CERES GROUP INC - 10-Q Quarterly Report

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, 2004		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 o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No o

The number of shares of common stock, par value $0.001 per share, outstanding as of November 1, 2004 was 34,508,048.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

CERES GROUP, INC. and SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(dollars in thousands)


	September 30,		December 31,
	2004		2003
	(Unaudited)
ASSETS
Investments
Fixed maturities available-for-sale, at fair value	$	478,550	$	479,089
Limited partnership		1,892		—
Surplus notes		—		1,006
Policy and mortgage loans		3,686		4,185

Total investments		484,128		484,280
Cash and cash equivalents (of which $6,560 and $6,978 is restricted, respectively)		31,058		26,394
Accrued investment income		4,537		5,658
Premiums receivable		4,092		4,443
Reinsurance receivable		135,534		143,397
Property and equipment, net		5,533		5,527
Deferred acquisition costs		66,412		69,609
Value of business acquired		11,432		13,034
Goodwill		10,657		10,657
Licenses		3,440		3,440
Other assets		7,013		7,475

Total assets	$	763,836	$	773,914

LIABILITIES AND STOCKHOLDERS’ EQUITY
Policy liabilities and benefits accrued
Future policy benefits, losses and claims	$	350,941	$	341,263
Unearned premiums		35,525		33,993
Other policy claims and benefits payable		104,875		129,237

		491,341		504,493
Deferred reinsurance gain		8,357		9,456
Other policyholders’ funds		17,102		20,821
Debt		11,313		13,000
Deferred federal income taxes payable		6,428		9,572
Other liabilities		26,633		31,433

Total liabilities		561,174		588,775

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, 34,495,363 and 34,391,398 shares issued and outstanding, respectively		34		34
Additional paid-in capital		133,920		133,549
Retained earnings		60,854		44,378
Accumulated other comprehensive income		7,854		7,178

Total stockholders’ equity		202,662		185,139

Total liabilities and stockholders’ equity	$	763,836	$	773,914

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

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,
	2004			2003		2004		2003
REVENUES
Premiums, net
Medical	$	60,097		$	72,593	$	187,989	$	236,754
Senior and other		46,182			43,439		134,698		128,698

Total premiums, net		106,279			116,032		322,687		365,452
Net investment income		6,285			6,588		19,234		18,572
Net realized gains		163			184		401		1,330
Fee and other income		4,463			6,758		13,565		20,496
Amortization of deferred reinsurance gain		337			355		1,098		1,431

		117,527			129,917		356,985		407,281

BENEFITS, LOSSES AND EXPENSES
Benefits, claims, losses and settlement expenses
Medical		44,468			53,327		131,167		174,632
Senior and other		34,494			32,200		101,802		96,604

Total benefits, claims, losses and settlement expenses		78,962			85,527		232,969		271,236
Selling, general and administrative expenses		34,528			35,713		101,102		111,101
Net amortization and change in acquisition costs and value of business acquired		187			1,756		4,626		4,813
Interest expense and financing costs		169			291		507		1,026

		113,846			123,287		339,204		388,176

Income from continuing operations before federal income taxes		3,681			6,630		17,781		19,105
Federal income tax expense (benefit)		(1,729	)		2,430		1,305		4,197

Income from continuing operations		5,410			4,200		16,476		14,908

Discontinued operations
Income from operations of Pyramid Life (less tax expense of $3,223)		—			—		—		5,732
Loss on sale of Pyramid Life (less tax benefit of $79)		—			—		—		(2,149	)

Income from discontinued operations		—			—		—		3,583

Net income	$	5,410		$	4,200	$	16,476	$	18,491

Basic earnings per share
Continuing operations	$	0.16		$	0.12	$	0.48	$	0.43
Discontinued operations		—			—		—		0.11

Net income	$	0.16		$	0.12	$	0.48	$	0.54

Diluted earnings per share
Continuing operations	$	0.16		$	0.12	$	0.47	$	0.43
Discontinued operations		—			—		—		0.11

Net income	$	0.16		$	0.12	$	0.47	$	0.54

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

CERES GROUP, INC. and SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

For the Nine Months Ended September 30, 2004

Unaudited
(dollars in thousands, except share amounts)


Common Stock
Balance at September 30, 2004	$	34

Additional Paid-in Capital
Balance at beginning of year	$	133,549
Issuance of stock:
Employee/agent benefit and stock purchase plans		371

Balance at September 30, 2004	$	133,920

Retained Earnings
Balance at beginning of year	$	44,378
Net income		16,476

Balance at September 30, 2004	$	60,854

Accumulated Other Comprehensive Income
Balance at beginning of year	$	7,178
Unrealized gain on securities, net of tax expense of $363 (1)		676

Balance at September 30, 2004	$	7,854

Total Stockholders’ Equity	$	202,662

Number of Shares of Common Stock
Balance at beginning of year		34,391,398
Issuance of stock:
Employee/agent benefit and stock purchase plans		42,034
Warrants exercised		61,931

Balance at September 30, 2004		34,495,363

(1)

Net of reclassification adjustments. See Note E. Comprehensive Income (Loss) for further information.

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

CERES GROUP, INC. and SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Unaudited
(dollars in thousands)


	Nine Months Ended
	September 30,
	2004			2003
Operating activities
Net income	$	16,476		$	18,491
Adjustments to reconcile net income to net cash provided by operating activities:
Net income from discontinued operations		—			(3,583	)
Depreciation and amortization		2,716			2,725
Net realized gains		(401	)		(1,330	)
Deferred federal income taxes		(3,506	)		(910	)
Impairment of intangible asset, licenses		—			146
Changes in assets and liabilities:
Accrued investment income		1,121			362
Reinsurance and premiums receivable		8,214			25,883
Deferred acquisition costs		2,985			3,301
Value of business acquired		1,641			1,512
Other assets		901			2,243
Future policy benefits, claims and funds payable		(22,516	)		(3,182	)
Unearned premium		1,532			(543	)
Deferred reinsurance gain		(1,098	)		(1,277	)
Federal income taxes payable/recoverable		(1,393	)		3,458
Other liabilities		(3,513	)		756

Net cash provided by operating activities		3,159			48,052

Investing activities
Net purchases of furniture and equipment		(910	)		(1,524	)
Purchase of fixed maturities available-for-sale		(87,272	)		(188,631	)
Investment in limited partnership (net of distributions)		(1,892	)		—
Decrease (increase) in policy and mortgage loans, net		499			(145	)
Proceeds from sales of fixed maturities available-for-sale		27,445			38,099
Proceeds from calls and maturities of fixed maturities available-for-sale		60,838			72,832
Net proceeds from sale of Pyramid Life		—			55,261

