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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 SEPTEMBER 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 No.)
incorporation or organization)
17800 ROYALTON ROAD, CLEVELAND, OHIO 44136
- --------------------------------------------- -----------
(Address of principal executive offices) (Zip Code)
(440) 572-2400
----------------------------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes (X) No ( )
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes (X) No ( )
The number of shares of common stock, par value $0.001 per share,
outstanding as of October 31, 2003 was 34,344,434.
CERES GROUP, INC. AND SUBSIDIARIES
INDEX
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets - September 30, 2003
(Unaudited) and December 31, 2002 1
Condensed Consolidated Statements of Operations - Three and nine
months ended September 30, 2003 and 2002 (Unaudited) 2
Condensed Consolidated Statement of Stockholders' Equity - Nine
months ended September 30, 2003 (Unaudited) 3
Condensed Consolidated Statements of Cash Flows - Nine months
ended September 30, 2003 and 2002 (Unaudited) 4
Notes to Condensed Consolidated Financial Statements - September 30,
2003 (Unaudited) 5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 17
Item 3. Quantitative and Qualitative Disclosure about Market Risk 32
Item 4. Controls and Procedures 32
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 33
Item 2. Changes in Securities and Use of Proceeds 33
Item 3. Defaults Upon Senior Securities 33
Item 4. Submission of Matters to a Vote of Security Holders 33
Item 5. Other Information 33
Item 6. Exhibits and Reports on Form 8-K 33
SIGNATURES 35
PART I. FINANCIAL INFORMATION
-----------------------------
ITEM 1. FINANCIAL STATEMENTS
- ----------------------------
CERES GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- -------------
(UNAUDITED) (NOTE A)
ASSETS
Investments
Fixed maturities available-for-sale, at fair value $ 469,592 $ 388,057
Surplus notes 4,036 5,151
Policy and mortgage loans 4,040 3,895
------------- -------------
Total investments 477,668 397,103
Cash and cash equivalents (of which $6,116 and $7,703 is restricted, respectively) 40,518 32,118
Accrued investment income 4,874 5,236
Premiums receivable 4,660 4,810
Reinsurance receivable 144,342 170,075
Property and equipment, net 5,728 5,387
Assets of Pyramid Life -- 157,774
Deferred acquisition costs 70,254 74,891
Value of business acquired 13,085 16,084
Goodwill 10,657 10,657
Licenses 3,440 3,586
Other assets 5,358 9,760
------------- -------------
TOTAL ASSETS $ 780,584 $ 887,481
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Policy liabilities and benefits accrued
Future policy benefits, losses and claims $ 341,947 $ 327,385
Unearned premiums 36,137 36,680
Other policy claims and benefits payable 131,784 147,938
------------- -------------
509,868 512,003
Deferred reinsurance gain 9,760 11,037
Other policyholders' funds 19,073 23,610
Federal income taxes payable 1,298 --
Debt 12,192 25,003
Liabilities of Pyramid Life -- 102,457
Deferred federal income taxes 10,988 11,746
Other liabilities 34,531 34,101
------------- -------------
TOTAL LIABILITIES 597,710 719,957
------------- -------------
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, 34,340,299 and
34,232,610 shares issued and outstanding, respectively 34 34
Additional paid-in capital 133,266 133,052
Retained earnings 39,921 21,430
Accumulated other comprehensive income 9,653 13,008
------------- -------------
TOTAL STOCKHOLDERS' EQUITY 182,874 167,524
------------- -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 780,584 $ 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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------ ------------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
REVENUES
Premiums, net
Medical $ 72,593 $ 90,702 $ 236,754 $ 277,793
Senior and other 43,439 42,102 128,698 127,462
------------ ------------ ------------ ------------
Total premiums, net 116,032 132,804 365,452 405,255
Net investment income 6,588 5,779 18,572 18,544
Net realized gains 184 2,102 1,330 1,657
Fee and other income 6,758 7,311 20,496 23,474
Amortization of deferred reinsurance gain 355 478 1,431 2,354
------------ ------------ ------------ ------------
129,917 148,474 407,281 451,284
------------ ------------ ------------ ------------
BENEFITS, LOSSES AND EXPENSES
Benefits, claims, losses and settlement expenses
Medical 53,327 66,315 174,632 222,909
Senior and other 32,200 31,163 96,604 95,434
------------ ------------ ------------ ------------
Total benefits, claims, losses and settlement expenses 85,527 97,478 271,236 318,343
Selling, general and administrative expenses 35,663 42,106 111,071 133,481
Net (deferral) amortization and change in acquisition costs
and value of business acquired 1,756 1,938 4,813 (4,312)
Interest expense and financing costs 291 490 1,026 1,536
Special charge -- -- -- 2,381
------------ ------------ ------------ ------------
123,237 142,012 388,146 451,429
------------ ------------ ------------ ------------
Income (loss) from continuing operations before federal
income taxes and minority interest 6,680 6,462 19,135 (145)
Federal income tax expense 2,430 2,253 4,197 102
------------ ------------ ------------ ------------
Income (loss) from continuing operations after tax and before
minority interest 4,250 4,209 14,938 (247)
Minority interest 50 (10) 30 (37)
------------ ------------ ------------ ------------
INCOME (LOSS) FROM CONTINUING OPERATIONS 4,200 4,219 14,908 (210)
------------ ------------ ------------ ------------
Discontinued operations
Income from operations of Pyramid Life (less tax expense
of $0, $1,674, $3,223 and $2,867, respectively) -- 3,078 5,732 5,244
Loss on sale of Pyramid Life (less tax benefit of $0 and
$79, respectively) -- -- (2,149) --
------------ ------------ ------------ ------------
INCOME FROM DISCONTINUED OPERATIONS -- 3,078 3,583 5,244
------------ ------------ ------------ ------------
NET INCOME $ 4,200 $ 7,297 $ 18,491 $ 5,034
============ ============ ============ ============
BASIC EARNINGS PER SHARE
Continuing operations $ 0.12 $ 0.12 $ 0.43 $ --
Discontinued operations -- 0.09 0.11 0.15
------------ ------------ ------------ ------------
Net income $ 0.12 $ 0.21 $ 0.54 $ 0.15
============ ============ ============ ============
DILUTED EARNINGS PER SHARE
Continuing operations $ 0.12 $ 0.12 $ 0.43 $ --
Discontinued operations -- 0.09 0.11 0.15
------------ ------------ ------------ ------------
Net income $ 0.12 $ 0.21 $ 0.54 $ 0.15
============ ============ ============ ============
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 NINE MONTHS ENDED SEPTEMBER 30, 2003
UNAUDITED
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
COMMON STOCK
Balance at September 30, 2003 $ 34
==============
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of year $ 133,052
Issuance of stock:
Employee benefit plans 214
--------------
Balance at September 30, 2003 $ 133,266
==============
RETAINED EARNINGS
Balance at beginning of year $ 21,430
Net income 18,491
--------------
Balance at September 30, 2003 $ 39,921
==============
ACCUMULATED OTHER COMPREHENSIVE INCOME
Balance at beginning of year $ 13,008
Unrealized gain on securities, net of tax expense of $207 389
Realized gains due to the sale of Pyramid Life, net of tax of $2,016 (3,744)
--------------
Balance at September 30, 2003 $ 9,653
==============
TOTAL STOCKHOLDERS' EQUITY $ 182,874
==============
NUMBER OF SHARES OF COMMON STOCK
Balance at beginning of year 34,232,610
Issuance of stock:
Employee benefit plans 107,689
--------------
Balance at September 30, 2003 34,340,299
==============
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)
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------------------------
2003 2002
------------- ------------
OPERATING ACTIVITIES
Net income $ 18,491 $ 5,034
