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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2003 COMMISSION FILE NUMBER 0-8483
CERES GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 34-1017531
--------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
17800 ROYALTON ROAD, CLEVELAND, OHIO 44136
- ------------------------------------------------------ ------------
(Address of principal executive offices) (Zip Code)
(440) 572-2400
----------------------------------------------
(Registrant's telephone number, including
area code)
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 whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes (X) No ( )
The number of shares of common stock, par value $0.001 per share,
outstanding as of May 1, 2003 was 34,238,164.
CERES GROUP, INC. AND SUBSIDIARIES
INDEX
PART I. FINANCIAL INFORMATION PAGE
Item 1. Financial Statements
Condensed Consolidated Balance Sheets - March 31, 2003 (Unaudited)
and December 31, 2002 1
Condensed Consolidated Statements of Operations - Three months ended
March 31, 2003 and 2002 (Unaudited) 2
Condensed Consolidated Statement of Stockholders' Equity - Three
months ended March 31, 2003 (Unaudited) 3
Condensed Consolidated Statements of Cash Flows - Three months
ended March 31, 2003 and 2002 (Unaudited) 4
Notes to Condensed Consolidated Financial Statements - March 31, 2003
(Unaudited) 5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 17
Item 3. Quantitative and Qualitative Disclosure about Market Risk 29
Item 4. Controls and Procedures 29
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 30
Item 2. Changes in Securities and Use of Proceeds 30
Item 3. Defaults Upon Senior Securities 30
Item 4. Submission of Matters to a Vote of Security Holders 30
Item 5. Other Information 30
Item 6. Exhibits and Reports on Form 8-K 30
SIGNATURES 31
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CERES GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
MARCH 31, DECEMBER 31,
2003 2002
---------------- -----------------
(UNAUDITED) (NOTE A)
ASSETS
Investments
Fixed maturities available-for-sale, at fair value $405,934 $388,057
Surplus notes 5,128 5,151
Policy and mortgage loans 4,022 3,895
-------- --------
Total investments 415,084 397,103
Cash and cash equivalents (of which $8,401 and $7,703 is restricted, respectively) 93,918 32,118
Accrued investment income 4,565 5,236
Premiums receivable 5,210 4,810
Reinsurance receivable 152,581 170,075
Property and equipment, net 6,115 5,387
Assets of Pyramid Life -- 157,774
Deferred acquisition costs 74,825 74,891
Value of business acquired 15,409 16,084
Goodwill 10,657 10,657
Licenses 3,586 3,586
Other assets 6,617 9,760
-------- --------
TOTAL ASSETS $788,567 $887,481
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Policy liabilities and benefits accrued
Future policy benefits, losses and claims $338,437 $327,385
Unearned premiums 38,802 36,680
Other policy claims and benefits payable 146,060 147,938
-------- --------
523,299 512,003
Deferred reinsurance gain 10,535 11,037
Other policyholders' funds 21,690 23,610
Debt 13,733 25,003
Liabilities of Pyramid Life -- 102,457
Deferred federal income taxes 13,678 11,746
Other liabilities 33,301 34,101
-------- --------
TOTAL LIABILITIES 616,236 719,957
-------- --------
Stockholders' equity
Non-voting preferred stock, $0.001 par value, 1,900,000 shares authorized, none issued -- --
Convertible voting preferred stock, $0.001 par value, at stated value, 100,000 shares
authorized, none issued -- --
Common stock, $0.001 par value, 50,000,000 shares authorized, 34,238,164 and
34,232,610 shares issued and outstanding, respectively 34 34
Additional paid-in capital 133,063 133,052
Retained earnings 28,809 21,430
Accumulated other comprehensive income 10,425 13,008
-------- --------
TOTAL STOCKHOLDERS' EQUITY 172,331 167,524
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $788,567 $887,481
======== ========
The accompanying notes are an integral part of
these condensed consolidated financial statements.
