. Instead of measuring
actual selling expenses, the amount capitalized for tax purposes is based on a
percentage of premiums. In general, the capitalized amounts are subject to
amortization over a ten-year period. Since this change only affects the timing
of the deductions, it does not, assuming stability of rates, affect the
provisions for taxes reflected in our financial statements prepared in
accordance with GAAP. However, by deferring deductions, the change has the
effect of increasing our current tax expense and reducing statutory surplus.
There was no material increase in our current income tax provision for any of
the three years in the period ended December 31, 2004 due to the existence of
our insurance company subsidiaries' net operating loss carryforwards.
The Jobs Creation Tax Act of 2004 contains a provision that places a two
year moratorium on the imposition of tax on distributions from Policyholder
Surplus Accounts ("PSA"). Additionally, the ordering rules were changed to
allow for the first dollar of any distribution to reduce the PSA. Any
distribution during 2005 and 2006 from an insurance company that has a PSA will
be treated as a distribution from its PSA account. However, the distribution
will not be subject to federal income tax. As of December 31, 2004, we had
$20.2 million of PSA balances, and have accrued $7.1 million in deferred tax
liabilities corresponding to those balances. The Jobs Creation Tax Act of 2004
provides the mechanism to eliminate this potential tax without the imposition
of any tax payment. However, the transactions required to trigger the
elimination of the potential tax would require pre-approval of the Insurance
Departments of the respective companies. There can be no assurance that we will
receive such approvals.
80
EFFECTS OF RECENTLY ISSUED AND PENDING ACCOUNTING PRONOUNCEMENTS
There was no material impact on our consolidated financial condition or
results of operations as a result of our adoption of the recently issued
accounting pronouncements. We do not anticipate any material impact from the
future adoption of the pending accounting pronouncements, other than the
adoption of Statement of Financial Accounting Standards No. 123 (revised 2004),
"Share-Based Payment" ("SFAS 123R"). SFAS 123R requires all companies to
recognize compensation costs for share-based payments to employees based on the
grant-date fair value of the award for financial statements for reporting
periods beginning after June 15, 2005. Refer to Consolidated Financial
Statements Note 2 - Recent and Pending Accounting Pronouncements.
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In general, market risk relates to changes in the value of financial
instruments that arise from adverse movements in interest rates, equity prices
and foreign exchange rates. We are exposed principally to changes in interest
rates that affect the market prices of our fixed income securities as well as
the cost of our variable rate debt. Additionally, we are exposed to changes in
the Canadian dollar that affects the translation of the financial position and
the results of operations of our Canadian subsidiary from Canadian dollars to
U.S. dollars.
Investment Interest Rate Sensitivity
Our profitability could be affected if we were required to liquidate fixed
income securities during periods of rising and/or volatile interest rates.
However, we attempt to mitigate our exposure to adverse interest rate movements
through a combination of active portfolio management and by staggering the
maturities of our fixed income investments to assure sufficient liquidity to
meet our obligations and to address reinvestment risk considerations. Our
insurance liabilities generally arise over relatively long periods of time,
which typically permits ample time to prepare for their settlement.
Certain classes of mortgage-backed securities are subject to significant
prepayment risk due to the fact that in periods of declining interest rates,
individuals may refinance higher rate mortgages to take advantage of the lower
rates then available. We monitor and adjust our investment portfolio mix to
mitigate this risk.
We regularly conduct various analyses to gauge the financial impact of
changes in interest rate on our financial condition. The ranges selected in
these analyses reflect our assessment as being reasonably possible over the
succeeding twelve-month period. The magnitude of changes modeled in the
accompanying analyses should not be construed as a prediction of future economic
events, but rather, be treated as a simple illustration of the potential impact
of such events on our financial results.
The sensitivity analysis of interest rate risk assumes an instantaneous
shift in a parallel fashion across the yield curve, with scenarios of interest
rates increasing and decreasing 100 and 200 basis points from their levels as of
December 31, 2004, and with all other variables held constant. A 100 basis point
increase in market interest rates would result in a pre-tax decrease in the
market value of our fixed income investments of $70.6 million and a 200 basis
point increase in market interest rates would result in $138.6 million decrease.
Similarly, a 100 basis point decrease in market interest rates would result in a
pre-tax increase in the market value of our fixed income investments of $77.4
million and a 200 basis point decrease in market interest rates would result in
a $160.2 million increase.
81
Debt
We pay interest on our term loan and a portion of our trust preferred
securities based on the London Inter Bank Offering Rate ("LIBOR") for one, two
or three months. Due to the variable interest rate, the Company would be subject
to higher interest costs if short-term interest rates rise. We have attempted to
mitigate our exposure to adverse interest rate movements by fixing the rate on
$15.0 million of the trust preferred securities for a five year period through
the contractual terms of the security at inception and an additional $35.0
million through the use of interest rate swaps.
We regularly conduct various analyses to gauge the financial impact of
changes in interest rate on our financial condition. The ranges selected in
these analyses reflect our assessment as being reasonably possible over the
succeeding twelve-month period. The magnitude of changes modeled in the
accompanying analyses should not be construed as a prediction of future economic
events, but rather, be treated as a simple illustration of the potential impact
of such events on our financial results.
The sensitivity analysis of interest rate risk assumes scenarios increases
or decreases in LIBOR of 100 and 200 basis points from their levels as of
December 31, 2004, and with all other variables held constant. The following
table summarizes the impact of changes in LIBOR, based on the weighted average
balance outstanding and the weighted average interest rates for the nine months
ended December 31, 2004.
Effect of Change in LIBOR on Pre-tax Income
for the year ended December 31, 2004
Weighted ---------------------------------------------
Weighted Average 200 Basis 100 Basis 100 Basis 200 Basis
Description of Floating Average Balance Point Point Point Point
Rate Debt Interest Rate Outstanding Decrease Decrease Increase Increase
- ----------------------- ------------- ----------- --------- --------- --------- ---------
(in millions)
Loan Payable 4.06% $ 75.8 $ 1.5 $ 0.8 $ (0.8) $ (1.5)
Other long term debt 5.69% $ 25.0 0.5 0.3 (0.3) (0.5)
--------- --------- --------- ---------
Total $ 2.0 $ 1.1 $ (1.1) $ (2.0)
========= ========= ========= =========
As noted above, we have fixed the interest rate on $50 million of our $176
million of total debt outstanding, leaving $125 million of the debt exposed to
rising interest rates. As of December 31, 2004 we had approximately $181 million
of cash and cash equivalents and $55 million in short duration floating rate
investment securities. We anticipate that the net investment income on this $236
million will be positively impacted by rising interest rates and will mitigate
the negative impact of rising interest rates on our debt.
Currency Exchange Rate Sensitivity
Portions of our operations are transacted using the Canadian dollar as the
functional currency. As of and for the year ended December 31, 2004,
approximately 12% of our assets, 9% of our revenues, excluding realized gains,
and 16% of our income before realized gains and taxes were derived from our
Canadian operations. As of and for the year ended December 31, 2003,
approximately 13% of our assets, 12% of our revenues, excluding realized gains,
and 21% of our income before realized gains and taxes were derived from our
Canadian operations. Accordingly, our earnings and shareholder's equity are
affected by fluctuations in the value of the U.S. dollar as compared to the
Canadian dollar. Although this risk is somewhat mitigated by the fact that both
the assets and liabilities for our foreign operations are denominated in
Canadian dollars, we are still subject to translation gains and losses.
82
We periodically conduct various analyses to gauge the financial impact of
changes in the foreign currency exchange rate on our financial condition. The
ranges selected in these analyses reflect our assessment of what is reasonably
possible over the succeeding twelve-month period.
A 10% strengthening of the U.S. dollar relative to the Canadian dollar, as
compared to the actual average exchange rate for the year ended December 31,
2004, would have resulted in a decrease in our income before realized gains and
taxes of approximately $1.2 million for the year ended December 31, 2004 and a
decrease in our shareholders' equity of approximately $4.9 million at December
31, 2004. A 10% weakening of the U.S. dollar relative to the Canadian dollar
would have resulted in an increase in our income before realized gains and taxes
of approximately $1.5 million for the year ended December 31, 2004 and an
increase in shareholders' equity of approximately $6.0 million at December 31,
2004. Our sensitivity analysis of the effects of changes in foreign currency
exchange rates does not factor in any potential change in sales levels, local
prices or any other variables.
The magnitude of changes reflected in the above analysis regarding
interest rates and foreign currency exchange rates should, in no manner, be
construed as a prediction of future economic events, but rather as a simple
illustration of the potential impact of such events on our financial results.
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary schedules are listed in the
accompanying Index to Consolidated Financial Statements and Financial Statement
Schedules on Page F - 1.
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A - CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and
Chief Financial Officer, has evaluated the effectiveness of our "disclosure
controls and procedures" (as defined in Exchange Act Rules 13a-15(e) and
15d-15(e)) as of December 31, 2004. Based on such evaluation, our Chief
Executive Officer and Chief Financial Officer have concluded that, as of
December 31, 2004, our disclosure controls and procedures are effective in
recording, processing, summarizing and reporting, on a timely basis, information
that we are required to disclose in the reports that we file or submit under the
Exchange Act.
83
Management's Annual Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate
internal control over financial reporting to provide reasonable assurance
regarding the reliability of our financial reporting and the preparation of
financial statements for external purposes in accordance with generally accepted
accounting principles. Management assessed our internal control over financial
reporting as of December 31, 2004, the end of our fiscal year. Management based
its assessment on criteria established in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission ("COSO"). Our management believes that the COSO framework is a
suitable framework for its evaluation of our internal control over financial
reporting because it is free from bias, permits reasonably consistent
qualitative and quantitative measurements of our internal controls, is
sufficiently complete so that those relevant factors that would alter a
conclusion about the effectiveness of our internal controls are not omitted and
is relevant to an evaluation of internal control over financial reporting.
Management's assessment included evaluation of such elements as the design and
operating effectiveness of key financial reporting controls, process
documentation, accounting policies, and our overall control environment.
Based on our assessment, management has concluded that our internal
control over financial reporting was effective as of the end of the fiscal year
to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external reporting purposes in
accordance with generally accepted accounting principles. Management has not
identified any material weaknesses in our internal control over financial
reporting. We reviewed the results of management's assessment with the Audit
Committee of our Board of Directors.
Attestation Report of Ernst & Young LLP
Our independent registered public accounting firm, Ernst & Young LLP,
audited management's assessment and independently assessed the effectiveness of
the company's internal control over financial reporting. Ernst & Young has
issued an attestation report on our internal controls that concurs with
management's assessment. This report is included on page F-3 of our consolidated
financial statements included in this Form 10-K.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal controls over financial reporting
during the quarter ended December 31, 2004 that have materially affected, or are
reasonably likely to materially affect, our internal controls over financial
reporting.
Inherent Limitations on Effectiveness of Controls
Our management, including our Chief Executive Officer and Chief Financial
Officer, does not expect that our disclosure controls and procedures or our
internal controls over financial reporting will prevent or detect all error and
all fraud. A control system, no matter how well designed and operated, can
provide only reasonable, not absolute, assurance that the objectives of the
control system are met. The design of a control system must reflect the fact
that there are resource constraints, and the benefits of controls must be
considered relative to their costs. Further, because of the inherent limitations
in all control systems, no evaluation of controls can provide absolute assurance
that misstatements due to error or fraud will not occur or that all control
issues and instances of fraud, if any, within Universal American have been
detected. These inherent limitations include the realities that judgments in
decision-making can be faulty and that breakdowns can occur because of simple
error or mistake. Controls can also be circumvented by the individual acts of
some persons or by collusion of two or more people. The design of any system of
84
controls is based in part on certain assumptions about the likelihood of future
events, and there can be no assurance that any design will succeed in achieving
its stated goals under all potential future conditions. Projections of any
evaluation of controls effectiveness to future periods are subject to risks.
Over time, controls may become inadequate because of changes in conditions or
deterioration in the degree of compliance with policies or procedures.
ITEM 9B - OTHER INFORMATION
None
PART III
ITEM 10 - MANAGEMENT
The information required by Item 10 is incorporated into Part III of this
Annual Report on Form 10-K by reference to our definitive Proxy Statement for
the Annual Meeting of Stockholders scheduled to be held on May 26, 2005.
ITEM 11 - EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated into Part III of this
Annual Report on Form 10-K by reference to our definitive Proxy Statement for
the Annual Meeting of Stockholders scheduled to be held on May 26, 2005.
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 is incorporated into Part III of this
Annual Report on Form 10-K by reference to our definitive Proxy Statement for
the Annual Meeting of Stockholders scheduled to be held on May 26, 2005.
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated into Part III of this
Annual Report on Form 10-K by reference to our definitive Proxy Statement for
the Annual Meeting of Stockholders scheduled to be held on May 26, 2005.
ITEM 14 - PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by Item 14 is incorporated into Part III of this
Annual Report on Form 10-K by reference to our definitive Proxy Statement for
the Annual Meeting of Stockholders scheduled to be held on May 26, 2005.
85
PART IV
ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
1 FINANCIAL STATEMENTS
See separate index to Financial Statements and Financial Statement
Schedules on Page F - 1 of this Form 10-K.
2 FINANCIAL STATEMENT SCHEDULES
See separate index to Financial Statements and Financial Statement
Schedules on Page F - 1 of this Form 10-K.
3 EXHIBITS
2.1 Agreement and Plan of Merger, dated as of March 9, 2004, among
Universal American Financial Corp., HHS Acquisition Corp.,
Heritage Health Systems, Inc. and Carlyle Venture Partners,
L.P., as the stockholder representative, incorporated by
reference to Form 8-K dated March 9, 2004.
3.1 Restated Certificate of Incorporation of Universal American
Financial Corp. incorporated by reference to Exhibit 3.1 to
the registrant's Amendment No. 2 to the Registration Statement
(No. 333-62036) on Form S-3 filed on July 11, 2001.
3.2 Amendment No. 1 to the Restated Certificate of Incorporation
of Universal American Financial Corp., incorporated by
reference to Exhibit 3 to Form 10-Q (File No. 0-11321) for the
quarter ended June 30, 2004, filed with the SEC on August 9,
2004.
3.3 Amended and Restated By-Laws of Universal American Financial
Corp., incorporated by reference to Exhibit A to Form 8-K
(File No. 0-11321) dated August 13, 1999.
3.4 By-Laws, as amended, incorporated by reference to Exhibit A to
Form 8-K dated August 13, 1999.
4.1 Form of Indenture dated as of December 2004 between Universal
American Financial Corp. and U.S. Bank National Association,
as Trustee, incorporated by reference to Exhibit 4.01 to
Amendment No. 1 to the Company's Registration Statement on
Form S-3 (File No. 333-120190) filed with the Securities and
Exchange Commission on December 10, 2004.
4.2 Form of Indenture dated as of December 2004 between Universal
American Financial Corp. and U.S. Bank National Association,
as Trustee, incorporated by reference to Exhibit 4.02 to
Amendment No. 1 to the Company's Registration Statement on
Form S-3 (File No. 333-120190) filed with the Securities and
Exchange Commission on December 10, 2004.
4.3 Shareholders Agreement dated July 30, 1999, among the Company,
Capital Z Financial Services Fund II, L.P., UAFC, L.P., AAM
Capital Partners, L.P., Chase Equity Associates, L.P., Richard
A. Barasch and others, incorporated by reference to Exhibit A
of Form 8-K dated August 13, 1999.
4.4 Registration Rights Agreement, dated July 30, 1999, among the
Company, Capital Z Financial Services Fund II, L.P.,
Wand/Universal American Investments L.P.I., Wand/Universal
American Investments L.P. II, Chase Equity Associates, L.P.,
Richard A. Barasch and others, incorporated by reference to
Exhibit A to Form 8-K dated August 13, 1999.
86
10.1 Amended and Restated Purchase Agreement among the Company,
dated December 31, 1999, as amended and restated on July 2,
1999, between Universal American, PennCorp Financial Group,
Inc. ("PFG") and several of PFG's subsidiaries, incorporated
by reference to Annex B of Proxy Statement dated July 12,
1999.
10.2 Share Purchase Agreement, as of December 31, 1998, between the
Company and Capital Z Financial Services Fund II, L.P. as
amended by Amendment, dated as of July 2, 1999, incorporated
by reference to Annex A of Proxy Statement dated July 12,
1999.
10.3 Credit Agreement dated as of July 30, 1999, among the
Registrant and the Chase Manhattan Bank as agent, the lender
and signatory thereto, incorporated by reference to Exhibit C
to Form 8-K/A dated March 16, 2001.
10.4 Employment Contracts, between Registrant and the following
officers:
Richard A. Barasch, dated July 30, 1999
Robert A. Waegelein, dated July 30, 1999
Gary W. Bryant, dated July 30, 1999
William E. Wehner, dated July 30, 1999
incorporated by reference to Exhibits D and E to Form 8-K/A
dated March 16, 2001.
10.5 Agent Equity Plan for Agents of Penn Union Companies
incorporated by reference to Amendment 1 to Registration
Statement on Form S-2, dated July 13, 2000.
10.6 Agent Equity Plan for Regional Managers and Sub Managers of
Penn Union Companies incorporated by reference to Amendment 1
to Registration Statement on Form S-2, dated July 13, 2000.
10.7 1998 Incentive Compensation Plan, incorporated by reference to
Annex A of Definitive Proxy Statement filed on Form 14A dated
April 29, 1998.
10.8 Purchase Agreement dated as of December 20, 2002, by and among
Universal American Financial Corp., Pennsylvania Life
Insurance Company, Ceres Group, Inc. and Continental General
Insurance Company incorporated by reference to Form 8-K dated
December 20, 2002.
10.9 Credit Agreement dated March 31, 2003, among the Company,
various lending institutions and, Bank of America, N.A., as
the Administrative Agent, the Collateral Agent and the L/C
Issuer incorporated by reference to Form 8-K dated March 27,
2003.
10.10 Agreement dated as of July 6, 2000, by and between ALICOMP, a
division of ALICARE, Inc. and Universal American Financial
Corp. incorporated by reference to Form 10-Q/A (Amendment No.
1) for the period ended September 30, 2003, dated December 23,
2003.
87
10.11 Amended and Restated Credit Agreement dated as of May 28,
2004, among the Company, various lending institutions and
Bank of America, N.A., as the Administrative Agent, the
Collateral Agent and the L/C Issuer, incorporated by
reference to Form 8-K dated May 28, 2004.
10.12 Amendment No. 1 to Universal American Financial Corp. 1998
Incentive Compensation Plan, incorporated by reference to
Amendment No. 1 to the registrant's Registration Statement on
Form S-4 (No. 333-120190) filed on December, 10, 2004.
10.13* Addendum II for Item 1A to agreement dated as of July 6,
2000, by and between ALICOMP, a division of ALICARE, Inc. and
Universal American Financial Corp.
12.1* Statement re Computation of Ratios of Earnings to Fixed
Charges.
21.1* List of Subsidiaries.
23.1* Consent of Ernst & Young LLP
31.1* Certification of Chief Executive Officer, as required by Rule
13a-14(a) of the Securities Exchange Act of 1934.
31.2* Certification of Chief Financial Officer, as required by Rule
13a-14(a) of the Securities Exchange Act of 1934.
32.1* Certification of the Chief Executive Officer and Chief
Financial Officer, as required by Rule 13a-14(b) of the
Securities Exchange Act of 1934 and 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
* Filed or furnished herewith.
