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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 JUNE 30, 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
incorporation or organization) No.)
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 August 1, 2003 was 34,340,299.
CERES GROUP, INC. AND SUBSIDIARIES
INDEX
PART I. FINANCIAL INFORMATION PAGE
----
Item 1. Financial Statements
Condensed Consolidated Balance Sheets - June 30, 2003 (Unaudited) 1
and December 31, 2002
Condensed Consolidated Statements of Operations - Three and six
months ended June 30, 2003 and 2002 (Unaudited) 2
Condensed Consolidated Statement of Stockholders' Equity - Six
months ended June 30, 2003 (Unaudited) 3
Condensed Consolidated Statements of Cash Flows - Six months
ended June 30, 2003 and 2002 (Unaudited) 4
Notes to Condensed Consolidated Financial Statements - June 30, 2003
(Unaudited) 5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 18
Item 3. Quantitative and Qualitative Disclosure about Market Risk 34
Item 4. Controls and Procedures 34
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 36
Item 2. Changes in Securities and Use of Proceeds 36
Item 3. Defaults Upon Senior Securities 36
Item 4. Submission of Matters to a Vote of Security Holders 36
Item 5. Other Information 36
Item 6. Exhibits and Reports on Form 8-K 36
SIGNATURES 38
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CERES GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
JUNE 30, DECEMBER 31,
2003 2002
---------------- -----------------
(UNAUDITED) (NOTE A)
ASSETS
Investments
Fixed maturities available-for-sale, at fair value $ 466,913 $ 388,057
Surplus notes 4,087 5,151
Policy and mortgage loans 4,065 3,895
----------- -----------
Total investments 475,065 397,103
Cash and cash equivalents (of which $5,534 and $7,703 is restricted, respectively) 40,499 32,118
Accrued investment income 5,572 5,236
Premiums receivable 5,774 4,810
Reinsurance receivable 147,489 170,075
Property and equipment, net 5,767 5,387
Assets of Pyramid Life -- 157,774
Deferred acquisition costs 72,937 74,891
Value of business acquired 14,790 16,084
Goodwill 10,657 10,657
Licenses 3,440 3,586
Other assets 5,822 9,760
----------- -----------
TOTAL ASSETS $ 787,812 $ 887,481
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Policy liabilities and benefits accrued
Future policy benefits, losses and claims $ 337,831 $ 327,385
Unearned premiums 37,916 36,680
Other policy claims and benefits payable 139,290 147,938
----------- -----------
515,037 512,003
Deferred reinsurance gain 10,116 11,037
Other policyholders' funds 18,614 23,610
Debt 12,962 25,003
Liabilities of Pyramid Life -- 102,457
Deferred federal income taxes 14,099 11,746
Other liabilities 32,434 34,101
----------- -----------
TOTAL LIABILITIES 603,262 719,957
----------- -----------
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, 34,332,967 and
34,232,610 shares issued and outstanding, respectively 34 34
Additional paid-in capital 133,246 133,052
Retained earnings 35,721 21,430
Accumulated other comprehensive income 15,549 13,008
----------- -----------
TOTAL STOCKHOLDERS' EQUITY 184,550 167,524
----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 787,812 $ 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 SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------------- ----------------------------
2003 2002 2003 2002
-------------- -------------- -------------- -----------
REVENUES
Premiums, net
Medical $ 79,042 $ 92,212 $ 164,161 $ 187,091
Senior and other 42,402 42,690 85,259 85,360
----------- ----------- ---------- -----------
Total premiums, net 121,444 134,902 249,420 272,451
Net investment income 6,460 6,308 11,984 12,765
Net realized gains (losses) 562 (561) 1,146 (445)
Fee and other income 7,396 8,196 13,738 16,163
Amortization of deferred reinsurance gain 419 838 1,076 1,876
----------- ----------- ---------- -----------
136,281 149,683 277,364 302,810
----------- ----------- ---------- -----------
BENEFITS, LOSSES AND EXPENSES
Benefits, claims, losses and settlement expenses
Medical 58,799 82,681 121,305 156,594
Senior and other 30,604 30,522 64,404 64,271
----------- ----------- ---------- -----------
Total benefits, claims, losses and settlement expenses 89,403 113,203 185,709 220,865
Selling, general and administrative expenses 37,228 46,006 75,408 91,375
Net (deferral) amortization and change in acquisition costs
and value of business acquired 2,656 (1,907) 3,057 (6,250)
Interest expense and financing costs 306 516 735 1,046
Special charge -- -- -- 2,381
----------- ----------- ---------- -----------
129,593 157,818 264,909 309,417
----------- ----------- ---------- -----------
Income (loss) from continuing operations before federal
income taxes and minority interest 6,688 (8,135) 12,455 (6,607)
Federal income tax expense (benefit) (253) (2,682) 1,767 (2,151)
----------- ----------- ---------- -----------
Income (loss) from continuing operations after tax and before
minority interest 6,941 (5,453) 10,688 (4,456)
Minority interest (10) (13) (20) (27)
----------- ----------- ---------- -----------
INCOME (LOSS) FROM CONTINUING OPERATIONS 6,951 (5,440) 10,708 (4,429)
----------- ----------- ---------- -----------
Discontinued operations
Income from operations of Pyramid Life (less tax expense
of $0, $888, $3,223 and $1,193, respectively) -- 1,649 5,732 2,166
Loss on sale of Pyramid Life (less tax benefit of $0 and
$79, respectively) (39) -- (2,149) --
----------- ----------- ---------- -----------
INCOME (LOSS) FROM DISCONTINUED OPERATIONS (39) 1,649 3,583 2,166
----------- ----------- ---------- -----------
NET INCOME (LOSS) $ 6,912 $ (3,791) $ 14,291 $ (2,263)
=========== =========== ========== ===========
BASIC EARNINGS (LOSS) PER SHARE
Continuing operations $ 0.20 $ (0.16) $ 0.31 $ (0.13)
Discontinued operations -- 0.05 0.11 0.06
----------- ----------- ---------- -----------
Net income (loss) $ 0.20 $ (0.11) $ 0.42 $ (0.07)
=========== =========== ========== ===========
DILUTED EARNINGS (LOSS) PER SHARE
Continuing operations $ 0.20 $ (0.16) $ 0.31 $ (0.13)
Discontinued operations -- 0.05 0.11 0.06
----------- ----------- ---------- -----------
Net income (loss) $ 0.20 $ (0.11) $ 0.42 $ (0.07)
=========== =========== ========== ===========
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 SIX MONTHS ENDED JUNE 30, 2003
UNAUDITED
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
