UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d)

OF THE SECURITIES EXCHANGE ACT OF 1934

CERES GROUP, INC.

(Exact name of registrant as specified in its charter)

(440) 572-2400

(Registrant’s telephone number, including area code)

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, par value $0.001 per share

(Title of class)

     Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES [X]  NO [ ]

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  [ ]

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

YES [X]  NO [ ]

     The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $153,383,690 computed based on the closing price of $6.14 per share of the common stock on June 30, 2004.

     The number of shares of common stock, par value $0.001 per share, outstanding as of March 1, 2005 was 34,536,353.

DOCUMENTS INCORPORATED BY REFERENCE:

     Portions of the registrant’s definitive proxy statement for the annual meeting of stockholders to be held May 17, 2005 are incorporated by reference into Part III of this Form 10-K.

     As used in this Form 10-K, the terms “Company,” “Ceres,” “Registrant,” “we,” “us,” and “our” mean Ceres Group, Inc. and its consolidated subsidiaries, taken as a whole, unless the context indicates otherwise. Except as otherwise stated, the information contained in this Form 10-K is as of December 31, 2004.

CERES GROUP, INC.

INDEX TO

ANNUAL REPORT ON FORM 10-K

For the Year Ended December 31, 2004

PART I

ITEM 1.   BUSINESS

Overview

      Ceres, through its insurance subsidiaries, provides a wide array of health and life insurance products through two primary business segments. Our Senior segment includes senior health, life and annuity products for Americans age 55 and over. The Medical segment includes catastrophic and comprehensive major medical health insurance for individuals, families, association members, and small to mid-size businesses. To help control medical costs, we also provide medical cost management services to our insureds. Our nationwide distribution channels include independent agents and our electronic distribution platform.

      Ceres (known as Central Reserve Life Corporation prior to December 1998) operated prior to 1998 primarily through its wholly-owned subsidiary, Central Reserve Life Insurance Company. Central Reserve markets and sells major medical health insurance to individuals, families, associations and small to mid-size employer groups. In late 2003, Central Reserve began marketing and selling senior health and life products.

      In 1998, we acquired Provident American Life and Health Insurance Company. Provident American Life discontinued new sales activities in 2001 and currently has less than 400 active major medical policyholders (HealthEdge product) and 400 life policyholders. In 2005, Provident American Life will begin marketing and selling senior health products.

      In 1999, we acquired Continental General Insurance Company which markets and sells both major medical and senior health and life products.

      Also, in 1999, we acquired, through foreclosure, United Benefit Life Insurance Company. All of United Benefit Life’s business is reinsured to Central Reserve and another unaffiliated reinsurance company. United Benefit Life discontinued new sales activities in July 2000 and terminated all of its existing business at the end of 2001.

      In March 2003, we sold Pyramid Life Insurance Company, a company we acquired in July 2000, for approximately $57.5 million in cash. Pyramid primarily markets and sells senior products. Immediately prior to the closing of the sale, Continental General acquired Pyramid Life’s Kansas City building and personal property and retained its employees. Continental General continued to administer Pyramid Life’s business out of the Kansas City location under a transition services agreement until December 31, 2003. In addition, Continental General reinsured a small block of certain life insurance policies of Pyramid Life.

      We also have various non-regulated subsidiaries that, through intercompany arrangements, provide a variety of services to our insurance subsidiaries, including personnel, administration, billing and collection, electronic distribution, managed care and sales support services.

      Our major medical operations are located in Strongsville (Cleveland), Ohio, (as well as our corporate offices) and Omaha, Nebraska, and our senior operations are located in Mission (Kansas City), Kansas.

      Our health and life insurance products protect individuals, families, association members, and small to mid-size employer groups during the years up to retirement, while our Medicare supplement, long-term care, other supplemental products, and life and annuity products provide ongoing coverage for senior Americans.

      Our strategy is to:

      Our Senior segment continued to produce profits for 2004, totaling $18.5 million in pre-tax profits for the year ended 2004 compared to $19.9 million in 2003. Our Medical segment’s pre-tax earnings were $5.2 million in 2004 (including a $3.1 million charge for litigation settlements) compared to $8.8 million in 2003.

      We believe our focus on consistent and selective growth will lead to more predictable earnings, enhanced profitability, and higher financial agency ratings of our insurance subsidiaries. We believe that our strategies in the Senior and Medical segments have proven effective in balancing our results. Our Senior segment continues to be poised for growth in 2005 and beyond. At the same time, we continue to target market in our Medical segment to maintain stable earnings results.

Our Core Businesses

      Senior health, life and annuity products. We continue to concentrate our efforts on the Senior segment because we believe this market has the potential for greater revenue growth and higher profit margins than our Medical segment. Our strategy is to expand this segment by emphasizing competitive markets, working with select distributors, exploring new marketing relationships, and increasing our agent base. The products in this segment are designed specifically for Americans age 55 and over, one of the country’s fastest growing age segments that is projected to increase to 103 million people by 2025. In addition, the senior population controls more than 75% of the nation’s financial wealth. Our senior products supplement other programs, such as Medicare, and also include specialty supplemental coverages and life insurance. According to the Centers for Medicare and Medicaid Services (CMS), the number of Medicare enrollees, age 65 and over, nearly doubled between 1966 and 2002, growing to 34.7 million from 19.1 million. By 2007, the Medicare population is expected to exceed 44 million. Approximately 61% of individuals age 65 and over have private insurance as well as Medicare. To address this demand, we will continue to concentrate on our primary product, Medicare supplement, and increase our market reach through new plan offerings.

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

      We market and administer preferred provider organization (PPO) plans and administer our existing traditional indemnity medical plans. We believe that increased costs and consumer dissatisfaction with limitations on choice of doctors and treatment have caused health maintenance organization (HMO) enrollments to decrease. We believe that PPO coverage provides greater freedom of choice of doctors and opportunity to seek care from doctors and facilities within networks to deliver healthcare at favorable rates compared to HMOs and traditional indemnity plans. PPO members generally are charged periodic prepaid premiums, co-payments, and deductibles. Traditional indemnity insurance typically allows policyholders substantial freedom of choice in selecting healthcare providers without the financial incentives or cost-control measures typical of managed care plans. We also now market health savings accounts (HSA)-qualified products to individuals, families and small businesses. We believe these plans provide insureds with greater flexibility to control their healthcare dollars.

Business Strategy

      Principal elements of our business strategy include:

      Increasing senior market focus. Because of favorable demographics and higher profit potential in the Senior segment, we intend to continue to focus our sales efforts on this part of our business. We believe the senior market will continue to produce more predictable earnings, particularly since these products are not as sensitive to medical inflation as major medical products. We will be concentrating more on our agent recruiting and a significant amount of our product development efforts on the senior market. We also intend to transition our major medical insureds into our senior products as they age. For the year ended December 31, 2004 our Senior segment comprised 43% of our total net premium revenues compared to 36% for 2003. One of our continuing objectives is to balance our segments’ revenue equally over the next several years. Our Senior segment products are administered at our Kansas facility, which we believe has superior and efficient technology and administration.