88
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.
UNIVERSAL AMERICAN FINANCIAL CORP.
March 16, 2005 By: /s/ Richard A. Barasch
----------------------
Richard A. Barasch
Chairman of the Board, President and
Chief Executive 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 following capacities and on the dates indicated.
Signature and Title Date
/s/Richard A. Barasch March 16, 2005
- -------------------------------------- --------------
Richard A. Barasch
Chairman of the Board, President,
Chief Executive Officer and Director
(Principal Executive Officer)
/s/Robert A. Waegelein March 16, 2005
- -------------------------------------- --------------
Robert A. Waegelein
Executive Vice President and Chief
Financial Officer
(Principal Financial Officer
and Principal Accounting Officer)
/s/Bradley E. Cooper March 16, 2005
- -------------------------------------- --------------
Bradley E. Cooper
Director
/s/Mark M. Harmeling March 16, 2005
- -------------------------------------- --------------
Mark M. Harmeling
Director
/s/Bertram Harnett March 16, 2005
- -------------------------------------- --------------
Bertram Harnett
Director
89
/s/Linda Lamel March 16, 2005
- -------------------------------------- --------------
Linda Lamel
Director
/s/Eric Leathers March 16, 2005
- -------------------------------------- --------------
Eric Leathers
Director
/s/Patrick J. McLaughlin March 16, 2005
- -------------------------------------- --------------
Patrick J. McLaughlin
Director
/s/Robert A. Spass March 16, 2005
- -------------------------------------- --------------
Robert A. Spass
Director
/s/Robert F. Wright March 16, 2005
- -------------------------------------- --------------
Robert F. Wright
Director
90
UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL
STATEMENT SCHEDULES OF THE REGISTRANT:
Report of Independent Registered Public Accounting Firm F-2
Report of Independent Registered Public Accounting Firm
on Internal Control over Financial Reporting F-3
Consolidated Balance Sheets as of December 31, 2004 and 2003 F-4
Consolidated Statements of Operations
for the Three Years Ended December 31, 2004 F-5
Consolidated Statements of Stockholders' Equity and Comprehensive Income
for the Three Years Ended December 31, 2004 F-6
Consolidated Statements of Cash Flows
for the Three Years Ended December 31, 2004 F-7
Notes to Consolidated Financial Statements F-8
Schedule I -- Summary of Investments - other than investments in related parties F-44
Schedule II -- Condensed Financial Information of Registrant F-45
Notes to Condensed Financial Information F-48
Schedule III -- Supplementary Insurance Information F-49
Schedule IV - Reinsurance
(incorporated in Note 13 to the Consolidated Financial Statements)
Schedule V - Valuation and Qualifying Accounts
(incorporated in Note 7 to the Consolidated Financial Statements)
Other schedules were omitted because they were not applicable
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of
Universal American Financial Corp.:
We have audited the accompanying consolidated balance sheets of Universal
American Financial Corp. and subsidiaries as of December 31, 2004 and 2003 and
the related consolidated statements of operations, stockholders' equity and
comprehensive income, and cash flows for each of the three years in the period
ended December 31, 2004. Our audits also included the financial statement
schedules listed in the Index at Item 15(a). These financial statements and
schedules are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and schedules based on
our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Universal American Financial Corp. and subsidiaries at December 31, 2004 and
2003 and the consolidated results of their operations and their cash flows for
each of the three years in the period ended December 31, 2004, in conformity
with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of Universal
American Financial Corp.'s internal control over financial reporting as of
December 31, 2004, based on criteria established in Internal Control-Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission and our report dated March 11, 2005 expressed an unqualified opinion
thereon.
/s/ Ernst & Young LLP
New York, New York
March 11, 2005
F-2
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Board of Directors and Stockholders of
Universal American Financial Corp.:
We have audited management's assessment, included in the accompanying
management's annual report on internal control over financial reporting, that
Universal American Financial Corp. maintained effective internal control over
financial reporting as of December 31, 2004, based on criteria established in
Internal Control--Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (the COSO criteria). Universal American
Financial Corp. management is responsible for maintaining effective internal
control over financial reporting and for its assessment of the effectiveness of
internal control over financial reporting. Our responsibility is to express an
opinion on management's assessment and an opinion on the effectiveness of the
company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
In our opinion, management's assessment that Universal American Financial Corp.
maintained effective internal control over financial reporting as of December
31, 2004, is fairly stated, in all material respects, based on the COSO
criteria. Also, in our opinion, Universal American Financial Corp. maintained,
in all material respects, effective internal control over financial reporting as
of December 31, 2004, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheets of
Universal American Financial Corp. and subsidiaries as of December 31, 2004 and
2003 and the related consolidated statements of operations, stockholders' equity
and comprehensive income, and cash flows for each of the three years in the
period ended December 31, 2004 and our report dated March 11, 2005 expressed an
unqualified opinion thereon.
/s/ Ernst & Young LLP
New York, New York
March 11, 2005
F-3
UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2004 AND 2003
(IN THOUSANDS)
2004 2003
------------- ------------
ASSETS
Investments (Notes 2 and 6):
Fixed maturities available for sale, at fair value
(amortized cost: 2004, $1,109,678; 2003, $1,081,954) $ 1,170,822 $ 1,141,392
Equity securities, at fair value (cost: 2004, $749; 2003, $1,481) 755 1,507
Policy loans 24,318 25,502
Other invested assets 1,187 1,583
------------- ------------
Total investments 1,197,082 1,169,984
Cash and cash equivalents 181,257 116,524
Accrued investment income 13,151 14,476
Deferred policy acquisition costs (Notes 2 and 12) 208,281 143,711
Amounts due from reinsurers (Note 13) 212,501 219,182
Due and unpaid premiums 6,474 7,433
Deferred income tax asset (Note 7) - 15,757
Present value of future profits and other amortizing intangible assets 60,804 44,047
Goodwill and other indefinite lived intangible assets (Notes 2 and 4) 75,180 13,117
Income taxes receivable 865 -
Other assets 61,493 36,717
------------- ------------
Total assets $ 2,017,088 $ 1,780,948
============= ============
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Policyholder account balances (Note 2) $ 478,373 $ 419,685
Reserves for future policy benefits 762,563 722,466
Policy and contract claims - life 10,802 8,672
Policy and contract claims - health (Note 11) 91,288 100,232
Loan payable (Note 14) 101,063 38,172
Other long term debt (Note 15) 75,000 75,000
Amounts due to reinsurers 6,023 6,779
Income taxes payable - 12,489
Deferred income tax liability (Note 7) 5,206 -
Other liabilities 67,349 51,715
------------- ------------
Total liabilities 1,597,667 1,435,210
------------- ------------
Commitments and contingencies (Note 17)
STOCKHOLDERS' EQUITY (Note 8)
Common stock (Authorized: 100 million shares, issued:
2004, 55.3 million shares; 2003, 54.1 million shares) 553 541
Additional paid-in capital 172,525 164,355
Accumulated other comprehensive income (Notes 8 and 21) 40,983 39,774
Retained earnings 206,329 142,458
Less: Treasury stock (2004, 0.1 million shares; 2003, 0.2 million shares) (969) (1,390)
------------- ------------
Total stockholders' equity 419,421 345,738
------------- ------------
Total liabilities and stockholders' equity $ 2,017,088 $ 1,780,948
============= ============
See notes to consolidated financial statements.
F-4
UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE YEARS ENDED DECEMBER 31, 2004
(IN THOUSANDS, PER SHARE AMOUNTS IN DOLLARS)
2004 2003 2002
----------- ----------- ------------
Revenues:
Direct premium and policyholder fees earned $ 858,921 $ 700,415 $ 586,686
Reinsurance premiums assumed 35,682 27,042 5,075
Reinsurance premiums ceded (249,419) (280,489) (325,184)
----------- ----------- ------------
Net premiums and policyholder fees earned (Note 13) 645,184 446,968 266,577
Net investment income (Note 6) 65,191 61,075 57,716
Net realized gains (losses) on investments (Note 6) 10,647 2,057 (5,083)
Fee and other income 14,323 12,648 12,313
----------- ----------- ------------
Total revenues 735,345 522,748 331,523
----------- ----------- ------------
Benefits, Claims and Expenses:
Claims and other benefits 421,710 292,211 168,526
Net increase in reserves for future policy benefits 21,275 14,423 12,880
Interest credited to policyholders 18,617 14,900 10,963
Increase in deferred acquisition costs (Note 12) (65,507) (51,104) (27,850)
Amortization of intangible assets (Note 4) 5,232 3,023 1,642
Commissions 142,412 135,937 115,074
Commission and expense allowances on
reinsurance ceded (50,463) (69,712) (94,689)
Interest expense 7,903 4,894 3,095
Early extinguishment of debt (Note 14) - 1,766 -
Other operating costs and expenses 137,698 109,931 97,852
----------- ----------- ------------
Total benefits, claims and other deductions 638,877 456,269 287,493
----------- ----------- ------------
Income before taxes 96,468 66,479 44,030
Income tax expense 32,597 23,427 13,903
----------- ----------- ------------
Net income $ 63,871 $ 43,052 $ 30,127
----------- ----------- ------------
Earnings per common share (Notes 2 and 20):
Basic $ 1.17 $ 0.80 $ 0.57
=========== =========== ============
Diluted $ 1.13 $ 0.78 $ 0.56
=========== =========== ============
See notes to consolidated financial statements.
F-5
UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
FOR THE THREE YEARS ENDED DECEMBER 31, 2004
(IN THOUSANDS)
Accumulated
Additional Other
Common Paid-In Comprehensive Retained Treasury
Stock Capital Income Earnings Stock Total
------ ---------- ------------- -------- -------- ---------
Balance, January 1, 2002 $ 528 $ 155,746 $ 5,603 $ 69,279 $ (386) $ 230,770
Net income - - - 30,127 - 30,127
Other comprehensive income (Note 21) - - 24,284 - - 24,284
---------
Comprehensive income - - - - - 54,411
---------
Issuance of common stock (Note 8) 4 1,016 - - - 1,020
Stock-based compensation (Note 9) - 1,412 - - - 1,412
Repayments of loans to officers (Note 8) - 10 - - - 10
Treasury shares purchased, at
cost (Note 8) - - - - (1,520) (1,520)
Treasury shares reissued (Note 8) - 80 - - 586 666
------ ---------- --------- -------- -------- ---------
Balance, December 31, 2002 532 158,264 29,887 99,406 (1,320) 286,769
Net income - - - 43,052 - 43,052
Other comprehensive income (Note 21) - - 9,887 - - 9,887
---------
Comprehensive income - - - - - 52,939
---------
Issuance of common stock (Note 8) 9 4,077 - - - 4,086
Stock-based compensation (Note 9) - 1,343 - - - 1,343
Repayments of loans to officers (Note 8) - 653 - - - 653
Treasury shares purchased, at
cost (Note 8) - - - - (1,113) (1,113)
Treasury shares reissued (Note 8) - 18 - - 1,043 1,061
------ ---------- --------- -------- -------- ---------
Balance, December 31, 2003 541 164,355 39,774 142,458 (1,390) 345,738
Net income - - - 63,871 - 63,871
Other comprehensive income (Note 21) - - 1,209 - - 1,209
---------
Comprehensive income - - - - - 65,080
---------
Issuance of common stock (Note 8) 12 4,779 - - - 4,791
Stock-based compensation (Note 9) - 3,010 - - - 3,010
Repayments of loans to officers (Note 8) - 126 - - - 126
Treasury shares purchased, at
cost (Note 8) - - - - (325) (325)
Treasury shares reissued (Note 8) - 255 - - 746 1,001
------ ---------- --------- -------- -------- ---------
Balance, December 31, 2004 $ 553 $ 172,525 $ 40,983 $206,329 $ (969) $ 419,421
====== ========== ========= ======== ======== =========
See notes to consolidated financial statements.
F-6
UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE YEARS ENDED DECEMBER 31, 2004
(IN THOUSANDS)
2004 2003 2002
--------- --------- ---------
Cash flows from operating activities:
Net income $ 63,871 $ 43,052 $ 30,127
Adjustments to reconcile net income to net cash
provided by operating activities, net of balances acquired (see Note
3 - Business Combinations):
Deferred income taxes 22,435 7,839 9,404
Change in reserves for future policy benefits 27,751 17,393 33,780
Change in policy and contract claims (16,080) 23 9,055
Change in deferred policy acquisition costs (65,507) (51,104) (27,850)
Amortization of present value of future profits and other intangibles 5,232 3,023 1,642
Net accretion of bond discount (3,724) (3,299) (3,716)
Amortization of capitalized loan origination fees 1,193 2,248 539
Change in policy loans 1,184 286 298
Change in accrued investment income 1,325 (1,371) 778
Change in reinsurance balances 5,825 18,327 (7,983)
Realized losses (gains) on investments (10,647) (2,057) 5,083
Change in income taxes payable (13,354) 10,488 (1,143)
Other, net 6,850 (548) (1,349)
--------- --------- ---------
Net cash provided by operating activities 26,354 44,300 48,665
--------- --------- ---------
Cash flows from investing activities:
Proceeds from sale or redemption of fixed maturities 304,886 271,968 266,541
Cost of fixed maturities purchased (304,803) (335,629) (362,141)
Purchase of business, net of cash acquired (Note 3) (65,961) (58,940) -
Other investing activities (19,803) (3,852) (3,734)
--------- --------- ---------
Net cash used by investing activities (85,681) (126,453) (99,334)
--------- --------- ---------
Cash flows from financing activities:
Net proceeds from issuance of common stock 4,916 4,741 1,020
Cost of treasury stock purchases (325) (1,113) (1,520)
Change in policyholder account balances 58,688 109,870 34,835
Change in reinsurance on policyholder account balances (35) 1,028 798
Principal repayment on loan payable (5,703) (8,653) (10,700)
Early extinguishment of debt (Note 14) - (68,950) -
Issuance of new debt (Note 14) 68,594 65,000 -
Cost of new debt issued (2,075) - -
Issuance of trust preferred securities (Note 15) - 60,000 15,000
--------- --------- ---------
Net cash provided by financing activities 124,060 161,923 39,433
--------- --------- ---------
Net increase (decrease) in cash and cash equivalents 64,733 79,770 (11,236)
Cash and cash equivalents at beginning of year 116,524 36,754 47,990
--------- --------- ---------
Cash and cash equivalents at end of year $ 181,257 $ 116,524 $ 36,754
========= ========= =========
Supplemental cash flow information:
Cash paid for interest $ 7,805 $ 4,804 $ 2,574
========= ========= =========
Cash paid for income taxes $ 20,464 $ 3,199 $ 3,707
========= ========= =========
See notes to consolidated financial statements.
F-7
UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND COMPANY BACKGROUND:
Universal American Financial Corp. was incorporated in the State of New
York in 1981 as a life and accident & health insurance holding company. The
consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States ("GAAP") and
consolidate the accounts of Universal American Financial Corp. ("Universal
American") and its subsidiaries (collectively the "Company"), American
Progressive Life & Health Insurance Company of New York ("American
Progressive"), American Pioneer Life Insurance Company ("American Pioneer"),
American Exchange Life Insurance Company ("American Exchange"), Pennsylvania
Life Insurance Company ("Pennsylvania Life"), Peninsular Life Insurance Company
("Peninsular"), Union Bankers Insurance Company ("Union Bankers"), Constitution
Life Insurance Company ("Constitution"), Marquette National Life Insurance
Company ("Marquette"), Penncorp Life Insurance Company, a Canadian company
("Penncorp Life (Canada)"), The Pyramid Life Insurance Company ("Pyramid Life"),
Heritage Health Systems, Inc., including SelectCare of Texas, L.L.C.
(collectively "Heritage"), and CHCS Services, Inc. ("CHCS").
Pyramid Life was acquired on March 31, 2003 and Heritage was acquired on
May 28, 2004. Operating results for these entities prior to the date of their
respective acquisitions are not included in Universal American's consolidated
results of operations.
Collectively, the insurance company subsidiaries are licensed to sell life
and accident & health insurance and annuities in all fifty states, the District
of Columbia, Puerto Rico and all the provinces of Canada. The principal
insurance products currently sold by the Company are Medicare Supplement and
Select, fixed benefit accident and sickness disability insurance, senior life
insurance and fixed annuities. The Company distributes these products through
independent general agents and its career agency systems. The independent
general agents sell for American Pioneer, American Progressive, Constitution and
Union Bankers while the career agents focus on sales for Pennsylvania Life,
Pyramid Life and Penncorp Life (Canada). Heritage operates Medicare Advantage
plans in Houston and Beaumont Texas, and our Medicare Advantage private
fee-for-service plan in the northeastern portion of the United States. CHCS, the
Company's administrative services company, acts as a service provider for both
affiliated and unaffiliated insurance companies for senior market insurance and
non-insurance programs.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
a. BASIS OF PRESENTATION: The accompanying consolidated financial
statements have been prepared in accordance with accounting
principles generally accepted in the United States ("GAAP"). For the
insurance subsidiaries, GAAP differs from statutory accounting
practices prescribed or permitted by regulatory authorities. The
accompanying consolidated financial statements include the accounts
of Universal American and its wholly-owned subsidiaries, including
the operations of acquired companies from the date of their
acquisition. All material intercompany transactions and balances
have been eliminated. The significant accounting policies followed
by Universal American and subsidiaries that materially affect
financial reporting are summarized below.
b. USE OF ESTIMATES: The preparation of our financial statements in
conformity with GAAP requires us to make estimates and assumptions
that affect the amounts of assets and liabilities and disclosures of
assets and liabilities reported by us at the date of the financial
statements and the revenues and expenses reported during the
reporting period. As additional information becomes available or
actual amounts become determinable, the recorded estimates may be
revised and reflected in operating results. Actual results could
differ from those estimates. In our judgment, the accounts involving
estimates and assumptions that are most critical to the preparation
of our financial statements are future policy benefits and claim
liabilities, deferred policy acquisition costs, goodwill, present
value of future profits and other intangibles, the valuation of
certain investments and income taxes. There have been no changes in
our critical accounting policies during the current year.
F-8
c. INVESTMENTS: The Company follows Statement of Financial Accounting
Standards ("SFAS") No. 115, "Accounting for Certain Debt and Equity
Securities" ("SFAS 115"). SFAS 115 requires that debt and equity
securities be classified into one of three categories and accounted
for as follows: Debt securities that the Company has the positive
intent and the ability to hold to maturity are classified as "held
to maturity" and reported at amortized cost. Debt and equity
securities that are held for current resale are classified as
"trading securities" and reported at fair value, with unrealized
gains and losses included in earnings. Debt and equity securities
not classified as held to maturity or as trading securities are
classified as "available for sale" and reported at fair value.
Unrealized gains and losses on available for sale securities are
excluded from earnings and reported as accumulated other
comprehensive income, net of tax and deferred policy acquisition
cost adjustments.
As of December 31, 2004 and 2003, all fixed maturity securities were
classified as available for sale and were carried at fair value,
with the unrealized gain or loss, net of tax and deferred policy
acquisition cost adjustments, included in accumulated other
comprehensive income. Equity securities are carried at current fair
value. Policy loans are stated at the unpaid principal balance.
Short-term investments are carried at cost, which approximates fair
value. Other invested assets include mortgage loans and collateral
loans. The collateral loans are carried at their underlying
collateral value, the cash surrender value of life insurance.
Mortgage loans are carried at the unpaid principal balance.