Adjustments to reconcile net income to cash provided by (used in)
operating activities:
Net income from discontinued operations (3,583) (5,244)
Depreciation and amortization 2,725 2,160
Net realized gains (1,330) (1,657)
Deferred federal income taxes (910) 2,147
Impairment of intangible asset, licenses 146 --
Changes in assets and liabilities:
Accrued investment income 362 1,262
Reinsurance and premiums receivable 25,883 31,466
Deferred acquisition costs 3,301 (5,774)
Value of business acquired 1,512 1,462
Other assets 2,243 (1,146)
Future policy benefits, claims and funds payable (3,182) (44,825)
Unearned premium (543) 1,399
Deferred reinsurance gain (1,277) (2,354)
Federal income taxes payable/recoverable 3,458 (2,029)
Other liabilities 756 (19,058)
------------- ------------
Net cash provided by (used in) operating activities 48,052 (37,157)
------------- ------------
INVESTING ACTIVITIES
Net purchases of furniture and equipment (1,524) (308)
Purchase of fixed maturities available-for-sale (188,631) (143,472)
Increase in policy and mortgage loans, net (145) (136)
Proceeds from sales of fixed maturities available-for-sale 38,099 119,688
Proceeds from calls and maturities of fixed maturities available-for-sale 72,832 37,759
Net proceeds from sale of Pyramid Life 55,261 --
------------- ------------
Net cash provided by (used in) investing activities (24,108) 13,531
------------- ------------
FINANCING ACTIVITIES
Increase in annuity account balances 10,680 5,555
Decrease in annuity account balances (13,627) (15,540)
Principal payments on debt (12,811) (4,915)
Proceeds from issuance of common stock related to employee benefit plans 214 739
------------- ------------
Net cash used in financing activities (15,544) (14,161)
------------- ------------
NET INCREASE (DECREASE) IN CASH 8,400 (37,787)
Cash and cash equivalents at beginning of year 32,118 68,506
------------- ------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 40,518 $ 30,719
============= ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest $ 745 $ 1,698
Cash paid during the period for federal income taxes 1,892 --
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
SEPTEMBER 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 nine months ended
September 30, 2003 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2003.
The condensed consolidated financial statements for September 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 nine months ended September
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
SEPTEMBER 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 September 30, 2003 and December
31, 2002, restricted cash was $6.1 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 35 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 three to 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 Accounting Principles Board 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 Statement of Financial Accounting Standards ("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 Financial Accounting Standards
Board ("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
6
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
SEPTEMBER 30, 2003
UNAUDITED
================================================================================
apply provisions of APB Opinion 25 and provide the pro forma disclosure required
by SFAS 123 and the amended disclosures required by SFAS 148.
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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------- -------------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Net income, as reported $ 4,200 $ 7,297 $ 18,491 $ 5,034
Total stock-based employee compensation
expense determined under fair value
based method for all awards, net of tax -- (139) -- (378)
------------ ------------ ------------ ------------
PRO FORMA NET INCOME $ 4,200 $ 7,158 $ 18,491 $ 4,656
============ ============ ============ ============
Earnings per share
Basic-as reported $ 0.12 $ 0.21 $ 0.54 $ 0.15
BASIC-PRO FORMA $ 0.12 $ 0.21 $ 0.54 $ 0.14
Diluted-as reported $ 0.12 $ 0.21 $ 0.54 $ 0.15
DILUTED-PRO FORMA $ 0.12 $ 0.21 $ 0.54 $ 0.14
RECLASSIFICATIONS
Certain prior period amounts have been reclassified to conform to the
current period presentation.
NEW ACCOUNTING PRONOUNCEMENTS
In July 2003, the American Institute of Certified Public Accountants issued
Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises
for Certain Nontraditional Long-Duration Contracts and for Separate Accounts
("SOP 03-1"). SOP 03-1 addresses a number of topics, the most significant of
which is the accounting for contracts with guaranteed minimum death benefits.
SOP 03-1 requires companies to evaluate the significance of guaranteed minimum
death benefits to determine whether the contract should be accounted for as an
investment or insurance contract. If the contract is determined to be an
insurance contract, companies are required to establish a reserve to recognize a
portion of the assessment (revenue) that compensates the insurance company for
benefits to be provided in future periods. SOP 03-1 also provides guidance on
separate account presentation, interest in separate accounts, gains and losses
on the transfer of assets from the general account to a separate account,
liability valuation, return based on a contractually referenced pool of assets
or index, annuitization options and sales inducements to contract holders. The
effective date of SOP 03-1 is for fiscal years beginning
7
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
SEPTEMBER 30, 2003
UNAUDITED
================================================================================
after December 15, 2003, with earlier adoption encouraged. If adopted early, the
provisions of SOP 03-1 must be applied as of the beginning of the fiscal year.
We are currently evaluating the impact that SOP 03-1 will have on our
consolidated results of operations, cash flows and 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). This Statement is 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, except for
mandatorily redeemable financial instruments of nonpublic entities. The FASB
deferred indefinitely, the application of various provisions as it related to
mandatorily redeemable financial instruments of nonpublic entities. We have
not entered into any financial instruments within the scope of SFAS 150 since
May 31, 2003, nor do we currently hold any significant financial instruments as
defined within the scope of this pronouncement.
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. The adoption of SFAS 149 on July 1, 2003 did not have a material impact on
our consolidated results of operations, cash flows or financial position.
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 consolidation by business enterprises of variable interest entities
which have certain characteristics by requiring that if a business enterprise
has a controlling interest in a variable interest entity (as defined by FIN 46),
the assets, liabilities, and results of activities of the variable interest
entity be included in the consolidated financial statements with those of the
business enterprise. FIN 46 applies to variable interest entities created after
January 31, 2003 and to variable interest entities in which an enterprise
obtains an interest after that date. For variable interests acquired before
February 1, 2003, FIN 46 applies in the first fiscal year or interim period
beginning after June 15, 2003. We have, and will continue to, adopt the various
provisions of FIN 46 as indicated above, but presently do not have any variable
interest entities that would be required to be included in our consolidated
results of operations, cash flows or financial position. We previously reported
that we would adopt FIN 46 for variable interests acquired before February 1,
2003 on July 1, 2003; however, the FASB staff has delayed the implementation
date for these provisions until the fourth quarter of 2003.