      Focusing on profitability in the major medical market. While historically the Medical segment has been the largest percentage of our revenue, we, like all health insurance companies, continue to face challenges in this marketplace due to higher expenses resulting from escalating healthcare and prescription drug costs. However, we believe that the programs that we have in place have lessened the inflationary impact. These programs include:

      Our selective marketing approach has enabled us to serve the demand for health insurance products while remaining profitable. In addition, we continue to improve our underwriting practices.

      The major medical market requires careful monitoring. We regularly watch our claims inventories and analyze our loss ratios to ensure profitability. As we move forward, we will continue to focus our efforts on specific states, strengthening relationships with our best distributors, monitoring our new business activity, and emphasizing our most profitable products. We believe that this approach will allow us to remain competitive in this market.

      In 2005, we expect increased production levels and the decline in major medical premium to moderate to approximately 5% on an annualized basis.

      Promoting electronic distribution. We promote the use of electronic distribution in both of our business segments to increase efficiency and agent productivity. This electronic platform brings significant benefits to both agents and consumers.

      Through electronic submission, our agents have their business processed faster, and have access to pending policy and claims status information. Agents also receive valuable electronic marketing tools which enhance their ability to increase sales. Advance commissions are available to qualifying agents for select senior health and life insurance products and on select major medical products for certain distributors.

      Consumers enjoy the advantages of faster policy issue including an electronic issue option, and personal local service through an agent partner at no additional cost. Our highly-trained call center staff is available for agent support, as well as to answer consumer questions.

      Reducing administrative costs. We are committed to reducing administrative costs through increases in efficiency, streamlined procedures, and consolidation of operations and services. Our areas of focus include

reductions in facility management costs, printing and supply costs, travel expenses, consolidation of corporate services, such as accounting, marketing, and distribution, and the utilization of new electronic technology. We expect to improve our efficiency and service as we move closer to a paperless environment. Our agency Internet software system program provides direct online communication for our agents to check the status of business they submit via their computers 24 hours a day.

      We review expense variances to budgets on a monthly basis and make needed adjustments. We expect to continue streamlining operations and reducing our general and administrative expenses through efficiency improvements and elimination of functions that do not support our core businesses.

Products and Services

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

      Major medical. Our major medical products include catastrophic, comprehensive, and basic coverage options from PPO benefit plans to traditional indemnity health insurance plans. Currently, we market only PPO plans. Some of our major medical plans can also be configured as HSA-qualified plans.

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

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

      We also have a program that reduces claims costs for prescription drugs on our medical products that include prescription drug coverage. We developed a system with varying levels of co-payment amounts to encourage insureds to use generic drugs and a money-saving mail-order program for maintenance prescription drugs. Our care coordination program has been added to most of our major medical products to provide service enhancements for our insureds.

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

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

      Small group products. Our Professional Multi-Option (PMO) product is a comprehensive major medical plan offered to our small business customers. We also offer our Partnership Plan, a major medical product in which we share the medical cost risk with the employer to small to mid-size businesses with 2-100 employees. This alternate funding mechanism allows the employer to limit expense and risk by self-insuring part of the coverage. This product can produce a year-end refund or carryover feature for low claims experience that is attractive to businesses with healthy employees. The savings generated with this plan can be used to provide other employee benefits. In 2004, we began marketing an HSA-qualified product to small employer groups. Sales of these products currently comprise 50% of new sales to small employer groups.

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

      Senior health insurance products. Our senior market products include a wide range of comprehensive and supplemental major medical benefit products, including Medicare supplement (our cornerstone product), long-term care, and other supplemental products.

      Senior life insurance and annuities. Our life insurance and annuity products include lower face amount life insurance policies offering coverages up to $25,000 and annuity plans with first-year bonus interest or interest rate guarantees.

      Medical cost management. We focus on reducing medical costs for our insureds by actively managing medical inflation and utilization rate costs. National health expenditures have grown from $1,067 per capita in 1980 to $5,670 per capita in 2003 and are projected to increase to $9,216 per capita in 2010, according to statistics compiled by CMS. Several factors have contributed to the dramatic increase in healthcare expenditures, including increased costs and utilization of high-technology diagnostic testing and treatments, the rising cost of malpractice insurance, higher operating costs for hospitals and physicians, changes in federal and state healthcare regulations, increased utilization and cost of pharmaceuticals, and the aging of the population.

      We have numerous programs designed to lower medical costs for our insureds. Some of these programs include:

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

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

Marketing and Sales

      Our distribution is critical for our continued growth. We market our products through independent agents with licenses in 48 states, the District of Columbia, and the U.S. Virgin Islands. We have initiated a systematic program to focus our marketing expenses on more productive agents. We compensate our agents for business produced by them on a commission basis at rates that we believe to be competitive with those of other life and health insurance companies.

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

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

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

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

Customer Base

      We had approximately 244,000 group certificates and individual policies in force as of December 31, 2004, representing approximately 327,000 insureds. Each group certificate represents an insured and any

spouse, children and other dependents. The following table reflects the breakdown by product of the group certificates and individual policies for the years ended December 31, 2004 and 2003.

      Because of the Health Insurance Portability and Accountability Act of 1996 (HIPAA) and state regulatory restrictions, we place greater emphasis on the sale of individual and association major medical products. For 2004, our major medical certificates included 65% for individual and association products and 35% for small group products, which were consistent with levels experienced in 2003.

      The geographic distribution of direct and assumed premiums, before reinsurance ceded, on a statutory basis of all of our subsidiaries in 2004 and 2003 is presented in the table below. The presentation on a statutory basis differs from U.S. generally accepted accounting principles (GAAP) in that our fee income and annuity considerations are considered premiums for statutory purposes. Effective March 31, 2003, Continental General entered into a reinsurance agreement with Pyramid Life under which Continental General reinsured on a 100% coinsurance basis and, to the extent policyholders consent or are deemed to consent thereto, on an assumption reinsurance basis, certain interest sensitive whole-life policies. The policy liabilities assumed by Continental General of $12.2 million were reported as assumed premiums for statutory purposes. The 2003 statutory premiums presented in the table below exclude the $12.2 million in policy liabilities assumed from Pyramid Life.

Pricing and Underwriting

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

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

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

adopted simplified policy issue procedures in which the applicant submits an application for coverage typically containing only a few health-related questions instead of a complete medical history.

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

Claims

      All claims for policy benefits are currently either processed by our claims department or outsourced to third party administrators. We currently outsource to third party vendors:

On August 1, 2004, we assumed the administration and claims processing of the claims for our Ohio insureds of Central Reserve. We had previously outsourced this claims processing to a third party vendor.

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

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

Systems

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

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

      Prior to 2004, a significant portion of our support systems was obtained from third party vendors, including an administrative services agreement with a third party vendor that terminated on March 31, 2004, whereby we outsourced all information and telephone systems at our Cleveland headquarters. We currently outsource the data center for our Cleveland facility to a third party vendor as well as administration of some blocks of business. We receive regular reports from our third party vendors that enable us to closely monitor our business on their systems.

