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FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

Quarterly Report Under Section 13 or 15(d) of
The Securities Exchange Act of 1934

For the three months and six months ended June 30, 2003

Commission File Number 2-39729

COTTON STATES LIFE INSURANCE COMPANY


(Exact name of registrant as specified in its charter)
     
GEORGIA   58-0830929

 
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer Identification Number)
     
244 Perimeter Center Parkway, N.E., Atlanta, Georgia   30346

 
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (770) 391-8600

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to the filing requirements for at least the past 90 days.

YES x NO o

Indicate by check mark whether the registrant is an accelerated Filer (as defined in Rule 126.2 of the Exchange Act).

YES o NO x

The Registrant as of June 30, 2003, has 6,322,737 shares of common stock outstanding.

 


 

COTTON STATES LIFE INSURANCE COMPANY

FORM 10-Q

FOR THE THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2003

INDEX

           
      Page
     
PART 1 - FINANCIAL INFORMATION
       
Item 1. Financial Statements
    1  
Independent Accountants’ Review Report
    1  
 
Consolidated Condensed Balance Sheets as of June 30, 2003 and December 31, 2002
    2  
 
Consolidated Condensed Statements of Earnings for the Three Months and Six Months Ended June 30, 2003 and 2002
    3  
 
Consolidated Condensed Statements of Cash Flows for the Six Months Ended June 30, 2003 and 2002
    4  
 
Consolidated Condensed Statements of Comprehensive Income for the Three Months and Six Months Ended June 30, 2003 and 2002
    5  
 
Notes to Unaudited Consolidated Condensed Financial Statements
    6  
Item 2. Management’s Discussion and Analysis of Consolidated Condensed Financial Condition and Results of Operations
    11  
Item 3. Quantitative and Qualitative Disclosures about Market Risk
    19  
Item 4. Controls and Procedures
    20  
PART II – OTHER INFORMATION
       
Item 1. Legal Proceedings
    21  
Item 2. Changes in Securities and Use of Proceeds
    21  
Item 3. Defaults Upon Senior Securities
    21  
Item 4. Submission of Matters to a Vote of Security Holders
    21  
Item 5. Other Information
    21  
Item 6. Exhibits and Reports on Form 8-K
    21  
SIGNATURES
    21  

 


 

INDEPENDENT ACCOUNTANTS’ REVIEW REPORT

To the Board of Directors and Shareholders of
Cotton States Life Insurance Company:

We have reviewed the accompanying consolidated condensed balance sheet of Cotton States Life Insurance Company and subsidiaries as of June 30, 2003, and the related consolidated condensed statements of earnings, comprehensive income and cash flows for the three-month and six-month periods ended June 30, 2003. These financial statements are the responsibility of the Company’s management. The consolidated condensed statements of earnings, comprehensive income and cash flows for the three-month and six-month periods ended June 30, 2002 were reviewed by other accountants whose report (dated August 6, 2002) stated that they were not aware of any material modifications that should be made to those statements for them to be in conformity with accounting principles generally accepted in the United States.

We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data, and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States, which will be performed for the full year with the objective of expressing an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the accompanying consolidated condensed financial statements at June 30, 2003, and for the three-month and six-month periods then ended for them to be in conformity with accounting principles generally accepted in the United States.

We have previously audited, in accordance with auditing standards generally accepted in the United States, the consolidated balance sheet of Cotton States Life Insurance Company and subsidiaries as of December 31, 2002, and the related consolidated statements of earnings, comprehensive income and cash flows for the year then ended and in our report dated February 25, 2003, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated condensed balance sheet as of December 31, 2002, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

  /s/ Ernst & Young LLP

Atlanta, Georgia
August 6, 2003

1


 

COTTON STATES LIFE INSURANCE COMPANY

ITEM I. CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

The following consolidated condensed financial statements have been prepared by management. In management’s opinion, all adjustments and reclassifications necessary for a fair statement of financial position at June 30, 2003 and December 31, 2002 and the results of operations for the three-months and six-months ended June 30, 2003 and 2002 have been made.

Consolidated Condensed Balance Sheets

                         
            June 30,   December 31,
            2003   2002
           
 
            (unaudited)        
ASSETS
               
Investments:
               
   
Fixed maturities, held for investment, at amortized cost (fair value of $4,556,377 in 2003 and $7,324,373 in 2002)
  $ 4,347,914       7,048,175  
   
Fixed maturities, available for sale, at fair value (amortized cost of $166,386,186 in 2003 and $146,159,339 in 2002)
    175,171,159       152,307,406  
   
Equity securities, at fair value (cost of $2,665,941 in 2003 and $2,984,720 in 2002)
    2,779,285       2,519,895  
   
First mortgage loans on real estate
    1,218,517       1,320,330  
   
Policy loans
    10,474,348       10,425,612  
   
Other invested assets
    582,000       582,000  
 
   
     
 
       
Total investments
    194,573,223       174,203,418  
Cash and cash equivalents
    8,596,820       18,913,861  
Accrued investment income
    2,427,246       2,406,298  
Amounts receivable, principally premiums
    3,859,064       3,777,671  
Amount due from reinsurers
    4,577,467       4,263,828  
Deferred policy acquisition costs
    60,597,752       57,686,410  
Federal income tax receivable
    169,028       98,457  
Other assets
    645,930       460,061  
 
   
     
 
 
  $ 275,446,530       261,810,004  
 
   
     
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Policy liabilities and accruals:
               
   
Future policy benefits
  $ 167,709,247       160,424,107  
   
Policy claims and benefits payable
    2,734,694       3,241,343  
 
   
     