COMMON STOCK
Balance at June 30, 2003 $ 34
==============
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of year $ 133,052
Issuance of stock:
Employee benefit plans 194
--------------
Balance at June 30, 2003 $ 133,246
==============
RETAINED EARNINGS
Balance at beginning of year $ 21,430
Net income 14,291
--------------
Balance at June 30, 2003 $ 35,721
==============
ACCUMULATED OTHER COMPREHENSIVE INCOME
Balance at beginning of year $ 13,008
Unrealized gain on securities, net of tax expense of $3,450 6,410
Realized gains due to the sale of Pyramid Life, net of tax of $2,016 (3,744)
Other (125)
--------------
Balance at June 30, 2003 $ 15,549
==============
TOTAL STOCKHOLDERS' EQUITY $ 184,550
==============
NUMBER OF SHARES OF COMMON STOCK
Balance at beginning of year 34,232,610
Issuance of stock:
Employee benefit plans 100,357
--------------
Balance at June 30, 2003 34,332,967
==============
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)
SIX MONTHS ENDED
JUNE 30,
----------------------------
2003 2002
------------ -----------
OPERATING ACTIVITIES
Net income (loss) $ 14,291 $ (2,263)
Adjustments to reconcile net income (loss) to cash provided by (used in)
operating activities:
Net income from discontinued operations (3,583) (2,166)
Depreciation and amortization 1,544 1,441
Net realized (gains) losses (1,146) 445
Deferred federal income taxes (976) (2,700)
Impairment of intangible asset, licenses 146 --
Changes in assets and liabilities:
Accrued investment income (336) 19
Reinsurance and premiums receivable 21,622 18,854
Deferred acquisition costs 1,763 (7,443)
Value of business acquired 1,294 1,193
Other assets 2,568 (1,893)
Future policy benefits, claims and funds payable (2,757) (26,556)
Unearned premium 1,236 2,424
Deferred reinsurance gain (920) (1,876)
Federal income taxes payable/recoverable 1,370 573
Other liabilities (1,452) (20,972)
--------- ---------
Net cash provided by (used in) operating activities 34,664 (40,920)
--------- ---------
INVESTING ACTIVITIES
Net purchases of furniture and equipment (1,041) (298)
Purchase of fixed maturities available-for-sale (134,669) (69,812)
Increase in policy and mortgage loans, net (170) (8)
Proceeds from sales of fixed maturities available-for-sale 30,614 48,360
Proceeds from calls and maturities of fixed maturities available-for-sale 36,010 27,313
Net proceeds from sale of Pyramid Life 55,261 --
--------- ---------
Net cash provided by (used in) investing activities (13,995) 5,555
--------- ---------
FINANCING ACTIVITIES
Increase in annuity account balances 7,078 4,194
Decrease in annuity account balances (7,519) (12,749)
Principal payments on debt (12,041) (3,832)
Proceeds from issuance of common stock related to employee benefit plans 194 635
--------- ---------
Net cash used in financing activities (12,288) (11,752)
--------- ---------
NET INCREASE (DECREASE) IN CASH 8,381 (47,117)
Cash and cash equivalents at beginning of year 32,118 68,506
--------- ---------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 40,499 $ 21,389
========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest $ 548 $ 1,240
Cash paid during the period for federal income taxes 1,663 --
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
JUNE 30, 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 six month period
ended June 30, 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 June 30, 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 condensed consolidated financial
statements for the three and six months ended June 30, 2002 have been
reclassified to present the discontinued operations of Pyramid Life separate
from continuing operations to conform to the current period's presentation.
The condensed consolidated 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
JUNE 30, 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 June 30, 2003 and December 31,
2002, restricted cash was $5.5 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 balance sheets.
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 ("APB Opinion 25"). 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 ("SFAS
123"), which permits entities to continue to apply the provisions of APB Opinion
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 123, had been applied. Additionally, in December 2002, the FASB issued
SFAS No. 148, Accounting For Stock-Based Compensation-Transition and Disclosure
("SFAS 148"). SFAS 148 amends SFAS 123, to provide alternative methods of
transition to SFAS 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 148 also amends the disclosure
provisions of SFAS 123 and APB Opinion No. 28, Interim Financial Reporting ("APB
Opinion 28"). We elected to continue to apply provisions of APB Opinion 25 and
provide the pro forma disclosure required by SFAS 123 and the amended
disclosures required by SFAS 148.
6
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
JUNE 30, 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 123.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------- --------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Net income (loss), as reported $ 6,912 $ (3,791) $ 14,291 $ (2,263)
Total stock-based employee compensation
expense determined under fair value
based method for all awards, net of tax -- (94) -- (239)
--------- --------- ---------- ---------
PRO FORMA NET INCOME (LOSS) $ 6,912 $ (3,885) $ 14,291 $ (2,502)
========= ========= ========== =========
Earnings (loss) per share
Basic-as reported $ 0.20 $ (0.11) $ 0.42 $ (0.07)
BASIC-PRO FORMA $ 0.20 $ (0.11) $ 0.42 $ (0.07)
Diluted-as reported $ 0.20 $ (0.11) $ 0.42 $ (0.07)
DILUTED-PRO FORMA $ 0.20 $ (0.11) $ 0.42 $ (0.07)
RECLASSIFICATIONS
Certain prior period amounts have been reclassified to conform to the
current period presentation.
NEW ACCOUNTING PRONOUNCEMENTS
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 ("SFAS 146"), 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) ("EITF Issue 94-3"). The
provisions of this Statement are effective for exit or disposal activities
initiated after December 31, 2002. SFAS 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
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 ("SFAS 144"). 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 ("SFAS 143"). The
adoption of this standard did not have a material effect on our consolidated
results of operations, cash flows, or financial position.