Net cash used in investing activities		(1,292	)		(24,108	)

Financing activities
Increase in annuity account balances		19,462			10,680
Decrease in annuity account balances		(15,349	)		(13,627	)
Principal payments on debt		(1,687	)		(12,811	)
Proceeds from issuance of common stock related to employee/agent benefit and stock purchase plans		371			214

Net cash provided by (used in) financing activities		2,797			(15,544	)

Net increase in cash		4,664			8,400
Cash and cash equivalents at beginning of year		26,394			32,118

Cash and cash equivalents at end of period	$	31,058		$	40,518

Supplemental disclosures of cash flow information
Cash paid during the period for interest	$	433		$	745
Cash paid during the period for federal income taxes		6,204			1,601

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

CERES GROUP, INC. and SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

September 30, 2004

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 of America 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 accounting principles generally accepted in the United States of America 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, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

The condensed consolidated financial statements for September 30, 2004 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, and United Benefit Life Insurance Company. On March 31, 2003, we sold the stock of Pyramid Life Insurance Company to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. See Note D. Discontinued Operations for further information. As a result of the sale of Pyramid Life, our condensed consolidated financial statements for the nine months ended September 30, 2003 present the discontinued operations of Pyramid Life separate from continuing operations.

The condensed consolidated balance sheet presented at December 31, 2003 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America 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, 2003.

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

Significant Accounting Policies

For further information, refer to “Critical Accounting Policies” and “Other Accounting Policies and Insurance Business Factors” in our Annual Report on Form 10-K for the year ended December 31, 2003.

CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
Unaudited

Use of Estimates

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

Cash and Cash Equivalents

Cash and cash equivalents include cash and all liquid securities with maturities of 90 days or less when purchased. At September 30, 2004 and December 31, 2003, restricted cash was $6.6 million and $7.0 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 have certificates of deposit and fixed maturity securities on deposit with various state insurance departments to satisfy regulatory requirements.

Property and Equipment

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.

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 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

CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
Unaudited

(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.

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,
	2004			2003			2004			2003
	(dollars in thousands, except per share amounts)
Net income, as reported	$	5,410		$	4,200		$	16,476		$	18,491
Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax		(146	)		(26	)		(28	)		1,011	(1)

Pro forma net income	$	5,264		$	4,174		$	16,448		$	19,502

Earnings per share
Basic-as reported	$	0.16		$	0.12		$	0.48		$	0.54
Basic-pro forma	$	0.15		$	0.12		$	0.48		$	0.57
Diluted-as reported	$	0.16		$	0.12		$	0.47		$	0.54
Diluted-pro forma	$	0.15		$	0.12		$	0.47		$	0.57

(1)

For the nine months ended September 30, 2003, there was a positive pro forma impact on net income due to the forfeiture of options resulting from employee terminations.

Reclassifications

Certain prior period amounts have been reclassified to conform to the current period presentation.

New Accounting Pronouncements

In March 2004, the Financial Accounting Standard Board’s Emerging Issues Task Force concluded its discussion of Issue No. 03-01, The Meaning of Other-Than-Temporary Impairments and Its Application to Certain Investments (EITF 03-01). EITF 03-01 provides accounting guidance regarding the determination of when an impairment (i.e., fair value is less than carrying value) of debt and marketable equity securities and investments accounted for under the cost method should be considered other-than-temporary and recognized in earnings.

CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
Unaudited

EITF 03-01 also requires annual disclosures of certain quantitative and qualitative factors of debt and marketable equity securities classified as available-for-sale or held-to-maturity that are in an unrealized loss position at the balance sheet date, but for which an other-than-temporary impairment has not been recognized. The disclosure requirements of EITF 03-01 were effective December 31, 2003. The recognition and measurement guidance of EITF 03-01 was effective on July 1, 2004. In September 2004, the FASB issued FASB Staff Position EITF 03-01-1, which delayed the original effective date of the recognition and measurement guidance of EITF 03-01 until the FASB deliberates certain issues related to the implementation of EITF 03-01.

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 after December 15, 2003, with earlier adoption encouraged. We adopted SOP 03-1 on January 1, 2004. The adoption of SOP 03-1 did not have a material impact on our consolidated results of operations, cash flows or financial position.

B. Debt


	September 30,		December 31,
	2004		2003
	(dollars in thousands)
Bank credit facility	$	11,313	$	13,000

On December 23, 2003, we entered into a new credit agreement among Ceres, the subsidiaries of Ceres which are signatories thereto, CIT Group, and National City Bank as Administrative Agent. Proceeds of the new $13.0 million term loan facility were used to pay-off the then existing term loan balance and to repurchase most of the stock of one of our non-regulated subsidiaries from certain agents of the Company. The early pay-off of the former credit agreement resulted in the immediate amortization of the capitalized loan fees relating to that debt, causing a pre-tax expense of approximately $0.3 million. The loan origination fee on the new credit agreement of 1.0% is being amortized over the lives of the new term loans.

CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
Unaudited

The new credit facility consists of a $4.0 million term loan A with National City Bank with quarterly principal payments of $250,000 through December 2005, $375,000 through December 2006, and a payment of $500,000 on March 1, 2007. The $9.0 million term loan B with CIT Group has quarterly principal payments of $312,500 through December 2004, $375,000 through December 2006, $562,500 through December 2007, and $1,250,000 through June 2008.

Both term loans bear interest at floating rates, based on either Prime or LIBOR, plus applicable spreads. Under Prime rate borrowings, the interest rate for term loan A and term loan B will be the Prime interest rate plus 0.50% and 1.25%, respectively. Under Eurodollar borrowings, the interest rate for term loan A and term loan B will be LIBOR plus 3.25% and 4.00%, respectively. At September 30, 2004, the interest rate on our term loan A balance of $3.2 million was 5.04% per annum and the interest rate on our term loan B balance of $8.1 million was 5.79% per annum.

Our obligations under the new credit agreement are guaranteed by certain non-regulated subsidiaries of the Company and are secured by pledges of the capital stock of Central Reserve, Continental General, and our non-regulated subsidiaries, as well as security interests in certain equipment and other tangible property of Ceres and the non-regulated subsidiaries.

The new credit agreement contains various covenants including financial covenants relating to leverage, fixed charge coverage, risk-based capital of regulated insurance subsidiaries and tangible net worth. It also has a number of affirmative and negative covenants, including limitations relating to indebtedness, liens, mergers, purchases and sales of assets, investments, dividends and stock repurchases. At September 30, 2004, we were in compliance with these covenants.