1
CERES GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
UNAUDITED
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED
MARCH 31,
-----------------------------
2003 2002
--------- ---------
REVENUES
Premiums, net
Medical $ 85,119 $ 94,879
Senior and other 42,857 42,670
--------- ---------
Total premiums, net 127,976 137,549
Net investment income 5,524 6,457
Net realized gains 584 116
Fee and other income 6,342 7,967
Amortization of deferred reinsurance gain 657 1,038
--------- ---------
141,083 153,127
--------- ---------
BENEFITS, LOSSES AND EXPENSES
Benefits, claims, losses and settlement expenses
Medical 62,506 73,913
Senior and other 33,800 33,749
--------- ---------
Total benefits, claims, losses and settlement expenses 96,306 107,662
Selling, general and administrative expenses 38,180 45,369
Net (deferral) amortization and change in acquisition costs and
value of business acquired 401 (4,343)
Interest expense and financing costs 429 530
Special charge -- 2,381
--------- ---------
135,316 151,599
--------- ---------
Income from continuing operations before federal income
taxes and minority interest 5,767 1,528
Federal income tax expense 2,020 531
--------- ---------
Income from continuing operations after tax and before
minority interest 3,747 997
Minority interest (10) (14)
--------- ---------
INCOME FROM CONTINUING OPERATIONS 3,757 1,011
--------- ---------
Discontinued operations
Income from operations of Pyramid Life (less tax expense of
$3,223 and $305, respectively) 5,732 517
Loss on sale of Pyramid Life (less tax benefit of $79) (2,110) --
--------- ---------
INCOME FROM DISCONTINUED OPERATIONS 3,622 517
--------- ---------
NET INCOME $ 7,379 $ 1,528
========= =========
BASIC EARNINGS PER SHARE
Continuing operations $ 0.11 $ 0.03
Discontinued operations 0.11 0.02
--------- ---------
Net income $ 0.22 $ 0.05
========= =========
DILUTED EARNINGS PER SHARE
Continuing operations $ 0.11 $ 0.03
Discontinued operations 0.11 0.02
--------- ---------
Net income $ 0.22 $ 0.05
========= =========
The accompanying notes are an integral part of
these condensed consolidated financial statements.
2
CERES GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE THREE MONTHS ENDED MARCH 31, 2003
UNAUDITED
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
COMMON STOCK
Balance at March 31, 2003 $ 34
============
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of year $ 133,052
Issuance of stock:
Employee benefit plans 11
------------
Balance at March 31, 2003 $ 133,063
============
RETAINED EARNINGS
Balance at beginning of year $ 21,430
Net income 7,379
------------
Balance at March 31, 2003 $ 28,809
============
ACCUMULATED OTHER COMPREHENSIVE INCOME
Balance at beginning of year $ 13,008
Unrealized gain on securities, net of tax expense of $742 1,382
Realized gains due to the sale of Pyramid Life, net of tax of $2,016 (3,744)
Other (221)
------------
Balance at March 31, 2003 $ 10,425
============
TOTAL STOCKHOLDERS' EQUITY $ 172,331
============
NUMBER OF SHARES OF COMMON STOCK
Balance at beginning of year 34,232,610
Issuance of stock:
Employee benefit plans 5,554
------------
Balance at March 31, 2003 34,238,164
============
The accompanying notes are an integral part of
these condensed consolidated financial statements.
3
CERES GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
UNAUDITED
(DOLLARS IN THOUSANDS)
THREE MONTHS ENDED
MARCH 31,
---------------------------
2003 2002
-------- --------
OPERATING ACTIVITIES
Net income $ 7,379 $ 1,528
Adjustments to reconcile net income to cash provided by (used in)
continuing operating activities:
Net income from discontinued operations (3,622) (517)
Depreciation and amortization 858 753
Net realized gains (losses) (584) (116)
Deferred federal income taxes 1,364 (120)
Changes in assets and liabilities:
Accrued investment income 671 701
Reinsurance and premiums receivable 17,094 11,838
Deferred acquisition costs (274) (4,917)
Value of business acquired 675 574
Other assets 2,193 (489)
Future policy benefits, claims and funds payable 7,747 (16,562)
Unearned premium 2,122 3,154
Deferred reinsurance gain (501) (1,038)
Federal income taxes payable/recoverable 950 573
Other liabilities (693) (12,772)
-------- --------
Net cash provided by (used in) operating activities 35,379 (17,410)
-------- --------
INVESTING ACTIVITIES
Net purchases of furniture and equipment (1,000) (108)
Purchase of fixed maturities available-for-sale (44,406) (50,479)
Increase in policy and mortgage loans, net (127) (12)
Proceeds from sales of fixed maturities available-for-sale 12,911 16,486
Proceeds from calls and maturities of fixed maturities available-for sale 15,495 10,617
Net proceeds from sale of Pyramid Life 55,300 --
-------- --------
Net cash provided by (used in) investing activities 38,173 (23,496)
-------- --------
FINANCING ACTIVITIES
Increase in annuity account balances 4,120 2,270
Decrease in annuity account balances (4,613) (7,537)
Principal payments on debt (11,270) (3,000)
Proceeds from issuance of common stock related to employee benefit plans 11 161
-------- --------
Net cash used in financing activities (11,752) (8,106)
-------- --------
NET INCREASE (DECREASE) IN CASH 61,800 (49,012)
Cash and cash equivalents at beginning of year 32,118 68,506
-------- --------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 93,918 $ 19,494
======== ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest $ 412 $ 759
Cash paid during the period for federal income taxes -- --
The accompanying notes are an integral part of
these condensed consolidated financial statements.
4
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2003
UNAUDITED
- -------------------------------------------------------------------------------
A. SUMMARY OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
SUMMARY OF BUSINESS
The accompanying unaudited condensed consolidated financial statements of
Ceres Group, Inc. and subsidiaries, included herein, have been prepared in
accordance with accounting principles generally accepted in the United States
for interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. In the opinion of management, all adjustments
(consisting of normal recurring accruals) considered necessary for a fair
presentation have been included. Operating results for the three month period
ended March 31, 2003 are not necessarily indicative of the results that may be
expected for the year ended December 31, 2003.
