UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

ý        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2005

OR

 

 

o        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

                                For the transition period from                                                                  to

 

 

Commission file number: 001-32377

 

KMG AMERICA CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

 

 

Registrant’s telephone number, including area code:  (952)  930-4800

 

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 ý No o

 

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

 

As of May 2, 2005, the number of shares of Common Stock outstanding was 22,071,641.

 

 

KMG AMERICA CORPORATION

 

FORM 10-Q

 

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005

TABLE OF CONTENTS

 

ITEM NO.
PART I. FINANCIAL INFORMATION
	ITEM 1.	FINANCIAL STATEMENTS
		CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 2004, AND MARCH 31, 2005 (UNAUDITED)
		CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE QUARTERS ENDED MARCH 31, 2004, AND 2005
		CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED) FOR THE QUARTERS ENDED MARCH 31, 2004, AND 2005
		NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
	ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
	ITEM 4.	CONTROLS AND PROCEDURES
PART II. OTHER INFORMATION
	ITEM 1.	LEGAL PROCEEDINGS
	ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
	ITEM 6.	EXHIBITS
SIGNATURES

 

i

 

PART I
FINANCIAL INFORMATION

 

ITEM 1.                                     FINANCIAL STATEMENTS.

 

KMG AMERICA CORPORATION AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

 

		December 31, 2004			March 31, 2005
					(Unaudited)
Assets
Investments:
Fixed maturity securities available for sale, at fair value (amortized cost of $409,613,186 and $488,127,072 as of December 31, 2004, and March 31, 2005, respectively)		$	409,613,186		$	481,406,851
Equity securities available for sale, at fair value (cost of $36,000 and $36,000 as of December 31, 2004, and March 31, 2005, respectively)		36,000			36,000
Mortgage loans		23,678,639			21,658,300
Policy loans		22,620,801			22,492,716
Other investments		5,192,525			5,075,327
Total investments		461,141,151			530,669,194
Cash and cash equivalents		117,400,156			41,928,551
Reinsurance balances recoverable		71,354,798			71,800,173
Accrued investment income		4,912,216			5,223,095
Real estate and equipment		9,701,754			9,619,084
Federal income tax recoverable		4,239,906			4,953,278
Deferred income tax asset		236,319			1,036,184
Amounts due from reinsurers		1,940,903			2,020,936
Deferred policy acquisition costs		—			3,015,307
Value of business acquired		74,481,295			73,740,420
Other assets		24,642,833			24,153,596
Total assets		$	770,051,331		$	768,159,818

See accompanying notes.

 

1

 

KMG AMERICA CORPORATION AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(Continued)

 

		December 31, 2004			March 31, 2005
					(Unaudited)
Liabilities and shareholders’ equity
Liabilities:
Policy and contract liabilities:
Life and annuity reserves		$	309,940,285		$	306,331,886
Accident and health reserves		200,801,846			206,566,178
Policy and contract claims		9,343,512			9,611,984
Other policyholder liabilities		10,829,794			11,267,621
Total policy and contract liabilities		530,915,437			533,777,669
Accounts payable and accrued expenses		18,794,922			18,176,468
Taxes, other than federal income taxes		528,262			515,851
Deferred income taxes		6,502,042			6,224,155
Liability for benefits for employees and agents		4,158,418			4,258,504
Funds held in suspense		4,724,004			3,930,156
Long term notes payable		15,022,603			15,210,103
Other liabilities		1,617,778			1,627,193
Total liabilities		582,263,466			583,720,099
Shareholders’ equity:
Common Stock, par value $0.01 per share, 75,000,000 shares authorized and 22,071,641 shares issued		220,716			220,716
Paid-in capital		187,742,702			187,742,702
Retained earnings		(175,553		)	844,445
Accumulated other comprehensive (loss)		—			(4,368,144		)
Total shareholders’ equity		187,787,865			184,439,719
Total liabilities and shareholders’ equity		$	770,051,331		$	768,159,818

 

See accompanying notes.

 

2

 

KMG AMERICA CORPORATION AND PREDECESSOR

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

 

		Predecessor			KMG America Corporation
		Quarter Ended March 31, 2004			Quarter Ended March 31, 2005
Revenue:
Insurance premiums		$	25,337,779		$	26,197,560
Net investment income		5,389,620			6,652,785
Commission and fee income		3,351,974			3,568,048
Realized investment gains		215,292			27,580
Other income		747,293			791,647
Total revenues		35,041,958			37,237,620
Benefits and expenses:
Policyholder benefits		22,540,589			20,429,834
Insurance commissions, net of deferrals		2,344,550			2,666,167
General insurance expenses, net of deferrals		6,095,307			9,459,535
Insurance taxes, licenses and fees		1,129,514			1,319,917
Depreciation		703,426			696,061
Amortization of deferred policy acquisition costs and value of business acquired		2,090,855			1,085,155
Total benefits and expenses		34,904,241			35,656,669
Income before income taxes		137,717			1,580,951
(Provision) for income taxes		(46,824		)	(560,953		)
Net income		$	90,893		$	1,019,998
Net income per share:
Basic		$	34.78		$	0.05
Diluted		$	31.39		$	0.05
Weighted-average shares outstanding:
Basic		2,612.83			22,071,641
Diluted		2,895.98			22,155,739

 

See accompanying notes.