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 continues to decline, fee income will decline. Dividends from the regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. In 2004, Continental General could pay a dividend to Ceres Group, the parent company, of up to $6.0 million without prior approval of the state regulator. Central Reserve is prohibited from paying any dividends without prior approval of its state regulator due to its level of statutory unassigned surplus.

CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
Unaudited

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, and an “A” rated carrier by A.M. Best Company, Inc. 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.

CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
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,
	2004			2003			2004			2003
				(dollars in thousands)
Premiums, net
Direct	$	125,413		$	139,970		$	383,390		$	437,178
Ceded		(19,134	)		(23,938	)		(60,703	)		(71,726	)

Total premiums, net	$	106,279		$	116,032		$	322,687		$	365,452

Benefits, claims, losses and settlement expenses, net
Benefits, claims, losses and settlement expenses	$	89,637		$	100,432		$	274,229		$	316,215
Reinsurance recoveries		(10,675	)		(14,905	)		(41,260	)		(44,979	)

Total benefits, claims, losses and settlement expenses, net	$	78,962		$	85,527		$	232,969		$	271,236

Selling, general and administrative expenses
Commissions	$	17,190		$	17,204		$	50,582		$	56,330
Other operating expenses		18,631			23,035			59,950			69,371
California litigation settlements		3,250			—			3,250			—
Reinsurance allowances		(4,543	)		(4,526	)		(12,680	)		(14,600	)

Total selling, general and administrative expenses	$	34,528		$	35,713		$	101,102		$	111,101

D. Discontinued Operations

On March 31, 2003, we sold the stock of our indirect subsidiary, Pyramid Life Insurance Company, 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 continued to process Pyramid Life’s business through an administrative services agreement until it terminated on December 31, 2003. 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. 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 for the nine months ended September 30, 2003.

CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
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,
	2004		2003		2004		2003
			(dollars in thousands)
Revenues
Premiums, net	$	—	$	—	$	—	$	27,964
Net investment income		—		—		—		1,568
Net realized gains		—		—		—		5,965

		—		—		—		35,497

Benefits, Losses and Expenses
Benefits, claims, losses and settlement expenses		—		—		—		20,285
Selling, general and administrative expenses		—		—		—		8,702
Net (deferral) amortization and change in acquisition costs and value of business acquired		—		—		—		(2,445	)

		—		—		—		26,542

Income from operations before federal income taxes		—		—		—		8,955
Federal income tax expense		—		—		—		3,223

Income from operations		—		—		—		5,732

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	$	—	$	—	$	—	$	3,583

E. Comprehensive Income (Loss)

Comprehensive income (loss) is as follows:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2004			2003			2004			2003
				(dollars in thousands)
Net income	$	5,410		$	4,200		$	16,476		$	18,491
Other comprehensive income (loss), net of tax:
Unrealized gain (loss) on securities, net of tax expense (benefit) of $3,479, ($2,230), $447 and $1,547, respectively		6,460			(4,138	)		832			2,878
Reclassification adjustments for net gains included in net income, net of tax expense of $17, $25, $23 and $352, respectively		(33	)		(49	)		(44	)		(655	)
Unrealized loss adjustment to deferred acquisition costs and value of business acquired, net of tax benefit of $498, $922, $61 and $988, respectively		(923	)		(1,709	)		(112	)		(1,834	)
Realized gain due to the sale of Pyramid Life, net of tax expense of $2,016		—			—			—			(3,744	)

Comprehensive income (loss)	$	10,914		$	(1,696	)	$	17,152		$	15,136

CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
Unaudited

F. 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 by the weighted average number of shares outstanding during the period. Diluted earnings per common share is computed by dividing net income 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,

2004

2003

2004

2003

Weighted average shares:

Basic

34,495,077

34,339,582

34,449,631

34,291,416

Stock awards and incremental shares from assumed exercise of stock options

260,053

55,714

575,299

19,021

Diluted

34,755,130

34,395,296

35,024,930

34,310,437

G. Contingencies and Commitments

The nature of our business subjects us to a variety of legal actions and claims relating to such things as denial of healthcare benefits, premium rate increases, termination of coverage, claims administration and alleged violations of state and federal statutes.

As previously disclosed, a California lawsuit was filed against United Benefit Life, Central Reserve, Ceres, the American Association for Consumer Benefits (AACB), and Does 1 through 100 inclusive in the Superior Court for San Luis Obispo County, California (Case No.: CV 020275, filed April 2002) by Annelie and Joseph Purdy, on behalf of themselves and all others similarly situated, seeking class action certification on behalf of individuals in California who purchased group health insurance from United Benefit Life through the AACB. Plaintiffs alleged causes of action for breach of contract, bad faith, violations of California’s Unfair Competition Law and fraud in the inception. Plaintiffs sought unspecified damages, including the return of premium rate increases during the relevant period of time. Plaintiffs’ motion for statewide class certification was granted in November 2003 and the case was scheduled to go to trial in January 2005. The plaintiffs also filed an action against Provident American Life containing somewhat similar allegations. On September 15, 2004, we announced that we had agreed to settle these lawsuits. The settlements contemplate payments to class members and others, as well as certain attorneys’ fees and costs. In the third quarter of 2004, we recorded a pre-tax charge of $3.25 million ($2.1 million after-tax or $0.06 per share). Although the final amount of the settlement payout may vary, we believe that the ultimate payout will not materially exceed that amount. These California litigation settlements do not involve any admission of wrongdoing by the Company or any subsidiary.

CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
Unaudited

that may arise from any of these other actions would not materially affect our audited consolidated financial position or results of operations. However, we cannot predict with certainty the outcome of any of these actions against us or the potential costs involved. Our evaluation of the likely impact of any of these actions could change in the future and an unfavorable outcome in any case could have a material adverse effect on our consolidated financial position, results of operations or cash flows of a future period.

H. Federal Income Taxes

We account for federal income taxes using the liability method in accordance with SFAS No. 109, Accounting for Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reviewed for recoverability and a valuation allowance is established, if necessary. During the third quarter of 2004, we evaluated our valuation allowance for deferred taxes and determined that no valuation allowance was required on the remaining net operating loss carryforwards of $3.8 million due to the continued profitability of the Company and the projection of a continued pattern of taxable income in future periods sufficient to utilize these net operating losses. Accordingly, our net change in the deferred tax valuation allowance during the three and nine months ended September 30, 2004, including the current year utilization, was $3.0 million, or $0.09 per share, and $5.0 million, or $0.14 per share, respectively. In the third quarter of 2003, the deferred tax valuation allowance was not adjusted. In the first nine months of 2003, the deferred tax valuation allowance was reduced by $2.7 million, or $0.08 per share as a result of the utilization of net operating loss carryforwards of certain subsidiaries in the Medical segment.