The condensed consolidated financial statements for March 31, 2003 include
the continuing operations of Central Reserve Life Insurance Company, Provident
American Life and Health Insurance Company, Continental General Corporation and
its wholly-owned subsidiary, Continental General Insurance Company, United
Benefit Life Insurance Company, and the discontinued operations of Pyramid Life
Insurance Company. On March 31, 2003, we sold the stock of Pyramid Life. See
Note D. Discontinued Operations for further information. As a result of the sale
of Pyramid Life, our previously reported consolidated financial statements for
the three month period ended March 31, 2002 have been reclassified to present
the discontinued operations of Pyramid Life separate from continuing operations
to conform to the current year's presentation.
The balance sheet presented at December 31, 2002 has been derived from the
audited financial statements at that date, but does not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. For further information, refer to the
consolidated financial statements and footnotes thereto included in our Annual
Report on Form 10-K for the year ended December 31, 2002.
Unless the context indicates otherwise, "we," "our" and "us" refers to
Ceres Group, Inc. and its subsidiaries on a consolidated basis.
SIGNIFICANT ACCOUNTING POLICIES
USE OF ESTIMATES
The preparation of the condensed 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.
5
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MARCH 31, 2003
UNAUDITED
- -------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash and all liquid securities with
maturities of 90 days or less when purchased. At March 31, 2003 and December 31,
2002, restricted cash was $8.4 million and $7.7 million, respectively.
Restricted cash primarily represents cash held related to fully insured employer
shared risk plans, which is restricted from any other use. We are entitled to
the investment income from these funds. A corresponding liability is included in
the accompanying condensed consolidated financial statements.
INVESTMENTS
Our insurance subsidiaries had certificates of deposit and fixed maturity
securities on deposit with various state insurance departments to satisfy
regulatory requirements.
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.
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.
6
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MARCH 31, 2003
UNAUDITED
- -------------------------------------------------------------------------------
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 the date of grant.
The following table illustrates the effect on net income and earnings per share
if we had applied the fair value recognition provisions of SFAS No. 123.
THREE MONTHS ENDED
MARCH 31,
----------------------------
2003 2002
--------- ---------
(dollars in thousands, except
per share amounts)
Net income, as reported $ 7,379 $ 1,528
Total stock-based employee compensation expense
determined under fair value based method for all awards, net of tax -- (145)
--------- ---------
PRO FORMA NET INCOME $ 7,379 $ 1,383
========= =========
Earnings per share
Basic-as reported $ 0.22 $ 0.05
BASIC-PRO FORMA $ 0.22 $ 0.04
Diluted-as reported $ 0.22 $ 0.05
DILUTED-PRO FORMA $ 0.22 $ 0.04
RECLASSIFICATIONS
Certain prior period amounts have been reclassified to conform to the
current period presentation.
NEW ACCOUNTING PRONOUNCEMENT
In June 2002, the Financial Accounting Standards Board, or FASB, issued
Statement of Financial Accounting Standards, or 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. The adoption of this standard did not have a material
effect on our results of operations, financial position or liquidity.
7
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MARCH 31, 2003
UNAUDITED
- -------------------------------------------------------------------------------
B. DEBT
MARCH 31, DECEMBER 31,
2003 2002
----------- ------------
(dollars in thousands)
Bank credit facility $ 13,733 $ 25,003
=========== ============
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 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 3.0% 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 4.0% 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 March 31, 2003, the interest rate on our tranche A term loan
balance of $8.7 million was 7.3% per annum and our $5.0 million CIT tranche B
term loan was 7.8% per annum. In conjunction with the sale of Pyramid Life and
the partial pay down of the term loans on March 31, 2003, the tranche A and
tranche B term loans were converted from Eurodollar Loans to Base Rate Loans.
The remaining loan balances of tranche A and tranche B were subsequently
converted back to Eurodollar Loans following the partial pay down.
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;
8
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MARCH 31, 2003
UNAUDITED
- -------------------------------------------------------------------------------
- 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.
Effective March 31, 2003, the credit agreement was amended in connection
with the sale of Pyramid Life. The amendment:
- permitted the sale of Pyramid Life;
- required $10.0 million of sale proceeds to be used as a partial pay
down of bank debt;
- waived the minimum risk-based capital ratio requirement of 125% for
Continental General at December 31, 2002;
- excluded intercompany tax sharing payments in the calculation of the
fixed charge coverage ratio at December 31, 2002;
- increased 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
9
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MARCH 31, 2003
UNAUDITED
- -------------------------------------------------------------------------------
- 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 March 31, 2003, 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 and Continental
General) could 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.