8
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
SEPTEMBER 30, 2003
UNAUDITED
================================================================================
In June 2002, the FASB, issued 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.
B. DEBT
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
(DOLLARS IN THOUSANDS)
Bank credit facility $ 12,192 $ 25,003
============= ============
We maintain a bank credit facility consisting of a tranche A term loan that
expires February 17, 2005 and a tranche B term loan that expires December 17,
2005. The term loans bear interest at either a fixed rate based on the prime
rate plus a spread or a floating rate based on LIBOR plus a spread. The
applicable rate for the tranche A term loan is the prime rate plus 3.0% or LIBOR
plus 4.0%. The applicable rate for the tranche B term loan is the prime rate
plus 3.5% or LIBOR plus 4.5%. At September 30, 2003, the interest rate on our
$7.6 million tranche A term loan was 5.1% and the interest rate on our $4.6
million tranche B term loan was 5.6%.
The credit agreement, as amended, contains customary covenants which, among
other matters, require us to achieve certain minimum financial results, prohibit
us from paying future cash dividends and restrict or limit our ability to incur
additional debt and dispose of assets outside the ordinary course of business.
At September 30, 2003, we were in compliance with all such covenants. Our
obligations under the credit agreement are secured by pledges of the common
stock of Central Reserve Life, Continental General, and most of our
non-regulated subsidiaries.
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.
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
9
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
SEPTEMBER 30, 2003
UNAUDITED
================================================================================
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. A significant
portion of our risks are reinsured with a single reinsurance company, Hannover
Life Reassurance Company of America, a health and life reinsurance company. 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
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.
10
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
SEPTEMBER 30, 2003
UNAUDITED
================================================================================
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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------ ---------------------------------
2003 2002 2003 2002
----------- ------------ ------------- --------------
(DOLLARS IN THOUSANDS)
PREMIUMS, NET
Direct $ 139,970 $ 161,455 $ 437,178 $ 497,132
Assumed -- 28 -- 73
Ceded (23,938) (28,679) (71,726) (91,950)
----------- ------------ ------------- --------------
Total premiums, net $ 116,032 $ 132,804 $ 365,452 $ 405,255
=========== ============ ============= ==============
BENEFITS, CLAIMS, LOSSES AND
SETTLEMENT EXPENSES, NET
Benefits, claims, losses and settlement
expenses $ 100,432 $ 113,471 $ 316,215 $ 381,474
Reinsurance recoveries (14,905) (15,993) (44,979) (63,131)
----------- ------------ ------------- --------------
Total benefits, claims, losses and
settlement expenses, net $ 85,527 $ 97,478 $ 271,236 $ 318,343
=========== ============ ============= ==============
SELLING, GENERAL AND ADMINISTRATIVE
EXPENSES
Commissions $ 17,204 $ 23,528 $ 56,330 $ 75,285
Other operating expenses 22,985 24,458 69,341 77,046
Reinsurance expenses -- -- -- 440
Reinsurance allowances (4,526) (5,880) (14,600) (19,290)
----------- ------------ ------------- --------------
Total selling, general and
administrative expenses $ 35,663 $ 42,106 $ 111,071 $ 133,481
=========== ============ ============= ==============
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 continue to process Pyramid
Life's business through an administrative services agreement until December 31,
2003. 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 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.
11
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
SEPTEMBER 30, 2003
UNAUDITED
================================================================================
Summarized financial data for Pyramid Life's operations are as follows:
STATEMENTS OF OPERATIONS
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------- ------------------------------
2003 2002 2003 2002
----------- ------------ ------------ ------------
(DOLLARS IN THOUSANDS)
REVENUES
Premiums, net $ -- $ 25,144 $ 27,964 $ 71,852
Net investment income -- 1,695 1,568 5,080
Net realized gains -- 976 5,965 131
----------- ------------ ------------ ------------
-- 27,815 35,497 77,063
----------- ------------ ------------ ------------
BENEFITS, LOSSES AND EXPENSES
Benefits, claims, losses and settlement expenses -- 17,640 20,285 53,280
Selling, general and administrative expenses -- 7,512 8,702 21,612
Net (deferral) amortization and change in acquisition
costs and value of business acquired -- (2,089) (2,445) (6,227)
Special charge -- -- -- 287
----------- ------------ ------------ ------------
-- 23,063 26,542 68,952
----------- ------------ ------------ ------------
Income from operations before federal income taxes -- 4,752 8,955 8,111
Federal income tax expense -- 1,674 3,223 2,867
----------- ------------ ------------ ------------
INCOME FROM OPERATIONS -- 3,078 5,732 5,244
----------- ------------ ------------ ------------
Loss on sale of Pyramid Life -- -- (2,228) --
Federal income tax benefit -- -- (79) --
----------- ------------ ------------ ------------
LOSS ON SALE OF PYRAMID LIFE, NET -- -- (2,149) --
----------- ------------ ------------ ------------
INCOME FROM DISCONTINUED OPERATIONS $ -- $ 3,078 $ 3,583 $ 5,244
=========== ============ ============ ============
12
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
SEPTEMBER 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.
13
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
SEPTEMBER 30, 2003
UNAUDITED
================================================================================
F. COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) is as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------- ------------------------------
2003 2002 2003 2002
------------ ----------- ----------- -----------
(DOLLARS IN THOUSANDS)
Net income $ 4,200 $ 7,297 $ 18,491 $ 5,034
Other comprehensive income (loss), net of tax:
Unrealized gain on securities, net of tax
expense (benefit) of $(3,177), $3,839,
$207 and $5,666, respectively (1) (5,896) 7,128 389 11,767
Realized gain due to the sale of Pyramid Life,
net of tax of $2,016 -- -- (3,744) --
------------ ----------- ----------- -----------
Comprehensive income (loss) $ (1,696) $ 14,425 $ 15,136 $ 16,801
============ ============ =========== ===========
- -----------
(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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------ -----------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Weighted average shares:
BASIC 34,339,582 34,034,196 34,291,416 33,967,712
Stock awards and incremental shares from
assumed exercise of stock options 55,714 -- 19,021 --
---------- ---------- ---------- ----------
DILUTED 34,395,296 34,034,196 34,310,437 33,967,712
========== ========== ========== ==========
H. CONTINGENCIES
We are involved in various legal and regulatory actions occurring in
the normal course of business, which could result in significant liabilities and
costs. Based on current information, including consultation with outside
counsel, we believe any ultimate liability that may arise from these actions
would not materially affect our consolidated financial position or results of
operations. However, we cannot predict with certainty the outcome of lawsuits
against the Company or the potential costs involved. Our evaluation of the
likely impact of these actions could change in the future and an unfavorable
outcome could have a material adverse effect on our consolidated financial
position, results of operations or cash flow of a future period.