Investments

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

      At December 31, 2004, approximately $474.6 million or 95.9% of our invested assets were fixed maturity securities of which we designated $456.1 million as available-for-sale securities and $18.5 million as trading securities. At December 31, 2004, 97.0% of our fixed maturity securities available-for-sale were of investment grade quality with 82.8% in securities rated A or better (typically National Association of Insurance Commissioners (NAIC) I) and 14.2% in securities rated BBB (typically NAIC II). We do not invest in derivatives, such as futures, forwards, swaps, option contracts or other financial instruments with similar characteristics.

      At December 31, 2004, the fair value of our investments in mortgage-backed securities totaled $160.4 million, or 32.4% of total invested assets. We minimize the credit risk of our mortgage-backed securities by holding primarily issues of U.S. Government agencies or high-quality non-agency issuers rated AA or better. Among the agency mortgage-backed securities, which comprises 21.1% of the portfolio, the securities are comprised of pass-through securities and planned amortization class collateralized mortgage obligations. The pass-through securities primarily are invested in current market coupons that should exhibit only moderate prepayments in a declining interest rate environment, while the planned amortization class collateralized mortgage obligations provide strong average life protection over a wide range of interest rates. The non-agency mortgage-backed securities, which represent 13.2% of the portfolio, consist of commercial and jumbo residential mortgage securities. The commercial mortgage-backed securities provide very strong prepayment protection through lockout and yield maintenance provisions, while the residential mortgage-backed securities are concentrated in non-accelerating securities that have several years of principal lockout provisions.

      The amortized cost and estimated fair value of available-for-sale securities as of December 31, 2004, were as follows:

      For more information, see Note B. Cash and Investments to our audited consolidated financial statements.

Reserves

      We establish and report liabilities or reserves on our balance sheet for unpaid healthcare costs by estimating the ultimate cost of incurred claims that have not yet been reported to us by our policyholders or their providers and reported claims that we have not yet paid. Since these reserves represent our estimates, the

process requires a degree of judgment. Reserves are established according to Actuarial Standards of Practice and generally accepted actuarial principles and are based on a number of factors, including experience derived from historical claims payments and actuarial assumptions to arrive at loss development factors.

      Such assumptions and other factors include:

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

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

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

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

      We may from time to time need to increase or decrease our claims reserves significantly in excess of our initial estimates and any adjustments would be reflected in our earnings. An inadequate estimate in reserves could have a material adverse impact on our business, financial condition and results of operations. For more information, please see “Critical Accounting Policies” section under Item 7. — Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Reinsurance

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

      Under quota share reinsurance, the reinsurer assumes or cedes an agreed percentage of certain risks insured by the ceding insurer and shares premium revenue and losses proportionately. When we cede business

to others, reinsurance does not discharge us from our primary liability to our insureds. However, the reinsurance company that provides the reinsurance coverage agrees to become the ultimate source of payment for the portion of the liability it is reinsuring and indemnifies us for that portion. However, we remain liable to our insureds with respect to ceded reinsurance if any reinsurer fails to meet its obligations to us.

      Existing Arrangements. In the ordinary course of business, we maintain reinsurance arrangements designed to limit the maximum amount of exposure that we retain on a given policy.

      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. In 2004, Hannover accounted for 93.4% of the total premiums ceded by our subsidiaries. Hannover has entered into reinsurance agreements with several of our subsidiaries, including Central Reserve, Provident American Life, United Benefit Life and Continental General. Our reinsurance agreements with Hannover are not cancelable or terminable by Hannover. In recent years, we have reduced our reliance on reinsurance. Our arrangements are generally for closed blocks of business, which means that Hannover is not reinsuring any new sales or business of any of our subsidiaries under these reinsurance agreements.

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

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

      The total premiums ceded by our subsidiaries in 2004 to unaffiliated reinsurers amounted to $79.2 million, of which Hannover represented approximately 93.4%. Our gross reinsurance receivables from unaffiliated reinsurers amounted to $130.3 million as of December 31, 2004, of which approximately 99.3% was attributable to Hannover, and of which approximately $128.8 million represented reserves held by our reinsurers under our various reinsurance treaties in place. Cash settlements are made quarterly with Hannover and timely paid.

      Hannover is a subsidiary of Hannover Rueckversicherungs, a German corporation, which had assets of $41.5 billion and total stockholders’ equity of $3.0 billion at December 31, 2003. Moody’s has assigned Hannover Rueckversicherungs a financial strength rating of Baa1 (adequate). Hannover and Hannover Rueckversicherungs each have an A (excellent) rating from A.M. Best Company, Inc. In addition, Hannover Rueckversicherungs has a financial strength rating of AA- (very strong) from Standard & Poor’s. Hannover’s failure to pay our claims in full or on a timely basis could have a material adverse effect on our business, financial condition and results of operations.

      For ordinary and group life claims, Continental General’s maximum retention is $125,000 and Central Reserve’s maximum retention is $50,000 with no retention maintained over age 70. For accident and health claims, maximum retention on individual claims is $500,000. For a complete discussion of our material reinsurance agreements, including recent reinsurance agreements, see Note K. Reinsurance Arrangements to our audited consolidated financial statements.

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

Competition

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

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

Ratings

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

      In April 2004, Fitch upgraded Central Reserve’s rating to BBB (good credit quality) and affirmed Continental General’s BBB (good credit quality) financial strength rating.

Government Regulation

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

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

of December 31, 1999. For Continental General, the most recent examination was performed by the State of Nebraska as of December 31, 2001. State insurance departments also periodically conduct market conduct examinations of our insurance subsidiaries.

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

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

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

      We calculated the risk-based capital for our insurance subsidiaries as of December 31, 2004, using the applicable RBC formula. Based on these calculations, the risk-based capital levels for each of our subsidiaries exceeded the levels required by regulatory authorities.

      Dividends paid by our insurance subsidiaries to Ceres are limited by state insurance regulations. The insurance regulator in the insurer’s state of domicile may disapprove any dividend which, together with other

dividends paid by an insurance company in the prior 12 months, exceeds the regulatory maximum as computed for the insurance company based on its statutory surplus and net income. In 2005, Continental General could pay a dividend to Ceres Group, the parent company, of up to $10.3 million without prior approval of the state regulator. In 2005, Central Reserve would be prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus. However, on February 24, 2005, Central Reserve received approval from the Ohio Department of Insurance to pay an extraordinary dividend of $12.0 million to Ceres.

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

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

      Healthcare Regulation and Reform. Government regulation and reform of the healthcare industry also affects the manner in which we conduct our business. The Gramm-Leach-Bliley Act mandated restrictions on the disclosure and safeguarding of our insureds’ financial information. The USA Patriot Act placed new federal compliance requirements relating to anti-money laundering, customer identification and information sharing. The Department of Labor regulations affected the timeframes for making a decision on claims submitted by those insured by an employer sponsored plan.

      HIPAA has mandated the adoption of extensive standards for the use and disclosure of health information. HIPAA also mandated the adoption of standards for the exchange of electronic health information in an effort to encourage overall administrative simplification and enhance the effectiveness and the efficiency of the healthcare industry. We have developed, and continue to enhance, electronic data interface (EDI) systems and relationships, relating to our claim adjudication operations. These electronic processes increase the efficiencies in the service provided to our customers.