The fair value of investments is based upon quoted market prices,
where available, or on values obtained from independent pricing
services. For certain mortgage and asset- backed securities, the
determination of fair value is based primarily upon the amount and
timing of expected future cash flows of the security. Estimates of
these cash flows are based on current economic conditions, past
credit loss experience and other factors.
The Company regularly evaluates the amortized cost of its
investments compared to the fair value of those investments.
Impairments of securities are generally recognized when a decline in
fair value below the amortized cost basis is considered to be
other-than-temporary. Impairment losses for certain mortgage and
asset-backed securities are recognized when an adverse change in the
amount or timing of estimated cash flows occurs, unless the adverse
change is solely a result of changes in estimated market interest
rates. The cost basis for securities determined to be impaired are
reduced to their fair value, with the excess of the cost basis over
the fair value recognized as a realized investment loss.
Realized investment gains and losses on the sale of securities are
based on the specific identification method.
Investment income is generally recorded when earned. Premiums and
discounts arising from the purchase of certain mortgage and
asset-backed securities are amortized into investment income over
the estimated remaining term of the securities, adjusted for
anticipated prepayments. The prospective method is used to account
for the impact on investment income of changes in the estimated
future cash for these securities. Premiums and discounts on other
fixed maturity securities are amortized using the interest method
over the remaining term of the security.
F-9
d. DEFERRED POLICY ACQUISITION COSTS: The cost of acquiring new
business, principally commissions and certain expenses of the
agency, policy issuance and underwriting departments, all of which
vary with, and are primarily related to the production of new and
renewal business, have been deferred. These costs are being
amortized in relation to the present value of expected gross profits
on the policies arising principally from investment, mortality and
expense margins in accordance with SFAS No. 97, "Accounting and
Reporting by Insurance Enterprises for Certain Long-Duration
Contracts and for Realized Gains and Losses from the Sale of
Investments", ("SFAS 97") for interest sensitive life and annuity
products and in proportion to premium revenue using the same
assumptions used in estimating the liabilities for future policy
benefits in accordance with SFAS No. 60, "Accounting and Reporting
by Insurance Enterprises", ("SFAS 60") for non-interest sensitive
life and all accident & health products. Deferred policy acquisition
costs are written off to the extent that it is determined that
future policy premiums and investment income or gross profits would
not be adequate to cover related losses and expenses.
The Company has several reinsurance arrangements in place on its
life and accident & health insurance risks (see Note 12 - Deferred
Acquisition Costs). Amounts capitalized for deferred acquisition
costs are reported net of the related commissions and expense
allowances received from the reinsurer on these costs.
e. PRESENT VALUE OF FUTURE PROFITS AND GOODWILL: Business combinations
accounted for as a purchase result in the allocation of the purchase
consideration to the fair values of the assets and liabilities
acquired, including the present value of future profits,
establishing such fair values as the new accounting basis. The
present value of future profits is based on an estimate of the cash
flows of the in force business acquired, discounted to reflect the
present value of those cash flows. The discount rate selected
depends upon the general market conditions at the time of the
acquisition and the inherent risk in the transaction. Purchase
consideration in excess of the fair value of net assets acquired,
including the present value of future profits and other identified
intangibles, for a specific acquisition, is allocated to goodwill.
Allocation of purchase price is performed in the period in which the
purchase is consummated. Adjustments, if any, in subsequent periods
relate to resolution of pre-acquisition contingencies and
refinements made to estimates of fair value in connection with the
preliminary allocation.
Amortization of present value of future profits is based upon the
pattern of the projected cash flows of the in-force business
acquired, over weighted average lives ranging from six to forty
years. Other identified intangibles are amortized over their
estimated lives.
At least annually, management reviews the unamortized balances of
present value of future profits, goodwill and other identified
intangibles to determine whether events or circumstances indicate
the carrying value of such assets is not recoverable, in which case
an impairment charge would be recognized. Management believes that
no impairments of present value of future profits, goodwill or other
identified intangibles existed as of December 31, 2004.
F-10
f. RECOGNITION OF REVENUES, CONTRACT BENEFITS AND EXPENSES FOR
INVESTMENT AND UNIVERSAL LIFE TYPE POLICIES: Revenues for universal
life-type policies and investment products consist of mortality
charges for the cost of insurance and surrender charges assessed
against policyholder account balances during the period. Amounts
received for investment and universal life type products are not
reflected as premium revenue; rather such amounts are accounted for
as deposits, with the related liability included in policyholder
account balances. Benefit claims incurred in excess of policyholder
account balances are expensed. The liability for policyholder
account balances for universal life-type policies and investment
products under SFAS 97 are determined following a "retrospective
deposit" method. The retrospective deposit method establishes a
liability for policy benefits at an amount determined by the account
or contract balance that accrues to the benefit of the policyholder,
which consists principally of policy account values before any
applicable surrender charges. The base rates on the annuity products
currently marketed by us range from 3% to 3.6%. We offer sales
inducements in the form of first year only bonus interest rates,
which range from 1% to 4%, on certain of our annuity products.
Including the bonus interest rates, our current credited rates on
our annuity products range from 3% to 7.3%. Our currently marketed
annuity products have minimum guaranteed interest rates ranging from
1.5% to 3%. For Universal Life products, current credited rates
range from 4% to 6%, which represent the minimum guaranteed rates.
There is no first year only bonus interest on our Universal Life
policies.
g. RECOGNITION OF PREMIUM REVENUES AND POLICY BENEFITS FOR ACCIDENT &
HEALTH INSURANCE PRODUCTS: Premiums are recorded when due and
recognized as revenue over the period to which the premiums relate.
Benefits and expenses associated with earned premiums are recognized
as the related premiums are earned so as to result in recognition of
profits over the life of the policies. This association is
accomplished by recording a provision for future policy benefits and
amortizing deferred policy acquisition costs. The liability for
future policy benefits for accident & health policies consists of
active life reserves and the estimated present value of the
remaining ultimate net cost of incurred claims. Active life reserves
include unearned premiums and additional reserves. The additional
reserves are computed on the net level premium method using
assumptions for future investment yield, mortality and morbidity
experience. The assumptions are based on past experience. Claim
reserves are established for future payments not yet due on incurred
claims, primarily relating to individual disability and long term
care insurance and group long-term disability insurance products.
These reserves are initially established based on past experience,
continuously reviewed and updated with any related adjustments
recorded to current operations. Claim liabilities represent policy
benefits due but unpaid and primarily relate to individual health
insurance products.
h. RECOGNITION OF PREMIUM REVENUES AND POLICY BENEFITS FOR TRADITIONAL
LIFE AND ANNUITY PRODUCTS: Premiums from traditional life and
annuity policies with life contingencies generally are recognized as
revenue when due. Benefits and expenses are matched with such
revenue so as to result in the recognition of profits over the life
of the contracts. This matching is accomplished by recording a
provision for future policy benefits and the deferral and subsequent
amortization of policy acquisition costs.
i. RECOGNITION OF PREMIUM REVENUES AND POLICY BENEFITS FOR MEDICARE
ADVANTAGE POLICIES: Premiums received pursuant to Medicare
Advantage contracts with the Federal government's Centers for
Medicare & Medicaid Services ("CMS") for Medicare enrollees are
recorded as revenue in the month in which members are entitled to
receive service. Premiums collected in advance are deferred.
Accounts receivable from CMS and healthplan members for coordinating
physician services and inpatient, outpatient and ancillary care are
included in other assets and are recorded net of estimated bad
debts. Policies and contract claims include actual claims reported
but not paid and estimates of health care services incurred but not
reported. The estimated claims incurred but not reported are based
on historical data, current enrollment, health service utilization
statistics and other related information. Although considerable
variability is inherent in such estimates, management believes that
the liability is adequate. Changes in
F-11
assumptions for medical costs caused by changes in actual experience
could cause these estimates to change in the near term.
j. RECOGNITION OF ADMINISTRATIVE SERVICE REVENUE: Fees for
administrative services generally are recognized over the period for
which the Company is obligated to provide service.
k. INCOME TAXES: The Company uses the asset and liability method of
accounting for income taxes. Under this method, deferred tax assets
and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying
amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years
in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that
includes the enactment date of a change in tax rates.
The Company establishes valuation allowances on its deferred tax
assets for amounts that it determines will not be recoverable based
upon an analysis of projected taxable income and its ability to
implement prudent and feasible tax planning strategies. Increases in
the valuation allowances are recognized as deferred tax expense.
Subsequent determinations that portions of the valuation allowances
are no longer necessary are reflected as deferred tax benefits. To
the extent that valuation allowances were established in conjunction
with acquisitions, changes in those allowances are first applied to
goodwill (but not below zero) or other intangibles related to the
acquisition and then are applied to income tax expense.
l. REINSURANCE: Amounts recoverable under reinsurance contracts are
included in total assets as amounts due from reinsurers rather than
net against the related policy asset or liability. The cost of
reinsurance related to long-duration contracts is accounted for over
the life of the underlying reinsured policies using assumptions
consistent with those used to account for the underlying policies.
m. FOREIGN CURRENCY TRANSLATION: The financial statement accounts of
the Company's Canadian operations, which are denominated in Canadian
dollars, are translated into U.S. dollars as follows: (i) assets and
liabilities are translated at the rates of exchange as of the
balance sheet dates and the related unrealized translation
adjustments are included as a component of accumulated other
comprehensive income, and (ii) revenues, expenses and cash flows are
translated using a weighted average of exchange rates for each
period presented.
n. DERIVATIVE INSTRUMENTS - CASH FLOW HEDGE: The Company uses
derivative instruments, interest rate swaps, to hedge risk arising
from interest rate volatility ("cash-flow" hedge). These cash-flow
hedges are recognized on the balance sheet at their fair value,
based on independent pricing sources. The fair value of the
cash-flow hedges are reported as assets or liabilities in other
assets or other liabilities. On the date the interest rate swap
contract is entered into, the Company designates it as a hedge of a
forecasted transaction or of the variability of cash flows to be
received or paid related to a recognized asset or liability. Changes
in the fair value of the interest rate swap that is designated and
qualifies as a cash-flow hedge are recorded in accumulated other
comprehensive income and are reclassified into earnings when the
variability of the cash flow hedged item impacts earnings. Gains and
losses on derivative contracts that are reclassified into earnings
are included in the line items in which the hedged item is recorded.
F-12
At the inception of the contract, the Company formally documents all
relationships between the hedging instrument and the hedged item, as
well as its risk-management objective and strategy for undertaking
each hedge transaction. The Company also formally assesses, both at
the hedge's inception and on an ongoing basis, whether the
derivative used in hedging transactions are highly effective in
offsetting changes in the cash flows of the hedged items.
o. EARNINGS PER COMMON SHARE: Basic earning per share ("EPS") excludes
dilution and is computed by dividing net income by the weighted
average number of shares outstanding for the period. Diluted EPS
gives the dilutive effect of the stock options outstanding during
the year. There were 109,250 and 2,000 stock options excluded from
the computation of diluted EPS at December 31, 2004 and December 31,
2003, respectively because they were anti-dilutive.
p. STOCK BASED COMPENSATION: The Company has elected to follow
Accounting Principles Board ("APB") Opinion No. 25. "Accounting for
Stock Issued to Employees" ("APB 25") and related interpretations in
accounting for its employee and director stock options. Accordingly,
no expense is recognized for those options issued with an exercise
price at or above market on the date of the award. For options
issued to employees with an exercise price that is less than market
on the date of grant the Company recognizes an expense for the
difference between the exercise price and the value of the options
on the date of grant. The Company follows SFAS No. 123 "Accounting
for Stock Based Compensation," ("SFAS 123") for determining the fair
value of options issued to agents and others. The fair value of
options awarded to agents and others are expensed over the vesting
period of each award.
q. CASH FLOW INFORMATION: Cash and cash equivalents include cash on
deposit, money market funds, and short term investments that had an
original maturity of three months or less from the time of purchase.
r. ADOPTION OF NEW ACCOUNTING PRONOUNCEMENTS: In January 2003, the
Financial Accounting Standards Board ("FASB") issued FASB
Interpretation No. 46 ("FIN 46"), "Consolidation of Variable
Interest Entities", an interpretation of Accounting Research
Bulletin No. 51, which requires an entity to assess its interests in
a variable interest entity to determine whether to consolidate that
entity. A variable interest entity ("VIE") is an entity in which the
equity investment at risk is not sufficient to permit the entity to
finance its activities without additional subordinated support from
other parties or the equity investors do not have the
characteristics of a controlling financial interest. FIN 46 requires
that a VIE be consolidated by its primary beneficiary, which is the
party that will absorb a majority of the entity's expected losses if
they occur, receive a majority of the entity's expected residual
returns if they occur, or both.
The provisions of FIN 46 were effective immediately for VIEs created
after January 31, 2003 and for VIEs for which the Company obtains an
interest after that date. For any VIEs acquired prior to February 1,
2003, the provisions of the interpretation of FIN 46, as amended by
FASB Staff Position No. 46-6, are effective for the quarter ending
December 31, 2003. An interpretation of FIN 46 was issued in
December 2003, which allowed the Company to defer the effective date
for consolidation of VIEs to the first reporting period that ends
after March 15, 2004. Adoption of the provisions of the
interpretation FIN 46 did not have a material impact on the
consolidated financial condition or results of operations.
F-13
In December 2003, the FASB issued a revised version of FIN 46 ("FIN
46R"), which incorporates a number of modifications and changes made
to the original version. FIN 46R replaces the previously issued FIN
46 and, subject to certain special provisions, is effective no later
than the end of the first reporting period that ends after December
15, 2003 for entities considered to be special-purpose entities and
no later than the end of the first reporting period that ends after
March 15, 2004 for all other VIEs. Although early adoption was
permitted, the Company adopted FIN 46R in the first quarter of 2004.
The adoption of FIN 46R resulted in the deconsolidation of the VIEs
that issued mandatorily redeemable preferred securities of a
subsidiary trust ("trust preferred securities"). The sole assets of
the VIEs are junior subordinated debentures issued by the Company
with repayment terms identical to the trust preferred securities.
Previously, the trust preferred securities were reported as a
separate liability on the Company's balance sheet as "company
obligated mandatorily redeemable preferred securities of subsidiary
trusts holding solely junior subordinated debentures". The dividends
on the trust preferred securities were reported as interest expense.
As a result of the deconsolidation, the liability for the junior
subordinated debentures issued by the Company to the subsidiary
trusts are reported as a separate liability in the Company's balance
sheet as "other long term debt". See Note 15 - Other Long Term Debt
for a description of the trust preferred securities.
In July 2003, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants issued a final
Statement of Position 03-1, "Accounting and Reporting by Insurance
Enterprises for Certain Nontraditional Long-Duration Contracts and
for Separate Accounts" ("SOP 03-1"). SOP 03-1 addresses a wide
variety of topics, however, the primary provision that applies to
the Company relates to capitalizing sales inducements that meet
specified criteria and amortizing such amounts over the life of the
contracts using the same methodology as used for amortizing deferred
acquisition costs. The Company adopted SOP 03-1 effective January 1,
2004.
The Company currently offers enhanced or bonus crediting rates to
contract-holders on certain of its individual annuity products. The
Company's policy in this regard was to defer only the portion of the
bonus interest amount that was offset by a corresponding reduction
in the sales commission to the agent. Effective January 1, 2004, all
bonus interest was deferred and amortized. The adoption of SOP 03-1
did not have a material impact on the consolidated financial
position or results of operations of the Company.
On December 31, 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation -- Transition and Disclosure" ("SFAS 148").
This standard amends SFAS No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123") to provide alternative methods of
transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. This standard also
requires prominent disclosures in both annual and interim financial
statements about the method of accounting for stock-based employee
compensation and the effect of the method used on reported results.
The Company has applied the disclosure provisions of SFAS 148 as of
December 31, 2003, as required and presented below.
As permitted by SFAS 123, the Company measured its stock-based
compensation for employees and directors using the intrinsic value
approach under APB 25. Accordingly, the Company did not recognize
compensation expense upon the issuance of its stock options because
the option terms were fixed and the exercise price equaled the
market price of the underlying common stock on the grant date. The
Company does not intend to adopt the fair value method of accounting
for stock-based compensation provisions of SFAS 123 for its
employees or directors. The Company complied with the provisions of
SFAS 123 by providing pro forma disclosures of net income and
related per share data giving consideration to the fair value method
provisions of SFAS 123. For purposes of pro forma disclosures, the
estimated fair value of the options is amortized to expense over the
options' vesting period.
F-14
The following table illustrates the effect on net income and
earnings per share if the fair value based method had been applied
during each period presented.
For the year ended December 31,
2004 2003 2002
---------- ---------- ----------
(in thousands, except per share amounts)
Reported net income $ 63,871 $ 43,052 $ 30,127
Add back: Stock-based compensation
expense included in reported net income,
net of tax 589 1,527 1,536
Less: Stock based compensation expense
determined under fair value based method
for all awards, net of tax (2,126) (2,895) (2,623)
---------- ---------- ----------
Pro forma net income $ 62,334 $ 41,684 $ 29,040
========== ========== ==========
Net income per share:
Basic, as reported $ 1.17 $ 0.80 $ 0.57
Basic, pro forma $ 1.14 $ 0.78 $ 0.55
Diluted, as reported $ 1.13 $ 0.78 $ 0.56
Diluted, pro forma $ 1.10 $ 0.76 $ 0.54
Pro forma compensation expense reflected for prior periods is not
indicative of future compensation expense that would be recorded by
the Company if it were to adopt the fair value based recognition
provisions of SFAS 123 for stock based compensation for its
employees and directors. Future expense may vary based upon factors
such as the number of awards granted by the Company and the
then-current fair market value of such awards.
The fair value for these options was estimated at the date of grant
using a Black-Scholes option pricing model with the following range
of assumptions:
Risk free interest rates 3.12%-6.68%
Dividend yields 0.0%
Expected volatility 40.00% - 48.64%
Expected lives of options (in years) 0 - 9.0
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options that have no vesting
restrictions and are fully transferable. In addition, option
valuation models require the input of highly subjective assumptions
including the expected stock price volatility. Because the Company's
employee stock options have characteristics significantly different
from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide
a reliable single measure of the fair value of its employee stock
options. Detailed information for activity in the Company's stock
plans can be found in Note 9 - Stock-Based Compensation.
s. PENDING ACCOUNTING PRONOUNCEMENTS: In December 2004, the FASB issued
SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"),
which replaces SFAS 123 and supercedes APB Opinion No. 25,
"Accounting for Stock Issued to Employees". SFAS 123R requires all
companies to recognize compensation costs for share-based payments
to employees based on the grant-date fair value of the award for
financial statements for reporting periods beginning after June 15,
2005. The pro forma disclosures previously permitted under SFAS 123
will no longer be an alternative to financial statement recognition.
The transition methods include prospective and retrospective
adoption options. The prospective method requires that compensation
expense be recorded for all unvested stock-based awards including
those granted prior to adoption of the fair value recognition
provisions of SFAS 123, at the beginning of the first quarter of
adoption of SFAS 123R, while the retrospective methods would record
compensation expense for all unvested stock-based awards beginning
with the first period restated. The Company will adopt SFAS 123R in
the third quarter of fiscal 2005 using the prospective method.