14
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
SEPTEMBER 30, 2003
UNAUDITED
================================================================================
I. OPERATING SEGMENTS
We apply SFAS No. 131, Disclosures about Segments of an Enterprise and
Related Information, which requires us to report information about our operating
segments according to the management approach for determining reportable
segments. This approach is based on the way management organizes segments within
a company for making operating decisions and assessing performance. We have
three distinct operating segments based upon product types: Medical, Senior and
Other, and Corporate and Other. Products included in the Medical segment include
catastrophic and comprehensive major medical plans. Significant products in the
Senior and Other segment include Medicare supplement, long-term care, dental,
life insurance, and annuities. The Corporate and Other segment encompasses all
other activities, including investment income, interest expense, and corporate
expenses, of the parent company. For all periods presented, the segment results
exclude the operations of Pyramid Life, which was sold March 31, 2003.
15
CERES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
SEPTEMBER 30, 2003
UNAUDITED
================================================================================
The following table presents the revenues, expenses and profit (loss) from
continuing operations before federal income taxes, for the three and nine months
ended September 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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------------- -------------------------------
2003 2002 2003 2002
-------------- ------------- ------------- ------------
(DOLLARS IN THOUSANDS)
MEDICAL
Revenues
Net premiums $ 72,593 $ 90,702 $ 236,754 $ 277,793
Investment income, realized gains 1,312 2,460 4,591 6,263
Other income 4,934 7,446 16,956 23,974
-------------- ------------- ------------- ------------
78,839 100,608 258,301 308,030
-------------- ------------- ------------- ------------
Expenses
Benefits and claims 53,327 66,315 174,632 222,909
Other operating expenses 23,180 31,677 75,918 93,412
-------------- ------------- ------------- ------------
76,507 97,992 250,550 316,321
-------------- ------------- ------------- ------------
Segment profit (loss) before federal income
taxes and minority interest $ 2,332 $ 2,616 $ 7,751 $ (8,291)
============== ============= ============= ============
SENIOR AND OTHER
Revenues
Net premiums $ 43,439 $ 42,102 $ 128,698 $ 127,462
Investment income, realized gains 5,345 5,311 14,980 13,606
Other income 2,173 343 4,965 1,854
-------------- ------------- ------------- ------------
50,957 47,756 148,643 142,922
-------------- ------------- ------------- ------------
Expenses
Benefits and claims 32,200 31,163 96,604 95,434
Other operating expenses 13,885 11,905 38,801 34,578
-------------- ------------- ------------- ------------
46,085 43,068 135,405 130,012
-------------- ------------- ------------- ------------
Segment profit before federal income taxes and
minority interest $ 4,872 $ 4,688 $ 13,238 $ 12,910
============== ============= ============= ============
CORPORATE AND OTHER
Revenues
Investment income, realized gains $ 115 $ 110 $ 331 $ 332
Other income 6 -- 6 --
-------------- ------------- ------------- ------------
121 110 337 332
-------------- ------------- ------------- ------------
Expenses
Interest and financing costs 291 490 1,026 1,536
Other operating expenses 354 462 1,165 1,179
Special charge -- -- -- 2,381
-------------- ------------- ------------- ------------
645 952 2,191 5,096
-------------- ------------- ------------- ------------
Segment loss before federal income taxes
and minority interest $ (524) $ (842) $ (1,854) $ (4,764)
============== ============= ============= ============
INCOME (LOSS) FROM CONTINUING OPERATIONS
BEFORE FEDERAL INCOME TAXES AND MINORITY
INTEREST $ 6,680 $ 6,462 $ 19,135 $ (145)
============== ============= ============= ============
16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
- --------------------------------------------------------------------------------
OF OPERATIONS
- -------------
This discussion should be read in conjunction with our condensed
consolidated financial statements, notes and tables included elsewhere in this
report, as well as, the Management's Discussion and Analysis of Financial
Condition and Results of Operations, or MD&A, contained in our 2002 Annual
Report on Form 10-K. MD&A may contain forward-looking statements that are
provided to assist in the understanding of anticipated future financial
performance. However, future performance involves risks and uncertainties, which
may cause actual results to differ materially from those expressed in the
forward-looking statements. See "Forward-Looking Statements" for further
information.
OVERVIEW
Ceres Group, through its insurance subsidiaries, provides a wide array of
health and life insurance products through two primary business segments. The
Senior segment includes senior health, life and annuity products for Americans
age 55 and over. The 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 and in late 2003, will market and sell
senior products. 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
discontinued new sales activities and currently has approximately 1,600 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 nine months ended September 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 nine months ended September 30, 2002
was reclassified to reflect the sale of Pyramid Life. The net
17
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.
18
QUARTER ENDED SEPTEMBER 30, 2003 COMPARED TO QUARTER ENDED SEPTEMBER 30, 2002
INCREASE
THREE MONTHS THREE MONTHS (DECREASE) FROM
ENDED % OF ENDED % OF PREVIOUS YEAR
SEPTEMBER 30, CONSOLIDATED SEPTEMBER 30, CONSOLIDATED -------------------
2003 REVENUES 2002 REVENUES DOLLARS %
------------- ------------ ------------- ------------ ------- ------
(dollars in thousands, except per share amounts)
Premiums, net
Medical $ 72,593 55.9% $ 90,702 61.1% $ (18,109) (20.0)%
Senior and other 43,439 33.4 42,102 28.4 1,337 3.2
---------- ------- ---------- ------- ---------
Total 116,032 89.3 132,804 89.5 (16,772) (12.6)
Net investment income 6,588 5.1 5,779 3.9 809 14.0
Net realized gains 184 0.1 2,102 1.4 (1,918) (91.2)
Fee and other income 6,758 5.2 7,311 4.9 (553) (7.6)
Amortization of deferred
reinsurance gain 355 0.3 478 0.3 (123) (25.7)
---------- ------- ---------- ------- ---------
Consolidated revenues 129,917 100.0 148,474 100.0 (18,557) (12.5)
---------- ------- ---------- ------- ---------
Benefits, claims, losses and settlement
expenses
Medical 53,327 41.0 66,315 44.7 (12,988) (19.6)
Senior and other 32,200 24.8 31,163 21.0 1,037 3.3
---------- ------- ---------- ------- ---------
Total 85,527 65.8 97,478 65.7 (11,951) (12.3)
Selling, general and administrative
expenses 35,663 27.5 42,106 28.3 (6,443) (15.3)
Net (deferral) amortization and change in
acquisition costs and value of business
acquired 1,756 1.4 1,938 1.3 (182) (9.4)
Interest expense and financing costs 291 0.2 490 0.3 (199) (40.6)
---------- ------- ---------- ------- ---------
123,237 94.9 142,012 95.6 (18,775) (13.2)
---------- ------- ---------- ------- ---------
Income from continuing operations
before federal income taxes and
minority interest 6,680 5.1 6,462 4.4 218 3.4
Federal income tax expense 2,430 1.9 2,253 1.6 177 7.9
---------- ------- ---------- ------- ---------
Income from continuing operations
after tax and before minority interest 4,250 3.2 4,209 2.8 41 1.0
Minority interest 50 -- (10) -- 60 N/M
---------- ------- ---------- ------- ---------
INCOME FROM CONTINUING OPERATIONS 4,200 3.2 4,219 2.8 (19) (0.5)
---------- ------- ---------- ------- ---------
Discontinued operations:
Income from operations of Pyramid
Life, net of tax -- -- 3,078 2.1 (3,078) (100.0)
Loss on sale of Pyramid Life, net of tax -- -- -- -- -- --
---------- ------- ---------- ------- ---------
INCOME FROM DISCONTINUED OPERATIONS -- -- 3,078 2.1 (3,078) (100.0)
---------- ------- ---------- ------- ---------
NET INCOME $ 4,200 3.2% $ 7,297 4.9% $ (3,097) (42.4)
========== ======= ========== ======= =========
Basic earnings per share $ 0.12 $ 0.21 $ (0.09) (42.9)
Diluted earnings per share 0.12 0.21 (0.09) (42.9)
- -----------
N/M = not meaningful
19
NET PREMIUMS (NET OF REINSURANCE CEDED)
For the quarter ended September 30, 2003, total net premiums decreased
12.6% to $116.0 million, compared to $132.8 million for the same quarter in
2002.