      HIPAA’s Security standards become effective April 20, 2005 and further mandate that specific requirements be met relating to maintaining the confidentiality and integrity of electronic health information and protecting it from anticipated hazards or uses and disclosures that are not permitted.

      There continues to be diverse legislative and regulatory initiatives at both the federal and state levels to affect aspects of the nation’s health care system. On December 8, 2003, President Bush signed into law the Medicare Prescription Drug Improvement and Modernization Act of 2003, or DIMA. DIMA makes many significant changes to the Medicare fee-for-service and Medicare+Choice programs, as well as other changes to the commercial health insurance marketplace. Most significantly, DIMA creates a prescription drug benefit for Medicare beneficiaries, establishes a new Medicare Advantage program to replace the Medicare+Choice program, and enacts health savings accounts (HSAs) for non-Medicare eligible individuals and groups. The effects of DIMA on our business, including any impact on our future prospects, are still unknown. We will continue to assess the impact, if any, of DIMA and any other new or proposed Medicare legislation.

      In addition to federal regulation and reform, many states have enacted, or are considering, various healthcare reform statutes. These reforms relate to, among other things, managed care practices, prompt pay payment practices, and mandated benefits. Most states have also enacted patient confidentiality laws that prohibit the disclosure of confidential information. As with all areas of legislation, the federal regulations establish minimum standards and preempt conflicting state laws that are less restrictive but will allow state

laws that are more restrictive. These laws or regulations may limit our operations and hinder our ability to effectively manage utilization and costs. We are unable to predict what state reforms will be enacted or how they would affect our business.

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

      One of the significant techniques we use to manage healthcare costs and facilitate care delivery is contracting with networks to give our insureds access to physicians, hospitals and other providers, who accept negotiated reimbursement and do not balance bill our insured. A number of organizations are advocating for legislation that would exempt some providers from federal and state antitrust laws. In any particular market, providers could refuse to contract, demand higher payments or take actions that could result in higher healthcare costs, less desirable products for insureds or difficulty meeting regulatory or accreditation requirements. In some markets, some providers, particularly hospitals, physician/hospital organizations or multi-specialty physician groups, may have significant market positions or near monopolies. In addition, physician or practice management companies, that aggregate physician practices for administrative efficiency and marketing leverage, continue to expand. These providers may compete directly with us. If these providers refuse to contract with the network we use, use their market position to negotiate less favorable contracts or place us at a competitive disadvantage, those activities could adversely affect our ability to market products or to be profitable in those areas.

      For several years, Congress and various states have been considering some form of the “Patients’ Bill of Rights.” This legislation, if enacted, is designed to provide, among other things, consumers more freedom of choice in the selection of doctors, facilities, and treatments. Although the bill was originally conceived to regulate HMOs, it affects all facets of the nation’s healthcare organizations and indemnity insurance plans. These changes are expected to result in higher total medical costs, which could encourage more partnerships and associations between medical providers and insurers to control costs, more community-based health organizations, and greater use of higher deductibles to lower insurance costs and reduce administrative expenses of smaller claims.

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

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

Employees

      We had approximately 637 employees at December 31, 2004. We consider our employee relations to be good. Our agents are independent contractors and not employees.

Available Information

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

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

      We have adopted a code of corporate conduct for our directors, officers and employees, known as the Code of Conduct and Ethics. The Code is available on our website at http://www.ceresgp.com or you may request a free copy of the Code of Conduct and Ethics from:

                    Ceres Group, Inc.

                    Attention: Investor Relations

                    17800 Royalton Road

                    Cleveland, Ohio 44136

                    (440) 572-2400

     Owned Properties (office space)

     Leased Properties (office space)

       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 contemplated payments to class members and others, as well as certain attorneys’ fees and costs. In 2004, we recorded (in selling, general and administrative expenses) a pre-tax charge of $3.1 million ($2.0 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.

      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.

       None.

PART II

       (a) Market Information. Our common stock trades on the NASDAQ National Market under the symbol CERG. The following table shows the high and low closing prices of our common stock for the quarters listed. These prices were taken from the NASDAQ Monthly Statistical Reports. On March 1, 2005, our common stock closed at $5.50 per share.

      (b) Holders. As of March 1, 2005, we had an estimated 1,978 record holders.

      (c) Dividends. We have not paid any cash dividends on our common stock since the end of 1996, and we do not anticipate paying any dividends in the foreseeable future. Our credit agreement, dated December 23, 2003, contains financial and other covenants that, among other matters, limit the payment of cash dividends on our common stock. For more information on our credit agreement, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”

      Dividends paid by our insurance subsidiaries to us are limited by state insurance regulations. The insurance regulator in the insurer’s state of domicile may disapprove any dividend which, together with other dividends paid by an insurance company in the prior 12 months, exceeds the regulatory maximum as computed for the insurance company based on its statutory surplus and net income. In 2005, Continental General could pay a dividend to Ceres Group, the parent company, of up to $10.3 million without prior approval of the state regulator. In 2005, Central Reserve would be prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus. However, on February 24, 2005, Central Reserve received approval from the Ohio Department of Insurance to pay an extraordinary dividend of $12.0 million to Ceres Group.

      (d) Sales of Unregistered Securities. On December 23, 2003, we issued a warrant to purchase 25,000 shares of our common stock at an exercise price of $5.27 per share to a current marketing agency of the Company which exchanged its QQLink stock for cash and the warrant. The warrant is exercisable at any time until December 23, 2008. Neither the warrant nor the shares of our common stock issuable upon exercise of the warrant are registered. This issuance was exempt from registration in accordance with Section 4(2) of the Securities Act of 1933, as amended, and Rule 506 of Regulation D promulgated thereunder and exemptions available under applicable state securities laws.

       The selected audited consolidated financial data presented below as of and for each of the five years ended December 31, 2004, 2003, 2002, 2001 and 2000 have been derived from our audited consolidated financial statements. However, financial data for 2001 and 2000 was reclassified to reflect the sale of Pyramid Life. For further information, see Note D. Discontinued Operations to our audited consolidated financial statements. The financial information for the years ended December 31, 2004, 2003, 2002, 2001 and 2000 includes the operations of all our subsidiaries for the entire year except for Pyramid Life. Pyramid Life, which is presented separately as discontinued operations, was acquired on July 26, 2000 and sold on March 31, 2003. The data for 2004, 2003 and 2002 should be read in conjunction with the more detailed information contained in the audited consolidated financial statements and accompanying notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this filing.

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

Overview

      Ceres Group, through its insurance subsidiaries, provides a wide array of health and life insurance products through two primary business 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. Provident American Life discontinued new sales activities and currently has less than 400 active major medical certificate holders and 400 life policyholders. In 2005, Provident American Life will begin marketing and selling senior products in certain states. 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.

      Effective March 31, 2003, Ceres sold its subsidiary, Pyramid Life Insurance Company to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. For more information on the Pyramid Life sale, see Note D. Discontinued Operations to our audited consolidated financial statements.

Critical Accounting Policies

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

      Liabilities for Other Policy Claims and Benefits Payable. The most significant accounting estimate in our audited consolidated financial statements is our liability for other policy claims and benefits payable.