 

3

 

KMG AMERICA CORPORATION AND PREDECESSOR

CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)

 

		Predecessor			KMG America Corporation
		Quarter Ended March 31, 2004			Quarter Ended March 31, 2005
Operating activities
Net income		$	90,893		$	1,019,998
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		637,193			977,083
Policy acquisition costs deferred		(3,847,600		)	(3,359,587		)
Amortization of deferred policy acquisition costs and value of business acquired		2,090,855			1,085,155
Realized investment (gains), net		(215,292		)	(27,580		)
Deferred income tax expense		948,830			1,274,325
Changes in operating assets and liabilities:
Reinsurance balances recoverable		(1,478,789		)	(445,375		)
Accrued investment income		(31,437		)	(310,879		)
Federal income tax recoverable		(593,115		)	(713,372		)
Other assets		(774,318		)	489,237
Amounts due from reinsurers		(976,536		)	(80,033		)
Policy and contract liabilities		5,941,236			2,862,232
Accounts payable and accrued expenses		4,895,632			(618,454		)
Long term notes payable		¾			187,500
Deferred stock option compensation expense		35,295			¾
Taxes, other than federal income taxes		64,475			(12,411		)
Funds held in suspense		294,608			(793,848		)
Liability for benefits for employees and agents		264,018			100,086
Other liabilities		33,151			9,415
Net cash provided by operating activities		7,379,099			1,643,492
Investing activities
Securities available for sale:
Sales		6,348,493			14,752,142
Maturities, calls and redemptions		2,343,827			42,279,225
Purchases		(17,443,525		)	(135,853,363		)
Repayments of mortgage loans		1,801,032			2,020,339
Mortgage loans originated		(692,951		)	¾
Increase in policy loans, net		57,705			128,085
Sale of real estate and property and equipment		¾			85,564
Purchases of real estate, property and equipment		(138,167		)	(527,089		)
Net cash (used in) investing activities		(7,723,586		)	(77,115,097		)
Net (decrease) in cash and cash equivalents		(344,487		)	(75,471,605		)
Cash and cash equivalents at beginning of period		7,204,805			117,400,156
Cash and cash equivalents at end of period		$	6,860,318		$	41,928,551
Supplemental disclosures of cash flow information
Federal income taxes paid		$	600,000		$	—

See accompanying notes.

 

4

 

KMG AMERICA CORPORATION AND PREDECESSOR

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1.  Organization, Initial Public Offering, Kanawha Acquisition and Nature of Operations

 

KMG America Corporation (“KMG America” or the “Company”) is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004.  KMG America commenced operations shortly before it completed its initial public offering of common stock on December 21, 2004, and its shares trade on the New York Stock Exchange under the symbol “KMA.”  Concurrently with the completion of its initial public offering, KMG America completed its acquisition of Kanawha Insurance Company (“Kanawha” or the “Predecessor”) and its subsidiaries, which are KMG America’s primary operating subsidiaries and which underwrite and sell life and health insurance products marketed primarily in the southeastern United States.

 

Kanawha, the primary operating subsidiary of KMG America, is licensed to issue life and accident and health insurance.  Kanawha is domiciled in South Carolina.  Kanawha has one wholly owned subsidiary, Kanawha HealthCare Solutions, Inc., a third-party administrator with operations in Lancaster and Greenville, South Carolina, and one wholly owned indirect subsidiary, Kanawha Marketing Group, Inc.

 

The Company’s primary businesses are life and health insurance risk assumption, third-party administration and medical management services.  Included in risk assumption are the Company’s product lines of individual life, annuity, supplemental health and short-term disability, as well as products specifically directed at the senior market including Medicare supplement, final expense life insurance and long-term care products.  The Company’s third-party administration and medical management businesses include a wide array of services with the primary emphasis in the offering of administrative service-only products.

 

The Company’s sales are primarily in the southeastern United States, predominantly in Florida, South Carolina and North Carolina, and are marketed by an internal sales force, as well as independent agents and brokers.  Premium revenues are concentrated in the individual life and accident and health lines of business.

 

2.  Significant Accounting Policies

 

Basis of Presentation

 

For accounting purposes, Kanawha is treated as KMG America’s predecessor entity and is referred to in these Notes as the “Predecessor.”  Financial information in the following discussion that relates to the Predecessor’s consolidated results of operations, cash flows and changes in shareholders’ equity for the quarter ended March 31, 2004, are reported on a historical basis without GAAP (generally accepted accounting principles in the United States) purchase accounting adjustments reflecting the acquisition of the Predecessor.  Financial information relating to the Company’s consolidated results of operations, cash flows and changes in shareholders’ equity for the quarter ended March 31, 2005, and the Company’s financial position as of December 31, 2004, and March 31, 2005, has been adjusted for GAAP purchase accounting adjustments reflecting the Predecessor’s acquisition.