7
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
JUNE 30, 2003
UNAUDITED
- -------------------------------------------------------------------------------
In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities ("SFAS 149"). SFAS 149 amends and
clarifies accounting for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities under SFAS
No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS
133"). SFAS 149 is generally effective for contracts entered into or modified
after June 30, 2003 and for hedging relationships designated after June 30,
2003. We do not expect the adoption of SFAS 149 to have a material impact on our
consolidated results of operations, cash flows or financial position.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity ("SFAS 150").
SFAS 150 establishes standards for how an issuer classifies and measures three
classes of freestanding financial instruments with characteristics of both
liabilities and equity. It requires that an issuer classify a financial
instrument that is within its scope as a liability (or an asset in some
circumstances). SFAS 150 was effective for financial instruments entered into or
modified after May 31, 2003, and otherwise is effective at the beginning of the
first interim period beginning after June 15, 2003. The Company has not entered
into any financial instruments within the scope of SFAS 150 since May 31, 2003,
nor does it currently hold any significant financial instruments as defined
within the scope of this pronouncement.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities, an Interpretation of ARB No. 51 ("FIN 46"). FIN 46
addresses the consolidation of entities whose equity holders have either (a) not
provided sufficient equity at risk to allow the entity to finance its own
activities or (b) do not possess certain characteristics of a controlling
financial interest. FIN 46 requires the consolidation of these entities, known
as variable interest entities ("VIEs"), by the primary beneficiary of the
entity. The primary beneficiary is the entity, if any, that is subject to a
majority of the risk of loss from the VIEs activities, entitled to receive a
majority of the VIEs residual returns, or both. FIN 46 applies immediately to
variable interests in VIEs created or obtained after January 31, 2003. For
variable interests in a VIE created before February 1, 2003, FIN 46 is applied
to the VIE no later than the beginning of the first interim or annual reporting
period beginning after June 15, 2003 (the quarter beginning July 1, 2003 for the
Company). The Interpretation requires certain disclosures in financial
statements issued after January 31, 2003, if it is reasonably possible that the
Company will consolidate or disclose information about variable interest
entities when the Interpretation becomes effective. The Company does not expect
this Interpretation to have an effect in the current period on our consolidated
results of operations, cash flows or financial position.
8
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
JUNE 30, 2003
UNAUDITED
- -------------------------------------------------------------------------------
B. DEBT
JUNE 30, DECEMBER 31,
2003 2002
------------- --------------
(DOLLARS IN THOUSANDS)
Bank credit facility $ 12,962 $ 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 June 30, 2003, the interest rate on our tranche A term loan
balance of $8.2 million was 5.3% per annum and our $4.8 million CIT tranche B
term loan was 5.6% per annum.
The credit agreement, as amended, contains financial and other covenants
that among other things:
o prohibit the payment of cash dividends on, or the repurchase of, shares
of our common stock;
o restrict the creation of liens and sales of assets;
o require 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
9
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
JUNE 30, 2003
UNAUDITED
- -------------------------------------------------------------------------------
o require that we, at a minimum, maintain:
o a leverage ratio (consolidated debt to consolidated total capital)
of 0.30 to 1.00;
o an interest coverage ratio (consolidated earnings before interest,
income taxes, depreciation, and amortization to consolidated
interest expense) of 3.00 to 1.00;
o 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;
o 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
o 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:
o permitted the sale of Pyramid Life;
o required $10.0 million of sale proceeds to be used as a partial pay
down of bank debt;
o waived the minimum risk-based capital ratio requirement of 125% for
Continental General at December 31, 2002;
o excluded intercompany tax sharing payments in the calculation of the
fixed charge coverage ratio at December 31, 2002;
o 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;
o 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
10
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
JUNE 30, 2003
UNAUDITED
- -------------------------------------------------------------------------------
o 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
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 June 30, 2003, we were in compliance with the covenants of 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) 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.
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. 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
11
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
JUNE 30, 2003
UNAUDITED
- -------------------------------------------------------------------------------
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 SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------- -------------------------
2003 2002 2003 2002
--------- ---------- --------- ---------
(DOLLARS IN THOUSANDS)
PREMIUMS, NET
Direct $ 144,952 $ 165,054 $ 297,208 $ 335,677
Assumed -- 28 -- 45
Ceded (23,508) (30,180) (47,788) (63,271)
--------- --------- --------- ---------
Total premiums, net $ 121,444 $ 134,902 $ 249,420 $ 272,451
========= ========= ========= =========
Benefits, claims, losses and settlement
expenses $ 103,004 $ 133,282 $ 215,783 $ 268,003
Reinsurance recoveries (13,601) (20,079) (30,074) (47,138)
--------- --------- --------- ---------
Total benefits, claims, losses and
settlement expenses $ 89,403 $ 113,203 $ 185,709 $ 220,865
========= ========= ========= =========
SELLING, GENERAL AND ADMINISTRATIVE
EXPENSES
Commissions $ 18,505 $ 25,147 $ 39,126 $ 51,757
Other operating expenses 23,589 26,551 46,356 52,588
Reinsurance expenses -- 185 -- 440
Reinsurance allowances (4,866) (5,877) (10,074) (13,410)
--------- --------- --------- ---------
Total selling, general and
administrative expenses $ 37,228 $ 46,006 $ 75,408 $ 91,375
========= ========= ========= =========
D. DISCONTINUED OPERATIONS
On March 31, 2003, we sold the stock of our indirect subsidiary, Pyramid
Life, which was primarily included in our Senior and Other segment, to the
Pennsylvania Life Insurance Company, a subsidiary of Universal American
Financial Corp., for approximately $57.5 million in cash. 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) was $13.8 million. Accordingly, we adjusted the carrying
value of Pyramid Life's assets held for sale
12
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
JUNE 30, 2003
UNAUDITED
- -------------------------------------------------------------------------------
to fair market value at December 31, 2002, which resulted in a charge of $11.6
million. In addition, we recorded a $2.2 million loss on the sale in 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 SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------- ------------------------
2003 2002 2003 2002
--------- --------- --------- ---------
(DOLLARS IN THOUSANDS)
REVENUES
Premiums, net $ -- $ 24,066 $ 27,964 $ 46,708
Net investment income -- 1,630 1,568 3,385
Net realized gains (losses) -- (840) 5,965 (845)
-------- -------- -------- --------
-- 24,856 35,497 49,248
-------- -------- -------- --------
BENEFITS, LOSSES AND EXPENSES
Benefits, claims, losses and settlement expenses -- 17,383 20,285 35,640
Selling, general and administrative expenses -- 7,119 8,702 14,100
Net (deferral) amortization and change in acquisition
costs and value of business acquired -- (2,184) (2,445) (4,138)
Special charge -- 1 -- 287
-------- -------- -------- --------
-- 22,319 26,542 45,889
-------- -------- -------- --------
Income from operations before federal income taxes -- 2,537 8,955 3,359
Federal income tax expense -- 888 3,223 1,193
-------- -------- -------- --------
INCOME FROM OPERATIONS -- 1,649 5,732 2,166
-------- -------- -------- --------
Loss on sale of Pyramid Life (39) -- (2,228) --
Federal income tax benefit -- -- (79) --
-------- -------- -------- --------
LOSS ON SALE OF PYRAMID LIFE, NET (39) -- (2,149) --
-------- -------- -------- --------
INCOME (LOSS) FROM DISCONTINUED OPERATIONS $ (39) $ 1,649 $ 3,583 $ 2,166
======== ======== ======== ========
13
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
JUNE 30, 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 remained
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.