 
       
Total policy liabilities and accruals
    170,443,941       163,665,450  
Federal income taxes:
               
   
Current
           
   
Deferred
    12,741,536       11,181,184  
   
Other liabilities
    6,087,005       5,592,961  
 
   
     
 
       
Total liabilities
    189,272,482       180,439,595  
 
   
     
 
Shareholders’ equity:
               
   
Common stock of $1 par value. Authorized 20,000,000 shares; issued: 6,987,331 shares in 2003 and 6,929,347 shares in 2002; outstanding: 6,322,737 shares in 2003 and 6,328,737 shares in 2002; restricted: 232,827 shares in 2003 and 174,843 shares in 2002
    6,987,331       6,929,347  
   
Additional paid-in capital
    3,762,724       3,434,018  
   
Accumulated other comprehensive income, net of tax
    5,194,607       3,226,975  
   
Retained earnings
    74,658,151       72,035,550  
   
Less:
               
     
Unearned compensation — restricted stock
    (880,701 )     (764,543 )
     
Treasury stock, at cost (431,767 shares in 2003 and 425,767 shares in 2002)
    (3,548,064 )     (3,490,938 )
 
   
     
 
       
Total shareholders’ equity
    86,174,048       81,370,409  
 
   
     
 
 
  $ 275,446,530       261,810,004  
 
   
     
 

See accompanying notes to unaudited consolidated condensed financial statements.

2


 

COTTON STATES LIFE INSURANCE COMPANY

Unaudited Consolidated Condensed Statements of Earnings
Three Months and Six Months ending June 30, 2003 and 2002

                                       
          Three months ended   Six months ended
          June 30,   June 30,
         
 
          2003   2002   2003   2002
         
 
 
 
Revenue:
                               
 
Premiums
  $ 8,824,057       8,007,993       17,023,006       15,674,310  
 
Investment income
    2,136,131       2,427,037       4,456,668       4,898,973  
 
Realized investment gains (losses)
    843,452       (48,821 )     1,235,899       108,151  
 
Brokerage commissions
    1,119,656       1,124,817       2,197,625       2,133,103  
 
 
   
     
     
     
 
     
Total revenue
    12,923,296       11,511,026       24,913,198       22,814,537  
 
 
   
     
     
     
 
Benefits and expenses:
                               
 
Benefits and claims
    5,483,542       4,628,159       10,292,718       8,984,955  
 
Interest credited
    1,465,818       1,516,837       2,968,432       2,963,067  
 
Amortization of policy acquisition costs
    1,281,489       949,468       2,307,691       1,930,734  
 
Operating expenses
    2,391,136       2,132,222       4,774,556       4,422,525  
 
 
   
     
     
     
 
     
Total benefits and expense
    10,621,985       9,226,686       20,343,397       18,301,281  
 
 
   
     
     
     
 
 
Income before income tax expense
    2,301,311       2,284,340       4,569,801       4,513,256  
 
Income tax expense
    730,459       590,622       1,437,213       1,288,370  
 
 
   
     
     
     
 
Net income
  $ 1,570,852       1,693,718       3,132,588       3,224,886  
 
 
   
     
     
     
 
Basic income per share of common stock
  $ 0.25       0.27       0.50       0.51  
 
 
   
     
     
     
 
Diluted income per share of common stock
  $ 0.23       0.26       0.47       0.50  
 
 
   
     
     
     
 
Weighted average number of shares used in computing income per share
                               
   
Basic
    6,323,363       6,339,964       6,324,328       6,337,709  
 
 
   
     
     
     
 
   
Diluted
    6,614,624       6,501,457       6,615,016       6,498,206  
 
 
   
     
     
     
 
Dividends paid per share
  $ 0.04       0.04       0.08       0.08  
 
 
   
     
     
     
 

See accompanying notes to unaudited consolidated condensed financial statements.

3


 

COTTON STATES LIFE INSURANCE COMPANY

Unaudited Consolidated Condensed Statements of Cash Flows
Six months ended June 30, 2003 and 2002

                       
          Six months ended
          June 30,
         
          2003   2002
         
 
Cash flows from operating activities:
               
 
Net income
  $ 3,132,588       3,224,886  
 
Adjustments to reconcile net income to net cash provided from operating activities:
               
   
Realized investment gains
    (1,235,899 )     (108,151 )
   
Increase in policy liabilities and accruals
    6,778,491       7,433,934  
   
(Increase) in deferred policy acquisition costs
    (2,677,528 )     (3,189,458 )
   
Increase in liability for income taxes
    396,656       163,371  
   
(Increase) decrease in amounts receivable and amounts due from reinsurers
    (395,032 )     561,429  
   
Increase (decrease) in amounts due affiliate
    246,230       (485,657 )
   
Other, net
    723,890       34,113  
 
 
   
     
 
 
Net cash provided from operating activities
    6,969,396       7,634,467  
 
 
   
     
 
Cash flows from investing activities:
               
 
Purchase of fixed maturities available for sale
    (72,369,150 )     (53,636,454 )
 
Purchase of equity securities
    (451,021 )     (1,104,600 )
 
Sale of fixed maturities held for investment
          450,000  
 
Sale of fixed maturities available for sale
    37,714,114       38,777,033  
 
Sale of equity securities
    441,175       1,084,643  
 
Proceeds from maturities of fixed maturities held for investment
    2,700,000       1,000,000  
 
Proceeds from maturity and redemption of fixed maturities held for sale
    15,456,245       7,822,348  
 
Principal collected on first mortgage loans
    101,813       131,524  
 
Net increase in policy loans
    (48,736 )     (284,514 )
 
