-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Eoz3FyLLvT6SY05hPFkGS3tn/XXt4t/UMYdMhNK0vgllBGAgzLW1eb/3yYmY8Hpg CCmEJ0uLrzEBFKHpZ3ZyOg== 0000950152-03-003774.txt : 20030331 0000950152-03-003774.hdr.sgml : 20030331 20030331171223 ACCESSION NUMBER: 0000950152-03-003774 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 20021231 FILED AS OF DATE: 20030331 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CERES GROUP INC CENTRAL INDEX KEY: 0000215403 STANDARD INDUSTRIAL CLASSIFICATION: LIFE INSURANCE [6311] IRS NUMBER: 341017531 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-08483 FILM NUMBER: 03631915 BUSINESS ADDRESS: STREET 1: 17800 ROYALTON RD CITY: STRONGSVILLE STATE: OH ZIP: 44136 BUSINESS PHONE: 2165722400 MAIL ADDRESS: STREET 1: 17800 ROYALTON RD CITY: STRONGSVILLE STATE: OH ZIP: 44136 FORMER COMPANY: FORMER CONFORMED NAME: CENTRAL RESERVE LIFE CORP DATE OF NAME CHANGE: 19920703 10-K 1 l99084ae10vk.txt CERES GROUP, INC. | FORM 10-K 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 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002 COMMISSION FILE NUMBER 0-8483 CERES GROUP, INC. (Exact name of registrant as specified in its charter) DELAWARE 34-1017531 --------------------------- ------------------------------------ (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 17800 ROYALTON ROAD, CLEVELAND, OHIO 44136 ----------------------------------------- --------- (Address of principal executive offices) (Zip Code)
(440) 572-2400 ------------------------------------------------ (Registrant's telephone number, including area code) 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. [X] 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 $97,133,537 computed based on the closing price of $3.90 per share of the common stock on June 30, 2002. The number of shares of common stock, par value $0.001 per share, outstanding as of March 25, 2003 was 34,238,164. - -------------------------------------------------------------------------------- DOCUMENTS INCORPORATED BY REFERENCE: Portions of the registrant's definitive proxy statement for the annual meeting of stockholders to be held May 20, 2003 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, 2002. CERES GROUP, INC. INDEX TO ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2002
PAGE ---- PART I Item 1 Business.................................................... 1 Item 2 Properties.................................................. 17 Item 3 Legal Proceedings........................................... 17 Item 4 Submission of Matters to a Vote of Security Holders......... 18 PART II Item 5 Market for Registrant's Common Equity and Related Stockholder Matters......................................... 19 Item 6 Selected Financial Data..................................... 20 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 22 Item 7A Quantitative and Qualitative Disclosures about Market Risk........................................................ 40 Item 8 Financial Statements and Supplementary Data................. 41 Schedule II - Condensed Financial Information of Registrant.................................................. 81 Schedule III - Supplemental Insurance Information........... 84 Schedule IV - Reinsurance................................... 85 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................................... 86 PART III Item 10 Directors and Executive Officers of the Registrant.......... 86 Item 11 Executive Compensation...................................... 86 Item 12 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.................. 86 Item 13 Certain Relationships and Related Transactions.............. 87 Item 14 Controls and Procedures..................................... 87 PART IV Item 15 Exhibits, Financial Statement Schedules and Reports on Form 8-K......................................................... 87 Signatures................................................................ 92
PART I ITEM 1. BUSINESS RECENT EVENTS Effective March 31, 2003, we sold our subsidiary, Pyramid Life Insurance Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash, subject to further adjustment based on Pyramid Life's final statutory capital and surplus as of March 31. Net proceeds of the sale were used as follows: (1) $10.0 million to repay a portion of our bank debt, and (2) the remainder to strengthen the statutory capital of our subsidiary, Continental General Insurance Company. Immediately prior to the closing of the sale, Continental General acquired Pyramid Life's Kansas City building and personal property and retained most of its employees. Continental General will continue to administer its senior health business out of the Kansas City location, as well as continue to administer Pyramid Life's business during a six to 18 month transition period. Immediately prior to the closing, Continental General also reinsured a small block of certain life insurance policies of Pyramid Life. AS A RESULT OF THE SALE OF PYRAMID LIFE, THE INFORMATION PROVIDED IN THIS SECTION "BUSINESS" DOES NOT INCLUDE PYRAMID LIFE, ITS OPERATIONS OR RESULTS, EXCEPT WHERE INDICATED. SEE "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- RECENT EVENTS" AND NOTE F. DISCONTINUED OPERATIONS AND SUBSEQUENT EVENT TO OUR CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL INFORMATION REGARDING PYRAMID LIFE. OVERVIEW Ceres provides a wide array of health and life insurance products to approximately 358,000 insureds 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, associations and small businesses. To help control medical costs, we also provide medical cost management services to our insureds. Our nationwide distribution channels include approximately 36,000 independent agents and QQLink, our fully transactional online distribution system. We acquired Continental General Insurance Company, Provident American Life & Health Insurance Company and United Benefit Life Insurance Company to supplement our major medical platform at Central Reserve Life Insurance Company. In addition, we acquired selected major medical insureds of Central Benefits Mutual Insurance Company and a block of individual and small group health insurance written by American Chambers Life Insurance Company. We entered into the senior market by acquiring Continental General, with its significant senior health insurance business. Our health and life insurance products protect individuals, families, associations, and small employer groups during the years up to retirement, while our Medicare supplement, long-term care, home healthcare and senior life products provide ongoing coverage for senior Americans. In the past, our operating results have been adversely impacted by industry-wide and historically high medical inflation. This environment caused us to enhance and accelerate a number of programs to lessen the inflationary impact, including: - target marketing; - premium rate increases; - modified product lines for new sales; - proactive medical cost management; and - lowered administrative and sales expenses. 1 Our senior segment continued to produce increasing profits for 2002, totaling $14.9 million in pre-tax profits for the year ended 2002 compared to $13.6 million in 2001. Our medical segment improved to a pre-tax loss of $6.0 million in 2002 compared to a pre-tax loss of $13.7 million in 2001. We believe our focus on internal growth, along with increased statutory capital, will lead to more predictable earnings, enhanced profitability and higher financial agency ratings of our insurance subsidiaries, which in turn should support greater internal growth capacity. OUR CORE BUSINESSES SENIOR HEALTH, LIFE AND ANNUITY PRODUCTS. We continue to focus on the senior segment because we believe this market has the potential for greater revenue growth and higher profit potential than our medical segment. These products 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 72% of the nation's 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 2001, growing to 34.0 million from 19.1 million. By 2007, the Medicare population is expected to exceed 44 million. 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 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 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. We plan to maintain or slightly reduce the current premium level of our medical segment by continuing to 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) and 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 usually allows policyholders substantial freedom of choice in selecting healthcare providers but without the financial incentives or cost-control measures typical of managed care plans. 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 and with the strengthened statutory capital at Continental General as a result of the Pyramid Life sale, 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, 2 2002, our senior segment comprised 31% of our total net premium revenues compared to 28% for 2001. Our senior segment products are administered at our Kansas facility. IMPROVING UNDERWRITING AND PRODUCT DESIGN. We believe that we have improved our underwriting through more consistent and rigorous risk evaluation and controls that reflect current medical practices and treatment patterns. To anticipate and respond to regulatory changes and actual market and profitability experience, we closely monitor and manage premium rate adjustments and provide our policyholders opportunities to adjust their co-insurance and deductible provisions to keep their premiums affordable. We actively pursue product redesign and curtailment of unprofitable product offerings, where necessary. An underwriting philosophy based on rational selection of risks has produced a number of changes to our underwriting guidelines. We have aligned our pricing decisions to more accurately reflect the associated morbidity. Through review of claim charges, we have also made general enhancements to our underwriting guidelines to better reflect current medical practices and treatment patterns. The Health Insurance Portability and Accountability Act of 1996 (HIPAA) has placed major restrictions on the sale of group insurance for small businesses with two to 50 employees. In effect, HIPAA requires guaranteed issuance of major medical insurance for small groups that meet continuing coverage and participation guidelines. HIPAA also includes specific rules on underwriting and coverage of pre-existing conditions. See "Government Regulation - Healthcare Regulations." Within our current small group business, we are more strictly enforcing group participation and eligibility requirements to maintain profitability targets. HIPAA allows insurance companies to require specific levels of employee participation in group health insurance plans offered by their employers. If participation falls below these levels, a group policy can be terminated after a required notification period. In addition, participants must be full-time employees of the group. Through a re-certification process, we have improved compliance with these requirements. Because of HIPAA and state regulatory restrictions, we place greater emphasis on the sale of individual and association major medical products. For 2002, our major medical certificates included 70.0% for individual and association products and 30.0% for small group products, which were consistent with levels experienced in 2001. One advantage of marketing individual and association products is greater flexibility in underwriting. We can accept, reject or apply higher premium rates to specific individuals with higher health risks. We can restrict or limit coverage for pre-existing conditions. We also have greater ability to raise future premium rates, if necessary, based on medical inflation and actual claims experience of our products. "Ceres Standards," a guideline of our best practices for underwriting of new business, are implemented for all major medical business processed at our insurance subsidiaries, and include standardization of organizational design, business rules, risk selection and processing requirements. We selectively pursue geographic markets, products and sales agencies that provide us the greatest potential for profitability. This strategy includes exiting markets that are unprofitable. In addition, our ongoing product design efforts in both of our business segments keeps our product portfolio attractive to our sales force. In our medical segment, we are emphasizing new product lines that provide consumers with lower monthly premiums offset by greater out-of-pocket payments for discretionary medical services and brand-name pharmaceuticals. ENHANCING MEDICAL COST MANAGEMENT. Our approach is to manage the cost of healthcare. We focus on reducing medical costs for our insureds by actively managing medical inflation and utilization rate costs. National health expenditures have grown from $1,872 per capita in 1986 to $4,177 per capita in 1999, 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. 3 In addition to monthly reviews of premium rate adequacy and taking actions to adjust rates on a product and state basis as needed, we also have numerous programs designed to lower medical costs for our insureds. Some of these programs include: - focusing our business with national and regional preferred provider organizations with superior pricing and management of costs; - use of a "Centers of Excellence" network providing our insureds access to transplant and other necessary high-risk procedures at approximately 50 renowned medical institutions that have the staff, experience and volume of patients to produce higher recovery rates while offering discounted costs; - a multiple benefit level pharmacy coverage to promote use of lower cost drugs when possible; - screening techniques to identify and move high-cost and high-risk insureds as early as possible into case management programs to enhance treatment programs and lower the long-term total medical expenses; - a program to detect fraud and abuse by medical providers, policyholders or agents; - medical protocol use to avoid claims for unnecessary procedures; - claims cost negotiation for long-term care expenses; - product design geared to encourage use of PPOs; and - enhanced communication to insureds on the features and benefits of these programs, emphasizing how they can reduce their total healthcare costs. The purpose of these programs is to provide quality care and improved 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 make better use of insurance benefits. Since the beginning of 2001, we reduced our PPO networks from 51 to 23. This reduction has resulted in reduced network access fees and additional provider discounts, along with quicker claims processing for our insureds. 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 COAST (Ceres Online Access SysTem) program provides direct online communication for our agents who are able 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. If cost-effective, we outsource certain functions to independent third parties. We currently outsource all information and telephone systems at our Cleveland headquarters, claims processing for our Central Reserve Life Ohio insureds, and claims processing and other administrative services for the American Chambers Life Insurance Company business and for our insurance subsidiaries, Provident American Life and United Benefit Life. We believe this outsourcing offers us the following advantages: - predictable operational, administrative and systems costs; - variable expenses based upon volume of business; - the benefits of the vendors' expertise in specialized areas; 4 - freeing our capital to be used for other aspects of our growth strategy; - efficiency and economies of scale; and - system consolidation and integration. 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 and small 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. Our major medical plans can also be configured as medical savings account 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. Our medical networks 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 traditional indemnity health insurance products offer access to 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 communicate these cost saving methods to our insureds. 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 all maintenance prescription drugs. Our Simplicity Series 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 medical savings account plans, which enables insureds to lower their insurance costs and have more control over their healthcare dollars. In addition, we are marketing a new hospital-only plan. 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 Employer's Choice product provides higher deductibles and co-payments and lower premium payments for our small business customers. In addition, we offer small businesses with 2-100 employees our Partnership Plan, a major medical product in which we share the medical cost risk with the employer. 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. 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. 5 SENIOR HEALTH INSURANCE PRODUCTS. Our senior market products include a wide range of comprehensive and supplemental major medical benefit products, including Medicare supplement, long-term care, home healthcare, extended convalescent care, cancer coverage and acute recovery care that includes shorter length facility care. We are focusing more product development attention in our senior segment on Medicare supplement and long-term care insurance products. Long-term care products provide needed benefits to supplement Medicare and Medicare Supplement coverage for nursing home and home healthcare expenses. SENIOR LIFE INSURANCE AND ANNUITIES. Our life insurance and annuity products include lower face amount life insurance policies offering coverages up to $50,000 and annuity plans with first-year bonus interest or interest rate guarantees. SERVICES AND NON-INSURANCE PRODUCTS. We offer the Senior Savers Plus Plan, which provides discounts on extended care and home healthcare services in addition to the other product and service discounts. We also added our care coordination program to most of our major medical products to provide service enhancements for our insureds. MARKETING AND SALES Our distribution is critical for our continued growth. We market our products through approximately 36,000 independent agents in 49 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 and reduce the number of low and non-producing 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 four distribution channels on organization of the agents and specific markets or products: 1. SENIOR BROKERAGE. These Continental General agents target Americans age 55 and over with a comprehensive product line. 2. MEDICAL CAREER. This channel is comprised of well-established marketing organizations that primarily market both Central Reserve and Continental General health insurance and supplemental health insurance. 3. MEDICAL BROKERAGE. Our Central Reserve brokerage agents concentrate on individuals, families, associations and small business owners. The product portfolio includes catastrophic medical coverage, individual medical plans, small group medical plans, medical savings account plans, basic medical coverage, short-term major medical, dental, life insurance and annuities. These agents may represent multiple insurance carriers. 4. QQLINK ELECTRONIC DISTRIBUTION. QQLink is our fully transactional online platform for Continental General's major medical and senior life and health products. QQLink, founded in late 2000, combines a traditional agent distribution system with direct online sales of insurance. Consumers are able to review and receive premium quotes and apply for insurance online, with or without the assistance of an agent. We believe that QQLink will enable agents to substantially increase the client base they serve. These agents may represent multiple insurance carriers. QQLink is 94% owned by Ceres with the remaining 6% primarily owned by 16 of our agents. 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. 6 We provide comprehensive support programs to attract and retain agents, including: - competitive products and commission structures; - advanced commissions on selected products for agents who qualify; - lead generation programs; - ongoing product development; - special incentive awards to new agents; - website development for QQLink participating agents; - user-friendly proposal software; - training seminars to introduce new products and sales material for our agents; and - consistent agent communication and quality sales materials. CUSTOMER BASE We had approximately 265,000 certificates and individual policies in force as of December 31, 2002, representing approximately 358,000 insureds. One association, Eagle Association, had approximately 24,200 certificate holders, or 9.1% of all our certificates and individual policies in force as of December 31, 2002. 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, 2002 and 2001.