C. REINSURANCE
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
10
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MARCH 31, 2003
UNAUDITED
- -------------------------------------------------------------------------------
insureds with respect to ceded reinsurance if any reinsurer fails to meet its
obligations to us. 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, which are amortized over the expected profit stream
of the in force business.
The following table summarizes the net impact of our reinsurance
arrangements on premiums and benefits, claims, losses and settlement expenses,
commissions, and other operating expenses:
THREE MONTHS ENDED
MARCH 31,
-----------------------------
2003 2002
--------- ---------
(DOLLARS IN THOUSANDS)
PREMIUMS, NET
Direct $ 152,256 $ 170,623
Assumed -- 17
Ceded (24,280) (33,091)
--------- ---------
Total premiums, net $ 127,976 $ 137,549
========= =========
BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES $ 112,779 $ 134,721
Reinsurance recoveries (16,473) (27,059)
--------- ---------
Total benefits, claims, losses and
settlement expenses $ 96,306 $ 107,662
========= =========
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Commissions $ 20,621 $ 26,610
Other operating expenses 22,767 26,037
Reinsurance expenses -- 255
Reinsurance allowances (5,208) (7,533)
--------- ---------
Total selling, general and administrative
expenses $ 38,180 $ 45,369
========= =========
We have reclassified certain prior period amounts in accordance with
current year treatment.
D. DISCONTINUED OPERATIONS
On March 31, 2003, we sold the stock of our indirect subsidiary, Pyramid
Life, which was primarily included in our senior segment, to the Pennsylvania
Life Insurance Company, a subsidiary of Universal American Financial Corp. for
$57.5 million in cash, subject to further adjustment based on Pyramid Life's
statutory capital and surplus as of March 31. Net proceeds from the sale were
used to strengthen Continental General's statutory capital and repay $10.0
million of our bank debt. 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 total loss from the sale (net of taxes
and expenses incurred) is expected to be $13.7 million. Accordingly, we adjusted
the carrying value of
11
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MARCH 31, 2003
UNAUDITED
- -------------------------------------------------------------------------------
Pyramid Life's assets held for sale to fair market value at December 31, 2002,
which resulted in a charge of $11.6 million. In addition, we recorded a $2.1
million loss on the sale at March 31, 2003. As a result of the sale, Pyramid
Life's operations were classified as discontinued operations and prior years'
financial information has been reclassified.
Summarized financial data for Pyramid Life's operations are as follows:
STATEMENTS OF OPERATIONS
THREE MONTHS ENDED
MARCH 31,
---------------------------
2003 2002
-------- --------
(dollars in thousands)
REVENUES
Premiums, net $ 27,964 $ 22,642
Net investment income 1,568 1,755
Net realized gains (losses) 5,965 (5)
-------- --------
35,497 24,392
-------- --------
BENEFITS, LOSSES AND EXPENSES
Benefits, claims, losses and settlement expenses 20,285 18,257
Selling, general and administrative expenses 8,702 6,981
Net (deferral) amortization and change in acquisition
costs and value of business acquired (2,445) (1,954)
Special charge -- 286
-------- --------
26,542 23,570
-------- --------
Income from operations before federal income taxes 8,955 822
Federal income tax expense 3,223 305
-------- --------
INCOME FROM OPERATIONS 5,732 517
-------- --------
Loss on sale of Pyramid Life (2,189) --
Federal income tax benefit (79) --
-------- --------
LOSS ON SALE OF PYRAMID LIFE, NET (2,110) --
-------- --------
INCOME FROM DISCONTINUED OPERATIONS $ 3,622 $ 517
======== ========
12
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MARCH 31, 2003
UNAUDITED
- -------------------------------------------------------------------------------
BALANCE SHEET
DECEMBER 31,
2002
------------
(dollars in
thousands)
ASSETS
Investments $106,231
Cash and cash equivalents 6,411
Accrued investment income 1,391
Premiums receivable 312
Reinsurance receivable 7,808
Property and equipment, net 1,000
Deferred acquisition costs 16,150
Value of business acquired 15,067
Other assets 3,404
--------
TOTAL ASSETS 157,774
--------
LIABILITIES AND STOCKHOLDERS' EQUITY
Policy liabilities and benefits accrued 96,866
Intercompany payable 1,797
Other liabilities 3,794
--------
TOTAL LIABILITIES 102,457
--------
NET ASSETS OF DISCONTINUED OPERATIONS $ 55,317
========
E. SPECIAL CHARGE
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.
13
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MARCH 31, 2003
UNAUDITED
- -------------------------------------------------------------------------------
F. COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) is as follows:
THREE MONTHS ENDED
MARCH 31,
-------------------------
2003 2002
------- -------
(DOLLARS IN THOUSANDS)
Net income $ 7,379 $ 1,528
Other comprehensive income (loss), net of tax:
Unrealized gain (loss) on securities, net of tax
expense (benefit) of $742 and $(942),
respectively (1) 1,382 (5,139)
Realized gain due to the sale of Pyramid Life,
net of tax of $2,016 (3,744) --
Other (221) (56)
------- -------
Comprehensive income (loss) $ 4,796 $(3,667)
======= =======
- -----------
(1) Net of reclassification adjustments for net gains (losses) included in net
income.