Other, net
    (263,764 )     73,563  
 
 
   
     
 
 
Net cash used in investing activities
    (16,719,324 )     (5,686,457 )
 
 
   
     
 
Cash flows from financing activities:
               
 
Cash dividends paid
    (509,987 )     (509,987 )
 
Purchase of treasury stock
    (57,126 )     (10,453 )
 
Stock issued under executive compensation plans
          65,232  
 
 
   
     
 
 
Net cash used by financing activities
    (567,113 )     (455,208 )
 
 
   
     
 
Net (decrease) increase in cash and cash equivalents:
    (10,317,041 )     1,492,802  
 
 
   
     
 
Cash and cash equivalents:
               
 
Beginning of period
    18,913,861       13,187,601  
 
 
   
     
 
 
End of period
  $ 8,596,820       14,680,403  
 
 
   
     
 

See accompanying notes to unaudited consolidated condensed financial statements.

4


 

COTTON STATES LIFE INSURANCE COMPANY

Unaudited Consolidated Condensed Statements of Comprehensive Income
Three Months and Six Months ended June 30, 2003 and 2002

                                     
        Three months ended   Six months ended
        June 30,   June 30,
       
 
        2003   2002   2003   2002
       
 
 
 
Net income
  $ 1,570,852       1,693,718       3,132,588       3,224,886  
 
Other comprehensive income (loss), before tax:
                               
 
Change in fair value of securities available for sale
    3,149,407       2,073,243       4,217,159       29,446  
 
Reclassification adjustment for realized (gains) losses included in net income
    (843,452 )     48,821       (1,235,899 )     (108,151 )
 
   
     
     
     
 
   
Total other comprehensive income (loss), before tax
    2,305,955       2,122,064       2,981,260       (78,705 )
 
Income tax expense related to items of other comprehensive income
    784,024       838,303       1,013,628       4,100  
 
   
     
     
     
 
 
Other comprehensive income (loss), net of tax
    1,521,931       1,283,761       1,967,632       (82,805 )
 
   
     
     
     
 
   
Total comprehensive income
  $ 3,092,783       2,977,479       5,100,220       3,142,081  
 
   
     
     
     
 

See accompanying notes to unaudited consolidated condensed financial statements.

5


 

Cotton States Life Insurance Company
Notes to Unaudited Consolidated Condensed Financial Statements
June 30, 2003

Note 1 — Basis of Presentation

The accompanying consolidated condensed financial statements include the accounts of Cotton States Life Insurance Company and its wholly owned subsidiaries CSI Brokerage Services, Inc., and CS Marketing Resources, Inc. Significant intercompany transactions and balances are eliminated in the consolidation.

The consolidated condensed financial statements for the three months and six months ended June 30, 2003 are unaudited and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. These consolidated condensed financial statements should be read in conjunction with the audited consolidated financial statements and footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2002.

In the opinion of management, all adjustments and reclassifications necessary to present fairly the financial position and the results of operations and cash flows for the interim periods have been made. All such adjustments are of a normal and recurring nature. The results of operations for any interim period are not necessarily indicative of the results of operations that the Company may achieve for the entire year.

Certain prior year amounts in the accompanying consolidated condensed financial statements have been reclassified in order to conform with current year presentation.

Note 2 – Stock-Based Compensation

In accordance with APB Opinion No. 25, $270,000 and $154,000 in compensation expense was recorded in the six months ended June 30, 2003 and 2002, respectively, for the various stock option and restricted stock awards granted. Had the Company determined compensation cost based on the fair value at the grant date for its stock options and restricted stock awards under SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company’s net income, basic net income per share, and diluted net income per share would have been reduced to the pro forma amounts indicated below:

6


 

Notes to Unaudited Condensed Consolidated Financial Statements
(continued)

                     
        Three months ended
        June 30,
       
        2003   2002
       
 
Net income:
               
   
As reported
  $ 1,570,852       1,693,718  
 
   
     
 
   
Pro forma
  $ 1,555,466       1,678,332  
 
   
     
 
Basic net income per share:
               
 
As reported
  $ 0.25       0.27  
 
   
     
 
 
Pro forma
  $ 0.25       0.27  
 
   
     
 
Diluted net income per share:
               
   
As reported
  $ 0.23       0.26  
 
   
     
 
   
Pro forma
  $ 0.23       0.25  
 
   
     
 
                     
        Six months ended
        June 30,
       
        2003   2002
       
 
Net income:
               
   
As reported
  $ 3,132,588       3,224,886  
 
   
     
 
   
Pro forma
  $ 3,101,816       3,194,114  
 
   
     
 
Basic net income per share:
               
 
As reported
  $ .50       0.51  
 
   
     
 
 
Pro forma
  $ .49       0.51  
 
   
     
 
Diluted net income per share:
               
   
As reported
  $ .47       0.50  
 
   
     
 
   
Pro forma
  $ .47       0.49  
 
   
     
 

The per share weighted-average fair value of stock options and restricted stock granted was estimated using an option pricing model with the following weighted-average assumptions: expected life of three years for restricted stock awarded in 2003 and 2002; expected dividend yield of 1.67% for 2003 and 2002 grants; risk-free interest rate of 3.5% for 2003 and 2002; and an expected volatility of 66% for 2003 grants and 2002 grants.

Note 3 – Accounting Pronouncements

The Financial Accounting Standards Board issued SFAS No. 143 “Accounting for Asset Retirement Obligations,” which is effective for fiscal years beginning after June 15, 2002, with early adoption encouraged. SFAS No. 143 applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and (or) the normal operation of a long-lived asset, except for certain obligations of lessees. The adoption of SFAS No. 143 did not affect the Company’s results of operations or financial position.