DECEMBER 31, 2002 DECEMBER 31, 2001 ------------------ ------------------- INDEMNITY PPO INDEMNITY PPO --------- ------ --------- ------- Major Medical.................................. 20,654 99,116 30,096 137,224 Senior and Supplemental Products............... 101,792 -- 115,259 -- ------- ------ ------- ------- Total Health.............................. 122,446 99,116 145,355 137,224 Life and Annuity Products...................... 43,716 -- 39,864 -- ------- ------ ------- ------- Total..................................... 166,162 99,116 185,219 137,224 ======= ====== ======= =======
The geographic distribution of direct and assumed premiums, before reinsurance ceded, on a statutory basis of all of our subsidiaries in 2002 and 2001 is presented in the table below. The presentation on a statutory basis differs from generally accepted accounting principles (GAAP) in that our fee income and annuity considerations are considered premiums for statutory purposes. 7
DECEMBER 31, 2002 DECEMBER 31, 2001 (DOLLARS IN THOUSANDS) (DOLLARS IN THOUSANDS) - --------------------------------------------- ---------------------------------------------- PERCENT PERCENT STATE AMOUNT OF TOTAL STATE AMOUNT OF TOTAL - ----- -------- -------- ----- -------- -------- Ohio.................... $ 94,043 13.8% Ohio.................... $ 75,407 12.3% Florida................. 61,567 9.0 Texas................... 58,033 9.4 Texas................... 53,474 7.8 Florida................. 54,789 8.9 Pennsylvania............ 47,223 6.9 Indiana................. 36,243 5.9 Indiana................. 37,535 5.5 Pennsylvania............ 32,815 5.3 Georgia................. 31,688 4.6 Georgia................. 25,875 4.2 Missouri................ 24,099 3.5 Missouri................ 22,816 3.7 Illinois................ 23,674 3.5 Tennessee............... 21,911 3.6 Kansas.................. 23,062 3.4 Illinois................ 19,996 3.3 Nebraska................ 22,838 3.3 Nebraska................ 19,872 3.2 Other................... 264,688 38.7 Other................... 247,304 40.2 -------- ----- -------- ----- Total......... $683,891 100.0% Total........... $615,061 100.0% ======== ===== ======== =====
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. We have adopted and follow "Ceres Standards," a guideline for the underwriting of new business. These detailed uniform underwriting procedures are designed to assess and quantify certain insurance risks before issuing individual 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, 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. 8 CLAIMS All claims for policy benefits are currently either processed by our claims department or outsourced to third party administrators. We outsource claims processing for our Central Reserve Ohio insureds and claims processing and other administrative services for the Chambers and Provident American Life's HealthEdge business to Antares Management Solutions, a division of Medical Mutual Services, which is a subsidiary of Medical Mutual of Ohio. We also outsource claims processing for the run-off business of Provident American Life and United Benefit Life to HealthPlan Services Corporation. 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. A significant portion of our support systems is obtained from third party vendors. Pursuant to an administrative services agreement with Antares Management Solutions, we outsource all information and telephone systems at our Cleveland headquarters, as well as claims processing for our Central Reserve Ohio insureds. In addition, we outsource claims processing and other administrative services for the Chambers and Provident American Life's HealthEdge business to Antares. The claims processing and other administrative services for our insurance subsidiaries, Provident American Life and United Benefit Life, prior to their termination or replacement, are outsourced to HealthPlan Services. We receive regular reports from our third party vendors that enable us to closely monitor our business on those 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 two and three years. At December 31, 2002, approximately 99.0% of our invested assets were fixed maturity securities, including surplus notes. At December 31, 2002, 94.0% of our fixed maturity securities were of investment grade quality with 81.7% in securities rated A or better (typically National Association of Insurance Commissioners (NAIC) I) and 12.3% 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. 9 At December 31, 2002, our investments in mortgage-backed securities totaled $140.9 million, or 35.5% 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 16.0% 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 19.5% 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 invested assets as of December 31, 2002, were as follows:
GROSS UNREALIZED AMORTIZED ----------------- ESTIMATED COST GAINS LOSSES FAIR VALUE --------- ------- ------- ---------- (DOLLARS IN THOUSANDS) Available-for-sale U.S. Treasury securities................... $ 14,684 $ 287 $ (3) $ 14,968 U.S. Agencies.............................. 37,502 1,411 -- 38,913 State and political subdivisions........... 1,063 15 -- 1,078 Corporate bonds............................ 177,104 8,173 (1,735) 183,542 Mortgage- and asset-backed securities...... 143,923 6,761 (1,128) 149,556 -------- ------- ------- -------- Total available-for-sale................ 374,276 16,647 (2,866) 388,057 Surplus notes................................ 5,020 131 -- 5,151 Mortgage loans............................... 52 -- -- 52 Policy notes................................. 3,843 -- -- 3,843 -------- ------- ------- -------- Total investments....................... $383,191 $16,778 $(2,866) $397,103 ======== ======= ======= ========
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: - healthcare cost trends; - the incidence of incurred claims; - the extent to which all claims have been reported; and - internal claims processing charges. 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. 10 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. 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 also are 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 ordinary 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 our claims reserves significantly in excess of our initial estimates. An inadequate estimate in reserves could have a material adverse impact on our business, 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. 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 M. Reinsurance Arrangements to our consolidated financial statements. 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. Hannover accounted for 91.7% 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 11 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, 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 has suffered significant losses as a result of our reinsurance agreements with respect to United Benefit Life and Provident American Life. The total premiums ceded by our subsidiaries in 2002 to unaffiliated reinsurers amounted to $113.0 million, of which Hannover represented approximately 91.7%. Our gross reinsurance receivables from unaffiliated reinsurers amounted to $170.1 million as of December 31, 2002, of which approximately 93.6% was attributable to Hannover. Hannover is a subsidiary of Hannover Rueckversicherungs, a German corporation, which had assets of $29.1 billion and total stockholders' equity of $1.5 billion at December 31, 2001. Moody's has assigned Hannover Rueckversicherungs a financial strength rating of A2 (good). Hannover maintains an A (excellent) rating and Hannover Rueckversicherungs maintains an A+ (superior) rating from A.M. Best Company, Inc. and a financial strength rating of AA (rated 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. 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., Mutual of Omaha Insurance Co., Fortis Benefits Insurance Company, American Medical Security Group, Inc., 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., Penn Treaty American Corp., Mutual of Omaha and Conseco, Inc. 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 competition from 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. 12 RATINGS Our ratings assigned by A.M. Best Company, Inc. and other nationally recognized rating agencies are important in evaluating our competitive position. Best ratings are based on an analysis of the financial condition of the companies rated. Best ratings are primarily based upon factors of concern to policyholders and insurance agents. In January 2003, the Best ratings of our insurance subsidiaries were affirmed. Additionally, the outlook for Central Reserve was upgraded to stable. However, Continental General's negative rating outlook remains unchanged due to the need to strengthen Continental General's capital. Central Reserve's rating is a B (fair) rating. Continental General's ratings is B+ (very good). Provident American Life's and United Benefit Life's ratings for 2001 were affirmed NR-3 (rating procedure inapplicable). This rating is defined by 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 retain only a small portion of their gross premiums. In December 2002, Fitch maintained Continental General's BBB (good credit quality) financial strength rating with "rating watch evolving" and placed Central Reserve's BB (speculative credit quality) financial strength rating on "rating watch positive." In light of the recent statutory capitalization and strengthened balance sheet from the sale of Pyramid Life, we are hopeful that the major rating agencies will give favorable consideration to our financial ratings in 2003. 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 changing 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 examination was performed by the State of Nebraska as of December 31, 2001. State insurance departments have also periodically conducted market conduct examinations of our insurance subsidiaries. Although many states' insurance laws and regulations are based on models developed by the 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 state, and variation from the model laws within the state is common. The National Association of Insurance Commissioners revised the Accounting Practices and Procedures Manual in a process referred to as Codification. The revised manual was effective January 1, 2001. The 13 domiciliary states of Ceres and its insurance subsidiaries have adopted the provisions of the revised manual. The revised manual has changed, to some extent, prescribed statutory accounting practices and has resulted in changes to the accounting practices that our insurance subsidiaries use to prepare their statutory-basis financial statements. The impact of these changes to statutory-basis capital and surplus of the insurance subsidiaries was not significant. 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. - The "Company Action Level" is triggered if a company's total adjusted capital is less than 200% but greater than or equal to 150% of its risk-based capital. At the "Company Action Level," a company must submit a comprehensive plan to the regulatory authority that discusses proposed corrective actions to improve its capital position. A company whose total adjusted capital is between 250% and 200% of its risk-based capital is subject to a trend test. The trend test calculates the greater of any decrease in the margin (i.e., the amount in dollars by which a company's adjusted capital exceeds its risk-based capital) between the current year and the prior year and between the current year and the average of the past three years, and assumes that the decrease could occur again in the coming year. If a similar decrease in margin in the coming year would result in a risk-based capital ratio of less than 190%, then "Company Action Level" regulatory action would be triggered. - The "Regulatory Action Level" is triggered if a company's total adjusted capital is less than 150% but greater than or equal to 100% of its risk-based capital. At the "Regulatory Action Level," the regulatory authority will perform a special examination of the company and issue an order specifying corrective actions that must be followed. - The "Authorized Control Level" is triggered if a company's total adjusted capital is less than 100% but greater than or equal to 70% of its risk-based capital, at which level the regulatory authority may take any action it deems necessary, including placing the company under regulatory control. - The "Mandatory Control Level" is triggered if a company's total adjusted capital is less than 70% of its risk-based capital, at which level the regulatory authority is mandated to place the company under its control. We calculated the risk-based capital for our insurance subsidiaries as of December 31, 2002, using the applicable RBC formula. Based on these calculations, our risk-based capital levels for each of our subsidiaries, except Continental General, exceeded the levels required by regulatory authorities. Continental General's statutory capital level was below "Company Action Level" at December 31, 2002. However, after the addition of the statutory capital generated from the sale of Pyramid Life, Continental General's risk-based capital level will exceed 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 2003, none of our 14 insurance subsidiaries can pay a dividend to Ceres without prior approval of their respective state regulators as a result of their respective statutory levels of unassigned surplus. 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 my 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. Government regulation of the healthcare industry also affects the manner in which we conduct our business. HIPAA mandates 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. Ensuring privacy and security of patient information -- "accountability" -- is one of the key factors driving the legislation. The other factor -- "portability" -- refers to Congress' intention to ensure that individuals may transfer insurability and waiting periods for coverage if they change employers. Among other things, HIPAA: - addresses group and individual market reforms increasing the transferability of health insurance; - permits medical savings accounts on a trial basis; and - increases the deductibility of health insurance for self-employed persons. Compliance with HIPAA's simplification mandate is required within the next two to three years. We must comply with the following: - standards for electronic transmission and medical procedure code sets; - national standard healthcare provider identifier; and - national standard employer identifier. We have recently developed an electronic data interface (EDI) system with one of our network providers to expedite our claims processing. Using the EDI system, claims handled through the system for many of our insureds will be sent directly from the medical providers to our network provider, who will image and automatically adjust the claims to network rates. These re-priced claims will then be electronically transmitted to our administrative facilities for processing and payment according to policy benefits. HIPAA's privacy requirements will govern who within our organization can receive protected information, the manner in which it will be maintained, the responsibility of third parties with whom we contract, and appropriate identification at time of receipt of protected information so that it may be appropriately controlled, maintained and retrieved as required. The new standards: - limit the routine and non-routine non-consensual use and release of private health information; - give patients new rights to access their medical records and to know who else has accessed them; - limit most disclosure of health information to the minimum needed for the intended purpose; 15 - establish procedures to ensure the protection of private health information; - establish new criminal and civil sanctions for improper use or disclosure; and - establish new requirements for access to records by researchers and others. Final privacy rules adopted in 2001 require changes in the way health information is handled. The privacy regulations require most covered entities to be in compliance by April 2003. Final regulations regarding the standard formats for the transmission of health care information have also been released and require compliance by October 2003. We have implemented, and continue to implement, new procedures to comply with the privacy regulations and continue to take action to comply with the standardization regulations. The regulations will have the effect of increasing our expenses. In recent years, we also have implemented procedures to comply with the privacy standards for personal information by the Gramm-Leach-Bliley Act. We implemented procedures to comply with U.S. Department of Labor regulations that revise claims procedures for employee benefit plans governed by ERISA. The regulations became effective for claims filed on or after July 1, 2002 and govern the time frame for making benefit decisions for claims and appeals and for notification of claimants' rights under the regulations. In addition to federal regulation, many states have enacted, or are considering, various healthcare reform statutes. These reforms relate to, among other things, managed care practices, such as requirements with respect to maternity stays, waiting period restrictions on pre-existing conditions, credit for certain prior coverage, limitations on rate increases and guaranteed renewability for small business plans and policies for individuals and limitations on association business. Most states have also enacted patient confidentiality laws that prohibit the disclosure of confidential medical information. The federal privacy rule will establish minimum standards and preempt conflicting state laws that are less restrictive than HIPAA regarding health information privacy but will allow state laws that are more restrictive than HIPAA. These laws or regulations may limit our operations and our ability to control which providers are part of our networks and may 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. Some 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 function 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 physicians, hospitals and other providers. As of December 31, 2002, our largest network, First Health Group Corporation, accounted for 31.6% of our PPO certificates and policies in force. 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 us, 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. Congress and various states are considering some form of the "Patients' Bill of Rights." This legislation, if enacted, is designed to provide consumers more freedom of choice in the selection of doctors, facilities, and treatments. Although the bill was originally conceived to regulate HMOs, it will affect all facets of the nation's 16 healthcare delivery system, including medical providers, PPOs, exclusive provider organizations, community-based healthcare organizations and indemnity insurance plans. These changes, if enacted, 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 members. 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 846 employees at December 31, 2002. We consider our employee relations to be good. Our approximately 36,000 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, Strongsville, 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. ITEM 2. PROPERTIES OWNED PROPERTIES (OFFICE SPACE)
LOCATION SEGMENT SQUARE FOOTAGE - -------- ------- -------------- Omaha, Nebraska..................... Continental General -- major 61,400 square feet medical Mission, Kansas..................... Continental General -- senior(1) 45,000 square feet
- --------------- (1) Immediately prior to the closing of the Pyramid Life sale, Continental General acquired Pyramid Life's building in Kansas. See Note F. Discontinued Operations and Subsequent Event for further information. LEASED PROPERTIES (OFFICE SPACE)
LOCATION SEGMENT SQUARE FOOTAGE - -------- ------- -------------- Strongsville, Ohio.................. Corporate headquarters and Central 121,625 square feet Reserve -- major medical Strongsville, Ohio.................. Additional space 19,484 square feet Chicago, Illinois................... Sales office 3,605 square feet Dallas, Texas....................... Sales office 4,365 square feet
ITEM 3. LEGAL PROCEEDINGS We are involved in various legal and regulatory actions occurring in the normal course of business. Based on current information, we believe any ultimate liability that may arise from these actions would not 17 materially affect our consolidated financial position or results of operations. However, our evaluation of the likely impact of these actions could change in the future and an unfavorable outcome could have a material adverse effect on our consolidated financial position, results of operations or cash flow of a future period. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 18 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Our common stock has traded on the Nasdaq National Market under the symbol CERG since December 1998 and under the symbol CRLC before that date. 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 25, 2003, our common stock closed at $1.73 per share.
HIGH LOW ----- ----- 2002 First Quarter.......................................... $4.69 $3.55 Second Quarter......................................... 5.45 3.61 Third Quarter.......................................... 4.10 1.93 Fourth Quarter......................................... 2.05 1.01 2001 First Quarter.......................................... $6.88 $5.44 Second Quarter......................................... 5.45 4.70 Third Quarter.......................................... 5.44 2.90 Fourth Quarter......................................... 3.75 2.90
As of March 25, 2003, we had 2,125 record holders. 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 with the JPMorgan Chase, dated February 17, 1999, as amended, contains financial and other covenants that, among other matters, prohibit the payment of cash dividends on our common stock. For more information on our credit agreement with Chase, 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 2002, none of our direct insurance subsidiaries (Central Reserve Life and Continental General) could pay a dividend to Ceres without the prior approval of their respective state insurance regulators as a result of their respective statutory levels of unassigned surplus at December 31, 2002. In 2003, none of our direct subsidiaries can pay a dividend without the prior approval of their respective state insurance regulators as a result of their respective statutory levels of unassigned surplus at December 31, 2002. 19 ITEM 6. SELECTED FINANCIAL DATA The selected consolidated financial data presented below as of and for each of the five years ended December 31, 2002, 2001, 2000, 1999, and 1998 have been derived from our audited consolidated financial statements. However, prior years 2001 and 2000 have been reclassed to reflect the sale of Pyramid Life. See Note F. Discontinued Operations and Subsequent Event for further information. The acquisitions of Provident American Life and Continental General occurred on December 31, 1998 and February 17, 1999, respectively. These acquisitions had no impact on our results of operations in 1998. Results for United Benefit Life are included from August 1, 1998 to July 20, 1999 under a reinsurance agreement and thereafter as an acquired entity. The financial information for the year ended December 31, 1999 includes the operations of Continental General since February 1, 1999 and for Provident American Life and United Benefit Life (through reinsurance) for the entire period. The financial information for the years ended December 31, 2000, 2001, and 2002 includes the operations of all our subsidiaries for the entire year except for Pyramid Life (acquired in July 2000), which is presented separately as discontinued operations, as previously noted. This data should be read in conjunction with the more detailed information contained in the 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.