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 the nine months ended September 30, 2003, the segment results exclude the operations of Pyramid Life, which was sold on March 31, 2003.

CERES GROUP, INC. and SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - Continued
September 30, 2004
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, 2004 and 2003 attributable to our operating segments. We do not separately allocate investments or other identifiable assets by operating segment, nor are income tax expenses (benefits) allocated by operating 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,
	2004			2003			2004			2003
				(dollars in thousands)
Medical
Revenues
Net premiums	$	60,097		$	72,593		$	187,989		$	236,754
Net investment income		964			1,315			3,458			4,248
Net realized gains (losses)		(6	)		(3	)		20			343
Other income		4,236			4,934			12,893			16,956

		65,291			78,839			204,360			258,301

Expenses
Benefits and claims		44,468			53,327			131,167			174,632
Other operating expenses		22,593			23,230			67,414			75,948

		67,061			76,557			198,581			250,580

Segment profit (loss) before federal income taxes	$	(1,770	)	$	2,282		$	5,779		$	7,721

Senior and Other
Revenues
Net premiums	$	46,182		$	43,439		$	134,698		$	128,698
Net investment income		5,317			5,268			15,772			14,319
Net realized gains		56			77			47			661
Other income		564			2,173			1,770			4,965

		52,119			50,957			152,287			148,643

Expenses
Benefits and claims		34,494			32,200			101,802			96,604
Other operating expenses		11,837			13,885			37,096			38,801

		46,331			46,085			138,898			135,405

Segment profit before federal income taxes	$	5,788		$	4,872		$	13,389		$	13,238

Corporate and Other
Revenues
Net investment income	$	4		$	5		$	4		$	5
Net realized gains		113			110			334			326
Other income		—			6			—			6

		117			121			338			337

Expenses
Interest expense and financing costs		169			291			507			1,026
Other operating expenses		285			354			1,218			1,165

		454			645			1,725			2,191

Segment loss before federal income taxes	$	(337	)	$	(524	)	$	(1,387	)	$	(1,854	)

Income from continuing operations before federal income taxes	$	3,681		$	6,630		$	17,781		$	19,105

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 more detailed Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, contained in our 2003 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 operating segments. The Medical segment includes major medical health insurance for individuals, families, associations and small to mid-size businesses. The Senior segment includes senior health, life and annuity products for Americans age 55 and over. To help control medical costs, Ceres also provides medical cost management services to its insureds.

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, began marketing and selling 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. Provident American Life also discontinued new sales activities and currently has less than 400 active major medical certificate holders and 400 life policyholders.

Critical Accounting Policies

Refer to Critical Accounting Policies in our 2003 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, 2004 and 2003 include the operations of all our subsidiaries for the entire period with the exception of Pyramid Life. As a result of the sale, Pyramid Life’s operations were classified as discontinued operations for the nine months ended September 30, 2003. For more information on the Pyramid Life sale, see

Quarter Ended September 30, 2004 Compared to Quarter Ended September 30, 2003


	Three Months Ended September 30,			Three Months Ended September 30,			Increase (Decrease) from Previous Year
	2004			2003			Dollars			%
	(dollars in thousands, except per share amounts)
Premiums, net
Medical	$	60,097		$	72,593		$	(12,496	)		(17.2	)%
Senior and other		46,182			43,439			2,743			6.3

Total		106,279			116,032			(9,753	)		(8.4	)
Net investment income		6,285			6,588			(303	)		(4.6	)
Net realized gains		163			184			(21	)		(11.4	)
Fee and other income		4,463			6,758			(2,295	)		(34.0	)
Amortization of deferred reinsurance gain		337			355			(18	)		(5.1	)

Consolidated revenues		117,527			129,917			(12,390	)		(9.5	)

Benefits, claims, losses and settlement expenses
Medical		44,468			53,327			(8,859	)		(16.6	)
Senior and other		34,494			32,200			2,294			7.1

Total		78,962			85,527			(6,565	)		(7.7	)
Selling, general and administrative expenses		34,528			35,713			(1,185	)		(3.3	)
Net amortization and change in acquisition costs and value of business acquired		187			1,756			(1,569	)		(89.4	)
Interest expense and financing costs		169			291			(122	)		(41.9	)

		113,846			123,287			(9,441	)		(7.7	)

Income from continuing operations before federal income taxes		3,681			6,630			(2,949	)		(44.5	)
Federal income tax expense (benefit)		(1,729	)		2,430			(4,159	)		(171.2	)

Net income	$	5,410		$	4,200		$	1,210			28.8

Basic earnings per share	$	0.16		$	0.12		$	0.04			33.3
Diluted earnings per share		0.16			0.12			0.04			33.3

Medical loss ratio		74.0	%		73.5	%		—			—
Senior loss ratio		74.7	%		74.1	%		—			—
Overall loss ratio		74.3	%		73.7	%		—			—

Net Premiums (net of reinsurance ceded)

For the quarter ended September 30, 2004, total net premiums decreased 8.4% to $106.3 million, compared to $116.0 million for the third quarter of 2003. The decrease was attributable to a 17.2% decrease in medical premiums offset by a 6.3% increase in senior and other premiums.

Medical

Medical premiums for the quarter ended September 30, 2004 were $60.1 million, compared to $72.6 million for the quarter ended September 30, 2003, a decrease of 17.2%. The decrease in medical premiums was primarily the result of a 23.2% decrease in major medical certificates in force from 91,580 at September 30, 2003 to 70,290 at September 30, 2004 due to higher lapsation rates. We believe that necessary rate increases implemented in excess of claim trends on certain blocks caused higher lapsation rates in 2003 and 2004. In addition, in 2004 we have experienced higher than anticipated lapse rates on new business.

New business production increased in the third quarter of 2004 compared to the third quarter of 2003, partially offsetting the higher than anticipated lapse rates. We plan to continue to focus sales in a reduced number of geographic locations which have historically produced favorable underwriting results. From the second quarter to the third quarter of 2004, the decline in major medical premium moderated to approximately 4% (or approximately 16% on an annualized basis), as the increased level of new business production is beginning to approach the level of renewal business which is lapsing. The decline in major medical premium is expected to moderate to approximately 5% on an annualized basis by the end of 2005.

Senior and Other

Senior and other premiums increased $2.7 million, or 6.3%, to $46.2 million for the quarter ended September 30, 2004, compared to $43.4 million for the same quarter in 2003. The increase was primarily due to an increase in new business production of Medicare supplement policies and growth of our senior life product in the third quarter of 2004, compared to the same period of 2003. The increase in Medicare supplement new business production was due primarily to the introduction of new standardized Medicare supplement plans at Continental General and Central Reserve. Medicare supplement premium is expected to increase approximately 8% overall in 2004, due primarily to the introduction of new standardized plans at Continental General and Central Reserve.

