CERES GROUP INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

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FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002 COMMISSION FILE NUMBER 0-8483

CERES GROUP, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 34-1017531
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)

17800 ROYALTON ROAD, CLEVELAND, OHIO 44136
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(Address of principal executive offices) (Zip Code)

(440) 572-2400
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(Registrant's telephone number, including area code)

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

COMMON STOCK, PAR VALUE $0.001 PER SHARE
------------------------------------------------
(Title of class)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
YES [X] NO [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the 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 Exchange Act Rule 12b-2).
YES [X] NO [ ]

The aggregate market value of the voting and non-voting common equity held
by non-affiliates of the registrant was $97,133,537 computed based on the
closing price of $3.90 per share of the common stock on June 30, 2002.

The number of shares of common stock, par value $0.001 per share,
outstanding as of March 25, 2003 was 34,238,164.
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DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the registrant's definitive proxy statement for the annual meeting
of stockholders to be held May 20, 2003 are incorporated by reference into Part
III of this Form 10-K.
- --------------------------------------------------------------------------------

As used in this Form 10-K, the terms "Company," "Ceres," "Registrant," "we,"
"us," and "our" mean Ceres Group, Inc. and its consolidated subsidiaries, taken
as a whole, unless the context indicates otherwise. Except as otherwise stated,
the information contained in this Form 10-K is as of December 31, 2002.

CERES GROUP, INC.
INDEX TO
ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2002

PART I

ITEM 1. BUSINESS

RECENT EVENTS

Effective March 31, 2003, we sold our subsidiary, Pyramid Life Insurance
Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal
American Financial Corp., for approximately $57.5 million in cash, subject to
further adjustment based on Pyramid Life's final statutory capital and surplus
as of March 31. Net proceeds of the sale were used as follows: (1) $10.0 million
to repay a portion of our bank debt, and (2) the remainder to strengthen the
statutory capital of our subsidiary, Continental General Insurance Company.

Immediately prior to the closing of the sale, Continental General acquired
Pyramid Life's Kansas City building and personal property and retained most of
its employees. Continental General will continue to administer its senior health
business out of the Kansas City location, as well as continue to administer
Pyramid Life's business during a six to 18 month transition period. Immediately
prior to the closing, Continental General also reinsured a small block of
certain life insurance policies of Pyramid Life.

AS A RESULT OF THE SALE OF PYRAMID LIFE, THE INFORMATION PROVIDED IN THIS
SECTION "BUSINESS" DOES NOT INCLUDE PYRAMID LIFE, ITS OPERATIONS OR RESULTS,
EXCEPT WHERE INDICATED. SEE "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS -- RECENT EVENTS" AND NOTE F. DISCONTINUED
OPERATIONS AND SUBSEQUENT EVENT TO OUR CONSOLIDATED FINANCIAL STATEMENTS FOR
ADDITIONAL INFORMATION REGARDING PYRAMID LIFE.

OVERVIEW

Ceres provides a wide array of health and life insurance products to
approximately 358,000 insureds through two primary business segments. Our senior
segment includes senior health, life and annuity products for Americans age 55
and over. The medical segment includes catastrophic and comprehensive major
medical health insurance for individuals, families, associations and small
businesses. To help control medical costs, we also provide medical cost
management services to our insureds. Our nationwide distribution channels
include approximately 36,000 independent agents and QQLink, our fully
transactional online distribution system.

We acquired Continental General Insurance Company, Provident American Life
& Health Insurance Company and United Benefit Life Insurance Company to
supplement our major medical platform at Central Reserve Life Insurance Company.
In addition, we acquired selected major medical insureds of Central Benefits
Mutual Insurance Company and a block of individual and small group health
insurance written by American Chambers Life Insurance Company. We entered into
the senior market by acquiring Continental General, with its significant senior
health insurance business.

Our health and life insurance products protect individuals, families,
associations, and small employer groups during the years up to retirement, while
our Medicare supplement, long-term care, home healthcare and senior life
products provide ongoing coverage for senior Americans.

In the past, our operating results have been adversely impacted by
industry-wide and historically high medical inflation. This environment caused
us to enhance and accelerate a number of programs to lessen the inflationary
impact, including:

- target marketing;

- premium rate increases;

- modified product lines for new sales;

- proactive medical cost management; and

- lowered administrative and sales expenses.

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Our senior segment continued to produce increasing profits for 2002,
totaling $14.9 million in pre-tax profits for the year ended 2002 compared to
$13.6 million in 2001. Our medical segment improved to a pre-tax loss of $6.0
million in 2002 compared to a pre-tax loss of $13.7 million in 2001.

We believe our focus on internal growth, along with increased statutory
capital, will lead to more predictable earnings, enhanced profitability and
higher financial agency ratings of our insurance subsidiaries, which in turn
should support greater internal growth capacity.

OUR CORE BUSINESSES

SENIOR HEALTH, LIFE AND ANNUITY PRODUCTS. We continue to focus on the
senior segment because we believe this market has the potential for greater
revenue growth and higher profit potential than our medical segment. These
products are designed specifically for Americans age 55 and over, one of the
country's fastest growing age segments that is projected to increase to 103
million people by 2025. In addition, the senior population controls 72% of the
nation's wealth. Our senior products supplement other programs, such as
Medicare, and also include specialty supplemental coverages and life insurance.
According to the Centers for Medicare and Medicaid Services (CMS), the number of
Medicare enrollees, age 65 and over, nearly doubled between 1966 and 2001,
growing to 34.0 million from 19.1 million. By 2007, the Medicare population is
expected to exceed 44 million.

CATASTROPHIC AND COMPREHENSIVE MAJOR MEDICAL INSURANCE. Historically,
major medical insurance has been our core business, accounting for a greater
percentage of our revenue than our senior segment. Our medical segment includes
insurance for individuals (under age 65), families, associations and small
businesses. With increasingly stringent federal and state restrictions on small
group insurance, we emphasize the sale of individual and association products,
which offer greater flexibility in both underwriting and design compared to
small group products. The associations we market to are groups that are formed
for the purpose of providing certain goods, services and information to
individuals who pay dues to be members in the association. Individual and
association products, which are individually underwritten for each applicant,
offer greater regulatory latitude in adjusting future premium rates,
establishing premium rates based on individual risk factors and rejecting
applicants with risk factors that exceed our pricing parameters. We plan to
maintain or slightly reduce the current premium level of our medical segment by
continuing to concentrate on targeted states, strengthening relationships with
selected distributors, emphasizing our most profitable products, adjusting
premium rates as necessary to keep pace with medical inflation and by focusing
on increasing profit margins through our medical management and expense
management programs.

We market and administer preferred provider organization (PPO) and
traditional indemnity medical plans. We believe that increased costs and
consumer dissatisfaction with limitations on choice of doctors and treatment
have caused health maintenance organization (HMO) enrollments to decrease. We
believe that PPO coverage, provides greater freedom of choice of doctors and
opportunity to seek care from doctors and facilities within networks to deliver
healthcare at favorable rates compared to HMOs and traditional indemnity plans.
PPO members generally are charged periodic prepaid premiums, co-payments and
deductibles. Traditional indemnity insurance usually allows policyholders
substantial freedom of choice in selecting healthcare providers but without the
financial incentives or cost-control measures typical of managed care plans.

BUSINESS STRATEGY

Principal elements of our business strategy include:

INCREASING SENIOR MARKET FOCUS. Because of favorable demographics and
higher profit potential in the senior segment and with the strengthened
statutory capital at Continental General as a result of the Pyramid Life sale,
we intend to continue to focus our sales efforts on this part of our business.
We believe the senior market will continue to produce more predictable earnings,
particularly since these products are not as sensitive to medical inflation as
major medical products. We will be concentrating more on our agent recruiting
and a significant amount of our product development efforts on the senior
market. We also intend to transition our major medical insureds into our senior
products as they age. For the year ended December 31,
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2002, our senior segment comprised 31% of our total net premium revenues
compared to 28% for 2001. Our senior segment products are administered at our
Kansas facility.

IMPROVING UNDERWRITING AND PRODUCT DESIGN. We believe that we have
improved our underwriting through more consistent and rigorous risk evaluation
and controls that reflect current medical practices and treatment patterns. To
anticipate and respond to regulatory changes and actual market and profitability
experience, we closely monitor and manage premium rate adjustments and provide
our policyholders opportunities to adjust their co-insurance and deductible
provisions to keep their premiums affordable. We actively pursue product
redesign and curtailment of unprofitable product offerings, where necessary.

An underwriting philosophy based on rational selection of risks has
produced a number of changes to our underwriting guidelines. We have aligned our
pricing decisions to more accurately reflect the associated morbidity. Through
review of claim charges, we have also made general enhancements to our
underwriting guidelines to better reflect current medical practices and
treatment patterns.

The Health Insurance Portability and Accountability Act of 1996 (HIPAA) has
placed major restrictions on the sale of group insurance for small businesses
with two to 50 employees. In effect, HIPAA requires guaranteed issuance of major
medical insurance for small groups that meet continuing coverage and
participation guidelines. HIPAA also includes specific rules on underwriting and
coverage of pre-existing conditions. See "Government Regulation - Healthcare
Regulations."

Within our current small group business, we are more strictly enforcing
group participation and eligibility requirements to maintain profitability
targets. HIPAA allows insurance companies to require specific levels of employee
participation in group health insurance plans offered by their employers. If
participation falls below these levels, a group policy can be terminated after a
required notification period. In addition, participants must be full-time
employees of the group. Through a re-certification process, we have improved
compliance with these requirements.

Because of HIPAA and state regulatory restrictions, we place greater
emphasis on the sale of individual and association major medical products. For
2002, our major medical certificates included 70.0% for individual and
association products and 30.0% for small group products, which were consistent
with levels experienced in 2001.

One advantage of marketing individual and association products is greater
flexibility in underwriting. We can accept, reject or apply higher premium rates
to specific individuals with higher health risks. We can restrict or limit
coverage for pre-existing conditions. We also have greater ability to raise
future premium rates, if necessary, based on medical inflation and actual claims
experience of our products.

"Ceres Standards," a guideline of our best practices for underwriting of
new business, are implemented for all major medical business processed at our
insurance subsidiaries, and include standardization of organizational design,
business rules, risk selection and processing requirements.

We selectively pursue geographic markets, products and sales agencies that
provide us the greatest potential for profitability. This strategy includes
exiting markets that are unprofitable. In addition, our ongoing product design
efforts in both of our business segments keeps our product portfolio attractive
to our sales force. In our medical segment, we are emphasizing new product lines
that provide consumers with lower monthly premiums offset by greater
out-of-pocket payments for discretionary medical services and brand-name
pharmaceuticals.

ENHANCING MEDICAL COST MANAGEMENT. Our approach is to manage the cost of
healthcare. We focus on reducing medical costs for our insureds by actively
managing medical inflation and utilization rate costs. National health
expenditures have grown from $1,872 per capita in 1986 to $4,177 per capita in
1999, according to statistics compiled by CMS. Several factors have contributed
to the dramatic increase in healthcare expenditures, including increased costs
and utilization of high-technology diagnostic testing and treatments, the rising
cost of malpractice insurance, higher operating costs for hospitals and
physicians, changes in federal and state healthcare regulations, increased
utilization and cost of pharmaceuticals and the aging of the population.

3

In addition to monthly reviews of premium rate adequacy and taking actions
to adjust rates on a product and state basis as needed, we also have numerous
programs designed to lower medical costs for our insureds. Some of these
programs include:

- focusing our business with national and regional preferred provider
organizations with superior pricing and management of costs;

- use of a "Centers of Excellence" network providing our insureds access to
transplant and other necessary high-risk procedures at approximately 50
renowned medical institutions that have the staff, experience and volume
of patients to produce higher recovery rates while offering discounted
costs;

- a multiple benefit level pharmacy coverage to promote use of lower cost
drugs when possible;

- screening techniques to identify and move high-cost and high-risk
insureds as early as possible into case management programs to enhance
treatment programs and lower the long-term total medical expenses;

- a program to detect fraud and abuse by medical providers, policyholders
or agents;

- medical protocol use to avoid claims for unnecessary procedures;

- claims cost negotiation for long-term care expenses;

- product design geared to encourage use of PPOs; and

- enhanced communication to insureds on the features and benefits of these
programs, emphasizing how they can reduce their total healthcare costs.

The purpose of these programs is to provide quality care and improved treatment
outcomes while reducing total costs for both the company and our insureds. We
also offer insureds opportunities to make changes in their benefits to lower
their premium payments. Our benefit design department works with our insureds to
structure benefit packages to meet their budgets.

Our care coordination program provides our insureds with 24-hour access to
medical information, case management early intervention programs and non-network
negotiation processes to lower medical expenses, as well as additional services
to help them extend and make better use of insurance benefits.

Since the beginning of 2001, we reduced our PPO networks from 51 to 23.
This reduction has resulted in reduced network access fees and additional
provider discounts, along with quicker claims processing for our insureds.

REDUCING ADMINISTRATIVE COSTS. We are committed to reducing administrative
costs through increases in efficiency, streamlined procedures and consolidation
of operations and services. Our areas of focus include reductions in facility
management costs, printing and supply costs, travel expenses, consolidation of
corporate services, such as accounting, marketing, and distribution, and the
utilization of new electronic technology. We expect to improve our efficiency
and service as we move closer to a paperless environment. Our COAST (Ceres
Online Access SysTem) program provides direct online communication for our
agents who are able to check the status of business they submit via their
computers 24 hours a day.

We review expense variances to budgets on a monthly basis and make needed
adjustments. If cost-effective, we outsource certain functions to independent
third parties. We currently outsource all information and telephone systems at
our Cleveland headquarters, claims processing for our Central Reserve Life Ohio
insureds, and claims processing and other administrative services for the
American Chambers Life Insurance Company business and for our insurance
subsidiaries, Provident American Life and United Benefit Life. We believe this
outsourcing offers us the following advantages:

- predictable operational, administrative and systems costs;

- variable expenses based upon volume of business;

- the benefits of the vendors' expertise in specialized areas;

4

- freeing our capital to be used for other aspects of our growth strategy;

- efficiency and economies of scale; and

- system consolidation and integration.

We expect to continue streamlining operations and reducing our general and
administrative expenses through efficiency improvements and elimination of
functions that do not support our core businesses.

PRODUCTS AND SERVICES

We primarily market health, life and annuity insurance products tailored to
meet the needs of individuals, families, associations and small businesses, and
senior Americans. We have specialized teams that focus on new product
development for each of our markets. These teams review our current product
offerings and compare them with our competitors' products and changing insured
needs. We systematically review our individual and small group major medical
plans to help us further develop our product mix.

MAJOR MEDICAL. Our major medical products include catastrophic,
comprehensive and basic coverage options from PPO benefit plans to traditional
indemnity health insurance plans. Our major medical plans can also be configured
as medical savings account plans.

Because our PPO products provide for healthcare delivery at lower premium
costs than traditional indemnity plans, we emphasize our PPO products and
encourage our insureds to purchase them or convert from traditional indemnity
health insurance. Our medical networks provide favorable rates and include other
cost control measures to save money for our insureds.

Our traditional indemnity health insurance products provide coverage for
services from any qualified medical provider. Like our PPO products, our
traditional indemnity health insurance products offer access to our negotiated
network savings. Although our indemnity insureds are not required to use our
network providers, we have established programs that reduce claims costs and
out-of-pocket expenses for our insureds who do use network providers. We
communicate these cost saving methods to our insureds.

We also have a program that reduces claims costs for prescription drugs on
our medical products that include prescription drug coverage. We developed a
system with varying levels of co-payment amounts to encourage insureds to use
generic drugs and a money-saving mail-order program for all maintenance
prescription drugs.

Our Simplicity Series products are designed with higher profit margins.
These products provide higher deductibles and co-payments and are designed to
shift to consumers a greater portion of the risk for discretionary medical and
brand-name pharmaceutical benefits. This benefit structure reduces premium
payments for consumers and is designed to lower the level of future premium rate
adjustments. We are also emphasizing medical savings account plans, which
enables insureds to lower their insurance costs and have more control over their
healthcare dollars. In addition, we are marketing a new hospital-only plan.

SHORT-TERM MAJOR MEDICAL. This product provides major medical coverage for
a limited amount of time for people who, for example, are between jobs or are
recent graduates.

SMALL GROUP PRODUCTS. Our Employer's Choice product provides higher
deductibles and co-payments and lower premium payments for our small business
customers. In addition, we offer small businesses with 2-100 employees our
Partnership Plan, a major medical product in which we share the medical cost
risk with the employer. This alternate funding mechanism allows the employer to
limit expense and risk by self-insuring part of the coverage. This product can
produce a year end refund or carryover feature for low claims experience that is
attractive to businesses with healthy employees. The savings generated with this
plan can be used to provide other employee benefits.

LIFE AND ANNUITY. We also market group life insurance and annuity plans.
We offer term life insurance as an ancillary product to our major medical
insureds. We also offer various single premium deferred annuities.

5

SENIOR HEALTH INSURANCE PRODUCTS. Our senior market products include a
wide range of comprehensive and supplemental major medical benefit products,
including Medicare supplement, long-term care, home healthcare, extended
convalescent care, cancer coverage and acute recovery care that includes shorter
length facility care.

We are focusing more product development attention in our senior segment on
Medicare supplement and long-term care insurance products. Long-term care
products provide needed benefits to supplement Medicare and Medicare Supplement
coverage for nursing home and home healthcare expenses.

SENIOR LIFE INSURANCE AND ANNUITIES. Our life insurance and annuity
products include lower face amount life insurance policies offering coverages up
to $50,000 and annuity plans with first-year bonus interest or interest rate
guarantees.

SERVICES AND NON-INSURANCE PRODUCTS. We offer the Senior Savers Plus Plan,
which provides discounts on extended care and home healthcare services in
addition to the other product and service discounts. We also added our care
coordination program to most of our major medical products to provide service
enhancements for our insureds.

MARKETING AND SALES

Our distribution is critical for our continued growth. We market our
products through approximately 36,000 independent agents in 49 states, the
District of Columbia and the U.S. Virgin Islands. We have initiated a systematic
program to focus our marketing expenses on more productive agents and reduce the
number of low and non-producing agents. We compensate our agents for business
produced by them on a commission basis at rates that we believe to be
competitive with those of other life and health insurance companies.

DISTRIBUTION CHANNELS. We use a variety of distribution systems in
marketing our products. Because product lines vary among many of these
distribution systems, we have some overlap of agents between channels. Some of
our agents are licensed and contracted with more than one of our distribution
channels.

We base our four distribution channels on organization of the agents and
specific markets or products:

1. SENIOR BROKERAGE. These Continental General agents target Americans age
55 and over with a comprehensive product line.

2. MEDICAL CAREER. This channel is comprised of well-established marketing
organizations that primarily market both Central Reserve and Continental
General health insurance and supplemental health insurance.

3. MEDICAL BROKERAGE. Our Central Reserve brokerage agents concentrate on
individuals, families, associations and small business owners. The
product portfolio includes catastrophic medical coverage, individual
medical plans, small group medical plans, medical savings account plans,
basic medical coverage, short-term major medical, dental, life insurance
and annuities. These agents may represent multiple insurance carriers.

4. QQLINK ELECTRONIC DISTRIBUTION. QQLink is our fully transactional online
platform for Continental General's major medical and senior life and
health products. QQLink, founded in late 2000, combines a traditional
agent distribution system with direct online sales of insurance.
Consumers are able to review and receive premium quotes and apply for
insurance online, with or without the assistance of an agent. We believe
that QQLink will enable agents to substantially increase the client base
they serve. These agents may represent multiple insurance carriers.
QQLink is 94% owned by Ceres with the remaining 6% primarily owned by 16
of our agents.

MARKETING SUPPORT. We compete with other insurance companies and other
sales operations for our agents. In addition, we compete with other companies
that our independent agents represent. Our marketing systems concentrate on
broad product portfolios and sales support to agents. Our strategy is to provide
the tools and resources needed by the sales force, so that our agents can devote
their time to selling.

6

We provide comprehensive support programs to attract and retain agents,
including:

- competitive products and commission structures;

- advanced commissions on selected products for agents who qualify;

- lead generation programs;

- ongoing product development;

- special incentive awards to new agents;

- website development for QQLink participating agents;

- user-friendly proposal software;

- training seminars to introduce new products and sales material for our
agents; and

- consistent agent communication and quality sales materials.

CUSTOMER BASE

We had approximately 265,000 certificates and individual policies in force
as of December 31, 2002, representing approximately 358,000 insureds. One
association, Eagle Association, had approximately 24,200 certificate holders, or
9.1% of all our certificates and individual policies in force as of December 31,
2002. Each group certificate represents an insured and any spouse, children and
other dependents. The following table reflects the breakdown by product of the
group certificates and individual policies for the years ended December 31, 2002
and 2001.

The geographic distribution of direct and assumed premiums, before
reinsurance ceded, on a statutory basis of all of our subsidiaries in 2002 and
2001 is presented in the table below. The presentation on a statutory basis
differs from generally accepted accounting principles (GAAP) in that our fee
income and annuity considerations are considered premiums for statutory
purposes.