F-15
As permitted by SFAS 123, the Company currently accounts for
share-based payments to employees using Opinion 25's intrinsic value
method and, as such, generally recognizes no compensation cost for
employee stock options. Accordingly, the adoption of SFAS 123(R)'s
fair value method will have a significant impact on our result of
operations, although it will have no impact on our overall financial
position. The impact of adoption of SFAS 123(R) cannot be predicted
at this time because it will depend on levels of share-based
payments granted in the future. However, had we adopted SFAS 123(R)
in prior periods, the impact of that standard would have
approximated the impact of SFAS 123 as described in the above
disclosure of pro forma net income and earnings per share. SFAS
123(R) also requires the benefits of tax deductions in excess of
recognized compensation cost to be reported as a financing cash
flow, rather than as an operating cash flow as required under
current literature. This requirement will reduce net operating cash
flows and increase net financing cash flows in periods after
adoption. While the company cannot estimate what those amounts will
be in the future (because they depend on, among other things, when
employees exercise stock options), the amount of operating cash
flows recognized in prior periods for such excess tax deductions
were $2.3, $0.1, and $0.1 in 2004, 2003 and 2002, respectively.
In March 2004, the Emerging Issues Task Force ("EITF") reached a
final consensus on Issue 03-1, "The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments" ("EITF
03-1"). EITF 03-1 adopts a three-step impairment model for
securities within its scope. The three-step model must be applied on
a security-by-security basis as follows:
Step 1: Determine whether an investment is impaired. An investment
is impaired if the fair value of the investment is less than its
amortized cost basis.
Step 2: Evaluate whether an impairment is other-than-temporary. For
debt securities that cannot be contractually prepaid or otherwise
settled in such a way that the investor would not recover
substantially all of its cost, an impairment is deemed
other-than-temporary if the investor does not have the ability and
intent to hold the investment until a forecasted market price
recovery or it is probable that the investor will be unable to
collect all amounts due according to the contractual terms of the
debt security.
Step 3: If the impairment is other-than-temporary, recognize an
impairment loss equal to the difference between the investment's
cost basis and its fair value.
Subsequent to an other-than-temporary impairment loss, a debt
security should be accounted for in accordance with Statement of
Position ("SOP") 03-3, "Accounting for Loans and Certain Debt
Securities Acquired in a Transfer". EITF 03-1 does not replace the
impairment guidance for investments accounted for under EITF Issue
99-20, "Recognition of Interest Income and Impairments on Purchased
and Retained Beneficial Interests in Securitized Financial Assets"
("EITF 99-20"), however, investors will be required to determine if
a security is other-than-temporarily impaired under EITF 03-1 if the
security is determined not to be impaired under EITF 99-20. The
disclosure provisions of EITF 03-1 adopted by the Company effective
December 31, 2003 and included in Note 6 - Investments of the
consolidated financial statements included in the Company's 2003
Annual Report on Form 10-K will prospectively include securities
subject to EITF 99-20.
In September 2004, the FASB staff issued clarifying guidance for
comment in FASB Staff Position ("FSP") EITF Issue 03-1-a,
"Implementation Guidance for the Application of Paragraph 16 of EITF
Issue No. 03-1, `The Meaning of Other-Than-Temporary Impairment and
Its Application to Certain Investments'", (FSP 03-1-a) and
subsequently voted to delay the implementation of the impairment
measurement and recognition guidance contained in paragraphs 10 - 20
of EITF 03-1 in order to reconsider certain aspects of the consensus
as well as the implementation guidance included in FSP 03-1-a. The
disclosure guidance including quantitative and qualitative
information regarding investments in an unrealized loss position
remain effective and are included in Note 6.
F-16
The ultimate impact the adoption of EITF 03-1 will have on the
Company's consolidated financial condition and results of operations
is still unknown. Depending on the nature of the ultimate guidance,
adoption of the standard could potentially result in the recognition
of unrealized losses, including those declines in value that are
attributable to interest rate movements, as other-than-temporary
impairments, except those deemed to be minor in nature. As of
December 31, 2004, the Company had $2.7 million of total gross
unrealized losses. The amount of impairments to be recognized, if
any, will depend on the final standard, market conditions and
management's intent and ability to hold securities with unrealized
losses at the time of the impairment evaluation.
t. RECLASSIFICATIONS: Certain reclassifications have been made to prior
years' financial statements to conform to current period
presentation.
3. BUSINESS COMBINATIONS:
Acquisition of Heritage Health Systems, Inc.
On May 28, 2004, the Company acquired 100% of the outstanding common stock
of Heritage, a privately owned managed care company that operates Medicare
Advantage plans in Houston and Beaumont Texas, for $98 million in cash plus
transaction costs of $1.6 million. Heritage generates its revenues and profits
from three sources. First, Heritage owns an interest in SelectCare of Texas,
L.L.C. ("SelectCare"), a health plan that offers coverage to Medicare
beneficiaries under a contract with CMS. Next, Heritage operates three separate
Management Service Organizations ("MSO's") that manage the business of
SelectCare and two affiliated Independent Physician Associations ("IPA's").
Lastly, Heritage participates in the net results derived from these IPA's. The
acquisition was financed with $66.5 million of net proceeds derived from the
amendment of the Company's credit facility (See Note 14 - Loan Payable) and
$33.1 million of cash on hand. As of the date of acquisition, Heritage had
approximately 16,000 Medicare members and annualized revenues of approximately
$140 million. Operating results generated by Heritage prior to May 28, 2004, the
date of acquisition, are not included in the Company's consolidated financial
statements.
On the acquisition date, the fair value of net tangible assets of Heritage
amounted to $23.2 million. The excess of the purchase price over the fair value
of net tangible assets acquired was $76.4 million. As of May 28, 2004, the
Company performed the initial allocation of the excess to identifiable
intangible assets. Based on this initial allocation, approximately $14.6 million
was assigned to amortizing intangible assets, including $12.1 million (net of
deferred income taxes of $6.5 million), which was assigned to the value of the
membership in force and determined to have a weighted average life of 6 years
and $2.2 million (net of deferred taxes of $1.2 million), which was assigned to
the IPA's, and determined to have a weighted average lives of between 6 and 13
years. Approximately $4.7 million was allocated to non-amortizing intangible
assets, including $4.0 million assigned to the value of trademarks and $0.7
million assigned to the value of Heritage's licenses. Each of these items was
determined to have indefinite lives. The balance of $57.1 million was assigned
to goodwill.
Acquisition of Pyramid Life
On March 31, 2003, the Company acquired all of the outstanding common
stock of Pyramid Life. In this transaction, the Company acquired a block of
in-force business as well as a career sales force skilled in selling senior
market insurance products. The purchase price of $57.5 million and transaction
costs of $2.4 million were financed with $20.1 million of net proceeds generated
from the refinancing of the Company's credit facility and $39.8 million of cash
on hand, including a portion of the proceeds from the issuance of trust
preferred securities in December 2002 and March 2003. (See Note 14 - Loan
Agreements and Note 15 - Trust Preferred Securities). Operating results
generated by Pyramid Life prior to March 31, 2003, the date of acquisition, are
not included in the Company's consolidated financial statements. At the time of
closing, the fair value of net tangible assets of the acquired company amounted
to $27.6 million. The excess of the purchase price over the fair value of net
tangible assets acquired was $32.3 million. At March 31, 2003, the Company
performed the initial allocation of the excess to identifiable intangible
assets. Based on this initial allocation, approximately $13.1 million (net of
deferred taxes of $7.1 million) was assigned to the present value of future
profits acquired and determined to have a
F-17
weighted average life of 7 years. Approximately $14.3 million (net of deferred
taxes of $7.7 million) was assigned to the distribution channel acquired and
determined to have a weighted average life of 30 years. The distribution channel
represents the estimated future new sales production from the career
distribution established by Pyramid Life. Pyramid Life distributes its products
on an exclusive basis through 32 Senior Sales Solution Centers ("SSSC's"). The
remaining $4.9 million was assigned to the value of the trademarks and licenses
acquired, which are deemed to have an indefinite life.
The condensed balance sheets of Heritage and Pyramid Life were as follows
on their respective dates of acquisition:
Heritage Pyramid Life
May 28, 2004 March 31, 2003
-------------- --------------
(in thousands) (in thousands)
Assets
Cash and Investments $ 38,150 $105,774
PVFP and other amortizing intangibles 22,013 42,263
Goodwill and other non-amortizing intangibles 61,849 4,867
Other 7,160 16,232
-------- --------
Total Assets $129,172 $169,136
======== ========
Liabilities
Policy related liabilities $ 9,265 $103,978
Other 20,296 5,297
-------- --------
Total Liabilities 29,561 109,275
Equity 99,611 59,861
-------- --------
Total Liabilities and Equity $129,172 $169,136
======== ========
The consolidated pro forma results of operations, assuming that Pyramid
Life and Heritage were purchased on January 1, 2004 and 2003 is as follows:
YEAR ENDED DECEMBER 31, 2004 2003
- ------------------------ -------- --------
(In thousands)
Total revenue $792,933 $680,829
Income before taxes (1) $101,731 $ 72,833
Net income (1) $ 67,293 $ 46,764
Earnings per common share:
Basic $ 1.23 $ 0.87
Diluted (1) $ 1.19 $ 0.85
(1) The above pro forma results of operations includes excess amortization of
capitalized loan fees of $1.9 million in 2003 as a result of the assumed
refinancing of the existing debt at January 1, 2003. This additional
expense reduced net income by $1.2 million or $0.02 per diluted share in
2003. The actual amount of excess amortization reported in 2003 was $1.8
million.
The pro forma results of operations reflect management's best estimate
based upon currently available information. The pro forma adjustments are
applied to the historical financial statements of Universal American, Pyramid
Life and Heritage to account for Pyramid Life and Heritage under the purchase
method of accounting. In accordance with SFAS No. 141, "Business Combinations",
the total purchase cost was allocated to the assets and liabilities of Pyramid
Life and Heritage based on their relative fair values. These allocations are
subject to valuations as of the date of the acquisition based upon appraisals
and other information at that time. Management has provided its best estimate of
the fair values of assets and liabilities for the purpose of this pro forma
information. The pro forma information presented above is for disclosure
purposes only and is not necessarily indicative of the results of operations
that would have occurred if the acquisition had been consummated on the dates
assumed, nor is the pro forma information intended to be indicative of Universal
American's future results of operations.
F-18
Acquisition of Ameriplus
On August 1, 2003, the Company acquired 100% of the outstanding common
stock of Ameriplus Preferred Care, Inc. ("Ameriplus"). Ameriplus is engaged in
the business of creating and maintaining a network of hospitals for the purpose
of providing discounts to our Medicare Select policyholders. Ameriplus' network
is utilized in connection with Medicare Select policies written by subsidiaries
of Universal American and can be offered to non-affiliated parties as well.
Ameriplus receives network fees when premiums for these Medicare Select policies
are collected.
The total purchase price was $2.0 million and was paid with cash of $1.0
million and 147,711 unregistered shares of common stock of Universal American.
At the time of the closing, Ameriplus had no material tangible assets.
Substantially the entire purchase price was allocated to the estimated value of
the future override fees, with the balance assigned to goodwill. The value of
the future fees has a weighted average estimated life of approximately 5 years.
(See Note 4 - Intangible Assets for additional detail).
4. INTANGIBLE ASSETS
The following table shows the Company's acquired intangible assets that
continue to be subject to amortization and accumulated amortization expense.
December 31, 2004 December 31, 2003
----------------------------- ---------------------------
Value Accumulated Value Accumulated
Assigned Amortization Assigned Amortization
-------- ------------ -------- ------------
(In thousands)
Senior Health Insurance:
Present value of future
profits ("PVFP") $18,472 $ 3,628 $ 18,472 $ 2,097
Distribution Channel 22,055 1,287 22,055 551
Life Insurance/Annuity - PVFP 4,127 1,308 4,127 661
Senior Managed Care - Medicare
Advantage:
PVFP 18,554 1,667 - -
Value of IPA's 3,459 234 - -
Senior Administrative Services
PVFP 7,672 7,035 7,672 6,770
Value of future override fees 1,796 172 1,820 20
------- -------- -------- --------
Total $76,135 $ 15,331 $ 54,146 $ 10,099
======= ======== ======== ========
The following table shows the changes in the present value of future
profits and other amortizing intangible assets.
2004 2003 2002
------- ------- --------
(In thousands)
Balance, beginning of year $44,047 $ 2,987 $ 3,463
Additions from acquisitions 21,989 44,083 1,166
Amortization, net of interest (5,232) (3,023) (1,642)
------- ------- --------
Balance, end of year $60,804 $44,047 $ 2,987
======= ======= ========
Estimated future net amortization expense (in thousands) is as follows:
2005 $ 6,464
2006 6,112
2007 5,742
2008 5,248
2009 4,283
Thereafter 32,955
--------
$ 60,804
========
F-19
The carrying amounts of goodwill and intangible assets with indefinite
lives are shown below.
December 31,
--------------------
2004 2003
------- -------
(In thousands)
Senior Market Health Insurance $ 8,760 $ 8,760
Senior Managed Care - Medicare Advantage 62,063 -
Senior Administrative Services 4,357 4,357
------- -------
Total $75,180 $13,117
======= =======
5. REINSURANCE TRANSACTIONS
Recapture of Reinsurance Ceded
Effective April 1, 2003, American Pioneer entered into agreements to
recapture approximately $48 million of Medicare Supplement business that had
previously been reinsured to Transamerica Occidental Life Insurance Company,
Reinsurance Division ("Transamerica") under two quota share contracts. In 1996,
American Pioneer entered into two reinsurance treaties with Transamerica.
Pursuant to the first of these contracts American Pioneer ceded to Transamerica
90% of approximately $50 million of annualized premium that it had acquired from
First National Life Insurance Company ("First National") in 1996. Under the
second contract, as subsequently amended, American Pioneer agreed to cede to
Transamerica 75% of certain new business from October 1996 through December 31,
1999. As of April 1, 2003, approximately $27 million remained ceded under the
First National treaty and approximately $16 million remained ceded under the new
business treaty.
As part of an effort to exit certain non-core lines of business,
Transamerica approached the Company in 2002 to determine our interest in
recapturing the two treaties. Under the terms of the recapture agreements,
Transamerica transferred approximately $18 million in cash to American Pioneer
to cover the statutory reserves recaptured by American Pioneer. No ceding
allowance was paid by American Pioneer in the recapture and American Pioneer
currently retains 100% of the risks on the $48 million of Medicare Supplement
business. No gain or loss was recognized on these recapture agreements.
Acquisition of Guarantee Reserve Marketing Organization
Effective July 1, 2003, Universal American entered into an agreement with
Swiss Re and its newly acquired subsidiary, Guarantee Reserve Life Insurance
Company ("Guarantee Reserve"), to acquire Guarantee Reserve's marketing
organization, including all rights to do business with its field force. The
primary product sold by this marketing organization is low face amount whole
life insurance, primarily for seniors.
Beginning July 1, 2003, the former Guarantee Reserve field force continued
to write this business through Guarantee Reserve, with Universal American
administering all new business and assuming 50% of the risk through a quota
share reinsurance arrangement. Beginning in April 2004, as the products were
approved for sale in each state, new business has been written by a Universal
American subsidiary, with 50% of the risk ceded to Swiss Re.
F-20
6. INVESTMENTS:
The amortized cost and fair value of fixed maturities are as follows:
December 31, 2004
----------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Classification Cost Gains Losses Value
- -------------------------------- ----------- ----------- ----------- -----------
(In thousands)
U.S. Treasury securities and
obligations of U.S. government $ 87,552 $ 718 $ (327) $ 87,943
Corporate debt securities 486,142 27,467 (1,830) 511,779
Foreign debt securities (1) 209,583 28,797 (33) 238,347
Mortgage and asset-
backed securities 326,401 6,879 (527) 332,753
----------- ----------- ----------- -----------
$ 1,109,678 $ 63,861 $ (2,717) $ 1,170,822
=========== =========== =========== ===========
December 31, 2003
----------------------------------------------------------------
Amortized Amortized Amortized Amortized
Classification Cost Cost Cost Cost
- -------------------------------- ----------- ----------- ----------- -----------
(In thousands)
U.S. Treasury securities and
obligations of U.S. government $ 74,187 $ 695 $ (219) $ 74,663
Corporate debt securities 544,744 36,892 (4,988) 576,648
Foreign debt securities (1) 218,011 19,041 (118) 236,934
Mortgage and asset-
backed securities 245,012 8,711 (576) 253,147
----------- ----------- ----------- -----------
$ 1,081,954 $ 65,339 $ (5,901) $ 1,141,392
=========== =========== =========== ===========
(1) Primarily Canadian dollar denominated bonds supporting our Canadian
insurance reserves.
The amortized cost and fair value of fixed maturities at December 31, 2004
by contractual maturity are shown below. Expected maturities will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.
Amortized Fair
Cost Value
---------- ----------
(In thousands)
Due in 1 year or less $ 34,890 $ 35,118
Due after 1 year through 5 years 197,124 208,709
Due after 5 years through 10 years 306,431 326,983
Due after 10 years 244,832 267,259
Mortgage and asset-backed securities 326,401 332,753
---------- ----------
$1,109,678 $1,170,822
========== ==========
The fair value and unrealized loss as of December 31, 2004 for fixed
maturity and equity securities, aggregated by investment category and length of
time that individual securities have been in a continuous unrealized loss
position, are shown below.
Less than 12 Months 12 Months or Longer Total
----------------------- ----------------------- -----------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Classification Value Loss Value Loss Value Loss
- -------------- -------- ---------- -------- ---------- -------- ----------
(In thousands)
U.S. Treasury securities
obligations of U.S. $ 44,558 $ 327 $ - $ - $ 44,558 $ 327
Corporate debt 15,787 188 45,718 1,643 61,505 1,831
Foreign debt securities 1,018 5 972 27 1,990 32
Mortgage and asset-
backed securities 67,092 369 3,493 158 70,585 527
-------- -------- -------- -------- -------- --------
Total fixed maturities 128,455 889 50,183 1,828 178,638 2,717
Equity securities 1 1 - - 1 1
-------- -------- -------- -------- -------- --------
Total $128,456 $ 890 $ 50,183 $ 1,828 $178,639 $ 2,718
======== ======== ======== ======== ======== ========
F-21
There were no fixed maturities as of December 31, 2004, with a fair value
less than 87% of the security's amortized cost. As of December 31, 2004, fixed
maturities represented more than 99% of the Company's unrealized loss amount,
which was comprised of 84 different securities.
The majority of the securities in an unrealized loss position for less
than twelve months are depressed due to the rise in long-term interest rates.
This group of securities was comprised of 61 securities. Approximately 99%, of
the less than twelve months total unrealized loss amount was comprised of
securities with fair value that is greater than 90% of amortized cost.
The group of securities depressed for twelve months or more was comprised
of 23 securities. This group consists primarily of corporate securities
purchased at a premium and had a total amortized cost of $52 million. The market
value for the group was approximately 97% of the amortized cost and 104% of the
par value for these securities. There was only one security with a market value
less than 90% of amortized cost with an unrealized loss of less than $0.1
million. A description of the events contributing to the security's unrealized
loss position and the factors considered in determining that recording an
other-than-temporary impairment was not warranted are outlined below.
As part of the Company's ongoing security monitoring process by a
committee of investment and accounting professionals, the Company has reviewed
its investment portfolio and concluded that there were no additional
other-than-temporary impairments as of December 31, 2004 and 2003. Due to the
issuers' continued satisfaction of the securities' obligations in accordance
with their contractual terms and the expectation that they will continue to do
so, management's intent and ability to hold these securities, as well as the
evaluation of the fundamentals of the issuers' financial condition and other
objective evidence (including evaluation of the underlying collateral of a
security), the Company believes that the prices of the securities in the sectors
identified above were temporarily depressed.