14
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
JUNE 30, 2003
UNAUDITED
- -------------------------------------------------------------------------------
F. COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) is as follows:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------ -----------------------
2003 2002 2003 2002
--------- --------- -------- --------
(DOLLARS IN THOUSANDS)
Net income (loss) $ 6,912 $ (3,791) $ 14,291 $ (2,263)
Other comprehensive income (loss), net of tax:
Unrealized gain on securities, net of tax
expense of $2,708, $2,746, $3,450
and $1,804, respectively (1) 5,028 9,736 6,410 4,597
Realized gain due to the sale of Pyramid Life,
net of tax of $2,016 -- -- (3,744) --
Other 96 98 (125) 42
-------- -------- -------- --------
Comprehensive income $ 12,036 $ 6,043 $ 16,832 $ 2,376
======== ======== ======== ========
- -----------
(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 SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------- --------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Weighted average shares:
BASIC 34,297,216 33,967,607 34,266,931 33,912,430
Stock awards and incremental shares from
assumed exercise of stock options 22,706 -- 5,043 --
---------- ---------- ---------- ----------
DILUTED 34,319,922 33,967,607 34,271,974 33,912,430
========== ========== ========== ==========
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
15
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
JUNE 30, 2003
UNAUDITED
- -------------------------------------------------------------------------------
financial position, results of operations or cash flow of a future period.
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. For all periods presented, the segment results
exclude the operations of Pyramid Life Insurance Company, which was sold on
March 31, 2003.
16
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
JUNE 30, 2003
UNAUDITED
- -------------------------------------------------------------------------------
The following table presents the revenues, expenses and profit (loss) from
continuing operations before federal income taxes, for the three and six months
ended June 30, 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 SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------ -------------------------
2003 2002 2003 2002
--------- --------- --------- ---------
(DOLLARS IN THOUSANDS)
MEDICAL
Revenues
Net premiums $ 79,042 $ 92,212 $ 164,161 $ 187,091
Investment income, realized gains (losses) 1,627 1,811 3,279 3,803
Other income 5,531 8,219 12,022 16,528
--------- --------- --------- ---------
86,200 102,242 179,462 207,422
--------- --------- --------- ---------
Expenses
Benefits and claims 58,799 82,681 121,305 156,594
Other operating expenses 25,961 32,139 52,738 61,735
--------- --------- --------- ---------
84,760 114,820 174,043 218,329
--------- --------- --------- ---------
Segment profit (loss) before federal income
taxes and minority interest $ 1,440 $ (12,578) $ 5,419 $ (10,907)
========= ========= ========= =========
SENIOR AND OTHER
Revenues
Net premiums $ 42,402 $ 42,690 $ 85,259 $ 85,360
Investment income, realized gains (losses) 5,296 3,828 9,635 8,295
Other income 2,284 815 2,792 1,511
--------- --------- --------- ---------
49,982 47,333 97,686 95,166
--------- --------- --------- ---------
Expenses
Benefits and claims 30,604 30,522 64,404 64,271
Other operating expenses 13,507 11,608 24,916 22,673
--------- --------- --------- ---------
44,111 42,130 89,320 86,944
--------- --------- --------- ---------
Segment profit before federal income taxes and
minority interest $ 5,871 $ 5,203 $ 8,366 $ 8,222
========= ========= ========= =========
CORPORATE AND OTHER
Revenues
Investment income, realized gains $ 99 $ 108 $ 216 $ 222
--------- --------- --------- ---------
Expenses
Interest and financing costs 306 516 735 1,046
Other operating expenses 416 352 811 717
Special charge -- -- -- 2,381
--------- --------- --------- ---------
722 868 1,546 4,144
--------- --------- --------- ---------
Segment loss before federal income taxes
and minority interest $ (623) $ (760) $ (1,330) $ (3,922)
========= ========= ========= =========
INCOME (LOSS) FROM CONTINUING OPERATIONS
BEFORE FEDERAL INCOME TAXES AND MINORITY
INTEREST $ 6,688 $ (8,135) $ 12,455 $ (6,607)
========= ========= ========= =========
17
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 and Other segment includes senior health, life and annuity products for
Americans age 55 and over. The 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 2,700
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. Results of
continuing operations for the three and six months ended June 30, 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
presented. Financial data for the three and six months ended June 30, 2002
18
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 condensed consolidated financial
statements for the periods presented. See Note D. Discontinued Operations to our
condensed consolidated financial statements for further information.