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

      Liabilities for unpaid claims are based on an estimation process that is complex and uses information obtained from both company specific and industry data, as well as general economic information. These estimates are developed using actuarial methods based upon historical data for payment patterns, medical inflation, product mix, seasonality, utilization of health care services, and other relevant factors. The amount recorded for unpaid claims liabilities is sensitive to judgments and assumptions made in the estimation process. The most significant assumptions used in the estimation process include determining utilization and

inflation trends, the expected consistency in the frequency and severity of claims incurred but not yet reported, changes in the timing of claims submission patterns from providers, changes in our speed of processing claims, and expected costs to settle unpaid claims.

      Actual conditions could differ from those assumed in the estimation process. Due to the uncertainties associated with the factors used in these assumptions, materially different amounts could be reported in our Statement of Operations for a particular period under different conditions or using different assumptions. As is common in the health insurance industry, we believe that actual results may vary within a reasonable range of possible outcomes. Management believes that our reasonable range of actual outcomes may vary up to 10% to 15% (excluding provisions for adverse deviation) of the total liabilities for other policy claims and benefits payable recorded at the end of a period.

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

      Management considered the volatile claims experience in recent periods when it established its liabilities for unpaid claims at December 31, 2004. Management believes that the recorded liabilities for unpaid claims at December 31, 2004 is within a reasonable range of outcomes. Management closely monitors and evaluates developments and emerging trends in claims costs to determine the reasonableness of judgments made. A retrospective test is performed on prior period claims liabilities and, as adjustments to the liabilities become necessary, the adjustments are reflected in current operations. Management believes that the amount of medical and other benefits payable is adequate to cover our liabilities for unpaid claims as of December 31, 2004.

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

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

      During 2002, we wrote-off $4.2 million of deferred acquisition costs associated with certain of our major medical business due to the continuing unprofitability of terminated blocks of business.

      Management believes the amount of deferred acquisition costs as of December 31, 2004 is recoverable.

Other Accounting Policies and Insurance Business Factors

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

      Goodwill and Other Intangible Assets. Goodwill represents the excess of purchase price over the fair value of tangible and identifiable intangible net assets acquired. At December 31, 2004, goodwill was $10.7 million and represented approximately 1.4% of our total assets. Additionally, other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination

with a related contract asset or liability. At December 31, 2004, our other intangible assets consisted of $3.4 million in licenses, or 0.4% of our total assets.

      Effective January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets issued by the Financial Accounting Standards Board (FASB), which provides that goodwill and intangibles with indefinite useful lives should not be amortized but instead be tested for impairment annually at the reporting unit level. In accordance with SFAS No. 142, we completed a transitional goodwill impairment test, which indicated that an impairment loss against our goodwill and other intangible assets was not required. Goodwill and intangibles with indefinite useful lives are tested for impairment on an annual basis and more often if indications of impairment exist. The estimated fair value of goodwill of a reporting unit is determined by applying the appropriate discount rates to estimated future cash flows for the reporting unit. The estimated fair value of licenses was determined by independent appraisals. The results of our analysis indicated that no reduction of goodwill or licenses was required in 2004. A slight reduction of $0.1 million was made to the carrying value of licenses in 2003 due to the cancellation of business in certain unprofitable states.

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

      Revenue recognition. Life insurance premiums are recognized as revenue when they become due. Health premiums are recognized as revenue over the terms of the policies. Revenues from interest sensitive contracts, principally universal life and annuity products, consist of mortality charges for the cost of insurance, contract administration charges, and surrender charges assessed against policyholder account balances during the period. Amounts received from interest sensitive contracts are not reflected in premium revenue; rather, such amounts are accounted for as deposits with the related liabilities included in future policy benefits, losses and claims.

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

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

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

      Lapsation and persistency. Other factors that affect our results of operations are lapsation and persistency, both of which relate to the renewal of insurance policies and certificates in force. Lapsation is the termination of a policy for nonrenewal and, pursuant to our practice, is automatic if and when premiums become more than 31 days overdue. However, policies may be reinstated, if approved, within 90 days after the

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

      Policies renew or lapse for a variety of reasons, due both to internal and external causes. We believe that our efforts to address any concerns or questions of our insureds in an expedient fashion help to ensure ongoing policy renewal. We work closely with our licensed agents, who play an integral role in obtaining policy renewals and communicating with our insureds. However, in 2004, we experienced higher than expected lapse rates on our major medical business as we believe that necessary rate increases implemented in excess of claims trends on certain blocks caused higher lapsation rates.

      External factors also contribute to policy renewal or lapsation. Economic cycles can influence an insured’s ability to continue to pay insurance premiums when due.

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

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

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

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

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

      Insurance. We use a combination of insurance and self-insurance for a number of our risks including property, general liability, directors’ and officers’ liability, workers’ compensation, vehicle liability, and

employee-related healthcare benefits. Liabilities associated with the risks that are retained are estimated by considering various historical trends and forward-looking assumptions. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends. Over the past couple of years, increases in the cost and availability of commercial insurance as a result of significant changes in the insurance market have impacted our insurance coverages. We have renewed most of our insurance policies for 2005. Other policies are up for renewal in mid-2005. We may not be successful in obtaining coverage on terms favorable to us or at all.

Results of Operations

      We have three reportable segments:

      The financial information for the years ended December 31, 2004, 2003 and 2002, includes the operations of all our subsidiaries for the entire period with the exception of Pyramid Life.

      Discontinued 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. Consistent with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, Pyramid Life was classified as held for sale as of December 31, 2002, and was measured at its fair value less costs to sell. Therefore, the financial information for the years ended December 31, 2003 and 2002 excludes the operations of Pyramid Life and the $13.8 million loss from the sale, net of taxes and expenses incurred (except where specifically noted). The net assets, results of operations, and cash flows of Pyramid Life have been reported separately as discontinued operations of a subsidiary in our audited consolidated financial statements for 2003 and 2002. See Note D. Discontinued Operations to our audited consolidated financial statements for further information.

      Overview and Outlook for 2005. Net income for 2004 was $19.1 million or $0.55 per diluted share, compared to net income for 2003 of $22.9 million or $0.67 per diluted share, which included $3.6 million or $0.11 per share from Pyramid Life.

      Pre-tax income from our Senior and Other segment was $18.5 million for 2004 compared to $19.9 million in 2003. Premiums in the Senior and Other segment increased 6.0% in 2004 due primarily to the introduction of new standardized Medicare supplement plans at our Central Reserve subsidiary. We expect premiums in this segment to increase approximately 13% in 2005. In addition, we will begin to sell Medicare supplement plans through our Provident American Life subsidiary. The 2004 segment results were impacted by a higher than expected loss ratio for our Medicare supplement business, partially offset by improved long-term care experience and favorable reserve development. The increase in the Medicare supplement loss ratio was caused by an increase in claims frequency on Medicare Part B physician claims. In addition, claims trend in 2004 exceeded our 2004 rate increases by 100%. We expect the 2005 Senior and Other loss ratio to be consistent with the 2004 loss ratio, or approximately 75%.