FOR THE YEARS ENDED DECEMBER 31, ---------------------------------------------------- 2002 2001 2000 1999 1998 -------- -------- -------- -------- -------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Premiums (net of reinsurance)........... $540,136 $555,522 $482,382 $327,746 $154,188 Net investment income................... 24,258 25,287 24,171 21,362 7,454 Net realized gains (losses)............. 2,262 2,265 (128) 107 211 Fee and other income.................... 30,705 36,155 32,590 17,410 7,694 Amortization of deferred reinsurance gain.................................. 2,843 4,958 6,093 5,468 600 -------- -------- -------- -------- -------- Total revenues..................... $600,204 $624,187 $545,108 $372,093 $170,147 ======== ======== ======== ======== ======== INCOME (LOSS) FROM CONTINUING OPERATIONS............................ $ 2,117 $ (5,529) $ 13,097 $ 11,704 $ (3,836) -------- -------- -------- -------- -------- Discontinued operations(1) Income from operations of Pyramid Life (less tax expense of $3,877, $4,513, and $1,804, respectively)...................... 7,109 7,861 3,353 -- -- Loss on sale of Pyramid Life (less tax benefit of $683)................... (11,627) -- -- -- -- -------- -------- -------- -------- -------- INCOME (LOSS) FROM DISCONTINUED OPERATIONS............................ (4,518) 7,861 3,353 -- -- -------- -------- -------- -------- -------- NET INCOME (LOSS)....................... (2,401) 2,332 16,450 11,704 (3,836) Gain on repurchase of the convertible voting preferred stock, net of dividends............................. -- 2,827 (327) -- -- -------- -------- -------- -------- -------- NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCKHOLDERS.......................... $ (2,401) $ 5,159 $ 16,123 $ 11,704 $ (3,836) ======== ======== ======== ======== ======== BASIC EARNINGS (LOSS) PER SHARE: Continuing operations................. $ 0.06 $ (0.15) $ 0.84 $ 0.88 $ (0.49) Discontinued operations(1)............ (0.13) 0.44 0.22 -- -- -------- -------- -------- -------- -------- Net income (loss)..................... $ (0.07) $ 0.29 $ 1.06 $ 0.88 $ (0.49) ======== ======== ======== ======== ======== DILUTED EARNINGS (LOSS) PER SHARE(2): Continuing operations................. $ 0.06 $ (0.15) $ 0.80 $ 0.77 $ (0.49) Discontinued operations(1)............ (0.13) 0.44 0.20 -- -- -------- -------- -------- -------- -------- Net income (loss)..................... $ (0.07) $ 0.29 $ 1.00 $ 0.77 $ (0.49) ======== ======== ======== ======== ========
20
DECEMBER 31, ---------------------------------------------------- 2002 2001 2000 1999 1998 -------- -------- -------- -------- -------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Investments............................. $397,103 $385,915 $338,019 $309,952 $ 89,826 Reinsurance receivable.................. 170,075 217,360 233,471 263,289 41,417 Assets of Pyramid Life(1)............... 157,774 151,168 136,587 -- -- Total assets............................ 887,481 947,666 880,918 717,868 180,233 Future policy benefits and claims payable............................... 512,003 566,608 545,339 538,732 97,113 Debt.................................... 25,003 31,000 57,018 48,157 8,284 Liabilities of Pyramid Life(1).......... 102,457 93,757 86,568 -- -- Retained earnings (accumulated deficit).............................. 21,430 23,831 18,672 2,549 (9,155) Stockholders' equity(3)................. 167,524 156,575 103,283 44,661 35,836 Equity per share: After accumulated other comprehensive income(4).......................... 4.89 4.62 5.52 3.26 3.12 Before accumulated other comprehensive income(4).......................... 4.51 4.61 5.88 4.59 3.02
- --------------- (1) On December 20, 2002, we entered into a definitive agreement to sell the stock of our subsidiary, Pyramid Life, to a subsidiary of Universal American Financial Corp. The transaction closed on March 31, 2003 for a purchase price of approximately $57.5 million in cash, subject to further adjustment based on Pyramid Life's final statutory capital and surplus as of March 31, 2003. See Note F. Discontinued Operations and Subsequent Event to our consolidated financial statements for further information. (2) The exercise of options and warrants is not assumed when a loss from operations is reported and the result would be antidilutive. (3) We received proceeds from a December 2001 public offering and private placement offerings in 2000, 1999 and 1998. For more information, see Note B. Equity Transactions to our consolidated financial statements. (4) "Accumulated other comprehensive income" relates primarily to the net unrealized gain (loss) on available-for-sale securities. 21 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion should be read in conjunction with the 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 to approximately 358,000 insureds through two primary business segments. The senior segment includes senior health, life and annuity products for Americans age 55 and over. The major medical segment includes major medical health insurance for individuals, families, associations and small businesses. Ceres' insurance subsidiaries include Central Reserve Life Insurance Company, Provident American Life & Health Insurance Company, United Benefit Life Insurance Company and Continental General Insurance Company. Central Reserve markets and sells major medical health insurance to individuals, families, associations and small employer groups. Continental General markets and sells both major medical and senior health and life products to individuals, families, associations and Americans age 55 and over. United Benefit Life discontinued new sales activities in July 2000 and terminated all of its existing business at the end of 2001. United Benefit Life has no active policyholders and its business was substantially wound down at December 31, 2002. Provident American Life also has discontinued new sales activities and currently has approximately 3,000 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, subject to further adjustment based on Pyramid Life's statutory capital and surplus at March 31, 2003. For more information on the Pyramid Life sale, see "Recent Events." 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 financial statements. 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 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 paid. 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, 22 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% of the total liabilities for other policy claims and benefits payable recorded at the end of a period. Note L. Liabilities for Other Policy Claims and Benefits Payable to our audited consolidated financial statements for the years ended December 31, 2002, 2001 and 2000 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 unfavorable claims experience in recent periods when it established its liabilities for unpaid claims at December 31, 2002. Management believes that the recorded liabilities for unpaid claims at December 31, 2002 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, 2002. 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 all expenses directly related to the acquisition of the policy, including commissions, underwriting and other policy issue expenses. 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 and 2001, we wrote off $4.2 million and $6.7 million, respectively, of deferred acquisition costs associated with major medical business in certain states due to the continuing unprofitability of the business in that state or in which we terminated the in force policies due to continued operating losses. Management and our independent outside consultants believe the amount of deferred acquisition costs as of December 31, 2002 is recoverable. OTHER ACCOUNTING POLICIES AND INSURANCE BUSINESS FACTORS Our results of operations are effected 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, 2002, goodwill was $10.7 million and represented approximately 1.2% 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 23 with a related contract asset or liability. At December 31, 2002, our other intangible assets consisted of $3.6 million in licenses, or 0.4% of our total assets. Effective January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets issued by the Financial Accounting Standards Board, or 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, together with our independent consultants, 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 and analysis prepared by independent consultants indicated that no reduction of goodwill and licenses was required. 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. Amounts received from interest sensitive contracts, principally universal life and annuity products, 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 unamoritized 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 six months after 24 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. 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. New government initiatives have raised public awareness of the escalating costs of healthcare, which we believe boosts new sales and promotes renewal payments. 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 anti-selection 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. 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 of occurrence 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 flow of a future period. INSURANCE. We use a combination of insurance and self-insurance for a number of 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 25 liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends. Over the past couple of years, 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 2003, although at additional premium cost and with increased exposure to losses. Other policies are up for renewal in mid-2003. We may not be successful in obtaining coverage on terms favorable to us or at all. RESULTS OF OPERATIONS We have three reportable segments: - medical -- includes catastrophic and comprehensive major medical plans; - senior and other -- includes Medicare supplement, long-term care, dental, life insurance and annuities; and - corporate and other -- includes primarily interest income, interest expense and corporate expenses of the holding company. All of our acquisitions were accounted for using the purchase method of accounting. The acquisitions of Provident American Life and Continental General had no impact on our results of operations in 1998. Results for United Benefit Life are included from August 1, 1998 to July 20, 1999 under a reinsurance agreement and thereafter as an acquired entity. The financial information for the year ended December 31, 1999 includes the operations of Continental General since February 1, 1999 and of Provident American Life for the entire year. The financial information for the years ended December 31, 2002 and 2001 include the operation of all our subsidiaries for the entire period with the exception of Pyramid Life. Consistent with Statement of Financial Accounting Standards, or SFAS, No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, Pyramid Life was classified as held for sale as of December 31, 2002, and was measured at its fair value less cost to sell. Therefore, the financial information for the years ended December 31, 2002, 2001 and 2000 excludes the operations of Pyramid Life for all periods presented and the $11.6 million net charge in the fourth quarter of 2002 related to the sale (each except where specifically noted). Financial data for 2001 and 2000 has been reclassified to reflect the sale of Pyramid Life. The net assets, results of operations, and cash flows of Pyramid Life have been reported separately as discontinued operations of a subsidiary in our consolidated financial statements for all periods presented. See Note F. Discontinued Operations and Subsequent Event to our consolidated financial statements for further information. RECENT EVENTS Effective March 31, 2003, we sold our subsidiary, Pyramid Life Insurance Company, to Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash, subject to further adjustment based on Pyramid Life's statutory capital and surplus as of March 31, 2003. Net proceeds of the sale were used as follows: (1) $10.0 million to repay a portion of our bank debt, and (2) the remainder to strengthen the statutory capital of Continental General. Immediately prior to the closing of the sale, Continental General acquired Pyramid Life's Kansas City building and personal property and retained most of its employees. Continental General will continue to administer its senior health business out of the Kansas City location, as well as continue to administer Pyramid Life's business during a six to 18 month transition period. Immediately prior to the closing, Continental General also reinsured a small block of certain life insurance policies of Pyramid Life. After the transaction, Continental General has approximately $55.0 million in statutory capital and surplus with a risk based capital ratio in excess of 350%, an increase of approximately $21.0 million from December 31, 2002. In addition, after the transaction, we have $13.7 million in outstanding bank debt compared to $25.0 million at year end. At December 31, 2002, Pyramid Life had assets of $157.8 million, net premiums of $98.0 million, net revenues of $104.8 million and net income from operations of $7.1 million. 26 2002 COMPARED TO 2001
INCREASE (DECREASE) % OF % OF FROM PREVIOUS YEAR CONSOLIDATED CONSOLIDATED ------------------- 2002 REVENUES 2001 REVENUES DOLLARS % -------- ------------ -------- ------------ --------- ------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Premiums, net Medical...................... $370,029 61.7% $402,214 64.4% $(32,185) (8.0)% Senior and other............. 170,107 28.3 153,308 24.6 16,799 11.0 -------- ----- -------- ----- -------- Total................... 540,136 90.0 555,522 89.0 (15,386) (2.8) Net investment income............. 24,258 4.0 25,287 4.0 (1,029) (4.1) Net realized gains................ 2,262 0.4 2,265 0.4 (3) (0.1) Fee and other income.............. 30,705 5.1 36,155 5.8 (5,450) (15.1) Amortization of deferred reinsurance gain................ 2,843 0.5 4,958 0.8 (2,115) (42.7) -------- ----- -------- ----- -------- Consolidated revenues... 600,204 100.0 624,187 100.0 (23,983) (3.8) -------- ----- -------- ----- -------- Benefits, claims, losses and settlement expenses Medical...................... 291,789 48.6 328,803 52.7 (37,014) (11.3) Senior and other............. 129,235 21.5 115,040 18.4 14,195 12.3 -------- ----- -------- ----- -------- Total................... 421,024 70.1 443,843 71.1 (22,819) (5.1) Selling, general and administrative expenses......... 175,232 29.2 197,008 31.6 (21,776) (11.1) Net (deferral) amortization and change in acquisition costs and value of business acquired...... (3,845) (0.6) (21,718) (3.4) 17,873 82.3 Amortization of goodwill.......... -- -- 672 0.1 (672) (100.0) Interest expense and financing costs........................... 2,001 0.3 4,679 0.7 (2,678) (57.2) Special charges................... 2,381 0.4 7,097 1.1 (4,716) (66.5) -------- ----- -------- ----- -------- 596,793 99.4 631,581 101.2 (34,788) (5.5) -------- ----- -------- ----- -------- Income (loss) from continuing operations before federal income taxes, minority interest, and preferred stock transactions.... 3,411 0.6 (7,394) (1.2) 10,805 146.1 Federal income tax expense (benefit)....................... 1,343 0.2 (1,810) (0.3) 3,153 174.2 -------- ----- -------- ----- -------- Income (loss) from continuing operations after tax, before minority interest and preferred stock transactions.............. 2,068 0.4 (5,584) (0.9) 7,652 137.0 Minority interest................. (49) -- (55) -- 6 10.9 -------- ----- -------- ----- -------- INCOME (LOSS) FROM CONTINUING OPERATIONS...................... 2,117 0.4 (5,529) (0.9) 7,646 138.3 -------- ----- -------- ----- -------- Discontinued operations: Income from operations of Pyramid Life, net of tax..... 7,109 1.1 7,861 1.3 (752) (9.6) Loss on sale of Pyramid Life, net of tax................... (11,627) (1.9) -- -- (11,627) N/M -------- ----- -------- ----- -------- INCOME (LOSS) FROM DISCONTINUED OPERATIONS...................... (4,518) (0.8) 7,861 1.3 (12,379) (157.5) -------- ----- -------- ----- -------- NET INCOME (LOSS)................. (2,401) (0.4) 2,332 0.4 (4,733) (203.0) Gain on repurchase of the convertible voting preferred stock, net of dividends......... -- -- 2,827 0.4 (2,827) (100.0) -------- ----- -------- ----- -------- NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCKHOLDERS............. $ (2,401) (0.4)% $ 5,159 0.8% $ (7,560) (146.5) ======== ===== ======== ===== ======== BASIC EARNINGS (LOSS) PER SHARE:.......................... $ (0.07) $ 0.29 $ (0.36) (124.1) DILUTED EARNINGS (LOSS) PER SHARE:.......................... $ (0.07) $ 0.29 $ (0.36) (124.1)
- --------------- N/M = not meaningful 27 NET PREMIUMS (NET OF REINSURANCE CEDED) For the year ended December 31, 2002, total net premiums were $540.1 million, a decrease of 2.8%, from $555.5 million for 2001. MEDICAL Medical premiums for 2002 were $370.0 million compared to $402.2 million for 2001, a decrease of 8.0%. The decrease in medical premiums was primarily the result of a 28% decrease in major medical certificates in force due to our decision in July 2001 to terminate or replace the policies at United Benefit Life and Provident American Life, to cancel other medical business in certain states and to target market in more profitable states, offset by the increase in new and renewal premiums averaging 20% to 30%. SENIOR AND OTHER Senior and other premiums were $170.1 million for 2002 compared to $153.3 million for 2001, an increase of 11.0%. The increase in senior and other premiums was primarily the result of premium rate increases averaging 10% to 12% on business in force. OTHER REVENUES Net investment income was $24.3 million for 2002 compared to $25.3 million for 2001, a decrease of 4.1%, due primarily to lower interest rates. Net realized gains were $2.3 million for 2002 and 2001. Realized gains were primarily a result of the sale of corporate bonds, which reduced the corporate bond sector. Cash was reinvested in agency backed planned amortization class mortgage securities, thirty year pass-throughs, and U.S. Government Agency bonds. Gains in 2002 were partially offset by the write-down for other-than-temporary impairment of $0.9 million on bonds held in WorldCom. Additionally, Pyramid Life had a $0.8 million write-down for other-than-temporary impairment on bonds held in WorldCom, which is reflected in discontinued operations. Fee and other income decreased to $30.7 million for 2002 compared to $36.2 million for 2001, a decrease of 15.1%. This decrease was primarily attributable to a smaller volume of business in force in the medical segment due to the United Benefit Life and Provident American Life termination or replacement program and the cancellation of other medical business in certain states. The amortization of deferred reinsurance gain of $2.8 million for 2002 represented the recognition of the ceding commission allowances received under our reinsurance agreements. The unamortized amount of $11.0 million at December 31, 2002 was accounted for as a deferred reinsurance gain on the consolidated balance sheet. The amortization of deferred reinsurance gain decreased from $5.0 million for 2001 as a result of lower amortization due to diminishing levels of in force certificates. BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES Total benefits, claims, losses and settlement expenses decreased to $421.0 million for 2002 compared to $443.8 million for 2001, a decrease of 5.1%. MEDICAL Medical benefits, claims, losses and settlement expenses were $291.8 million for 2002 compared to $328.8 million for 2001, a decrease of 11.3%. The decrease was primarily the result of a smaller volume of business in force due to the termination or replacement program, cancellation of other medical business as previously mentioned. The medical loss ratio was 78.9% for 2002 compared to 81.7% for 2001. The medical loss ratio decreased due to the termination or replacement program and the cancellation of business in poor performing markets, as well as, pricing increases and benefit changes to keep pace with medical inflation. However, the decrease was partially offset by a higher severity of claims than anticipated in the December 31, 2001 claim inventory. 28 SENIOR AND OTHER Senior and other benefits, claims, losses and settlement expenses were $129.2 million for 2002 compared to $115.0 million for 2001, an increase of 12.3%. The increase was a result of additional claims and benefits paid on a larger volume of business in force and reserve strengthening of $2.5 million on a block of long-term care business. The senior and other loss ratio increased to 76.0% for 2002 compared to 75.0% for 2001, primarily due to higher than anticipated long-term care benefits. OTHER EXPENSES AND NET INCOME Selling, general and administrative expenses decreased to $175.2 million in 2002 compared to $197.0 million in 2001, a decrease of 11.1%. Commissions decreased $19.9 million and other operating expenses decreased $19.4 million as a direct result of our cancelled or replaced business offset by reduced reinsurance allowances of $17.5 million resulting from a lower volume of ceded premiums. As a percentage of revenues, selling, general and administrative expenses have decreased to 29.2% in 2002 compared to 31.6% in 2001 due to a reduced workforce at our Cleveland facility, economies of scale achieved from the conversion of the senior business to our Kansas City facility, and a decrease in the overall commission rate. The net (deferral) amortization and change in acquisition costs (DAC) and value of business acquired (VOBA) resulted in a net deferral of $3.8 million for 2002 compared to a net deferral of $21.7 million for 2001. The decrease in the net deferral was primarily attributable to lower capitalization of DAC due to decreases in new business sales and a $1.3 million increase in the amortization of VOBA. The Company also wrote-off $4.2 million in DAC in 2002 compared to $6.7 million in 2001 due to the unprofitability of the major medical business in certain states. Interest expense and financing costs decreased to $2.0 million in 2002 compared to $4.7 million in 2001 as a result of a decrease in outstanding debt and declining interest rates. 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 P. Special Charges to our consolidated financial statements for further information. Special charges of $7.1 million in the first quarter of 2001 represented a $5.9 million write-off of the DAC asset for United Benefit Life and Provident American Life and a $1.2 million write-off of costs associated with United Benefit Life. The DAC asset was written off due to the planned termination of this business. Federal income tax expense was $1.3 million, or 39.4% of the income before federal taxes, for 2002. In 2001, a federal income tax benefit was established of $1.8 million, or 24.5% of the loss before federal taxes. The higher effective tax rate in 2002 was primarily due to changes in pre-tax income (loss) in relation to permanent differences. Specifically, the 50% elimination on meals and entertainment expenses and certain other non-deductible expenses. Income from continuing operations was $2.1 million, or $0.06 per share, for 2002 compared to a loss of $5.5 million, or $0.31 per share, for 2001. Income from the operations of Pyramid Life (classified as discontinued operations) was $7.1 million, or $0.21 per share, for 2002 compared to $7.9 million, or $0.44 per share, for 2001. Therefore, income including continuing and discontinued operations (excluding loss on sale of Pyramid Life) for 2002 was $9.2 million, or $0.27 per share, compared to $2.3 million, or $0.13 per share, for 2001. The loss on the sale of Pyramid Life recorded in the fourth quarter of 2002 was $11.6 million, or $0.34 per share. As a result of the foregoing, for 2002, net loss attributable to common stockholders was $2.4 million, or $0.07 basic and diluted loss per share of common stock, compared to net income attributable to common stockholders of $5.2 million, or $0.29 basic and diluted income per share of common stock, for 2001. 29 2001 COMPARED TO 2000