19
QUARTER ENDED JUNE 30, 2003 COMPARED TO QUARTER ENDED JUNE 30, 2002
INCREASE
THREE MONTHS THREE MONTHS (DECREASE) FROM
ENDED % OF ENDED % OF PREVIOUS YEAR
JUNE 30, CONSOLIDATED JUNE 30, CONSOLIDATED --------------------
2003 REVENUES 2002 REVENUES DOLLARS %
------------ ------------- ----------- ------------- --------- -------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Premiums, net
Medical $ 79,042 58.0% $ 92,212 61.6% $ (13,170) (14.3)%
Senior and other 42,402 31.1 42,690 28.5 (288) (0.7)
--------- ----- --------- ----- ---------
Total 121,444 89.1 134,902 90.1 (13,458) (10.0)
Net investment income 6,460 4.8 6,308 4.2 152 2.4
Net realized gains (losses) 562 0.4 (561) (0.4) 1,123 N/M
Fee and other income 7,396 5.4 8,196 5.5 (800) (9.8)
Amortization of deferred
reinsurance gain 419 0.3 838 0.6 (419) (50.0)
--------- ----- --------- ----- ---------
Consolidated revenues 136,281 100.0 149,683 100.0 (13,402) (9.0)
--------- ----- --------- ----- ---------
Benefits, claims, losses and settlement
expenses
Medical 58,799 43.1 82,681 55.2 (23,882) (28.9)
Senior and other 30,604 22.5 30,522 20.4 82 0.3
--------- ----- --------- ----- ---------
Total 89,403 65.6 113,203 75.6 (23,800) (21.0)
Selling, general and administrative
expenses 37,228 27.3 46,006 30.7 (8,778) (19.1)
Net (deferral) amortization and change in
acquisition costs and value of business
acquired 2,656 2.0 (1,907) (1.3) 4,563 N/M
Interest expense and financing costs 306 0.2 516 0.4 (210) (40.7)
--------- ----- --------- ----- ---------
129,593 95.1 157,818 105.4 (28,225) (17.9)
--------- ----- --------- ----- ---------
Income (loss) from continuing operations
before federal income taxes and
minority interest 6,688 4.9 (8,135) (5.4) 14,823 N/M
Federal income tax expense (benefit) (253) (0.2) (2,682) (1.8) 2,429 90.6
--------- ----- --------- ----- ---------
Income (loss) from continuing operations
after tax and before minority interest 6,941 5.1 (5,453) (3.6) 12,394 N/M
Minority interest (10) -- (13) -- 3 23.1
--------- ----- --------- ----- ---------
INCOME (LOSS) FROM CONTINUING
OPERATIONS 6,951 5.1 (5,440) (3.6) 12,391 N/M
--------- ----- --------- ----- ---------
Discontinued operations:
Income from operations of Pyramid
Life, net of tax -- -- 1,649 1.1 (1,649) N/M
Loss on sale of Pyramid Life, net of
tax (39) -- -- -- (39) N/M
--------- ----- --------- ----- ---------
INCOME (LOSS) FROM DISCONTINUED
OPERATIONS (39) -- 1,649 1.1 (1,688) N/M
--------- ----- --------- ----- ---------
NET INCOME (LOSS) $ 6,912 5.1% $ (3,791) (2.5)% $ 10,703 N/M
========= ===== ========= ===== =========
Basic earnings (loss) per share $ 0.20 $ (0.11) $ 0.31 N/M
Diluted earnings (loss) per share 0.20 (0.11) 0.31 N/M
- -------------
N/M = not meaningful
20
NET PREMIUMS (NET OF REINSURANCE CEDED)
For the quarter ended June 30, 2003, total net premiums decreased 10% to
$121.4 million, compared to $134.9 million for the same quarter in 2002.
MEDICAL
Medical premiums for the quarter ended June 30, 2003 were $79.0 million
compared to $92.2 million for the quarter ended June 30, 2002, a decrease of
14.3%. The decrease in medical premiums was primarily the result of a decrease
in major medical certificates in force due to the cancellation of medical
business in unprofitable states and a 70% decline in new business production
offset by a lower level of reinsurance and renewal premium increases averaging
20% to 30%.
SENIOR AND OTHER
Senior and other premiums decreased $0.3 million to $42.4 million for the
quarter ended June 30, 2003 compared to $42.7 million for the same quarter in
2002. The decrease in senior and other premiums was primarily the result of a
decrease in policies in force and a 17% reduction in new business production
offset by premium rate increases.
OTHER REVENUES
Net investment income was $6.5 million for the second quarter of 2003
compared to $6.3 million for the second quarter of 2002, an increase of 2.4%,
due primarily to an increase in invested assets from the proceeds of the sale of
Pyramid Life. Net investment income is expected to decline during the balance of
the year as new money rates at June 30, 2003 are 150 basis points lower than the
current yield of the portfolio.
Net realized gains increased to $0.6 million for the second quarter of 2003
compared to a net realized loss of $0.6 million for the second quarter of 2002
as a result of gains generated on the sale of collateralized mortgage
obligations ("CMOs") and corporate bonds. The prior year period also included
$0.9 million for other-than-temporary impairment in our investment in WorldCom
bonds.
Fee and other income decreased to $7.4 million for the quarter ended June
30, 2003 compared to $8.2 million for the same quarter of 2002, a decrease of
9.8%. This decrease was primarily attributable to the cancellation of medical
business in certain unprofitable states and the decline in new business in the
Medical segment and was partially offset by $1.9 million of TPA fees in the
Senior and Other segment related to the processing of Pyramid Life's senior
business for Universal American.
The amortization of deferred reinsurance gain of $0.4 million for the
quarter ended June 30, 2003 represented the recognition of the ceding commission
allowances received under our reinsurance agreements. The unamortized amount of
$10.1 million at June 30, 2003 was accounted for as a deferred reinsurance gain
on the condensed consolidated balance sheet. The amortization of deferred
reinsurance gain decreased from $0.8 million for the quarter ended June 30, 2002
as a result of lower amortization due to diminishing levels of in force
certificates.
21
BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES
Total benefits, claims, losses and settlement expenses decreased to $89.4
million for the quarter ended June 30, 2003 compared to $113.2 million for the
same quarter in 2002, a decrease of 21.0%.