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PRICING AND UNDERWRITING

Effective, consistent and accurate underwriting is a critical element of
our profitability and depends on our ability to adequately predict claims
liability when determining the prices for our products. Premiums charged on
insurance products are based, in part, on assumptions about expected mortality
and morbidity experience and competitive factors. We have adopted and follow
"Ceres Standards," a guideline for the underwriting of new business. These
detailed uniform underwriting procedures are designed to assess and quantify
certain insurance risks before issuing individual life insurance, certain health
insurance policies and certain annuity policies to individuals. These procedures
are generally based on industry practices, reinsurer underwriting manuals and
our prior underwriting experience. To implement these procedures, we employ an
experienced professional underwriting staff.

In most circumstances, our pricing and underwriting decisions follow a
prospective rating process. A fixed premium rate is determined at the beginning
of the policy period. Unanticipated increases in medical costs may not be able
to be recovered in the current policy year. However, prior experience, in the
aggregate, is considered in determining premium rates for future periods.

Applications for insurance are reviewed on the basis of answers to
application questions. Where appropriate, based on the type and amount of
insurance applied for and the applicant's age and medical history, additional
information is required, such as medical examinations, statements from doctors
who have treated the applicant in the past, and where indicated, special medical
tests. For certain coverages, we may verify information with the applicant by
telephone. After reviewing the information collected, we either issue the policy
as applied for, issue the policy with an extra premium charge due to unfavorable
factors, issue the policy excluding benefits for certain conditions, either
permanently or for a period of time, or reject the application. For some of our
products, we have adopted simplified policy issue procedures in which the
applicant submits an application for coverage typically containing only a few
health-related questions instead of a complete medical history.

Our profitability depends on our ability to adequately increase rates for
both new business and at renewal. We have implemented procedures that permit us
to apply to regulatory authorities for corrective rate actions on a timely basis
with respect to both new business rates and the current market rates. This
allows us to analyze whether these rates sufficiently cover benefits, expenses
and commissions. For renewal business, we analyze our loss ratios and compare
them to our target loss ratios. When this analysis is complete, we immediately
implement any necessary corrective action, including rate increases.

8

CLAIMS

All claims for policy benefits are currently either processed by our claims
department or outsourced to third party administrators. We outsource claims
processing for our Central Reserve Ohio insureds and claims processing and other
administrative services for the Chambers and Provident American Life's
HealthEdge business to Antares Management Solutions, a division of Medical
Mutual Services, which is a subsidiary of Medical Mutual of Ohio. We also
outsource claims processing for the run-off business of Provident American Life
and United Benefit Life to HealthPlan Services Corporation.

We periodically utilize the services of personnel from our medical cost
management subsidiary to review certain claims. When a claim is filed, we may
engage medical cost management personnel to review the claim, including the
specific health problem of the insured and the nature and extent of healthcare
services being provided. Medical cost management personnel often assist the
insured by determining that the services provided to the insured, and the
corresponding benefits paid, are appropriate under the circumstances.

All of our claims processing, including the claims that are outsourced,
must apply the same claims management standards. In addition, we perform random
audits of both our internal and outsourced claims processing.

SYSTEMS

Our ability to continue providing quality service to our insureds and
agents, including policy issuance, billing, claims processing, commission
reports and accounting functions is critical to our ongoing success. We believe
that our overall systems are an integral part in delivering that service. We
regularly evaluate, upgrade and enhance the information systems that support our
operations.

Our business depends significantly on effective information systems. We
have many different information systems for our various businesses, including
the use of our third party vendors' systems. Our information systems require an
ongoing commitment of significant capital and human resources to maintain and
enhance existing systems and develop new systems or relationships with third
party vendors in order to keep pace with continuing changes in information
processing technology, evolving industry and regulatory standards, and changing
customer preferences. A significant portion of our support systems is obtained
from third party vendors.

Pursuant to an administrative services agreement with Antares Management
Solutions, we outsource all information and telephone systems at our Cleveland
headquarters, as well as claims processing for our Central Reserve Ohio
insureds. In addition, we outsource claims processing and other administrative
services for the Chambers and Provident American Life's HealthEdge business to
Antares. The claims processing and other administrative services for our
insurance subsidiaries, Provident American Life and United Benefit Life, prior
to their termination or replacement, are outsourced to HealthPlan Services. We
receive regular reports from our third party vendors that enable us to closely
monitor our business on those systems.

INVESTMENTS

We attempt to minimize our business risk through conservative investment
policies. Our investment objectives are to maximize yields, preserve principal
and maintain liquidity. Investments for insurance companies must comply with the
insurance laws of the state of domicile. These laws prescribe the kind, quality
and concentration of investments that may be made. Due to the restrictive nature
of these laws, there may be occasions when we may be precluded from making
certain otherwise attractive investments. We periodically evaluate these
securities. The effective durations of our investments vary from subsidiary to
subsidiary with the life insurance subsidiaries between four and five years and
the health companies between two and three years.

At December 31, 2002, approximately 99.0% of our invested assets were fixed
maturity securities, including surplus notes. At December 31, 2002, 94.0% of our
fixed maturity securities were of investment grade quality with 81.7% in
securities rated A or better (typically National Association of Insurance
Commissioners (NAIC) I) and 12.3% in securities rated BBB (typically NAIC II).
We do not invest in derivatives, such as futures, forwards, swaps, option
contracts or other financial instruments with similar characteristics.

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At December 31, 2002, our investments in mortgage-backed securities totaled
$140.9 million, or 35.5% of total invested assets. We minimize the credit risk
of our mortgage-backed securities by holding primarily issues of U.S. Government
agencies or high-quality non-agency issuers rated AA or better. Among the agency
mortgage-backed securities, which comprises 16.0% of the portfolio, the
securities are comprised of pass-through securities and planned amortization
class collateralized mortgage obligations. The pass-through securities primarily
are invested in current market coupons that should exhibit only moderate
prepayments in a declining interest rate environment, while the planned
amortization class collateralized mortgage obligations provide strong average
life protection over a wide range of interest rates. The non-agency
mortgage-backed securities, which represent 19.5% of the portfolio, consist of
commercial and jumbo residential mortgage securities. The commercial
mortgage-backed securities provide very strong prepayment protection through
lockout and yield maintenance provisions, while the residential mortgage-backed
securities are concentrated in non-accelerating securities that have several
years of principal lockout provisions.

The amortized cost and estimated fair value of invested assets as of
December 31, 2002, were as follows:

RESERVES

We establish and report liabilities or reserves on our balance sheet for
unpaid healthcare costs by estimating the ultimate cost of incurred claims that
have not yet been reported to us by our policyholders or their providers and
reported claims that we have not yet paid. Since these reserves represent our
estimates, the process requires a degree of judgment. Reserves are established
according to Actuarial Standards of Practice and generally accepted actuarial
principles and are based on a number of factors, including experience derived
from historical claims payments and actuarial assumptions to arrive at loss
development factors.

Such assumptions and other factors include:

- healthcare cost trends;

- the incidence of incurred claims;

- the extent to which all claims have been reported; and

- internal claims processing charges.

Due to the variability inherent in these estimates, reserves are sensitive to
changes in medical claims payment patterns and changes in medical cost trends. A
deterioration, or improvement, of the medical cost trend or changes in claims
payment patterns from the trends and patterns assumed in estimating reserves
would trigger a change.

10

The majority of Central Reserve's, Provident American Life's and United
Benefit Life's reserves and liabilities for claims are for the health insurance
business. The majority of Continental General's reserves and liabilities for
claims are for the life and annuity and long-term care business. For our
individual and group accident and health business, we establish an active life
reserve plus a liability for due and unpaid claims, claims in course of
settlement and incurred but not yet reported claims, as well as a reserve for
the present value of amounts not yet due on claims. These reserves and
liabilities also are impacted by many factors, such as economic and social
conditions, inflation, hospital and pharmaceutical costs, changes in doctrines
of legal liability and damage awards for pain and suffering. Therefore, the
reserves and liabilities established are necessarily based on estimates and
prior years' experience.

Liabilities for future policy reserves on ordinary life insurance have
generally been provided on a net level premium method based upon estimates of
future investment yield, mortality, and withdrawals using our experience and
actuarial judgment with an allowance for possible unfavorable deviation from the
expected experience. The various actuarial factors are determined from mortality
tables and interest rates in effect when the policy is issued.

Liabilities for interest sensitive contracts such as deferred annuities and
universal life-type contracts are based on the retrospective deposit method.
This is the full account value before any surrender charges are applied.

We may from time to time need to increase our claims reserves significantly
in excess of our initial estimates. An inadequate estimate in reserves could
have a material adverse impact on our business, financial condition and results
of operations.

REINSURANCE

GENERAL. Consistent with the general practice of the insurance industry,
we reinsure portions of the coverage provided by our insurance products to
unaffiliated insurance companies under reinsurance agreements. Reinsurance
provides a greater diversification of underwriting risk, minimizes our aggregate
exposure on major risks and limits our potential losses on reinsured business.
Reinsurance involves one or more insurance companies participating in the
liabilities or risks of another insurance company in exchange for a portion of
the premiums. Although the effect of reinsurance is to lessen our risks, it may
lower net income. We have entered into a variety of reinsurance arrangements
under which we cede business to other insurance companies to mitigate risk. We
also have assumed risk on a "quota share" basis from other insurance companies.

Under quota share reinsurance, the reinsurer assumes or cedes an agreed
percentage of certain risks insured by the ceding insurer and shares premium
revenue and losses proportionately. When we cede business to others, reinsurance
does not discharge us from our primary liability to our insureds. However, the
reinsurance company that provides the reinsurance coverage agrees to become the
ultimate source of payment for the portion of the liability it is reinsuring and
indemnifies us for that portion. However, we remain liable to our insureds with
respect to ceded reinsurance if any reinsurer fails to meet its obligations to
us.

EXISTING ARRANGEMENTS. In the ordinary course of business, we maintain
reinsurance arrangements designed to limit the maximum amount of exposure that
we retain on a given policy. For ordinary and group life claims, Continental
General's maximum retention is $125,000 and Central Reserve's maximum retention
is $50,000 with no retention maintained over age 70. For accident and health
claims, maximum retention on individual claims is $500,000. For a complete
discussion of our material reinsurance agreements, including recent reinsurance
agreements, see Note M. Reinsurance Arrangements to our consolidated financial
statements.

A significant portion of our risks are reinsured with a single reinsurance
company, Hannover Life Reassurance Company of America, a health and life
reinsurance company. Hannover accounted for 91.7% of the total premiums ceded by
our subsidiaries. Hannover has entered into reinsurance agreements with several
of our subsidiaries, including Central Reserve, Provident American Life, United
Benefit Life and Continental General. Our reinsurance agreements with Hannover
are not cancelable or terminable by Hannover. In recent

11

years, we have reduced our reliance on reinsurance. Our arrangements are
generally for closed blocks of business which means that Hannover is not
reinsuring any new sales or business of any of our subsidiaries under these
reinsurance agreements.

In July 2001, we implemented a program to terminate or replace the United
Benefit Life and Provident American Life policies. Some policyholders in some
states were offered a replacement product, HealthEdge, underwritten by Provident
American Life. Through June 30, 2002, Hannover reinsured the HealthEdge product
on the same basis as the reinsurance under the prior reinsurance agreements.
Beginning July 1, 2002, Provident American Life retained 100% of the business
and risk on the remaining HealthEdge policies in force. At the end of 2001, all
other health policies of United Benefit Life and Provident American Life were
terminated.

To evaluate the claims paying ability and financial strength of Hannover,
we review financial information provided to us by Hannover, and hold meetings
with its management to review operations, marketing, reinsurance and financial
issues. Hannover has suffered significant losses as a result of our reinsurance
agreements with respect to United Benefit Life and Provident American Life.

The total premiums ceded by our subsidiaries in 2002 to unaffiliated
reinsurers amounted to $113.0 million, of which Hannover represented
approximately 91.7%. Our gross reinsurance receivables from unaffiliated
reinsurers amounted to $170.1 million as of December 31, 2002, of which
approximately 93.6% was attributable to Hannover.

Hannover is a subsidiary of Hannover Rueckversicherungs, a German
corporation, which had assets of $29.1 billion and total stockholders' equity of
$1.5 billion at December 31, 2001. Moody's has assigned Hannover
Rueckversicherungs a financial strength rating of A2 (good). Hannover maintains
an A (excellent) rating and Hannover Rueckversicherungs maintains an A+
(superior) rating from A.M. Best Company, Inc. and a financial strength rating
of AA (rated very strong) from Standard & Poor's. Hannover's failure to pay our
claims in full or on a timely basis could have a material adverse effect on our
business, financial condition and results of operations.

Our future growth may be dependent on our ability to obtain reinsurance in
the future. While we expect to continue our relationship with Hannover in the
future, we will continue to identify new companies with respect to new
reinsurance agreements. The amount and cost of reinsurance available to us would
be subject, in large part, to prevailing market conditions beyond our control.
We may be unable to obtain reinsurance in the future, if necessary, at
competitive rates or at all.

COMPETITION

The insurance business is highly competitive. In our major medical
business, we compete with large national, regional and specialty health
insurers, including Golden Rule Resources Ltd., Mutual of Omaha Insurance Co.,
Fortis Benefits Insurance Company, American Medical Security Group, Inc.,
various Blue Cross/Blue Shield companies and United Healthcare Corporation. In
our senior business, we compete with other national, regional and specialty
insurers, including Universal American Financial Corp., Penn Treaty American
Corp., Mutual of Omaha and Conseco, Inc. Many of our competitors have
substantially greater financial resources, broader product lines, or greater
experience than we do. In addition to claims paying ratings, we compete on the
basis of price, reputation, diversity of product offerings and flexibility of
coverage, ability to attract and retain agents and the quality and level of
services provided to agents and insureds.

We face competition from a trend among healthcare providers and insurance
companies to combine and form networks in order to contract directly with small
businesses and other prospective customers to provide healthcare services. In
addition, because many of our products are marketed through independent agents,
most of which represent more than one company, we compete with other companies
for the marketing focus of each agent.

12

RATINGS

Our ratings assigned by A.M. Best Company, Inc. and other nationally
recognized rating agencies are important in evaluating our competitive position.
Best ratings are based on an analysis of the financial condition of the
companies rated. Best ratings are primarily based upon factors of concern to
policyholders and insurance agents. In January 2003, the Best ratings of our
insurance subsidiaries were affirmed. Additionally, the outlook for Central
Reserve was upgraded to stable. However, Continental General's negative rating
outlook remains unchanged due to the need to strengthen Continental General's
capital. Central Reserve's rating is a B (fair) rating. Continental General's
ratings is B+ (very good). Provident American Life's and United Benefit Life's
ratings for 2001 were affirmed NR-3 (rating procedure inapplicable). This rating
is defined by Best to mean that normal rating procedures do not apply due to
unique or unusual business features. Provident American Life and United Benefit
Life fall into this category because, due to reinsurance, they both retain only
a small portion of their gross premiums.

In December 2002, Fitch maintained Continental General's BBB (good credit
quality) financial strength rating with "rating watch evolving" and placed
Central Reserve's BB (speculative credit quality) financial strength rating on
"rating watch positive." In light of the recent statutory capitalization and
strengthened balance sheet from the sale of Pyramid Life, we are hopeful that
the major rating agencies will give favorable consideration to our financial
ratings in 2003.

GOVERNMENT REGULATION

Government regulation of health and life insurance, annuities and
healthcare coverage and health plans is a changing area of law and varies from
state to state. We strive to maintain compliance with the various federal and
state regulations applicable to our operations. To maintain compliance with
these changing regulations, we may need to make changes occasionally to our
services, products, structure or operations. We are unable to predict what
additional government regulations affecting our business may be enacted in the
future or how existing or future regulations might be interpreted. Additional
governmental regulation or future interpretation of existing regulations could
increase the cost of our compliance or materially affect our operations,
products or profitability. We carefully monitor state and federal legislative
and regulatory activity as it affects our business. We believe that we are
compliant in all material respects with all applicable federal and state
regulations.

INSURANCE REGULATION. We are subject to regulation and supervision by
state insurance regulatory agencies. This regulation is primarily intended to
protect insureds rather than investors. These regulatory bodies have broad
administrative powers relating to standards of solvency which must be met on a
continuing basis, granting and revoking of licenses, licensing of agents,
approval of policy forms, approval of rate increases, maintenance of adequate
reserves, claims payment practices, form and content of financial statements,
types of investments permitted, issuance and sale of stock, payment of dividends
and other matters pertaining to insurance. We are required to file detailed
annual statements with the state insurance regulatory bodies and are subject to
periodic examination. The most recent completed regulatory examination for
Central Reserve, Provident American Life and United Benefit Life was performed
by the State of Ohio as of December 31, 1999. For Continental General, the
examination was performed by the State of Nebraska as of December 31, 2001.
State insurance departments have also periodically conducted market conduct
examinations of our insurance subsidiaries.

Although many states' insurance laws and regulations are based on models
developed by the NAIC and are therefore similar, variations among the laws and
regulations of different states are common. The NAIC is a voluntary association
of all of the state insurance commissioners in the United States. The primary
function of the NAIC is to develop model laws on key insurance regulatory issues
that can be used as guidelines for individual states in adopting or enacting
insurance legislation. While the NAIC model laws are accorded substantial
deference within the insurance industry, these laws are not binding on insurance
companies unless adopted by state, and variation from the model laws within the
state is common.

The National Association of Insurance Commissioners revised the Accounting
Practices and Procedures Manual in a process referred to as Codification. The
revised manual was effective January 1, 2001. The
13

domiciliary states of Ceres and its insurance subsidiaries have adopted the
provisions of the revised manual. The revised manual has changed, to some
extent, prescribed statutory accounting practices and has resulted in changes to
the accounting practices that our insurance subsidiaries use to prepare their
statutory-basis financial statements. The impact of these changes to
statutory-basis capital and surplus of the insurance subsidiaries was not
significant.

The NAIC has Risk-Based Capital (RBC) requirements for life and health
insurers to evaluate the adequacy of statutory capital and surplus in relation
to investment and insurance risks associated with asset quality, mortality and
morbidity, asset and liability matching and other business factors. The RBC
formula is used by state insurance regulators to monitor trends in statutory
capital and surplus for the purpose of initiating regulatory action. In general,
under these laws, an insurance company must submit a report of its RBC level to
the insurance department of its state of domicile as of the end of the previous
calendar year. These laws require increasing degrees of regulatory oversight and
intervention as an insurance company's RBC declines. The level of regulatory
oversight ranges from requiring the insurance company to inform and obtain
approval from the domiciliary insurance commissioner of a comprehensive
financial plan for increasing its RBC to mandatory regulatory intervention
requiring an insurance company to be placed under regulatory control in a
rehabilitation or liquidation proceeding.

The RBC Model Act provides for four different levels of regulatory
attention depending on the ratio of a company's total adjusted capital, defined
as the total of its statutory capital, surplus and asset valuation reserve, to
its risk-based capital.

- The "Company Action Level" is triggered if a company's total adjusted
capital is less than 200% but greater than or equal to 150% of its
risk-based capital. At the "Company Action Level," a company must submit
a comprehensive plan to the regulatory authority that discusses proposed
corrective actions to improve its capital position. A company whose total
adjusted capital is between 250% and 200% of its risk-based capital is
subject to a trend test. The trend test calculates the greater of any
decrease in the margin (i.e., the amount in dollars by which a company's
adjusted capital exceeds its risk-based capital) between the current year
and the prior year and between the current year and the average of the
past three years, and assumes that the decrease could occur again in the
coming year. If a similar decrease in margin in the coming year would
result in a risk-based capital ratio of less than 190%, then "Company
Action Level" regulatory action would be triggered.

- The "Regulatory Action Level" is triggered if a company's total adjusted
capital is less than 150% but greater than or equal to 100% of its
risk-based capital. At the "Regulatory Action Level," the regulatory
authority will perform a special examination of the company and issue an
order specifying corrective actions that must be followed.

- The "Authorized Control Level" is triggered if a company's total adjusted
capital is less than 100% but greater than or equal to 70% of its
risk-based capital, at which level the regulatory authority may take any
action it deems necessary, including placing the company under regulatory
control.

- The "Mandatory Control Level" is triggered if a company's total adjusted
capital is less than 70% of its risk-based capital, at which level the
regulatory authority is mandated to place the company under its control.

We calculated the risk-based capital for our insurance subsidiaries as of
December 31, 2002, using the applicable RBC formula. Based on these
calculations, our risk-based capital levels for each of our subsidiaries, except
Continental General, exceeded the levels required by regulatory authorities.
Continental General's statutory capital level was below "Company Action Level"
at December 31, 2002. However, after the addition of the statutory capital
generated from the sale of Pyramid Life, Continental General's risk-based
capital level will exceed the levels required by regulatory authorities.

Dividends paid by our insurance subsidiaries to Ceres are limited by state
insurance regulations. The insurance regulator in the insurer's state of
domicile may disapprove any dividend which, together with other dividends paid
by an insurance company in the prior 12 months, exceeds the regulatory maximum
as computed for the insurance company based on its statutory surplus and net
income. In 2003, none of our
14

insurance subsidiaries can pay a dividend to Ceres without prior approval of
their respective state regulators as a result of their respective statutory
levels of unassigned surplus.

Many states have also enacted insurance holding company laws, which require
registration and periodic reporting by insurance companies controlled by other
corporations. These laws vary from state to state but typically require periodic
disclosure concerning the corporation which controls the insurer and prior
notice to, or approval by, the applicable regulator of inter-company transfers
of assets and other transactions, including payments of dividends in excess of
specified amounts by the insurer, within the holding company system. These laws
often also require the prior approval for the acquisition of a significant
direct or indirect ownership interest (for example, 10% or more) in an insurance
company. Our insurance subsidiaries are subject to these laws and we believe
they are in compliance in all material respects with all applicable insurance
holding company laws and regulations.