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with GAAP for interim financial information.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In the opinion of management, all adjustments considered necessary for a fair presentation have been included.  All significant intercompany accounts and transactions have been eliminated in consolidation.  Operating results for the quarter ended March 31, 2005, are not necessarily indicative of the results that may be expected for the year ended December 31, 2005.  Certain prior year amounts have been reclassified to conform with the current year presentation.

 

The Company also submits financial statements to insurance industry regulatory authorities.  Those financial statements are prepared on the basis of statutory accounting practices (“SAP”) and are significantly different from financial statements prepared in accordance with GAAP (see Note 4).

 

5

 

KMG AMERICA CORPORATION AND PREDECESSOR

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Use of Estimates and Assumptions

 

The presentation of the accompanying consolidated financial statements requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and accompanying notes.  Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein.

 

Investments

 

Effective December 31, 2004, under GAAP purchase accounting rules, the Company recorded the Predecessor’s investments at fair value.

 

Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Fixed Maturity and Equity Securities, requires that all fixed maturity and equity securities be classified into one of three categories—held to maturity, available-for-sale, or trading.  The Company has no securities classified as held to maturity.  Management determines the appropriate classification of fixed maturities at the time of purchase.

 

Investments are reported on the following basis:

 

•                    Fixed maturity securities classified as available-for-sale are stated at fair value with unrealized gains and losses reported directly in shareholders’ equity as accumulated other comprehensive income.  Fair values for fixed maturity securities are based on quoted market prices, where available.  For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services.

 

•                    Equity securities classified as available-for-sale are stated at fair value with unrealized gains and losses reported directly in shareholders’ equity as accumulated other comprehensive income.

 

•                    Assets supporting the deferred compensation plan are classified as trading.  Trading account assets are held for resale in anticipation of short-term market movements.  Trading account assets, consisting of mutual funds, are stated at fair value.  Gains and losses, both realized and unrealized, are included in realized gains and losses on deferred compensation investments.

 

•                    Mortgage loans on real estate are typically stated at unpaid balances, net of allowances for unrecoverable amounts.  However, due to the Company’s acquisition of the Predecessor, effective December 31, 2004, under GAAP purchase accounting rules, mortgage loans were recorded at fair value.  Valuation allowances for mortgage loans are established when the Company determines it is probable that it will be unable to collect all amounts (both principal and interest) due according to the contractual terms of the loan agreement.  Such allowances are based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, if foreclosure is probable, on the estimated fair value of the underlying real estate.

 

•                    Policy loans are stated at their unpaid balances.

 

•                    Interest on loans is generally recorded over the term of the loan based on the unpaid principal balance.  Accrual of interest is discontinued when either principal or interest becomes 90 days past due or when, in management’s opinion, collection of such interest is doubtful.  In addition, any previously accrued interest is reversed when the loan becomes 90 days past due.

 

•                    Other investments are stated at market, or the lower of cost or market, as appropriate.

 

•                    Amortization of premiums and accrual of discounts on investments in fixed maturity securities are reflected in earnings over the contractual terms of the investments in a manner that produces a constant effective yield.  Realized gains and losses on dispositions of securities are determined by the specific-identification method.

 

6

 

Deferred Policy Acquisition Costs

 

Acquisition costs incurred by the Predecessor and the Company in the process of acquiring new business are deferred and amortized into income as discussed below.  Costs deferred consist primarily of commissions and certain policy underwriting, issue and agency expenses that vary with and are primarily related to production of new business.

 

For most insurance products, the amortization of deferred acquisition costs is recognized in proportion to the ratio of annual premium revenue to the total anticipated premium revenue, which gives effect to expected terminations.  Deferred acquisition costs are amortized over the premium-paying period of the related policies.  Anticipated premium revenue is determined using assumptions consistent with those utilized in the determination of liabilities for insurance reserves.  For interest-sensitive life insurance and investment products such as deferred annuities (no longer sold by the Company) to the extent recoverable from future gross profits, deferred policy acquisition costs are amortized generally in proportion to the present value of expected gross profits from surrender charges and investment, mortality and expense margins.

 

The Predecessor’s deferred acquisition costs at December 31, 2004, were eliminated upon the closing of the acquisition of the Predecessor as part of the application of GAAP purchase accounting requirements.  The Company began recording deferred acquisition costs prospectively on January 1, 2005.

 

Value of Business Acquired

 

Value of business acquired is the value assigned to the insurance in force of acquired insurance companies or blocks of insurance business at the date of acquisition.

 

The amortization of value of business acquired is recognized using amortization schedules established at the time of the acquisitions based upon expected annual premium.  Certain of these amortization schedules include actual to expected adjustments to reflect actual experience as it emerges.  The value of business acquired for premium paying policies is amortized in proportion to future expected premiums.  The value of business acquired for policies paid up as of the acquisition date is amortized in proportion to expected future earnings.

 

The Predecessor’s historical value of business acquired was eliminated upon the closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements.  Value of business acquired was simultaneously re-established, by the Company, for the value of the Predecessor’s in force business.  Interest rate assumptions used to amortize the value of business acquired were reset upon the closing of the Kanawha acquisition.