MEDICAL
Medical benefits, claims, losses and settlement expenses were $58.8 million
for the quarter ended June 30, 2003 compared to $82.7 million for the same
quarter in 2002, a decrease of 28.9%. 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 74.4% for the quarter
ended June 30, 2003 compared to 89.7% for the same quarter of 2002. The medical
loss ratio decreased due to the cancellation of business in poor performing
markets, rate increases, and a higher severity of claims than anticipated in
the December 31, 2001 claim inventory, which adversely impacted 2002 loss
ratios.
SENIOR AND OTHER
Senior and other benefits, claims, losses and settlement expenses slightly
increased to $30.6 million for the quarter ended June 30, 2003 compared to $30.5
million for the same quarter of 2002. The senior and other loss ratio was 72.2%
for the second quarter of 2003 compared to 71.5% for the second quarter of 2002
primarily due to lower utilization in the Medicare supplement business offset by
higher utilization in the long-term care business.
OTHER EXPENSES AND NET INCOME
Selling, general and administrative expenses decreased to $37.2 million in
the second quarter of 2003 compared to $46.0 million in the second quarter of
2002, a decrease of 19.1%. Commissions decreased $6.6 million and other
operating expenses decreased $3.2 million as a direct result of our cancelled or
replaced business offset by reduced reinsurance allowances of $1.0 million as a
result of a lower volume of ceded premiums. As a percentage of revenues,
selling, general and administrative expenses decreased to 27.3% in the second
quarter of 2003 compared to 30.7% in the second 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 $2.7 million
for the second quarter of 2003 compared to a net deferral of $1.9 million for
the second 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.
Interest expense and financing costs decreased to $0.3 million in the
second quarter of 2003 compared to $0.5 million in the second quarter of 2002 as
a result of a decrease in outstanding debt.
22
A federal income tax benefit of $0.3 million was recorded for the second
quarter of 2003, which included a $2.7 million reduction to the deferred tax
valuation allowance as a result of the improved profitability of certain
subsidiaries in the Medical segment. The effective tax rate, excluding the
deferred tax valuation allowance adjustment, was 36.5% for the second quarter of
2003. In the second quarter of 2002, a federal income tax benefit of $2.7
million was recorded, or 33.0% of the loss from continuing operations before
federal taxes. The reduction of the Company's deferred tax valuation allowance
is based on the utilization of approximately $5.4 million of net operating loss
carry forwards in 2003 for which a full valuation allowance was established at
December 31, 2002.
Income from continuing operations was $7.0 million, or $0.20 per share, for
the second quarter of 2003 compared to a loss of $5.4 million, or $0.16 per
share, for the second quarter of 2002. For the second quarter of 2003, net
income was $6.9 million, or $0.20 basic and diluted income per share of common
stock, compared to a net loss of $3.8 million, or $0.11 basic and diluted loss
per share of common stock, for the second quarter of 2002.
23
SIX MONTHS ENDED JUNE 30, 2003 COMPARED TO SIX MONTHS ENDED JUNE 30, 2002
INCREASE
SIX MONTHS SIX MONTHS (DECREASE) FROM
ENDED % OF ENDED % OF PREVIOUS YEAR
JUNE 30, CONSOLIDATED JUNE 30, CONSOLIDATED ---------------------
2003 REVENUES 2002 REVENUES DOLLARS %
------------ ------------- ----------- ------------- --------- -------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Premiums, net
Medical $ 164,161 59.2% $ 187,091 61.8% $ (22,930) (12.3)%
Senior and other 85,259 30.7 85,360 28.2 (101) (0.1)
--------- ----- --------- ----- ---------
Total 249,420 89.9 272,451 90.0 (23,031) (8.5)
Net investment income 11,984 4.3 12,765 4.2 (781) (6.1)
Net realized gains (losses) 1,146 0.4 (445) (0.1) 1,591 N/M
Fee and other income 13,738 5.0 16,163 5.3 (2,425) (15.0)
Amortization of deferred
reinsurance gain 1,076 0.4 1,876 0.6 (800) (42.6)
--------- ----- --------- ----- ---------
Consolidated revenues 277,364 100.0 302,810 100.0 (25,446) (8.4)
--------- ----- --------- ----- ---------
Benefits, claims, losses and settlement
expenses
Medical 121,305 43.7 156,594 51.7 (35,289) (22.5)
Senior and other 64,404 23.2 64,271 21.2 133 0.2
--------- ----- --------- ----- ---------
Total 185,709 66.9 220,865 72.9 (35,156) (15.9)
Selling, general and administrative
expenses 75,408 27.2 91,375 30.2 (15,967) (17.5)
Net (deferral) amortization and change in
acquisition costs and value of business
acquired 3,057 1.1 (6,250) (2.1) 9,307 148.9
Interest expense and financing costs 735 0.3 1,046 0.3 (311) (29.7)
Special charge -- -- 2,381 0.8 (2,381) (100.0)
--------- ----- --------- ----- ---------
264,909 95.5 309,417 102.1 (44,508) (14.4)
--------- ----- --------- ----- ---------
Income (loss) from continuing operations
before federal income taxes and
minority interest 12,455 4.5 (6,607) (2.1) 19,062 N/M
Federal income tax expense (benefit) 1,767 0.6 (2,151) (0.7) 3,918 N/M
--------- ----- --------- ----- ---------
Income (loss) from continuing operations
after tax and before minority interest 10,688 3.9 (4,456) (1.4) 15,144 N/M
Minority interest (20) -- (27) -- 7 25.9
--------- ----- --------- ----- ---------
INCOME (LOSS) FROM CONTINUING
OPERATIONS 10,708 3.9 (4,429) (1.4) 15,137 N/M
--------- ----- --------- ----- ---------
Discontinued operations:
Income from operations of Pyramid
Life, net of tax 5,732 2.1 2,166 0.7 3,566 164.6
Loss on sale of Pyramid Life, net of
tax (2,149) (0.8) -- -- (2,149) N/M
--------- ----- --------- ----- ---------
INCOME FROM DISCONTINUED
OPERATIONS 3,583 1.3 2,166 0.7 1,417 65.4
--------- ----- --------- ----- ---------
NET INCOME (LOSS) $ 14,291 5.2% $ (2,263) (0.7)% $ 16,554 N/M
========= ===== ========= ===== =========
Basic earnings (loss) per share $ 0.42 $ (0.07) $ 0.49 N/M
Diluted earnings (loss) per share 0.42 (0.07) 0.49 N/M
- -----------
N/M = not meaningful
24
NET PREMIUMS (NET OF REINSURANCE CEDED)
For the six months ended June 30, 2003, total net premiums decreased 8.5%
to $249.4 million, compared to $272.5 million for the same period in 2002.