The evaluation for other-than-temporary impairments is a quantitative and
qualitative process, which is subject to risks and uncertainties in the
determination of whether declines in the fair value of investments are
other-than-temporary. The risks and uncertainties include changes in general
economic conditions, the issuer's financial condition or near term recovery
prospects and the effects of changes in interest rates.
Gross unrealized gains and gross unrealized losses of equity securities as
of December 31, are as follows:
2004 2003
--------- ---------
(In thousands)
Gross unrealized gains $ 7 $ 34
Gross unrealized losses (1) (8)
--------- ---------
Net unrealized gains $ 6 $ 26
========= =========
The components of the change in unrealized gains and losses included in
the consolidated statements of stockholders' equity are as follows:
2004 2003 2002
----------- ------------- -----------
(In thousands)
Change in net unrealized gains (losses):
Fixed maturities $ 1,706 $ 8,542 $ 38,522
Equity securities (20) 42 124
Foreign currency 2,329 9,090 679
Fair value of cash flow swap 636 196 -
Adjustment relating to deferred
policy acquisition costs (2,791) (2,665) (1,958)
----------- ------------ -----------
Change in net unrealized gains
before income tax 1,860 15,205 37,367
Income tax (expense) (651) (5,318) (13,083)
----------- ------------ -----------
Change in net unrealized gains $ 1,209 $ 9,887 $ 24,284
=========== ============ ===========
F-22
The details of net investment income are as follows:
2004 2003 2002
------------ -------------- ------------
(In thousands)
Investment Income:
Fixed maturities $ 62,342 $ 59,528 $ 54,553
Cash and cash equivalents 2,155 882 1,044
Equity securities 34 93 197
Other 967 744 1,279
Policy loans 1,678 1,652 1,697
Mortgage loans 19 62 134
------------ ------------- ------------
Gross investment income 67,195 62,961 58,904
Investment expenses (2,004) (1,886) (1,188)
------------ ------------- ------------
Net investment income $ 65,191 $ 61,075 $ 57,716
============ ============= ============
There were no non-income producing fixed maturity securities for the years
ended December 31, 2004, 2003 or 2002.
Gross realized gains and gross realized losses included in the
consolidated statements of operations are as follows:
2004 2003 2002
------------- -------------- ------------
(In thousands)
Realized gains:
Fixed maturities $ 12,400 $ 3,497 $ 10,435
Equity securities and other invested assets 32 476 72
------------- ------------ ------------
Total realized gains 12,432 3,973 10,507
------------- ------------ ------------
Realized losses:
Fixed maturities (1,344) (1,811) (14,914)
Equity securities and other invested assets (441) (105) (676)
------------- ------------ ------------
Total realized losses (1,785) (1,916) (15,590)
------------- ------------ ------------
Net realized gains (losses) $ 10,647 $ 2,057 $ (5,083)
============= ============ ============
The Company did not write down the value of any fixed maturity securities
during 2004. The Company wrote down the value of certain fixed maturity
securities by $1.3 million during 2003, and $10.6 million during 2002, primarily
as a result of the impairment of our WorldCom bonds. The WorldCom bonds were
disposed of in the third quarter of 2002 at a price approximating their carrying
value after the other-than-temporary decline was recognized. These write downs
represent management's estimate of other-than-temporary declines in value and
were included in net realized gains (losses) on investments.
At December 31, 2004 and 2003, the Company held unrated or
less-than-investment grade corporate debt securities as follows:
2004 2003
--------- ----------
(In thousands)
Carrying value (estimated fair value) $ 7,003 $ 8,361
========= ==========
Percentage of total assets 0.3% 0.5%
========= ==========
The holdings of less-than-investment grade securities are diversified and
the largest investment in any one such security was $3.0 million at December 31,
2004, and $3.1 million at December 31, 2003, which was less than 0.2% of total
assets each year.
Included in fixed maturities at December 31, 2004 and 2003 were securities
with carrying values of $41.8 million and $44.1 million, respectively, held by
various states as security for the policyholders of the Company within such
states.
F-23
7. INCOME TAXES:
The parent holding company files a consolidated return for federal income
tax purposes that includes all of the non-life insurance company subsidiaries,
including Heritage. American Progressive was included in the consolidated return
through March 31, 2002 and American Pioneer was included through June 30, 2002.
American Exchange and its subsidiaries and Penncorp Life (Canada) are not
currently included. American Exchange and its subsidiaries, including American
Progressive since April 1, 2002 and American Pioneer since July 1, 2002, file a
separate consolidated federal income tax return. Penncorp Life (Canada) files a
separate return with Revenue Canada.
Income before taxes by geographic distribution is as follows:
2004 2003 2002
------------- ------------- -----------
(In thousands)
United States $ 77,457 $ 51,597 $ 30,290
Canada 19,011 14,882 13,740
------------- ------------- -----------
Total income before taxes $ 96,468 $ 66,479 $ 44,030
============= ============= ===========
The Company's federal and state income tax expense (benefit) is as
follows:
2004 2003 2002
------------- -------------- ----------
(In thousands)
Current - United States $ (825) $ 303 $ 208
Current - Canada 3,173 15,285 4,291
------------- ------------ ----------
Sub total current 2,348 15,588 4,499
Deferred - United States 27,148 17,821 8,268
Deferred - Canada 3,101 (9,982) 1,136
------------- ------------ ----------
Sub total deferred 30,249 7,839 9,404
------------- ------------ ----------
Total tax expense $ 32,597 $ 23,427 $ 13,903
============= ============ ==========
A reconciliation of the "expected" tax expense at 35% with the Company's actual
tax expense applicable to operating income before taxes reported in the
Consolidated Statements of Operations is as follows:
2004 2003 2002
-------- -------------- ----------
(In thousands)
Expected tax expense $ 33,764 $ 23,268 $ 15,410
Change in valuation allowance 3,163 (4,507) (1,694)
Reserve for prior year taxes
of acquired entities (3,805) 4,439 -
Other (525) 227 187
-------- ---------- ---------
Actual tax expense $ 32,597 $ 23,427 $ 13,903
======== ========== =========
In addition to federal and state income tax, the Company is subject to
state premium taxes, which taxes are included in other operating costs and
expenses in the accompanying statements of operations.
F-24
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying value of assets and liabilities for financial reporting
purposes and the amount used for income tax purposes. The tax effects of
temporary differences that give rise to significant portions of the deferred tax
assets and deferred tax liabilities are as follows:
2004 2003
------------ ------------
(In thousands)
Deferred tax assets:
Reserves for future policy benefits $ 43,733 $ 36,180
Deferred policy acquisition costs (6,998) 5,309
Loss carryforwards 5,218 5,851
Asset valuation differences 4,403 6,462
Deferred revenues 1,113 998
Tax credit carryforwards 1,234 320
Other (2,444) (4,083)
------------ ------------
Total gross deferred tax assets 46,259 51,037
Less valuation allowance (3,756) (593)
------------ ------------
Net deferred tax assets 42,503 50,444
------------ ------------
Present value of future profits (25,641) (13,270)
Unrealized gains on investments (22,068) (21,417)
------------ ------------
Total gross deferred tax liabilities (47,709) (34,687)
------------ ------------
Net deferred tax (liability) asset $ (5,206) $ 15,757
============ ============
At December 31, 2004, the Company (exclusive of American Exchange and its
subsidiaries and PennCorp Life) had net operating loss carryforwards of
approximately $7.9 million (including $6.9 million from Heritage) that expire in
2015 and 2024 and capital loss carryforwards of $1.3 million that expire in
2007. At December 31, 2004, the Company also had an Alternative Minimum Tax
(AMT) credit carryforward for federal income tax purposes of approximately $0.5
million that can be carried forward indefinitely. At December 31, 2004, American
Exchange and its subsidiaries had net operating loss carryforwards, most of
which relate to the companies acquired in 1999 (and were incurred prior to their
acquisition), of approximately $6.9 million that expire between 2009 and 2017.
At December 31, 2004, American Exchange and its subsidiaries also had capital
loss carryforwards of $7.9 million that expire in 2007 and an AMT credit
carryforward for federal income tax purposes of approximately $0.7 million that
can be carried forward indefinitely. As a result of changes in ownership of the
Company in July 1999, the use of most of the loss carryforwards of the Company
are subject to annual limitations.
At December 31, 2004 and 2003, the Company carried valuation allowances of
$3.8 million and $0.6 million, respectively, with respect to its deferred tax
assets. The Company establishes a valuation allowance based upon an analysis of
projected taxable income and its ability to implement prudent and feasible tax
planning strategies. As a result of uncertainty regarding the ability to
generate taxable capital gains to utilize capital loss carryforwards, the
Company established a valuation allowance in the amount of $3.2 million during
2004 that was recorded as a deferred income tax expense. Additionally, the
Company released $3.8 million relating to a portion of reserve amounts
established for pre-acquisition tax years of certain life insurance subsidiaries
that were being examined by the Internal Revenue Service. At December 31, 2003,
the valuation allowance on certain of the life tax loss carryforwards no longer
was considered necessary. The amount of the valuation allowance released during
2003 was $4.5 million and was recorded as a deferred income tax benefit. In
2003, the Company established a reserve for pre-acquisition tax years of certain
life insurance subsidiaries that were being examined by the Internal Revenue
Service. As a result of the increased profitability of the Administrative
Services segment, valuation allowances on certain of the non-life tax loss
carryforwards no longer were considered necessary as of December 31, 2003. The
amount of the valuation allowance released during 2003 was $0.1 million and was
also recorded as a deferred income tax benefit. Management believes it is more
likely than not that the Company will realize the recorded value of its net
deferred tax assets.
F-25
8. STOCKHOLDERS' EQUITY
Preferred Stock
The Company has 2.0 million authorized shares of preferred stock with no
such shares issued or outstanding at December 31, 2004 or 2003.
Common Stock
The par value of common stock is $.01 per share with 100 million shares
authorized for issuance. The shareholders approved a proposal to amend the
Company's Restated Certificate of Incorporation to increase the number of
authorized shares of common stock, par value $0.01 per share, from 80 million
shares to 100 million shares at the Annual Meeting on May 26, 2004.
Changes in the number of shares of common stock issued were as follows:
YEARS ENDED DECEMBER 31, 2004 2003 2002
- ------------------------------------------- ---------- ---------- ----------
Common stock issued, beginning of year 54,111,923 53,184,381 52,799,899
Stock options exercised 1,190,018 389,412 284,748
Stock issued in connection with acquisition - 147,711 -
Agent stock award - 41,872 69,484
Stock purchases pursuant to agents' stock
purchase and deferred compensation plans 24,151 348,547 30,250
---------- ---------- ----------
Common stock issued, end of period 55,326,092 54,111,923 53,184,381
========== ========== ==========
Treasury Stock
The Board of Directors has approved a plan for the Company to repurchase
up to 1.5 million shares of the Company's commons stock in the open market. The
primary purpose of the plan is to fund employee stock bonuses.
FOR THE YEAR ENDED DECEMBER 31,
2004 2003
--------------------------------------- ---------------------------------------
WEIGHTED WEIGHTED
AVERAGE COST AVERAGE COST
SHARES AMOUNT PER SHARE SHARES AMOUNT PER SHARE
------- -------------- ------------ -------- ------------- ------------
(In thousands) (In thousands)
Treasury stock beginning of year 192,863 $ 1,390 $ 7.21 241,076 $ 1,320 $ 5.48
Shares repurchased 30,929 325 10.52 141,718 1,113 7.85
Shares distributed in the form of
employee bonuses (98,851) (746) 10.12 (189,931) (1,043) 5.58
------- ---------- -------- -------
Treasury stock, end of period 124,941 $ 969 $ 7.75 192,863 $ 1,390 $ 7.21
======= ========== ======== =======
Through December 31, 2004, the Company had repurchased 791,119 shares at
an aggregate cost of $4.4 million. As of December 31, 2004, 708,881 shares
remained available for repurchase under the program. Additional repurchases may
be made from time to time at prevailing prices, subject to restrictions on
volume and timing.
Additional Paid In Capital
In connection with the 1999 acquisition the Company provided loans to
certain members of management to purchase shares of common stock. The loans
totaled $1.0 million at inception and were accounted for as a reduction of
additional paid in capital in the financial statements. Repayments of these
loans amounted to $0.1 million in 2004 and $0.7 million in 2003 and are reported
as an increase to additional paid in capital. As of December 31, 2004, the
outstanding balance of these loans was $0.1 million.
F-26
Accumulated Other Comprehensive Income
The components of accumulated other comprehensive income are as follows:
December 31,
2004 2003 2002
--------- -------------- ------------
(In thousands)
Net unrealized appreciation
on investments $ 61,150 $ 59,464 $ 50,880
Deferred acquisition cost adjustment (7,776) (4,985) (2,320)
Foreign currency translation gains (losses) 8,845 6,516 (2,574)
Fair value of cash flow swap 832 196 -
Deferred tax on the above (22,068) (21,417) (16,099)
--------- --------- ---------
Accumulated other comprehensive income $ 40,983 $ 39,774 $ 29,887
========= ========= =========
9. STOCK BASED COMPENSATION
1998 Incentive Compensation Plan
On May 28, 1998, the Company's shareholders approved the 1998 Incentive
Compensation Plan (the "1998 ICP"). The 1998 ICP superceded the Company's 1993
Incentive Stock Option Plan. Options previously granted under the Company's
Incentive Stock Option Plan will remain outstanding in accordance with their
terms and the terms of the respective plans. The 1998 ICP provides for grants of
stock options, stock appreciation rights ("SARs"), restricted stock, deferred
stock, other stock-related awards, and performance or annual incentive awards
that may be settled in cash, stock, or other property ("Awards").
The total number of shares of the Company's Common Stock reserved and
available for delivery to participants in connection with Awards under the 1998
ICP is (i) 1.5 million, plus (ii) the number of shares of Common Stock subject
to awards under Preexisting Plans that become available (generally due to
cancellation or forfeiture) after the effective date of the 1998 ICP, plus (iii)
13% of the number of shares of Common Stock issued or delivered by the
Corporation during the term of the 1998 ICP (excluding any issuance or delivery
in connection with Awards, or any other compensation or benefit plan of the
Corporation), provided, however, that the total number of shares of Common Stock
with respect to which incentive stock options ("ISOs") may be granted shall not
exceed 1.5 million. On May 26, 2004, the Company's shareholders approved an
amendment to increase the the number of shares of common stock authorized for
issuance under the 1998 ICP by 2.5 million shares. As of December 31, 2004, a
total of 9.8 million shares were eligible for grant under the plan of which 4.9
million shares were reserved for delivery under outstanding options awarded
under the 1998 ICP, 2.8 million shares had been issued pursuant to previous
awards and 2.1 million shares were reserved for issuance under future Awards at
December 31, 2004.
Executive officers, directors, and other officers and employees of the
Corporation or any subsidiary, as well as other persons who provide services to
the Company or any subsidiary, are eligible to be granted Awards under the 1998
ICP, which is administered by the Board or a Committee established pursuant to
the Plan. The Committee, may, in its discretion, accelerate the exercisability,
the lapsing of restrictions, or the expiration of deferral or vesting periods of
any Award, and such accelerated exercisability, lapse, expiration and vesting
shall occur automatically in the case of a "change in control" of the Company,
except to the extent otherwise determined by the Committee at the date of grant
or thereafter. The Committee has not yet exercised any of its discretions noted
above.
Employee Stock Awards
In accordance with the 1998 ICP, the Company grants restricted stock to
its officers and non-officer employees. These grants vest upon issue. The
non-officer grants are expensed and awarded in the same year. The Company
granted awards to non-officer employees of 1,661 shares with a fair value of
$15.70 per share during 2004, 5,119 shares with a fair value of $9.71 per share
during 2003 and 7,721 shares with a fair value of $5.92 per share during 2002.
Executive officers are granted restricted stock in connection with the bonuses.
This restricted stock vests over four years. The award for 2004 performance has
not yet been determined. Executive officers were awarded 79,132 shares with a
fair value of $10.11per share for 2003 performance and 50,269 shares with a fair
value of $5.57 for 2002
F-27
performance. The expense for these awards is recognized over the vesting period.
For 2002 and prior, other officers were also granted stock awards in connection
with their bonuses. These awards vested immediately. Officer grants were accrued
for during the year for which they were earned and awarded the following year.
The Company granted awards to officers of 130,847 shares with a fair value of
$5.57 per share during 2003 for 2002. The Company recognized compensation
expense of $0.2 million for the year ended December 31, 2003, and $1.1 million
for 2002.
Agent's Stock Purchase Plan
The Company offers shares of its common stock for sale to qualifying
agents of the Insurance Subsidiaries pursuant to the Company's Agents Stock
Purchase Plan ("ASPP"). Shares are sold at market price and, accordingly, no
expense is recognized. Pursuant to the ASPP, agents purchased 5,100 shares at a
weighted average price of 10.73 per share in 2004, 183,286 shares at a weighted
average price of $6.20 per share in 2003, and 30,250 shares at a weighted
average price of $6.30 per share in 2002.
Agent's Deferred Compensation Plan
The Company also offers shares of Common Stock for sale to its agents
pursuant to the Company's Deferred Compensation Plan for Agents ("DCP"). Under
the DCP, agents may elect to defer receipt between 5% and 100% of their first
year commission, which deferral will be matched by a contribution by the
Company, initially set at 25% of the amount of the deferral, up to a maximum of
5% of the agent's commissions. Both the agent's participation in the DCP and the
Company's obligation to match the agent's deferral are subject to the agent
satisfying and continuing to satisfy minimum earning, production and persistency
standards. Shares are sold under the plan at market price and, accordingly, no
expense is recognized, except for the fair value of the shares representing the
Company match on the date of the contribution to the DCP. Agents deferred
commissions amounting to $0.3 million in 2004, $0.1 million in 2003, and $0.3
million in 2002.