Other Revenues

Net investment income was $6.3 million for the third quarter of 2004, compared to $6.6 million for the third quarter of 2003, a decrease of 4.6%. The book yield of our investment portfolio at September 30, 2004 was 5.23%, which produces an annualized income stream of approximately $25.4 million, compared to a book yield of 5.51% at September 30, 2003.

Net realized gains were $0.2 million for the third quarter of 2004, which was comparable to the third quarter of 2003.

Fee and other income decreased to $4.5 million for the quarter ended September 30, 2004, compared to $6.8 million for the same quarter of 2003, a decrease of 34.0%. This decrease was

primarily attributable to the decline in major medical policies and the associated policy fee income and $1.9 million of fees in the third quarter of 2003 related to the transition processing of senior business for Pyramid Life. This transition agreement terminated on December 31, 2003.

The amortization of deferred reinsurance gain of $0.3 million for the quarter ended September 30, 2004 represented the recognition of the ceding commission allowances received under our reinsurance agreements. The unamortized amount of $8.4 million at September 30, 2004 was accounted for as a deferred reinsurance gain on the condensed consolidated balance sheet.

Benefits, Claims, Losses and Settlement Expenses

Total benefits, claims, losses and settlement expenses decreased to $79.0 million for the quarter ended September 30, 2004, compared to $85.5 million for the third quarter of 2003, a decrease of 7.7%.

Medical

Medical benefits, claims, losses and settlement expenses were $44.5 million for the quarter ended September 30, 2004, compared to $53.3 million for the third quarter of 2003, a decrease of 16.6%. The decrease was primarily the result of a smaller volume of business in force due to the reduction in medical business as a result of higher than anticipated lapse rates. In addition, the medical loss ratio was 74.0% for the quarter ended September 30, 2004, compared to 73.5% for the same quarter of 2003. The loss ratio is expected to increase in the fourth quarter of the year as policyholders meet their annual required co-payments and deductibles.

Senior and Other

Senior and other benefits, claims, losses and settlement expenses were $34.5 million for the quarter ended September 30, 2004, compared to $32.2 million in the third quarter of 2003, an increase of 7.1%. The senior and other loss ratio was 74.7% for the third quarter of 2004, compared to 74.1% for the third quarter of 2003. Improved long-term care experience and favorable development in long-term care reserves were more than offset by an increase in the Medicare supplement loss ratio. The Medicare supplement loss ratio for the third quarter of 2004 was 75.2%, compared to 63.7% in the same quarter of last year. The increase in the Medicare supplement loss ratio was caused by an increase in claim frequency on Medicare Part B physician claims. For 2004, rate increases on this block were approximately 5% based on the Company’s estimate of claims trends when the 2004 rate increases were filed. However, the Company’s current estimate of claims trends with respect to 2004 is now approximately 10%. The Medicare supplement loss ratio was expected to be lower in the second half of the year due to the moderation of a higher claim trend, as well as the historical seasonality of this product. However, now only a marginal moderation of the higher claim trend and a reduced positive impact due to seasonality is expected in the fourth quarter.

Other Expenses and Net Income

Selling, general and administrative expenses decreased to $34.5 million in the third quarter of 2004, compared to $35.7 million in the third quarter of 2003, a decrease of 3.3%. Included in selling, general and administrative expenses in the third quarter of 2004, is a $3.25 million charge relating to the settlement of two California lawsuits against the Company and several of

its insurance subsidiaries. A pre-tax charge of $3.25 million ($2.1 million after-tax or $0.06 per share) was recorded in the third quarter of 2004. Although the final amount of the settlement payout may vary, the ultimate payout is not expected to materially exceed this amount. For more information, see Note G. Contingencies and Commitments to our condensed consolidated financial statements. Excluding this charge, other operating expenses decreased $4.4 million as a direct result of the decline in major medical premiums. As a percentage of premium, selling, general and administrative expenses, including the California litigation settlements, were 32.5% in the third quarter of 2004, compared to 30.8% for the third quarter of 2003.

The net amortization and change in acquisition costs (DAC) and value of business acquired (VOBA) resulted in net amortization of $0.2 million for the third quarter of 2004, compared to net amortization of $1.8 million for the third quarter of 2003. In the third quarter of 2004, the level of costs capitalized in the Senior segment increased due to higher levels of Medicare supplement production. The rate of decline on the DAC asset continued to moderate in the third quarter of 2004 and this level is expected to continue in subsequent quarters. The Company maintains a conservative approach of deferring new business costs in the Medical segment due to the historical volatility in this segment.

Interest expense and financing costs decreased to $0.2 million in the third quarter of 2004, compared to $0.3 million in the third quarter of 2003, as a result of a decrease in outstanding debt.

Income from continuing operations before federal income taxes, including the $3.25 million charge for the California litigation settlements, was $3.7 million for the third quarter of 2004 compared to $6.6 million for the same period in 2003.

A federal income tax benefit of $1.7 million was recorded for the third quarter of 2004, which included a $3.0 million reduction to the deferred tax valuation allowance, or $0.09 per share, as a result of the continued profitability of the Company and the projection of a continued pattern of taxable income in future periods. In the third quarter of 2003, a federal income tax expense of $2.4 million was recorded, or 36.7% of the income from continuing operations before federal taxes.

For the third quarter of 2004, net income was $5.4 million, or $0.16 per share, compared to $4.2 million, or $0.12 per share, for the third quarter of 2003.