7


 

The Financial Accounting Standards Board also issued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” which supercedes SFAS No. 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,” and the accounting and reporting provisions of APB Opinion No. 30 “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” and is effective for fiscal years beginning after December 15, 2001. SFAS No.144 establishes a single accounting model for the disposal of long-lived assets. The adoption of SFAS No.144 did not affect the Company’s results of operations or financial position.

The Financial Accounting Standards Board also issued SFAS No. 145 “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections,” which is effective for financial statements issued after May 15, 2002. The adoption of SFAS No. 145 did not affect the Company’s results of operations or financial position.

In July 2002, the Financial Accounting Standards Board issued SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities,” which is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The adoption of SFAS No. 146 did not affect the Company’s results of operations or financial position.

In November 2002, the Financial Accounting Standards Board issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” for which accounting requirements are effective for guarantees issued or modified after December 15, 2002. The adoption of Interpretation No. 45 did not affect the Company’s results of operations or financial position.

In December 2002, the Financial Accounting Standards Board issued SFAS No. 148 “Accounting for Stock Based Compensation – Transition and Disclosure,” which is effective for financial statements issued after December 15, 2002. The adoption of SFAS No. 148 did not affect the Company’s results of operations or financial position.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. There is no impact on the Company’s financial position or results of operations for the second quarter of 2003 under FIN 46. The Company also expects no impact in future periods under FIN 46.

Note 4 – Business Segments

The Company’s operations include the following three major segments, differentiated primarily by their respective methods of distribution and the nature of related products: individual life insurance, guaranteed and simplified issue life insurance, and brokerage operations. The Company’s operations in each segment are concentrated within its southeastern state geographic market. Individual life insurance products are distributed through the Company’s multi-line exclusive agents, guaranteed and simplified issue products are distributed through independent agents as well as exclusive agents, and brokerage operations all involve third party products distributed through the Company’s exclusive and independent agents.

8


 

The Company does not group items on the consolidated condensed balance sheet into segments, nor does it analyze those items by segment when making management decisions. Investment income is allocated to the individual life insurance and guaranteed and simplified issue life insurance segments based on their respective average future policy benefit reserves. Investment income for the brokerage operations segment is determined directly by each subsidiary’s investment portfolio.

Total revenue and net income by business segment are as follows:

                                     
        Three months ended   Six months ended
        March 31,   June 30,
        (Dollars in thousands)   (Dollars in thousands)
       
 
        2003   2002   2003   2002
       
 
 
 
Individual life insurance:
                               
 
Premiums
  $ 5,306       4,922       10,060       9,571  
 
Investment income
    1,890       2,192       3,957       4,439  
 
Realized investment (losses) gains
    749       (44 )     1,098       98  
 
   
     
     
     
 
   
Total revenue
  $ 7,945       7,070       15,115       14,108  
 
   
     
     
     
 
 
Net income
  $ 1,014       1,119       2,058       2,063  
 
   
     
     
     
 
Guaranteed and simplified issue life insurance:
                               
 
Premiums
  $ 3,518       3,086       6,963       6,103  
 
Investment income
    243       230       496       450  
 
Realized investment (losses) gains
    95       (5 )     138       10  
 
   
     
     
     
 
   
Total revenue
  $ 3,856       3,311       7,597       6,563  
 
   
     
     
     
 
 
Net income
  $ 18       20       26       126  
 
   
     
     
     
 
Brokerage:
                               
 
Commission income
  $ 1,120       1,125       2,198       2,133  
 
Investment income
    2       5       3       10  
 
   
     
     
     
 
   
Total revenue
  $ 1,122       1,130       2,201       2,143  
 
   
     
     
     
 
 
Net income
  $ 539       555       1,049       1,036  
 
   
     
     
     
 
Total revenue
  $ 12,923       11,511       24,913       22,814  
 
   
     
     
     
 
Total net income
  $ 1,571       1,694       3,133       3,225  
 
   
     
     
     
 

9


 

Note 5 — Legal Proceedings

The Company is a defendant in various actions incidental to the conduct of its business. The Company intends to vigorously defend the litigation and while the ultimate outcome of these matters cannot be estimated with certainty, management does not believe the actions will result in any material loss to the Company.

The Company has reached partial settlement regarding $900,000 in reinsurance coverage. A lawsuit was initiated by the Company in the third quarter 2001. To date, the Company has received $475,000 and continues to seek additional recoveries against reinsurance brokers through already existing legal channels. The remaining amount outstanding is included in Amounts due from reinsurers on the consolidated condensed balance sheet.

Note 6 — Income Taxes

The Company accounts for income taxes using the asset and liability method prescribed by SFAS No. 109, “Accounting for Income Taxes”. Under the asset and liability method of SFAS No. 109, 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 basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which these temporary differences are expected to be recovered or settled. Under SFAS No. 109, 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.

Income tax expense recognized by the Company in any one year is impacted by the extent to which the Company qualifies for the small life company deduction. The small life company deduction is 60% of life insurance company taxable income up to a maximum taxable income of $3 million. This deduction is phased out on taxable income above $3 million up to and including a maximum of $15 million. To the extent, if any, that the Company’s taxable income exceeds $3 million, its effective Federal income tax rate will increase.

Note 7 — Treasury Stock

During the six months ended June 30, 2003 the Company purchased 6,000 shares of its common stock, which is held in treasury. For the same period, the Company issued no shares of common stock out of treasury for its restricted stock performance award program.

There were no changes in the Company’s capital structure for the six months ended June 30, 2003.