Option Awards
A summary of the status of the Company's stock option plans during the
three years ended December 31, 2004 and changes during the years ending on those
dates is presented below:
2004 2003 2002
------------------------ ------------------------ ------------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Options Price Options Price Options Price
-------------- -------- -------------- -------- -------------- --------
(In thousands) (In thousands) (In thousands)
Outstanding-beginning of year 5,659 $ 4.17 5,513 $3.87 4,916 $3.31
Granted 832 10.69 745 6.28 940 6.64
Exercised (1,190) 3.99 (389) 3.63 (284) 3.30
Terminated (121) 7.12 (210) 4.77 (59) 4.21
----- ----- -----
Outstanding-end of year 5,180 $ 5.19 5,659 $4.17 5,513 $3.87
===== ===== =====
Options exercisable at end of Year 3,560 $ 4.46 4,019 $3.78 3,601 $3.51
===== ===== =====
A summary of the weighted average fair value of options granted during the
three years ended December 31, 2004 is presented below:
2004 2003 2002
--------------------------- -------------------------- --------------------------
Weighted- Weighted- Weighted-
Average Average Average
Options Fair Value Options Fair Value Options Fair Value
-------------- ----------- -------------- ---------- -------------- ----------
(In thousands) (In thousands) (In thousands)
Above market 173 $3.10 306 $1.85 176 $ 2.11
At market 659 5.84 439 2.84 629 4.08
Below market - - - - 135 3.01
--- --- ---
Total granted 832 $5.27 745 $2.43 940 $ 3.55
=== === ===
F-28
The following table summarizes information about stock options outstanding at
December 31, 2004:
Number Weighted- Number
Outstanding Average Weighted- Exercisable Weighted-
Range of at Remaining Average at Average
Exercise Prices December 31, 2004 Contractual Life Exercise Price December 31, 2004 Exercise Price
- --------------- ----------------- ---------------- -------------- ----------------- --------------
(In thousands) (In thousands)
$ 1.88 - 3.12 754 3.0 years $ 2.46 754 $ 2.46
3.15 1,718 4.6 years 3.15 1,191 3.15
3.25 - 4.79 593 5.4 years 4.03 489 4.04
5.00 - 8.42 1,303 5.9 years 6.53 937 6.64
10.11- 12.32 812 8.2 years 10.73 189 11.01
----- -----
$ 1.88 - 12.32 5,180 5.4 years $ 5.19 3,560 $ 4.46
===== =====
A summary of the activity relating to the options awarded by the Company
for employees, directors and agents is as follows:
Agents & Range of Exercise
Employees Directors Others Total Prices
-------------- --------- -------- ------- -----------------
(In thousands)
Balance, January 1, 2002 3,598 210 1,108 4,916
Granted 571 53 316 940 $ 4.75 - $ 8.55
Exercised (131) (10) (143) (284) $ 2.00 - $ 5.31
Terminated (34) (11) (14) (59) $ 2.25 - $ 6.45
----- --- ----- -----
Balance, December 31, 2002 4,004 242 1,267 5,513
Granted 391 48 306 745 $ 5.57 - $10.56
Exercised (162) (2) (225) (389) $ 2.00 - $ 8.42
Terminated (122) (9) (79) (210) $ 2.62 - $ 8.42
----- --- ----- -----
Balance, December 31, 2003 4,111 279 1,269 5,659
Granted 610 48 174 832 $10.11 - $12.32
Exercised (420) (14) (756) (1,190) $ 1.01 - $10.11
Terminated (35) - (86) (121) $ 3.15 - $10.56
----- --- ----- -----
Balance, December 31, 2004 4,266 313 601 5,180
===== === ===== =====
At December 31, 2004, approximately 2.9 million, 0.2 million, and 0.4
million options were exercisable by employees, directors and agents,
respectively.
Options Granted to Employees
Options are generally granted to eligible employees at a price not less
than the market price of the Company's common stock on the date of the grant.
Option shares may be exercised subject to the terms prescribed by the individual
grant agreement. During 2004, there were approximately 245,000 options issued to
management in connection with the management bonus, 25,000 issued for new
employees and 340,000 issued to Heritage employees in connection with the
acquisition. During 2003, there were 301,000 options issued in connection with
the management bonus and 90,000 for new employees. During 2002, there were
377,000 options issued in connection with the management bonus, 176,000 issued
for new employees and 18,000 issued to relocated employees. Vested options must
be exercised not later than ten years after the date of the grant or following
earlier termination of employment. Because these awards are made at a price
equal to or greater than market on the date of grant, no compensation cost is
recognized for such awards.
On August 1, 1999, the Company issued 2.3 million below market stock
options with an exercise price of $3.15 per share to certain employees and
members of management. During 2000, the Company issued an additional 0.2 million
below market stock options with an exercise price of $3.15 per share to certain
relocated employees and members of management on July 31, 2000. As of December
31, 2004, the number of these options outstanding decreased to 1.7 million,
through employee terminations and exercises. These options are fully vested,
except for 0.6 million which will become vested after seven years. These options
must be exercised not later than ten years after the date of the grant or
following earlier termination of employment. The Company recorded an expense for
the difference between the exercise price of $3.15 per share and the value of
the options on the date of grant of $0.1 million for the year ended December 31,
2004, $0.4 million for 2003, and $0.6 million for 2002.
F-29
Stock Options Issued to Directors
Directors of the Company are eligible for options under the 1998 ICP. The
1998 ICP provides that unless otherwise determined by the Board, each
non-employee director would be granted an option to purchase 4,500 shares of
Common Stock upon approval of the 1998 ICP by shareholders or, as to directors
thereafter elected, his or her initial election to the Board, and at each annual
meeting of shareholders starting in 1999 at which he or she qualifies as a
non-employee director. The 1998 ICP also provides that the non-employee
directors for American Progressive and Penncorp Life (Canada) would be granted
an option to purchase 1,500 shares of Common Stock at each annual meeting.
Unless otherwise determined by the Board, such options will have an exercise
price equal to 100% of the fair market value per share on the date of grant and
will become exercisable in three equal installments after each of the first,
second and third anniversaries of the date of grant based on continued service
as a director. Because these are made at a price equal to market, no
compensation expense is recognized for such awards.
Stock Option and Stock Award Plans for Agents
Both career agents and independent general agents are eligible for options
under the 1998 ICP. Options are awarded to agents based on production. These
options vest in equal installments over a two year period and expire five years
from the date of grant. The exercise prices are set at between 110% and 125% of
the fair market value of Universal American common stock on the date of the
award. During 2004, career agents were awarded a total of approximately 75,000
options and independent general agents were awarded approximately 99,000 options
with a weighted average exercise price of $11.45 per share for 2003 sales
performance. During 2003 career agents were awarded a total of approximately
167,000 options and independent general agents were awarded approximately
139,000 options with a weighted average exercise price of $7.03 per share for
2002 sales performance. During 2002 career agents were awarded a total of
approximately 150,000 options and independent general agents were awarded
approximately 166,000 options with a weighted average exercise price of $6.84
per share for 2002 sales performance. The fair values of these options are
expensed over the vesting period of each award.
The Company also grants awards of common stock to qualifying Career
agents. These shares vest after two years. During 2004, Career agents were
awarded stock grants of approximately 36,000 shares with a fair value of $9.71
per share for 2003 sales performance. During 2003, Career agents were awarded
stock grants of approximately 49,000 shares with a fair value of $5.92 per share
for 2002 sales performance. During 2002, Career agents were awarded stock grants
of approximately 71,000 shares with a fair value of $6.63 per share for 2001
sales performance.
Total expense relating to the above plans was $0.6 million for the year
ended December 31, 2004, $0.9 million for 2003, and $0.7 million for 2002.
10. STATUTORY FINANCIAL DATA:
The insurance subsidiaries are required to maintain minimum amounts of
statutory capital and surplus as required by regulatory authorities. However,
substantially more than such minimum amounts are needed to meet statutory and
administrative requirements of adequate capital and surplus to support the
current level of our insurance subsidiaries' operations. Each of the life
insurance subsidiaries' statutory capital and surplus exceeds its respective
minimum statutory requirement at levels we believe are sufficient to support
their current levels of operation. Additionally, the National Association of
Insurance Commissioners ("NAIC") imposes regulatory risk-based capital ("RBC")
requirements on life insurance enterprises. At December 31, 2004, all of our
life insurance subsidiaries maintained ratios of total adjusted capital to RBC
in excess of the "authorized control level". The combined statutory capital and
surplus, including asset valuation reserve, of the U.S. life insurance
subsidiaries totaled $127.9 million at December 31, 2004 and $117.1 million at
December 31, 2003. Statutory net income for the year ended December 31, 2004 was
$5.4 million, which included after-tax net realized gains of $0.9 million, and
for the year ended December 31, 2003 was $6.0 million, which included after-tax
net realized losses of $0.3 million. The net statutory loss for the year ended
December 31, 2002 was $9.1 million, which included after-tax net realized losses
of $16.8 million.
F-30
Heritage's insurance subsidiary, SelectCare of Texas is also required to
maintain minimum amounts of capital and surplus, as required by regulatory
authorities and is also subject to RBC requirements. SelectCare's statutory
capital and surplus exceeds its minimum requirement and its RBC is in excess of
the "authorized control level". The statutory capital and surplus for SelectCare
was $9.6 million at December 31, 2004 and $3.8 million at December 31, 2003.
Statutory net income for the year ended December 31, 2004 was $5.5 million and
for the year ended December 31, 2003 was $2.9 million.
Penncorp Life (Canada) reports to Canadian regulatory authorities based
upon Canadian statutory accounting principles that vary in some respects from
U.S. statutory accounting principles. Penncorp Life (Canada)'s net assets based
upon Canadian statutory accounting principles were C$57.4 million (US$47.8
million) as of December 31, 2004 and were C$82.9 million (US$63.5 million) as of
December 31, 2003. Net income based on Canadian generally accepted accounting
principles was C$8.4 million (US$6.5 million) for the year ended December 31,
2004, C$34.4 million (US$24.6 million) for 2003 and C$12.8 million (US$8.2
million) for 2002. Penncorp Life (Canada) maintained a Minimum Continuing
Capital and Surplus Requirement Ratio ("MCCSR") in excess of the minimum
requirement at December 31, 2004.
11. ACCIDENT AND HEALTH POLICY AND CONTRACT CLAIM LIABILITIES:
Activity in the accident & health policy and contract claim liability is
as follows:
2004 2003 2002
-------- -------- --------
(In thousands)
Balance at beginning of year $100,232 $ 88,216 $ 79,596
Less reinsurance recoverables (39,014) (48,925) (44,685)
-------- -------- --------
Net balance at beginning of year 61,218 39,291 34,911
-------- -------- --------
Balances acquired 9,265 18,744 3,198
Incurred related to:
Current year 390,814 249,862 138,429
Prior years (2,141) (1,949) (1,506)
-------- -------- --------
Total incurred 388,673 247,913 136,923
-------- -------- --------
Paid related to:
Current year 348,887 220,602 114,769
Prior years 47,401 25,302 21,074
-------- -------- --------
Total paid 396,288 245,904 135,843
-------- -------- --------
Foreign currency adjustment 630 1,174 102
-------- -------- --------
Net balance at end of year 63,498 61,218 39,291
Plus reinsurance recoverables 27,789 39,014 48,925
-------- -------- --------
Balance at end of year $ 91,288 $100,232 $ 88,216
======== ======== ========
In 2004, the Company acquired Heritage. In 2003, the Company acquired
Pyramid Life and recaptured a block of Medicare Supplement business previously
ceded to Transamerica. In 2002, the Company acquired, through a 100% quota share
reinsurance agreement, a block of Medicare Supplement business representing
approximately $20.0 million of annualized premium in force. The balances
acquired represent the accident and health claim liabilities acquired in these
transactions.
During 2004, the favorable development related primarily to the Medicare
supplement business in the Senior Health Insurance Segment. During 2003 and
2002, the favorable development on the accident and health claims reserves
resulted from the improvement in claims management processes in the Specialty
Health Insurance segment.
F-31
12. DEFERRED POLICY ACQUISITION COSTS:
Details with respect to deferred policy acquisition costs (in thousands)
are as follows:
2004 2003 2002
------------ --------------- ------------
(In thousands)
Balance, beginning of year $ 143,711 $ 92,093 $ 66,025
Capitalized costs 114,411 88,505 40,550
Adjustment relating to unrealized gains on
fixed maturities (2,791) (2,665) (1,958)
Adjustment relating to recapture of
reinsurance - 275 -
Foreign currency adjustment 1,854 2,904 176
Amortization (48,904) (37,401) (12,700)
----------- -------------- ------------
Balance, end of year $ 208,281 $ 143,711 $ 92,093
=========== ============== ============
The increase in the amount of acquisition costs capitalized during 2003
and the corresponding increase in amortization is directly related to the
increase in new business as a result of the acquisitions of Pyramid Life and the
Guarantee Reserve marketing organization, the recapture of the Transamerica
reinsurance and the increase in retention on new business, as well as the
increase in annuities written during the year. The increase in the amount
capitalized during 2004 is primarily the result of the full year impact of the
above transactions along with an increase in new business in existing companies.
13. REINSURANCE:
In the normal course of business, the Company reinsures portions of
certain policies that it underwrites. The Company enters into reinsurance
arrangements with unaffiliated reinsurance companies to limit our exposure on
individual claims and to limit or eliminate risk on our non-core or
underperforming blocks of business. Accordingly, the Company is party to several
reinsurance agreements on its life and accident and health insurance risks. The
Company's senior market accident and health insurance products are generally
reinsured under quota share coinsurance treaties with unaffiliated insurers,
while the life insurance risks are reinsured under either quota share
coinsurance or yearly-renewable term treaties with unaffiliated insurers. Under
quota share coinsurance treaties, the Company pays the reinsurer an agreed upon
percentage of all premiums and the reinsurer reimburses the Company that same
percentage of any losses. In addition, the reinsurer pays the Company certain
allowances to cover commissions, cost of administering the policies and premium
taxes. Under yearly-renewable term treaties, the reinsurer receives premiums at
an agreed upon rate for its share of the risk on a yearly-renewable term basis.
The Company also uses excess of loss reinsurance agreements for certain policies
whereby the Company limits its loss in excess of specified thresholds. The
Company's quota share coinsurance agreements are generally subject to
cancellation on 90 days notice as to future business, but policies reinsured
prior to such cancellation remain reinsured as long as they remain in force.
The Company evaluates the financial condition of its reinsurers and
monitors concentrations of credit risk to minimize its exposure to significant
losses from reinsurer insolvencies. The Company is obligated to pay claims in
the event that any reinsure to whom we have ceded an insured claim fails to meet
its obligations under the reinsurance agreement.
The Company has several quota share reinsurance agreements in place with
General Re Life Corporation ("General Re"), Hannover Life Re of America
("Hannover") and Swiss Re Life & Health America ("Swiss Re"), (collectively, the
"Reinsurers"), which Reinsurers are rated A or better by A.M. Best. These
agreements cover various insurance products, primarily Medicare Supplement, long
term care and senior life policies, written or acquired by the Company and
contain ceding percentages ranging between 15% and 100%. Effective January 1,
2004, the Company increased its retention on all new Medicare Supplement
business to 100%. Therefore, the Company no longer reinsures new Medicare
Supplement business. During 2004, we ceded premiums of $109.0 million to General
Re, $105.3 million to Hannover, and $7.7 million to Swiss Re, representing 12%,
12% and 1%, respectively, of our total direct and assumed premiums. During 2003,
we ceded premiums of $123.5 million to General Re, $116.3 million to Hannover
and $4.9 million to Swiss Re, representing 17%, 16% and 1%, respectively, of our
total direct and assumed premiums.
F-32
Amounts recoverable from all our reinsurers were as follows:
2004 2003
-------- --------
(In thousands)
Reinsurer
General Re $ 83,696 $ 95,907
Hannover 68,463 69,544
Swiss Re 14,583 11,099
Other 45,759 42,632
-------- --------
Total $212,501 $219,182
======== ========
At December 31, 2004, the total amount recoverable from reinsurers
included $208.3 million recoverable on future policy benefits and unpaid claims
and $4.2 million for amounts due from reinsurers on paid claims, commissions and
expense allowances net of premiums reinsured. At December 31, 2003, the total
amount recoverable from reinsurers included $215.5 million recoverable on future
policy benefits and unpaid claims and $3.7 million for amounts due from
reinsurers on paid claims, commissions and expense allowances net of premiums
reinsured. A summary of reinsurance is presented below:
As of December 31,
---------------------------------------------------
2004 2003 2002
--------------- --------------- ---------------
(In thousands)
Life insurance in force
Gross amount $ 3,932,446 $ 3,757,618 $ 3,105,477
Ceded to other companies (833,452) (788,761) (692,132)
Assumed from other companies 138,849 145,028 62,423
--------------- --------------- ---------------
Net amount $ 3,237,843 $ 3,113,885 $ 2,475,768
=============== =============== ===============
Percentage of assumed to net 4% 5% 3%
=============== =============== ===============
Year Ended December 31,
---------------------------------------------
2004 2003 2002
------------ -------------- -------------
(In thousands)
Premiums
Life insurance $ 60,450 $ 44,268 $ 37,682
Accident and health 798,471 656,147 549,004
------------ -------------- -------------
Total gross premiums 858,921 700,415 586,686
------------ -------------- -------------
Ceded to other companies
Life insurance (14,766) (8,142) (7,656)
Accident and health (234,653) (272,347) (317,528)
------------ -------------- -------------
Total ceded premiums (249,419) (280,489) (325,184)
------------ -------------- -------------
Assumed from other companies
Life insurance 7,376 3,339 1,044
Accident and health 28,306 23,703 4,031
------------ -------------- -------------
Total assumed premium 35,682 27,042 5,075
------------ -------------- -------------
Net amount
Life insurance 53,060 39,465 31,070
Accident and health 592,124 407,503 235,507
------------ -------------- -------------
Total net premium $ 645,184 $ 446,968 $ 266,577
============ ============== =============
Percentage of assumed to net
Life insurance 14% 8% 3%
Accident and health 5% 6% 2%
------------ -------------- -------------
Total assumed to total net 6% 6% 2%
============ ============== =============
Claims recovered $ 192,856 $ 189,626 $ 224,676
============ ============== =============
F-33
14. LOAN PAYABLE:
Credit Facility, as Amended in May 2004
In connection with the acquisition of Pyramid Life (see Note 3 - Business
Combinations), the Company obtained an $80 million credit facility (the "Credit
Agreement") on March 31, 2003 to repay the then existing loan and provide funds
for the acquisition of Pyramid Life. The Credit Agreement consisted of a $65
million term loan which was drawn to fund the acquisition and a $15 million
revolving loan facility. The Credit Agreement initially called for interest at
the London Interbank Offering Rate ("LIBOR") for one, two or three months, at
the option of the Company, plus 300 basis points. Effective March 31, 2004, the
spread over LIBOR was reduced to 275 basis points in accordance with the terms
of the Credit Agreement. Principal repayments were scheduled over a five-year
period with a final maturity date of March 31, 2008. The Company incurred loan
origination fees of approximately $2.1 million, which were capitalized and are
being amortized on a straight-line basis over the life of the Credit Agreement.
In connection with the acquisition of Heritage on May 28, 2004 (see Note 3
- - Business Combinations), the Company amended the Credit Agreement by increasing
the facility to $120 million from $80 million (the "Amended Credit Agreement"),
including an increase in the term loan portion to $105 million from $36.4
million (the balance outstanding at May 28, 2004) and maintaining the $15
million revolving loan facility. None of the revolving loan facility has been
drawn as of December 31, 2004. Under the Amended Credit Agreement, the spread
over LIBOR was reduced to 225 basis points. Effective January 1, 2005, the
interest rate on the term loan is 4.8%. Principal repayments are scheduled at
$5.3 million per year over a five-year period with a final payment of $80.1
million due upon maturity on March 31, 2009. The Company incurred additional
loan origination fees of approximately $2.1 million, which were capitalized and
are being amortized on a straight-line basis over the life of the Amended Credit
Agreement along with the continued amortization of the origination fees incurred
in connection with the Credit Agreement. The Company pays an annual commitment
fee of 50 basis points on the unutilized revolving loan facility. The
obligations of the Company under the Amended Credit Facility are guaranteed by
WorldNet Services Corp., CHCS Services Inc., CHCS Inc., Quincy Coverage
Corporation, Universal American Financial Services, Inc., Heritage, HHS-HPN
Network, Inc., Heritage Health Systems of Texas, Inc., PSO Management of Texas,
LLC, HHS Texas Management, Inc. and HHS Texas Management LP (collectively the
"Guarantors") and secured by substantially all of the assets of each of the
Guarantors. In addition, as security for the performance by the Company of its
obligations under the Amended Credit Facility, the Company, WorldNet Services
Corp., CHCS Services Inc., Heritage and HHS Texas Management, Inc. have each
pledged and assigned substantially all of their respective securities (but not
more than 65% of the issued and outstanding shares of voting stock of any
foreign subsidiary), all of their respective limited liability company and
partnership interests, all of their respective rights, title and interest under
any service or management contract entered into between or among any of their
respective subsidiaries and all proceeds of any and all of the foregoing.