INCREASE (DECREASE) FROM % OF % OF PREVIOUS YEAR CONSOLIDATED CONSOLIDATED ----------------- 2001 REVENUES 2000 REVENUES DOLLARS % -------- ------------ -------- ------------ -------- ------ (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Premiums, net Medical.......................... $402,214 64.4% $372,816 68.4% $ 29,398 7.9% Senior and other................. 153,308 24.6 109,566 20.1 43,742 39.9 -------- ----- -------- ----- -------- Total.......................... 555,522 89.0 482,382 88.5 73,140 15.2 Net investment income................ 25,287 4.0 24,171 4.4 1,116 4.6 Net realized gains (losses).......... 2,265 0.4 (128) -- 2,393 N/M Fee and other income................. 36,155 5.8 32,590 6.0 3,565 10.9 Amortization of deferred reinsurance gain............................... 4,958 0.8 6,093 1.1 (1,135) (18.6) -------- ----- -------- ----- -------- Consolidated revenues.......... 624,187 100.0 545,108 100.0 79,079 14.5 -------- ----- -------- ----- -------- Benefits, claims, losses and settlement expenses Medical.......................... 328,803 52.7 286,387 52.5 42,416 14.8 Senior and other................. 115,040 18.4 84,174 15.5 30,866 36.7 -------- ----- -------- ----- -------- Total.......................... 443,843 71.1 370,561 68.0 73,282 19.8 Selling, general and administrative expenses........................... 197,008 31.6 176,434 32.3 20,574 11.7 Net (deferral) amortization and change in acquisition costs and value of business acquired......... (21,718) (3.4) (27,991) (5.1) 6,273 22.4 Amortization of goodwill............. 672 0.1 891 0.2 (219) (24.6) Interest expense and financing costs.............................. 4,679 0.7 5,566 1.0 (887) (15.9) Special charges...................... 7,097 1.1 -- -- 7,097 N/M -------- ----- -------- ----- -------- 631,581 101.2 525,461 96.4 106,120 20.2 -------- ----- -------- ----- -------- Income (loss) from continuing operations before federal income taxes, minority interest, and preferred stock transactions....... (7,394) (1.2) 19,647 3.6 (27,041) (137.6) Federal income tax expense (benefit).......................... (1,810) (0.3) 6,576 1.2 (8,386) (127.5) -------- ----- -------- ----- -------- Income (loss) from continuing operations after tax, before minority interest and preferred stock transactions................. (5,584) (0.9) 13,071 2.4 (18,655) (142.7) Minority interest.................... (55) -- (26) -- (29) (111.5) -------- ----- -------- ----- -------- INCOME (LOSS) FROM CONTINUING OPERATIONS......................... (5,529) (0.9) 13,097 2.4 (18,626) (142.2) -------- ----- -------- ----- -------- Discontinued operations: Income from operations of Pyramid Life, net of tax................. 7,861 1.3 3,353 0.6 4,508 134.4 -------- ----- -------- ----- -------- INCOME FROM DISCONTINUED OPERATIONS......................... 7,861 1.3 3,353 0.6 4,508 134.4 -------- ----- -------- ----- -------- NET INCOME........................... 2,332 0.4 16,450 3.0 (14,118) (85.8) Gain on repurchase of the convertible voting preferred stock, net of dividends.......................... 2,827 0.4 (327) -- 3,154 N/M -------- ----- -------- ----- -------- NET INCOME ATTRIBUTABLE TO COMMON STOCKHOLDERS....................... $ 5,159 0.8% $ 16,123 3.0% $(10,964) (68.0) ======== ===== ======== ===== ======== BASIC EARNINGS PER SHARE:............ $ 0.29 $ 1.06 $ (0.77) (72.6) DILUTED EARNINGS PER SHARE:.......... $ 0.29 $ 1.00 $ (0.71) (71.0)
- --------------- N/M = not meaningful 30 NET PREMIUMS (NET OF REINSURANCE CEDED) For the year ended December 31, 2001, total net premiums were $555.5 million, an increase of 15.2%, from $482.4 million for 2000. Medical premiums for 2001 were $402.2 million compared to $372.8 million for 2000, an increase of 7.9%. The increase in medical premiums was primarily the result of new sales, premium rate increases and reduced premiums ceded under reinsurance agreements. This increase was offset by our decision to terminate or replace the policies at United Benefit Life and Provident American Life and the cancellation of other medical business in certain states. Senior and other premiums were $153.3 million for 2001 compared to $109.6 million for 2000, an increase of 39.9%. The increase in senior and other premiums was primarily the result of increased Medicare supplement sales and premium rate increases. OTHER REVENUES Net investment income increased to $25.3 million for 2001 from $24.2 million for 2000, an increase of 4.6%, due primarily to a higher investment base. Net realized gains (losses) increased to $2.3 million for 2001 from a net realized loss of $0.1 million for 2000 as a result of the sale of 30-year mortgage pass-through securities which reduced prepayment risk, and the sale of callable agency bonds which reduced call risk. Portfolio durations were also shortened to reduce the impact on bond values in a potentially rising interest rate environment. Cash was reinvested in corporate bonds and planned amortization class non-agency mortgage securities, which provide average life protection in a fluctuating interest rate environment. These gains were marginally offset by the write-down for other than temporary impairment of $0.8 million recorded on the two commercial collateralized, mortgage-backed bonds with leasehold interests in the World Trade Center complex, most of which was destroyed by terrorists on September 11, 2001. No default has occurred on contractual payments for these securities. Fee and other income increased to $36.2 million for 2001 compared to $32.6 million for 2000, an increase of 10.9%. This net increase was attributable to new administrative fees introduced at Continental General in May 2000, fees received on a larger volume of business in force and partially offset by the United Benefit Life and Provident American Life termination or replacement program and the cancellation of other medical business in certain states. The amortization of deferred reinsurance gain of $5.0 million for 2001 represented the recognition of the ceding commission allowances received under our reinsurance agreements. The unamortized amount of $13.9 million at December 31, 2001 was accounted for as a deferred reinsurance gain on the consolidated balance sheet. BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES Total benefits, claims, losses and settlement expenses increased to $443.8 million for 2001 compared to $370.6 million for 2000, an increase of 19.8%. Medical benefits, claims, losses and settlement expenses were $328.8 million for 2001 compared to $286.4 million for 2000, an increase of 14.8%. The increase was a result of higher than anticipated benefit utilization in 2001 versus 2000 in the medical segment related to increased costs of services, greater utilization of medical services and greatly increased expenditures on prescription drugs, and a larger volume of business in force. Additionally, for these same reasons, a $17.0 million deficiency in 2000 reserves emerged in 2001. The medical loss ratio was 81.7% for 2001 compared to 76.8% for 2000. The increase was due to the above mentioned items. Senior and other benefits, claims, losses and settlement expenses were $115.0 million for 2001 compared to $84.2 million for 2000, an increase of 36.7%. The increase was a result of claims and benefits paid on a larger volume of business in force. The senior and other loss ratio decreased to 75.0% for 2001 compared to 76.8% for 2000, primarily attributable to increased volume of new premiums and lower benefit utilization. 31 OTHER EXPENSES AND NET INCOME Selling, general and administrative expenses increased to $197.0 million in 2001 compared to $176.4 million in 2000, an increase of 11.7%. The increase in selling, general and administrative expenses represented a $5.4 million decrease in commissions, a $5.5 million increase in other operating and reinsurance expenses attributable to our increased business base, and reduced reinsurance allowances of $20.5 million resulting from a lower volume of ceded premiums. As a percentage of revenues, selling, general and administrative expenses have decreased to 31.6% in 2001 compared to 32.3% in 2000. The net (deferral) amortization and change in acquisition costs (DAC) and value of business acquired (VOBA) resulted in a net deferral of $21.7 million for 2001 compared to a net deferral of $28.0 million for 2000. The decrease was primarily attributable to the write-off of DAC of approximately $6.7 million in six states due to the continuing unprofitability of the major medical business in those states. Interest expense and financing costs decreased to $4.7 million in 2001 compared to $5.6 million in 2000 as a result of lower interest rates and lower debt outstanding. Special charges of $7.1 million in the first quarter of 2001 represented a $5.9 million write-off of the DAC asset for United Benefit Life and Provident American Life and a $1.2 million write-off of costs associated with United Benefit Life. See Note P. Special Charges to our consolidated financial statements for further information. The DAC asset was written off due to the planned termination of the business. A federal income tax benefit of $1.8 million, or 24.5% of the loss before federal taxes, was established for 2001. The 2000 effective rate was 33.5%. The decrease in the effective tax rate resulted from changes in pre-tax income (loss) in relation to permanent differences. Specifically, the 50% elimination on meals and entertainment expenses and certain other non-deductible expenses. As a result of the foregoing, for 2001, net income was $2.3 million and net income attributable to common stockholders was $5.2 million, or $0.29 basic and diluted earnings per share of common stock, compared to net income of $16.5 million and net income attributable to common stockholders was $16.1 million, or $1.06 basic and $1.00 diluted earnings per share of common stock, for 2000. Excluding the United Benefit Life and Provident American Life operating losses and special charges, net income attributable to common stockholders would have been $17.9 million, or $1.00 per diluted share, for 2001. LIQUIDITY AND CAPITAL RESOURCES Liquidity is our ability to generate adequate amounts of cash to meet our financial commitments. Our major needs for cash are to enable our insurance subsidiaries to pay claims and expenses as they come due and for Ceres to pay interest on, and to repay principal of, its indebtedness. The primary sources of cash are premiums, investment income, fee income, equity and debt financings, and reimbursements from reinsurers. Payments consist of current claim payments to insureds, medical cost management expenses, operating expenses such as salaries, employee benefits, commissions, taxes and interest on debts. Net cash used in operating activities in 2002 was $17.6 million due primarily to the funding of a $17.3 million reinsurance trust established at December 31, 2001 and a significant reduction in the major medical claim inventory during 2002. Assets decreased 6.4% to $887.5 million (including $157.8 million for Pyramid Life) at December 31, 2002 from $947.7 million at December 31, 2001. Assets of $397.1 million, or 44.7% of the total assets, were in investments at December 31, 2002. Fixed maturities, our primary investment, were $388.1 million, or 97.7% of total investments, at December 31, 2002. Other investments consist of surplus notes, policy loans and mortgage loans. We have classified all of our fixed maturities as "available-for-sale" and accordingly have reported them at estimated fair value at December 31, 2002. Approximately 94.0% of our bonds were of investment grade quality at December 31, 2002. In addition to the fixed maturities, we also had $32.1 million in cash and cash equivalents of which, $7.7 million was restricted at December 31, 2002. 32 The total reinsurance receivable was $170.1 million at December 31, 2002. Of this amount, $153.9 million represents reserves held by our reinsurers under our various reinsurance treaties in place. Hannover holds most of these reserves. Additionally, total reinsurance receivable includes a $7.1 million receivable for investments held in trust under a commuted reinsurance agreement. The total policy liabilities and benefits accrued were 71.1% of the total liabilities at December 31, 2002 compared to 71.6% at December 31, 2001. CREDIT AGREEMENT. To provide funds for the acquisition of Continental General, on February 17, 1999, we entered into a credit agreement among Ceres, various lending institutions, and JPMorgan Chase (formerly the Chase Manhattan Bank) as Administrative Agent. Under the agreement, we borrowed $40.0 million under a tranche A term loan and secured a $10.0 million revolver. The credit agreement was amended on July 25, 2000 to increase the revolver from $10.0 million to $15.0 million in connection with the acquisition of Pyramid Life. Any amount outstanding on the revolver had to be repaid on February 17, 2002. The revolver bore interest at the same rate choices as the tranche A term loan. On February 17, 2002, the balance of the revolver was permanently repaid from proceeds of our December 2001 public offering. On March 30, 2001, this credit agreement was amended to enter into a new $10.0 million term loan with CIT Equipment Financing, Inc. The proceeds of this term loan, the tranche B term loan, were used to permanently pay down $10.0 million of our then fully-drawn $15.0 million revolver agreement. The terms of this amendment provide for CIT Group to participate equally with the syndicate of banks and Chase under the credit agreement. Interest on the outstanding balance of the term loans is determined based on our selection each quarter of either a Base Rate Loan or a Eurodollar Loan. Under the Base Rate Loan, the interest rate will be 2.5% per annum plus the higher of (a) the rate which is 0.50% of 1.0% in excess of a federal funds rate or (b) Chase's prime rate as in effect from time to time. Under the Eurodollar Loan, the interest rate will be 3.5% per annum plus a Eurodollar rate, which is the arithmetic average of the offered quotation to first-class banks in the interbank Eurodollar market by Chase, adjusted for certain reserve requirements. The interest rate of the tranche B term loan is 0.5% per annum higher than the above rates. At December 31, 2002, the interest rate on our tranche A term loan balance of $16.0 million was 4.9% per annum and our $9.0 million CIT tranche B term loan was 5.4% per annum. The credit agreement, as amended, contains financial and other covenants that among other things: - prohibit the payment of cash dividends on, or the repurchase of, shares of our common stock; - restrict the creation of liens and sales of assets; - requires us to repay the term loans with 25% of the net cash proceeds from any future sale or issuance of our equity, excluding warrants and compensation awards or plans; and - require that we, at a minimum, maintain: - a leverage ratio (consolidated debt to consolidated total capital) of 0.30 to 1.00; - an interest coverage ratio (consolidated earnings before interest, income taxes, depreciation, and amortization to consolidated interest expense) of 3.00 to 1.00; - a risk-based capital (RBC) ratio at year end for any of our regulated insurance company subsidiaries of not less than 125.0% of the RBC Company Action level; - consolidated net worth, excluding goodwill, of no less than the sum of (i) $85.0 million plus (ii) 80% of the net proceeds from the equity offering excluding the $5.0 million repurchase of our convertible voting preferred stock plus (iii) 50% of our aggregate consolidated net income calculated quarterly; and - a fixed charge coverage ratio of not less than 1.05 to 1.00 through June 30, 2003, and 1.10 to 1.00 thereafter. 33 Effective March 31, 2003, the credit agreement was amended in connection with the sale of Pyramid Life. The amendment: - permits the sale of Pyramid Life; - requires $10.0 million of sale proceeds to be used as a partial pay down of bank debt; - waives the minimum risk-based capital ratio requirement of 125% for Continental General at December 31, 2002; - excludes intercompany tax sharing payments in the calculation of the fixed charge coverage ratio at December 31, 2002; - increases the interest rate on the tranche A and tranche B term loans for the Base Rate Loans to Base Rate plus 3.0% and 3.5%, respectively and for the Eurodollar Loans to LIBOR plus 4.0% and 4.5%, respectively; - restructured the tranche A term loan debt payments as follows: quarterly principal payments of $547,000 through November 17, 2003, $509,000 through November 17, 2004, and a payment of approximately $5,040,000 on February 17, 2005; and - restructured the tranche B term loan debt payments as follows: quarterly principal payments of $223,000 through December 17, 2003, $216,000 on March 17, 2004, $412,000 through December 17, 2004, $434,000 on March 17, 2005, and $820,000 through December 17, 2005. We do not have transactions or relationships with "special purpose" entities, and we do not have any off balance sheet financing other than normal operating leases. The following schedule summarizes current and future contractual obligations as of December 31, 2002:
PAYMENTS DUE BY YEAR ----------------------------------------------------- LESS THAN AFTER 5 CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR 1-3 YEARS 4-5 YEARS YEARS - ----------------------- ------- --------- --------- --------- ------- (IN THOUSANDS) Long-term debt............................... $25,003 $5,080 $18,723 $1,200 $ -- Operating leases............................. 29,697 3,197 5,084 4,028 17,388 ------- ------ ------- ------ ------- Total contractual obligations.............. $54,700 $8,277 $23,807 $5,228 $17,388 ======= ====== ======= ====== =======
The following schedule summarizes current and future contractual obligations as of December 31, 2002 after giving effect to the March 31, 2003 $10.0 million partial pay down of our long-term debt:
PAYMENTS DUE BY YEAR ----------------------------------------------------- LESS THAN AFTER 5 CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR 1-3 YEARS 4-5 YEARS YEARS - ----------------------- ------- --------- --------- --------- ------- (IN THOUSANDS) Long-term debt............................... $15,003 $3,580 $11,423 $ -- $ -- Operating leases............................. 29,697 3,197 5,084 4,028 17,388 ------- ------ ------- ------ ------- Total contractual obligations.............. $44,700 $6,777 $16,507 $4,028 $17,388 ======= ====== ======= ====== =======
In addition, the common stock of Central Reserve, Continental General, and most of our non-regulated subsidiaries are pledged as security for the credit agreement. At December 31, 2002, we were in compliance with our credit agreement, as amended or waived. We believe that cash flow from operating activities will be sufficient to meet the currently anticipated operating and capital expenditure requirements of our subsidiaries over the next 12 months. Funds to meet our debt obligations are generated from fee income from our non-regulated subsidiaries. Our ability to make scheduled payments of the principal and interest on our indebtedness depends on our future performance and the future performance of our non-regulated subsidiaries, which are subject to economic, financial, competitive and other factors beyond our control. Fee income is derived from fees charged primarily on our major 34 medical business. As that business declines, fee income declines. Dividends from our regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. In 2003, none of our insurance subsidiaries (Central Reserve and Continental General) can pay a dividend to Ceres Group, the parent company, without prior approval of their respective state regulators as a result of their respective statutory levels of unassigned surplus. If our non-regulated subsidiaries do not generate sufficient fee income to service all of our debt obligations, there may be a material adverse effect on our business, financial condition and results of operations, and a significant adverse effect on the market value of our common stock. In addition, if necessary, additional financing may not be available on terms favorable to us or at all. NET OPERATING LOSS CARRYFORWARD At December 31, 2002, we had a tax net operating loss, or NOL, carryforward of approximately $21.7 million for federal income tax purposes, which expires through 2015. 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 $21.7 million, is subject to certain restrictions, including an annual limitation of approximately $5.4 million. Losses incurred subsequent to this offering are available without annual limitation to offset future income. We determine a valuation allowance of our deferred tax asset based on an analysis of amounts recoverable in the statutory carryback period and available tax planning strategies. In assessing the valuation allowance established at December 31, 2002 and 2001, estimates were made as to the potential financial impact of recent NOLs and our financial condition. 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.