Additional regulatory initiatives my be undertaken in the future, either at
the federal or state level, to engage in structural reform of the insurance
industry in order to reduce the escalation of insurance costs or to make
insurance more accessible. These future regulatory initiatives could have a
material adverse effect on our business, financial condition and results of
operations.

HEALTHCARE REGULATION. Government regulation of the healthcare industry
also affects the manner in which we conduct our business. HIPAA mandates the
adoption of standards for the exchange of electronic health information in an
effort to encourage overall administrative simplification and enhance the
effectiveness and the efficiency of the healthcare industry. Ensuring privacy
and security of patient information -- "accountability" -- is one of the key
factors driving the legislation. The other factor -- "portability" -- refers to
Congress' intention to ensure that individuals may transfer insurability and
waiting periods for coverage if they change employers.

Among other things, HIPAA:

- addresses group and individual market reforms increasing the
transferability of health insurance;

- permits medical savings accounts on a trial basis; and

- increases the deductibility of health insurance for self-employed
persons.

Compliance with HIPAA's simplification mandate is required within the next
two to three years. We must comply with the following:

- standards for electronic transmission and medical procedure code sets;

- national standard healthcare provider identifier; and

- national standard employer identifier.

We have recently developed an electronic data interface (EDI) system with
one of our network providers to expedite our claims processing. Using the EDI
system, claims handled through the system for many of our insureds will be sent
directly from the medical providers to our network provider, who will image and
automatically adjust the claims to network rates. These re-priced claims will
then be electronically transmitted to our administrative facilities for
processing and payment according to policy benefits.

HIPAA's privacy requirements will govern who within our organization can
receive protected information, the manner in which it will be maintained, the
responsibility of third parties with whom we contract, and appropriate
identification at time of receipt of protected information so that it may be
appropriately controlled, maintained and retrieved as required.

The new standards:

- limit the routine and non-routine non-consensual use and release of
private health information;

- give patients new rights to access their medical records and to know who
else has accessed them;

- limit most disclosure of health information to the minimum needed for the
intended purpose;

15

- establish procedures to ensure the protection of private health
information;

- establish new criminal and civil sanctions for improper use or
disclosure; and

- establish new requirements for access to records by researchers and
others.

Final privacy rules adopted in 2001 require changes in the way health
information is handled. The privacy regulations require most covered entities to
be in compliance by April 2003. Final regulations regarding the standard formats
for the transmission of health care information have also been released and
require compliance by October 2003. We have implemented, and continue to
implement, new procedures to comply with the privacy regulations and continue to
take action to comply with the standardization regulations. The regulations will
have the effect of increasing our expenses. In recent years, we also have
implemented procedures to comply with the privacy standards for personal
information by the Gramm-Leach-Bliley Act.

We implemented procedures to comply with U.S. Department of Labor
regulations that revise claims procedures for employee benefit plans governed by
ERISA. The regulations became effective for claims filed on or after July 1,
2002 and govern the time frame for making benefit decisions for claims and
appeals and for notification of claimants' rights under the regulations.

In addition to federal regulation, many states have enacted, or are
considering, various healthcare reform statutes. These reforms relate to, among
other things, managed care practices, such as requirements with respect to
maternity stays, waiting period restrictions on pre-existing conditions, credit
for certain prior coverage, limitations on rate increases and guaranteed
renewability for small business plans and policies for individuals and
limitations on association business. Most states have also enacted patient
confidentiality laws that prohibit the disclosure of confidential medical
information. The federal privacy rule will establish minimum standards and
preempt conflicting state laws that are less restrictive than HIPAA regarding
health information privacy but will allow state laws that are more restrictive
than HIPAA. These laws or regulations may limit our operations and our ability
to control which providers are part of our networks and may hinder our ability
to effectively manage utilization and costs. We are unable to predict what state
reforms will be enacted or how they would affect our business.

Some states have also enacted small group insurance and rating reforms,
which generally limit the ability of insurers and health plans to use risk
selection as a method of controlling costs for small group businesses. These
laws may generally limit or eliminate use of pre-existing condition exclusions,
experience rating, and industry class rating and limit the amount of rate
increases from year to year. We have discontinued selling certain policies in
states where, due to these healthcare reform measures, we cannot function
profitably. We may discontinue sales in other states in the future. Our
operations also may be subject to PPO or managed care laws and regulations in
certain states. PPO and managed care regulations generally contain requirements
pertaining to provider networks, provider contracting, and reporting
requirements that vary from state to state.

One of the significant techniques we use to manage healthcare costs and
facilitate care delivery is contracting with physicians, hospitals and other
providers. As of December 31, 2002, our largest network, First Health Group
Corporation, accounted for 31.6% of our PPO certificates and policies in force.
A number of organizations are advocating for legislation that would exempt some
providers from federal and state antitrust laws. In any particular market,
providers could refuse to contract, demand higher payments or take actions that
could result in higher healthcare costs, less desirable products for insureds or
difficulty meeting regulatory or accreditation requirements. In some markets,
some providers, particularly hospitals, physician/hospital organizations or
multi-specialty physician groups, may have significant market positions or near
monopolies. In addition, physician or practice management companies, that
aggregate physician practices for administrative efficiency and marketing
leverage, continue to expand. These providers may compete directly with us. If
these providers refuse to contract with us, use their market position to
negotiate less favorable contracts or place us at a competitive disadvantage,
those activities could adversely affect our ability to market products or to be
profitable in those areas.

Congress and various states are considering some form of the "Patients'
Bill of Rights." This legislation, if enacted, is designed to provide consumers
more freedom of choice in the selection of doctors, facilities, and treatments.
Although the bill was originally conceived to regulate HMOs, it will affect all
facets of the nation's
16

healthcare delivery system, including medical providers, PPOs, exclusive
provider organizations, community-based healthcare organizations and indemnity
insurance plans. These changes, if enacted, are expected to result in higher
total medical costs, which could encourage more partnerships and associations
between medical providers and insurers to control costs, more community-based
health organizations, and greater use of higher deductibles to lower insurance
costs and reduce administrative expenses of smaller claims.

Statutory and regulatory changes may also significantly alter our ability
to manage pharmaceutical costs through restricted formularies of products
available to our members.

E-COMMERCE REGULATION. We may be subject to additional federal and state
statutes and regulations in connection with our changing product strategy, which
includes Internet services and products. On an increasingly frequent basis,
federal and state legislators are proposing laws and regulations that apply to
Internet based commerce and communications. Areas being affected by this
regulation include user privacy, pricing, content, taxation, copyright
protection, distribution and quality of products and services. To the extent
that our products and services would be subject to these laws and regulations,
the sale of our products and our business could be harmed.

EMPLOYEES

We had approximately 846 employees at December 31, 2002. We consider our
employee relations to be good. Our approximately 36,000 agents are independent
contractors and not employees.

AVAILABLE INFORMATION

Ceres Group, Inc. is a Delaware corporation. Our principal executive
offices are located at 17800 Royalton Road, Strongsville, Ohio 44136 and our
telephone number at that address is 440-572-2400.

Our annual report on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K and amendments to those reports filed or furnished pursuant
to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available
free of charge through the company's website at http://www.ceresgp.com as soon
as reasonably practicable after we electronically file such reports with the
Securities and Exchange Commission.

ITEM 2. PROPERTIES

OWNED PROPERTIES (OFFICE SPACE)

- ---------------

(1) Immediately prior to the closing of the Pyramid Life sale, Continental
General acquired Pyramid Life's building in Kansas. See Note F. Discontinued
Operations and Subsequent Event for further information.

LEASED PROPERTIES (OFFICE SPACE)

ITEM 3. LEGAL PROCEEDINGS

We are involved in various legal and regulatory actions occurring in the
normal course of business. Based on current information, we believe any ultimate
liability that may arise from these actions would not

17

materially affect our consolidated financial position or results of operations.
However, our evaluation of the likely impact of these actions could change in
the future and an unfavorable outcome could have a material adverse effect on
our consolidated financial position, results of operations or cash flow of a
future period.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

18

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock has traded on the Nasdaq National Market under the symbol
CERG since December 1998 and under the symbol CRLC before that date. The
following table shows the high and low closing prices of our common stock for
the quarters listed. These prices were taken from the Nasdaq Monthly Statistical
Reports. On March 25, 2003, our common stock closed at $1.73 per share.

As of March 25, 2003, we had 2,125 record holders.

We have not paid any cash dividends on our common stock since the end of
1996, and we do not anticipate paying any dividends in the foreseeable future.
Our credit agreement with the JPMorgan Chase, dated February 17, 1999, as
amended, contains financial and other covenants that, among other matters,
prohibit the payment of cash dividends on our common stock. For more information
on our credit agreement with Chase, see "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Liquidity and Capital
Resources."

Dividends paid by our insurance subsidiaries to us are limited by state
insurance regulations. The insurance regulator in the insurer's state of
domicile may disapprove any dividend which, together with other dividends paid
by an insurance company in the prior 12 months, exceeds the regulatory maximum
as computed for the insurance company based on its statutory surplus and net
income. In 2002, none of our direct insurance subsidiaries (Central Reserve Life
and Continental General) could pay a dividend to Ceres without the prior
approval of their respective state insurance regulators as a result of their
respective statutory levels of unassigned surplus at December 31, 2002. In 2003,
none of our direct subsidiaries can pay a dividend without the prior approval of
their respective state insurance regulators as a result of their respective
statutory levels of unassigned surplus at December 31, 2002.

19

ITEM 6. SELECTED FINANCIAL DATA

The selected consolidated financial data presented below as of and for each
of the five years ended December 31, 2002, 2001, 2000, 1999, and 1998 have been
derived from our audited consolidated financial statements. However, prior years
2001 and 2000 have been reclassed to reflect the sale of Pyramid Life. See Note
F. Discontinued Operations and Subsequent Event for further information. The
acquisitions of Provident American Life and Continental General occurred on
December 31, 1998 and February 17, 1999, respectively. These acquisitions had no
impact on our results of operations in 1998. Results for United Benefit Life are
included from August 1, 1998 to July 20, 1999 under a reinsurance agreement and
thereafter as an acquired entity. The financial information for the year ended
December 31, 1999 includes the operations of Continental General since February
1, 1999 and for Provident American Life and United Benefit Life (through
reinsurance) for the entire period. The financial information for the years
ended December 31, 2000, 2001, and 2002 includes the operations of all our
subsidiaries for the entire year except for Pyramid Life (acquired in July
2000), which is presented separately as discontinued operations, as previously
noted. This data should be read in conjunction with the more detailed
information contained in the consolidated financial statements and accompanying
notes, "Management's Discussion and Analysis of Financial Condition and Results
of Operations" and other financial information included elsewhere in this
filing.

- ---------------

(1) On December 20, 2002, we entered into a definitive agreement to sell the
stock of our subsidiary, Pyramid Life, to a subsidiary of Universal American
Financial Corp. The transaction closed on March 31, 2003 for a purchase
price of approximately $57.5 million in cash, subject to further adjustment
based on Pyramid Life's final statutory capital and surplus as of March 31,
2003. See Note F. Discontinued Operations and Subsequent Event to our
consolidated financial statements for further information.

(2) The exercise of options and warrants is not assumed when a loss from
operations is reported and the result would be antidilutive.

(3) We received proceeds from a December 2001 public offering and private
placement offerings in 2000, 1999 and 1998. For more information, see Note
B. Equity Transactions to our consolidated financial statements.

(4) "Accumulated other comprehensive income" relates primarily to the net
unrealized gain (loss) on available-for-sale securities.

21

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

This discussion should be read in conjunction with the consolidated
financial statements, notes and tables included elsewhere in this report.
Management's discussion and analysis contains forward-looking statements that
are provided to assist in the understanding of anticipated future financial
performance. However, future performance involves risks and uncertainties which
may cause actual results to differ materially from those expressed in the
forward-looking statements. See "Forward-Looking Statements."

OVERVIEW

Ceres Group, through its insurance subsidiaries, provides a wide array of
health and life insurance products to approximately 358,000 insureds through two
primary business segments. The senior segment includes senior health, life and
annuity products for Americans age 55 and over. The major medical segment
includes major medical health insurance for individuals, families, associations
and small businesses.

Ceres' insurance subsidiaries include Central Reserve Life Insurance
Company, Provident American Life & Health Insurance Company, United Benefit Life
Insurance Company and Continental General Insurance Company. Central Reserve
markets and sells major medical health insurance to individuals, families,
associations and small employer groups. Continental General markets and sells
both major medical and senior health and life products to individuals, families,
associations and Americans age 55 and over. United Benefit Life discontinued new
sales activities in July 2000 and terminated all of its existing business at the
end of 2001. United Benefit Life has no active policyholders and its business
was substantially wound down at December 31, 2002. Provident American Life also
has discontinued new sales activities and currently has approximately 3,000
active policyholders.

Effective March 31, 2003, Ceres sold its subsidiary, Pyramid Life Insurance
Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal
American Financial Corp., for approximately $57.5 million in cash, subject to
further adjustment based on Pyramid Life's statutory capital and surplus at
March 31, 2003. For more information on the Pyramid Life sale, see "Recent
Events."

CRITICAL ACCOUNTING POLICIES

Management has identified the following items that represent our most
sensitive and subjective accounting estimates that have or could have a material
impact on our financial statements. These estimates required management to make
assumptions about matters that were highly uncertain at the time the estimates
were made. Changes to these estimates occur from period to period and may have a
material impact on our financial statements. Management has discussed the
development, selection and disclosure of these estimates with our Audit
Committee.

LIABILITIES FOR OTHER POLICY CLAIMS AND BENEFITS PAYABLE. The most
significant accounting estimate in our consolidated financial statements is our
liability for other policy claims and benefits payable.

We recognize claim costs in the period the service was provided to our
insureds. However, claim costs incurred in a particular period are not known
with certainty until after we receive, process and pay the claim. The receipt
and payment date of claims may lag significantly from the date the service was
provided. Consequently, we must estimate our liabilities for claims that are
incurred but not yet paid.

Liabilities for unpaid claims are based on an estimation process that is
complex and uses information obtained from both company specific and industry
data, as well as general economic information. These estimates are developed
using actuarial methods based upon historical data for payment patterns, medical
inflation, product mix, seasonality, utilization of health care services and
other relevant factors. The amount recorded for unpaid claims liabilities is
sensitive to judgments and assumptions made in the estimation process. The most
significant assumptions used in the estimation process include determining
utilization and inflation trends, the expected consistency in the frequency and
severity of claims incurred but not yet reported,

22

changes in the timing of claims submission patterns from providers, changes in
our speed of processing claims and expected costs to settle unpaid claims.

Actual conditions 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 statement of
operations for a particular period under different conditions or using different
assumptions. As is common in the health insurance industry, we believe that
actual results may vary within a reasonable range of possible outcomes.
Management believes that our reasonable range of actual outcomes may vary up to
10% to 15% of the total liabilities for other policy claims and benefits payable
recorded at the end of a period.

Note L. Liabilities for Other Policy Claims and Benefits Payable to our
audited consolidated financial statements for the years ended December 31, 2002,
2001 and 2000 provides historical information regarding the accrual and payment
of our unpaid claims liability. Components of the total incurred claims for each
year include amounts accrued for current year estimated claims expense, as well
as adjustments to prior year estimated accruals.

Management considered the unfavorable claims experience in recent periods
when it established its liabilities for unpaid claims at December 31, 2002.
Management believes that the recorded liabilities for unpaid claims at December
31, 2002 is within a reasonable range of outcomes. Management closely monitors
and evaluates developments and emerging trends in claims costs to determine the
reasonableness of judgments made. A retrospective test is performed on prior
period claims liabilities and, as adjustments to the liabilities become
necessary, the adjustments are reflected in current operations. Management
believes that the amount of medical and other benefits payable is adequate to
cover our liabilities for unpaid claims as of December 31, 2002.

DEFERRED ACQUISITION COSTS. In connection with the sale of our insurance
policies, we defer and amortize a portion of the policy acquisition costs over
the related premium paying periods of the life of the policy. These costs
include all expenses directly related to the acquisition of the policy,
including commissions, underwriting and other policy issue expenses. The
amortization of deferred acquisition costs is determined using the same
projected actuarial assumptions used in computing policy reserves. Deferred
acquisition costs associated with traditional life and accident and health
contracts are charged to expense over the premium-paying period or as premiums
are earned over the life of the contract. Deferred acquisition costs associated
with interest-sensitive life and annuity products are charged to expense over
the estimated duration of the policies in relation to the present value of the
estimated gross profits from surrender charges and investments, mortality, and
expense margins.

We evaluate the recoverability of our deferred acquisition costs on a
quarterly basis. The recoverability of our deferred acquisition costs is
sensitive to judgments and assumptions made in projecting future cash flows on
our various blocks of business. The most significant assumptions are claim cost
trends, magnitude of rate increases, lapsation and persistency, and mortality.

During 2002 and 2001, we wrote off $4.2 million and $6.7 million,
respectively, of deferred acquisition costs associated with major medical
business in certain states due to the continuing unprofitability of the business
in that state or in which we terminated the in force policies due to continued
operating losses.

Management and our independent outside consultants believe the amount of
deferred acquisition costs as of December 31, 2002 is recoverable.

OTHER ACCOUNTING POLICIES AND INSURANCE BUSINESS FACTORS

Our results of operations are effected by the following accounting and
insurance business factors:

GOODWILL AND OTHER INTANGIBLE ASSETS. Goodwill represents the excess of
purchase price over the fair value of tangible and identifiable intangible net
assets acquired. At December 31, 2002, goodwill was $10.7 million and
represented approximately 1.2% of our total assets. Additionally, other
intangible assets represent purchased assets that also lack physical substance
but can be distinguished from goodwill because of other legal rights or because
the asset is capable of being sold or exchanged either on its own or in
combination

23

with a related contract asset or liability. At December 31, 2002, our other
intangible assets consisted of $3.6 million in licenses, or 0.4% of our total
assets.

Effective January 1, 2002, we adopted SFAS No. 142, Goodwill and Other
Intangible Assets issued by the Financial Accounting Standards Board, or FASB,
which provides that goodwill and intangibles with indefinite useful lives should
not be amortized but instead be tested for impairment annually at the reporting
unit level. In accordance with SFAS No. 142, we, together with our independent
consultants, completed a transitional goodwill impairment test, which indicated
that an impairment loss against our goodwill and other intangible assets was not
required. Goodwill and intangibles with indefinite useful lives are tested for
impairment on an annual basis and more often if indications of impairment exist.
The estimated fair value of goodwill of a reporting unit is determined by
applying the appropriate discount rates to estimated future cash flows for the
reporting unit. The estimated fair value of licenses was determined by
independent appraisals. The results of our analysis and analysis prepared by
independent consultants indicated that no reduction of goodwill and licenses was
required.

LONG-LIVED ASSETS. Property and intangible assets are reviewed for
possible impairment when events indicate that the carrying amount of an asset
may not be recoverable. Assumptions and estimates used in the evaluation of
impairment may affect the carrying value of long-lived assets, which could
result in impairment charges in future periods. Depreciation and amortization
policies reflect judgments on the estimated useful lives of assets.

REVENUE RECOGNITION. Life insurance premiums are recognized as revenue
when they become due. Health premiums are recognized as revenue over the terms
of the policies. Amounts received from interest sensitive contracts, principally
universal life and annuity products, are not reflected in premium revenue;
rather, such amounts are accounted for as deposits with the related liabilities
included in future policy benefits, losses and claims.

VALUE OF BUSINESS ACQUIRED. A portion of the purchase price paid for
Continental General Corporation was allocated to the value of business acquired
based on the actuarially-determined present value of the expected pre-tax future
profits from the business assuming a discount rate of 15.0%. Interest is accrued
on the balance annually at a rate consistent with the rate credited on the
acquired policies on the acquisition date, which ranges from 4.0% to 8.75%.
Recoverability of the value of business acquired is evaluated periodically by
comparing the current estimate of the present value of expected pre-tax future
profits to the unamoritized asset balance. If the current estimate is less than
the existing asset balance, the difference would be charged to expense, and if
the current estimate is higher than the existing asset balance, the difference
will emerge into profits as earned.

For accident and health and ordinary life business, the value of business
acquired is amortized over the estimated life of the in force business using
assumptions consistent with those in computing reserves. Interest of 6.5% for
Continental General is credited to the unamortized balance. For interest
sensitive products such as universal life and deferred annuities, the value of
business acquired is amortized over the expected profit stream of the in force
business. The expected profit stream is based upon actuarial assumptions as to
mortality, lapses and expenses. Earned interest was assumed to be 6.0% for
Continental General, the market rate at the time of acquisition.

THE NUMBER OF YEARS A POLICY HAS BEEN IN EFFECT. Claims costs tend to be
higher on policies that have been in force for a longer period of time. As the
policy ages, it is more likely that the insured will need services covered by
the policy. However, generally, the longer the policy is in effect, the more
premium we will receive for major medical and Medicare supplement policies. For
other health, life and annuity policies/contracts, reserve liabilities are
established for policy benefits expected to be paid for in future years.