 

Benefit Reserves

 

Insurance reserves for individual life insurance, individual accident and health insurance, group life insurance and group accident and health insurance are associated with earned premiums so as to recognize profits over the premium-paying period.  This association is accomplished by recognizing the liabilities for insurance reserves on a net level premium method based on assumptions deemed appropriate at the date of issue as to future investment yield, mortality, morbidity, withdrawals and maintenance expenses, and including margins for adverse deviations.  Interest assumptions are based on interest rate levels and expectations at the time policies are sold.  Mortality, morbidity and withdrawal assumptions are based on recognized actuarial tables or the Predecessor’s experience, as appropriate.  Life reserves are calculated using mean reserve factors.  Accident and health reserves are calculated using mid-terminal reserve factors.  Benefit reserves for investment products are computed under a retrospective deposit method and represent policy account balances before applicable surrender charges.  Policy benefits and claims that are charged to expense include benefit claims incurred in the period in excess of related policy account balances.

 

The Predecessor’s benefit reserves, net of related reinsurance recoverable, at December 31, 2004, were adjusted to reflect the closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements.  The valuation interest rate assumptions were generally lowered to reflect the current and expected interest rate environment at the time the acquisition closed.  This change resulted in an increase in benefit reserves.  Valuation assumptions for mortality, morbidity and withdrawal were changed to reflect current expectations, which resulted in an increase in benefit reserves.  Finally, the valuation assumptions for future premium rates on long term

 

7

 

care coverage were increased to account for implemented and expected rate increases.  These changes reduced benefit reserves for this coverage.

 

Loss recognition testing of the Company’s policy benefit reserves is performed annually.  This testing involves a comparison of the Company’s actual net liability position (all liabilities less deferred acquisition costs, or DAC) to the present value of future liabilities calculated using then-current assumptions.  These assumptions are based on the Company’s best estimate of future experience.  To the extent a premium deficiency exists, it would be recognized immediately by a charge to the statement of income and a corresponding reduction in DAC.  Any additional deficiency would be recognized as a premium deficiency reserve.  Historically, loss recognition testing has not resulted in an adjustment to DAC or reserves.  These adjustments would occur only if economic, mortality and/or morbidity conditions significantly deviated from the underlying assumptions.

 

Stock-Based Compensation

 

The Company has adopted the disclosure-only requirements of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), as amended by FASB Statement No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure (“SFAS 148”).  As permitted by the provisions of this Statement, the Predecessor accounted for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and Related Interpretations.

 

Accordingly, the Company and the Predecessor recognized no compensation expense for stock option awards to employees or directors when the option price was not less than the market value of the stock at the date of award.

 

SFAS 123 requires the presentation of pro forma information as if the Company and the Predecessor had accounted for their employee and director stock options granted after December 31, 1994, under the fair value method of that Statement.

 

The following is a reconciliation of reported net income and pro forma information as if the Company and the Predecessor had adopted SFAS 123 for its employee and director stock option awards for the quarterly periods presented:

 

 

Recently Issued Accounting Standards

 

In March 2004, the Emerging Issues Task Force (“EITF”) reached a final consensus on EITF 03-1, which is effective for fiscal periods beginning after June 15, 2004.  EITF 03-1 requires that when the fair value of an investment security is less than its carrying value, an impairment exists for which a determination must be made as to whether the impairment is other-than-temporary.  An impairment loss should be recognized equal to the

 

8

 

difference between the investment’s carrying value and its fair value when an impairment is other-than-temporary.  Subsequent to an other-than-temporary impairment loss, a debt security should be accounted for in accordance with Statement of Position No. 03-3, Accounting for Loans and Certain Debt Securities Acquired in a Transfer, which allows the accretion of the discount between the carrying value and expected value of a security if the amount and timing of the recognition of that difference in cash is reasonably estimable.  EITF 03-1 also indicates that, although not presumptive, a pattern of selling investments prior to the forecasted recovery may call into question an investor’s intent to hold the security until it recovers its value.

 

The final consensus on EITF 03-1 included additional disclosure requirements incremental to those adopted by the Predecessor effective December 31, 2003, that are effective for fiscal years ending after June 15, 2004.

 

In October 2004, the FASB delayed the implementation of the accounting requirements included in EITF 03-1 until further study could be completed regarding the impact of this guidance, particularly with respect to “available-for-sale” portfolios.  The disclosure requirements included in EITF 03-1 remain in effect.

 

In December 2004, the FASB enacted SFAS No. 123 (revised 2004) (“SFAS 123 (revised 2004)”), Share-Based Payment, which replaces SFAS No. 123 (“SFAS 123”), Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees.  SFAS 123 (revised 2004) requires the measurement of all employee share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in the Company’s consolidated statements of income.  The accounting provisions of SFAS 123 (revised 2004) are effective for reporting periods beginning after January 1, 2006.  The Company is required to adopt SFAS 123 (revised 2004) in the first quarter of 2006.