G. EARNINGS PER SHARE
Basic and diluted earnings per common share are calculated in accordance
with SFAS No. 128, Earnings per Share. Basic earnings per common share is
computed by dividing net income (loss) 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. Basic and diluted weighted average
shares of common stock are as follows:
THREE MONTHS ENDED
MARCH 31,
------------------------------
2003 2002
---------- ----------
Weighted average shares:
BASIC 34,236,313 33,900,336
Stock awards and incremental shares from
assumed exercise of stock options -- 31,582
---------- ----------
DILUTED 34,236,313 33,931,918
========== ==========
H. 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.
14
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MARCH 31, 2003
UNAUDITED
- -------------------------------------------------------------------------------
I. 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 major 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.
15
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
MARCH 31, 2003
UNAUDITED
- -------------------------------------------------------------------------------
The following table presents the revenues, expenses and profit (loss) from
continuing operations before federal income taxes, for the three month period
ended March 31, 2003 and 2002 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.
Revenues from each segment are primarily generated from premiums charged to
external policyholders and interest earned on cash and investments.
THREE MONTHS ENDED
MARCH 31,
-----------------------------
2003 2002
--------- ---------
(DOLLARS IN THOUSANDS)
MEDICAL
Revenues
Net premiums $ 85,119 $ 94,879
Investment income, realized gains (losses) 1,652 1,992
Other income 6,491 8,309
--------- ---------
93,262 105,180
--------- ---------
Expenses
Benefits and claims 62,506 73,913
Other operating expenses 26,777 29,596
--------- ---------
89,283 103,509
--------- ---------
Segment profit before federal income
taxes and minority interest $ 3,979 $ 1,671
========= =========
SENIOR AND OTHER
Revenues
Net premiums $ 42,857 $ 42,670
Investment income, realized gains (losses) 4,339 4,467
Other income 508 696
--------- ---------
47,704 47,833
--------- ---------
Expenses
Benefits and claims 33,800 33,749
Other operating expenses 11,409 11,065
--------- ---------
45,209 44,814
--------- ---------
Segment profit before federal income taxes and
minority interest $ 2,495 $ 3,019
========= =========
CORPORATE AND OTHER
Revenues
Investment income, realized gains (losses) $ 117 $ 114
--------- ---------
Expenses
Interest and financing costs 429 530
Other operating expenses 395 365
Special charge -- 2,381
--------- ---------
824 3,276
--------- ---------
Segment loss before federal income taxes
and minority interest $ (707) $ (3,162)
========= =========
INCOME FROM CONTINUING OPERATIONS BEFORE
FEDERAL INCOME TAXES AND MINORITY INTEREST $ 5,767 $ 1,528
========= =========
16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This discussion should be read in conjunction with our condensed
consolidated financial statements, notes and tables included elsewhere in this
report, as well as, the Management's Discussion and Analysis of Financial
Condition and Results of Operations, or MD&A, contained in our 2002 Annual
Report on Form 10-K. MD&A may contain 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" for further
information.
OVERVIEW
Ceres Group, through its insurance subsidiaries, provides a wide array of
health and life insurance products 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.
Our insurance subsidiaries include Central Reserve Life Insurance
Company, Provident American Life & Health Insurance Company, United Benefit Life
Insurance Company and Continental General Insurance Company. Central Reserve
markets and sells 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.
CRITICAL ACCOUNTING POLICIES
Refer to Critical Accounting Policies in our 2002 Annual Report on Form
10-K for information on accounting policies that we consider critical in
preparing our consolidated financial statements. These policies include
significant estimates made by management using information available at the time
the estimates were made. However, these estimates could change materially if
different information or assumptions were used.
RESULTS OF OPERATIONS
On March 31, 2003, we sold our indirect subsidiary, Pyramid Life Insurance
Company, to the Pennsylvania Life Insurance Company, a subsidiary of Universal
American Financial Corp. for approximately $57.5 million in cash, subject to
further adjustment based on Pyramid Life's statutory capital and surplus at
March 31. Results of continuing operations for the three months ended March 31,
2003 and 2002 include the operations 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
at December 31, 2002, and was measured at its fair value less cost to sell.
Therefore, the financial information excludes the operations of Pyramid Life for
the periods
17
presented. Financial data for the first quarter of 2002 was reclassified to
reflect the sale of Pyramid Life. The net assets, results of operations, and
cash flows of Pyramid Life were reported separately as discontinued operations
of a subsidiary in our consolidated financial statements for the periods
presented. See Note D. Discontinued Operations to our condensed consolidated
financial statements for further information.