LAPSATION AND PERSISTENCY. Other factors that affect our results of
operations are lapsation and persistency, both of which relate to the renewal of
insurance policies and certificates in force. Lapsation is the termination of a
policy for nonrenewal and, pursuant to our practice, is automatic if and when
premiums become more than 31 days overdue, however, policies may be reinstated,
if approved, within six months after

24

the policy lapses. Persistency represents the percentage of total certificates
in force at the end of a period less any newly-issued certificates divided by
the total certificates in force at the beginning of the period.

Policies renew or lapse for a variety of reasons, due both to internal and
external causes. We believe that our efforts to address any concerns or
questions of our insureds in an expedient fashion help to ensure ongoing policy
renewal. We work closely with our licensed agents, who play an integral role in
obtaining policy renewals and communicating with our insureds.

EXTERNAL FACTORS ALSO CONTRIBUTE TO POLICY RENEWAL OR LAPSATION. Economic
cycles can influence an insured's ability to continue to pay insurance premiums
when due. New government initiatives have raised public awareness of the
escalating costs of healthcare, which we believe boosts new sales and promotes
renewal payments.

Lapsation and persistency may positively or adversely impact future
earnings. Higher persistency generally results in higher renewal premium.
However, higher persistency may lead to increased claims in future periods.
Additionally, increased lapsation can result in reduced premium collection,
accelerated amortization of deferred acquisition cost and anti-selection of
higher-risk insureds.

REINSURANCE. Consistent with the general practice of the insurance
industry, we reinsure portions of the coverage by our insurance products to
unaffiliated insurance companies under reinsurance agreements. Reinsurance
provides a greater diversification of underwriting risk, minimizes our aggregate
exposure on major risks and limits our potential losses on reinsured business.
Reinsurance involves one or more insurance companies participating in the
liabilities or risks of another insurance company in exchange for a portion of
the premiums. Although the effect of reinsurance is to lessen our risks, it may
lower net income. We have entered into a variety of reinsurance arrangements
under which we cede business to other insurance companies to mitigate risk. We
also have assumed risk on a "quota share" basis from other insurance companies.
Our results of operations are presented net of reinsurance.

LIABILITIES FOR LITIGATION. We are involved in various litigation and
regulatory actions. Such actions typically involve disputes over policy coverage
and benefits, but may also relate to premium rates, agent and employment related
issues, regulatory compliance and market conduct, contractual relationships and
other matters. These disputes are resolved by settlement, dismissal or upon a
decision rendered by a judge, jury or regulatory official.

In determining the amount to be recorded as a litigation reserve, judgments
are generally made by management, in consultation with legal counsel and other
experts both within and outside the company, on a case-by-case basis based on
the facts and the merits of the case, the general litigation and regulatory
environment of the originating state, our past experience with outcomes of cases
in particular jurisdictions, historical results of similar cases and other
relevant factors. We closely monitor and evaluate developments and emerging
facts of each case to determine the reasonableness of judgments and assumptions
on which litigation reserves are based. Such assumptions relate to matters that
are highly uncertain. Estimates could be made based on other reasonable
assumptions or judgments that would differ materially from those estimates
recorded. We will accrue a liability if the likelihood of an adverse outcome is
probable of occurrence and the amount is estimable. We will not accrue a
liability if either the likelihood of an adverse outcome is only reasonably
possible or an estimate is not determinable. Our evaluation of the likely
outcome of these actions and the resulting estimate of the potential liability
are subject to periodic adjustments that may have a material impact on our
financial condition and results of operations of a future period.

Inherent uncertainties surround legal proceedings and actual results could
differ materially from those assumed in estimating the liabilities. The
possibility exists that a decision could be rendered against us, and, in some
circumstances, include punitive or other damage awards in excess of amounts
reserved, that may have a material impact on our financial condition, results of
operations or cash flow of a future period.

INSURANCE. We use a combination of insurance and self-insurance for a
number of risks including property, general liability, directors' and officers'
liability, workers' compensation, vehicle liability and employee-related
healthcare benefits. Liabilities associated with the risks that are retained are
estimated by considering various historical trends and forward-looking
assumptions. The estimated accruals for these
25

liabilities could be significantly affected if future occurrences and claims
differ from these assumptions and historical trends. Over the past couple of
years, the cost and availability of commercial insurance as a result of
significant changes in the insurance market have impacted our insurance
coverages. We have renewed most of our insurance policies for 2003, although at
additional premium cost and with increased exposure to losses. Other policies
are up for renewal in mid-2003. We may not be successful in obtaining coverage
on terms favorable to us or at all.

RESULTS OF OPERATIONS

We have three reportable segments:

- medical -- includes catastrophic and comprehensive major medical plans;

- senior and other -- includes Medicare supplement, long-term care, dental,
life insurance and annuities; and

- corporate and other -- includes primarily interest income, interest
expense and corporate expenses of the holding company.

All of our acquisitions were accounted for using the purchase method of
accounting. The acquisitions of Provident American Life and Continental General
had no impact on our results of operations in 1998. Results for United Benefit
Life are included from August 1, 1998 to July 20, 1999 under a reinsurance
agreement and thereafter as an acquired entity. The financial information for
the year ended December 31, 1999 includes the operations of Continental General
since February 1, 1999 and of Provident American Life for the entire year. The
financial information for the years ended December 31, 2002 and 2001 include the
operation of all our subsidiaries for the entire period with the exception of
Pyramid Life. Consistent with Statement of Financial Accounting Standards, or
SFAS, No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets,
Pyramid Life was classified as held for sale as of December 31, 2002, and was
measured at its fair value less cost to sell. Therefore, the financial
information for the years ended December 31, 2002, 2001 and 2000 excludes the
operations of Pyramid Life for all periods presented and the $11.6 million net
charge in the fourth quarter of 2002 related to the sale (each except where
specifically noted). Financial data for 2001 and 2000 has been reclassified to
reflect the sale of Pyramid Life. The net assets, results of operations, and
cash flows of Pyramid Life have been reported separately as discontinued
operations of a subsidiary in our consolidated financial statements for all
periods presented. See Note F. Discontinued Operations and Subsequent Event to
our consolidated financial statements for further information.

RECENT EVENTS

Effective March 31, 2003, we sold our subsidiary, Pyramid Life Insurance
Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal
American Financial Corp., for approximately $57.5 million in cash, subject to
further adjustment based on Pyramid Life's statutory capital and surplus as of
March 31, 2003. Net proceeds of the sale were used as follows: (1) $10.0 million
to repay a portion of our bank debt, and (2) the remainder to strengthen the
statutory capital of Continental General.

Immediately prior to the closing of the sale, Continental General acquired
Pyramid Life's Kansas City building and personal property and retained most of
its employees. Continental General will continue to administer its senior health
business out of the Kansas City location, as well as continue to administer
Pyramid Life's business during a six to 18 month transition period. Immediately
prior to the closing, Continental General also reinsured a small block of
certain life insurance policies of Pyramid Life.

After the transaction, Continental General has approximately $55.0 million
in statutory capital and surplus with a risk based capital ratio in excess of
350%, an increase of approximately $21.0 million from December 31, 2002. In
addition, after the transaction, we have $13.7 million in outstanding bank debt
compared to $25.0 million at year end.

At December 31, 2002, Pyramid Life had assets of $157.8 million, net
premiums of $98.0 million, net revenues of $104.8 million and net income from
operations of $7.1 million.

26

2002 COMPARED TO 2001

- ---------------

N/M = not meaningful

27

NET PREMIUMS (NET OF REINSURANCE CEDED)

For the year ended December 31, 2002, total net premiums were $540.1
million, a decrease of 2.8%, from $555.5 million for 2001.

MEDICAL

Medical premiums for 2002 were $370.0 million compared to $402.2 million
for 2001, a decrease of 8.0%. The decrease in medical premiums was primarily the
result of a 28% decrease in major medical certificates in force due to our
decision in July 2001 to terminate or replace the policies at United Benefit
Life and Provident American Life, to cancel other medical business in certain
states and to target market in more profitable states, offset by the increase in
new and renewal premiums averaging 20% to 30%.

SENIOR AND OTHER

Senior and other premiums were $170.1 million for 2002 compared to $153.3
million for 2001, an increase of 11.0%. The increase in senior and other
premiums was primarily the result of premium rate increases averaging 10% to 12%
on business in force.

OTHER REVENUES

Net investment income was $24.3 million for 2002 compared to $25.3 million
for 2001, a decrease of 4.1%, due primarily to lower interest rates.

Net realized gains were $2.3 million for 2002 and 2001. Realized gains were
primarily a result of the sale of corporate bonds, which reduced the corporate
bond sector. Cash was reinvested in agency backed planned amortization class
mortgage securities, thirty year pass-throughs, and U.S. Government Agency
bonds. Gains in 2002 were partially offset by the write-down for
other-than-temporary impairment of $0.9 million on bonds held in WorldCom.
Additionally, Pyramid Life had a $0.8 million write-down for
other-than-temporary impairment on bonds held in WorldCom, which is reflected in
discontinued operations.

Fee and other income decreased to $30.7 million for 2002 compared to $36.2
million for 2001, a decrease of 15.1%. This decrease was primarily attributable
to a smaller volume of business in force in the medical segment due to the
United Benefit Life and Provident American Life termination or replacement
program and the cancellation of other medical business in certain states.

The amortization of deferred reinsurance gain of $2.8 million for 2002
represented the recognition of the ceding commission allowances received under
our reinsurance agreements. The unamortized amount of $11.0 million at December
31, 2002 was accounted for as a deferred reinsurance gain on the consolidated
balance sheet. The amortization of deferred reinsurance gain decreased from $5.0
million for 2001 as a result of lower amortization due to diminishing levels of
in force certificates.

BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES

Total benefits, claims, losses and settlement expenses decreased to $421.0
million for 2002 compared to $443.8 million for 2001, a decrease of 5.1%.

MEDICAL

Medical benefits, claims, losses and settlement expenses were $291.8
million for 2002 compared to $328.8 million for 2001, a decrease of 11.3%. The
decrease was primarily the result of a smaller volume of business in force due
to the termination or replacement program, cancellation of other medical
business as previously mentioned. The medical loss ratio was 78.9% for 2002
compared to 81.7% for 2001. The medical loss ratio decreased due to the
termination or replacement program and the cancellation of business in poor
performing markets, as well as, pricing increases and benefit changes to keep
pace with medical inflation. However, the decrease was partially offset by a
higher severity of claims than anticipated in the December 31, 2001 claim
inventory.

28

SENIOR AND OTHER

Senior and other benefits, claims, losses and settlement expenses were
$129.2 million for 2002 compared to $115.0 million for 2001, an increase of
12.3%. The increase was a result of additional claims and benefits paid on a
larger volume of business in force and reserve strengthening of $2.5 million on
a block of long-term care business. The senior and other loss ratio increased to
76.0% for 2002 compared to 75.0% for 2001, primarily due to higher than
anticipated long-term care benefits.

OTHER EXPENSES AND NET INCOME

Selling, general and administrative expenses decreased to $175.2 million in
2002 compared to $197.0 million in 2001, a decrease of 11.1%. Commissions
decreased $19.9 million and other operating expenses decreased $19.4 million as
a direct result of our cancelled or replaced business offset by reduced
reinsurance allowances of $17.5 million resulting from a lower volume of ceded
premiums. As a percentage of revenues, selling, general and administrative
expenses have decreased to 29.2% in 2002 compared to 31.6% in 2001 due to a
reduced workforce at our Cleveland facility, economies of scale achieved from
the conversion of the senior business to our Kansas City facility, and a
decrease in the overall commission rate.

The net (deferral) amortization and change in acquisition costs (DAC) and
value of business acquired (VOBA) resulted in a net deferral of $3.8 million for
2002 compared to a net deferral of $21.7 million for 2001. The decrease in the
net deferral was primarily attributable to lower capitalization of DAC due to
decreases in new business sales and a $1.3 million increase in the amortization
of VOBA. The Company also wrote-off $4.2 million in DAC in 2002 compared to $6.7
million in 2001 due to the unprofitability of the major medical business in
certain states.

Interest expense and financing costs decreased to $2.0 million in 2002
compared to $4.7 million in 2001 as a result of a decrease in outstanding debt
and declining interest rates.

The special charge for 2002 represented a pre-tax non-recurring charge of
$2.7 million ($2.4 million in continuing operations and $0.3 million in
discontinued operations) related to the retirement of Peter W. Nauert, our
former CEO. See Note P. Special Charges to our consolidated financial statements
for further information. Special charges of $7.1 million in the first quarter of
2001 represented a $5.9 million write-off of the DAC asset for United Benefit
Life and Provident American Life and a $1.2 million write-off of costs
associated with United Benefit Life. The DAC asset was written off due to the
planned termination of this business.

Federal income tax expense was $1.3 million, or 39.4% of the income before
federal taxes, for 2002. In 2001, a federal income tax benefit was established
of $1.8 million, or 24.5% of the loss before federal taxes. The higher effective
tax rate in 2002 was primarily due to changes in pre-tax income (loss) in
relation to permanent differences. Specifically, the 50% elimination on meals
and entertainment expenses and certain other non-deductible expenses.

Income from continuing operations was $2.1 million, or $0.06 per share, for
2002 compared to a loss of $5.5 million, or $0.31 per share, for 2001. Income
from the operations of Pyramid Life (classified as discontinued operations) was
$7.1 million, or $0.21 per share, for 2002 compared to $7.9 million, or $0.44
per share, for 2001. Therefore, income including continuing and discontinued
operations (excluding loss on sale of Pyramid Life) for 2002 was $9.2 million,
or $0.27 per share, compared to $2.3 million, or $0.13 per share, for 2001. The
loss on the sale of Pyramid Life recorded in the fourth quarter of 2002 was
$11.6 million, or $0.34 per share. As a result of the foregoing, for 2002, net
loss attributable to common stockholders was $2.4 million, or $0.07 basic and
diluted loss per share of common stock, compared to net income attributable to
common stockholders of $5.2 million, or $0.29 basic and diluted income per share
of common stock, for 2001.

29

2001 COMPARED TO 2000

- ---------------

N/M = not meaningful

30

NET PREMIUMS (NET OF REINSURANCE CEDED)

For the year ended December 31, 2001, total net premiums were $555.5
million, an increase of 15.2%, from $482.4 million for 2000.

Medical premiums for 2001 were $402.2 million compared to $372.8 million
for 2000, an increase of 7.9%. The increase in medical premiums was primarily
the result of new sales, premium rate increases and reduced premiums ceded under
reinsurance agreements. This increase was offset by our decision to terminate or
replace the policies at United Benefit Life and Provident American Life and the
cancellation of other medical business in certain states.

Senior and other premiums were $153.3 million for 2001 compared to $109.6
million for 2000, an increase of 39.9%. The increase in senior and other
premiums was primarily the result of increased Medicare supplement sales and
premium rate increases.

OTHER REVENUES

Net investment income increased to $25.3 million for 2001 from $24.2
million for 2000, an increase of 4.6%, due primarily to a higher investment
base.

Net realized gains (losses) increased to $2.3 million for 2001 from a net
realized loss of $0.1 million for 2000 as a result of the sale of 30-year
mortgage pass-through securities which reduced prepayment risk, and the sale of
callable agency bonds which reduced call risk. Portfolio durations were also
shortened to reduce the impact on bond values in a potentially rising interest
rate environment. Cash was reinvested in corporate bonds and planned
amortization class non-agency mortgage securities, which provide average life
protection in a fluctuating interest rate environment. These gains were
marginally offset by the write-down for other than temporary impairment of $0.8
million recorded on the two commercial collateralized, mortgage-backed bonds
with leasehold interests in the World Trade Center complex, most of which was
destroyed by terrorists on September 11, 2001. No default has occurred on
contractual payments for these securities.

Fee and other income increased to $36.2 million for 2001 compared to $32.6
million for 2000, an increase of 10.9%. This net increase was attributable to
new administrative fees introduced at Continental General in May 2000, fees
received on a larger volume of business in force and partially offset by the
United Benefit Life and Provident American Life termination or replacement
program and the cancellation of other medical business in certain states.

The amortization of deferred reinsurance gain of $5.0 million for 2001
represented the recognition of the ceding commission allowances received under
our reinsurance agreements. The unamortized amount of $13.9 million at December
31, 2001 was accounted for as a deferred reinsurance gain on the consolidated
balance sheet.

BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES

Total benefits, claims, losses and settlement expenses increased to $443.8
million for 2001 compared to $370.6 million for 2000, an increase of 19.8%.

Medical benefits, claims, losses and settlement expenses were $328.8
million for 2001 compared to $286.4 million for 2000, an increase of 14.8%. The
increase was a result of higher than anticipated benefit utilization in 2001
versus 2000 in the medical segment related to increased costs of services,
greater utilization of medical services and greatly increased expenditures on
prescription drugs, and a larger volume of business in force. Additionally, for
these same reasons, a $17.0 million deficiency in 2000 reserves emerged in 2001.
The medical loss ratio was 81.7% for 2001 compared to 76.8% for 2000. The
increase was due to the above mentioned items.

Senior and other benefits, claims, losses and settlement expenses were
$115.0 million for 2001 compared to $84.2 million for 2000, an increase of
36.7%. The increase was a result of claims and benefits paid on a larger volume
of business in force. The senior and other loss ratio decreased to 75.0% for
2001 compared to 76.8% for 2000, primarily attributable to increased volume of
new premiums and lower benefit utilization.
31

OTHER EXPENSES AND NET INCOME

Selling, general and administrative expenses increased to $197.0 million in
2001 compared to $176.4 million in 2000, an increase of 11.7%. The increase in
selling, general and administrative expenses represented a $5.4 million decrease
in commissions, a $5.5 million increase in other operating and reinsurance
expenses attributable to our increased business base, and reduced reinsurance
allowances of $20.5 million resulting from a lower volume of ceded premiums. As
a percentage of revenues, selling, general and administrative expenses have
decreased to 31.6% in 2001 compared to 32.3% in 2000.

The net (deferral) amortization and change in acquisition costs (DAC) and
value of business acquired (VOBA) resulted in a net deferral of $21.7 million
for 2001 compared to a net deferral of $28.0 million for 2000. The decrease was
primarily attributable to the write-off of DAC of approximately $6.7 million in
six states due to the continuing unprofitability of the major medical business
in those states.

Interest expense and financing costs decreased to $4.7 million in 2001
compared to $5.6 million in 2000 as a result of lower interest rates and lower
debt outstanding.

Special charges of $7.1 million in the first quarter of 2001 represented a
$5.9 million write-off of the DAC asset for United Benefit Life and Provident
American Life and a $1.2 million write-off of costs associated with United
Benefit Life. See Note P. Special Charges to our consolidated financial
statements for further information. The DAC asset was written off due to the
planned termination of the business.

A federal income tax benefit of $1.8 million, or 24.5% of the loss before
federal taxes, was established for 2001. The 2000 effective rate was 33.5%. The
decrease in the effective tax rate resulted from changes in pre-tax income
(loss) in relation to permanent differences. Specifically, the 50% elimination
on meals and entertainment expenses and certain other non-deductible expenses.

As a result of the foregoing, for 2001, net income was $2.3 million and net
income attributable to common stockholders was $5.2 million, or $0.29 basic and
diluted earnings per share of common stock, compared to net income of $16.5
million and net income attributable to common stockholders was $16.1 million, or
$1.06 basic and $1.00 diluted earnings per share of common stock, for 2000.
Excluding the United Benefit Life and Provident American Life operating losses
and special charges, net income attributable to common stockholders would have
been $17.9 million, or $1.00 per diluted share, for 2001.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity is our ability to generate adequate amounts of cash to meet our
financial commitments. Our major needs for cash are to enable our insurance
subsidiaries to pay claims and expenses as they come due and for Ceres to pay
interest on, and to repay principal of, its indebtedness. The primary sources of
cash are premiums, investment income, fee income, equity and debt financings,
and reimbursements from reinsurers. Payments consist of current claim payments
to insureds, medical cost management expenses, operating expenses such as
salaries, employee benefits, commissions, taxes and interest on debts. Net cash
used in operating activities in 2002 was $17.6 million due primarily to the
funding of a $17.3 million reinsurance trust established at December 31, 2001
and a significant reduction in the major medical claim inventory during 2002.

Assets decreased 6.4% to $887.5 million (including $157.8 million for
Pyramid Life) at December 31, 2002 from $947.7 million at December 31, 2001.
Assets of $397.1 million, or 44.7% of the total assets, were in investments at
December 31, 2002. Fixed maturities, our primary investment, were $388.1
million, or 97.7% of total investments, at December 31, 2002. Other investments
consist of surplus notes, policy loans and mortgage loans. We have classified
all of our fixed maturities as "available-for-sale" and accordingly have
reported them at estimated fair value at December 31, 2002.

Approximately 94.0% of our bonds were of investment grade quality at
December 31, 2002. In addition to the fixed maturities, we also had $32.1
million in cash and cash equivalents of which, $7.7 million was restricted at
December 31, 2002.

32

The total reinsurance receivable was $170.1 million at December 31, 2002.
Of this amount, $153.9 million represents reserves held by our reinsurers under
our various reinsurance treaties in place. Hannover holds most of these
reserves. Additionally, total reinsurance receivable includes a $7.1 million
receivable for investments held in trust under a commuted reinsurance agreement.

The total policy liabilities and benefits accrued were 71.1% of the total
liabilities at December 31, 2002 compared to 71.6% at December 31, 2001.