YEAR ENDED DECEMBER 31, ------------------------------ 2002 2001 2000 -------- -------- -------- (DOLLARS IN THOUSANDS) MEDICAL Revenues Net premiums........................................... $370,029 $402,214 $372,816 Investment income, realized gains (losses)............. 8,511 11,644 9,014 Other income........................................... 30,481 37,772 36,086 -------- -------- -------- 409,021 451,630 417,916 -------- -------- -------- Expenses Benefits and claims.................................... 291,789 328,803 286,387 Other operating expenses............................... 123,183 129,382 121,991 Special charges........................................ -- 7,097 -- -------- -------- -------- 414,972 465,282 408,378 -------- -------- -------- Segment profit (loss) before federal income taxes, minority interest and preferred stock transactions..... $ (5,951) $(13,652) $ 9,538 ======== ======== ========
35
YEAR ENDED DECEMBER 31, ------------------------------ 2002 2001 2000 -------- -------- -------- (DOLLARS IN THOUSANDS) SENIOR AND OTHER Revenues Net premiums........................................... $170,107 $153,308 $109,566 Investment income, realized gains (losses)............. 17,566 15,285 14,508 Other income........................................... 3,067 3,341 2,597 -------- -------- -------- 190,740 171,934 126,671 -------- -------- -------- Expenses Benefits and claims.................................... 129,235 115,040 84,174 Other operating expenses............................... 46,637 43,316 25,324 -------- -------- -------- 175,872 158,356 109,498 -------- -------- -------- Segment profit before federal income taxes, minority interest and preferred stock transactions.............. $ 14,868 $ 13,578 $ 17,173 ======== ======== ======== CORPORATE AND OTHER Revenues Investment income, realized gains (losses)............. $ 443 $ 623 $ 521 -------- -------- -------- Expenses Interest and financing expenses........................ 2,001 4,679 5,566 Other operating expenses............................... 1,567 3,264 2,019 Special charges........................................ 2,381 -- -- -------- -------- -------- 5,949 7,943 7,585 -------- -------- -------- Segment loss before federal income taxes, minority interest and preferred stock transactions.............. $ (5,506) $ (7,320) $ (7,064) ======== ======== ======== INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE FEDERAL INCOME TAXES, MINORITY INTEREST AND PREFERRED STOCK TRANSACTIONS.............................................. $ 3,411 $ (7,394) $ 19,647 ======== ======== ========
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. 36 In addition, insurance companies are subject to extensive federal and state regulation and compliance with these regulations could increase the insurance companies' operating costs. In some circumstances, failure to comply with certain insurance regulations could subject an insurance company to regulatory actions by such insurance company's state of domicile. For example, states have statutory risk-based capital, or RBC, requirements for health and other insurance companies based on the RBC Model Act. These RBC requirements are intended to assess the capital adequacy of life and health insurers, taking into account the risk characteristics of an issuer's investments and products. In general, under these laws, an insurance company must submit a report of its RBC level to the insurance department of its state of domicile as of the end of the previous calendar year. These laws provide for four different levels of regulatory attention depending on the ratio of an insurance company's total adjusted capital (defined as the total of its statutory capital, surplus and asset valuation reserve) to its risk-based capital. As of December 31, 2002, our risk-based capital levels for each of our insurance subsidiaries, except for Continental General, exceeded the levels required by regulatory authorities. Continental General's statutory capital level was below "Company Action Level" at December 31, 2002. However, after the addition of the capital generated from the sale of Pyramid Life, Continental General's risk-based capital level exceeded the levels required by regulatory authorities. Investment Impairment Risk is the risk that all amounts due (both principal and interest) on our fixed maturity investments will not be collected according to the security's contractual terms. We attempt to minimize this risk by adhering to a conservative investment strategy. With the exception of short-term investments and securities on deposit with various state regulators, investment responsibilities have been delegated to external investment managers within the investment parameters established by the company. Our external investment managers prepare a monthly investment surveillance list to analyze our fixed maturity portfolio for potential other-than-temporary impairment. The following factors are reviewed for inclusion on our surveillance list: - debt downgrades or other events that adversely affects an investee's access to, or cost of, financing; - negative economic factors and conditions specific to the issuers industry; - adverse changes in the regulatory environment specific to the issuers industry; - all spread changes exceeding 50 basis points; or - corporate bond prices that move more then 10% over the past week, 20% over the past month, or 30% over the past three months. All of our fixed maturity investments are reported at fair market value at December 31, 2002. The amortized cost and estimated fair value of fixed maturities on our investment surveillance list at December 31, 2002 were $10.1 million and $8.3 million, respectively. Credit Risk is the risk that parties, including reinsurers that have obligations to us, will not pay or perform. We attempt to minimize this risk by maintaining sound reinsurance and credit collection policies. Interest Rate Risk is the risk that interest rates will change and cause a decrease in the value of an insurer's investments. This change in rates may cause certain interest-sensitive products to become uncompetitive or may cause disintermediation if we attempt to mitigate this risk by charging fees for non-conformance with certain policy provisions and/or by attempting to match the maturity schedule of our assets with the expected payouts of its liabilities. To the extent that liabilities come due more quickly than assets mature, we would have to sell assets prior to maturity and recognize a gain or loss. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical decline in fair value of stockholders' equity is estimated to be $13.6 million after-tax at December 31, 2002. This amount represents approximately 8.1% of our stockholders' equity at such date. We also have long-term debt that bears interest at variable rates. Therefore, our results of operations would be affected by interest rate changes. We do not expect a significant rate change in the near future that would have a material effect on our near-term results of operations. 37 Seasonality is the risk of fluctuations of revenues and operating results. Historically, our revenues and operating results have varied from quarter to quarter and are expected to continue to fluctuate in the future. These fluctuations have been due to a number of factors, including higher benefit utilization by our insureds during the winter months and the use of deductibles. More specifically, our senior segment's seasonality is the opposite of our medical segment's, meaning that earnings in the senior segment are generally lower in the first quarter and higher later in the year. This is mainly a factor of our Medicare Supplement products that pay the Medicare deductible for our insureds generally during the early months of the year. IMPACT OF INFLATION Inflation rates impact our financial condition and operating results in several areas. Changes in inflation rates impact the market value of the investment portfolio and yields on new investments. Inflation has had an impact on claim costs and overall operating costs and although it has been lower in the last few years, hospital and medical costs have still increased at a higher rate than general inflation, especially prescription drug costs. New, more expensive and wider use of pharmaceuticals is inflating health care costs. We will continue to establish premium rates in accordance with trends in hospital and medical costs along with concentrating on various cost containment programs. However, there can be no assurance that these efforts by us will fully offset the impact of inflation or that premiums will equal or exceed increasing healthcare costs. FORWARD-LOOKING STATEMENTS This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are necessarily based on estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, us. In particular, forward-looking statements can be identified by the use of words such as "may," "will," "should," "expect," "anticipate," "estimate," "continue" or similar words. In light of the risks and uncertainties inherent in all future projections, the inclusion of forward-looking statements in this report should not be considered as a representation by us or any other person that our objectives or plans will be achieved. Numerous factors could cause our actual results to differ materially and adversely from those in the forward-looking statements, including those risks outlined above in "Market Risk and Management Policies," and the following: - unforeseen losses with respect to loss and settlement expense reserves for unreported and reported claims or adverse changes in persistency or profitability of insurance contracts that would accelerate the amortization of our deferred acquisition costs; - our ability to implement increases in premium rates and to develop, distribute and administer competitive products and services in a timely, cost-effective manner; - rising healthcare costs, especially the rising costs of prescription drug costs that are rising faster than other medical costs, and rising utilization rates; - developments in healthcare reform and other regulatory issues, including the Health Insurance Portability and Accountability Act of 1996 and increased privacy regulation, and changes in laws and regulations in key states in which we operate; - our ability to meet risk-based or statutory capital requirements and the outcome of our efforts to meet these capital requirements; - our ability to continue to meet the terms of our debt obligations under our credit agreement which contains a number of significant financial and other covenants; 38 - the adequacy of funds, including fee income, received from our non-regulated subsidiaries, and the restrictions on our insurance subsidiaries' ability to pay dividends to Ceres, to meet our debt obligations; - the performance of others on whom we rely for reinsurance, particularly Hannover Life Reassurance Company of America upon whom we have relied for substantially all of our reinsurance; - the risk of material adverse outcomes in litigation; - the risk of selling investments to meet liquidity requirements; - our ability to obtain additional debt or equity financing on terms favorable to us to facilitate our long-term growth; - the risk that issuers of securities owned by Ceres will default or that other parties will not pay or perform; - our financial and claims paying ratings, including any potential downgrades; - our ability to maintain our current PPO network arrangements; - dependence on senior management and key personnel; - the performance of others on whom we rely for administrative and operations services; - changes in accounting and reporting practices; - the failure to successfully manage our operations and integrate future acquisitions, if any, including the failure to achieve cost savings; - payments to state assessment funds; - business conditions and competition in the healthcare industry; - changes in tax laws; and - our ability to fully collect all agent advances. The factors listed above should not be constructed 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 June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which supercedes Emerging Issues Task Force, or EITF, Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring). The provisions of this Statement are effective for exit or disposal activities initiated after December 31, 2002. SFAS No. 146 requires recognition of a liability for costs associated with an exit or disposal activity when the liability is incurred, rather than when the entity commits to an exit plan under EITF Issue No. 94-3. This Statement applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a disposal activity covered by SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Additionally, this Statement does not apply to costs associated with the retirement of a long-lived asset covered by SFAS No. 143, Accounting for Asset Retirement Obligations. We anticipate that the adoption of this standard will not have a material effect on our results of operations, financial position or liquidity. In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. This Statement rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, SFAS No. 44, Accounting for Intangible Assets of Motor Carriers, and SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This Statement amends SFAS No. 13, Accounting for Leases, to eliminate an inconsistency between the 39 required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of SFAS No. 145, related to the rescission of SFAS No. 4, require any gain or loss on extinguishment of debt that was classified as an extraordinary item in prior periods presented that does not meet the criteria in APB Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for classification as an extraordinary item to be reclassified. The adoption of SFAS No. 145 on May 15, 2002 did not have a material effect on our results of operations, financial position or liquidity. In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations, which addressed financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This Statement is effective for financial statements issued for fiscal years beginning after June 15, 2002. The adoption of this standard on June 15, 2002 did not have a material effect on our results of operations, financial position or liquidity. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK See "Market Risk and Management Policies" section under Item 7. -- Management's Discussion and Analysis of Financial Condition and Results of Operations. 40 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CERES GROUP, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
PAGE ---- Report of Independent Auditors.............................. 42 CONSOLIDATED FINANCIAL STATEMENTS Consolidated Balance Sheets as of December 31, 2002 and 2001...................................................... 43 Consolidated Statements of Operations for the years ended December 31, 2002, 2001 and 2000.......................... 44 Consolidated Statements of Stockholders' Equity for the years ended December 31, 2002, 2001 and 2000.............. 45 Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001 and 2000.......................... 46 Notes to Consolidated Financial Statements for the years ended December 31, 2002, 2001 and 2000.................... 47 FINANCIAL STATEMENT SCHEDULES Schedule II -- Condensed Financial Information of Registrant - Ceres Group, Inc. (Parent Only)............................................. 81 Schedule III -- Supplemental Insurance Information.......... 84 Schedule IV -- Reinsurance.................................. 85
41 REPORT OF INDEPENDENT AUDITORS Stockholders and Board of Directors Ceres Group, Inc. We have audited the accompanying consolidated balance sheets of Ceres Group, Inc. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2002. We have also audited the information 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 audits. We conducted our audits in accordance with auditing standards generally accepted in the 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Ceres Group, Inc. and subsidiaries at December 31, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States. 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. As described in Notes A, F and J, 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, F, and O as to which the date is March 31, 2003 42 CERES GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2002 AND 2001 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
2002 2001 -------- -------- ASSETS Investments Fixed maturities available-for-sale, at fair value........ $388,057 $376,969 Surplus notes............................................. 5,151 5,211 Policy and mortgage loans................................. 3,895 3,735 -------- -------- Total investments -- Note D............................ 397,103 385,915 Cash and cash equivalents (of which $7,703 and $9,881 is restricted, respectively) -- Note D....................... 32,118 68,506 Accrued investment income................................... 5,236 5,809 Premiums receivable......................................... 4,810 4,986 Reinsurance receivable -- Note M............................ 170,075 217,360 Property and equipment, net -- Note E....................... 5,387 6,240 Assets of Pyramid Life -- Note F............................ 157,774 151,168 Deferred acquisition costs -- Note H........................ 74,891 68,934 Value of business acquired -- Note I........................ 16,084 17,910 Goodwill -- Note J.......................................... 10,657 14,243 Licenses -- Note J.......................................... 3,586 -- Other assets................................................ 9,760 6,595 -------- -------- TOTAL ASSETS......................................... $887,481 $947,666 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Policy liabilities and benefits accrued Future policy benefits, losses and claims................. $327,385 $342,757 Unearned premiums......................................... 36,680 37,068 Other policy claims and benefits payable -- Note L........ 147,938 186,783 -------- -------- 512,003 566,608 Deferred reinsurance gain -- Note M......................... 11,037 13,881 Other policyholders' funds.................................. 23,610 28,659 Debt -- Note O.............................................. 25,003 31,000 Liabilities of Pyramid Life -- Note F....................... 102,457 93,757 Deferred federal income taxes payable -- Note K............. 11,746 453 Other liabilities........................................... 34,101 56,733 -------- -------- TOTAL LIABILITIES...................................... 719,957 791,091 -------- -------- Stockholders' equity Non-voting preferred stock, $.001 par value, 1,900,000 shares authorized, none issued -- Note R............... -- -- Convertible voting preferred stock, $.001 par value, at stated value, 100,000 shares authorized, none issued - Notes B and R.......................................... -- -- Common stock, $.001 par value, 50,000,000 shares authorized, 34,232,610 and 33,857,895 shares issued and outstanding, respectively -- Note B.................... 34 34 Additional paid-in capital................................ 133,052 132,061 Retained earnings......................................... 21,430 23,831 Accumulated other comprehensive income.................... 13,008 649 -------- -------- TOTAL STOCKHOLDERS' EQUITY............................. 167,524 156,575 -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY........... $887,481 $947,666 ======== ========
The accompanying notes are an integral part of these consolidated financial statements. 43 CERES GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
2002 2001 2000 -------- -------- -------- REVENUES Premiums, net -- Note M Medical................................................... $370,029 $402,214 $372,816 Senior and other.......................................... 170,107 153,308 109,566 -------- -------- -------- Total premiums, net..................................... 540,136 555,522 482,382 Net investment income -- Note D............................. 24,258 25,287 24,171 Net realized gains (losses)................................. 2,262 2,265 (128) Fee and other income........................................ 30,705 36,155 32,590 Amortization of deferred reinsurance gain -- Note M......... 2,843 4,958 6,093 -------- -------- -------- 600,204 624,187 545,108 -------- -------- -------- BENEFITS, LOSSES AND EXPENSES Benefits, claims, losses and settlement expenses -- Note M Medical................................................... 291,789 328,803 286,387 Senior and other.......................................... 129,235 115,040 84,174 -------- -------- -------- Total benefits, claims, losses and settlement expenses.............................................. 421,024 443,843 370,561 Selling, general and administrative expenses -- Note M...... 175,232 197,008 176,434 Net (deferral) amortization and change in acquisition costs and value of business acquired -- Notes H and I........... (3,845) (21,718) (27,991) Amortization of goodwill.................................... -- 672 891 Interest expense and financing costs........................ 2,001 4,679 5,566 Special charges -- Note P................................... 2,381 7,097 -- -------- -------- -------- 596,793 631,581 525,461 -------- -------- -------- Income (loss) from continuing operations before federal income taxes, minority interest, and preferred stock transactions.............................................. 3,411 (7,394) 19,647 Federal income tax expense (benefit) -- Note K.............. 1,343 (1,810) 6,576 -------- -------- -------- Income (loss) from continuing operations after tax, before minority interest and preferred stock transactions........ 2,068 (5,584) 13,071 Minority interest........................................... (49) (55) (26) -------- -------- -------- INCOME (LOSS) FROM CONTINUING OPERATIONS.................... 2,117 (5,529) 13,097 -------- -------- -------- Discontinued operations -- Note F: Income from operations of Pyramid Life (less tax expense of $3,877, $4,513, and $1,804, respectively)............ 7,109 7,861 3,353 Loss on sale of Pyramid Life (less tax benefit of $683)... (11,627) -- -- -------- -------- -------- INCOME (LOSS) FROM DISCONTINUED OPERATIONS.................. (4,518) 7,861 3,353 -------- -------- -------- NET INCOME (LOSS)........................................... (2,401) 2,332 16,450 Gain on repurchase of the convertible voting preferred stock, net of dividends -- Notes B and R.................. -- 2,827 (327) -------- -------- -------- NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCKHOLDERS....... $ (2,401) $ 5,159 $ 16,123 ======== ======== ======== BASIC EARNINGS (LOSS) PER SHARE -- NOTE U: Continuing operations..................................... $ 0.06 $ (0.15) $ 0.84 Discontinued operations................................... (0.13) 0.44 0.22 -------- -------- -------- Net income (loss)......................................... $ (0.07) $ 0.29 $ 1.06 ======== ======== ======== DILUTED EARNINGS (LOSS) PER SHARE -- NOTE U: Continuing operations..................................... $ 0.06 $ (0.15) $ 0.80 Discontinued operations................................... (0.13) 0.44 0.20 -------- -------- -------- Net income (loss)......................................... $ (0.07) $ 0.29 $ 1.00 ======== ======== ========