 

The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition.  Although the Company has not yet determined whether the adoption of SFAS 123 (revised 2004) will result in amounts that are similar to the current pro forma disclosures under SFAS 123, the Company is evaluating the requirements under SFAS 123 (revised 2004) and expects the adoption to have an impact on its consolidated statements of income and net income per share that is substantially similar to the current pro forma disclosure under SFAS 123.

 

3.  Investments

 

Aggregate amortized cost, aggregate fair value and gross unrealized gains and losses of investments in fixed maturity and equity securities are summarized in the following table.  Effective December 31, 2004, the Company recorded the Predecessor’s investments at fair value and thereby eliminated all unrealized gains and losses in the Predecessor’s portfolio, as part of the application of GAAP purchase accounting requirements.

 

		Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses			Fair Value
Available for sale securities at March 31, 2005:
Fixed maturity securities		$	488,127,072		$	669,869		$	7,390,090		$	481,406,851
Equity securities		36,000			—			—			36,000
Securities available for sale		$	488,163,072		$	669,869		$	7,390,090		$	481,442,851

 

4.  Statutory Financial Information

 

State insurance laws and regulations prescribe accounting practices for determining statutory net income and equity for insurance companies.  In addition, state regulators may permit statutory accounting practices that differ from prescribed practices.  The Company does not have any accounting practices that differ from prescribed statutory accounting practices.

 

Under South Carolina insurance regulations, Kanawha is required to maintain minimum capital of $1.2 million and minimum surplus of $1.2 million.  Additionally, Kanawha is restricted as to amounts that can be transferred in the form of dividends, loans, or advances without the approval of the South Carolina Insurance Commissioner.  Under these restrictions, during 2005, dividends, loans or advances by Kanawha in excess of $8.4 million will require the approval of the South Carolina Insurance Commissioner.

 

9

 

5.  Employee Benefits

 

As of the dates indicated, the net periodic retirement benefit cost of the Company’s defined benefit pension plan for the quarters presented included the following components:

 

		Predecessor			KMG America
		Quarter Ended March 31, 2004			Quarter Ended March 31, 2005
Components of net periodic benefit cost:
Service cost		$	206,269		$	227,579
Interest cost		200,513			228,171
Expected return on plan assets		(131,529		)	(207,384		)
Amortization of transition liability		4,343			4,343
Recognized net actuarial loss		51,913			42,608
Net periodic benefit cost		$	331,509		$	295,317

 

The Company expects that its aggregate contributions to its defined benefit pension plan will be between $0 and $850,000 in 2005.  No contributions were made during the quarter ended March 31, 2005.

 

In the quarter ended March 31, 2005, the Company granted options to purchase an aggregate of 82,250 shares of its common stock.  The options vest in four equal annual installments beginning on the first anniversary of the date of grant.  Subject to certain conditions set forth in the option agreements, options are exercisable upon vesting until the tenth anniversary of the date of grant.

 

6.  Comprehensive Income (Loss)

 

Total comprehensive income (loss) for the quarters ended March 31, 2004 and 2005 was $7,666,992 and $(3,348,146), respectively.  The difference between comprehensive income and net income for these periods was unrealized gains (losses) of $7,576,099 and $(4,368,144), respectively.

 

7.  Commitments and Contingencies

 

The Company is occasionally named as a defendant in various legal actions arising principally from claims made under insurance policies and contracts.  Those actions are considered by the Company in estimating the policy and contract liabilities and management believes adequate reserves have been established for such cases.  Management believes that the resolution of those actions will not have a material effect on the Company’s financial position or results of operations.

 

On February 18, 2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company and ReliaStar Life Insurance Company of New York, both indirect wholly-owned subsidiaries of ING America US, in the Fourth Judicial District Court in Hennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and another individual.  Messrs. Kuk, Kraemer and Moore are officers of KMG America and former employees of the plaintiffs.  The complaint alleges misappropriation of trade secrets, conversion, tortious interference with business and employment relationships, breach of fiduciary duties and breach of contract by KMG America, Kanawha and Messrs. Kuk, Kraemer, and Moore.  The complaint seeks injunctive relief and unspecified monetary damages.  KMG America believes the allegations are without merit, intends to defend the action and believes that the outcome of this matter will not have a material adverse effect on its consolidated financial position or results of operations.

 

On December 21, 2004, the Company entered into a $15.0 million five-year subordinated promissory note to fund a portion of the purchase price for the Kanawha acquisition.  Interest on the promissory note accrues at 5% per annum and is added to the principal balance on December 31 of each year and is payable on the maturity date.  No cash payments are required under the promissory note until maturity, at which time approximately $19.1 million

 

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of principal and accrued interest will be due and payable.  The terms of the promissory note limit the Company’s and Kanawha’s ability to incur additional debt.

 

8.  Business Segments

 

The Company has five reportable segments that are differentiated by their respective methods of distribution and the nature of the related products: worksite insurance business, senior market insurance business, third party administration business, acquired business and corporate and other.  Management makes decisions regarding the Company’s business based on these segment classifications.  No segments have been aggregated other than including the marketing business in the corporate and other segment.