MEDICAL
Medical premiums for the quarter ended September 30, 2003 were $72.6
million compared to $90.7 million for the quarter ended September 30, 2002, a
decrease of 20.0%. 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, higher than anticipated policy lapse
rates, and a 66% 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 increased $1.3 million to $43.4 million for the
quarter ended September 30, 2003 compared to $42.1 million for the same quarter
in 2002. The increase in senior and other premiums was primarily the result of
premium rate increases and an increase in Medicare supplement new business
production.
OTHER REVENUES
Net investment income was $6.6 million for the third quarter of 2003
compared to $5.8 million for the third quarter of 2002, an increase of 14.0%,
due primarily to an increase in invested assets from the proceeds of the sale of
Pyramid Life.
Net realized gains decreased to $0.2 million for the third quarter of 2003
compared to $2.1 million for the third quarter of 2002. The prior year quarter
reflected a partial redistribution of our investment portfolio, which resulted
in the realization of capital gains.
Fee and other income decreased to $6.8 million for the quarter ended
September 30, 2003 compared to $7.3 million for the same quarter of 2002, a
decrease of 7.6%. 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
third party administrator ("TPA") fees in the Senior and Other segment related
to the processing of senior business for Pyramid Life. This TPA agreement is
expected to terminate at December 31, 2003.
The amortization of deferred reinsurance gain of $0.4 million for the
quarter ended September 30, 2003 represented the recognition of the ceding
commission allowances received under our reinsurance agreements. The unamortized
amount of $9.8 million at September 30, 2003 was accounted for as a deferred
reinsurance gain on the condensed consolidated balance sheet. The amortization
of deferred reinsurance gain decreased from $0.5 million for the quarter ended
September 30, 2002 as a result of lower amortization due to diminishing levels
of in force certificates.
20
BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES
Total benefits, claims, losses and settlement expenses decreased to $85.5
million for the quarter ended September 30, 2003 compared to $97.5 million for
the same quarter in 2002, a decrease of 12.3%.
MEDICAL
Medical benefits, claims, losses and settlement expenses were $53.3 million
for the quarter ended September 30, 2003 compared to $66.3 million for the same
quarter in 2002, a decrease of 19.6%. 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 and higher than anticipated policy lapse rates.
The medical loss ratio was 73.5% for the quarter ended September 30, 2003
compared to 73.1% for the same quarter of 2002.
SENIOR AND OTHER
Senior and other benefits, claims, losses and settlement expenses
increased to $32.2 million for the quarter ended September 30, 2003 compared to
$31.2 million for the same quarter of 2002. The senior and other loss ratio was
74.1% for the third quarter of 2003 compared to 74.0% for the third quarter of
2002 primarily due to higher claims experience on the long-term care business.
OTHER EXPENSES AND NET INCOME
Selling, general and administrative expenses decreased to $35.7 million in
the third quarter of 2003 compared to $42.1 million in the third quarter of
2002, a decrease of 15.3%. Commissions decreased $6.3 million and other
operating expenses decreased $1.5 million as a direct result of the decline in
medical premiums. As a percentage of revenues, selling, general and
administrative expenses decreased to 27.5% in the third quarter of 2003 compared
to 28.3% in the third quarter of 2002 primarily due to the decrease in the
overall commissions rate as a result of lower new sales, a reduced workforce at
our Cleveland facility, 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 $1.8 million
for the third quarter of 2003 which was comparable to net amortization of $1.9
million for the third quarter of 2002.
Interest expense and financing costs decreased to $0.3 million in the third
quarter of 2003 compared to $0.5 million in the third quarter of 2002 as a
result of a decrease in outstanding debt.
A federal income tax expense of $2.4 million was recorded for the third
quarter of 2003, or 36.4% of the income from continuing operations before
federal taxes. In the third quarter of 2002, a federal income tax expense of
$2.3 million was recorded, or 34.9% of the income from continuing operations
before federal taxes.
21
Income from continuing operations was $4.2 million, or $0.12 per share, for
the third quarter of 2003, which was comparable to the third quarter of 2002.
For the third quarter of 2003, net income was $4.2 million, or $0.12 per share,
compared to $7.3 million, or $0.21 per share, for the third quarter of 2002.