      Pre-tax income for our Medical segment was $5.2 million, including a $3.1 million charge for the California litigation settlements, for 2004, compared to $8.8 million for 2003. Premiums in the Medical segment decreased approximately 19.1% in 2004 due to the decline in major medical certificates in force as well as higher than expected lapse rates. By the end of 2004, the decline in premiums had moderated to approximately 7% on an annualized basis. In 2005, we expect premiums to decrease approximately 5% on an annualized basis as new business production begins to approach the level of renewal business that is lapsing. The loss ratio in the Medical segment was 71.3% in 2004, compared to 74.1% for 2003. This improvement was primarily due to favorable run-off of prior year claim reserves. In 2005, we expect the loss ratio to remain consistent with 2004.

Net Premiums (net of reinsurance ceded)

      For the year ended December 31, 2004, total net premiums decreased 10.1% to $430.2 million, compared to $478.3 million for 2003.

      Medical premiums for 2004 were $247.0 million, compared to $305.4 million for 2003, a decrease of 19.1%. The decrease in medical premiums was primarily the result of a 20.7% decrease in major medical certificates in force from 84,167 at December 31, 2003 to 66,724 at December 31, 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 experienced higher than anticipated lapse rates on new business.

      However, new business production increased in 2004, compared to the same period in 2003, partially offsetting the higher than anticipated lapse rates. We plan to continue to focus sales in a select number of geographic locations which have historically produced favorable underwriting results. From the third quarter to the fourth quarter of 2004, the decline in major medical premium has moderated to approximately 1.8% (or approximately 7% 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 in 2005.

      Senior and other premiums increased $10.3 million, or 6.0%, to $183.2 million for the year ended December 31, 2004, compared to $172.9 million for 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 2004 compared to 2003 due primarily to the introduction of new standardized Medicare supplement plans at Central Reserve and a new standardized plan at Continental General.

Other Revenues

      Net investment income was $26.2 million for 2004, compared to $25.1 million for 2003, an increase of 4.5%. 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. In addition, net investment income included $0.8 million of unrealized gains on our fixed maturity and equity securities trading portfolios in 2004. The book yield of our available-for-sale investment portfolio at December 31, 2004 was 5.34% compared to a book yield of 5.39% at December 31, 2003.

      Net realized gains decreased to $0.4 million for 2004, compared to $1.9 million for 2003. The decrease was primarily attributable to gains generated on the sale of mortgage-backed securities and corporate bonds in 2003.

      Fee and other income decreased to $19.5 million for 2004, compared to $28.9 million for 2003, a decrease of 32.6%. This decrease was attributable to the decline in major medical policies and the associated policy fee income as well as $5.7 million of fees in 2003 related to the transition processing of senior business for Pyramid Life. This transition agreement terminated on December 31, 2003.

Benefits, Claims, Losses and Settlement Expenses

      Total benefits, claims, losses and settlement expenses decreased to $314.6 million for 2004, compared to $353.7 million for 2003, a decrease of 11.1%.

      Medical benefits, claims, losses and settlement expenses were $176.1 million for 2004, compared to $226.2 million for 2003, a decrease of 22.1%. 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 71.3% for 2004, compared to 74.1% for 2003. The improvement in the loss ratio was due primarily to favorable run-off of prior year claim reserves.

      Senior and other benefits, claims, losses and settlement expenses were $138.5 million for 2004, compared to $127.5 million for 2003. The senior and other loss ratio was 75.6% for 2004, compared to 73.7% for 2003. The Medicare supplement loss ratio was higher than expected in 2004. The Medicare supplement loss ratio for 2004 was 71.9%, compared to 67.1% in 2003. 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 2004 claims trend was approximately 10%, resulting in the higher than expected loss ratio for the full year.

Other Expenses and Net Income

      Selling, general and administrative expenses decreased to $134.6 million in 2004, compared to $146.9 million in 2003, a decrease of 8.4%. Included in selling, general and administrative expenses for 2004, is a $3.1 million pre-tax charge ($2.0 million after-tax or $0.06 per share) relating to the settlement of two California lawsuits. 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 L. Contingencies and Commitments to our audited consolidated financial statements. Excluding this charge, other operating expenses decreased $14.3 million and commissions decreased $4.4 million as a direct result of the decline in medical premiums offset by reduced reinsurance allowances of $3.3 million resulting from a lower volume of ceded premium. As a percentage of premium, selling, general and administrative expenses, including the California litigation settlements, were 31.3% in 2004, compared to 30.7% in 2003. The increase in the selling, general and administrative expense ratio was primarily due to the $3.1 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 2004, compared to net amortization of $6.0 million for 2003. In the Senior segment, a net deferral of $3.3 million was recorded for 2004 compared to net amortization of $1.2 million for 2003. In 2004, the level of costs capitalized increased due to higher levels of Medicare supplement new business production. In the Medical segment, net amortization was $7.9 million for 2004 compared to $4.8 million in 2003. The $3.1 million increase in the net amortization was due to higher assumed lapsed rates on existing business which caused an increase in the level of DAC amortization in the first quarter of 2004. The rate of decline on the DAC asset in the Medical segment moderated in the balance of the year.

      Interest expense and financing costs decreased to $0.7 million in 2004, compared to $1.6 million in 2003, as a result of a decrease in outstanding debt and a decrease in the amortization of deferred debt costs in 2004 as compared to 2003. The early pay-off of our former credit agreement resulted in the immediate amortization of the capitalized loan fees relating to that debt, causing additional interest expense of $0.3 million in 2003.

      Income from continuing operations before federal income taxes, including the $3.1 million charge from the California litigation settlements, was $21.9 million for 2004, compared to $26.0 million for 2003.

      A federal income tax expense of $2.8 million was recorded for 2004, which included a $5.0 million reduction to the deferred tax valuation allowance. As a result of our continued profitability, a projection of continued taxable income in future periods, and the corresponding utilization of a portion of the net operating

loss (NOL) carryforwards against 2004 taxable income, the deferred tax valuation allowance was reduced by $5.0 million, or $0.14 per share, to $0 in 2004. At December 31, 2004, we have a deferred tax asset of approximately $4.8 million established related to the remaining NOLs. The effective tax rate, including the $5.0 million reduction to the deferred tax valuation allowance, was 12.6% of the income from continuing operations before federal income taxes. In 2003, a federal income tax expense of $6.6 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 2003, including the $2.7 million reduction to the deferred tax valuation allowance, was 25.6% of the income from continuing operations before federal income taxes. See Note I. Federal Income Taxes for a detailed reconciliation of our effective tax rate.

      Income from continuing operations was $19.1 million, or $0.55 per share, for 2004, compared to $19.4 million, or $0.56 per share for 2003. Income from the discontinued operations of Pyramid Life for 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 2004, net income was $19.1 million, or $0.55 per share, compared to $22.9 million, or $0.67 per share, for 2003, which included $3.6 million, or $0.11 per share, from Pyramid Life.

N/M = not meaningful

Net Premiums (net of reinsurance ceded)

      For the year ended December 31, 2003, total net premiums were $478.3 million, a decrease of 11.4%, from $540.1 million for 2002.