CREDIT AGREEMENT. To provide funds for the acquisition of Continental
General, on February 17, 1999, we entered into a credit agreement among Ceres,
various lending institutions, and JPMorgan Chase (formerly the Chase Manhattan
Bank) as Administrative Agent. Under the agreement, we borrowed $40.0 million
under a tranche A term loan and secured a $10.0 million revolver. The credit
agreement was amended on July 25, 2000 to increase the revolver from $10.0
million to $15.0 million in connection with the acquisition of Pyramid Life. Any
amount outstanding on the revolver had to be repaid on February 17, 2002. The
revolver bore interest at the same rate choices as the tranche A term loan. On
February 17, 2002, the balance of the revolver was permanently repaid from
proceeds of our December 2001 public offering.

On March 30, 2001, this credit agreement was amended to enter into a new
$10.0 million term loan with CIT Equipment Financing, Inc. The proceeds of this
term loan, the tranche B term loan, were used to permanently pay down $10.0
million of our then fully-drawn $15.0 million revolver agreement. The terms of
this amendment provide for CIT Group to participate equally with the syndicate
of banks and Chase under the credit agreement.

Interest on the outstanding balance of the term loans is determined based
on our selection each quarter of either a Base Rate Loan or a Eurodollar Loan.
Under the Base Rate Loan, the interest rate will be 2.5% per annum plus the
higher of (a) the rate which is 0.50% of 1.0% in excess of a federal funds rate
or (b) Chase's prime rate as in effect from time to time. Under the Eurodollar
Loan, the interest rate will be 3.5% per annum plus a Eurodollar rate, which is
the arithmetic average of the offered quotation to first-class banks in the
interbank Eurodollar market by Chase, adjusted for certain reserve requirements.
The interest rate of the tranche B term loan is 0.5% per annum higher than the
above rates. At December 31, 2002, the interest rate on our tranche A term loan
balance of $16.0 million was 4.9% per annum and our $9.0 million CIT tranche B
term loan was 5.4% per annum.

The credit agreement, as amended, contains financial and other covenants
that among other things:

- prohibit the payment of cash dividends on, or the repurchase of, shares
of our common stock;

- restrict the creation of liens and sales of assets;

- requires us to repay the term loans with 25% of the net cash proceeds
from any future sale or issuance of our equity, excluding warrants and
compensation awards or plans; and

- require that we, at a minimum, maintain:

- a leverage ratio (consolidated debt to consolidated total capital)
of 0.30 to 1.00;

- an interest coverage ratio (consolidated earnings before interest,
income taxes, depreciation, and amortization to consolidated
interest expense) of 3.00 to 1.00;

- a risk-based capital (RBC) ratio at year end for any of our
regulated insurance company subsidiaries of not less than 125.0% of
the RBC Company Action level;

- consolidated net worth, excluding goodwill, of no less than the sum
of (i) $85.0 million plus (ii) 80% of the net proceeds from the
equity offering excluding the $5.0 million repurchase of our
convertible voting preferred stock plus (iii) 50% of our aggregate
consolidated net income calculated quarterly; and

- a fixed charge coverage ratio of not less than 1.05 to 1.00 through
June 30, 2003, and 1.10 to 1.00 thereafter.

33

Effective March 31, 2003, the credit agreement was amended in connection
with the sale of Pyramid Life. The amendment:

- permits the sale of Pyramid Life;

- requires $10.0 million of sale proceeds to be used as a partial pay down
of bank debt;

- waives the minimum risk-based capital ratio requirement of 125% for
Continental General at December 31, 2002;

- excludes intercompany tax sharing payments in the calculation of the
fixed charge coverage ratio at December 31, 2002;

- increases the interest rate on the tranche A and tranche B term loans for
the Base Rate Loans to Base Rate plus 3.0% and 3.5%, respectively and for
the Eurodollar Loans to LIBOR plus 4.0% and 4.5%, respectively;

- restructured the tranche A term loan debt payments as follows: quarterly
principal payments of $547,000 through November 17, 2003, $509,000
through November 17, 2004, and a payment of approximately $5,040,000 on
February 17, 2005; and

- restructured the tranche B term loan debt payments as follows: quarterly
principal payments of $223,000 through December 17, 2003, $216,000 on
March 17, 2004, $412,000 through December 17, 2004, $434,000 on March 17,
2005, and $820,000 through December 17, 2005.

We do not have transactions or relationships with "special purpose"
entities, and we do not have any off balance sheet financing other than normal
operating leases.

The following schedule summarizes current and future contractual
obligations as of December 31, 2002:

The following schedule summarizes current and future contractual
obligations as of December 31, 2002 after giving effect to the March 31, 2003
$10.0 million partial pay down of our long-term debt:

In addition, the common stock of Central Reserve, Continental General, and
most of our non-regulated subsidiaries are pledged as security for the credit
agreement. At December 31, 2002, we were in compliance with our credit
agreement, as amended or waived.

We believe that cash flow from operating activities will be sufficient to
meet the currently anticipated operating and capital expenditure requirements of
our subsidiaries over the next 12 months. Funds to meet our debt obligations are
generated from fee income from our non-regulated subsidiaries. Our ability to
make scheduled payments of the principal and interest on our indebtedness
depends on our future performance and the future performance of our
non-regulated subsidiaries, which are subject to economic, financial,
competitive and other factors beyond our control. Fee income is derived from
fees charged primarily on our major

34

medical business. As that business declines, fee income declines. Dividends from
our regulated insurance subsidiaries are subject to, and limited by, state
insurance regulations. In 2003, none of our insurance subsidiaries (Central
Reserve and Continental General) can pay a dividend to Ceres Group, the parent
company, without prior approval of their respective state regulators as a result
of their respective statutory levels of unassigned surplus. If our non-regulated
subsidiaries do not generate sufficient fee income to service all of our debt
obligations, there may be a material adverse effect on our business, financial
condition and results of operations, and a significant adverse effect on the
market value of our common stock. In addition, if necessary, additional
financing may not be available on terms favorable to us or at all.

NET OPERATING LOSS CARRYFORWARD

At December 31, 2002, we had a tax net operating loss, or NOL, carryforward
of approximately $21.7 million for federal income tax purposes, which expires
through 2015. Changes in ownership, as defined by Sections 382 and 383 of the
Internal Revenue Code, could limit the amount of NOL carryforwards used in any
one year. Our December 2001 public offering resulted in an "ownership change" as
defined in Section 382 of the Code and the regulations issued thereunder.
Pursuant to Section 382, our ability to use our NOLs originating prior to the
offering, accounting for approximately $21.7 million, is subject to certain
restrictions, including an annual limitation of approximately $5.4 million.
Losses incurred subsequent to this offering are available without annual
limitation to offset future income.

We determine a valuation allowance of our deferred tax asset based on an
analysis of amounts recoverable in the statutory carryback period and available
tax planning strategies. In assessing the valuation allowance established at
December 31, 2002 and 2001, estimates were made as to the potential financial
impact of recent NOLs and our financial condition.

FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS FROM CONTINUING OPERATIONS

The following table presents the revenues, expenses and profit (loss) from
continuing operations before federal income taxes, for the last three years
attributable to our industry segments. We do not separately allocate investments
or other identifiable assets by industry segment, nor are income tax expenses
(benefits) allocated by industry segment.

MARKET RISK AND MANAGEMENT POLICIES

The following is a description of certain risks facing health and life
insurers and how we mitigate those risks:

Inadequate Pricing Risk is the risk that the premium charged for insurance
and insurance related products is insufficient to cover the costs associated
with the distribution of such products, including benefits, claims and losses,
settlement expenses, acquisition expenses and other corporate expenses. We
utilize a variety of actuarial and qualitative methods to set such pricing
levels. Any negative fluctuation in our estimates of the effect of continued
medical inflation and high benefit utilization could have a material adverse
impact on our results of operations.

Legal/Regulatory Risk is the risk that changes in the legal or regulatory
environment in which an insurer operates will create additional expenses not
anticipated by the insurer in pricing its products. For example, regulatory
initiatives designed to reduce insurer profits or otherwise affecting the
industry in which the insurer operates, new legal theories or insurance company
insolvencies through guaranty fund assessments, may create costs for the insurer
beyond those recorded in the financial statements. We attempt to mitigate this
risk by offering a wide range of products and by operating in many states, thus
reducing our exposure to any single product and by employing underwriting
practices that identify and minimize the adverse impact of this risk.

36

In addition, insurance companies are subject to extensive federal and state
regulation and compliance with these regulations could increase the insurance
companies' operating costs. In some circumstances, failure to comply with
certain insurance regulations could subject an insurance company to regulatory
actions by such insurance company's state of domicile. For example, states have
statutory risk-based capital, or RBC, requirements for health and other
insurance companies based on the RBC Model Act. These RBC requirements are
intended to assess the capital adequacy of life and health insurers, taking into
account the risk characteristics of an issuer's investments and products. In
general, under these laws, an insurance company must submit a report of its RBC
level to the insurance department of its state of domicile as of the end of the
previous calendar year. These laws provide for four different levels of
regulatory attention depending on the ratio of an insurance company's total
adjusted capital (defined as the total of its statutory capital, surplus and
asset valuation reserve) to its risk-based capital. As of December 31, 2002, our
risk-based capital levels for each of our insurance subsidiaries, except for
Continental General, exceeded the levels required by regulatory authorities.
Continental General's statutory capital level was below "Company Action Level"
at December 31, 2002. However, after the addition of the capital generated from
the sale of Pyramid Life, Continental General's risk-based capital level
exceeded the levels required by regulatory authorities.

Investment Impairment Risk is the risk that all amounts due (both principal
and interest) on our fixed maturity investments will not be collected according
to the security's contractual terms. We attempt to minimize this risk by
adhering to a conservative investment strategy. With the exception of short-term
investments and securities on deposit with various state regulators, investment
responsibilities have been delegated to external investment managers within the
investment parameters established by the company.

Our external investment managers prepare a monthly investment surveillance
list to analyze our fixed maturity portfolio for potential other-than-temporary
impairment. The following factors are reviewed for inclusion on our surveillance
list:

- debt downgrades or other events that adversely affects an investee's
access to, or cost of, financing;

- negative economic factors and conditions specific to the issuers
industry;

- adverse changes in the regulatory environment specific to the issuers
industry;

- all spread changes exceeding 50 basis points; or

- corporate bond prices that move more then 10% over the past week, 20%
over the past month, or 30% over the past three months.

All of our fixed maturity investments are reported at fair market value at
December 31, 2002. The amortized cost and estimated fair value of fixed
maturities on our investment surveillance list at December 31, 2002 were $10.1
million and $8.3 million, respectively.

Credit Risk is the risk that parties, including reinsurers that have
obligations to us, will not pay or perform. We attempt to minimize this risk by
maintaining sound reinsurance and credit collection policies.

Interest Rate Risk is the risk that interest rates will change and cause a
decrease in the value of an insurer's investments. This change in rates may
cause certain interest-sensitive products to become uncompetitive or may cause
disintermediation if we attempt to mitigate this risk by charging fees for
non-conformance with certain policy provisions and/or by attempting to match the
maturity schedule of our assets with the expected payouts of its liabilities. To
the extent that liabilities come due more quickly than assets mature, we would
have to sell assets prior to maturity and recognize a gain or loss. Assuming an
immediate increase of 100 basis points in interest rates, the net hypothetical
decline in fair value of stockholders' equity is estimated to be $13.6 million
after-tax at December 31, 2002. This amount represents approximately 8.1% of our
stockholders' equity at such date.

We also have long-term debt that bears interest at variable rates.
Therefore, our results of operations would be affected by interest rate changes.
We do not expect a significant rate change in the near future that would have a
material effect on our near-term results of operations.

37

Seasonality is the risk of fluctuations of revenues and operating results.
Historically, our revenues and operating results have varied from quarter to
quarter and are expected to continue to fluctuate in the future. These
fluctuations have been due to a number of factors, including higher benefit
utilization by our insureds during the winter months and the use of deductibles.
More specifically, our senior segment's seasonality is the opposite of our
medical segment's, meaning that earnings in the senior segment are generally
lower in the first quarter and higher later in the year. This is mainly a factor
of our Medicare Supplement products that pay the Medicare deductible for our
insureds generally during the early months of the year.

IMPACT OF INFLATION

Inflation rates impact our financial condition and operating results in
several areas. Changes in inflation rates impact the market value of the
investment portfolio and yields on new investments.

Inflation has had an impact on claim costs and overall operating costs and
although it has been lower in the last few years, hospital and medical costs
have still increased at a higher rate than general inflation, especially
prescription drug costs. New, more expensive and wider use of pharmaceuticals is
inflating health care costs. We will continue to establish premium rates in
accordance with trends in hospital and medical costs along with concentrating on
various cost containment programs. However, there can be no assurance that these
efforts by us will fully offset the impact of inflation or that premiums will
equal or exceed increasing healthcare costs.

FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. Forward-looking statements are necessarily based on
estimates and assumptions that are inherently subject to significant business,
economic and competitive uncertainties and contingencies, many of which, with
respect to future business decisions, are subject to change. These uncertainties
and contingencies can affect actual results and could cause actual results to
differ materially from those expressed in any forward-looking statements made
by, or on behalf of, us.

In particular, forward-looking statements can be identified by the use of
words such as "may," "will," "should," "expect," "anticipate," "estimate,"
"continue" or similar words. In light of the risks and uncertainties inherent in
all future projections, the inclusion of forward-looking statements in this
report should not be considered as a representation by us or any other person
that our objectives or plans will be achieved. Numerous factors could cause our
actual results to differ materially and adversely from those in the
forward-looking statements, including those risks outlined above in "Market Risk
and Management Policies," and the following:

- unforeseen losses with respect to loss and settlement expense reserves
for unreported and reported claims or adverse changes in persistency or
profitability of insurance contracts that would accelerate the
amortization of our deferred acquisition costs;

- our ability to implement increases in premium rates and to develop,
distribute and administer competitive products and services in a timely,
cost-effective manner;

- rising healthcare costs, especially the rising costs of prescription drug
costs that are rising faster than other medical costs, and rising
utilization rates;

- developments in healthcare reform and other regulatory issues, including
the Health Insurance Portability and Accountability Act of 1996 and
increased privacy regulation, and changes in laws and regulations in key
states in which we operate;

- our ability to meet risk-based or statutory capital requirements and the
outcome of our efforts to meet these capital requirements;

- our ability to continue to meet the terms of our debt obligations under
our credit agreement which contains a number of significant financial and
other covenants;
38

- the adequacy of funds, including fee income, received from our
non-regulated subsidiaries, and the restrictions on our insurance
subsidiaries' ability to pay dividends to Ceres, to meet our debt
obligations;

- the performance of others on whom we rely for reinsurance, particularly
Hannover Life Reassurance Company of America upon whom we have relied for
substantially all of our reinsurance;

- the risk of material adverse outcomes in litigation;

- the risk of selling investments to meet liquidity requirements;

- our ability to obtain additional debt or equity financing on terms
favorable to us to facilitate our long-term growth;

- the risk that issuers of securities owned by Ceres will default or that
other parties will not pay or perform;

- our financial and claims paying ratings, including any potential
downgrades;

- our ability to maintain our current PPO network arrangements;

- dependence on senior management and key personnel;

- the performance of others on whom we rely for administrative and
operations services;

- changes in accounting and reporting practices;

- the failure to successfully manage our operations and integrate future
acquisitions, if any, including the failure to achieve cost savings;

- payments to state assessment funds;

- business conditions and competition in the healthcare industry;

- changes in tax laws; and

- our ability to fully collect all agent advances.

The factors listed above should not be constructed as exhaustive. We
undertake no obligation to release publicly the results of any future revisions
we may make to forward-looking statements to reflect events or circumstances
after the date of this report or to reflect the occurrence of unanticipated
events.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities, which supercedes Emerging Issues Task Force,
or EITF, Issue No. 94-3, Liability Recognition for Certain Employee Termination
Benefits and other Costs to Exit an Activity (Including Certain Costs Incurred
in a Restructuring). The provisions of this Statement are effective for exit or
disposal activities initiated after December 31, 2002. SFAS No. 146 requires
recognition of a liability for costs associated with an exit or disposal
activity when the liability is incurred, rather than when the entity commits to
an exit plan under EITF Issue No. 94-3. This Statement applies to costs
associated with an exit activity that does not involve an entity newly acquired
in a business combination or with a disposal activity covered by SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets. Additionally,
this Statement does not apply to costs associated with the retirement of a
long-lived asset covered by SFAS No. 143, Accounting for Asset Retirement
Obligations. We anticipate that the adoption of this standard will not have a
material effect on our results of operations, financial position or liquidity.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections. This Statement rescinds SFAS No. 4, Reporting Gains and Losses from
Extinguishment of Debt, SFAS No. 44, Accounting for Intangible Assets of Motor
Carriers, and SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements. This Statement amends SFAS No. 13, Accounting for Leases, to
eliminate an inconsistency between the
39

required accounting for sale-leaseback transactions and the required accounting
for certain lease modifications that have economic effects that are similar to
sale-leaseback transactions. This Statement also amends other existing
authoritative pronouncements to make various technical corrections, clarify
meanings, or describe their applicability under changed conditions.

The provisions of SFAS No. 145, related to the rescission of SFAS No. 4,
require any gain or loss on extinguishment of debt that was classified as an
extraordinary item in prior periods presented that does not meet the criteria in
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, for classification as an
extraordinary item to be reclassified. The adoption of SFAS No. 145 on May 15,
2002 did not have a material effect on our results of operations, financial
position or liquidity.

In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement
Obligations, which addressed financial accounting and reporting for obligations
associated with the retirement of tangible long-lived assets and the associated
asset retirement costs. This Statement is effective for financial statements
issued for fiscal years beginning after June 15, 2002. The adoption of this
standard on June 15, 2002 did not have a material effect on our results of
operations, financial position or liquidity.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

See "Market Risk and Management Policies" section under Item 7. --
Management's Discussion and Analysis of Financial Condition and Results of
Operations.

40

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

CERES GROUP, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND
FINANCIAL STATEMENT SCHEDULES

41

REPORT OF INDEPENDENT AUDITORS

Stockholders and Board of Directors
Ceres Group, Inc.

We have audited the accompanying consolidated balance sheets of Ceres
Group, Inc. and subsidiaries as of December 31, 2002 and 2001, and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each of the three years in the period ended December 31, 2002. We have also
audited the information presented in the financial statement schedules listed in
the Index at Item 15(a). These financial statements and financial statement
schedules are the responsibility of Ceres Group's management. Our responsibility
is to express an opinion on these consolidated financial statements and
financial statement schedules based on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the 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 financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Ceres Group,
Inc. and subsidiaries at December 31, 2002 and 2001, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2002, in conformity with accounting principles
generally accepted in the United States. Also in our opinion, the related
financial statement schedules when considered in relation to the basic
consolidated financial statements taken as a whole, present fairly, in all
material respects, the information set forth therein.

As described in Notes A, F and J, Ceres Group adopted Statements of
Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets,and
No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, as of
January 1, 2002.

Ernst & Young LLP

Cleveland, Ohio
March 4, 2003, except for
Notes A, F, and O as to which
the date is March 31, 2003

42

CERES GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

DECEMBER 31, 2002 AND 2001
(DOLLARS IN THOUSANDS)
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

The accompanying notes are an integral part of these consolidated financial
statements.
43

CERES GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

The accompanying notes are an integral part of these consolidated financial
statements.
44

CERES GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

The accompanying notes are an integral part of these consolidated financial
statements.
45

CERES GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(DOLLARS IN THOUSANDS)
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

The accompanying notes are an integral part of these consolidated financial
statements.
46

CERES GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2002, 2001 AND 2000
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

A. SUMMARY OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES

SUMMARY OF BUSINESS

Ceres Group, Inc. operated in 1998 and prior periods primarily through its
wholly-owned subsidiary, Central Reserve Life Insurance Company. As of December
31, 2002, 2001 and 2000, the Company's consolidated statements also include the
continuing operations of Provident American Life & Health Insurance Company
acquired on December 31, 1998, Continental General Corporation and its
wholly-owned subsidiary, Continental General Insurance Company, acquired on
February 17, 1999, and United Benefit Life Insurance Company under a reinsurance
arrangement effective August 1, 1998 and acquired on July 21, 1999 (through
foreclosure), and the discontinued operations of Pyramid Life Insurance Company
acquired on July 26, 2000. On December 20, 2002, we entered into a definitive
agreement to sell the stock of Pyramid Life. See Note F. Discontinued Operations
and Subsequent Event for further information. As a result of the sale of Pyramid
Life, our previously reported consolidated financial statements for 2001 and
2000 have been reclassified to present the discontinued operations of Pyramid
Life separate from continuing operations to conform to the current year's
presentation.

We provide, through our insurance subsidiaries, a wide array of health and
life insurance products to over 358,000 insureds. While we, through our
subsidiaries, are licensed in 49 states, the District of Columbia and the U.S.
Virgin Islands, approximately 61.3% of our total premium volume is generated
from ten states: Ohio, Florida, Texas, Pennsylvania, Indiana, Georgia, Missouri,
Illinois, Kansas and Nebraska.

Unless the context indicates otherwise, "we," "our," and "us" refers to
Ceres Group, Inc. and its subsidiaries on a consolidated basis.