18
QUARTER ENDED MARCH 31, 2003 COMPARED TO QUARTER ENDED MARCH 31, 2002
INCREASE
THREE MONTHS THREE MONTHS (DECREASE) FROM
ENDED % OF ENDED % OF PREVIOUS YEAR
MARCH 31, CONSOLIDATED MARCH 31, CONSOLIDATED ------------------------
2003 REVENUES 2002 REVENUES DOLLARS %
------------ ------------ ------------ ------------- ----------- ------------
(dollars in thousands, except per share amounts)
Premiums, net
Medical $ 85,119 60.3% $ 94,879 62.0% $ (9,760) (10.3)%
Senior and other 42,857 30.4 42,670 27.8 187 0.4
--------- ----- --------- ----- ---------
Total 127,976 90.7 137,549 89.8 (9,573) (7.0)
Net investment income 5,524 3.9 6,457 4.2 (933) (14.4)
Net realized gains 584 0.4 116 0.1 468 N/M
Fee and other income 6,342 4.5 7,967 5.2 (1,625) (20.4)
Amortization of deferred
reinsurance gain 657 0.5 1,038 0.7 (381) (36.7)
--------- ----- --------- ----- ---------
Consolidated revenues 141,083 100.0 153,127 100.0 (12,044) (7.9)
--------- ----- --------- ----- ---------
Benefits, claims, losses and settlement
expenses
Medical 62,506 44.3 73,913 48.3 (11,407) (15.4)
Senior and other 33,800 24.0 33,749 22.0 51 0.2
--------- ----- --------- ----- ---------
Total 96,306 68.3 107,662 70.3 (11,356) (10.5)
Selling, general and administrative
expenses 38,180 27.1 45,369 29.6 (7,189) (15.8)
Net (deferral) amortization and change in
acquisition costs and value of business
acquired 401 0.2 (4,343) (2.8) 4,744 N/M
Interest expense and financing costs 429 0.3 530 0.3 (101) (19.1)
Special charge -- -- 2,381 1.6 (2,381) (100.0)
--------- ----- --------- ----- ---------
135,316 95.9 151,599 99.0 (16,283) (10.7)
--------- ----- --------- ----- ---------
Income from continuing operations
before federal income taxes and
minority interest 5,767 4.1 1,528 1.0 4,239 277.4
Federal income tax expense 2,020 1.4 531 0.3 1,489 280.4
--------- ----- -------- ----- ---------
Income from continuing operations
after tax and before minority interest 3,747 2.7 997 0.7 2,750 275.8
Minority interest (10) -- (14) -- 4 28.6
--------- ----- --------- ----- ---------
INCOME FROM CONTINUING
OPERATIONS 3,757 2.7 1,011 0.7 2,746 271.6
--------- ----- --------- ----- ---------
Discontinued operations:
Income from operations of Pyramid
Life, net of tax 5,732 4.0 517 0.3 5,215 N/M
Loss on sale of Pyramid Life, net of
tax (2,110) (1.5) -- -- (2,110) N/M
--------- ----- --------- ----- ---------
INCOME FROM DISCONTINUED
OPERATIONS 3,622 2.5 517 0.3 3,105 N/M
--------- ----- --------- ----- ---------
NET INCOME $ 7,379 5.2% $ 1,528 1.0% $ 5,851 382.9
========= ===== ========= ===== =========
Basic earnings per share $ 0.22 $ 0.05 $ 0.17 340.0
Diluted earnings per share 0.22 0.05 0.17 340.0
- ------------
N/M = not meaningful
19
NET PREMIUMS (NET OF REINSURANCE CEDED)
For the quarter ended March 31, 2003, total net premiums were $128.0
million, a decrease of 7.0%, from $137.5 million for the same quarter in 2002.
MEDICAL
Medical premiums for the quarter ended March 31, 2003 were $85.1 million
compared to $94.9 million for the quarter ended March 31, 2002, a decrease of
10.3%. The decrease in medical premiums was primarily the result of a 31%
decrease in major medical certificates in force due to the cancellation of
medical business in unprofitable states offset by a lower level of reinsurance
and renewal premium increases averaging 20.0% to 30.0%.
SENIOR AND OTHER
Senior and other premiums were $42.9 million for the quarter ended March
31, 2003 compared to $42.7 million for the quarter ended March 31, 2002, an
increase of 0.4%. The increase in senior and other premiums was primarily the
result of premium rate increases offset by a decrease in certificates in force
due to other companion products to the medical business.
OTHER REVENUES
Net investment income was $5.5 million for the first quarter of 2003
compared to $6.5 million for the first quarter of 2002, a decrease of 14.4%, due
primarily to a decrease in invested assets and a lower yield.
Net realized gains increased to $0.6 million for the first quarter of 2003
compared to $0.1 million for the first quarter of 2002 as a result of gains
generated on the sale of CMOs.
Fee and other income decreased to $6.3 million for the quarter ended March
31, 2003 compared to $8.0 million for the same quarter of 2002, a decrease of
20.4%. This decrease was primarily attributable to the cancellation of medical
business in certain unprofitable states and a decline in new business.