 

The worksite insurance business provides life and health insurance products to employers and their employees.  The primary insurance products include life, short-term disability, dental, indemnity health and critical illness.  This segment includes business sold through the career agency distribution channel, which is a group of agents and managers that are employees of the Company or its subsidiaries.

 

The senior market insurance business provides individual insurance products, primarily long-term care insurance, tailored to the needs of older individuals.

 

The third party administration business provides fee-based administrative and managed care services to employers with self funded health care plans, insurance carriers, reinsurance companies and others.

 

The acquired business represents closed blocks of life and health insurance business that have been acquired through reinsurance transactions over a period of years.

 

The corporate and other segment includes investment income earned on the investment portfolio allocated to capital and surplus, as well as all realized capital gains and losses, which are not allocated by line of business.  This segment also includes marketing allowances, commissions and related expenses pertaining to product sales for other insurance carriers, which are currently not material.  In addition, this segment includes certain unallocated expenses, primarily deferred compensation and incentive compensation costs, and other non-allocated immaterial items.

 

The following represents a summary of the Company’s and the Predecessor’s statements of income and asset composition by reportable segment.  The financial statement information of the Predecessor for the quarter ended March 31, 2004, is reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition of the Predecessor, while the Company’s financial statement information for the quarter ended March 31, 2005, has been adjusted for GAAP purchase accounting adjustments reflecting the acquisition.

 

		Predecessor			KMG America Corporation
		Quarter Ended March 31, 2004			Quarter Ended March 31, 2005
Worksite Insurance Business
Insurance premiums		$	14,024,664		$	14,658,027
Net investment income		1,404,387			1,781,787
Commissions and fees		—			—
Net realized gains		—			—
Other income		130,195			49,437
Total revenues		15,559,246			16,489,251
Policyholder benefits		11,530,192			10,890,125
Commissions		872,747			1,077,650
Expenses, taxes, fees and depreciation		2,297,522			3,555,616
Amortization of DAC		1,221,886			820,006
Total benefits and expenses		15,922,347			16,343,397
(Loss) income before Federal income tax		$	(363,101	)	$	145,854
Total assets		$	152,155,353		$	168,714,162

 

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		Predecessor			KMG America Corporation
		Quarter Ended March 31, 2004			Quarter Ended March 31, 2005
Senior Market Insurance Business
Insurance premiums		$	10,323,112		$	10,601,060
Net investment income		781,628			1,011,456
Commissions and fees		—			—
Net realized gains		—			—
Other income		495,612			657,362
Total revenues		11,600,352			12,269,878
Policyholder benefits		8,924,411			8,344,925
Commissions		1,364,714			1,489,165
Expenses, taxes, fees and depreciation		544,374			1,139,320
Amortization of DAC		179,571			370,438
Total benefits and expenses		11,013,070			11,343,848
Income before Federal income tax		$	587,282		$	926,030
Total assets		$	125,540,938		$	168,485,632
Third-Party Administration Business
Insurance premiums		$	—		$	—
Net investment income		—			—
Commissions and fees		3,346,267			3,483,387
Net realized gains		—			—
Other income		626			862
Total revenues		3,346,893			3,484,249
Policyholder benefits		—			—
Commissions		—			—
Expenses, taxes, fees and depreciation		2,934,886			3,206,326
Amortization of DAC		—			—
Total benefits and expenses		2,934,886			3,206,326
Income before Federal income tax		$	412,007		$	277,923
Total assets		$	7,170,994		$	8,406,380
Acquired Business
Insurance premiums		$	990,003		$	938,473
Net investment income		2,212,046			2,062,616
Commissions and fees		—			—
Net realized gains		—			—
Other income		25,354			13,381
Total revenues		3,227,403			3,014,470
Policyholder benefits		2,085,986			1,194,784
Commissions		107,089			99,352
Expenses, taxes, fees and depreciation		686,250			704,629
Amortization of DAC		689,398			(105,289		)
Total benefits and expenses		3,568,723			1,893,476
(Loss) income before Federal income tax		$	(341,320	)	$	1,120,994
Total assets		$	201,032,795		$	212,187,641

 

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		Predecessor			KMG America Corporation
		Quarter Ended March 31, 2004			Quarter Ended March 31, 2005
Corporate and Other
Insurance premiums		$	—		$	—
Net investment income		991,559			1,796,926
Commissions and fees		5,707			84,661
Net realized gains		215,292			27,580
Other income		95,506			70,605
Total revenues		1,308,064			1,979,772
Policyholder benefits		—			—
Commissions		—			—
Expenses, taxes, fees and depreciation		1,465,215			2,869,622
Amortization of DAC		—			—
Total benefits and expenses		1,465,215			2,869,622
(Loss) before Federal income tax		$	(157,151	)	$	(889,850	)
Total assets		$	223,488,791		$	210,366,003
Total Company
Insurance premiums		$	25,337,779		$	26,197,560
Net investment income		5,389,620			6,652,785
Commissions and fees		3,351,974			3,568,048
Net realized gains		215,292			27,580
Other income		747,293			791,647
Total revenues		35,041,958			37,237,620
Policyholder benefits		22,540,589			20,429,834
Commissions		2,344,550			2,666,167
Expenses, taxes, fees and depreciation		7,928,247			11,475,513
Amortization of DAC		2,090,855			1,085,155
Total benefits and expenses		34,904,241			35,656,669
Income before Federal income tax		$	137,717		$	1,580,951
Total assets		$	709,388,871		$	768,159,818