SIGNIFICANT ACCOUNTING POLICIES

PRINCIPLES OF CONSOLIDATION

The accompanying consolidated financial statements include the continuing
operations of Ceres and its wholly-owned subsidiaries, except for Pyramid Life,
which is included in discontinued operations. All intercompany transactions have
been eliminated in consolidation.

The accompanying financial statements have been prepared in accordance with
accounting principles generally accepted in the United States, which differ from
accounting practices prescribed or permitted by the various state departments of
insurance in which the insurance subsidiaries are domiciled. See Note S.
Statutory Financial Information for further information.

BUSINESS COMBINATIONS

All of our acquisitions were accounted for using the purchase method of
accounting. Additionally, since the issuance of Statement of Financial
Accounting Standards, or SFAS, No. 141, Business Combinations, by the Financial
Accounting Standards Board, or FASB, business combinations initiated after June
30, 2001, are required to be accounted for by the purchase method. Results of
operations of the acquired business are included in the income statement from
the date of acquisition. Additionally, SFAS No. 141 expanded the criteria for
recording intangible assets separate from goodwill.

The FASB staff also issued Emerging Issues Task Force, or EITF, D-100:
Clarification of Paragraph 61(b) of FASB Statement No. 141 and Paragraph 49(b)
of FASB No. 142, which further clarified what the FASB staff believed was the
Board's intent for reclassifying an intangible asset out of goodwill of a
previously acquired intangible asset.

47

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED

DECEMBER 31, 2002, 2001 AND 2000
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

Accordingly, following the guidance of both SFAS No. 141 and EITF D-100 and
in conjunction with our goodwill testing (see Goodwill and Other Intangible
Assets below), we have reclassed licenses of $3.6 million as a separate
indefinite-lived intangible asset from goodwill.

GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill represents the excess of purchase price over the fair value of
tangible and identifiable net assets acquired. Other intangible assets are
defined as purchased assets that also lack physical substance but can be
distinguished from goodwill because of contractual or other legal rights or
because the asset is capable of being sold or exchanged either on its own or in
combination with a related contract, asset or liability.

On January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible
Assets. Under the provisions of SFAS No. 142, goodwill is no longer ratably
amortized into the income statement over an estimated life, but rather is tested
at least annually for impairment. Intangible assets which have finite lives
continue to be amortized over their estimated useful lives and also continue to
be subject to impairment testing. Prior to the adoption of SFAS No. 142,
goodwill was amortized on a straight-line basis over periods of 25 years or
less. See Note J. Goodwill and Other Intangible Assets for a summary of our
goodwill and other intangible assets, as well as further detail related to the
impact of the adoption of SFAS No. 142.

USE OF ESTIMATES

The preparation of the consolidated financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts reported in
the financial statements and accompanying notes. Actual results could differ
from those estimates.

CASH AND CASH EQUIVALENTS

Cash and cash equivalents include cash and all liquid securities with
maturities of 90 days or less when purchased. See Note D. Cash and Investments
for further information.

INVESTMENTS

Investments in bonds and mandatorily redeemable preferred stocks are
designated at purchase as held-to-maturity or available-for-sale.
Held-to-maturity investments are securities which management has the positive
intent and ability to hold until maturity, and are reported at amortized cost.
Available-for-sale investments and surplus notes are stated at fair value, with
unrealized holding gains and losses reported in accumulated other comprehensive
income (loss), net of deferred federal income taxes. All investments as of
December 31, 2002 are designated as available-for-sale.

Investments in policy notes and mortgage loans are reported at cost which
approximates fair value.

Premiums and discounts arising from the purchase of mortgage-backed
securities are amortized using the interest method over the estimated remaining
term of the securities, adjusted for anticipated prepayments. Premiums and
discounts on other debt instruments are amortized using the interest method over
the remaining term of the security.

Realized gains and losses on the sale of investments are determined using
the specific-identification method, and are credited or charged to income. Also
charged to income are unrealized losses on investment securities for which a
decline in fair market value is deemed to be other than temporary.

The estimated fair value of investments is based upon quoted market prices,
where available, or on values obtained from independent pricing services.

48

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DECEMBER 31, 2002, 2001 AND 2000
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OTHER-THAN-TEMPORARY DECLINES IN FAIR VALUE

We regularly review our investment portfolio for factors that may indicate
that a decline in fair value of an investment is other-than-temporary. Some
factors considered in evaluating whether or not a decline in fair value is other
than temporary include:

- our ability and intent to retain the investment for a period of time to
allow for a recovery in value;

- the duration and extent to which the fair value has been less than cost;
and

- the financial condition and prospects of the issuer.

DEFERRED ACQUISITION COSTS

Certain excess policy acquisition costs associated with issuing an
insurance policy, including commissions and underwriting, all of which vary with
and are primarily related to the production of new business, have been deferred
and reported as deferred acquisition costs. Deferred acquisition costs
associated with traditional life and accident and health contracts are charged
to expense over the premium-paying period or as premiums are earned over the
life of the contract. Deferred acquisition costs associated with
interest-sensitive life and annuity products are charged to expense over the
estimated duration of the policies in relation to the present value of the
estimated gross profits from surrender charges and investments, mortality, and
expense margins.

The Company evaluates the recoverability of deferred acquisition costs on a
quarterly basis and determines that these amounts are recoverable.

PROPERTY AND EQUIPMENT AND PROPERTY HELD FOR SALE

Property and equipment are carried at cost less allowances for depreciation
and amortization. Office buildings are depreciated on the straight-line method
over 31.5 years, except for certain components, which are depreciated over 15
years. Depreciation for other property and equipment is computed on the
straight-line basis over the estimated useful lives of the equipment,
principally five and seven years. Property held for sale is stated at estimated
fair value less cost to sell. No depreciation or amortization is provided for
property held for sale.

MEASUREMENT OF IMPAIRMENT OF LONG-LIVED ASSETS

Effective January 1, 2002, we adopted SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. This Statement superseded 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
Accounting Principles Board Opinion, or 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, for the disposal of a segment of a business. This Statement also
amended Accounting Research Bulletin No. 51, Consolidated Financial Statements.

This Statement requires that one accounting model be used for long-lived
assets to be disposed of by sale, whether previously held and used or newly
acquired, and broadens the presentation of discontinued operations to include
more disposal transactions. The adoption of SFAS No. 144 on January 1, 2002 did
not have a material effect on our results of operations, financial position or
liquidity. See Note F. Discontinued Operations for further detail related to the
adoption of SFAS No. 144.

49

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DECEMBER 31, 2002, 2001 AND 2000
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FUTURE POLICY BENEFITS, LOSSES AND CLAIMS

Liabilities for future policy reserves for accident and health and ordinary
life business are based on the net level premium basis and estimates of future
claims, investment yield, lapses using the Company's experience and actuarial
judgment with an allowance for possible future adverse deviations from expected
experience. Interest rates used range from 4.5% to 6.0%. Liabilities for
interest sensitive products such as deferred annuities and universal life are
based on the retrospective deposit method. This is the policyholder fund balance
before adjusting for any surrender charges. Guaranteed minimum rates for
universal life contracts are 4.0% to 5.0%. At December 31, 2002, credited rates
ranged from 4.0% to 4.5%. Guaranteed base minimum rates for deferred annuities
range from 3.0% to 5.0% depending on the duration of the contract. Current rates
credited range from 3.0% to 5.8%.

OTHER POLICY CLAIMS AND BENEFITS PAYABLE

Liabilities for unpaid life and accident and health claims, which include a
provision for estimated costs to investigate and settle claims, are estimated
based upon past experience for pending, incurred but not reported, and reopened
claims. Accident and health claims incurred but not reported are computed using
actuarially-determined factors based on a combination of claim completion and
projected claim cost methods, utilizing durational experience, seasonal cycle,
changes in health care practice, changes in inflation rates, and the claims
backlog.

Claim liabilities with a long pay out period, such as long-term care and
disability income claims, are discounted at an interest rate of 4.5%. Although
considerable variability is inherent in such computations, management believes
that the liabilities for unpaid life and accident and health claims are
adequate. The estimates are continually reviewed and adjusted as necessary as
experience develops or new information becomes known with such adjustments
included in current operations.

OTHER POLICYHOLDERS' FUNDS

Other policyholders' funds consist of supplementary contracts without life
contingencies, premiums, and annuity considerations received in advance and
remittance and items not allocated.

INSURANCE RELATED ASSESSMENTS

Statement of Position No. 97-3, Accounting by Insurance and Other
Enterprises for Insurance-Related Assessments, provides guidance for determining
when an insurance or other enterprise should recognize a liability for
guaranty-fund and other insurance-related assessments and guidance for measuring
the liability.

COMPREHENSIVE INCOME

Comprehensive income in 2002, 2001 and 2000 includes a change in unrealized
gains or losses on available-for-sale securities, in addition to reported net
income as prescribed by SFAS No. 130, Reporting Comprehensive Income. See Note
T. Comprehensive Income for further information.

PREMIUM REVENUE

Life premiums are recognized as revenue when they become due. Accident and
health premiums are recognized as revenue over the terms of the policies.
Amounts received from interest sensitive contracts, principally universal life
and annuity products, are not reflected in premium revenue; rather, such amounts
are accounted for as deposits with the related liabilities included in future
policy benefits, losses and claims.

50

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DECEMBER 31, 2002, 2001 AND 2000
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FEE AND OTHER INCOME

Fee and other income consist of collection, management, and administrative
fees, and are recognized when earned.

DEFERRED REINSURANCE GAIN

Deferred reinsurance gain consists of initial ceding allowances received
from reinsurers, less amounts amortized into income over the estimated remaining
life of the underlying policies reinsured, except for interest sensitive
products that are amortized over the expected profit stream of the in force
business.

FEDERAL INCOME TAXES

Federal income taxes have been provided using the liability method in
accordance with SFAS No. 109, Accounting for Income Taxes issued by the FASB.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date. Deferred tax assets are reviewed for
recoverability and a valuation allowance is established, if necessary.

STOCK-BASED COMPENSATION

Stock-based compensation plans are accounted for using the intrinsic value
method prescribed by APB Opinion No. 25, Accounting for Stock Issued to
Employees. In accordance with the intrinsic value method, compensation cost is
measured as the excess, if any, of the quoted market price of the equity
instrument awarded at the measurement date over the amount an employee must pay
to acquire the equity instrument. Stock-based compensation costs are recognized
over the period in which employees render services associated with the awards.

We adopted SFAS No. 123, Accounting for Stock-Based Compensation, which
permits entities to continue to apply the provisions of APB Opinion No. 25 and
provide pro forma net income and pro forma earnings per share disclosures for
employee stock option grants as if the fair-value-based method, as defined in
SFAS No. 123, had been applied. Additionally, in December 2002, the FASB issued
SFAS No. 148, Accounting For Stock-Based Compensation-Transition and Disclosure.
SFAS No. 148 amends SFAS No. 123, to provide alternative methods of transition
to SFAS No. 123's fair value method of accounting for stock-based employee
compensation, but does not require companies to account for employee stock
options using the fair value method. SFAS No. 148 also amends the disclosure
provisions of SFAS No. 123 and APB Opinion, No. 28, Interim Financial Reporting.
We elected to continue to apply provisions of APB Opinion No. 25 and provide the
pro forma disclosure required by SFAS No. 123 and the amended disclosures
required by SFAS No. 148. See Note Q. Stock Plans for further information.

No stock-based employee compensation cost is reflected in net income, as
all options granted under our plan generally had an exercise price equal to or
higher than the fair value of the underlying common stock on

51

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED

DECEMBER 31, 2002, 2001 AND 2000
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the date of grant. The following table illustrates the effect on net income, net
income attributable to common stockholders, and earnings per share if we had
applied the fair value recognition provisions of SFAS No. 123.

EARNINGS PER SHARE

Basic earnings per share is computed by dividing the income available to
common stockholders by the weighted average number of common shares outstanding
for the period. Diluted earnings per share reflects the potential dilution that
could occur if common stock equivalents were exercised and shared in the
earnings of the Company. Only those potential common shares, which are dilutive,
are included in the computation of diluted earnings per share. See Note U.
Computation of Net Income Per Common Share for further information.

RECLASSIFICATION

Certain amounts presented in the prior years' financial statements have
been reclassified to conform to the current year's method of presentation.

NEW ACCOUNTING PRONOUNCEMENTS

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities, which supercedes EITF Issue No. 94-3,
Liability Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity (Including Certain Costs Incurred in a Restructuring). The
provisions of this Statement are effective for exit or disposal activities
initiated after December 31, 2002. SFAS No. 146 requires recognition of a
liability for costs associated with an exit or disposal activity when the
liability is incurred, rather than when the entity commits to an exit plan under
EITF Issue No. 94-3. This Statement applies to costs associated with an exit
activity that does not involve an entity newly acquired in a business
combination or with a disposal activity covered by SFAS No. 144, Accounting for
the Impairment or Disposal of Long-Lived Assets. Additionally, this Statement
does not apply to costs associated with the retirement of a long-lived asset
covered by SFAS No. 143, Accounting for Asset Retirement Obligations. We

52

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED

DECEMBER 31, 2002, 2001 AND 2000
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anticipate that the adoption of this standard will not have a material effect on
our results of operations, financial position or liquidity.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections. This Statement rescinds SFAS No. 4, Reporting Gains and Losses from
Extinguishment of Debt, SFAS No. 44, Accounting for Intangible Assets of Motor
Carriers, and SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements. This Statement amends SFAS No. 13, Accounting for Leases, to
eliminate an inconsistency between the required accounting for sale-leaseback
transactions and the required accounting for certain lease modifications that
have economic effects that are similar to sale-leaseback transactions. This
Statement also amends other existing authoritative pronouncements to make
various technical corrections, clarify meanings, or describe their applicability
under changed conditions.

The provisions of SFAS No. 145, related to the rescission of SFAS No. 4,
require any gain or loss on extinguishment of debt that was classified as an
extraordinary item in prior periods presented that does not meet the criteria in
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, for classification as an
extraordinary item to be reclassified. The adoption of SFAS No. 145 on May 15,
2002 did not have a material effect on our results of operations, financial
position or liquidity.

In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement
Obligations, which addressed financial accounting and reporting for obligations
associated with the retirement of tangible long-lived assets and the associated
asset retirement costs. This Statement is effective for financial statements
issued for fiscal years beginning after June 15, 2002. The adoption of this
standard on June 15, 2002 did not have a material effect on our results of
operations, financial position or liquidity.

B. EQUITY TRANSACTIONS

On December 27, 2001, we sold 16.1 million shares of common stock, at $3.20
per share, which included the exercise of the underwriter's over-allotment
option of 2.1 million shares, in a follow-on public offering (the December 2001
public offering). We used the net proceeds of $46.5 million from this sale to:

- repay $10.0 million of our tranche A term loan (See Note O. Debt for
further information);

- repay the remaining balance of $2.5 million of our revolver on February
17, 2002;

- repurchase our convertible voting preferred stock for $5.0 million (See
Note R. Preferred Shares for further information);

- contribute $28.0 million to the capital of our insurance subsidiaries;
and

- $1.0 million for general corporate purposes and working capital.

On July 25, 2000, we sold 3,333,334 shares of our common stock at $6.00 per
share in a private placement offering, and, on July 26, 2000, we sold 75,000
shares of our convertible voting preferred stock at $100.00 per share to United
Insurance Company of America in a private placement offering. The $27.5 million
proceeds from these sales were used for the purchase of Pyramid Life from United
Insurance, a subsidiary of Unitrin, Inc. See Note C. Business Combinations and
Note R. Preferred Shares for further information.

C. BUSINESS COMBINATIONS

The acquisition described below was accounted for using the purchase method
of accounting, with the excess of the purchase price over the estimated
fair-value of the identifiable net assets recorded as goodwill.

53

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DECEMBER 31, 2002, 2001 AND 2000
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THE PYRAMID LIFE INSURANCE COMPANY ACQUISITION

On July 26, 2000, the Company, through Continental General Insurance
Company, completed the purchase of Pyramid Life from United Insurance. Pyramid
Life, based in Mission, Kansas, provides health and life insurance primarily for
the senior market, including Medicare supplement, long-term care, home health
care, and senior life insurance products. Pyramid Life markets senior insurance
products through approximately 2,500 independent agents in 40 states.

The $67.5 million purchase price was financed as follows:

- $20.0 million from the sale of 3,333,334 newly-issued shares of common
stock at $6.00 per share, in a private placement offering;

- $7.5 million from the sale to United of 75,000 newly-issued shares of
convertible voting preferred stock;

- $25.0 million from a special pre-closing dividend paid by Pyramid Life to
United in connection with the acquisition; and

- $15.0 million from a combination of funds from Continental General and
financing provided by the Chase Manhattan Bank and associated banks.

In connection with purchase accounting rules, the total purchase cost for
the acquisition has been allocated to the assets and liabilities of Pyramid Life
based on their fair values.

Pyramid Life's results of operations had been previously included in our
consolidated results of operations since the date of acquisition. However, due
to the planned sale of Pyramid Life, its operations have been classified as
discontinued operations and prior years' financial information has been
reclassified. See Note F. Discontinued Operations and Subsequent Event for
further information.

D. CASH AND INVESTMENTS

The amortized cost and estimated fair value of invested assets as of
December 31, 2002 were as follows:

54

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED

DECEMBER 31, 2002, 2001 AND 2000
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The amortized cost and estimated fair value of invested assets as of
December 31, 2001 were as follows:

Except for bonds and notes of the U.S. Government or of a U.S. Government
agency or authority, no investment of the Company exceeds 10% of total
stockholders' equity at December 31, 2002 and 2001.

The amortized cost and estimated fair value of invested assets as of
December 31, 2002 by contractual maturity were as follows:

Expected maturities will differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without
penalties.

55

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED

DECEMBER 31, 2002, 2001 AND 2000
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Proceeds, gross realized gains and gross realized losses from the sales
(excluding calls, maturities and pay downs) of fixed maturities
available-for-sale during each year were as follows:

The following is a summary of net investment income by category of
investment:

At December 31, 2002 and 2001, the Company's insurance subsidiaries had
certificates of deposit and fixed maturity securities with a carrying value of
$33.1 million and $32.4 million, respectively, on deposit with various state
insurance departments to satisfy regulatory requirements.

At December 31, 2002 and 2001, $6.5 million and $7.4 million, respectively,
of cash was held for fully insured employer shared risk plans, which is
restricted to use. The Company is entitled to investment income from these
funds.

At December 31, 2002, the Company held no unrated bonds and 6.0% of fixed
maturity investments were in less-than-investment grade securities. Corporate
bonds representing approximately 1.8% of fixed maturities were downgraded by
rating agencies. Approximately 4.2% of the portfolio was invested in BB rated
subordinated non-agency residential and commercial mortgage-backed securities.
These securities include jumbo residential mortgages and commercial mortgages
with strong prepayment protection. In June 2002, the Company wrote down
approximately $0.9 million for other-than-temporary impairment on bonds held in
WorldCom. The bonds were subsequently sold. The Company performs periodic
evaluations of the relative credit standings of the issuers of the bonds held in
the Company's portfolio. The Company considers these evaluations in its overall
investment strategy.

56

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED

DECEMBER 31, 2002, 2001 AND 2000
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E. PROPERTY AND EQUIPMENT

Property and equipment are stated at cost and are summarized by category as
follows:

Other property and equipment consists principally of software, leasehold
improvements and office equipment. Depreciation expense for the years ended
December 31, 2002, 2001 and 2000 was $1.2 million, $1.6 million, and $1.4
million, respectively.

F. DISCONTINUED OPERATIONS AND SUBSEQUENT EVENT

We entered into a definitive agreement dated as of December 20, 2002 to
sell the stock of our subsidiary, Pyramid Life, which was primarily included in
our senior segment, to a subsidiary of Universal American Financial Corp.
Additionally, we will continue to process Pyramid Life's business for a period
of six to 18 months after the sale through an administrative services agreement.
The loss from the sale (net of taxes and expenses incurred) is expected to be
$11.6 million. The sale was completed March 31, 2003 for $57.5 million in cash,
subject to further adjustment based on Pyramid Life's statutory capital and
surplus as of March 31. Proceeds from the sale were used to strengthen
Continental General's statutory capital and repay $10.0 million of our bank
debt. As a result of the planned sale, Pyramid Life's operations were classified
as discontinued operations and prior years' financial information has been
reclassified. Accordingly, we adjusted the carrying value of Pyramid Life's
assets held for sale to fair market value at December 31, 2002, which resulted
in an $11.6 million charge in the fourth quarter of 2002.

57

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED

DECEMBER 31, 2002, 2001 AND 2000
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Summarized financial data for Pyramid Life's operations are as follows:

STATEMENTS OF OPERATIONS

58

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED

DECEMBER 31, 2002, 2001 AND 2000
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BALANCE SHEETS

G. LEASES

On May 25, 2001, we entered into an agreement with Royalton Investors, LLC
and Big T Investments, LLC, an unaffiliated third party, to sell our Cleveland
headquarters. The transaction was effective July 31, 2001. The building was sold
to Royalton Investors, LLC and Big T Investments, LLC for $16.0 million and
concurrently we leased it back for a term of 15 years with four optional
five-year extensions.