22
NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO NINE MONTHS ENDED
SEPTEMBER 30, 2002
INCREASE
NINE MONTHS NINE MONTHS (DECREASE) FROM
ENDED % OF ENDED % OF PREVIOUS YEAR
SEPTEMBER 30, CONSOLIDATED SEPTEMBER 30, CONSOLIDATED ----------------------
2003 REVENUES 2002 REVENUES DOLLARS %
---------- ------------ ---------- ------------ ---------- -------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Premiums, net
Medical $ 236,754 58.1% $ 277,793 61.6% $ (41,039) (14.8)%
Senior and other 128,698 31.6 127,462 28.2 1,236 1.0
---------- ----- ---------- ----- ----------
Total 365,452 89.7 405,255 89.8 (39,803) (9.8)
Net investment income 18,572 4.6 18,544 4.1 28 0.2
Net realized gains 1,330 0.3 1,657 0.4 (327) (19.7)
Fee and other income 20,496 5.0 23,474 5.2 (2,978) (12.7)
Amortization of deferred
reinsurance gain 1,431 0.4 2,354 0.5 (923) (39.2)
---------- ----- ---------- ----- ----------
Consolidated revenues 407,281 100.0 451,284 100.0 (44,003) (9.8)
---------- ----- ---------- ----- ----------
Benefits, claims, losses and settlement
expenses
Medical 174,632 42.9 222,909 49.4 (48,277) (21.7)
Senior and other 96,604 23.7 95,434 21.1 1,170 1.2
---------- ----- ---------- ----- ----------
Total 271,236 66.6 318,343 70.5 (47,107) (14.8)
Selling, general and administrative
expenses 111,071 27.3 133,481 29.6 (22,410) (16.8)
Net (deferral) amortization and change in
acquisition costs and value of business
acquired 4,813 1.2 (4,312) (0.9) 9,125 N/M
Interest expense and financing costs 1,026 0.2 1,536 0.4 (510) (33.2)
Special charge -- -- 2,381 0.5 (2,381) (100.0)
---------- ----- ---------- ----- ----------
388,146 95.3 451,429 100.1 (63,283) (14.0)
---------- ----- ---------- ----- ----------
Income (loss) from continuing operations
before federal income taxes and
minority interest 19,135 4.7 (145) (0.1) 19,280 N/M
Federal income tax expense 4,197 1.1 102 -- 4,095 N/M
---------- ----- ---------- ----- ----------
Income (loss) from continuing operations
after tax and before minority interest 14,938 3.6 (247) (0.1) 15,185 N/M
Minority interest 30 -- (37) -- 67 181.1
---------- ----- ---------- ----- ----------
INCOME (LOSS) FROM CONTINUING
OPERATIONS 14,908 3.6 (210) (0.1) 15,118 N/M
---------- ----- ---------- ----- ----------
Discontinued operations:
Income from operations of Pyramid
Life, net of tax 5,732 1.4 5,244 1.2 488 9.3
Loss on sale of Pyramid Life, net of tax (2,149) (0.5) -- -- (2,149) N/M
---------- ----- ---------- ----- ----------
INCOME FROM DISCONTINUED
OPERATIONS 3,583 0.9 5,244 1.2 (1,661) (31.7)
---------- ----- ---------- ---- ----------
NET INCOME $ 18,491 4.5% $ 5,034 1.1% $ 13,457 N/M
========== ===== ========== ===== ==========
Basic earnings per share $ 0.54 $ 0.15 $ 0.39 N/M
Diluted earnings per share 0.54 0.15 0.39 N/M
- -----------
N/M = not meaningful
23
NET PREMIUMS (NET OF REINSURANCE CEDED)
For the nine months ended September 30, 2003, total net premiums decreased
9.8% to $365.5 million, compared to $405.3 million for the same period in 2002.
MEDICAL
Medical premiums for the nine months ended September 30, 2003 were $236.8
million compared to $277.8 million for the nine months ended September 30, 2002,
a decrease of 14.8%. 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 65% 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 $128.7 million for the nine months ended
September 30, 2003 compared to $127.5 million for the same period in 2002. The
increase in senior and other premiums was primarily the result of premium rate
increases and an increase in Medicare supplement new business production.
OTHER REVENUES
Net investment income was $18.6 million for the first nine months of 2003
compared to $18.5 million for the first nine months of 2002, an increase of
0.2%. The decline in the overall portfolio yield to 5.5% was offset by the
increase in average invested assets.
Net realized gains decreased to $1.3 million for the first nine months of
2003 compared to $1.7 million for the first nine months of 2002. The prior year
period reflected a partial redistribution of our investment portfolio, which
resulted in the realization of capital gains, offset by the write-down for
other-than-temporary impairment on bonds held in WorldCom of $0.9 million.
Fee and other income decreased to $20.5 million for the nine months ended
September 30, 2003 compared to $23.5 million for the same nine months of 2002, a
decrease of 12.7%. 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 $3.8 million of TPA fees in the Senior and Other
segment related to the processing of senior business for Pyramid Life. This TPA
agreement is expected to terminate at December 31, 2003.
The amortization of deferred reinsurance gain of $1.4 million for the nine
months ended September 30, 2003 represented the recognition of the ceding
commission allowances received under our reinsurance agreements. The unamortized
amount of $9.8 million at September 30, 2003 was accounted for as a deferred
reinsurance gain on the condensed consolidated balance sheet. The amortization
of deferred reinsurance gain decreased from $2.4 million for the nine months
ended September 30, 2002 as a result of lower amortization due to diminishing
levels of in force certificates.
24
BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES
Total benefits, claims, losses and settlement expenses decreased to $271.2
million for the nine months ended September 30, 2003 compared to $318.3 million
for the nine months ended September 30, 2002, a decrease of 14.8%.
MEDICAL
Medical benefits, claims, losses and settlement expenses were $174.6
million for the nine months ended September 30, 2003 compared to $222.9 million
for the same period in 2002, a decrease of 21.7%. 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
73.8% for the nine months ended September 30, 2003 compared to 80.2% 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
increased to $96.6 million for the nine months ended September 30, 2003 compared
to $95.4 million for the same period of 2002. The senior and other loss ratio
was 75.1% for the first nine months of 2003 compared to 74.9% for the first nine
months of 2002. The higher loss ratio in the current period was primarily due to
higher claims experience on the long-term care and senior life business, which
was partially offset in part by improved Medicare supplement experience.
OTHER EXPENSES AND NET INCOME
Selling, general and administrative expenses decreased to $111.1 million
for the first nine months of 2003 compared to $133.5 million in the first nine
months of 2002, a decrease of 16.8%. Commissions decreased $19.0 million and
other operating expenses decreased $8.1 million as a direct result of our
cancelled or replaced business offset by reduced reinsurance allowances of $4.7
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
first nine months of 2003 compared to 29.6% in the first nine months of 2002
primarily due to the decrease in the overall commissions rate as a result of
lower new sales, a reduced 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 $4.8 million
for the first nine months of 2003 compared to a net deferral of $4.3 million for
the first nine 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 $1.0 million in the first
nine months of 2003 compared to $1.5 million in the first nine months of 2002 as
a result of a decrease in outstanding debt.
25
The special charge for the nine months ended September 30, 2002 represented
a pre-tax non-recurring charge of $2.7 million ($2.4 million in continuing
operations and $0.3 million in discontinued operations) related to the
retirement of Peter W. Nauert, our former CEO. See Note E. Special Charge to our
condensed consolidated financial statements for further information.
A federal income tax expense of $4.2 million was recorded for the first
nine 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, including the
deferred tax valuation allowance adjustment of $2.7 million, was 21.9% for the
nine months ended September 30, 2003. In the first nine months of 2002, a
federal income tax expense of $0.1 million was recorded, which included a $0.2
million adjustment for permanent differences related to penalties and meals and
entertainment.