The accompanying notes are an integral part of these consolidated financial statements. 44 CERES GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
2002 2001 2000 ---------- ---------- ---------- CONVERTIBLE VOTING PREFERRED STOCK Balance at beginning of year................................ $ -- $ 7,500 $ -- Issuance of stock........................................... -- -- 7,500 Dividends distributed....................................... -- 699 -- Repurchase of stock......................................... -- (8,199) -- ---------- ---------- ---------- Balance at end of year................................ $ -- $ -- $ 7,500 ========== ========== ========== COMMON STOCK Balance at beginning of year................................ $ 34 $ 17 $ 14 Issuance of common stock: Public equity offering.................................... -- 16 -- Employee benefit plans.................................... -- 1 3 ---------- ---------- ---------- Balance at end of year................................ $ 34 $ 34 $ 17 ========== ========== ========== ADDITIONAL PAID-IN CAPITAL Balance at beginning of year................................ $ 132,061 $ 82,943 $ 60,290 Issuance of stock: Public equity offering.................................... -- 46,495 -- Private placement......................................... -- -- 21,093 Employee benefit plans.................................... 991 2,623 1,560 ---------- ---------- ---------- Balance at end of year................................ $ 133,052 $ 132,061 $ 82,943 ========== ========== ========== DIVIDENDS DISTRIBUTABLE, CONVERTIBLE VOTING PREFERRED STOCK Balance at beginning of year................................ $ -- $ 327 $ -- Dividends distributable..................................... -- 774 327 Dividends distributed....................................... -- (699) -- Repurchase of stock......................................... -- (402) -- ---------- ---------- ---------- Balance at end of year................................ $ -- $ -- $ 327 ========== ========== ========== RETAINED EARNINGS Balance at beginning of year................................ $ 23,831 $ 18,672 $ 2,549 Net income (loss)........................................... (2,401) 2,332 16,450 Dividends distributable, convertible voting preferred stock..................................................... -- (774) (327) Repurchase of convertible voting preferred stock............ -- 3,601 -- ---------- ---------- ---------- Balance at end of year................................ $ 21,430 $ 23,831 $ 18,672 ========== ========== ========== ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) Balance at beginning of year................................ $ 649 $ (6,176) $ (18,192) Unrealized gain on securities, net of tax of $5,885, $37 and $0, respectively.......................................... 12,173 7,280 11,806 Other....................................................... 186 (455) 210 ---------- ---------- ---------- Balance at end of year................................ $ 13,008 $ 649 $ (6,176) ========== ========== ========== TOTAL STOCKHOLDERS' EQUITY.................................. $ 167,524 $ 156,575 $ 103,283 ========== ========== ========== NUMBER OF SHARES OF CONVERTIBLE VOTING PREFERRED STOCK Balance at beginning of year................................ -- 75,000 -- Issuance of stock........................................... -- -- 75,000 Dividends distributed....................................... -- 6,986 -- Repurchase of stock......................................... -- (81,986) -- ---------- ---------- ---------- Balance at end of year................................ -- -- 75,000 ========== ========== ========== NUMBER OF SHARES OF COMMON STOCK Balance at beginning of year................................ 33,857,895 17,278,704 13,706,726 Issuance of stock: Public equity offering.................................... -- 16,100,000 -- Private placement......................................... -- -- 3,333,334 Employee benefit plans.................................... 374,715 479,191 238,644 ---------- ---------- ---------- Balance at end of year................................ 34,232,610 33,857,895 17,278,704 ========== ========== ==========
The accompanying notes are an integral part of these consolidated financial statements. 45 CERES GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
2002 2001 2000 -------- -------- -------- OPERATING ACTIVITIES Net income (loss)......................................... $ (2,401) $ 2,332 $ 16,450 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Net income (loss) from discontinued operations........ 4,518 (7,861) (3,353) Depreciation and amortization......................... 3,391 3,335 2,280 Net realized (gains) losses........................... (2,262) (2,265) 128 Deferred federal income taxes......................... 6,613 741 1,348 Changes in assets and liabilities: Premiums receivable................................ 176 507 (588) Reinsurance receivable............................. 47,285 16,111 29,818 Value of business acquired......................... 1,826 559 (1,739) Goodwill and licenses.............................. -- 672 6,781 Federal income taxes payable/recoverable........... (1,587) (1,212) (810) Accrued investment income.......................... 573 (65) (510) Other assets....................................... (1,578) 915 495 Future policy benefits, claims and funds payable... (43,061) 23,295 17,760 Unearned premium................................... (388) 3,442 1,581 Other liabilities.................................. (22,196) 4,680 3,575 Deferred acquisition costs......................... (5,671) (16,409) (26,252) Deferred reinsurance gain.......................... (2,843) (4,958) (2,093) -------- -------- -------- Net cash provided by (used in) operating activities......... (17,605) 23,819 44,871 -------- -------- -------- INVESTING ACTIVITIES Net purchases of furniture and equipment.................. (317) (674) (1,750) Purchase of fixed maturities available-for-sale........... (179,873) (173,930) (43,664) Proceeds from sale of Cleveland headquarters.............. -- 15,586 -- Acquisition of Pyramid Life Insurance Company, net of $7,159 cash acquired.................................... -- -- (37,823) Decrease (increase) in mortgage and policy loans, net..... (160) (151) 339 Proceeds from sales of fixed maturities available-for-sale...................................... 129,594 94,219 11,569 Proceeds from calls and maturities of fixed maturities available-for-sale...................................... 53,184 40,329 12,663 Proceeds from sale of property held for sale.............. -- -- 2,115 -------- -------- -------- Net cash provided by (used in) investing activities......... 2,428 (24,621) (56,551) -------- -------- -------- FINANCING ACTIVITIES Increase in annuity account balances...................... 7,740 22,429 23,173 Decrease in annuity account balances...................... (23,945) (23,484) (34,026) Principal payments on mortgage note payable............... -- (8,018) (139) Increase in debt borrowings............................... -- 10,000 15,000 Principal payments on debt................................ (5,997) (28,000) (6,000) Proceeds from public equity offering...................... -- 46,511 -- Proceeds from issuance of common stock related to employee benefit plans........................................... 991 2,624 1,560 Proceeds from private placement of common stock, net of acquisition costs....................................... -- -- 21,096 Proceeds from private placement of convertible voting preferred stock......................................... -- -- 7,500 Repurchase of convertible voting preferred stock.......... -- (5,000) -- -------- -------- -------- Net cash provided by (used in) financing activities......... (21,211) 17,062 28,164 -------- -------- -------- NET INCREASE (DECREASE) IN CASH............................. (36,388) 16,260 16,484 Cash and cash equivalents acquired from Pyramid Life Insurance Company......................................... -- -- (7,159) Cash and cash equivalents at beginning of year.............. 68,506 52,246 42,921 -------- -------- -------- CASH AND CASH EQUIVALENTS AT END OF YEAR.................... $ 32,118 $ 68,506 $ 52,246 ======== ======== ======== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the year for interest.................... $ 1,985 $ 4,193 $ 6,051 Cash paid during the year for federal income taxes........ -- -- 1,100
The accompanying notes are an integral part of these consolidated financial statements. 46 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- A. SUMMARY OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES SUMMARY OF BUSINESS Ceres Group, Inc. operated in 1998 and prior periods primarily through its wholly-owned subsidiary, Central Reserve Life Insurance Company. As of December 31, 2002, 2001 and 2000, the Company's consolidated statements also include the continuing operations of Provident American Life & Health Insurance Company acquired on December 31, 1998, Continental General Corporation and its wholly-owned subsidiary, Continental General Insurance Company, acquired on February 17, 1999, and United Benefit Life Insurance Company under a reinsurance arrangement effective August 1, 1998 and acquired on July 21, 1999 (through foreclosure), and the discontinued operations of Pyramid Life Insurance Company acquired on July 26, 2000. On December 20, 2002, we entered into a definitive agreement to sell the stock of Pyramid Life. See Note F. Discontinued Operations and Subsequent Event for further information. As a result of the sale of Pyramid Life, our previously reported consolidated financial statements for 2001 and 2000 have been reclassified to present the discontinued operations of Pyramid Life separate from continuing operations to conform to the current year's presentation. We provide, through our insurance subsidiaries, a wide array of health and life insurance products to over 358,000 insureds. While we, through our subsidiaries, are licensed in 49 states, the District of Columbia and the U.S. Virgin Islands, approximately 61.3% of our total premium volume is generated from ten states: Ohio, Florida, Texas, Pennsylvania, Indiana, Georgia, Missouri, Illinois, Kansas and Nebraska. Unless the context indicates otherwise, "we," "our," and "us" refers to Ceres Group, Inc. and its subsidiaries on a consolidated basis. SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the continuing operations of Ceres and its wholly-owned subsidiaries, except for Pyramid Life, which is included in discontinued operations. All intercompany transactions have been eliminated in consolidation. The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States, which differ from accounting practices prescribed or permitted by the various state departments of insurance in which the insurance subsidiaries are domiciled. See Note S. Statutory Financial Information for further information. BUSINESS COMBINATIONS All of our acquisitions were accounted for using the purchase method of accounting. Additionally, since the issuance of Statement of Financial Accounting Standards, or SFAS, No. 141, Business Combinations, by the Financial Accounting Standards Board, or FASB, business combinations initiated after June 30, 2001, are required to be accounted for by the purchase method. Results of operations of the acquired business are included in the income statement from the date of acquisition. Additionally, SFAS No. 141 expanded the criteria for recording intangible assets separate from goodwill. The FASB staff also issued Emerging Issues Task Force, or EITF, D-100: Clarification of Paragraph 61(b) of FASB Statement No. 141 and Paragraph 49(b) of FASB No. 142, which further clarified what the FASB staff believed was the Board's intent for reclassifying an intangible asset out of goodwill of a previously acquired intangible asset. 47 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Accordingly, following the guidance of both SFAS No. 141 and EITF D-100 and in conjunction with our goodwill testing (see Goodwill and Other Intangible Assets below), we have reclassed licenses of $3.6 million as a separate indefinite-lived intangible asset from goodwill. GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill represents the excess of purchase price over the fair value of tangible and identifiable net assets acquired. Other intangible assets are defined as purchased assets that also lack physical substance but can be distinguished from goodwill because of contractual or 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. On January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets. Under the provisions of SFAS No. 142, goodwill is no longer ratably amortized into the income statement over an estimated life, but rather is tested at least annually for impairment. Intangible assets which have finite lives continue to be amortized over their estimated useful lives and also continue to be subject to impairment testing. Prior to the adoption of SFAS No. 142, goodwill was amortized on a straight-line basis over periods of 25 years or less. See Note J. Goodwill and Other Intangible Assets for a summary of our goodwill and other intangible assets, as well as further detail related to the impact of the adoption of SFAS No. 142. USE OF ESTIMATES The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS Cash and cash equivalents include cash and all liquid securities with maturities of 90 days or less when purchased. See Note D. Cash and Investments for further information. INVESTMENTS Investments in bonds and mandatorily redeemable preferred stocks are designated at purchase as held-to-maturity or available-for-sale. Held-to-maturity investments are securities which management has the positive intent and ability to hold until maturity, and are reported at amortized cost. Available-for-sale investments and surplus notes are stated at fair value, with unrealized holding gains and losses reported in accumulated other comprehensive income (loss), net of deferred federal income taxes. All investments as of December 31, 2002 are designated as available-for-sale. Investments in policy notes and mortgage loans are reported at cost which approximates fair value. Premiums and discounts arising from the purchase of mortgage-backed securities are amortized using the interest method over the estimated remaining term of the securities, adjusted for anticipated prepayments. Premiums and discounts on other debt instruments are amortized using the interest method over the remaining term of the security. Realized gains and losses on the sale of investments are determined using the specific-identification method, and are credited or charged to income. Also charged to income are unrealized losses on investment securities for which a decline in fair market value is deemed to be other than temporary. The estimated fair value of investments is based upon quoted market prices, where available, or on values obtained from independent pricing services. 48 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- OTHER-THAN-TEMPORARY DECLINES IN FAIR VALUE We regularly review our investment portfolio for factors that may indicate that a decline in fair value of an investment is other-than-temporary. Some factors considered in evaluating whether or not a decline in fair value is other than temporary include: - our ability and intent to retain the investment for a period of time to allow for a recovery in value; - the duration and extent to which the fair value has been less than cost; and - the financial condition and prospects of the issuer. DEFERRED ACQUISITION COSTS 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, have been deferred and reported as deferred acquisition costs. 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. The Company evaluates the recoverability of deferred acquisition costs on a quarterly basis and determines that these amounts are recoverable. PROPERTY AND EQUIPMENT AND PROPERTY HELD FOR SALE Property and equipment are carried at cost less allowances for depreciation and amortization. Office buildings are depreciated on the straight-line method over 31.5 years, except for certain components, which are depreciated over 15 years. Depreciation for other property and equipment is computed on the straight-line basis over the estimated useful lives of the equipment, principally five and seven years. Property held for sale is stated at estimated fair value less cost to sell. No depreciation or amortization is provided for property held for sale. MEASUREMENT OF IMPAIRMENT OF LONG-LIVED ASSETS Effective January 1, 2002, we adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. This Statement superseded SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, and the accounting and reporting provisions of Accounting Principles Board Opinion, or APB Opinion, No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business. This Statement also amended Accounting Research Bulletin No. 51, Consolidated Financial Statements. This Statement requires that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and broadens the presentation of discontinued operations to include more disposal transactions. The adoption of SFAS No. 144 on January 1, 2002 did not have a material effect on our results of operations, financial position or liquidity. See Note F. Discontinued Operations for further detail related to the adoption of SFAS No. 144. 49 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- FUTURE POLICY BENEFITS, LOSSES AND CLAIMS Liabilities for future policy reserves for accident and health and ordinary life business are based on the net level premium basis and estimates of future claims, investment yield, lapses using the Company's experience and actuarial judgment with an allowance for possible future adverse deviations from expected experience. Interest rates used range from 4.5% to 6.0%. Liabilities for interest sensitive products such as deferred annuities and universal life are based on the retrospective deposit method. This is the policyholder fund balance before adjusting for any surrender charges. Guaranteed minimum rates for universal life contracts are 4.0% to 5.0%. At December 31, 2002, credited rates ranged from 4.0% to 4.5%. Guaranteed base minimum rates for deferred annuities range from 3.0% to 5.0% depending on the duration of the contract. Current rates credited range from 3.0% to 5.8%. OTHER POLICY CLAIMS AND BENEFITS PAYABLE Liabilities for unpaid life and accident and health claims, which include a provision for estimated costs to investigate and settle claims, are estimated based upon past experience for pending, incurred but not reported, and reopened claims. Accident and health claims incurred but not reported are computed using actuarially-determined factors based on a combination of claim completion and projected claim cost methods, utilizing durational experience, seasonal cycle, changes in health care practice, changes in inflation rates, and the claims backlog. Claim liabilities with a long pay out period, such as long-term care and disability income claims, are discounted at an interest rate of 4.5%. Although considerable variability is inherent in such computations, management believes that the liabilities for unpaid life and accident and health claims are adequate. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known with such adjustments included in current operations. OTHER POLICYHOLDERS' FUNDS Other policyholders' funds consist of supplementary contracts without life contingencies, premiums, and annuity considerations received in advance and remittance and items not allocated. INSURANCE RELATED ASSESSMENTS Statement of Position No. 97-3, Accounting by Insurance and Other Enterprises for Insurance-Related Assessments, provides guidance for determining when an insurance or other enterprise should recognize a liability for guaranty-fund and other insurance-related assessments and guidance for measuring the liability. COMPREHENSIVE INCOME Comprehensive income in 2002, 2001 and 2000 includes a change in unrealized gains or losses on available-for-sale securities, in addition to reported net income as prescribed by SFAS No. 130, Reporting Comprehensive Income. See Note T. Comprehensive Income for further information. PREMIUM REVENUE Life premiums are recognized as revenue when they become due. Accident and health premiums are recognized as revenue over the terms of the policies. Amounts received from interest sensitive contracts, principally universal life and annuity products, 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. 50 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- FEE AND OTHER INCOME Fee and other income consist of collection, management, and administrative fees, and are recognized when earned. DEFERRED REINSURANCE GAIN Deferred reinsurance gain consists of initial ceding allowances received from reinsurers, less amounts amortized into income over the estimated remaining life of the underlying policies reinsured, except for interest sensitive products that are amortized over the expected profit stream of the in force business. FEDERAL INCOME TAXES Federal income taxes have been provided using the liability method in accordance with SFAS No. 109, Accounting for Income Taxes issued by the FASB. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reviewed for recoverability and a valuation allowance is established, if necessary. STOCK-BASED COMPENSATION Stock-based compensation plans are accounted for using the intrinsic value method prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees. In accordance with the intrinsic value method, compensation cost is measured as the excess, if any, of the quoted market price of the equity instrument awarded at the measurement date over the amount an employee must pay to acquire the equity instrument. Stock-based compensation costs are recognized over the period in which employees render services associated with the awards. We adopted SFAS No. 123, Accounting for Stock-Based Compensation, which permits entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants as if the fair-value-based method, as defined in SFAS No. 123, had been applied. Additionally, in December 2002, the FASB issued SFAS No. 148, Accounting For Stock-Based Compensation-Transition and Disclosure. SFAS No. 148 amends SFAS No. 123, to provide alternative methods of transition to SFAS No. 123's fair value method of accounting for stock-based employee compensation, but does not require companies to account for employee stock options using the fair value method. SFAS No. 148 also amends the disclosure provisions of SFAS No. 123 and APB Opinion, No. 28, Interim Financial Reporting. We elected to continue to apply provisions of APB Opinion No. 25 and provide the pro forma disclosure required by SFAS No. 123 and the amended disclosures required by SFAS No. 148. See Note Q. Stock Plans for further information. No stock-based employee compensation cost is reflected in net income, as all options granted under our plan generally had an exercise price equal to or higher than the fair value of the underlying common stock on 51 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- the date of grant. The following table illustrates the effect on net income, net income attributable to common stockholders, and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123.