The Amended Credit Facility requires the Company and its subsidiaries to
meet certain financial tests, including a minimum fixed charge coverage ratio, a
minimum risk based capital test and a minimum consolidated net worth test. The
Amended Credit Facility also contains covenants, which among other things, limit
the incurrence of additional indebtedness, dividends, capital expenditures,
transactions with affiliates, asset sales, acquisitions, mergers, prepayments of
other indebtedness, liens and encumbrances and other matters customarily
restricted in such agreements.
The Amended Credit Facility contains customary events of default,
including, among other things, payment defaults, breach of representations and
warranties, covenant defaults, cross-acceleration, cross-defaults to certain
other indebtedness, certain events of bankruptcy and insolvency and judgment
defaults.
The Company made regularly scheduled principal payments of $5.7 million
and paid $3.1 million in interest in connection with its credit facilities
during the year ended December 31, 2004. During the year ended December 31,
2003, the Company made regularly scheduled principal payments of $8.7 million
and paid $2.7 million in interest in connection with its credit facilities.
F-34
The following table shows the schedule of principal payments (in
thousands) remaining on the Amended Credit Agreement, with the final payment in
March 2009:
2005 $ 5,250
2006 5,250
2007 5,250
2008 5,250
2009 80,063
-----------
$ 101,063
===========
2003 Refinancing of Debt
On March 31, 2003, the Credit Facility issued in 1999 was repaid from the
proceeds of the Credit Agreement obtained in connection with the acquisition of
Pyramid Life. The early extinguishment of this debt resulted in the immediate
amortization of the related capitalized loan origination fees, resulting in a
pre-tax expense of approximately $1.8 million.
The following table sets forth certain summary information with respect to
total borrowings of the Company:
As of December 31, Year Ended December 31,
-------------------------- --------------------------------------------
Weighted
Maximum Average Average
Amount Interest Amount Amount Interest
Outstanding Rate Outstanding Outstanding(a) Rate (b)
-------------- -------- -------------- -------------- --------
(In thousands) (In thousands) (In thousands)
2004 $ 101,063 4.29% $ 105,000 $ 75,775 4.06%
============== ==== ========= ======== ====
2003 $ 38,172 4.14% $ 65,000 $ 49,889 4.50%
============== ==== ========= ======== ====
2002 $ 50,775 5.33% $ 61,475 $ 55,731 5.44%
============== ==== ========= ======== ====
- ----------------------
(a) The average amounts of borrowings outstanding were computed by
determining the arithmetic average of the months' average outstanding in
borrowings.
(b) The weighted-average interest rates were determined by dividing
interest expense related to total borrowings by the average amounts
outstanding of such borrowings.
15. OTHER LONG TERM DEBT:
The Company has formed statutory business trusts, which exist for the
exclusive purpose of issuing trust preferred securities representing undivided
beneficial interests in the assets of the trust, investing the gross proceeds of
the trust preferred securities in junior subordinated deferrable interest
debentures of the Company (the "Junior Subordinated Debt") and engaging in only
those activities necessary or incidental thereto. In accordance with the
adoption of FIN 46R, the Company has deconsolidated the trusts. For further
discussion of the adoption of FIN 46R, see Note 2 - Recent and Pending
Accounting Pronouncements.
Separate subsidiary trusts of the Company (the "Trusts") have issued a
combined $75.0 million in thirty year trust preferred securities (the "Capital
Securities") as detailed in the following table:
Amount Spread Rate as of
Maturity Date Issued Term Over LIBOR December 31, 2004
- ------------- -------------- -------------- -------------- -----------------
(In thousands) (Basis points)
December 2032 $ 15,000 Fixed/Floating 400(1) 6.7%
March 2033 10,000 Floating 400 6.1%
May 2033 15,000 Floating 420 6.6%
May 2033 15,000 Fixed/Floating 410(2) 7.4%
October 2033 20,000 Fixed/Floating 395(3) 7.0%
--------
$ 75,000
========
(1) Effective September 2003, the Company entered into a swap agreement
whereby it will pay a fixed rate of 6.7% in exchange for a floating rate
of LIBOR plus 400 basis points. The swap contract expires in December
2007.
(2) The rate on this issue is fixed at 7.4% for the first five years, after
which it is converted to a floating rate equal to LIBOR plus 410 basis
points.
(3) Effective April 29, 2004, the Company entered into a swap agreement
whereby it will pay a fixed rate of 6.98% in exchange for a floating rate
of LIBOR plus 395 basis points. The swap contract expires in October 2008.
F-35
The Trusts have the right to call the Capital Securities at par after five
years from the date of issuance. The proceeds from the sale of the Capital
Securities, together with proceeds from the sale by the Trusts of their common
securities to the Company, were invested in thirty-year floating rate Junior
Subordinated Debt of the Company. From the proceeds of the trust preferred
securities, $26.0 million was used to pay down debt during 2003. The balance of
the proceeds has been used, in part to fund acquisitions, to provide capital to
the Company's insurance subsidiaries to support growth and to be held for
general corporate purposes.
The Capital Securities represent an undivided beneficial interest in the
Trusts' assets, which consist solely of the Junior Subordinated Debt. Holders of
the Capital Securities have no voting rights. The Company owns all of the common
securities of the Trusts. Holders of both the Capital Securities and the Junior
Subordinated Debt are entitled to receive cumulative cash distributions accruing
from the date of issuance, and payable quarterly in arrears at a floating rate
equal to the three-month LIBOR plus a spread. The floating rate resets quarterly
and is limited to a maximum of 12.5% during the first sixty months. Due to the
variable interest rate for these securities, the Company would be subject to
higher interest costs if short-term interest rates rise. The Capital Securities
are subject to mandatory redemption upon repayment of the Junior Subordinated
Debt at maturity or upon earlier redemption. The Junior Subordinated Debt is
unsecured and ranks junior and subordinate in right of payment to all present
and future senior debt of the Company and is effectively subordinated to all
existing and future obligations of the Company's subsidiaries. The Company has
the right to redeem the Junior Subordinated Debt after five years from the date
of issuance.
The Company has the right at any time, and from time to time, to defer
payments of interest on the Junior Subordinated Debt for a period not exceeding
20 consecutive quarters up to each debenture's maturity date. During any such
period, interest will continue to accrue and the Company may not declare or pay
any cash dividends or distributions on, or purchase, the Company's common stock
nor make any principal, interest or premium payments on or repurchase any debt
securities that rank equally with or junior to the Junior Subordinated Debt. The
Company has the right at any time to dissolve the Trusts and cause the Junior
Subordinated Debt to be distributed to the holders of the Capital Securities.
The Company has guaranteed, on a subordinated basis, all of the Trusts'
obligations under the Capital Securities including payment of the redemption
price and any accumulated and unpaid distributions to the extent of available
funds and upon dissolution, winding up or liquidation but only to the extent the
Trusts have funds available to make such payments.
The Company paid $4.7 million in interest in connection with the Junior
Subordinated Debt during the year ended December 31, 2004, and paid $2.1 million
during 2003.
16. DERIVATIVE INSTRUMENTS - CASH FLOW HEDGE
Effective September 4, 2003, the Company entered into a swap agreement
whereby it pays a fixed rate of 6.7% on a $15.0 million notional amount relating
to the December 2002 trust preferred securities issuance, in exchange for a
floating rate of LIBOR plus 400 basis points, capped at 12.5%. The swap contract
expires in December 2007. Effective April 29, 2004, the Company entered into a
second swap agreement whereby it pays a fixed rate of 6.98% on a $20.0 million
notional amount relating to the October 2003 trust preferred securities
issuance, in exchange for a floating rate of LIBOR plus 395 basis points, capped
at 12.45%. The swap contract expires in October 2008. The swaps are designated
and qualify as cash flow hedges, and changes in their fair value are recorded in
accumulated other comprehensive income. The combined fair value of the swaps was
$0.8 million at December 31, 2004 and $0.2 million at December 31, 2003 and is
included in other assets.
F-36
17. COMMITMENTS AND CONTINGENCIES:
Lease Obligations
We are obligated under certain lease arrangements for our executive and
administrative offices in New York, Florida, Indiana, Tennessee, Texas, and
Ontario, Canada. Rent expense was $2.6 million for the year ended December 31,
2004, $1.9 million for 2003 and $1.7 million for 2002. Annual minimum rental
commitments, subject to escalation, under non-cancelable operating leases (in
thousands) are as follows:
2005 $ 2,526
2006 2,605
2007 2,588
2008 2,328
2009 and thereafter 9,236
--------
Totals $ 19,283
========
In addition to the above, Pennsylvania Life and Penncorp Life (Canada) are
the named lessees on 71 properties occupied by Career Agents for use as field
offices. The Career Agents reimburse Pennsylvania Life and Penncorp Life
(Canada) the actual rent for these field offices. The total annual rent paid by
the Company and reimbursed by the Career Agents for these field offices during
2004 was approximately $1.1 million.
Litigation
The Company has litigation in the ordinary course of business, including
claims for medical, disability and life insurance benefits, and in some cases,
seeking punitive damages. Management and counsel believe that after reserves and
liability insurance recoveries, none of these will have a material adverse
effect on the Company.
18. UNIVERSAL AMERICAN FINANCIAL CORP. 401(K) SAVINGS PLAN:
Effective April 1, 1992, the Company adopted the Universal American
Financial Corp. 401(k) Savings Plan ("Savings Plan"). The Savings Plan is a
voluntary contributory plan under which employees may elect to defer
compensation for federal income tax purposes under Section 401(k) of the
Internal Revenue Code of 1986. The employee is entitled to participate in the
Savings Plan by contributing through payroll deductions up to 100% of the
employee's compensation. The participating employee is not taxed on these
contributions until they are distributed. Moreover, the employer's contributions
vest at the rate of 25% per plan year, starting at the end of the second year.
Amounts credited to employee's accounts under the Savings Plan are invested by
the employer-appointed investment committee. Currently, the Company matches 50%
of the employee's first 4% of contributions to 2% of the employee's eligible
compensation with Company common stock. The Company made matching contributions
under the Savings Plan of $0.6 million in 2004, $0.4 million in 2003 and $0.3
million in 2002. Employees are required to hold the employer contribution in
Company common stock until vested, at which point the employee has the option to
transfer the amount to any of the other investments available under the Savings
Plan. The Savings Plan held 565,034 shares of the Company's common stock at
December 31, 2004, which represented 47% of total plan assets and 528,722 shares
at December 31, 2003, which represented 41% of total plan assets. Generally, a
participating employee is entitled to distributions from the Savings Plan upon
termination of employment, retirement, death or disability. Savings Plan
participants who qualify for distributions may receive a single lump sum, have
the assets transferred to another qualified plan or individual retirement
account, or receive a series of specified installment payments.
F-37
19. DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS:
The following methods and assumptions were used to estimate the fair value
of each class of financial instruments for which it is practicable to estimate
that value:
Fixed maturities available for sale: Fair value of fixed maturities is
based upon quoted market prices, where available, or on values obtained
from independent pricing services. For certain mortgage and asset-backed
securities, the determination of fair value is based primarily upon the
amount and timing of expected future cash flows of the security. Estimates
of these cash flows are based current economic conditions, past credit
loss experience and other circumstances.
Equity securities: For equity securities carried at fair value, based on
quoted market price.
Other invested assets: Other invested assets consists of collateralized
loans which are carried at the underlying collateral value, cash value of
life insurance and mortgage loans which are carried at the aggregate
unpaid balance. The determination of fair value for these invested assets
is not practical because there is no active trading market for such
invested assets and therefore, the carrying value is a reasonable estimate
of fair value.
Cash and cash equivalents and policy loans: For cash and cash equivalents
and policy loans, the carrying amount is a reasonable estimate of fair
value.
Cash flow swap: The cash flow swap is carried at fair value, obtained from
a pricing service.
Investment contract liabilities: For annuity and universal life type
contracts, the carrying amount is the policyholder account value;
estimated fair value equals the policyholder account value less surrender
charges.
Loan payable and trust preferred securities: Fair value for the loan
payable and trust preferred securities is equal to the carrying amount.
The estimated fair values of the Company's financial instruments are as
follows:
2004 2003
------------------------- -------------------------
Carrying Carrying
Amount Fair Value Amount Fair Value
----------- ----------- ----------- -----------
(In thousands) (In thousands)
Financial assets:
Fixed maturities available for sale $ 1,170,822 $ 1,170,822 $ 1,141,392 $ 1,141,392
Equity securities 755 755 1,507 1,507
Policy loans 24,318 24,318 25,502 25,502
Other invested assets 1,187 1,187 1,583 1,583
Cash and cash equivalents 181,257 181,257 116,524 116,524
Cash flow swap 832 832 196 196
Financial liabilities:
Investment contract liabilities 478,373 444,068 419,685 391,315
Loan payable 101,063 101,063 38,172 38,172
Trust preferred securities 75,000 75,000 75,000 75,000
F-38
20. EARNINGS PER SHARE:
The reconciliation of the numerators and the denominators for the
computation of basic and diluted EPS is as follows:
For the Year Ended December 31, 2004
--------------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
------------ ------------- -----------
(In thousands, per share amounts in dollars)
Weighted average common stock outstanding 54,780
Less: Weighted average treasury shares (153)
------
Basic earnings per share $ 63,871 54,627 $ 1.17
============ ====== ======
Effect of dilutive Securities 2,005
------
Diluted EPS $ 63,871 56,632 $ 1.13
============ ====== ======
For the Year Ended December 31, 2003
--------------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
------------ ------------- -----------
(In thousands, per share amounts in dollars)
Weighted average common stock outstanding 53,670
Less: Weighted average treasury shares (148)
------
Basic earnings per share $ 43,052 53,522 $0.80
========= ====== =====
Effect of dilutive Securities 1,508
------
Diluted EPS $ 43,052 55,030 $0.78
========= ====== =====
For the Year Ended December 31, 2002
--------------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
------------ ------------- ---------
(In thousands, per share amounts in dollars)
Weighted average common stock outstanding 53,071
Less: Weighted average treasury shares (132)
------
Basic earnings per share $ 30,127 52,939 $ 0.57
========== ====== ======
Effect of dilutive Securities 1,319
------
Diluted EPS $ 30,127 54,258 $ 0.56
========== ====== ======
F-39
21. OTHER COMPREHENSIVE INCOME
The components of other comprehensive income, and the related tax effects
for each component, are as follows:
Before Tax Tax Expense Net of Tax
Amount (Benefit) Amount
---------- ----------- ----------
(In thousands)
For the year ended December 31, 2004
Net unrealized gain arising during
the year (net of deferred acquisition costs) $ 9,542 $ 3,339 $ 6,203
Reclassification adjustment for gains
included in net income (10,647) (3,726) (6,921)
-------- -------- --------
Net unrealized loss (1,105) (387) (718)
Cash flow hedge 636 223 413
Foreign currency translation adjustment 2,329 815 1,514
-------- -------- --------
Other comprehensive income $ 1,860 $ 651 $ 1,209
======== ======== ========
Before Tax Tax Expense Net of Tax
Amount (Benefit) Amount
---------- ----------- ----------
(In thousands)
For the year ended December 31, 2003
Net unrealized gain arising during
the year (net of deferred acquisition costs) $ 7,976 $ 2,791 $ 5,185
Reclassification adjustment for gains
included in net income (2,057) (720) (1,337)
-------- ------- -------
Net unrealized gain 5,919 2,071 3,848
Cash flow hedge 196 69 127
Foreign currency translation adjustment 9,090 3,178 5,912
-------- ------- -------
Other comprehensive income $ 15,205 $ 5,318 $ 9,887
======== ======= =======
Before Tax Tax Expense Net of Tax
Amount (Benefit) Amount
---------- ----------- ----------
(In thousands)
For the year ended December 31, 2002
Net unrealized gain arising during
the year (net of deferred acquisition costs) $ 31,605 $ 11,066 $ 20,539
Reclassification adjustment for losses
included in net income 5,083 1,779 3,304
-------- -------- --------
Net unrealized gain 36,688 12,845 23,843
Foreign currency translation adjustment 679 238 441
-------- -------- --------
Other comprehensive income $ 37,367 $ 13,083 $ 24,284
======== ======== ========
F-40
22. BUSINESS SEGMENT INFORMATION:
The Company's principal business segments are based on product and
include: Senior Market Health Insurance, Specialty Health Insurance, Life
Insurance/Annuities, Senior Managed Care - Medicare Advantage and Senior
Administrative Services. The Company also reports the activities of our holding
company in a separate segment. Previously, the Company reported its segments
based on distribution channel. The Company's former Senior Market Brokerage and
Career Agency segments have been replaced with the three new segments: Senior
Market Health Insurance, Life Insurance/Annuity and Specialty Health Insurance.
The Senior Managed Care - Medicare Advantage and Administrative Services
segments will be unchanged. Management believes that this new segmentation will
provide even greater clarity to the results of the Company. Reclassifications
have been made to conform prior year amounts to the current year presentation. A
description of these segments follows:
SENIOR MARKET HEALTH INSURANCE -- This segment consists primarily of our
Medicare Supplement business and other senior market health products distributed
through our carrer agency sales force and through our network of independent
general agencies.
SPECIALTY HEALTH INSURANCE -- The Specialty Health Insurance segment includes
specialty health insurance products, primarily fixed benefit accident and
sickness disability insurance sold to the middle income self-employed market in
the United States and Canada. This segment also includes certain products that
we no longer sell such as long term care and major medical. This segment's
products are distributed primarily by our career agents.
LIFE INSURANCE/ANNUITY -- This segment includes all of the life insurance and
annuity business sold in the United States. This segment's products include
senior, traditional and universal life insurance and fixed annuities and are
distributed through both independent general agents and our career agency
distribution systems.
SENIOR MANAGED CARE - MEDICARE ADVANTAGE - The Senior Managed Care - Medicare
Advantage segment includes the operations of Heritage and our other initiatives
in managed care for seniors. Heritage operates Medicare Advantage plans in
Houston and Beaumont Texas, and our Medicare Advantage private fee-for-service
plan in the northeastern portion of the United States. Heritage generates its
revenues and profits from three sources. First, Heritage owns an interest in
SelectCare, a health plan that offers coverage to Medicare beneficiaries under a
contract with CMS. Next, Heritage operates three separate Management Service
Organizations ("MSO's") that manage the business of SelectCare and two
affiliated Independent Physician Associations ("IPA's"). Lastly, Heritage
participates in the net results derived from these IPA's. Heritage's Medicare
Advantage plans are sold by our career agency sales force and directly by
employee representatives. Our Medicare Advantage private fee-for-service plans
were introduced during the second quarter of 2004 and are sold by independent
agents.
SENIOR ADMINISTRATIVE SERVICES -- Our senior administrative services subsidiary
acts as a third party administrator and service provider of senior market
insurance products and geriatric care management for both affiliated and
unaffiliated insurance companies. The services provided include policy
underwriting and issuance, telephone and face-to-face verification, policyholder
services, claims adjudication, case management, care assessment and referral to
health care facilities.