 

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ITEM 2.                             MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

Business Overview

 

KMG America is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004.  We commenced our operations shortly before we completed our initial public offering of common stock on December 21, 2004, and our shares trade on the New York Stock Exchange under the symbol “KMA.”  Concurrently with the completion of our initial public offering, we completed our acquisition of Kanawha Insurance Company (“Kanawha”) and its subsidiaries, which are our primary operating subsidiaries and which underwrite and sell life and health insurance products marketed primarily in the southeastern United States.  For GAAP accounting purposes, Kanawha is treated as KMG America’s predecessor entity and is referred to herein as our “predecessor.”  Financial information in the following discussion that relates to our predecessor’s consolidated results of operations, cash flows and changes in shareholders’ equity for the quarter ended March 31, 2004, are reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition.  Financial information relating to our consolidated results of operations, cash flows and changes in shareholders’ equity for the quarter ended March 31, 2005, and our financial position as of December 31, 2004, and March 31, 2005, has been adjusted for GAAP purchase accounting adjustments reflecting the acquisition.  Our operations are conducted in the five following business segments.

 

Worksite insurance business.  Our worksite insurance business is a provider of voluntary life and health insurance products to employers and their employees in the southeastern United States.  The primary insurance products that we underwrite include: life insurance; short-term disability insurance; dental insurance; indemnity health insurance; and critical illness insurance.  For the quarter ended March 31, 2005, our worksite insurance business reported premiums, commissions and fees, excluding intercompany payments, of $14.7 million, which accounted for 49.3% of our premiums, commissions and fees, excluding intercompany payments in that period.  Our business strategy is to operate our existing worksite insurance business efficiently while developing a new worksite marketing and distribution organization that targets larger employer groups nationwide with an expanded variety of life and health insurance products which will add a new set of employer-paid life insurance, disability and health products to our existing voluntary products.  In December 2004, we opened sales offices hosting regional sales managers in Boston, Massachusetts and Irvine, California, a Los Angeles suburb.  During 2005, we have opened regional sales offices in Tampa, Florida; Chicago, Illinois; New York, New York; Atlanta, Georgia; Dallas, Texas; and Cleveland, Ohio.  We expect to open additional regional sales offices later in 2005 and thereafter.  We have begun and expect to continue to add and train additional sales and support staff and marketing personnel at these facilities, and will recognize the costs associated with these additions before we recognize revenues resulting from new sales activity.  Consequently, we expect negative cash flow and operating losses in the short term.  We expect cash flows from our new sales and marketing organization to be positive by 2006 but we cannot assure you that this will occur.

 

Senior market insurance business.  Our senior market insurance business is a provider in the southeastern United States of individual insurance products tailored to the needs of older individuals.  The primary insurance products that this business offers include long-term care insurance that we underwrite and Medicare supplement insurance underwritten by another carrier.  For the quarter ended March 31, 2005, our senior market insurance business reported premiums, commissions and fees, excluding intercompany payments, of $10.6 million, which accounted for 35.6% of our premiums, commissions and fees, excluding intercompany payments, in that period.  While growing this business is not a primary component of our business strategy, we intend to operate this business efficiently and may consider expanding its geographic target market.

 

Third-party administration business.  Our third-party administration business provides a wide range of insurance product administration, claims handling, eligibility administration, call center and support services.  This business primarily administers the insurance plans offered by our worksite insurance business and senior market insurance business.  Our third-party administration business also provides administrative and managed care services to third parties, such as employers with self-funded health care plans, other insurance carriers, reinsurers and managed care plans.  For the quarter ended March 31, 2005, our third-party administration business reported commissions and fees, excluding intercompany payments, of $3.5 million, which accounted for 11.7% of our premiums, commissions and fees, excluding intercompany payments, in that period.  Our primary business strategy for this business is to grow this business as it administers the increasing volume of policies and products that we anticipate will be sold by the worksite insurance business as we attempt to grow that business.  In addition, as our

 

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national worksite marketing business develops, we intend to opportunistically market our third-party administration services to self-insured plans, stop loss insurers, pharmacy benefit organizations, managed care service providers, other insurance carriers and reinsurers nationwide.  It is expected that any incremental costs associated with this expanded marketing will be modest and will be funded out of the operations of our third-party administration business.

 

Acquired business.  In addition, we have retained our predecessor’s closed block of life and health business reported in the acquired business segment.  While acquisitions of books of business from other insurance carriers is not one of our principal growth strategies, we will consider making acquisitions on an opportunistic basis if we can complete the acquisitions on favorable financial terms that we expect to be generally accretive to earnings per share and return on equity while maintaining our financial strength ratings.