10


 

ITEM 2 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF CONSOLIDATED CONDENSED FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

Statements made in the following discussion that state the Company’s or management’s intentions, hopes, beliefs, expectations or predictions of the future are forward-looking statements. Without limiting the foregoing, forward-looking statements include statements which represent the Company’s beliefs concerning future levels of sales and redemption of the Company’s products, investment spreads and yields, the earnings and profitability of the Company’s activities, and the sufficiency of the Company’s cash flows for liquidity purposes.

Forward-looking statements are necessarily based on estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond the Company’s control and many of which are subject to change. These uncertainties and contingencies could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable developments. Some may be national in scope, such as general economic conditions, changes in tax law and changes in interest rates. Some may be related to the insurance industry generally, such as pricing competition, regulatory developments and industry consolidation. Others may relate to the Company specifically, such as credit, volatility and other risks associated with the Company’s investment portfolio. Investors are also directed to consider other risks and uncertainties discussed in Form 10-K filed by the Company with the Securities and Exchange Commission. If the Company’s assumptions and estimates are incorrect or do not come to fruition, or if the Company does not achieve all of these key factors, then the Company’s actual performance could differ materially from the forward-looking statements made herein. The Company disclaims any obligation to update forward-looking information.

Results of Operations

                             
        Three months ended        
        June 30,        
        (Dollars in thousands)        
        2003   2002   Increase
       
 
 
Premiums
                       
Guaranteed and simplified issue life insurance
  $ 3,518       3,086       14 %
Individual life insurance:
                       
 
Traditional life
    1,906       1,814       5 %
 
Universal life
    3,400       3,108       9 %
 
   
     
         
   
Total individual life insurance
    5,306       4,922       8 %
 
   
     
         
   
Total premiums
  $ 8,824       8,008       10 %
 
   
     
         

11


 

                             
        Six months ended        
        June 30,        
        (Dollars in thousands)        
        2003   2002   Increase
       
 
 
Premiums
                       
Guaranteed and simplified issue life insurance
  $ 6,963       6,103       14 %
Individual life insurance:
                       
 
Traditional life
    3,495       3,367       4 %
 
Universal life
    6,565       6,204       6 %
 
   
     
         
   
Total individual life insurance
    10,060       9,571       5 %
 
   
     
         
   
Total premiums
  $ 17,023       15,674       9 %
 
   
     
         

Guaranteed and simplified issue life insurance premiums continued to show strong growth as a result of higher production by the independent agency force which had approximately 4,500 and 4200 agents under contract at June 30, 2003 and 2002, respectively. This product is also distributed by the Company’s multi-line exclusive agents and is available for purchase over the Internet at the Company’s home page. (www.cottonstatesinsurance.com).

Individual life insurance products are principally sold by the Company’s exclusive agent producers. Growth in individual life premiums largely reflects the popularity of universal life products. The Company had 262 exclusive agents under contract at June 30, 2003.

The rate of increases in premium growth has slowed during 2003 which the Company believes to be caused by a weakened economy, unemployment rates and the resulting alternative uses of potential customers’ resources.

Investment Income and Realized Gains and Losses

Investment income decreased 12% for the second quarter of fiscal 2003 as compared to a 5% decrease in the second quarter of fiscal 2002. For the first six months of 2003, investment income decreased 9% compared to a 4% decrease for the same period of fiscal 2002. This decrease was primarily a result of a decrease in the annualized average yield to 5.1% compared to 6.0% for the first six-months of 2002, which occurred as a result of continued pressure on lower interest rates.

During the first quarter of 2003 the Company realized a pre-tax investment loss of $356,000 from the write-down of the carrying value of twelve equity securities. These write-downs were the result of the Company determining that an other-than-temporary impairment had occurred.

During the second quarter of 2002 the Company realized an investment loss of $850,000 from a write-down of the carrying value on a Worldcom, Inc. debt security. This write-down was the result of the Company determining that an other-than-temporary impairment had occurred on the security.

12


 

The Company has procedures in place to monitor all debt and equity securities for possible other-than-temporary impairments. Securities are tracked comparing both unrealized losses as a percentage of original cost and length of time the security has been below a predetermined percentage of cost. Monthly discussions are held with Company’s investment managers to gather information and documentation as to their outlook for future recovery of the securities making the Company’s “watch list”. As of June 30, 2003 there were no debt or equity securities whose unrealized losses would be deemed to be other-than-temporary impairments.

Brokerage Commissions

Exclusive agents also sell products that the Cotton States Group does not underwrite (both life and property and casualty). Property and casualty business lines, principally non-standard auto, continue to show strong growth with commissions increasing 13% with one carrier for the first six-months of 2003 compared to the first six-months of 2002 and met management expectations for the quarter. This was partially offset by lower than expected override commissions on multi-peril Federal crop insurance, mobile home insurance and one other non-standard auto carrier. Brokerage commissions for the quarter were flat compared to the prior period due to lower than expected overrides from one non-standard auto carrier.