Income from continuing operations was $14.9 million, or $0.43 per share,
for the first nine months of 2003 compared to a loss of $0.2 million for the
first nine 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 nine
months of 2003 compared to $5.2 million, or $0.15 per share, for the first nine
months of 2002. For the first nine months of 2003, net income was $18.5 million,
or $0.54 per share, compared to $5.0 million, or $0.15 per share, 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 rent,
salaries, employee benefits, commissions, taxes, and interest on debts. Net cash
provided by operating activities for the period ended September 30, 2003 was
$48.1 million compared to net cash used in operating activities of $37.2 million
at September 30, 2002. The increase was primarily attributable to an improvement
in earnings and the current year settlements of our reinsurance receivables.
Assets decreased 12.0% to $780.6 million at September 30, 2003 from $887.5
million at December 31, 2002 due primarily to the sale of Pyramid Life. Assets
of $477.7 million, or 61.2% of the total assets, were in investments at
September 30, 2003. Fixed maturities, our primary investment, were $469.6
million, or 98.3% of total investments, at September 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 September 30, 2003.
Approximately 95.5% of our bonds were of investment grade quality at
September 30, 2003. In addition to the fixed maturities, we also had $40.5
million in cash and cash equivalents of which $6.1 million was restricted at
September 30, 2003.
26
The total reinsurance receivable was $144.3 million at September 30, 2003.
Of this amount, $144.1 million represents reserves held by our reinsurers under
our various reinsurance treaties in place. Hannover holds substantially all of
these reserves.
The total policy liabilities and benefits accrued were 85.3% of the total
liabilities at September 30, 2003 compared to 71.1% at December 31, 2002. This
increase was primarily due to the sale of Pyramid Life.
CREDIT AGREEMENT. We maintain a bank credit facility consisting of a
tranche A term loan that expires February 17, 2005 and a tranche B term loan
that expires December 17, 2005. The term loans bear interest at either a fixed
rate based on the prime rate plus a spread or a floating rate based on LIBOR
plus a spread. The applicable rate for the tranche A term loan is the prime rate
plus 3.0% or LIBOR plus 4.0%. The applicable rate for the tranche B term loan is
the prime rate plus 3.5% or LIBOR plus 4.5%. At September 30, 2003, the interest
rate on our $7.6 million tranche A term loan was 5.1% and the interest rate on
our $4.6 million tranche B term loan was 5.6%.
The credit agreement, as amended, contains customary covenants which, among
other matters, require us to achieve certain minimum financial results, prohibit
us from paying future cash dividends and restrict or limit our ability to incur
additional debt and dispose of assets outside the ordinary course of business.
At September 30, 2003, we were in compliance with all such covenants. Our
obligations under the credit agreement are secured by pledges of the common
stock of Central Reserve Life, Continental General, and most of our
non-regulated subsidiaries.
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.
The following schedule summarizes current and future contractual
obligations as of September 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 $ 12,192 $ 3,336 $ 8,856 $ -- $ --
Operating leases 27,392 2,807 4,692 3,976 15,917
------------ ------------ ------------ --------- ------------
Total contractual obligations $ 39,584 $ 6,143 $ 13,548 $ 3,976 $ 15,917
============ ============ ============ ========= ============
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
27
dividend to Ceres Group, the parent company, without prior approval of their
respective state regulators as a result of their respective statutory levels of
unassigned surplus. If our non-regulated subsidiaries do not generate sufficient
fee income to service all of our debt obligations, there may be a material
adverse effect on our business, financial condition and results of operations,
and a significant adverse effect on the market value of our common stock. In
addition, if necessary, additional financing may not be available on terms
favorable to us or at all.
FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS
We have three segments: Medical, which includes catastrophic and
comprehensive major medical plans; Senior and Other, which includes Medicare
supplement, long-term care, dental, life insurance and annuities; and Corporate
and Other, which includes interest income, interest expense, and corporate
expenses of the parent company. See Note I. Operating Segments, to the Notes to
our Condensed Consolidated Financial Statements for further information.
MARKET RISK AND MANAGEMENT POLICIES
The following is a description of certain risks facing health and life
insurers and how we mitigate those risks:
Inadequate Pricing Risk is the risk that the premium charged for insurance
and insurance related products is insufficient to cover the costs associated
with the distribution of such products, including benefits, claims and losses,
settlement expenses, acquisition expenses and other corporate expenses. We
utilize a variety of actuarial and qualitative methods to set such pricing
levels. Any negative fluctuation in our estimates of the effect of continued
medical inflation and high benefit utilization could have a material adverse
impact on our results of operations.
Legal/Regulatory Risk is the risk that changes in the legal or regulatory
environment in which an insurer operates will create additional expenses not
anticipated by the insurer in pricing its products. For example, regulatory
initiatives designed to reduce insurer profits or otherwise affecting the
industry in which the insurer operates, new legal theories or insurance company
insolvencies through guaranty fund assessments, may create costs for the insurer
beyond those recorded in the financial statements. We attempt to mitigate this
risk by offering a wide range of products and by operating in many states, thus
reducing our exposure to any single product and by employing underwriting
practices that identify and minimize the adverse impact of this risk.
In addition, insurance companies are subject to extensive federal and state
regulation and compliance with these regulations could increase the insurance
companies' operating costs. In some circumstances, failure to comply with
certain insurance regulations could subject an insurance company to regulatory
actions by such insurance company's state of domicile. For example, states have
statutory risk-based capital, or RBC, requirements for health and other
insurance companies based on the RBC Model Act. These RBC requirements are
intended to 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
28
December 31, 2002, our risk-based capital levels for each of our insurance
subsidiaries, except for Continental General, exceeded the levels required by
regulatory authorities. Continental General's statutory capital level was below
"Company Action Level" at December 31, 2002. However, after the addition of the
capital generated from the sale of Pyramid Life on March 31, 2003, Continental
General's risk-based capital level exceeded the levels required by regulatory
authorities.
Investment Impairment Risk is the risk that all amounts due (both principal
and interest) on our fixed maturity investments will not be collected according
to the security's contractual terms. We attempt to minimize this risk by
adhering to a conservative investment strategy. With the exception of short-term
investments and securities on deposit with various state regulators, investment
responsibilities have been delegated to external investment managers within the
investment parameters established by the Company.
Our external investment managers prepare a monthly investment surveillance
list to analyze our fixed maturity portfolio for potential other-than-temporary
impairment. The following factors are reviewed for inclusion on our surveillance
list:
- debt downgrades or other events that adversely affects an investee's
access to, or cost of, financing;
- negative economic factors and conditions specific to the issuers
industry;
- adverse changes in the regulatory environment specific to the issuers
industry;
- all spread changes exceeding 50 basis points; or
- corporate bond prices that move more 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
September 30, 2003. The amortized cost and estimated fair value of fixed
maturities on our investment surveillance list at September 30, 2003 were $5.4
million and $4.9 million, respectively.
Credit Risk is the risk that parties, including reinsurers that have
obligations to us, will not pay or perform. We attempt to minimize this risk by
maintaining sound reinsurance and credit collection policies.