      Medical premiums for 2003 were $305.4 million compared to $370.0 million for 2002, a decrease of 17.5%. The change in medical premiums was primarily the result of the following:

      Our 2004 marketing strategy continued to focus on a reduced number of geographic locations which have historically produced favorable underwriting results. We had expected increased production levels in 2004 and the decline in major medical premium to moderate to 10-15%.

      Senior and other premiums were $172.9 million for 2003 compared to $170.1 million for 2002, an increase of 1.6%. The change in senior and other premiums was primarily the result of the following:

Other Revenues

      Net investment income was $25.1 million for 2003 compared to $24.3 million for 2002, an increase of 3.4%. The decline in the overall portfolio yield of 0.65% was offset by the 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 December 31, 2003 was 5.39%, which produces an annualized income stream of approximately $25.7 million.

      Net realized gains were $1.9 million for 2003 compared to $2.3 million for 2002. The prior year reflected a partial redistribution of our investment portfolio, that 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 $28.9 million for 2003 compared to $33.5 million for 2002, a decrease of 13.9%. This decrease was primarily attributable to the decline in major medical policies and the associated policy fee income and was partially offset by $5.7 million of third party administrator fees in the Senior and Other segment related to the transition processing of senior business for Pyramid Life. This transition agreement terminated on December 31, 2003. Due to the decline in our medical business and the termination of this transition agreement, we expected total policy fee income to decline approximately 35% in 2004.

Benefits, Claims, Losses and Settlement Expenses

      Total benefits, claims, losses and settlement expenses decreased to $353.7 million for 2003 compared to $421.0 million for 2002, a decrease of 16.0%.

     Medical

      Medical benefits, claims, losses and settlement expenses were $226.2 million for 2003 compared to $291.8 million for 2002, a decrease of 22.5%. The decrease was primarily the result of a smaller volume of business in force due to the cancellation of medical business in certain unprofitable states. In addition, the medical loss ratio decreased to 74.1% for 2003 compared to 78.9% for 2002. The medical loss ratio primarily decreased due to the following:

     Senior and Other

      Senior and other benefits, claims, losses and settlement expenses were $127.5 million for 2003 compared to $129.2 million for 2002, a decrease of 1.3%. The senior and other loss ratio decreased to 73.7% for 2003 compared to 76.0% for 2002. The lower loss ratio in the current year was primarily due to the improvement in Medicare supplement loss ratios from 69.8% in 2002 to 67.1% in 2003.

Other Expenses and Net Income

      Selling, general and administrative expenses decreased to $146.9 million in 2003 compared to $175.2 million in 2002, a decrease of 16.2%. Commissions decreased $25.2 million and other operating expenses decreased $8.7 million as a direct result of our cancelled business offset by reduced reinsurance allowances of $5.6 million resulting from a lower volume of ceded premiums. As a percentage of premium, selling, general and administrative expenses decreased to 30.7% in 2003 compared to 32.4% in 2002 due to the decrease in the overall commissions rate as a result of lower new sales, and a reduced workforce.

      The net (deferral) amortization and change in acquisition costs (DAC) and value of business acquired (VOBA) resulted in net amortization of $6.0 million for 2003 compared to a net deferral of $3.8 million for 2002. The decrease in the net deferral was primarily attributable to lower capitalization of DAC due to decreases in new business sales.

      Interest expense and financing costs decreased to $1.6 million in 2003 compared to $2.0 million in 2002 as a result of a decrease in outstanding debt.

      The special charge for 2002 represented a pre-tax non-recurring charge of $2.7 million ($2.4 million in continuing operations and $0.3 million in discontinued operations) related to the retirement of Peter W. Nauert, our former CEO. See Note N. Special Charge to our audited consolidated financial statements for further information.

      Income from continuing operations before federal income taxes was $26.0 million for 2003 compared to $3.5 million for 2002.

      Federal income tax expense was $6.6 million, or 25.6% of the income from continuing operations before federal taxes for 2003. In 2002, the federal income tax expense was $1.3 million, or 38.8% of the income from continuing operations before federal taxes. The lower effective tax rate in 2003 was primarily due to the reduction in the deferred tax valuation allowance of $2.7 million on our net operating loss carryforwards due to the utilization of the net operating loss carryforwards in the current period.

      Income from continuing operations was $19.4 million, or $0.56 per share, for 2003 compared to $2.1 million, or $0.06 per share, for 2002. Income from the discontinued operations of Pyramid Life was $3.6 million, or $0.11 per share, (which included $3.9 million of net realized investment gains, $1.9 million of operating income and an additional loss on the sale of $2.2 million) for 2003, compared to a loss of $4.5 million, or $0.13 per share for 2002, (which included $0.2 million of net realized investment gains, $6.9 million of operating income and a loss on the sale of $11.6 million). For 2003, net income was $22.9 million, or $0.67 per share, compared to a loss of $2.4 million, or $0.07 per share for 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, and operating expenses such as salaries, employee benefits, commissions, taxes, and interest on debts. Net cash used in operating activities in 2004 was $15.4 million compared to net cash provided by operating activities of $43.0 million in 2003. The decrease was primarily attributable to the following:

      Assets decreased 1.0% to $766.0 million at December 31, 2004 from $773.9 million at December 31, 2003. Assets of $495.0 million, or 64.6% of the total assets, were in investments at December 31, 2004. Fixed maturities, our primary investment, were $474.6 million, or 95.9% of total investments, at December 31, 2004. Other investments consist of equity securities, an investment in a limited partnership, policy loans, and mortgage loans. We have classified $456.1 million of our fixed maturities as available-for-sale and $18.5 million as trading and accordingly have reported them at their estimated fair values at December 31, 2004.

      Approximately 97.0% of our fixed maturities available-for-sale were of investment grade quality at December 31, 2004. In addition to the fixed maturities, we also had $22.6 million in cash and cash equivalents of which $7.0 million was restricted at December 31, 2004.

      The total reinsurance receivable was $130.3 million at December 31, 2004. Of this amount, $128.8 million represents reserves held by our reinsurers under our various reinsurance treaties in place. Hannover holds most of these reserves.

      The total policy liabilities and benefits accrued were 87.3% of the total liabilities at December 31, 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 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.

      Our current 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 December 31, 2004, the interest rate on our term loan A balance of $3.0 million was 5.65% per annum and our $7.8 million term loan B was 6.40% per annum.

      Our obligations under the credit agreement are guaranteed by four of our non-regulated subsidiaries 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 credit agreement contains various covenants including financial covenants relating to leverage, fixed charge coverage, risk-based capital of the 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 December 31, 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 December 31, 2004:

In December 2003, Continental General committed to invest $5.0 million in a limited partnership, NYLIM-GCR Fund I-2002, L.P., for an ownership share of approximately 4.13%. 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 2004, the partnership made capital calls on Continental General’s limited partnership commitment of $4.4 million. At December 31, 2004, we had outstanding unfunded commitments totaling $0.6 million related to this limited partnership.

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

      Dividends from our regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. In 2005, Continental General could pay a dividend to Ceres Group, the parent company, of up to $10.3 million without prior approval of the state regulator. In 2005, Central Reserve is prohibited from paying any dividends without prior approval of its state regulator due to its statutory level of unassigned surplus. However, on February 24, 2005, Central Reserve received approval from the Ohio Department of Insurance to pay an extraordinary dividend of $12.0 million to Ceres Group. 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 necessary, additional financing may not be available on terms favorable to us or at all.