 

Corporate and other.  We have also retained our predecessor’s investment and marketing activities reported in the corporate and other segment.  We expect to realize earnings from our investment portfolio.  Insurance companies in both the life and health and property and casualty insurance industries earn profits on the investment float, which reflects the investment income earned on the premiums paid to the insurer between the time of receipt and the time benefits are paid-out under the policy.  Volatility in the capital markets, changes in interest rates and changes in economic conditions can all impact the amount of earnings that we will realize from our investment portfolio.

 

Results of Operations

 

Consolidated Overview

 

The following table presents historical consolidated financial information for the quarter ended March 31, 2004, for our predecessor, and consolidated financial information for the quarter ended March 31, 2005, for KMG America.

 

(1)                                 Net investment income for the three months ended March 31, 2004, was negatively impacted by a $1.6 million incentive payment to one of Kanawha’s outside investment managers at the conclusion of the contract period.  There are no other incentive arrangements of this type in force, and this contract was terminated upon the closing of our acquisition of Kanawha.

 

(2)                                 The benefits to premiums ratio is equal to policyholder benefits (equal to incurred claims plus increases in policyholder active life reserves) divided by insurance premiums.

 

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Consolidated Results of Operations by Business Segment

 

Note 8., Business Segments, of the Notes to Consolidated Financial Statements included in this report, which includes a summary of our and our predecessor’s statements of income and asset composition by reportable segment, is incorporated herein by reference.

 

Quarter Ended March 31, 2005, Compared to Quarter Ended March 31, 2004

 

Financial Results Overview

 

Net income for the quarter ended March 31, 2005, increased $0.9 million, or 900.0%, to $1.0 million from net income of $0.1 million for the quarter ended March 31, 2004.  The increase in net income was primarily due to increases in premiums and net investment income combined with decreases in policyholder benefits, partially offset by an increase in general expenses, all of which are described in greater detail below.

 

Revenues

 

Total revenues for the quarter ended March 31, 2005, increased $2.2 million, or 6.3%, to $37.2 million from total revenues of $35.0 million for the quarter ended March 31, 2004.  The primary factors causing the increase are explained below under the captions “—Premiums,” “—Net Investment Income,” “—Commission and Fee Income,” “—Realized Investment Gains and Losses” and “—Other Income.”

 

Premiums

 

The following table presents the distribution of premiums by type and business segment.

 

		For the quarter ended March 31, 2004												For the quarter ended March 31, 2005												Increase (decrease)
		Worksite			Senior			Acquired			Total			Worksite			Senior			Acquired			Total			Worksite			Senior			Acquired			Total
		(dollars in millions)
Direct
New		$	3.2		$	1.5		$	—		$	4.7		$	3.8		$	0.5		$	—		$	4.3		$	0.6		$	(1.0	)	$	—		$	(0.4	)
Renewal		11.2			12.2			—			23.4			11.4			13.5			—			24.9			0.2			1.3			—			1.5
Total		14.4			13.7			—			28.1			15.2			14.0			—			29.2			0.8			0.3			—			1.1
Assumed
New		—			—			—			—			—			—			—			—			—			—			—			—
Renewal		—			—			1.0			1.0			—			—			0.9			0.9			—			—			(0.1		)	(0.1		)
Total		—			—			1.0			1.0			—			—			0.9			0.9			—			—			(0.1		)	(0.1		)
Ceded
New		(0.2		)	(0.9		)	—			(1.1		)	(0.3		)	(0.3		)	—			(0.6		)	(0.1		)	0.6			—			0.5
Renewal		(0.2		)	(2.5		)	—			(2.7		)	(0.2		)	(3.1		)	—			(3.3		)	—			(0.6		)	—			(0.6		)
Total		(0.4		)	(3.4		)	—			(3.8		)	(0.5		)	(3.4		)	—			(3.9		)	(0.1		)	—			—			(0.1		)
Net
New		3.0			0.6			—			3.6			3.5			0.2			—			3.7			0.5			(0.4		)	—			0.1
Renewal		11.0			9.7			1.0			21.7			11.2			10.4			0.9			22.5			0.2			0.7			(0.1		)	0.8
Total		14.0			10.3			1.0			25.3			14.7			10.6			0.9			26.2			0.7			0.3			(0.1		)	0.9

 

Worksite net new premiums increased $0.5 million, or 16.7%, to $3.5 million for the quarter ended March 31, 2005, from $3.0 million for the quarter ended March 31, 2004, due to increased sales volumes. New sales increased $0.9 million, or 40.9%, to $3.1 million for the quarter ended March 31, 2005, from $2.2 million for the quarter ended March 31, 2004.  Net renewal premiums increased $0.2 million, or 1.8%, due to the increased amount of insurance in force created by prior year sales.

 

Senior market net new premiums, composed of long term care policies, decreased $0.4 million, or 66.7%, to $0.2 million for the quarter ended March 31, 2005, from $0.6 million for the quarter ended March 31, 2004 due to decreased sales volumes.  New sales decreased $0.9 million, or 69.2%, to $0.4 million for the quarter ended March

 

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