MEDICAL
Medical premiums for the six months ended June 30, 2003 were $164.2 million
compared to $187.1 million for the six months ended June 30, 2002, a decrease of
12.3%. The decrease in medical premiums was primarily the result of a decrease
in major medical certificates in force due to the cancellation of medical
business in unprofitable states and a 64% decline in new business production
offset by a lower level of reinsurance and renewal premium increases averaging
20% to 30%.
SENIOR AND OTHER
Senior and other premiums were $85.3 million for the six months ended June
30, 2003 compared to $85.4 million for the same period in 2002. The decrease in
senior and other premiums was primarily the result of a decrease in policies in
force and a 23% reduction in new business production offset by premium rate
increases.
OTHER REVENUES
Net investment income was $12.0 million for the first six months of 2003
compared to $12.8 million for the first six months of 2002, a decrease of 6.1%
due primarily to a decrease in the average yield on our investment portfolio.
Net investment income is expected to decline during the balance of the year as
new money rates at June 30, 2003 are 150 basis points lower than the current
yield of the portfolio.
Net realized gains increased to $1.1 million for the first half of 2003
compared to a net realized loss of $0.4 million for the first half of 2002 as a
result of gains generated on the sale of CMOs and corporate bonds. The prior
year period also included $0.9 million for other-than-temporary impairment in
our investment in WorldCom bonds.
Fee and other income decreased to $13.7 million for the six months ended
June 30, 2003 compared to $16.2 million for the same six months of 2002, a
decrease of 15.0%. This decrease was primarily attributable to the cancellation
of medical business in certain unprofitable states and a decline in new business
and was partially offset by $1.9 million of TPA fees in the Senior and Other
segment related to the processing of Pyramid Life's senior business for
Universal American.
The amortization of deferred reinsurance gain of $1.1 million for the six
months ended June 30, 2003 represented the recognition of the ceding commission
allowances received under our reinsurance agreements. The unamortized amount of
$10.1 million at June 30, 2003 was accounted for as a deferred reinsurance gain
on the condensed consolidated balance sheet. The amortization of deferred
reinsurance gain decreased from $1.9 million for the six months ended June 30,
2002 as a result of lower amortization due to diminishing levels of in force
certificates.
25
BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES
Total benefits, claims, losses and settlement expenses decreased to $185.7
million for the six months ended June 30, 2003 compared to $220.9 million for
the six months ended in 2002, a decrease of 15.9%.
MEDICAL
Medical benefits, claims, losses and settlement expenses were $121.3
million for the six months ended June 30, 2003 compared to $156.6 million for
the same period in 2002, a decrease of 22.5%. 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
73.9% for the six months ended June 30, 2003 compared to 83.7% for the same
period of 2002. The medical loss ratio decreased due to the cancellation of
business in poor performing markets, rate increases, and a higher severity of
claims than anticipated in the December 31, 2001 claim inventory, which
adversely impacted 2002 loss ratios.
SENIOR AND OTHER
Senior and other benefits, claims, losses and settlement expenses slightly
increased to $64.4 million for the six months ended June 30, 2003 compared to
$64.3 million for the same period of 2002. The senior and other loss ratio was
75.5% for the first six months of 2003 compared to 75.3% for the first six
months of 2002 primarily due to lower utilization in the Medicare supplement
business offset by higher utilization in the long-term care business.
OTHER EXPENSES AND NET INCOME
Selling, general and administrative expenses decreased to $75.4 million for
the first six months of 2003 compared to $91.4 million in the first six months
of 2002, a decrease of 17.5%. Commissions decreased $12.6 million and other
operating expenses decreased $6.7 million as a direct result of our cancelled or
replaced business offset by reduced reinsurance allowances of $3.3 million as a
result of a lower volume of ceded premiums. As a percentage of revenues,
selling, general and administrative expenses decreased to 27.2% in the first six
months of 2003 compared to 30.2% in the first six months 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 $3.1 million
for the first six months of 2003 compared to a net deferral of $6.3 million for
the first six months of 2002. The decrease in the net deferral was primarily
attributable to the lower capitalization of DAC due to decreases in new business
sales.
Interest expense and financing costs decreased to $0.7 million in the first
six months of 2003 compared to $1.0 million in the first six months of 2002 as a
result of a decrease in outstanding debt.
26
A federal income tax expense of $1.8 million was recorded for the first six
months of 2003, which included a $2.7 million reduction to the deferred tax
valuation allowance as a result of the improved profitability of certain
subsidiaries in the Medical segment. The effective tax rate, excluding the
deferred tax valuation allowance adjustment, was 35.8% for the six months ended
June 30, 2003. In the first six months of 2002, a federal income tax benefit of
$2.2 million was recorded, or 32.6% of the loss from continuing operations
before federal taxes.
Income from continuing operations was $10.7 million, or $0.31 per share,
for the first six months of 2003 compared to a loss of $4.4 million, or $0.13
per share, for the first six months 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 six months of 2003 compared to $2.2 million, or $0.06 per share, for the
first six months of 2002. For the six months of 2003, net income was $14.3
million, or $0.42 basic and diluted income per share of common stock, compared
to a net loss of $2.3 million, or $0.07 basic and diluted loss per share of
common stock, for the same period 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 period ended June 30, 2003 was $34.7
million compared to net cash used in operating activities of $40.9 million at
June 30, 2002. The increase was primarily attributable to an improvement in
earnings and the current year settlements of our reinsurance receivables.
Assets decreased 11.2% to $787.8 million at June 30, 2003 from $887.5
million at December 31, 2002 due primarily to the sale of Pyramid Life. Assets
of $475.1 million, or 60.3% of the total assets, were in investments at June 30,
2003. Fixed maturities, our primary investment, were $466.9 million, or 98.3% of
total investments, at June 30, 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 June 30, 2003.