YEAR ENDED DECEMBER 31, -------------------------- 2002 2001 2000 ------- ------ ------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Net income (loss), as reported.............................. $(2,401) $2,332 $16,450 Total stock-based employee compensation expenses determined under fair value based method for all awards, net of tax....................................................... (427) (835) (684) ------- ------ ------- PRO FORMA NET INCOME (LOSS)................................. $(2,828) $1,497 $15,766 ======= ====== ======= Net income (loss) attributable to common stockholders, as reported.................................................. $(2,401) $5,159 $16,123 Total stock-based employee compensation expenses determined under fair value based method for all awards, net of tax....................................................... (427) (835) (684) ------- ------ ------- PRO FORMA NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCKHOLDERS.............................................. $(2,828) $4,324 $15,439 ======= ====== ======= Earnings (loss) per share Basic-as reported......................................... $ (0.07) $ 0.29 $ 1.06 BASIC-PRO FORMA........................................... $ (0.08) $ 0.24 $ 1.02 Diluted-as reported....................................... $ (0.07) $ 0.29 $ 1.00 DILUTED-PRO FORMA......................................... $ (0.08) $ 0.24 $ 0.96
EARNINGS PER SHARE Basic earnings per share is computed by dividing the income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if common stock equivalents were exercised and shared in the earnings of the Company. Only those potential common shares, which are dilutive, are included in the computation of diluted earnings per share. See Note U. Computation of Net Income Per Common Share for further information. RECLASSIFICATION Certain amounts presented in the prior years' financial statements have been reclassified to conform to the current year's method of presentation. NEW ACCOUNTING PRONOUNCEMENTS In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which supercedes EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring). The provisions of this Statement are effective for exit or disposal activities initiated after December 31, 2002. SFAS No. 146 requires recognition of a liability for costs associated with an exit or disposal activity when the liability is incurred, rather than when the entity commits to an exit plan under EITF Issue No. 94-3. This Statement applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a disposal activity covered by SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Additionally, this Statement does not apply to costs associated with the retirement of a long-lived asset covered by SFAS No. 143, Accounting for Asset Retirement Obligations. We 52 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- anticipate that the adoption of this standard will not have a material effect on our results of operations, financial position or liquidity. In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. This Statement rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, SFAS No. 44, Accounting for Intangible Assets of Motor Carriers, and SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This Statement amends SFAS No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of SFAS No. 145, related to the rescission of SFAS No. 4, require any gain or loss on extinguishment of debt that was classified as an extraordinary item in prior periods presented that does not meet the criteria in APB Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for classification as an extraordinary item to be reclassified. The adoption of SFAS No. 145 on May 15, 2002 did not have a material effect on our results of operations, financial position or liquidity. In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations, which addressed financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This Statement is effective for financial statements issued for fiscal years beginning after June 15, 2002. The adoption of this standard on June 15, 2002 did not have a material effect on our results of operations, financial position or liquidity. B. EQUITY TRANSACTIONS On December 27, 2001, we sold 16.1 million shares of common stock, at $3.20 per share, which included the exercise of the underwriter's over-allotment option of 2.1 million shares, in a follow-on public offering (the December 2001 public offering). We used the net proceeds of $46.5 million from this sale to: - repay $10.0 million of our tranche A term loan (See Note O. Debt for further information); - repay the remaining balance of $2.5 million of our revolver on February 17, 2002; - repurchase our convertible voting preferred stock for $5.0 million (See Note R. Preferred Shares for further information); - contribute $28.0 million to the capital of our insurance subsidiaries; and - $1.0 million for general corporate purposes and working capital. On July 25, 2000, we sold 3,333,334 shares of our common stock at $6.00 per share in a private placement offering, and, on July 26, 2000, we sold 75,000 shares of our convertible voting preferred stock at $100.00 per share to United Insurance Company of America in a private placement offering. The $27.5 million proceeds from these sales were used for the purchase of Pyramid Life from United Insurance, a subsidiary of Unitrin, Inc. See Note C. Business Combinations and Note R. Preferred Shares for further information. C. BUSINESS COMBINATIONS The acquisition described below was accounted for using the purchase method of accounting, with the excess of the purchase price over the estimated fair-value of the identifiable net assets recorded as goodwill. 53 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- THE PYRAMID LIFE INSURANCE COMPANY ACQUISITION On July 26, 2000, the Company, through Continental General Insurance Company, completed the purchase of Pyramid Life from United Insurance. Pyramid Life, based in Mission, Kansas, provides health and life insurance primarily for the senior market, including Medicare supplement, long-term care, home health care, and senior life insurance products. Pyramid Life markets senior insurance products through approximately 2,500 independent agents in 40 states. The $67.5 million purchase price was financed as follows: - $20.0 million from the sale of 3,333,334 newly-issued shares of common stock at $6.00 per share, in a private placement offering; - $7.5 million from the sale to United of 75,000 newly-issued shares of convertible voting preferred stock; - $25.0 million from a special pre-closing dividend paid by Pyramid Life to United in connection with the acquisition; and - $15.0 million from a combination of funds from Continental General and financing provided by the Chase Manhattan Bank and associated banks. In connection with purchase accounting rules, the total purchase cost for the acquisition has been allocated to the assets and liabilities of Pyramid Life based on their fair values. Pyramid Life's results of operations had been previously included in our consolidated results of operations since the date of acquisition. However, due to the planned sale of Pyramid Life, its operations have been classified as discontinued operations and prior years' financial information has been reclassified. See Note F. Discontinued Operations and Subsequent Event for further information. D. CASH AND INVESTMENTS The amortized cost and estimated fair value of invested assets as of December 31, 2002 were as follows:
GROSS UNREALIZED AMORTIZED ----------------------- ESTIMATED COST GAINS LOSSES FAIR VALUE --------- ---------- ---------- ---------- (DOLLARS IN THOUSANDS) Available-for-sale U.S. Treasury securities................... $ 14,684 $ 287 $ (3) $ 14,968 U.S. Agencies.............................. 37,502 1,411 -- 38,913 State and political subdivisions........... 1,063 15 -- 1,078 Corporate bonds............................ 177,104 8,173 (1,735) 183,542 Mortgage- and asset-backed securities...... 143,923 6,761 (1,128) 149,556 -------- ------- ------- -------- Total available-for-sale.............. 374,276 16,647 (2,866) 388,057 Surplus notes................................ 5,020 131 -- 5,151 Mortgage loans............................... 52 -- -- 52 Policy notes................................. 3,843 -- -- 3,843 -------- ------- ------- -------- Total investments..................... $383,191 $16,778 $(2,866) $397,103 ======== ======= ======= ========
54 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The amortized cost and estimated fair value of invested assets as of December 31, 2001 were as follows:
GROSS UNREALIZED AMORTIZED ----------------------- ESTIMATED COST GAINS LOSSES FAIR VALUE --------- --------- ---------- ---------- (DOLLARS IN THOUSANDS) Available-for-sale U.S. Treasury securities................... $ 17,066 $ 338 $ (5) $ 17,399 U.S. Agencies.............................. 8,843 302 (11) 9,134 State and political subdivisions........... 1,083 -- (11) 1,072 Corporate bonds............................ 229,688 2,555 (4,837) 227,406 Mortgage- and asset-backed securities...... 120,874 1,983 (899) 121,958 -------- ------ ------- -------- Total available-for-sale.............. 377,554 5,178 (5,763) 376,969 Surplus notes................................ 5,045 166 -- 5,211 Mortgage loans............................... 57 -- -- 57 Policy notes................................. 3,678 -- -- 3,678 -------- ------ ------- -------- Total investments..................... $386,334 $5,344 $(5,763) $385,915 ======== ====== ======= ========
Except for bonds and notes of the U.S. Government or of a U.S. Government agency or authority, no investment of the Company exceeds 10% of total stockholders' equity at December 31, 2002 and 2001. The amortized cost and estimated fair value of invested assets as of December 31, 2002 by contractual maturity were as follows:
AMORTIZED ESTIMATED COST FAIR VALUE --------- ---------- (DOLLARS IN THOUSANDS) Fixed maturities Due in one year or less................................... $ 17,018 $ 17,176 Due after one year through five years..................... 67,993 71,116 Due after five years through ten years.................... 86,981 91,325 Due after ten years....................................... 58,362 58,885 Mortgage- and asset-backed securities..................... 143,922 149,555 -------- -------- Total fixed maturities................................. 374,276 388,057 Surplus notes............................................... 5,020 5,151 Mortgage loans.............................................. 52 52 Policy notes................................................ 3,843 3,843 -------- -------- Total invested assets.................................. $383,191 $397,103 ======== ========
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalties. 55 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Proceeds, gross realized gains and gross realized losses from the sales (excluding calls, maturities and pay downs) of fixed maturities available-for-sale during each year were as follows:
YEAR ENDED DECEMBER 31, ---------------------------- 2002 2001 2000 -------- ------- ------- (DOLLARS IN THOUSANDS) Proceeds............................................... $129,594 $94,219 $11,569 Gross realized gains................................... 5,634 3,851 161 Gross realized losses.................................. 3,807 998 80
The following is a summary of net investment income by category of investment:
YEAR ENDED DECEMBER 31, --------------------------- 2002 2001 2000 ------- ------- ------- (DOLLARS IN THOUSANDS) Fixed maturities........................................ $24,215 $23,557 $21,327 Policy loans............................................ 269 260 279 Cash equivalents........................................ 643 2,036 2,765 Other................................................... 365 339 826 ------- ------- ------- Investment income..................................... 25,492 26,192 25,197 Investment expenses..................................... (1,234) (905) (1,026) ------- ------- ------- Net investment income................................. $24,258 $25,287 $24,171 ======= ======= =======
At December 31, 2002 and 2001, the Company's insurance subsidiaries had certificates of deposit and fixed maturity securities with a carrying value of $33.1 million and $32.4 million, respectively, on deposit with various state insurance departments to satisfy regulatory requirements. At December 31, 2002 and 2001, $6.5 million and $7.4 million, respectively, of cash was held for fully insured employer shared risk plans, which is restricted to use. The Company is entitled to investment income from these funds. At December 31, 2002, the Company held no unrated bonds and 6.0% of fixed maturity investments were in less-than-investment grade securities. Corporate bonds representing approximately 1.8% of fixed maturities were downgraded by rating agencies. Approximately 4.2% of the portfolio was invested in BB rated subordinated non-agency residential and commercial mortgage-backed securities. These securities include jumbo residential mortgages and commercial mortgages with strong prepayment protection. In June 2002, the Company wrote down approximately $0.9 million for other-than-temporary impairment on bonds held in WorldCom. The bonds were subsequently sold. The Company performs periodic evaluations of the relative credit standings of the issuers of the bonds held in the Company's portfolio. The Company considers these evaluations in its overall investment strategy. 56 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- E. PROPERTY AND EQUIPMENT Property and equipment are stated at cost and are summarized by category as follows:
DECEMBER 31, ----------------------- 2002 2001 --------- --------- (DOLLARS IN THOUSANDS) Home office building........................................ $ 4,078 $ 3,996 Land........................................................ 489 489 Furniture and fixtures...................................... 2,446 2,476 Information technology equipment............................ 662 3,356 Other property and equipment................................ 3,211 3,642 ------- ------- 10,886 13,959 Accumulated depreciation.................................... (5,499) (7,719) ------- ------- Total..................................................... $ 5,387 $ 6,240 ======= =======
Other property and equipment consists principally of software, leasehold improvements and office equipment. Depreciation expense for the years ended December 31, 2002, 2001 and 2000 was $1.2 million, $1.6 million, and $1.4 million, respectively. F. DISCONTINUED OPERATIONS AND SUBSEQUENT EVENT We entered into a definitive agreement dated as of December 20, 2002 to sell the stock of our subsidiary, Pyramid Life, which was primarily included in our senior segment, to a subsidiary of Universal American Financial Corp. Additionally, we will continue to process Pyramid Life's business for a period of six to 18 months after the sale through an administrative services agreement. The loss from the sale (net of taxes and expenses incurred) is expected to be $11.6 million. The sale was completed March 31, 2003 for $57.5 million in cash, subject to further adjustment based on Pyramid Life's statutory capital and surplus as of March 31. Proceeds from the sale were used to strengthen Continental General's statutory capital and repay $10.0 million of our bank debt. As a result of the planned sale, Pyramid Life's operations were classified as discontinued operations and prior years' financial information has been reclassified. Accordingly, we adjusted the carrying value of Pyramid Life's assets held for sale to fair market value at December 31, 2002, which resulted in an $11.6 million charge in the fourth quarter of 2002. 57 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Summarized financial data for Pyramid Life's operations are as follows: STATEMENTS OF OPERATIONS
YEAR ENDED DECEMBER 31, ---------------------------- 2002 2001 2000 -------- ------- ------- (DOLLARS IN THOUSANDS) REVENUES Premiums, net.......................................... $ 97,953 $79,517 $29,160 Net investment income.................................. 6,559 6,712 2,700 Net realized gains (losses)............................ 260 2,688 30 Fee and other income................................... -- -- 128 -------- ------- ------- 104,772 88,917 32,018 -------- ------- ------- BENEFITS, LOSSES AND EXPENSES Benefits, claims, losses and settlement expenses....... 72,490 56,632 19,250 Selling, general and administrative expenses........... 29,422 26,933 9,955 Net (deferral) amortization and change in acquisition costs and value of business acquired................. (8,413) (7,454) (2,522) Amortization of goodwill............................... -- 432 178 Special charges........................................ 287 -- -- -------- ------- ------- 93,786 76,543 26,861 -------- ------- ------- Income from operations before federal income taxes..... 10,986 12,374 5,157 Federal income tax expense............................. 3,877 4,513 1,804 -------- ------- ------- INCOME FROM OPERATIONS................................. 7,109 7,861 3,353 -------- ------- ------- Loss on sale of Pyramid Life........................... (12,310) -- -- Federal income tax benefit............................. (683) -- -- -------- ------- ------- LOSS ON SALE OF PYRAMID LIFE, NET...................... (11,627) -- -- -------- ------- ------- INCOME (LOSS) FROM DISCONTINUED OPERATIONS............. $ (4,518) $ 7,861 $ 3,353 ======== ======= =======
58 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- BALANCE SHEETS