Net Operating Loss Carryforward

      At December 31, 2004, we had a tax net operating loss, or NOL, carryforward of approximately $13.6 million for federal income tax purposes, which expires through 2021. Changes in ownership, as defined by Sections 382 and 383 of the Internal Revenue Code, could limit the amount of NOL carryforwards used in any one year. Our December 2001 public offering resulted in an “ownership change” as defined in Section 382 of the Code and the regulations issued thereunder. Pursuant to Section 382, our ability to use our NOLs originating prior to the offering, accounting for approximately $12.3 million, is subject to certain restrictions, including an annual limitation of approximately $5.9 million. Losses incurred subsequent to this offering are available without annual limitation to offset future income.

      We determine whether a valuation allowance for our deferred tax asset is necessary based on an analysis of amounts recoverable in the statutory carryback period and available tax planning strategies. During 2004, we evaluated our valuation allowance for deferred taxes and determined that no valuation allowance was required on the remaining NOL carryforwards of $13.6 million due to our continued profitability and the projection of a continued pattern of taxable income in future periods sufficient to utilize these NOLs. Accordingly, our net change in the deferred tax valuation allowance during 2004, including the current year utilization, was $5.0 million, or $0.14 per share. In 2003, the deferred tax valuation allowance was reduced by $2.7 million, or $0.08 per share, as a result of the utilization of NOL carryforwards of certain subsidiaries in the Medical segment.

Financial Information about Industry Segments from Continuing Operations

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

Market Risk and Management Policies

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

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

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

      In addition, insurance companies are subject to extensive federal and state regulation and compliance with these regulations could increase our 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, 2004, our 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 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:

      All of our fixed maturity investments are reported at fair market value at December 31, 2004. The amortized cost and estimated fair value of fixed maturities on our investment surveillance list at December 31, 2004 were $0.1 million and $0.2 million, respectively. For more information, see Note B. Cash and Investments to our audited consolidated financial statements.

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

      Interest Rate Risk is the risk that interest rates will change and cause a decrease in the value of an insurer’s investments. This change in rates may cause certain interest-sensitive products to become uncompetitive or may cause disintermediation if we attempt to mitigate this risk by charging fees for non-conformance with certain policy provisions and/or by attempting to match the maturity schedule of our assets with the expected payouts of its liabilities. To the extent that liabilities come due more quickly than assets mature, we would have to sell assets prior to maturity and recognize a gain or loss. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical decline in fair value of stockholders’ equity is estimated to be $12.7 million after-tax at December 31, 2004. This amount represents approximately 6.2% of our stockholders’ equity at such date.

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

      Seasonality is the risk of fluctuations of revenues and operating results. Historically, our revenues and operating results have varied from quarter to quarter and are expected to continue to fluctuate in the future. These fluctuations have been due to a number of factors, including higher benefit utilization by our insureds during the winter months and the use of deductibles. More specifically, our Senior segment’s seasonality is the opposite of our Medical segment’s, meaning that earnings in the Senior segment are generally lower in the first quarter and higher throughout the remainder of the year. This is mainly a factor of certain of our standardized Medicare supplement plans that pay the Medicare Part B deductible for our insureds generally during the early months of the year. The earnings in our Medical segment are generally lower in the fourth quarter as policyholders meet their annual required co-payments and deductibles. In 2004, we experienced a higher level of seasonality in the fourth quarter as policyholders shifted to products with higher average deductible levels.

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:

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

Recently Issued Accounting Pronouncements

      In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123R (Revised 2004), Share-Based Payment (SFAS 123R), which amends SFAS 123 and will be effective for public companies for interim or annual periods beginning after June 15, 2005. SFAS 123R eliminates the intrinsic value method under APB Opinion 25 as an alternative method of accounting for stock-based compensation. SFAS 123R also revises the fair value-based method of accounting for share-based payment liabilities, forfeitures and modifications of stock-based awards and clarifies SFAS 123’s guidance in several areas, including measuring fair value, classifying an award as equity or as a liability and attributing compensation cost to reporting periods. In addition, SFAS 123R amends SFAS No. 95, Statement of Cash Flows, to require that excess tax benefits be reported as a financing cash flow rather than as a reduction to taxes paid, which is included within operating cash flows. We currently use the intrinsic value method of APB Opinion 25 to value stock options, and accordingly, do not recognize compensation expense in our Consolidated Statements of Operations. On a quarterly and annual basis, we disclose the pro forma effect of stock-based compensation on net income (loss) and earnings (loss) per share. Upon adoption, pro forma disclosure will no longer be an alternative. The new statement may be adopted in one of three ways — the modified prospective transition method, a variation of the modified prospective transition method, or the modified retrospective method. We are currently evaluating the method of adoption and the effect that the adoption of SFAS 123R will have on our consolidated results of operations, cash flows and financial position.

      In March 2004, the FASB’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. 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 significant impact on our consolidated results of operations, cash flows or financial position.

       See “Market Risk and Management Policies” section under Item 7. — Management’s Discussion and Analysis of Financial Condition and Results of Operations.

CERES GROUP, INC. AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND

FINANCIAL STATEMENT SCHEDULES

Report of Independent Registered Public Accounting Firm

Stockholders and Board of Directors

Ceres Group, Inc.

      We have audited the accompanying consolidated balance sheets of Ceres Group, Inc. (the “Company”) as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the years then ended. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.

      We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

      In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2004 and 2003, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

      We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on criteria established in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 18, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

KPMG LLP

Columbus, Ohio

March 18, 2005

Report of Independent Registered Public Accounting Firm

Stockholders and Board of Directors

Ceres Group, Inc.

      We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting contained in Item 9A, “Controls and Procedures” of Ceres Group, Inc.’s (the “Company”) 2004 Annual Report on Form 10-K, that the Company maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

      We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

      A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

      Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

      In our opinion, management’s assessment that Ceres Group, Inc. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also, in our opinion, Ceres Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission.

      We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Ceres Group, Inc. as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the years then ended, and our report dated March 18, 2005 expressed an unqualified opinion on those consolidated financial statements.

KPMG LLP

Columbus, Ohio

March 18, 2005

Report of Independent Registered Public Accounting Firm

Stockholders and Board of Directors

Ceres Group, Inc.

      We have audited the accompanying consolidated statement of operations, stockholders’ equity, and cash flows for the year ended December 31, 2002. We have also audited the information related to 2002 presented in the financial statement schedules listed in the Index at Item 15(a). These financial statements and financial statement schedules are the responsibility of Ceres Group’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audit.

      We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

      In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of Ceres Group, Inc. and subsidiaries for the year ended December 31, 2002, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules when considered in relation to the basic 2002 consolidated financial statements taken as a whole, present fairly, in all material respects, the 2002 information set forth therein.

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

Ernst & Young LLP

Cleveland, Ohio

March 4, 2003, except for

     Notes A and D as to which

     the date is March 31, 2003

CERES GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2004 and 2003

(dollars in thousands)