The amortization of deferred reinsurance gain of $0.7 million for the
quarter ended March 31, 2003 represented the recognition of the ceding
commission allowances received under our reinsurance agreements. The unamortized
amount of $10.5 million at March 31, 2003 was accounted for as a deferred
reinsurance gain on the condensed consolidated balance sheet. The amortization
of deferred reinsurance gain decreased from $1.0 million for the quarter ended
March 31, 2002 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 $96.3
million for the quarter ended March 31, 2003 compared to $107.7 million for the
same quarter in 2002, a decrease of 10.5%.
20
MEDICAL
Medical benefits, claims, losses and settlement expenses were $62.5 million
for the quarter ended March 31, 2003 compared to $73.9 million for the same
quarter in 2002, a decrease of 15.4%. The decrease was primarily a result of a
smaller volume of business in force due to the cancellation of medical business
in certain unprofitable states. The medical loss ratio was 73.4% for the quarter
ended March 31, 2003 compared to 77.9% for the same quarter of 2002. The medical
loss ratio decreased due to the cancellation of business in poor performing
markets, as well as pricing increases.
SENIOR AND OTHER
Senior and other benefits, claims, losses and settlement expenses slightly
increased to $33.8 million for the quarter ended March 31, 2003 compared to
$33.7 million for the same quarter of 2002. The senior and other loss ratio was
78.9% for the first quarter of 2003 compared to 79.1% for the first quarter of
2002 primarily due to lower utilization in the Medicare segment offset by higher
utilization in the long-term care business.
OTHER EXPENSES AND NET INCOME
Selling, general and administrative expenses decreased to $38.2 million in
the first quarter of 2003 compared to $45.4 million in the first quarter of
2002, a decrease of 15.8%. Commissions decreased $6.0 million and other
operating expenses decreased $3.5 million as a direct result of our cancelled or
replaced business offset by reduced reinsurance allowances of $2.3 million as a
result of a lower volume of ceded premiums. As a percentage of revenues,
selling, general and administrative expenses decreased to 27.1% in the first
quarter of 2003 compared to 29.6% in the first quarter of 2002 primarily due to
the decrease in the overall commissions rate as a result of lower new sales, the
reduction in the workforce at our Cleveland facility and economies of scale
achieved from the conversion of the senior business to our Kansas City facility
in 2002, offset by the decrease in reinsurance allowances due to a lower volume
of ceded premiums as a result of our cancelled business.
The net (deferral) amortization and change in acquisition costs (DAC) and
value of business acquired (VOBA) resulted in net amortization of $0.4 million
for the first quarter of 2003 compared to a net deferral of $4.3 million for the
first quarter of 2002. The decrease in the net deferral was primarily
attributable to the lower capitalization of DAC due to decreases in new business
sales and a $0.1 million increase in the amortization of VOBA.
Interest expense and financing costs decreased to $0.4 million in the first
quarter of 2003 compared to $0.5 million in the first quarter of 2002 as a
result of a decrease in outstanding debt.
A federal income tax expense of $2.0 million, or 35.0% of the income before
federal taxes, was established for the first quarter of 2003. In the first
quarter of 2002, federal income tax expense was $0.5 million, or 34.8% of the
income before federal taxes.
Income from continuing operations was $3.8 million, or $0.11 per share, for
the first quarter of 2003 compared to $1.0 million, or $0.03 per share, for the
first quarter of 2002. Income from the operations of Pyramid Life (classified as
discontinued operations) was $3.6 million, or $0.11 per share, (which included
$3.9 million of net realized investment gains, $1.8 million of operating income
and a loss on the sale of $2.1 million) for the first quarter of 2003 compared
to
21
$0.5 million, or $0.02 per share, for the first quarter of 2002. As a result of
the foregoing, for the first quarter of 2003, net income was $7.4 million, or
$0.22 basic and diluted income per share of common stock, compared to $1.5
million, or $0.05 basic and diluted income per share of common stock, for the
first quarter of 2002.
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
provided by operating activities for the quarter ended March 31, 2003 was $35.4
million compared to net cash used in operating activities of $17.4 million at
March 31, 2002. The net cash provided at March 31, 2003 was primarily due to a
decrease in reinsurance receivable related to first quarter settlements and an
increase in future policy benefits payable due to the assumption of reserves
from Pyramid Life related to a new reinsurance treaty established in conjunction
with the Pyramid Life sale.
Assets decreased 11.1% to $788.6 million at March 31, 2003 from $887.5
million at March 31, 2002 due to the sale of Pyramid Life. Assets of $415.1
million, or 52.6% of the total assets, were in investments at March 31, 2003.
Fixed maturities, our primary investment, were $405.9 million, or 97.8% of total
investments, at March 31, 2003. 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 March 31, 2003.