Nine Months Ended September 30, 2004 Compared to Nine Months Ended September 30, 2003


	Nine Months Ended September 30,			Nine Months Ended September 30,			Increase (Decrease) from Previous Year
	2004			2003			Dollars			%
	(dollars in thousands, except per share amounts)
Premiums, net
Medical	$	187,989		$	236,754		$	(48,765	)		(20.6	)%
Senior and other		134,698			128,698			6,000			4.7

Total		322,687			365,452			(42,765	)		(11.7	)
Net investment income		19,234			18,572			662			3.6
Net realized gains		401			1,330			(929	)		(69.8	)
Fee and other income		13,565			20,496			(6,931	)		(33.8	)
Amortization of deferred reinsurance gain		1,098			1,431			(333	)		(23.3	)

Consolidated revenues		356,985			407,281			(50,296	)		(12.3	)

Benefits, claims, losses and settlement expenses
Medical		131,167			174,632			(43,465	)		(24.9	)
Senior and other		101,802			96,604			5,198			5.4

Total		232,969			271,236			(38,267	)		(14.1	)
Selling, general and administrative expenses		101,102			111,101			(9,999	)		(9.0	)
Net amortization and change in acquisition costs and value of business acquired		4,626			4,813			(187	)		(3.9	)
Interest expense and financing costs		507			1,026			(519	)		(50.6	)

		339,204			388,176			(48,972	)		(12.6	)

Income from continuing operations before federal income taxes		17,781			19,105			(1,324	)		(6.9	)
Federal income tax expense		1,305			4,197			(2,892	)		(68.9	)

Income from continuing operations		16,476			14,908			1,568			10.5

Discontinued operations:
Income from operations of Pyramid Life, net of tax		—			5,732			(5,732	)		(100.0	)
Loss on sale of Pyramid Life, net of tax		—			(2,149	)		2,149			100.0

Income from discontinued operations		—			3,583			(3,583	)		(100.0	)

Net income	$	16,476		$	18,491		$	(2,015	)		(10.9	)

Basic earnings per share	$	0.48		$	0.54		$	(0.06	)		(11.1	)
Diluted earnings per share		0.47			0.54			(0.07	)		(13.0	)

Medical loss ratio		69.8	%		73.8	%		—			—
Senior loss ratio		75.6	%		75.1	%		—			—
Overall loss ratio		72.2	%		74.2	%		—			—

Net Premiums (net of reinsurance ceded)

For the nine months ended September 30, 2004, total net premiums decreased 11.7% to $322.7 million, compared to $365.5 million for the same period in 2003.

Medical

Medical premiums for the nine months ended September 30, 2004 were $188.0 million, compared to $236.8 million for the nine months ended September 30, 2003, a decrease of 20.6%. The decrease in medical premiums was primarily the result of a 23.2% decrease in major medical certificates in force from 91,580 at September 30, 2003 to 70,290 at September 30, 2004 due to higher lapsation rates. We believe that necessary rate increases implemented in excess of claim trends on certain blocks caused higher lapsation rates in 2003 and 2004. In addition, in 2004 we have experienced higher than anticipated lapse rates on new business.

New business production increased in the first nine months of 2004, compared to the same period in 2003, partially offsetting the higher than anticipated lapse rates. The decline in major medical premium has moderated to less than 5% (or 16% on an annualized basis) in the third quarter of 2004 as the increased level of new business production is beginning to approach the level of renewal business which is lapsing. The decline in major medical premium is expected to moderate to approximately 5% on an annualized basis by the end of 2005.

Senior and Other

Senior and other premiums increased $6.0 million, or 4.7%, to $134.7 million for the nine months ended September 30, 2004, compared to $128.7 million for the same period in 2003. The increase in senior and other premiums was primarily the result of an increase in new business production of our Medicare supplement policies and growth of our senior life product. New business production of Medicare supplement policies increased in the first nine months of 2004, compared to the same period of 2003, due primarily to the introduction of new standardized Medicare supplement plans at Continental General and Central Reserve. Medicare supplement premium is expected to increase approximately 8% overall in 2004, due primarily to the introduction of new standardized plans at Continental General and Central Reserve.

Other Revenues

Net investment income was $19.2 million for the first nine months of 2004, compared to $18.6 million for the first nine months of 2003, an increase of 3.6%. This increase was the result of an increase in average invested assets due to the investment of most of the proceeds from the sale of Pyramid Life on March 31, 2003 and the assumption of a related block of life business with approximately $12.1 million in invested assets. The book yield of our investment portfolio at September 30, 2004 was 5.23%, which produces an annualized income stream of approximately $25.4 million, compared to a book yield of 5.51% at September 30, 2003.

Net realized gains decreased to $0.4 million for the first nine months of 2004, compared to $1.3 million for the first nine months of 2003. The decrease was primarily attributable to gains generated on the sale of collateralized mortgage obligations (CMOs) and corporate bonds in the first nine months of 2003.

Fee and other income decreased to $13.6 million for the nine months ended September 30, 2004, compared to $20.5 million for the same nine months of 2003, a decrease of 33.8%. This decrease was attributable to the decline in major medical policies and the associated policy fee income and $3.8 million of fees in the second and third quarters of 2003 related to the transition processing of senior business for Pyramid Life. This transition agreement terminated on December 31, 2003.

The amortization of deferred reinsurance gain of $1.1 million for the nine months ended September 30, 2004 represented the recognition of the ceding commission allowances received under our reinsurance agreements. The unamortized amount of $8.4 million at September 30, 2004 was accounted for as a deferred reinsurance gain on the condensed consolidated balance sheet. The amortization of deferred reinsurance gain decreased from $1.4 million for the first nine months of 2003 due to diminishing levels of in force certificates.

Benefits, Claims, Losses and Settlement Expenses

Total benefits, claims, losses and settlement expenses decreased to $233.0 million for the nine months ended September 30, 2004, compared to $271.2 million for the first nine months of 2003, a decrease of 14.1%.

Medical

Medical benefits, claims, losses and settlement expenses were $131.2 million for the nine months ended September 30, 2004, compared to $174.6 million for the same period in 2003, a decrease of 24.9%. The decrease was primarily the result of a smaller volume of business in force due to the reduction in medical business as a result of exiting unprofitable states and higher than anticipated lapse rates. In addition, the medical loss ratio was 69.8% for the nine months ended September 30, 2004, compared to 73.8% for the same period in 2003. The improvement in the loss ratio was due primarily to favorable run-off of prior year claim reserves. The loss ratio is expected to increase in the fourth quarter of this year as policyholders meet their annual required co-payments and deductibles.

Senior and Other

Senior and other benefits, claims, losses and settlement expenses were $101.8 million for the nine months ended September 30, 2004, compared to $96.6 million for the same period in 2003. The senior and other loss ratio was 75.6% for the first nine months of 2004, compared to 75.1% for the same period in 2003. The Medicare supplement loss ratio continued to be higher than expected for the first nine months, as well as compared to the same period a year ago. The Medicare supplement loss ratio for the first nine months of 2004 was 72.3%, compared to 67.5% in 2003. The increase is primarily a result of an increase in claims frequency that was previously expected to moderate in the second half of the year. The increase in the Medicare supplement loss ratio was caused by an increase in claim frequency on Medicare Part B physician claims. For 2004, rate increases on this block were approximately 5% based on the Company’s estimate of claims trends when the 2004 rate increases were filed. However, the Company’s current estimate of claims trends with respect to 2004 is now approximately 10%.