59

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DECEMBER 31, 2002, 2001 AND 2000
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Rent expense for the Cleveland headquarters was approximately $1.7 million
in 2002, $0.7 million in 2001, and zero in 2000. Future rent payments for the
Cleveland headquarters are as follows (dollars in thousands):

2003........................................................ $ 1,742
2004........................................................ 1,800
2005........................................................ 1,800
2006........................................................ 1,883
2007........................................................ 2,000
Thereafter.................................................. 17,667
-------
Total future minimum rent payments.......................... $26,892
=======

H. DEFERRED ACQUISITION COSTS

Unamortized deferred policy acquisition costs are summarized as follows:

- ---------------

(1) See Note P. Special Charges for further information.

I. VALUE OF BUSINESS ACQUIRED

A portion of the purchase price paid by the Company for Continental General
Corporation was allocated to the value of business acquired based on the
actuarially-determined present value of the expected pre-tax future profits from
the business assuming a discount rate of 15.0%. Interest is accrued on the
balance annually at a rate consistent with the rate credited on the acquired
policies on the acquisition date, which ranges from 4.0% to 8.75%.
Recoverability of the value of business acquired is evaluated periodically by
comparing the current estimate of the present value of expected pre-tax future
profits to the unamoritized asset balance. If such current estimate is less than
the existing asset balance, the difference would be charged to expense.

For accident and health and ordinary life business, the value of business
acquired is amortized over the estimated life of the in force business using
assumptions consistent with those in computing reserves. Interest of 6.5% is
credited to the unamortized balance for Continental General Corporation. For
interest sensitive products such as universal life and deferred annuities, the
value of business acquired is amortized over the expected profit stream of the
in force business. The expected profit stream is based upon actuarial
assumptions as to mortality, lapses and expenses. Earned interest was assumed to
be 6.0% for Continental General Corporation which was the market rate at the
time of acquisition.

60

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The value of business acquired is summarized as follows:

The increased expense reserve is primarily a result of the higher
commission rates paid in the initial policy years of the Medicare supplement
business acquired. Under the current assumptions, amortization for the next five
years is expected to be as follows (dollars in thousands):

J. GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill represents the excess of purchase price over the fair value of
tangible and identifiable intangible net assets acquired. At December 31, 2002,
goodwill was $10.7 million and represented approximately 1.2% of our total
assets. Additionally, other intangible assets represent purchased assets that
also lack physical substance but can be distinguished from goodwill because of
other legal rights or because the assets are capable of being sold or exchanged
either on its own or in combination with a related contract asset or liability.
At December 31, 2002, our other intangible assets consisted of $3.6 million in
licenses, which represented 0.4% of our total assets.

Effective January 1, 2002, we adopted Statement of Financial Accounting
Standards, or SFAS, No. 142, Goodwill and Other Intangible Assets issued by the
Financial Accounting Standards Board, or FASB, which provides that goodwill and
intangibles with indefinite useful lives should not be amortized but instead be
tested for impairment annually at the reporting unit level. In accordance with
SFAS No. 142, we, together with our independent consultants, completed a
transitional goodwill impairment test which indicated that an impairment loss
against our goodwill and other intangible assets was not required. Goodwill and
intangibles with indefinite useful lives are tested for impairment on an annual
basis and more often if indications of impairment exist. The estimated fair
value of goodwill of a reporting unit is determined by applying the appropriate
discount rates to estimated future cash flows for the reporting unit. The
estimated fair value of licenses was determined by independent appraisals. The
results of our analysis and analysis prepared by independent consultants
indicated that no reduction of goodwill and licenses was required.

In 2001, goodwill and licenses amortization was $0.7 million ($0.4 million
on an after-tax basis, or $0.02 per diluted shared). In 2000, goodwill and
licenses amortization was $0.9 million ($0.6 million on an after-tax basis, or
$0.04 per diluted share).

61

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DECEMBER 31, 2002, 2001 AND 2000
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The following table reflects the consolidated results adjusted as though
the adoption of SFAS No. 142 occurred as of the beginning of fiscal 2000:

The changes in the carrying amount of goodwill for the year ended December
31, 2002, were as follows:

The changes in the carrying amount of licenses, for the year ended December
31, 2002, were as follows:

K. FEDERAL INCOME TAXES

The Company files a consolidated federal income tax return with its
subsidiaries, except for Continental General, which is required to file a
separate return through fiscal year 2003.

62

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DECEMBER 31, 2002, 2001 AND 2000
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Federal income tax expense (benefit) from continuing operations was
composed of the following:

Federal income tax expense (benefit) was allocated as follows:

Income tax expense (benefit) attributable to income from continuing
operations differs from the amounts computed by applying the U.S. federal income
tax rate of 35%. Those effects are summarized as follows:

The federal income tax returns for the Company and its subsidiaries have
been examined by the Internal Revenue Service (IRS) through 1998. Currently, the
1999 tax year is being examined by the IRS.

63

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The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities at December 31,
2002 and 2001 are presented below:

At December 31, 2002, the Company had a tax net operating loss
carryforward, or NOL, of approximately $21.7 million for federal income tax
purposes, which expires through 2015. Future changes in ownership, as defined by
Sections 382 and 383 of the Internal Revenue Code, could limit the amount of NOL
carryforwards used in any one year. Our December 2001 public offering resulted
in an "ownership change" as defined in Section 382 of the Code and the
regulations issued thereunder. Pursuant to Section 382, our ability to use our
NOLs originating prior to the offering, accounting for approximately $21.7
million, is subject to certain restrictions, including an annual limitation of
approximately $5.4 million. Losses incurred subsequent to this offering are
available without annual limitation to offset future income.

The Company determines a valuation allowance based on an analysis of
amounts recoverable in the statutory carryback period and available tax planning
strategies. In assessing the valuation allowance established at December 31,
2002 and 2001, estimates were made as to the potential financial impact on the
Company of recent NOLs and our financial condition.

In accordance with federal tax law, a portion of insurance companies' net
income, prior to 1984, is not subject to federal income taxes (within certain
limitations) until it is distributed to policyholders, at which time it is taxed
at regular corporate rates. For federal income tax purposes this untaxed income
is accumulated in a memorandum account designated "policyholders' surplus." At
December 31, 2002, the accumulated untaxed policyholders' surplus for the
Company, all of which relates to Central Reserve, was $2.9 million.
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L. LIABILITY FOR OTHER POLICY CLAIMS AND BENEFITS PAYABLE

The following table reflects the activity in the liability for other policy
claims and benefits payable, including the claims adjustment expenses, net of
reinsurance recoverables, as follows:

The foregoing indicates that a $8.4 million deficiency in the 2001 reserves
emerged in 2002 as a result of higher-than-anticipated claims cost associated
with a reduction in pending claims inventory in the medical segment. In 2001, a
$17.0 million deficiency in the 2000 reserves emerged as a result of higher
utilization in the medical segment related to increased costs of services, a
greater utilization of medical services and greatly increased expenditures on
prescription drugs. In 2000, a $7.9 million deficiency in the 1999 reserves
emerged as a result of higher utilization in all segments.

M. REINSURANCE ARRANGEMENTS

CENTRAL RESERVE LIFE INSURANCE COMPANY

In December 2000, Central Reserve entered into a reinsurance transaction
with Lincoln National Reassurance Company, or Lincoln, for a ceding allowance of
$4,000,000. The policies reinsured, on a combined coinsurance and modified
coinsurance basis, were 80% of all group term life insurance and 35% of all
individual deferred annuities in force on and after December 31, 2000. The
ceding allowance is being accounted for as a deferred reinsurance gain in the
accompanying consolidated financial statements and will be amortized into income
over the duration of the underlying policies.

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In December 1999, Central Reserve entered into a reinsurance transaction
with Hannover for certain health insurance policies issued during the period
from July 1, 1998 through June 30, 1999. As part of the coinsurance funds
withheld transaction, Hannover will pay Central Reserve on a quarterly basis, an
experience refund, the amount of which shall be based upon the earnings derived
from the business reinsured. Concurrent with this transaction, Hannover will
reinsure to Continental General on a stop loss basis 100% of any losses incurred
for the business reinsured in excess of a pre-determined aggregate annualized
loss ratio of 76.0% in 2000, 78.0% in 2001 and 80.0% thereafter. In exchange for
coverage under the stop loss reinsurance, Hannover pays Continental General a
stop loss premium on the business reinsured. The effects of the transaction,
except the net risk charge to Hannover, are eliminated in consolidation. This
reinsurance agreement was terminated effective December 31, 2002 by mutual
consent of the parties.

In December 1997, Central Reserve entered into a retroactive reinsurance
treaty (the "1997 Treaty") with Hannover. The quota share treaty was effective
January 1, 1997, and covered certain group accident and health policies in force
and written during 1997. Under the provisions of the 1997 Treaty, Central
Reserve cedes 50% of the premiums of the eligible policies, and in return
receives reimbursement for 50% of the claims paid, plus a commission and expense
allowance. In connection with the 1997 Treaty, Central Reserve transferred $24.5
million of reserves to Hannover, and received an initial ceding allowance of
$10.0 million, resulting in a net cash transfer of $14.5 million to Hannover.
The initial ceding allowance was reported as a deferred reinsurance gain, and is
being amortized into income over the duration of the underlying block of
business.

CONTINENTAL GENERAL LIFE INSURANCE COMPANY

In December 2001, Continental General entered into a reinsurance
transaction with London Life International Reinsurance Corporation, or London,
for a 75% quota share of certain health policies issued after February 1, 1999.
Under the provisions of the treaty, effective January 1, 2001, Continental
General cedes 75% of the premiums of the eligible policies, and in return
receives reimbursement for 75% of the claims paid, plus a commission and expense
allowance. If the combined loss ratio (defined as benefits plus expense
allowances divided by premium) is less than 100%, an experience refund will be
paid from London to Continental General. The expense and profit charge is 200
basis points and 85 basis points of reinsurance premium for 2002 and 2001,
respectively. Beginning January 1, 2002, London retroceded any losses on these
policies in excess of a combined ratio of 110% to Central Reserve. In exchange
for coverage on this business, Central Reserve received 100 basis points of
reinsurance premium in 2002 from London. On June 2, 2002, these reinsurance
agreements were terminated. The Company has determined that this contract does
not transfer risk in accordance with generally accepted accounting principles
and has reflected this agreement as a deposit.

In February 1999, Continental General entered into a reinsurance agreement
with Hannover, under which Hannover reinsured 50% of all insurance business in
force at Continental General for a ceding allowance of $13.0 million. The ceding
allowance is being accounted for as a deferred reinsurance gain in the
accompanying consolidated financial statements and will be amortized into income
over the duration of the underlying block of business. Various assets, primarily
comprised of fixed income securities with a market value of $188.4 million, were
transferred from Continental General to Hannover for the policy liabilities
assumed by Hannover.

PROVIDENT AMERICAN LIFE & HEALTH INSURANCE COMPANY

Prior to the acquisition of Provident American Life, all of the insurance
business of Provident American Life in force at December 31, 1998 was ceded to
Provident Indemnity. Hannover reinsured all the individual and small group
health insurance in force at December 31, 1998, of Provident Indemnity for a
ceding

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allowance of approximately $10.0 million. On January 1, 1999, Hannover ceded 10%
of this insurance in force to Central Reserve and Central Reserve paid a $1.0
million ceding commission.

Effective January 1, 1999, Provident American Life entered into a
reinsurance agreement with Provident Indemnity, whereby Provident American Life
reinsured 100% of Provident Indemnity's business written after December 31,
1998. In a separate reinsurance agreement, Provident American Life ceded to
Hannover 50% of its direct business written after December 31, 1998 and 50% of
the business reinsured from Provident Indemnity.

On December 31, 2002, Provident American Life and Hannover entered into an
agreement, which amended the reinsurance arrangement relative to the policies of
Provident American Life and Provident Indemnity. For claims incurred June 30,
2002 and prior, Hannover continues to be responsible for its quota share
percentage. For premiums earned and claims incurred July 1, 2002 and subsequent,
Provident American Life retains 100% of the business and risk on the remaining
closed block of policies.

UNITED BENEFIT LIFE INSURANCE COMPANY

Effective August 1, 1998, Central Reserve entered into a reinsurance treaty
with United Benefit Life, a life and accident and health insurer in Texas. Under
the terms of the treaty, Central Reserve agreed to assume 100% of United Benefit
Life's block of business, until such time as profits earned by Central Reserve
on the assumed block reach a contractual threshold, which approximates $20.0
million of pre-tax income. Central Reserve paid to United Benefit Life a $20.0
million ceding allowance in connection with this transaction.

In connection with the United Benefit Life reinsurance treaty, Central
Reserve ceded 80% of the business in force on August 1, 1998 to Hannover,
thereby retaining a net risk of 20%. Additionally, Central Reserve ceded 50% of
the policies written by United Benefit Life subsequent to August 1, 1998 and
reinsured by Central Reserve to Hannover. This treaty provided Central Reserve
an initial ceding allowance of $20.0 million, which was being accounted for as a
deferred reinsurance gain in the accompanying consolidated financial statements,
and was amortized into income over the duration of the underlying block of
business. In 1999, Central Reserve acquired through foreclosure the stock of
United Benefit Life.

On December 31, 2002, United Benefit Life and Hannover entered into an
agreement which amended these reinsurance arrangements. For claims incurred June
30, 2002 and prior, Hannover continues to be responsible for its quota share
percentage. For claims incurred July 1, 2002 and subsequent, Central Reserve
retains 100% of the risk.

In the ordinary course of business, the Company maintains other reinsurance
arrangements with other insurers. These arrangements are designed to limit the
maximum amount of exposure that the Company retains on a given policy. For
ordinary and group life claims, Continental's maximum retention is $125,000 and
Central Reserve's maximum retention is $50,000 with no retention maintained over
age 70. For accident and health claims, maximum retention on individual claims
is $500,000.

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The following table summarizes the net impact of reinsurance arrangements
on premiums and benefits, claims, losses and settlement expenses, and selling,
general and administrative expenses:

The insurance companies remain obligated for amounts ceded in the event
that the reinsurers do not meet their obligations. Initial ceding allowances
received from reinsurers are accounted for as deferred reinsurance gain and are
amortized into income over the estimated remaining life of the underlying
policies reinsured, except for interest sensitive products that are amortized
over the expected profit stream of the in force business. The above table does
not include the amortization of initial ceding allowances received from
reinsurers. Amortization of deferred reinsurance gain for the years ended
December 31, 2002, 2001 and 2000 was $2.8 million, $5.0 million, and $6.1
million, respectively.

N. CONTINGENCIES

We are involved in various legal and regulatory actions occurring in the
normal course of business. Based on current information, we believe any ultimate
liability that may arise from these actions would not materially affect our
consolidated financial position or results of operations. However, our
evaluation of the likely impact of these actions could change in the future and
an unfavorable outcome could have a material adverse effect on our consolidated
financial position, results of operations or cash flow of a future period.

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O. DEBT

To provide funds for the acquisition of Continental General, on February
17, 1999, we entered into a credit agreement among Ceres, various lending
institutions, and JPMorgan Chase (formerly the Chase Manhattan Bank) as
Administrative Agent. Under the agreement, we borrowed $40.0 million under a
tranche A term loan and secured a $10.0 million revolver. The credit agreement
was amended on July 25, 2000 to increase the revolver from $10.0 million to
$15.0 million in connection with the acquisition of Pyramid Life. Any amount
outstanding on the revolver had to be repaid on February 17, 2002. The revolver
bore interest at the same rate choices as the tranche A term loan. On February
17, 2002, the balance of the revolver was permanently repaid from proceeds of
our December 2001 public offering.

On March 30, 2001, this credit agreement was amended to enter into a new
$10.0 million term loan with CIT Equipment Financing, Inc. The proceeds of this
term loan, the tranche B term loan, were used to permanently pay down $10.0
million of our then fully-drawn $15.0 million revolver agreement. The terms of
this amendment provide for CIT Group to participate equally with the syndicate
of banks and Chase under the credit agreement.

Interest on the outstanding balance of the term loans is determined based
on our selection each quarter of either a Base Rate Loan or a Eurodollar Loan.
Under the Base Rate Loan, the interest rate will be 2.5% per annum plus the
higher of (a) the rate which is 0.50% of 1.0% in excess of a federal funds rate
or (b) Chase's prime rate as in effect from time to time. Under the Eurodollar
Loan, the interest rate will be 3.5% per annum plus a Eurodollar rate, which is
the arithmetic average of the offered quotation to first-class banks in the
interbank Eurodollar market by Chase, adjusted for certain reserve requirements.
The interest rate of the tranche B term loan is 0.5% per annum higher than the
above rates. At December 31, 2002, the interest rate on our tranche A term loan
balance of $16.0 million was 4.9% per annum and our $9.0 million CIT tranche B
term loan was 5.4% per annum.

The credit agreement, as amended, contains financial and other covenants
that among other things:

- prohibit the payment of cash dividends on, or the repurchase of, shares
of our common stock;

- restrict the creation of liens and sales of assets;

- requires us to repay the term loans with 25% of the net cash proceeds
from any future sale or issuance of our equity, excluding warrants and
compensation awards or plans; and

- require that we, at a minimum, maintain:

- a leverage ratio (consolidated debt to consolidated total capital)
of 0.30 to 1.00;

- an interest coverage ratio (consolidated earnings before interest,
income taxes, depreciation, and amortization to consolidated
interest expense) of 3.00 to 1.00;

- a risk-based capital (RBC) ratio at year end for any of our
regulated insurance company subsidiaries of not less than 125.0% of
the RBC Company Action level;

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- consolidated net worth, excluding goodwill, of no less than the sum
of (i) $85.0 million plus (ii) 80% of the net proceeds from the
equity offering excluding the $5.0 million repurchase of our
convertible voting preferred stock plus (iii) 50% of our aggregate
consolidated net income calculated quarterly; and

- a fixed charge coverage ratio of not less than 1.05 to 1.00 through
June 30, 2003, and 1.10 to 1.00 thereafter.

Effective March 31, 2003, the credit agreement was amended in connection
with the sale of Pyramid Life. The amendment:

- permits the sale of Pyramid Life;

- requires $10.0 million of sale proceeds to be used as a partial pay down
of bank debt;

- waives the minimum risk-based capital ratio requirement of 125% for
Continental General at December 31, 2002;

- excludes intercompany tax sharing payments in the calculation of the
fixed charge coverage ratio at December 31, 2002;

- increases the interest rate on the tranche A and tranche B term loans for
the Base Rate Loans to Base Rate plus 3.0% and 3.5%, respectively, and
for the Eurodollar Loans to LIBOR plus 4.0% and 4.5%, respectively;

- restructured the tranche A term loan debt payments as follows: quarterly
principal payments of $547,000 through November 17, 2003, $509,000
through November 17, 2004, and a payment of approximately $5,040,000 on
February 17, 2005; and

- restructured the tranche B term loan debt payments as follows: quarterly
principal payments of $223,000 through December 17, 2003, $216,000 on
March 17, 2004, $412,000 through December 17, 2004, $434,000 on March 17,
2005, and $820,000 through December 17, 2005.

We do not have transactions or relationships with "special purpose"
entities, and we do not have any off balance sheet financing other than normal
operating leases.

In addition, the common stock of Central Reserve, Continental General, and
most of our non-regulated subsidiaries are pledged as security for the credit
agreement. At December 31, 2002, we were in compliance with our credit
agreement, as amended and waived.

We believe that cash flow from operating activities will be sufficient to
meet the currently anticipated operating and capital expenditure requirements of
our subsidiaries over the next 12 months. Funds to meet our debt obligations are
generated from fee income from our non-regulated subsidiaries. Our ability to
make scheduled payments of the principal and interest on our indebtedness
depends on our future performance and the future performance of our
non-regulated subsidiaries, which are subject to economic, financial,
competitive and other factors beyond our control. Fee income is derived from
fees primarily in connection with our major medical business. As that business
declines, fee income declines. Dividends from the regulated insurance
subsidiaries are subject to, and limited by, state insurance regulations. In
2003, none of the insurance subsidiaries (Central Reserve Life and Continental
General) can pay a dividend to Ceres Group, the parent company, without prior
approval of their respective state regulators as a result of their respective
statutory levels of unassigned surplus.

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P. SPECIAL CHARGES

2002

On April 15, 2002, Peter W. Nauert announced his retirement from his
position as our Chief Executive Officer effective June 1, 2002. He will remain
as Chairman of the Board of Directors through June 2003. In the first quarter of
2002, we reported a pre-tax non-recurring special charge to operations of
approximately $2.7 million ($2.4 million in continuing operations and $0.3
million in discontinued operations) related to the early termination of his
employment agreement and the payment of certain benefits through June 2003.

2001

We reported special charges of $7.1 million in the first quarter of 2001
related to:

- the elimination of $5.9 million deferred acquisition cost (DAC) asset on
all products of United Benefit Life and Provident American Life; and

- $1.2 million loss on United Benefit Life.

From 1998 to 2001, we experienced excessive losses at United Benefit Life
and Provident American Life due to high benefit utilization and
higher-than-anticipated claims costs. In July 2001, we implemented a program to
mitigate future losses of United Benefit Life and Provident American Life by
notifying policyholders that their policies would be terminated or replaced with
a different Provident American Life product. The business was substantially
wound down by the end of 2002.

As a result of the termination of the business in these subsidiaries, these
blocks had a $2.5 million pre-tax loss in 2002 compared to $17.9 million pre-tax
loss in 2001 including special charges and legal expenses.