Benefits and Claims

Life benefits and claims, including reserve increases on traditional life and guaranteed and simplified issue products are as follows:

                                       
          Three months ended
          June 30,
          (Dollars in Thousands)
          2003   2002
         
 
          Benefits and   % of   Benefits and   % of
          Claims   Premium   Claims   Premium
         
 
 
 
Benefits and Claims
                               
Guaranteed and simplified issue
  $ 2,934       83 %     2,356       76 %
Individual life insurance
                   
 
Traditional life
    1,369       72 %     1,272       70 %
 
Universal life
    1,181       35 %     1,000       32 %
 
   
             
         
   
Total individual life insurance
    2,550       48 %     2,272       46 %
 
   
             
         
     
Total benefits and claims
  $ 5,484       62 %     4,628       58 %
 
   
             
         

13


 

                                       
          Six months ended
          June 30,
          (Dollars in Thousands)
          2003   2002
         
 
          Benefits and   % of   Benefits and   % of
          Claims   Premium   Claims   Premium
         
 
 
 
Benefits and Claims
                               
Guaranteed and simplified issue
  $ 5,645       81 %     4,590       75 %
Individual life insurance
                   
 
Traditional life
    2,477       71 %     2,273       68 %
 
Universal life
    2,171       33 %     2,122       34 %
 
   
             
         
   
Total individual life insurance
    4,648       46 %     4,395       46 %
 
   
             
         
     
Total benefits and claims
  $ 10,293       60 %     8,985       57 %
 
   
             
         

Benefits and claims as a percentage of premium fluctuate within a normal range reflecting volatility in mortality, changes in mix of business, and age of policyholders. Guaranteed and simplified issue experience in 2003 was slightly higher than Company expectations but due to the Company’s size fluctuations can and do occur in any particular quarter. Individual life insurance claims were up for the quarter as claims greater than the Company’s retention level were approximately $400,000 less than the first quarter. Year-to-date claims as a percentage of premiums were flat compared to 2002. Overall benefits and claims were within managements’ expectation. The Company offsets the effects of annual mortality fluctuations by routinely purchasing annual aggregate stop loss reinsurance coverage in excess of 120% of expected mortality.

Interest Credited to Policyholders

Interest credited to universal life contracts was flat for the first six months of 2003 compared to 2002 and decreased 3% for the quarter ended June 30, 2003 as compared to the same quarter in 2002. The annual interest rate credited to universal life contract accumulations was 5.75% for the first two months of 2003. Effective March 1, 2003 the annual interest rate credited to policyholders was changed to 5.64%. The annual interest rate credited was 5.6% for the six month period ended June 30, 2003 and 6.2% for the comparable period of 2002.

Amortization of Policy Acquisition Costs and Operating Expenses

The amortization of policy acquisition costs as a percentage of premiums was 14% for the six months ended June 30, 2003 compared to 12% for the same period of 2002. 2003 and 2002 results are within the Company’s expected range of 12-14%. Amortization for the first six months reflects better than expected mortality in the universal life line of business and a decrease in the annual interest rate credited to policyholders. Amortization for the quarter ended June 30, 2003 was higher compared to the same period of 2002 due to higher lapses in the traditional lines of business which reflects increased term rate competition in the market place.

Operating expenses as a percentage of premiums were 27% for the second quarter of 2003 and 2002. For the six months ended June 30, 2003 and 2002 the percentage was 28%. The Company’s expectations for the fiscal year 2003 are between 28-31%.

14


 

Income Tax Expense

The effective tax rate for the first six months of 2003 was 31% compared to 29% for the same period last year. The effective tax rate increased due to the effects of the estimated phase out of the small life company deduction. The effective rate reflects the Company’s best estimate of the annual effective rate.

Net Income

                             
        Three months ended        
        June 30        
        (Dollars in Thousands)        
                        Increase
        2003   2002   (Decrease)
       
 
 
Net Income
                       
Guaranteed and simplified issue
  $ 18       20       (10 %)
 
   
     
         
Individual life insurance:
                       
 
Traditional
    292       352       (17 %)
 
Universal life
    722       767       (6 %)
 
   
     
         
Total individual life insurance
    1,014       1,119       9 %
 
   
     
         
Brokerage operations
    539       555       (3 %)
 
   
     
         
   
Net Income
  $ 1,571       1,694       (7 %)
 
   
     
         
                             
        Six months ended        
        June 30        
        (Dollars in Thousands)        
                        Increase
        2003   2002   (Decrease)
       
 
 
Net Income
                       
Guaranteed and simplified issue
  $ 26       126       (79 %)
 
   
     
         
Individual life insurance:
                       
 
Traditional
    575       715       (20 )%
 
Universal life
    1,483       1,348       10 %
 
   
     
         
Total individual life insurance
    2,058       2,063        
 
   
     
         
Brokerage operations
    1,049       1,036       1 %
 
   
     
         
   
Net Income
  $ 3,133       3,225       (3 )%
 
   
     
         

Net income for the quarter and six months decreased compared to the prior periods primarily due to lower than expected sales believed to be caused by a continued weakened economy, and slightly lower investment income due to continued uncertainty with interest rates. These were partially offset by positive contributions by the Company’s subsidiaries and benefits and claim costs that, although slightly higher were within management’s expectations.

15


 

Critical Accounting Policies

The accounting policies described below are those the Company considers critical in preparing its consolidated financial statements. These polices include significant estimates made by management using information available at the time the estimates are made. However, as described below, these estimates could change materially if different information or assumptions were used.

Insurance Related Assets and Liabilities

The Company establishes an insurance related asset for deferred policy acquisition costs, and insurance related liabilities for future policy benefits and claims relating to its insurance policies under contract. Such assets and liabilities are developed using actuarial principles and assumptions which consider a number of factors, including: investment yields, withdrawal rates, mortality and morbidity. The Company accounts for its traditional individual life insurance policies using a net level premium method and assumptions as to the factors enumerated above. Generally, the Company’s earnings in any given calendar year will not be impacted by differences in emerging experience on its traditional individual business unless such differences are severe enough to call into question the profitability of the entire block of traditional life business.