Approximately 95.6% of our bonds were of investment grade quality at June
30, 2003. In addition to the fixed maturities, we also had $40.5 million in cash
and cash equivalents (including a portion of the cash proceeds from the sale of
Pyramid Life) of which $5.5 million was restricted at June 30, 2003.
The total reinsurance receivable was $147.5 million at June 30, 2003. Of
this amount, $146.2 million represents reserves held by our reinsurers under our
various reinsurance treaties in place. Hannover holds substantially all of these
reserves.
27
The total policy liabilities and benefits accrued were 85.4% of the total
liabilities at June 30, 2003 compared to 71.1% at December 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 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 June 30, 2003, the interest rate on our tranche A term loan
balance of $8.2 million was 5.3% per annum and our $4.8 million CIT tranche B
term loan was 5.6% per annum.
The credit agreement, as amended, contains financial and other covenants
that among other things:
o prohibit the payment of cash dividends on, or the repurchase of, shares
of our common stock;
o restrict the creation of liens and sales of assets;
o require 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
o require that we, at a minimum, maintain:
o a leverage ratio (consolidated debt to consolidated total capital)
of 0.30 to 1.00;
o an interest coverage ratio (consolidated earnings before interest,
income taxes, depreciation, and amortization to consolidated
interest expense) of 3.00 to 1.00;
28
o 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;
o 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
o 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:
o permitted the sale of Pyramid Life;
o required $10.0 million of sale proceeds to be used as a partial pay
down of bank debt;
o waived the minimum risk-based capital ratio requirement of 125% for
Continental General at December 31, 2002;
o excluded intercompany tax sharing payments in the calculation of the
fixed charge coverage ratio at December 31, 2002;
o 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;
o 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
o 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
operating leases.
29
The following schedule summarizes current and future contractual
obligations as of June 30, 2003:
PAYMENTS DUE BY YEAR
----------------------------------------------------------------------
LESS THAN
CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR 1-3 YEARS 4-5 YEARS AFTER 5 YEARS
- ----------------------------------- ------- ------- --------- ----------- --------------
(DOLLARS IN THOUSANDS)
Long-term debt $12,962 $ 3,185 $ 9,777 $ -- $ --
Operating leases 28,099 2,901 4,786 4,005 16,407
------- ------- ------- ------- -------
Total contractual obligations $41,061 $ 6,086 $14,563 $ 4,005 $16,407
======= ======= ======= ======= =======
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 June 30, 2003, we were in compliance with the covenants of 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 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) 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.
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
30
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 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:
o debt downgrades or other events that adversely affects an investee's
access to, or cost of, financing;
o negative economic factors and conditions specific to the issuers
industry;
o adverse changes in the regulatory environment specific to the issuers
industry;
31
o all spread changes exceeding 50 basis points; or
o corporate bond prices that move more than 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
June 30, 2003. The amortized cost and estimated fair value of fixed maturities
on our investment surveillance list at June 30, 2003 were $5.5 million and $5.0
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 $12.1 million
after-tax at June 30, 2003. This amount represents approximately 6.6% 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.
32
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:
o 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;
o our ability to implement increases in premium rates and to develop,
distribute and administer competitive products and services in a
timely, cost-effective manner;
o rising healthcare costs, especially the rising costs of prescription
drug costs that are rising faster than other medical costs, and rising
utilization rates;
o 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;
o our ability to meet risk-based or statutory capital requirements;
o 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;
o 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;
o 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;
o the risk of material adverse outcomes in litigation;
o the risk of selling investments to meet liquidity requirements;
33
o our ability to obtain additional debt or equity financing on terms
favorable to us to facilitate our long-term growth;
o the risk that issuers of securities owned by Ceres will default or that
other parties will not pay or perform;
o our financial and claims paying ratings, including any potential
downgrades;
o our ability to maintain our current PPO network arrangements;
o dependence on senior management and key personnel;
o the performance of others on whom we rely for administrative and
operations services;
o changes in accounting and reporting practices;
o the failure to successfully manage our operations and integrate future
acquisitions, if any, including the failure to achieve cost savings;
o payments to state assessment funds;
o business conditions and competition in the healthcare industry;
o changes in tax laws; and
o our ability to fully collect all agent advances.
The factors listed above should not be constructed as exhaustive. We
undertake no obligation to publicly release 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 PRONOUNCEMENTS
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
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-15(e)) as of June
30, 2003. Based upon
34
that evaluation, our President and Chief Executive Officer along with our Chief
Financial Officer concluded that our disclosure controls and procedures are
effective.
35
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
a) The Annual Meeting of Stockholders was held on May 20, 2003.
b) Proxies were solicited for election of directors by Ceres' management
pursuant to Regulation 14A under the Securities Exchange Act of 1934.
No solicitation in opposition to management's nominees as listed in the
proxy statement were made. All of management's nominees were elected to
hold office until the next annual election of directors and until their
successors are elected and qualified pursuant to a vote of
stockholders.
c) The matters voted upon were the following:
1. With respect to the election of three Class I directors to
serve for a term of three years ending at the 2006 Annual Meeting
of Stockholders:
Name For
---- ---
Susan S. Fleming 29,052,940
Thomas J. Kilian 27,930,315
Robert J. Lunn 29,053,141
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits:
31.1 CEO certification pursuant to Section 302 of Sarbanes-Oxley Act
of 2002.
36
31.2 CFO certification pursuant to Section 302 of Sarbanes-Oxley Act
of 2002.
32 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:
On April 14, 2003, we filed a current report on Form 8-K to disclose
the completion of the sale of Pyramid Life Insurance Company.
On May 8, 2003, we filed a current report on Form 8-K to disclose our
earnings for the first quarter of 2003.
On June 26, 2003, we filed a current report on Form 8-K to disclose a
change in our independent accounting firm.
37
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: August 14, 2003 By: /s/ David I. Vickers
---------------- ------------------------------------
David I. Vickers
Executive Vice President and Chief
Financial Officer (Principal Financial
Officer and Chief Accounting Officer)
38