Interest Rate Risk is the risk that interest rates will change and cause a
decrease in the value of an insurer's investments. This change in rates may
cause certain interest-sensitive products to become uncompetitive or may cause
disintermediation if we attempt to mitigate this risk by charging fees for
non-conformance with certain policy provisions and/or by attempting to match the
maturity schedule of our assets with the expected payouts of its liabilities. To
the extent that liabilities come due more quickly than assets mature, we would
have to sell assets prior to maturity and recognize a gain or loss. Assuming an
immediate increase of 100 basis points in interest rates, the net hypothetical
decline in fair value of stockholders' equity is estimated to be $13.1 million
after-tax at September 30, 2003. This amount represents approximately 7.2% of
our stockholders' equity at such date.
29
We also have long-term debt that bears interest at variable rates.
Therefore, our results of operations would be affected by interest rate changes.
We do not expect a significant rate change in the near future that would have a
material effect on our near-term results of operations.
Seasonality is the risk of fluctuations of revenues and operating results.
Historically, our revenues and operating results have varied from quarter to
quarter and are expected to continue to fluctuate in the future. These
fluctuations have been due to a number of factors, including higher benefit
utilization by our insureds during the winter months and the use of deductibles.
More specifically, our Senior segment's seasonality is the opposite of our
Medical segment's, meaning that earnings in the Senior segment are generally
lower in the first quarter and higher later in the year. This is mainly a factor
of our Medicare Supplement products that pay the Medicare deductible for our
insureds generally during the early months of the year.
IMPACT OF INFLATION
Inflation rates impact our financial condition and operating results in
several areas. Changes in inflation rates impact the market value of the
investment portfolio and yields on new investments.
Inflation has had an impact on claim costs and overall operating costs and
although it has been lower in the last few years, hospital and medical costs
have still increased at a higher rate than general inflation, especially
prescription drug costs. New, more expensive and wider use of pharmaceuticals is
inflating health care costs. We will continue to establish premium rates in
accordance with trends in hospital and medical costs along with concentrating on
various cost containment programs. However, there can be no assurance that these
efforts by us will fully offset the impact of inflation or that premiums will
equal or exceed increasing healthcare costs.
FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. Forward-looking statements are necessarily based on
estimates and assumptions that are inherently subject to significant business,
economic and competitive uncertainties and contingencies, many of which, with
respect to future business decisions, are subject to change. These uncertainties
and contingencies can affect actual results and could cause actual results to
differ materially from those expressed in any forward-looking statements made
by, or on behalf of, us.
In particular, forward-looking statements can be identified by the use of
words such as "may," "will," "should," "expect," "anticipate," "estimate,"
"continue" or similar words. In light of the risks and uncertainties inherent in
all future projections, the inclusion of forward-looking statements in this
report should not be considered as a representation by us or any other person
that our objectives or plans will be achieved. Numerous factors could cause our
actual results to differ materially and adversely from those in the
forward-looking statements, including those risks outlined above in "Market Risk
and Management Policies," and the following:
- unforeseen losses with respect to loss and settlement expense reserves
for unreported and reported claims or adverse changes in persistency or
profitability of insurance contracts that would accelerate the
amortization of our deferred acquisition costs;
30
- our ability to implement increases in premium rates and to
develop, distribute and administer competitive products and services in
a timely, cost-effective manner;
- rising healthcare costs, especially the rising costs of prescription
drug costs that are rising faster than other medical costs, and rising
utilization rates;
- developments in healthcare reform and other regulatory issues,
including the Health Insurance Portability and Accountability Act of
1996, increased privacy regulation, and changes in laws and regulations
in key states in which we operate;
- our ability to meet risk-based or statutory capital requirements;
- our ability to continue to meet the terms of our debt obligations under
our credit agreement which contains a number of significant financial
and other covenants;
- the adequacy of funds, including fee income, received from our
non-regulated subsidiaries, and the restrictions on our insurance
subsidiaries' ability to pay dividends to Ceres, to meet our debt
obligations;
- the performance of others on whom we rely for reinsurance,
particularly Hannover Life Reassurance Company of America upon whom we
have relied for substantially all of our reinsurance;
- the risk of material adverse outcomes in litigation;
- the risk of selling investments to meet liquidity requirements;
- our ability to obtain additional debt or equity financing on terms
favorable to us to facilitate our long-term growth;
- the risk that issuers of securities owned by Ceres will default or
that other parties will not pay or perform;
- our financial and claims paying ratings, including any potential
downgrades;
- our ability to maintain our current PPO network arrangements;
- dependence on senior management and key personnel;
- the performance of others on whom we rely for administrative and
operations services;
- changes in accounting and reporting practices;
- the failure to successfully manage our operations and integrate future
acquisitions, if any, including the failure to achieve cost savings;
- payments to state assessment funds;
- business conditions and competition in the healthcare industry;
31
- changes in tax laws; and
- our ability to fully collect all agent advances.
The factors listed above should not be construed 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
September 30, 2003. Based upon that evaluation, our President and Chief
Executive Officer along with our Chief Financial Officer concluded that our
disclosure controls and procedures are effective. There have been no changes in
our internal control over financial reporting that occurred during the most
recent fiscal quarter that have materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting.
32
PART II. OTHER INFORMATION
--------------------------
ITEM 1. LEGAL PROCEEDINGS
- --------------------------
We are involved in various legal and regulatory actions occurring in the
normal course of business, which could result in significant liabilities and
costs. Based on current information, including consultation with outside
counsel, we believe any ultimate liability that may arise from these actions
would not materially affect our consolidated financial position or results of
operations. However, we cannot predict with certainty the outcome of lawsuits
against the Company or the potential costs involved. Our evaluation of the
likely impact of these actions could change in the future and an unfavorable
outcome could have a material adverse effect on our consolidated financial
position, results of operations or cash flow of a future period.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
- --------------------------------------------------
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
- ----------------------------------------
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- ------------------------------------------------------------
None.
ITEM 5. OTHER INFORMATION
- --------------------------
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
- -----------------------------------------
a) Exhibits:
10.42 Employment Agreement dated, August 18, 2003, between Bradley
A. Wolfram and Ceres Group, Inc.
31.1 CEO certification pursuant to Section 302 of Sarbanes-Oxley
Act of 2002.
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 August 7, 2003, we filed a current report on Form 8-K to disclose
our earnings for the second quarter of 2003.
On August 20, 2003, we amended our current report on Form 8-K, dated
June 26, 2003, to disclose that the client-auditor relationship between
the Company and Ernst & Young, LLP ceased upon the completion of second
quarter review procedures on August 14, 2003.
33
On September 15, 2003, we filed a current report on Form 8-K to
disclose that we engaged KPMG, LLP as our independent accountants.
34
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: November 14, 2003 By: /s/ David I. Vickers
----------------- ----------------------------------
David I. Vickers
Executive Vice President and Chief
Financial Officer (Principal Financial
Officer and Chief Accounting Officer)
35