CORPORATE -- This segment reflects the activities of Universal American,
including debt service, certain senior executive compensation, and compliance
with requirements resulting from our status as a public company.
Intersegment revenues and expenses are reported on a gross basis in each
of the operating segments but eliminated in the consolidated results. These
intersegment revenues and expenses affect the amounts reported on the individual
financial statement line items, but are eliminated in consolidation and do not
change income before taxes. The significant items eliminated include
intersegment revenue and expense relating to services performed by the Senior
Administrative Services segment for our other segments and interest on notes
payable or receivable between the Corporate segment and the other operating
segments.
F-41
Financial data by segment, including a reconciliation of segment revenues
and segment income (loss) before income taxes to total revenue and net income in
accordance with generally accepted accounting principles is as follows:
2004 2003 2002
---------------------- ---------------------- ----------------------
Income Income Income
(Loss) (Loss) (Loss)
Before Before Before
Income Income Income
Revenue Taxes Revenue Taxes Revenue Taxes
--------- --------- --------- --------- --------- ---------
(in thousands)
Senior Market Health Insurance $ 360,349 $ 35,407 $ 271,619 $ 27,734 $ 106,902 $ 8,564
Specialty Health Insurance 174,649 26,316 172,131 24,435 162,325 25,603
Life Insurance/Annuity 84,523 13,370 67,090 11,981 56,817 14,207
Senior Managed Care - Medicare
Advantage 93,528 10,136 - - - -
Senior Administrative Services 56,668 13,090 48,531 11,018 43,218 7,632
Corporate 289 (12,498) 232 (10,746) 857 (6,893)
Intersegment revenues (44,340) - (37,068) - (32,197) -
Adjustments to segment amounts:
Net realized gains (losses)(1) 10,647 10,647 2,057 2,057 (5,083) (5,083)
Premium revenue adjustment(2) (968) - (1,844) - (1,316) -
--------- --------- --------- --------- --------- ---------
Total $ 735,345 $ 96,468 $ 522,748 $ 66,479 $ 331,523 $ 44,030
========= ========= ========= ========= ========= =========
(1) We evaluate the results of operations of our segments based on
income before realized gains and losses and income taxes. Management
believes that realized gains and losses are not indicative of overall
operating trends.
(2) We evaluate the results of our insurance segments based on incurred
premium net of the change in unearned premium. The change in unearned
premium is reported as part of the net increase in future policy benefits
in the consolidated statements of operations. Management believes that
including the change in unearned premium in revenue provides more
indicative trends for the purpose of evaluating loss ratios.
Identifiable assets by segment are as follows:
As of December 31,
--------------------------
2004 2003
----------- -----------
(in thousands)
Senior Market Health Insurance $ 385,487 $ 357,753
Specialty Health Insurance 732,680 720,539
Life Insurance/Annuity 723,343 652,673
Senior Managed Care - Medicare
Advantage 136,349 --
Senior Administrative Services 19,401 19,321
Corporate 608,722 475,377
Intersegment assets(1) (588,894) (444,715)
----------- -----------
Total Assets $ 2,017,088 $ 1,780,948
=========== ===========
(1) Intersegment assets include the elimination of the parent holding
company's investment in its subsidiaries as well as the elimination of
other intercompany balances.
23. FOREIGN OPERATIONS:
A portion of the Company's operations is conducted in Canada through
Penncorp Life (Canada). These assets and liabilities are located in Canada where
the insurance risks are written. Revenues, excluding capital gains and losses,
of the Company by geographic distribution by country are as follows:
For the year ended December 31,
2004 2003 2002
-------- -------- --------
(In thousands)
United States $655,724 $456,631 $280,871
Canada 68,974 64,060 55,735
-------- -------- --------
Total $724,698 $520,691 $336,606
======== ======== ========
Total assets and liabilities of Penncorp Life (Canada), located entirely
in Canada, are as follows:
December 31,
2004 2003
--------- ---------
(In thousands)
Assets $ 233,741 $ 236,185
========= =========
Liabilities $ 188,125 $ 175,253
========= =========
F-42
24. CONDENSED QUARTERLY RESULTS OF OPERATIONS (UNAUDITED):
The quarterly results of operations are presented below. Due to the use of
weighted average shares outstanding when determining the denominator for
earnings per share, the sum of the quarterly per common share amounts may not
equal the per common share amounts.
2004 Three Months Ended
- ------------------------------------------ --------------------------------------------------
March 31, June 30, September 30, December 31,
--------- -------- ------------- ------------
(In thousands)
Total revenue 158,538 166,507 203,721 206,579
Total benefits, claims and other expenses 137,353 146,582 174,403 180,539
------- ------- ------- -------
Income before income taxes 21,185 19,925 29,318 26,040
Income tax expense 7,309 6,874 9,776 8,638
------- ------- ------- -------
Net income 13,876 13,051 19,542 17,402
======= ======= ======= =======
Basic earnings per share 0.26 0.24 0.36 0.32
======= ======= ======= =======
Diluted earnings per share 0.25 0.23 0.34 0.30
======= ======= ======= =======
2003 Three Months Ended
- ------------------------------------------ --------------------------------------------------
March 31, June 30, September 30, December 31,
--------- -------- ------------- ------------
(In thousands)
Total revenue $ 97,913 $138,109 $ 139,803 $ 146,923
Total benefits, claims and other expenses 86,262 121,464 122,106 126,438
--------- -------- --------- ---------
Income before income taxes 11,651 16,645 17,697 20,485
Income tax expense 4,103 5,645 6,281 7,398
--------- -------- --------- ---------
Net income $ 7,548 $ 11,000 $ 11,416 $ 13,087
========= ======== ========= =========
Basic earnings per share $ 0.14 $ 0.21 $ 0.21 $ 0.24
========= ======== ========= =========
Diluted earnings per share $ 0.14 $ 0.20 $ 0.21 $ 0.23
========= ======== ========= =========
2002 Three Months Ended
- ----------------------------------------- --------------------------------------------------
March 31, June 30, September 30, December 31,
--------- -------- ------------- ------------
(In thousands)
Total revenue $ 82,166 $ 76,690 $ 83,956 $ 88,711
Total benefits, claims and other expenses 70,541 72,217 71,079 73,656
--------- -------- --------- ---------
Income before income taxes 11,625 4,473 12,877 15,055
Income tax expense 4,127 1,155 4,558 4,063
--------- -------- --------- ---------
Net income $ 7,498 $ 3,318 $ 8,319 $ 10,992
========= ======== ========= =========
Basic earnings per share $ 0.14 $ 0.06 $ 0.16 $ 0.21
========= ======== ========= =========
Diluted earnings per share $ 0.14 $ 0.06 $ 0.15 $ 0.20
========= ======== ========= =========
Significant Fourth Quarter Adjustments
During the fourth quarter, the Company performs an annual evaluation of
the recoverability of its tax net operating loss carryforwards, based on a
projection of future taxable income and other factors. As a result of the
continued profitability of the Company's operating segments, valuation
allowances on certain of the Company's tax loss carryforwards were no longer
considered necessary. The tax valuation allowance released through deferred tax
expense was $1.6 million, or $0.03 per diluted share, during the fourth quarter
of 2002. There were no significant fourth quarter adjustments during 2003 and
2004.
F-43
SCHEDULE I - SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES
UNIVERSAL AMERICAN FINANCIAL CORP.
DECEMBER 31, 2004 AND 2003
December 31, 2004
----------------------------------------------------
Face Amortized Fair Carrying
Classification Value Cost Value Value
- ---------------------------------------- --------- ------------ ------------- ------------
(In thousands)
U.S. Treasury securities and obligations
of U.S. Government $ 85,547 $ 87,552 $ 87,943 $ 87,943
Corporate bonds 474,322 486,142 511,779 511,779
Foreign bonds (1) 424,613 209,583 238,347 238,347
Asset and mortgage-backed securities 358,466 326,401 332,753 332,753
Equity securities 748 755 755
------------ ------------- ------------
Sub-total 1,110,426 $ 1,171,577 1,171,577
=============
Policy loans 24,318 24,318
Other invested assets 1,187 1,187
------------ ------------
Total investments $ 1,135,931 $ 1,197,082
============ ============
December 31, 2003
----------------------------------------------------
Face Amortized Fair Carrying
Classification Value Cost Value Value
- ---------------------------------------- --------- ------------ ------------- ------------
(In thousands)
U.S. Treasury securities and obligations
of U.S. Government $ 72,362 $ 74,187 $ 74,663 $ 74,663
Corporate bonds 536,221 544,744 576,648 576,648
Foreign bonds (1) 213,516 218,011 236,934 236,934
Asset and mortgage-backed securities 280,076 245,012 253,147 253,147
Equity securities 1,481 1,507 1,507
------------ ------------- ------------
Sub-total 1,083,435 $ 1,142,899 1,142,899
=============
Policy loans 25,502 25,502
Other invested assets 1,583 1,583
------------ ------------
Total investments $ 1,110,520 $ 1,169,984
============ ============
(1) Primarily Canadian dollar denominated bonds supporting our Canadian
insurance reserves.
F-44
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
UNIVERSAL AMERICAN FINANCIAL CORP.
(PARENT COMPANY)
CONDENSED BALANCE SHEETS
DECEMBER 31, 2004 AND 2003
2004 2003
---------- ----------
(In thousands)
ASSETS
Cash and cash equivalents $ 3,020 $ 16,239
Investments in subsidiaries, at equity 535,277 382,115
Surplus note receivable from affiliate 48,450 60,000
Short term notes receivable from affiliates 821 3,214
Due from affiliates - agent balance financing 8,894 7,631
Deferred loan origination fees 5,331 4,168
Deferred tax asset 1,537 1,373
Other assets 5,392 637
---------- ----------
Total assets $ 608,722 $ 475,377
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Loan payable $ 101,063 $ 38,172
Other long term debt 75,000 75,000
Note payable to affiliates 3,407 6,925
Due to subsidiary 3,870 4,430
Retiree plan termination liability 2,681 3,285
Accounts payable and other liabilities 3,280 1,827
---------- ----------
Total liabilities 189,301 129,639
---------- ----------
Total stockholders' equity 419,421 345,738
---------- ----------
Total liabilities and stockholders' equity $ 608,722 $ 475,377
========== ==========
See notes to condensed financial statements.
F-45
Schedule II - continued
UNIVERSAL AMERICAN FINANCIAL CORP.
(PARENT COMPANY)
CONDENSED STATEMENTS OF OPERATIONS
FOR THE THREE YEARS ENDED DECEMBER 31, 2004
2004 2003 2002
-------- -------- --------
(In thousands)
REVENUES:
Surplus note investment income $ 2,389 $ 2,845 $ 3,285
Realized losses - - (1,307)
Other income 298 230 857
-------- -------- --------
Total revenues 2,687 3,075 2,835
-------- -------- --------
EXPENSES:
Selling, general and administrative expenses 5,743 4,308 3,987
Early extinguishment of debt - 1,766 -
Interest expense - loan payable 3,074 2,245 3,033
Interest expense - subsidiary trusts 4,829 2,649 62
Interest expense - other affiliated 502 991 1,721
-------- -------- --------
Total expenses 14,148 11,959 8,803
-------- -------- --------
Loss before income taxes and equity in
income of subsidiaries (11,461) (8,884) (5,968)
Income tax benefit (4,680) (3,635) (2,085)
-------- -------- --------
Loss before equity in income of subsidiaries (6,781) (5,249) (3,883)
Equity in income of subsidiaries 70,652 48,301 34,010
-------- -------- --------
Net income $ 63,871 $ 43,052 $ 30,127
======== ======== ========
See notes to condensed financial statements.
F-46
Schedule II - continued
UNIVERSAL AMERICAN FINANCIAL CORP.
(PARENT COMPANY)
CONDENSED STATEMENTS OF CASH FLOWS
FOR THE THREE YEARS ENDED DECEMBER 31, 2004
2004 2003 2002
--------- --------- ---------
(In thousands)
Cash flows from operating activities:
Net income $ 63,871 $ 43,052 $ 30,127
Adjustments to reconcile net income to
net cash used by operating activities:
Realized losses - - 1,307
Stock based compensation 92 422 200
Equity in income of subsidiaries (70,652) (48,903) (34,010)
Change in surplus note interest receivable - - 583
Change in amounts due to/from subsidiaries (560) (223) (1,815)
Amortization of deferred loan origination fees 727 2,206 529
Deferred income taxes (164) (1,177) 1,251
Change in other assets and liabilities 2,262 84 (1,146)
--------- --------- ---------
Net cash used by operating activities (4,424) (4,539) (2,974)
--------- --------- ---------
Cash flows from investing activities:
Proceeds from sale of fixed maturities - - 1,721
Redemption of surplus note due from affiliate 11,550 - 10,000
Capital contributions to subsidiaries (17,800) (36,500) (14,209)
Purchase of additional common stock of Penncorp Life
(Canada) - (18,121)
Purchase of business (100,149) - -
Loans to subsidiaries - (3,500) -
Repayments of loans to subsidiaries 2,397 1,102 1,034
Purchase of agent balances from subsidiaries, net of
collections (1,263) (5,840) 507
Other investing activities - (1,966) (464)
--------- --------- ---------
Net cash used by investing activities (105,265) (46,704) (19,532)
--------- --------- ---------
Cash flows from financing activities:
Net proceeds from issuance of common stock 4,791 4,086 1,042
Purchase of treasury stock (325) (1,113) (1,271)
Repayment of stock loans 125 653 -
Issuance of debt to subsidiary - - 18,511
Repayments of debt to subsidiaries (3,518) (9,111) (4,875)
Issuance of trust preferred securities - 60,000 15,000
Issuance of new debt 68,594 65,000 -
Early extinguishment of debt - (68,950) -
Principal repayment on debt (5,704) (8,653) (10,700)
Dividends received from subsidiaries 34,582 16,568 15,001
Other financing activities (2,075) (3,860) -
--------- --------- ---------
Net cash provided from financing activities 96,470 54,620 32,708
--------- --------- ---------
Net increase (decrease) in cash and cash equivalents (13,219) 3,377 10,202
Cash and cash equivalents:
At beginning of year 16,239 12,862 2,660
--------- --------- ---------
At end of year $ 3,020 $ 16,239 $ 12,862
========= ========= =========
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Interest $ 8,307 $ 5,863 $ 2,574
========= ========= =========
Income taxes $ (4,717) $ (3,525) $ (3,232)
========= ========= =========
See notes to condensed financial statements
F-47
UNIVERSAL AMERICAN FINANCIAL CORP.
(PARENT COMPANY)
NOTES TO CONDENSED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION:
In the parent-company-only financial statements, the parent company's
investment in subsidiaries is stated at cost plus equity in undistributed
earnings of subsidiaries since date of acquisition. The parent company's share
of net income of its wholly owned unconsolidated subsidiaries is included in its
net income using the equity method. Parent-company-only financial statements
should be read in conjunction with the Company's consolidated financial
statements. Certain reclassifications have been made to prior years' financial
statements to conform to current period presentation.
2. EARLY EXTINGUISHMENT OF DEBT:
On March 31, 2003, the company repaid the balance of its existing credit
facility from the proceeds of the new loan obtained in connection with the
acquisition of Pyramid Life Insurance Company. The early extinguishment of debt
resulted in the immediate amortization of the related capitalized loan
origination fees, resulting in a pre-tax expense of approximately $1.8 million.
3. RETIREE PLAN TERMINATION LIABILITY:
Certain of the companies acquired in July 1999 had post-retirement benefit
plans in place prior to their acquisition and Universal American maintained the
liability for the expected cost of such plans. In October 2000, participants
were notified of the termination of the plans in accordance with their terms.
The liability will be reduced as, and to the extent, it becomes certain that we
will incur no liabilities for the plans as a result of the termination. During
the fourth quarter of 2004, $ 0.6 million of the liability was released. During
the fourth quarter of 2003, $0.4 million of the liability was released. The
future projected releases of the liability are $1.9 million in 2005, $0.7
million in 2006, and $0.1 million in 2007.
F-48
SCHEDULE III - SUPPLEMENTAL INSURANCE INFORMATION
UNIVERSAL AMERICAN FINANCIAL CORP.
(In thousands)
Reserves
for Policy
Deferred Future and Net Net Other
Acquisition Policy Unearned Contract Premium Investment Policyholder Net Change Operating
Costs Benefits Premiums Claims Earned Income Benefits in DAC Expense
----------- ---------- -------- -------- ---------- ---------- ------------ ---------- ---------
2004
Senior Market Health
Insurance $ 81,889 $ 122,130 $ - $ 50,743 $ 355,322 $ 4,167 $ 246,019 $ (32,878) $ 109,828
Specialty Health Insurance 66,310 472,716 - 26,276 147,781 26,351 96,836 (8,292) 59,774
Life Insurance/Annuities 60,082 646,090 - 10,623 50,037 34,207 53,461 (24,337) 41,105
Senior Managed Care -
Medicare Advantage - - - 14,448 93,011 333 66,449 - 15,042
Senior Administrative
Services - - - - - 9 - - 43,160
Corporate - - - - - 247 - - 13,398
Intersegment and other
adjustments - - - - (967) (123) (1,163) - (44,757)
----------- ---------- ----- -------- --------- ---------- ------------ --------- ---------
Segment Total $ 208,281 $1,240,936 $ - $102,090 $ 645,184 $ 65,191 $ 461,602 $ (65,507) $ 237,550
=========== ========== ===== ======== ========= ========== ============ ========= =========
2003
Senior Market Health
Insurance $ 48,909 $ 117,637 $ - $ 73,325 $ 268,057 $ 3,341 $ 184,493 $ (21,914) $ 79,482
Specialty Health Insurance 56,150 444,419 - 27,058 144,615 26,970 97,204 (10,553) 61,033
Life Insurance/Annuities 38,652 580,095 - 8,521 36,140 30,742 41,311 (18,637) 31,617
Senior Administrative
Services - - - - - 48 - - 37,143
Corporate - - - - - 190 - - 11,959
Intersegment and
other adjustments - - - - (1,844) (216) (1,474) - (38,418)
----------- ---------- ----- -------- --------- ---------- ------------ --------- ---------
Segment Total $ 143,711 $1,142,151 $ - $108,904 $ 446,968 $ 61,075 $ 321,534 $ (51,104) $ 182,816
=========== ========== ===== ======== ========= ========== ============ ========= =========
2002
Senior Market Health
Insurance $ 26,696 $ 112,470 $ - $ 63,632 $ 104,926 $ 1,853 $ 73,482 $ (10,201) $ 34,946
Specialty Health Insurance 42,836 378,351 - 24,783 134,219 27,737 88,371 (11,805) 60,172
Life Insurance/Annuities 22,561 407,931 - 6,519 28,748 27,865 31,536 (5,844) 16,916
Senior Administrative
Services - - - - - 470 - - 34,072
Corporate - - - - - 229 - - 8,803
Intersegment and
other adjustments - - - - (1,316) (438) (1,020) - (33,577)
----------- ---------- ----- -------- --------- ---------- ------------ --------- ---------
Segment Total $ 92,093 $ 898,752 $ - $ 94,934 $ 266,577 $ 57,716 $ 192,369 $ (27,850) $ 121,332
=========== ========== ===== ======== ========= ========== ============ ========= =========
See accompanying independent auditor's report
F-49