Q. STOCK PLANS

STOCK OPTION PLANS

In 1999, 373 employees each received 1,000 common stock options under the
1998 Employee Stock Option Plan. A second grant was made for new employees hired
from January 1, 1999 through September 30, 1999, and still employed as of
December 31, 1999. Under this second grant in 2000, 75 employees received 1,000
common stock options. Each grant vests after three years and expires ten years
from the date of the grant, with accelerated vesting upon an event of a change
in control. The Company terminated this plan in December 2000. At December 31,
2002, there were options outstanding under the plan to purchase 243,000 shares.

In 1998, pursuant to the 1998 Key Employee Share Incentive Plan, the
Company granted common stock options to certain key employees. In 1999 through
2002, the Company granted additional common stock options to certain employees
under the 1998 Key Employee Share Incentive Plan. In general, such grants vest
over three years and expire ten years from the date of the grant. In the event
of a change in control, all options granted immediately vest and become
exercisable in full. There are 2,000,000 shares of our common stock reserved for
issuance under this plan. At December 31, 2002, there were options outstanding
under the plan to purchase 1,483,628 shares.

In 1998 and 1999, pursuant to various individual employment agreements, the
Company granted non-qualified options to purchase 815,000 shares of our common
stock to certain key employees. Such grants generally vest over three years. At
December 31, 2002, there were options outstanding under the plan to purchase
815,000 shares.

In 1999, pursuant to the 1999 Special Agents' Stocks Option Plan, the
Company granted 78,706 common stock options to certain Regional Sales Directors
and Managing General Agents. Each grant vested
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immediately and expires ten years from the date of grant. The Company terminated
this plan at the end of 2000. At December 31, 2002, there were options
outstanding under the plan to purchase 78,706 shares.

A summary of the Company's stock option activity is presented below:

Exercise prices for options outstanding at December 31, 2002 ranged from
$3.90 to $10.50. While some options have no expiration date, management
estimates the remaining average contractual life of options awarded is 5 years.
A summary of the options by range of exercise price is as follows:

WARRANTS

The Company also had outstanding at December 31, 2002, 3,657,743 warrants
at $5.41, expiring in 2005.

STOCK PURCHASE PLAN

Our 2000 Employee Stock Purchase Plan was adopted by our stockholders on
June 27, 2000. Under the plan, employees may purchase shares of our common stock
at a 15% discount from fair value. All of our full time employees, including
officers, are eligible to participate in the employee stock purchase plan,
subject to limited exceptions. Eligible employees participate voluntarily, and
may withdraw from an offering at any time before the stock is purchased.
Participation terminates automatically upon termination of employment other than
for death, disability or retirement. Six-month offerings are made available
beginning May 1 and November 1 of each year. The purchase price per share in an
offering will not be less than 85% of the lesser of

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the stock's fair value at the beginning of the offering period or on the
applicable exercise date and may be paid through payroll deductions. As of
December 31, 2002 and 2001, 63,954 and 62,761 shares, respectively, had been
issued under the employee plan.

AGENT STOCK PURCHASE PLAN

We also have a 2000 Agent Stock Purchase Plan similar to the employee plan
under which certain of our agents may purchase shares of our common stock at the
same discount from fair value. The agent stock purchase plan does not qualify as
an employee stock purchase plan within the meaning of Section 423 of the Code.
As of December 31, 2002 and 2001, 164,164 and 76,621 shares, respectively, had
been issued under the agent plan. There are 1,000,000 shares of common stock
reserved for issuance in the aggregate under both plans. Both of the plans will
terminate when all of the shares reserved for issuance under the plans have been
purchased unless sooner terminated by the Board of Directors.

STOCK AWARD

Also, pursuant to employment contracts, the Company provided an award of
common shares to Peter W. Nauert. The number of shares awarded was contingent
upon the weighted average fair value of the common shares over specified
periods, but is based on a stock award equal to $1.0 million per year through
July 1, 2001 and $0.5 million per year through May 31, 2002, which was revised
from July 1, 2003 due to his retirement as Chief Executive Officer. For the year
ended December 31, 2002, 88,661 shares were awarded.

STOCK-BASED COMPENSATION

The Company recognized stock compensation expense of $0.2 million, $0.9
million, and $1.1 million in 2002, 2001 and 2000, respectively. As required by
FASB Statement 123, Accounting for Stock-Based Compensation, the Company has
estimated the pro forma impact on net income and earnings per share of
stock-based compensation under the fair value method, using the Black-Scholes
option valuation model.

The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options, which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because 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.

Significant underlying assumptions made are summarized as follows:

Based on the methodology and assumptions delineated above, the weighted
average fair value of options was $1.39, $1.18 and $1.25 per share for 2002,
2001 and 2000, respectively. The pro forma impact would be to decrease net
income by $0.4 million, $0.8 million and $0.7 million and decrease net income
per share by $0.01, $0.05 and $0.04 for basic and for diluted for the years
ended December 31, 2002, 2001 and 2000, respectively.

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R. PREFERRED SHARES

The Company has authorized 1,900,000 Non-Voting Preferred Shares, $.001 par
value. The Company has never issued any Non-Voting Preferred Shares. However,
the Board of Directors is authorized at any time to provide for the issuance of,
such shares in one or more series, and to determine the designations,
preferences, limitations and other rights of the shares issued, including but
not limited to the dividend rate, liquidation preference, redemption rights and
price, sinking fund requirements, conversion rights and restrictions on the
issuance of such shares. Holders of non-voting preferred shares shall have no
voting rights except as required by law.

The Company has authorized 100,000 Convertible Voting Preferred Shares,
$.001 par value, of which none are outstanding at December 31, 2002. On December
27, 2001, the Company repurchased its convertible voting preferred stock for
$5.0 million from the proceeds of the public offering. The carrying value of the
convertible voting preferred stock was $8.2 million and the related dividends
distributable was $0.4 million. The resulting gain from repurchase of the
convertible voting preferred stock was $3.6 million. The gain was recorded in
retained earnings and was reflected as a component of net income attributable to
common stockholders. For more information regarding our convertible voting
preferred stock, see Note B. Equity Transactions and Note C. Business
Combinations for further information.

S. STATUTORY FINANCIAL INFORMATION

State insurance laws and regulations prescribe accounting practices for
determining statutory net income and equity for insurance companies. In
addition, state regulators may permit statutory accounting practices that differ
from prescribed practices. The use of such permitted practices by Ceres and its
insurance subsidiaries did not have a material effect on their statutory equity
at December 31, 2002 and 2001.

Statutory accounting practices prescribed or permitted by regulatory
authorities for Ceres' insurance subsidiaries differ from generally accepted
accounting principles. Shareholders' equity and net income, unaudited, as
determined in accordance with statutory accounting practices, for Ceres and its
subsidiaries are summarized as follows:

- ---------------

(1) Statutory capital and surplus for Central Reserve includes Provident
American Life and United Benefit Life. Central Reserve's statutory net gain
(loss) for the years ended December 31, 2002 and 2001 includes losses of
Provident American Life and United Benefit Life.

(2) Statutory capital and surplus for Continental General includes Pyramid Life.

Generally, the capital and surplus of Ceres' insurance subsidiaries
available for transfer to the parent company are limited to the amounts that the
insurance subsidiaries' capital and surplus, as determined in accordance with
statutory accounting practices, exceed minimum statutory capital requirements.
However,

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payments of the amounts as dividends may be subject to approval by regulatory
authorities. Ceres' insurance subsidiaries cannot pay any dividends in 2003
without prior regulatory approval.

The National Association of Insurance Commissioners revised the Accounting
Practices and Procedures Manual in a process referred to as Codification. The
revised manual was effective January 1, 2001. The domiciliary states of Ceres
and its insurance subsidiaries have adopted the provisions of the revised
manual. The revised manual has changed, to some extent, prescribed statutory
accounting practices and has resulted in changes to the accounting practices
that Ceres and its subsidiaries use to prepare their statutory-basis financial
statements. The impact of these changes to statutory-basis capital and surplus
of Ceres insurance subsidiaries was not significant.

The NAIC also has Risk-Based Capital (RBC) requirements for life and health
insurers to evaluate the adequacy of statutory capital and surplus in relation
to investment and insurance risks associated with asset quality, mortality and
morbidity, asset and liability matching and other business factors. The RBC
formula is used by state insurance regulators to monitor trends in statutory
capital and surplus for the purpose of initiating regulatory action. The Company
calculated the risk-based capital for its insurance subsidiaries as of December
31, 2002 using the applicable RBC formula. Based on these calculations, the RBC
levels of each of the insurance subsidiaries, except Continental General,
exceeded the levels required by regulatory authorities. Continental General's
statutory capital level was below "Company Action Level" at December 31, 2002.
However, after the addition of the statutory capital generated from the sale of
Pyramid Life, Continental General's RBC level will exceed the levels required by
regulatory authorities.

T. COMPREHENSIVE INCOME

Comprehensive income is as follows:

- ---------------

(1) Net of reclassification adjustments for net gains (losses) included in net
income.

U. COMPUTATION OF NET INCOME PER COMMON SHARE

Basic and diluted earnings per share are calculated in accordance with SFAS
No. 128, Earnings per Share. Basic earnings per common share is computed by
dividing net income (loss) attributable to common stockholders by the weighted
average number of shares outstanding during the period. Diluted earnings per
common share is computed by dividing net income (loss) by the weighted average
number of shares outstanding during the period including the effect of the
assumed exercise of dilutive stock options under the treasury stock method. In
2001, the diluted earnings per share calculation was adjusted for a one time net
gain on repurchase of the convertible voting preferred stock. All stock options
and warrants were antidilutive for the

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year ended December 31, 2002 and therefore are excluded from the calculation of
diluted earnings per share. Basic and diluted weighted average shares of common
stock are as follows:

V. EMPLOYEE BENEFIT PLAN

The Company sponsors the Ceres Group, Inc. 401(k) Plan, a defined
contribution 401(k) savings plan (the Plan). Effective January 1, 2001, the Plan
was amended to increase the employer match (Company Match Contribution) to 50%
of the first 6% of each participant's salary deferrals.

Effective June 1, 2002, the Plan was amended so that participants can elect
to make pre-tax contributions from 1% to 25% of their compensation and after-tax
contributions were no longer permitted. In addition to the Company Match
Contribution, Ceres will match 100% of each participant's contributions (Stock
Match Contribution) to the Ceres Group, Inc. Stock Fund, up to maximum of $1,000
per year provided the participant agrees that the pre-tax contributions will not
be transferred out of the fund for a minimum of one year.

In addition, Ceres may contribute a Profit Sharing Contribution to the
Plan, as determined by the Board of Directors. All eligible, active employees
who have worked over 1,000 hours during the plan year and who are employed on
the last day of the plan year share in this contribution. Participants who leave
employment during the plan year due to retirement, death or disability will also
share in the contribution. There were no Profit Sharing Contributions made for
the 2002, 2001 and 2000 plan years, respectively.

A participant's interest in the Company Match Contribution, Stock Match
Contribution and Profit Sharing Contribution allocated to the participant's
account becomes vested over a five-year graded vesting schedule with 100%
vesting over five years. Total matching contributions by the Company were
approximately $642,000 for 2002, $768,000 for 2001, and $376,000 for 2000.

W. OPERATING SEGMENTS

We apply SFAS No. 131, Disclosures about Segments of an Enterprise and
Related Information, which requires us to report information about our operating
segments according to the management approach for determining reportable
segments. This approach is based on the way management organizes segments within
a company for making operating decisions and assessing performance. We have
three distinct operating segments based upon product types: medical, senior and
other, and corporate and other. Products included in the medical segment include
catastrophic and comprehensive medical plans. Significant products in the senior
and other segment include Medicare supplement, long-term care, dental, life
insurance, and annuities. The corporate and other segment encompasses all other
activities, including investment income, interest expense, and corporate
expenses of the parent company.

The following table presents the revenues, expenses and profit (loss) from
continuing operations before federal income taxes, for the last three years
attributable to our industry segments. We do not separately allocate investments
or other identifiable assets by industry segment, nor are income tax expenses
(benefits)
76

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED

DECEMBER 31, 2002, 2001 AND 2000
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

allocated by industry segment. Revenues from each segment are primarily
generated from premiums charged to external policyholders and interest earned on
cash and investments.

77

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED

DECEMBER 31, 2002, 2001 AND 2000
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

We do not separately allocate investments or other identifiable assets by
industry segment, nor are income tax expenses (benefits) allocated by industry
segment. The Company also expanded the detail of its disclosures for 2002, 2001
and 2000, which included certain reclassifications.

X. FAIR VALUES OF FINANCIAL INSTRUMENTS

Fair values of financial instruments are based upon quoted market prices,
where available, or on values obtained from independent pricing services. In
cases where quoted market prices are not available, fair value is based on
estimates using present value or other valuation techniques. These techniques
are significantly affected by the assumptions used, including the discount rate
and estimates of future cash flows. Although fair value estimates are calculated
using assumptions that management believes are appropriate, differences between
estimated and actual outcomes or changes in the underlying assumptions could
cause these values to vary materially. Consequently, calculated fair value
estimates cannot be substantiated by comparison to independent markets and, in
many cases, could not be realized by the immediate settlement of the
instruments.

The tax ramifications of the related unrealized gains and losses can have a
significant effect on fair value estimates and have not been considered in the
estimates.

The following methods and assumptions were used by the Company in
estimating its fair value disclosures:

INVESTMENT SECURITIES -- Fair value for fixed maturity securities is based
on quoted market prices, where available. For fixed maturity securities not
actively traded, fair value is estimated using values obtained from independent
pricing services.

CASH, CASH EQUIVALENTS, PREMIUMS RECEIVABLE, REINSURANCE RECEIVABLE,
SURPLUS NOTES, MORTGAGE LOANS AND POLICY NOTES -- The carrying amounts reported
in the consolidated balance sheets for these instruments approximate their fair
value.

ANNUITY CONTRACTS -- The fair value for the annuity reserves included in
the liability for future policy benefit, losses, and claims is the amount
payable on demand.

78

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED

DECEMBER 31, 2002, 2001 AND 2000
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

OTHER POLICYHOLDERS' FUNDS -- The carrying amount reported in the
consolidated balance sheets for these instruments approximate their fair value.

MORTGAGE NOTE PAYABLE, DEBT AND REINSURANCE PAYABLE -- The carrying amounts
reported in the consolidated balance sheets for the mortgage note payable and
long-term debt approximates their fair value.

Carrying amounts and estimated fair values of financial instruments at
December 31, 2002 and 2001, are summarized as follows:

Y. CONCENTRATIONS OF CREDIT RISK

Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of fixed maturity investments,
cash, cash equivalents, and reinsurance receivable.

The Company maintains cash and short-term investments with various
financial institutions, and performs periodic evaluations of the relative credit
standings of those financial institutions.

Substantially all of the Company's reinsurance recoverable is due from a
single reinsurer, Hannover. At December 31, 2002, Hannover maintained an "A"
rating from the A.M. Best Company. The Company performs periodic evaluations of
this reinsurer's credit standing.

79

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED

DECEMBER 31, 2002, 2001 AND 2000
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

Z. QUARTERLY RESULTS OF OPERATIONS - (UNAUDITED)

The following is a summary of quarterly results of operations for the years
ended December 31, 2002 and 2001. All prior quarters have been reclassed to
reflect the pending sale of Pyramid Life:

80

SCHEDULE II

CERES GROUP, INC. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CERES GROUP, INC. (PARENT ONLY)
BALANCE SHEETS
DECEMBER 31, 2002 AND 2001
(DOLLARS IN THOUSANDS)
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

- ---------------

(1) Eliminated in consolidation.

(2) Includes $9.5 million and $8.0 million in advances from non-regulated
subsidiaries in 2002 and 2001, respectively.

See accompanying independent auditors' report.
81

SCHEDULE II

CERES GROUP, INC. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CERES GROUP, INC. (PARENT ONLY)
STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(DOLLARS IN THOUSANDS)
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

- ---------------

(1) Represents dividend income from non-regulated subsidiaries, which is
eliminated in consolidation.

(2) Eliminated in consolidation.

(3) Includes the parent company's equity of regulated and non-regulated
subsidiaries, which is eliminated in consolidation.

See accompanying independent auditors' report.
82

SCHEDULE II

CERES GROUP, INC. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CERES GROUP, INC. (PARENT ONLY)
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(DOLLARS IN THOUSANDS)
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

- ---------------

(1) Eliminated in consolidation.

See accompanying independent auditors' report.
83

SCHEDULE III

CERES GROUP, INC. AND SUBSIDIARIES
SUPPLEMENTAL INSURANCE INFORMATION
(DOLLARS IN THOUSANDS)

See accompanying independent auditors' report.

84

SCHEDULE IV

CERES GROUP, INC. AND SUBSIDIARIES
REINSURANCE
(DOLLARS IN THOUSANDS)
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

- ---------------

N/M = not meaningful

See accompanying independent auditors' report.
85

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by Item 10 is incorporated by reference to our
Proxy Statement in connection with our 2003 Annual Meeting of Stockholders to be
held on May 20, 2003. We expect to file the Proxy Statement on or about April
10, 2003.

ITEM 11. EXECUTIVE COMPENSATION

The information required by Item 11 is incorporated by reference to our
Proxy Statement in connection with our 2003 Annual Meeting of Stockholders to be
held on May 20, 2003.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS

EQUITY COMPENSATION PLAN INFORMATION

As of December 31, 2002, the following table presents information regarding
all of the company's option plans or awards with respect to Equity Compensation
Plans approved by our stockholders:

As of December 31, 2002, the following table presents information regarding
all of the Company's option plans or awards with respect to Equity Compensation
Plans not previously approved by our stockholders:

86

- ---------------

* Plan terminated by Board of Directors and no future grants will be made. The
outstanding grants under the plan were not affected by the termination.

For additional information regarding our equity compensation plans, see
"Note Q -- Stock Plans" in the accompanying consolidated financial statements in
this Form 10-K.

Additional information required by Item 12 is incorporated by reference to
our Proxy Statement in connection with our 2003 Annual Meeting of Stockholders
to be held on May 20, 2003.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by Item 13 is incorporated by reference to our
Proxy Statement in connection with our 2003 annual meeting of stockholders to be
held on May 20, 2003.

ITEM 14. CONTROLS AND PROCEDURES

Within the 90 days prior to the date of this report, we carried out an
evaluation, under the supervision and with the participation of management,
including our President and Chief Executive Officer along with our Chief
Financial Officer, of the effectiveness of our disclosure controls and
procedures (as defined in Exchange Act Rule 13a-14(c)). Based upon that
evaluation, our President and Chief Executive Officer along with our Chief
Financial Officer concluded that our disclosure controls and procedures are
effective. There have been no significant changes in our internal controls or in
other factors, which could significantly affect internal controls subsequent to
the date we carried out our evaluation.

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) Filed documents.

The following documents are filed as part of this report:

1. Financial Statements.

Ceres Group, Inc. and Subsidiaries: Audit Report.

Consolidated Balance Sheets -- December 31, 2002 and 2001.

Consolidated Statements of Operations -- Years ended December 31, 2002,
2001 and 2000.

Consolidated Statements of Stockholders' Equity -- Years ended December
31, 2002, 2001 and 2000.

Consolidated Statements of Cash Flows -- Years ended December 31, 2002,
2001 and 2000.

Notes to Consolidated Financial Statements.

2. Financial Statement Schedules.

Ceres Group, Inc.:

II. Condensed Financial Information of Registrant -- Ceres Group, Inc.
(parent only).

III. Supplementary Insurance Information.

IV. Reinsurance.

Other schedules are omitted because of the absence of conditions under
which they are required or because the required information is given in the
consolidated financial statements or notes thereto.

87

(b) Reports on Form 8-K: Form 8-K report filed on December 26, 2002
disclosing the announcement of definitive agreement to sell Pyramid Life to a
subsidiary of Universal American Financial Corp.

(c) Exhibits.

- ---------------

* Filed herewith.

91

SIGNATURES

PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934, THE COMPANY HAS DULY CAUSED THIS REPORT TO BE SIGNED ON
ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.

CERES GROUP, INC.

Date: March 31, 2003 By: /s/ THOMAS J. KILIAN
-----------------------------------------------------
Thomas J. Kilian, 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 COMPANY
AND IN THE CAPACITIES AND ON THE DATES INDICATED.

92

CERTIFICATIONS PURSUANT TO 17 CFR SECTION 240.13a-14

I, Thomas J. Kilian, President and Chief Executive Officer of Ceres Group, Inc.,
certify that:

1. I have reviewed this annual report on Form 10-K of Ceres Group, Inc.

2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;

b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and

c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

Date: March 31, 2003

/s/ THOMAS J. KILIAN
- ------------------------------------
Thomas J. Kilian
President and Chief Executive
Officer
(Principal Executive Officer)

93

I, David I. Vickers, Executive Vice President and Chief Financial Officer of
Ceres Group, Inc., certify that:

1. I have reviewed this annual report on Form 10-K of Ceres Group, Inc.

2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;

b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and

c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

Date: March 31, 2003

/s/ DAVID I. VICKERS
- ------------------------------------
David I. Vickers
Executive Vice President and
Chief Financial Officer
(Principal Financial Officer)

Simultaneously with the filing of this annual report on Form 10-K, the
Company submitted to the Securities and Exchange Commission the certification of
this report by its chief executive and chief financial officer required by 18
U.S.C. sec. 1350 as adopted pursuant to sec. 906 of the Sarbanes-Oxley Act of
2002.

94

EXHIBIT INDEX

- ---------------

* Filed herewith.

98