The Company does, however, experience fluctuations in its earnings as a result of current mortality experience differing from that expected in any given year. For the six months ended June 30, 2003 and 2002, the Company experienced emerged mortality of 101% and 86% of amounts expected, respectively, related to its traditional individual life insurance business. The Company routinely purchases annual aggregate stop loss reinsurance coverage which limits experience to 120% of expected mortality in any one year.

The Company accounts for its interest-sensitive and universal life insurance polices and annuities under the provisions of 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 No. 97 requires the remeasurement of the Company’s deferred acquisition costs each period in a manner that amortizes such deferred costs as a level percentage of actual emerged profit over the expected gross profits.

Each period, the Company estimates the relevant factors, based primarily on its emerging experience, and uses this information to determine the assumptions underlying its asset and liability calculations. An extensive degree of judgment is used in this estimation process.

Any adjustments required to properly state insurance assets and liabilities are charged or credited to benefit expense in the period in which the need for the adjustment becomes known.

Accounting for Income Taxes

The Company accounts for income taxes using the asset and liability method prescribed by SFAS No. 109, “Accounting for Income Taxes.” Under the asset and liability method of SFAS No. 109, 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 basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which these temporary differences are expected to be recovered or settled. Under SFAS No. 109, 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.

16


 

Income tax expense recognized by the Company in any one year is impacted by the extent to which the Company qualifies for the small life company deduction. The small life company deduction is 60% of life insurance company taxable income up to a maximum taxable income of $3 million. This deduction is phased out on taxable income above $3 million up to and including a maximum of $15 million. To the extent, if any, that the Company’s taxable income exceeds $3 million, its effective Federal income tax rate will increase.

Recent Accounting Pronouncements

The Financial Accounting Standards Board issued SFAS No. 143 “Accounting for Asset Retirement Obligations,” which is effective for fiscal years beginning after June 15, 2002, with early adoption encouraged. SFAS 143 applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and (or) the normal operation of a long-lived asset, except for certain obligations of lessees. The adoption of SFAS No. 143 did not affect the Company’s results of operations or financial position.

The Financial Accounting Standards Board also issued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” which supercedes SFAS No. 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,” and the accounting and reporting provisions of APB Opinion No. 30 “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” and is effective for fiscal years beginning after December 15, 2001. SFAS No.144 establishes a single accounting model for the disposal of long-lived assets. The adoption of SFAS No.144 did not affect the Company’s results of operations or financial position.

The Financial Accounting Standards Board also issued SFAS No. 145 “Rescission of FASB Statements No. 4,44 and 64, Amendment of FASB Statement No.13, and Technical Corrections,” which is effective for financial statements issued after May 15, 2002. The adoption of SFAS No. 145 did not affect the Company’s results of operations or financial position.

In July 2002, the Financial Accounting Standards Board issued SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities,” which is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The adoption of SFAS No. 146 did not affect the Company’s results of operations or financial position.

In November 2002 the Financial Accounting Standards Board issued Interpretation NO. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees for Indebtedness of Others,” for which accounting requirements are effective for guarantees issued or modified after December 31, 2002 and disclosure requirements are effective for financial statements issued after December 15, 2002. The adoption of Interpretation No. 45 did not affect the Company’s results of operations or financial position.

In December 2002, the Financial Accounting Standards Board issued SFAS No. 148 “Accounting for Stock Based Compensation – Transition and Disclosure,” which is effective for financial statements issued after December 15, 2002. The adoption of SFAS No. 148 did not affect the Company’s results of operations or financial position.

17


 

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. There is no impact on the Company’s financial position or results of operations for the second quarter of 2003 under FIN 46. The Company also expects no impact in future periods under FIN 46.

Liquidity and Capital Resources

Cash Flow

As of June 30, 2003 the Company’s insurance operations generated positive cash flows in excess of its immediate needs. Cash flows provided by operations were $7.0 million in the first six months of 2003 compared to $7.6 million for the comparable period last year.

Operating cash flow is primarily used to purchase debt securities. The Company received proceeds of $18.2 million from investment maturities and repayments in 2003, adding to available cash flows. Such proceeds were $8.8 million in 2002. When market opportunities arise, the Company disposes of selected debt securities available for sale to improve future investment yields and/or improve duration matching of its assets and liabilities. Therefore, dispositions before maturity can vary significantly from year to year. Proceeds from sales prior to maturity were $37.7 million in 2003, and $39.2 million for the comparable period of 2002.

The Company’s principal financing activity is payment of dividends to the Company’s shareholders. Dividends are normally declared quarterly and must be approved by the Board of Directors. Under regulatory requirements, the maximum amount of dividends that may be paid in 2003 by the Company to its shareholders without prior regulatory approval is approximately $2.9 million.

Other than noted above, the Company does not have any debt, lease obligations, purchase obligations, lines of credit, guarantees, off-balance sheet arrangements, trading activities involving non-exchange traded contracts accounted for at fair value or relationships with persons or entities that derive benefits from a non-independent relationship with the Company or the Company’s related parties.

Liquidity

Liquidity pertains to a company’s ability to meet the demand for cash requirements of its business operations and financial obligations. The Company’s two sources of short-term liquidity include its positive cash flow from operations and its portfolio of marketable securities as described above. The Company believes that these sources are sufficient to meet its liquidity needs for the next 12 months.

Investments

Since December 31, 2002, there has not been a material change in mix or credit quality of the Company’s investment portfolio. All bond purchases have been available for sale and over 87% of the holdings at June 30, 2003 and 91% in December 31, 2002 are rated “A” or better by Standard & Poor’s Corporation. For all fixed maturities, 13% in 2003 and 9% in 2002 are rated BBB. Ratings of BBB- and higher are considered investment grade by the rating services.