Approximately 94.1% of our bonds were of investment grade quality at March
31, 2003. In addition to the fixed maturities, we also had $93.9 million in cash
and cash equivalents (including the cash proceeds from the sale of Pyramid Life)
of which $8.4 million was restricted at March 31, 2003.
The total reinsurance receivable was $152.6 million at March 31, 2003. Of
this amount, $150.3 million represents reserves held by our reinsurers under our
various reinsurance treaties in place. Hannover holds most of these reserves.
The total policy liabilities and benefits accrued were 84.9% of the total
liabilities at March 31, 2003 compared to 71.1% at March 31, 2002. This increase
was primarily due to the sale of Pyramid Life.
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 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
22
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 3.0% 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 4.0% 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 March 31, 2003, the interest rate on our tranche A term loan
balance of $8.7 million was 7.3% per annum and our $5.0 million CIT tranche B
term loan was 7.8% per annum. In conjunction with the sale of Pyramid Life and
the partial pay down of the term loans on March 31, 2003, the tranche A and
tranche B term loans were converted from Eurodollar Loans to Base Rate Loans.
The remaining loan balances of tranche A and tranche B were subsequently
converted back to Eurodollar Loans following the partial pay down.
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.
23
Effective March 31, 2003, the credit agreement was amended in connection
with the sale of Pyramid Life. The amendment:
- permitted the sale of Pyramid Life;
- required $10.0 million of sale proceeds to be used as a partial pay
down of bank debt;
- waived the minimum risk-based capital ratio requirement of 125% for
Continental General at December 31, 2002;
- excluded intercompany tax sharing payments in the calculation of the
fixed charge coverage ratio at December 31, 2002;
- increased 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 March 31, 2003:
PAYMENTS DUE BY YEAR
-------------------------------------------------------------------------------
LESS THAN 1
CONTRACTUAL OBLIGATIONS TOTAL YEAR 1-3 YEARS 4-5 YEARS AFTER 5 YEARS
----------------------- ------- ----------- --------- --------- -------------
(dollars in thousands)
Long-term debt $13,733 $ 3,035 $10,698 $ -- $ --
Operating leases 28,837 3,022 4,925 3,994 16,896
------- ------- ------- ------- -------
Total contractual obligations $42,570 $ 6,057 $15,623 $ 3,994 $16,896
======= ======= ======= ======= =======
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 March 31, 2003, 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
24
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 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) could 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.
FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS
We have three segments: medical, which includes catastrophic and
comprehensive major medical plans; senior and other, which includes Medicare
supplement, long-term care, dental, life insurance and annuities; and corporate
and other, which includes interest income, interest expense, and corporate
expenses of the parent company. See Note I. Operating Segments, to the Notes to
our Condensed Consolidated Financial Statements for further information.
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.
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
25
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 on March 31, 2003, 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
March 31, 2003. The amortized cost and estimated fair value of fixed maturities
on our investment surveillance list at March 31, 2003 were $8.0 million and $6.6
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
26
interest rates, the net hypothetical decline in fair value of stockholders'
equity is estimated to be $10.6 million after-tax at March 31, 2003. This amount
represents approximately 6.2% 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.
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
27
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;
- 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;
- 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;
28
- 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.
NEW ACCOUNTING PRONOUNCEMENT
See Note A. Summary of Business and Significant Accounting Policies, to the
notes to our condensed consolidated financial statements for a discussion of
recently issued Accounting Standards.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The information called for by this item is provided under the caption
"Market Risk and Management Policies" under Item 2 - Management's Discussion and
Analysis of Financial Condition and Results of Operations.
ITEM 4. 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.
29
PART II. OTHER INFORMATION
ITEM 1. 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 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 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits: 99.1 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-
Oxley Act of 2002.
b) Reports on Form 8-K: None.
30
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CERES GROUP, INC.
Date: May 15, 2003 By: /s/ David I. Vickers
---------------- --------------------
David I. Vickers
Executive Vice President and Chief
Financial Officer (Principal Financial
Officer and Chief Accounting Officer)
31
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 quarterly report on Form 10-Q of Ceres Group, Inc.
2. Based on my knowledge, this quarterly 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 quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly 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 quarterly 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
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly 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
quarterly 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: May 15, 2003
/s/ Thomas J. Kilian
- ---------------------------
THOMAS J. KILIAN
President and Chief Executive Officer
(Principal Executive Officer)
I, David I. Vickers, Executive Vice President and Chief Financial Officer of
Ceres Group, Inc., certify that:
1. I have reviewed this quarterly report on Form 10-Q of Ceres Group, Inc.
2. Based on my knowledge, this quarterly 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 quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly 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 quarterly 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
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly 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
quarterly 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: May 15, 2003
/s/ David I. Vickers
- -------------------------
DAVID I. VICKERS
Executive Vice President and Chief Financial Officer
(Principal Financial Officer)
Simultaneously with the filing of this quarterly report on Form 10-Q, 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. ss. 1350 as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of
2002.