Other Expenses and Net Income

Selling, general and administrative expenses decreased to $101.1 million in the first nine months of 2004, compared to $111.1 million for the same period in 2003, a decrease of 9.0%. Included in selling, general and administrative expenses for the first nine months of 2004, is a $3.25 million charge relating to the settlement of two California lawsuits. A pre-tax charge of $3.25 million ($2.1 million after-tax or $0.06 per share) was recorded in the third quarter of 2004. Although the final amount of the settlement payout may vary, the ultimate payout is not expected to materially exceed this amount. For more information, see Note G. Contingencies and Commitments to our condensed consolidated financial statements. Excluding this charge, other operating expenses decreased $9.4 million and commissions decreased $5.7 million as a direct result of the decline in medical premiums. As a percentage of premium, selling, general and administrative expenses, including the California litigation settlements, were 31.3% in the first nine months of 2004, compared to 30.4% in the first nine months of 2003. The increase in the selling, general and administrative expense ratio was primarily due to the $3.25 million charge from the California litigation settlements and an increase in consulting expenses and salaries of approximately $1.0 million due to bringing our Cleveland data processing and programming back in-house from a third party vendor.

The net amortization and change in acquisition costs (DAC) and value of business acquired (VOBA) resulted in net amortization of $4.6 million for the first nine months of 2004, compared to net amortization of $4.8 million for the first nine months of 2003. The rate of decline on the DAC asset moderated in the second and third quarters of 2004 and is expected to continue to moderate in subsequent quarters. The Company maintains a conservative approach of deferring new business costs in the Medical segment due to the historical volatility of this segment.

Interest expense and financing costs decreased to $0.5 million in the first nine months of 2004, compared to $1.0 million in the first nine months of 2003, as a result of a decrease in outstanding debt.

Income from continuing operations before federal income taxes, including the $3.25 million charge from the California litigation settlements, was $17.8 million for the first nine months of 2004, compared to $19.1 million for the same period in 2003.

A federal income tax expense of $1.3 million was recorded for the first nine months of 2004, which included a $5.0 million reduction to the deferred tax valuation allowance. As a result of the continued profitability of the Company, a projection of continued taxable income in future periods, and the corresponding utilization of the net operating loss (NOL) carryforwards against 2004 taxable income, the deferred tax valuation allowance was reduced $5.0 million, or $0.14 per share, in the first nine months of 2004. At September 30, 2004, the Company has a deferred tax asset of approximately $3.8 million established related to the remaining NOLs. The effective tax rate, including the $5.0 million reduction to the deferred tax valuation allowance, was 7.3% of the income from continuing operations before federal income taxes. In the first nine months of 2003, a federal income tax expense of $4.2 million was recorded, which included a $2.7 million reduction to the deferred tax valuation allowance, or $0.08 per share, as a result of the improved profitability of certain subsidiaries in the Medical segment. The effective tax rate for the first nine months of 2003, including the $2.7 million reduction to the deferred tax valuation allowance, was 22.0% of the income from continuing operations before federal income taxes.

Income from continuing operations was $16.5 million, or $0.47 per share, for the first nine months of 2004, compared to $14.9 million, or $0.43 per share for the first nine months of 2003. Income from the discontinued operations of Pyramid Life for the first nine months of 2003 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 an additional loss on the sale of $2.1 million). For the first nine months of 2004, net income was $16.5 million, or $0.47 per share, compared to $18.5 million, or $0.54 per share, for the first nine months of 2003, which included $3.6 million, or $0.11 per share, from Pyramid Life.

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, 2004 was $3.2 million, compared to $48.1 million at September 30, 2003. The decrease in cash provided by operating activities was primarily the result of the following:

• a significant reduction in our major medical claims inventory as of September 30, 2004;

• the prior period included a $12.1 million increase in future policy benefits, claims and funds payable due to Continental General’s assumption of certain interest sensitive whole-life policies from Pyramid Life on March 31, 2003;

• the prior period reflected a larger reduction in our reinsurance receivable due to the final settlement of our London Life reinsurance receivable in the first nine months of 2003 and a larger decline in our reinsurance receivable and reserves ceded balances; and

• an increase in current federal income taxes paid.

Assets decreased 1.3% to $763.8 million at September 30, 2004 from $773.9 million at December 31, 2003. Assets of $484.1 million, or 63.4% of the total assets, were in investments at September 30, 2004. Fixed maturities, our primary investment, were $478.6 million, or 98.8% of total investments, at September 30, 2004, compared to $479.1 million at December 31, 2003. Other investments consist of policy loans and mortgage loans, and an investment in a limited partnership. We have classified all of our fixed maturities as “available-for-sale” and accordingly have reported them at estimated fair value at September 30, 2004.

Approximately 96.4% of our bonds were of investment grade quality at September 30, 2004. In addition to the fixed maturities, we also had $31.1 million in cash and cash equivalents of which $6.6 million was restricted at September 30, 2004.

The total reinsurance receivable was $135.5 million at September 30, 2004. Of this amount, $133.6 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 87.6% of the total liabilities at September 30, 2004, compared to 85.7% at December 31, 2003.

Credit Agreement. On December 23, 2003, we entered into a new credit agreement among Ceres, the subsidiaries of Ceres which are signatories thereto, CIT Group, and National City Bank as Administrative Agent. Proceeds of the new $13.0 million term loan facility were used to pay-off the then existing term loan balance under the former credit agreement and to repurchase most of the stock of one of our non-regulated subsidiaries from certain agents of the Company. The early pay-off of the former credit agreement resulted in the immediate amortization of the capitalized loan fees relating to that debt, causing a pre-tax expense of approximately $0.3 million. The loan origination fee on the new credit agreement of 1.0% is being amortized over the lives of the new term loans.

The new credit agreement contains various covenants including financial covenants relating to leverage, fixed charge coverage, risk-based capital of regulated insurance subsidiaries, and tangible net worth. It also has a number of affirmative and negative covenants, including limitations relating to indebtedness, liens, mergers, purchases and sales of assets, investments, dividends, and stock repurchases. At September 30, 2004, we were in compliance with these covenants.

Off-Balance Sheet Arrangements. We do not have transactions or relationships with variable interest entities, and we do not have any off-balance sheet financing other than normal operating leases.

Contractual Obligations. The following schedule summarizes current and future contractual obligations as of September 30, 2004:


	Payments Due by Year
			Less than						After 5
Contractual Obligations	Total		1 year		1-3 years		4-5 years		years
	(dollars in thousands)
Long-term debt	$	11,313	$	2,438	$	5,813	$	3,062	$	—
Operating leases		25,090		2,741		4,440		3,948		13,961
Unfunded investment commitments (1)		2,871		2,871		—		—		—

Total contractual obligations	$	39,274	$	8,050	$	10,253	$	7,010	$	13,961

(1)

Represents estimated timing for fulfilling unfunded commitments for investments in a limited partnership. Outstanding commitments with this limited partnership are included in payments due in less than one year since the timing of funding these commitments cannot be reasonably estimated.