18


 

During the second quarter of 2002, the Company sold a security out of its held-to-maturity portfolio due to evidence of a significant deterioration in the issuer’s credit worthiness. At the time of the sale the security had an amortized cost of $499,768. The Company realized a loss of $49,768 on the transaction.

Mortgage Loans

The Company’s mortgage loan policy limits the amounts of loans to no more than 80% of the collateral value on residential loans and no more than 75% of the collateral value on commercial loans. The Company grants loans only to employees (excluding officers and directors) and agents.

The geographic distribution of the loan portfolio is:

                                     
                        Book Value
Number of Loans          

          (dollars in thousands)
June 30,   December 31,           June 30,   December 31,
2003   2002   State   2003   2002

 
 
 
 
  2       2     Alabama   $ 96       100  
  6       6     Florida     263       283  
  24       25     Georgia     860       937  
 
     
             
     
 
  32       33             $ 1,219       1,320  
 
     
             
     
 

Three loans representing $89,000 in principal are over 30 days delinquent. The loan-to-value ratio on delinquent loans is 18%.

ITEM 3 — QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Credit Risk

Credit risk is the risk that issuers of securities owned by the Company will default, or other parties, including reinsurers, which owe the Company money, will not pay. The Company attempts to minimize these risks by following a conservative investment strategy and by contracting with reinsuring companies that meet high standards for rating criteria and other qualifications. The Company invests principally in government, governmental agency and high quality corporate bonds having an A rating or better. The fixed maturity portfolio had an average rating of Aa- as rated by Standard & Poor’s Corporation at June 30, 2003 and 2002.

Interest Rate Risk

Interest rate risk is the risk that interest rates will change and cause a decrease in the value of an insurer’s investments. The Company’s fixed maturity investments are subject to interest rate risk. The Company seeks to manage the impact of interest rate fluctuation through cash flow modeling, which attempts to match the maturity schedule of its assets with expected payout of its liabilities. Liabilities for interest sensitive products are carried at full account value. The fixed maturity portfolio at June 30, 2003 and June 30, 2002 had an effective duration of 4.4 years and 4.3 years, respectively.

The table below summarizes the Company’s interest rate risk and shows the effect of a hypothetical 100 basis point increase/decrease in interest rates on the fair values of the fixed investment portfolio. The selection of 100 basis point increases/decrease in interest rates should not be construed as a prediction by

19


 

the Company’s management of future market events, but rather, to illustrate the potential impact of such events. These calculations may not fully capture the impact of the changes in the ratio of long-term rates to short-term rates.

                                   
                              Hypothetical
                      Estimated Fair   Percentage
                      Value After   Increase
              Estimated Change   Hypothetical   (Decrease) In
      Estimated Value   in Interest Rates   Change in   Shareholders'
      June 30, 2003   (bp-Basis Points)   Interest Rates   Equity
     
 
 
 
      (dollars in thousands)                        
Fixed Maturities – Held for Investment
  $ 4,556     100 bp decrease     4,738       N/A  
 
          100 bp increase     4,374       N/A  
Fixed Maturities – Available
  $ 175,171     100 bp decrease     182,178       8.1 %
 
for Sale
          100 bp increase     168,164       (8.1 )%

ITEM 4. CONTROLS AND PROCEDURES

The Company’s Chief Executive Officer and Chief Accounting Officer evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in SEC Rule 13a-15(e)) as of June 30, 2003. Based on that evaluation, such officers have concluded that the Company’s disclosure controls and procedures are effective.

During the quarter ended June 30, 2003, there was no change in the Company’s control over financial reporting (as defined in SEC Rule 13a-15(f)) that has materially affected, or is reasonably likely to materially affect the Company’s internal control over financial reporting.

20


 

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

The Company is a defendant in various actions incidental to the conduct of its business. The Company intends to vigorously defend the litigation and while the ultimate outcome of these matters cannot be estimated with certainty, management does not believe the actions will result in any material loss to the Company.

The Company has reached partial settlement of a $900,000 in reinsurance coverage. A lawsuit was initiated by the Company in the third quarter of 2001. To date, the Company has received $475,000 and continues to seek additional recoveries against the reinsurance brokers through already existing legal channels. The remaining amount outstanding is included in Amounts due from reinsurers on the consolidated condensed balance sheet.

Item 2. Changes in Securities and Use of Proceeds

NONE

Item 3. Defaults Upon Senior Securities

NONE

Item 4. Submission of Matters to a Vote of Security Holders

NONE

Item 5. Other Information

NONE

Item 6. Exhibits and Reports on Form 8-K

  The Company furnished a report on Form 8-K on August 7, 2003 pursuant to Item 12 of Form 8-K, “Disclosures of Results of Operations and Financial Condition” as directed by the Securities and Exchange commission in Release No. 23-47583.

Exhibit 11 — Statement re: Computation of Per Share Earnings

Exhibit 15 — Letter Regarding Unaudited Interim Financial Information

Exhibit 31.1 — Section 302 Certification of Chief Executive Officer

Exhibit 31.2 — Section 302 Certification of Vice President of Finance

Exhibit 32 — Section 906 Certification of Chief Executive Officer and Vice President of Finance

Pursuant to the requirements 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.

     
    COTTON STATES LIFE INSURANCE COMPANY
Registrant
     
Date: 08/6/03   /s/ J. Ridley Howard
   
    J. Ridley Howard, Chairman
President and Chief Executive Officer
     
Date: 08/6/03   /s/ William J. Barlow
   
    William J. Barlow
Vice President of Finance and Assistant Treasurer

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