In December 2003, Continental General committed to invest $5.0 million in a limited partnership, NYLIM-GCR Fund I-2002, L.P. Investments by this Fund are expected to consist primarily of a diversified pool of subordinated real estate mezzanine debt and sub-tranche loans with an expected concentration in office assets located in major metropolitan areas. These capital commitments can be called by the partnership at any time during the commitment period to fund working capital needs or to purchase new investments. Once the commitment period expires, we are under no obligation to fund the remaining unfunded commitment, but may elect to do so. In the third quarter of 2004, the partnership made capital calls on Continental General’s limited partnership commitment of $0.2 million. At September 30, 2004, we had outstanding unfunded commitments totaling $2.9 million related to this limited partnership.

Dividends from our regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. In 2004, Continental General could pay a dividend to Ceres Group, the parent company, of up to $6.0 million without prior approval of the state regulator. Central Reserve is prohibited from paying any dividends without prior approval of its state regulator due to its level of statutory unassigned surplus.

If our non-regulated subsidiaries do not generate sufficient fee income or we are unable to take dividends from our insurance subsidiaries 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 needed, additional financing may not be available on terms favorable to us or at all.

Legal Proceedings

The nature of our business subjects us to a variety of legal actions and claims, which from time to time may be material. For more information, see “Part II. Other Information, Item 1. Legal Proceedings” on page 34.

Financial Information about Operating 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 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 (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, 2003, the risk-based capital levels for each of our insurance subsidiaries 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 us.

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 issuer’s industry;

• adverse changes in the regulatory environment specific to the issuer’s 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.

We evaluate our investment policies consistent with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and have determined that all of our investments are to be classified as available-for-sale. Available-for-sale securities are carried at fair value. If management believes a decline in the value of a particular investment is temporary, the decline is reported as an unrealized capital loss in Stockholders’ Equity, and if the decline is “other-than-temporary”, the carrying value of the investment is written down and a realized capital loss is reported in the Consolidated Statements of Operations. As of September 30, 2004, we had gross unrealized losses on individual available-for-sale investments of $1.6 million, compared to $2.9 million at December 31, 2003. There were 15 securities that were in a continuous unrealized loss position for twelve months or longer with unrealized losses totaling $1.1 million at September 30, 2004, compared to six securities with unrealized losses totaling $0.4 million at December 31, 2003. None of our investments are delinquent or in default and there are no conditions present that indicate a high probability that all amounts will not be collected. Based on our evaluation along with our external investment managers, there were no investments in an unrealized loss position that had experienced a decline in market value that was considered by us to be significant and other-than-temporary at September 30, 2004.

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 $14.4 million after-tax at September 30, 2004. This amount represents approximately 7.1% of our stockholders’ equity at such date.

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

Seasonality is the risk of fluctuations of revenues and operating results. Historically, our revenues and operating results during each fiscal year 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 Medical segment has seasonality such that earnings in the Medical segment are generally higher in the first quarter and lower later in the year. This is mainly a factor of our insureds meeting their annual required co-payments and deductibles.

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;

• increases in the frequency or severity of claims;

• 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;

• the risk of material adverse outcomes in litigation;

• changes or developments in healthcare reform and other regulatory issues, including Medicare reform and the Health Insurance Portability and Accountability Act of 1996 and increased privacy and security regulation, and changes in laws and regulations in key states in which we operate, could increase our costs, cause us to discontinue marketing products in certain states or cause us to change our business or operations significantly;

• 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 insurance and reinsurance, particularly Hannover Life Reassurance Company of America upon whom we have relied for substantially all of our reinsurance;

• failure of our information systems;

• 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 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;

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

• changes in accounting and reporting practices;

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

• payments to state assessment funds;

• business conditions and competition in the healthcare industry;

• changes in tax laws; and

• our ability to fully collect all agent advances.

The factors listed above should not be 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 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

Evaluation of disclosure controls and procedures. We carried out an evaluation, under the supervision and with the participation of our President and Chief Executive Officer along with our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)) as of September 30, 2004. 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 and designed to ensure that material information relating to us and our consolidated subsidiaries would be made known to allow timely decisions regarding required disclosure.

Changes in internal control. There have been no changes in our internal control over financial reporting that occurred during the last fiscal quarter that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

In addition, we are involved in various other legal and regulatory actions occurring in the normal course of business that could result in significant liabilities and costs. Based on current information, including consultation with outside counsel, we believe that any ultimate liability that may arise from any of these other actions would not materially affect our audited consolidated financial position or results of operations. However, we cannot predict with certainty the outcome of any of these actions against us or the potential costs involved. Our evaluation of the likely impact of any of these actions could change in the future and an unfavorable outcome in any case could have a material adverse effect on our consolidated financial position, results of operations or cash flows of a future period.

Item 2. Unregistered Sales of Equity 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

Exhibits:

31.1 CEO certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2 CFO certification pursuant to Section 302 of the 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.


	CERES GROUP, INC.
Date: November 9, 2004	By:	/s/ David I. Vickers
		David I. Vickers
		Executive Vice President and Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer)

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	Page
Part I. Financial Information
Item 1. Financial Statements
Condensed Consolidated Balance Sheets – September 30, 2004 (Unaudited) and December 31, 2003		1
Condensed Consolidated Statements of Operations – Three and nine months ended September 30, 2004 and 2003 (Unaudited)		2
Condensed Consolidated Statement of Stockholders’ Equity – Nine months ended September 30, 2004 (Unaudited)		3
Condensed Consolidated Statements of Cash Flows – Nine months ended September 30, 2004 and 2003 (Unaudited)		4
Notes to Condensed Consolidated Financial Statements – September 30, 2004 (Unaudited)		5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		16
Item 3. Quantitative and Qualitative Disclosure about Market Risk		33
Item 4. Controls and Procedures		33
Part II. Other Information
Item 1. Legal Proceedings		34
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		34
Item 3. Defaults Upon Senior Securities		34
Item 4. Submission of Matters to a Vote of Security Holders		35
Item 5. Other Information		35
Item 6. Exhibits		35
Signatures		36
EX-31.1 CEO Certification Pursuant to Section 302
EX-31.2 CFO Certification Pursuant to Section 302
EX-32 Certification Pursuant to 18 U.S.C. Section 1350

31.1		CEO certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		CFO certification pursuant to Section 302 of the 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.