DECEMBER 31, ----------------------- 2002 2001 ---------- ---------- (DOLLARS IN THOUSANDS) ASSETS Investments................................................. $106,231 $ 96,707 Cash and cash equivalents................................... 6,411 6,067 Accrued investment income................................... 1,391 1,391 Premiums receivable......................................... 312 244 Reinsurance receivable...................................... 7,808 5,970 Property and equipment, net................................. 1,000 1,860 Deferred federal income taxes............................... -- 1,565 Deferred acquisition costs.................................. 16,150 8,443 Value of business acquired.................................. 15,067 15,560 Goodwill.................................................... -- 10,200 Intercompany receivable..................................... -- 483 Other assets................................................ 3,404 2,678 -------- -------- TOTAL ASSETS.............................................. 157,774 151,168 -------- -------- LIABILITIES AND STOCKHOLDERS' EQUITY Policy liabilities and benefits accrued..................... 96,866 87,945 Federal income taxes payable................................ -- 1,832 Intercompany payable........................................ 1,797 141 Other liabilities........................................... 3,794 3,839 -------- -------- TOTAL LIABILITIES......................................... 102,457 93,757 -------- -------- NET ASSETS OF DISCONTINUED OPERATIONS....................... $ 55,317 $ 57,411 ======== ========
G. LEASES On May 25, 2001, we entered into an agreement with Royalton Investors, LLC and Big T Investments, LLC, an unaffiliated third party, to sell our Cleveland headquarters. The transaction was effective July 31, 2001. The building was sold to Royalton Investors, LLC and Big T Investments, LLC for $16.0 million and concurrently we leased it back for a term of 15 years with four optional five-year extensions. 59 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Rent expense for the Cleveland headquarters was approximately $1.7 million in 2002, $0.7 million in 2001, and zero in 2000. Future rent payments for the Cleveland headquarters are as follows (dollars in thousands): 2003........................................................ $ 1,742 2004........................................................ 1,800 2005........................................................ 1,800 2006........................................................ 1,883 2007........................................................ 2,000 Thereafter.................................................. 17,667 ------- Total future minimum rent payments.......................... $26,892 =======
H. DEFERRED ACQUISITION COSTS Unamortized deferred policy acquisition costs are summarized as follows:
YEAR ENDED DECEMBER 31, ------------------------------ 2002 2001 2000 -------- -------- -------- (DOLLARS IN THOUSANDS) Balance at beginning of year......................... $ 68,934 $ 53,225 $ 26,650 Current year's costs deferred........................ 27,791 42,007 42,855 -------- -------- -------- 96,725 95,232 69,505 Amortization for the year............................ (21,834) (20,430) (16,280) Write-off of deferred acquisition costs related to United Benefit Life and Provident American Life(1)............................................ -- (5,868) -- -------- -------- -------- Balance at end of the year........................... $ 74,891 $ 68,934 $ 53,225 ======== ======== ========
- --------------- (1) See Note P. Special Charges for further information. I. VALUE OF BUSINESS ACQUIRED A portion of the purchase price paid by the Company 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 unamoritized asset balance. If such current estimate is less than the existing asset balance, the difference would be charged to expense. 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% is credited to the unamortized balance for Continental General Corporation. 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 Corporation which was the market rate at the time of acquisition. 60 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The value of business acquired is summarized as follows:
YEAR ENDED DECEMBER 31, --------------------------- 2002 2001 2000 ------- ------- ------- (DOLLARS IN THOUSANDS) Balance at beginning of year............................ $17,910 $18,469 $16,731 Amortization............................................ (1,275) (1,262) (1,601) Adjustments to expense reserve.......................... (551) 703 3,339 ------- ------- ------- Balance at end of the year.............................. $16,084 $17,910 $18,469 ======= ======= =======
The increased expense reserve is primarily a result of the higher commission rates paid in the initial policy years of the Medicare supplement business acquired. Under the current assumptions, amortization for the next five years is expected to be as follows (dollars in thousands):
AMORTIZATION ------------ 2003........................................................ $2,048 2004........................................................ 2,352 2005........................................................ 2,214 2006........................................................ 1,900 2007........................................................ 1,670
J. 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, 2002, goodwill was $10.7 million and represented approximately 1.2% 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 assets are capable of being sold or exchanged either on its own or in combination with a related contract asset or liability. At December 31, 2002, our other intangible assets consisted of $3.6 million in licenses, which represented 0.4% of our total assets. Effective January 1, 2002, we adopted Statement of Financial Accounting Standards, or SFAS, No. 142, Goodwill and Other Intangible Assets issued by the Financial Accounting Standards Board, or 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, together with our independent consultants, 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 and analysis prepared by independent consultants indicated that no reduction of goodwill and licenses was required. In 2001, goodwill and licenses amortization was $0.7 million ($0.4 million on an after-tax basis, or $0.02 per diluted shared). In 2000, goodwill and licenses amortization was $0.9 million ($0.6 million on an after-tax basis, or $0.04 per diluted share). 61 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The following table reflects the consolidated results adjusted as though the adoption of SFAS No. 142 occurred as of the beginning of fiscal 2000:
YEAR ENDED DECEMBER 31, -------------------------- 2002 2001 2000 ------- ------ ------- (DOLLARS IN THOUSANDS) Net income (loss), as reported........................... $(2,401) $2,332 $16,450 Goodwill and licenses amortization, net of tax........... -- 437 579 ------- ------ ------- PRO FORMA NET INCOME (LOSS)............................ $(2,401) $2,769 $17,029 ======= ====== ======= Net income (loss) attributable to common stockholders, as reported............................................... $(2,401) $5,159 $16,123 Goodwill and licenses amortization, net of tax........... -- 437 579 ------- ------ ------- PRO FORMA NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCKHOLDERS........................................ $(2,401) $5,596 $16,702 ======= ====== ======= Basic earnings (loss) per share, as reported............. $ (0.07) $ 0.29 $ 1.06 Goodwill and licenses amortization, net of tax........... -- 0.02 0.04 ------- ------ ------- PRO FORMA BASIC EARNINGS (LOSS) PER SHARE.............. $ (0.07) $ 0.31 $ 1.10 ======= ====== ======= Diluted earnings (loss) per share, as reported........... $ (0.07) $ 0.29 $ 1.00 Goodwill and licenses amortization, net of tax........... -- 0.02 0.04 ------- ------ ------- PRO FORMA DILUTED EARNINGS (LOSS) PER SHARE............ $ (0.07) $ 0.31 $ 1.04 ======= ====== =======
The changes in the carrying amount of goodwill for the year ended December 31, 2002, were as follows:
SENIOR AND OTHER TOTAL MEDICAL SEGMENT SEGMENT GOODWILL --------------- ---------------- -------- (DOLLARS IN THOUSANDS) BALANCE AS OF JANUARY 1, 2002................ $749 $13,494 $14,243 Reclassification of licenses as a separate line item.................................. (749) (2,837) (3,586) ---- ------- ------- BALANCE AS OF DECEMBER 31, 2002.............. $ -- $10,657 $10,657 ==== ======= =======
The changes in the carrying amount of licenses, for the year ended December 31, 2002, were as follows:
SENIOR AND OTHER TOTAL MEDICAL SEGMENT SEGMENT LICENSES --------------- ---------------- -------- (DOLLARS IN THOUSANDS) BALANCE AS OF JANUARY 1, 2002................. $ -- $ -- $ -- Reclassification of licenses as a separate line item................................... 749 2,837 3,586 ---- ------ ------ BALANCE AS OF DECEMBER 31, 2002............... $749 $2,837 $3,586 ==== ====== ======
K. FEDERAL INCOME TAXES The Company files a consolidated federal income tax return with its subsidiaries, except for Continental General, which is required to file a separate return through fiscal year 2003. 62 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Federal income tax expense (benefit) from continuing operations was composed of the following:
YEAR ENDED DECEMBER 31, -------------------------- 2002 2001 2000 ------- ------- ------ (DOLLARS IN THOUSANDS) Current.................................................. $(5,894) $ (300) $ 464 Deferred................................................. 7,237 (1,510) 6,112 ------- ------- ------ Total.................................................. $ 1,343 $(1,810) $6,576 ======= ======= ======
Federal income tax expense (benefit) was allocated as follows:
YEAR ENDED DECEMBER 31, ------------------------- 2002 2001 2000 ------ ------- ------ (DOLLARS IN THOUSANDS) Continuing operations..................................... $1,343 $(1,810) $6,576 Discontinued operations................................... 3,877 4,513 1,804 ------ ------- ------ Total................................................... $5,220 $ 2,703 $8,380 ====== ======= ======
Income tax expense (benefit) attributable to income from continuing operations differs from the amounts computed by applying the U.S. federal income tax rate of 35%. Those effects are summarized as follows:
YEAR ENDED DECEMBER 31, ------------------------- 2002 2001 2000 ------ ------- ------ (DOLLARS IN THOUSANDS) Expected tax expense (benefit) at 35%..................... $1,194 $(2,588) $6,876 Tax exempt interest....................................... (30) (8) (4) Meals and entertainment................................... 165 365 27 Non deductible goodwill................................... -- 264 293 Non deductible expenses................................... 103 10 (616) Other..................................................... (89) 147 -- ------ ------- ------ $1,343 $(1,810) $6,576 ====== ======= ======
The federal income tax returns for the Company and its subsidiaries have been examined by the Internal Revenue Service (IRS) through 1998. Currently, the 1999 tax year is being examined by the IRS. 63 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2002 and 2001 are presented below:
DECEMBER 31, ---------------------- 2002 2001 --------- --------- (DOLLARS IN THOUSANDS) Deferred tax liabilities Value of business acquired................................ $ 5,629 $ 6,269 Deferred acquisition costs................................ 12,699 16,861 Unrealized gain adjustment................................ 5,045 990 Other..................................................... 3,914 1,804 ------- ------- 27,287 25,924 ------- ------- Deferred tax assets Ceding commission......................................... -- 2,475 Reinsurance transactions.................................. 3,863 4,858 Deferred gain on Cleveland headquarters................... 2,323 2,486 Depreciation.............................................. (65) 293 Severance pay............................................. 139 7 Alternative minimum tax................................... 332 624 Reserves.................................................. 5,396 6,123 Net operating loss carryfoward............................ 7,598 9,124 Advance premium........................................... 685 854 Other..................................................... 3,658 7,015 ------- ------- 23,929 33,859 Valuation allowance......................................... 8,388 8,388 ------- ------- Net deferred tax liabilities................................ $11,746 $ 453 ======= =======
At December 31, 2002, the Company had a tax net operating loss carryforward, or NOL, of approximately $21.7 million for federal income tax purposes, which expires through 2015. Future 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 $21.7 million, is subject to certain restrictions, including an annual limitation of approximately $5.4 million. Losses incurred subsequent to this offering are available without annual limitation to offset future income. The Company determines a valuation allowance based on an analysis of amounts recoverable in the statutory carryback period and available tax planning strategies. In assessing the valuation allowance established at December 31, 2002 and 2001, estimates were made as to the potential financial impact on the Company of recent NOLs and our financial condition. In accordance with federal tax law, a portion of insurance companies' net income, prior to 1984, is not subject to federal income taxes (within certain limitations) until it is distributed to policyholders, at which time it is taxed at regular corporate rates. For federal income tax purposes this untaxed income is accumulated in a memorandum account designated "policyholders' surplus." At December 31, 2002, the accumulated untaxed policyholders' surplus for the Company, all of which relates to Central Reserve, was $2.9 million. 64 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- L. LIABILITY FOR OTHER POLICY CLAIMS AND BENEFITS PAYABLE The following table reflects the activity in the liability for other policy claims and benefits payable, including the claims adjustment expenses, net of reinsurance recoverables, as follows:
DECEMBER 31, ------------------------------ 2002 2001 2000 -------- -------- -------- (DOLLARS IN THOUSANDS) Gross balance at beginning of year................... $186,783 $164,746 $149,538 Less: Reserves ceded................................. 58,078 67,227 85,347 -------- -------- -------- Adjusted net beginning balance....................... 128,705 97,519 64,191 -------- -------- -------- Paid claims and claims adjustments expenses, net of reinsurance, for Current year....................................... 268,036 286,795 243,552 Prior years........................................ 136,693 114,140 71,597 -------- -------- -------- Total paid.................................... 404,729 400,935 315,149 -------- -------- -------- Incurred claims and claims adjustment expenses, net of reinsurance, for Current year....................................... 368,935 420,288 341,020 Prior years........................................ 8,394 17,011 7,865 -------- -------- -------- Total incurred................................ 377,329 437,299 348,885 -------- -------- -------- Net reserve balance at end of year................... 101,305 133,883 97,927 Plus: Reserves ceded at end of year.................. 28,622 58,078 67,227 -------- -------- -------- Balance before reinsurance recoveries on paid claims............................................. 129,927 191,961 165,154 Plus: Increase (decrease) in reinsurance recoveries on paid claims..................................... 18,011 (5,178) (408) -------- -------- -------- Gross balance at end of year......................... $147,938 $186,783 $164,746 ======== ======== ========
The foregoing indicates that a $8.4 million deficiency in the 2001 reserves emerged in 2002 as a result of higher-than-anticipated claims cost associated with a reduction in pending claims inventory in the medical segment. In 2001, a $17.0 million deficiency in the 2000 reserves emerged as a result of higher utilization in the medical segment related to increased costs of services, a greater utilization of medical services and greatly increased expenditures on prescription drugs. In 2000, a $7.9 million deficiency in the 1999 reserves emerged as a result of higher utilization in all segments. M. REINSURANCE ARRANGEMENTS CENTRAL RESERVE LIFE INSURANCE COMPANY In December 2000, Central Reserve entered into a reinsurance transaction with Lincoln National Reassurance Company, or Lincoln, for a ceding allowance of $4,000,000. The policies reinsured, on a combined coinsurance and modified coinsurance basis, were 80% of all group term life insurance and 35% of all individual deferred annuities in force on and after December 31, 2000. The ceding allowance is being accounted for as a deferred reinsurance gain in the accompanying consolidated financial statements and will be amortized into income over the duration of the underlying policies. 65 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- In December 1999, Central Reserve entered into a reinsurance transaction with Hannover for certain health insurance policies issued during the period from July 1, 1998 through June 30, 1999. As part of the coinsurance funds withheld transaction, Hannover will pay Central Reserve on a quarterly basis, an experience refund, the amount of which shall be based upon the earnings derived from the business reinsured. Concurrent with this transaction, Hannover will reinsure to Continental General on a stop loss basis 100% of any losses incurred for the business reinsured in excess of a pre-determined aggregate annualized loss ratio of 76.0% in 2000, 78.0% in 2001 and 80.0% thereafter. In exchange for coverage under the stop loss reinsurance, Hannover pays Continental General a stop loss premium on the business reinsured. The effects of the transaction, except the net risk charge to Hannover, are eliminated in consolidation. This reinsurance agreement was terminated effective December 31, 2002 by mutual consent of the parties. In December 1997, Central Reserve entered into a retroactive reinsurance treaty (the "1997 Treaty") with Hannover. The quota share treaty was effective January 1, 1997, and covered certain group accident and health policies in force and written during 1997. Under the provisions of the 1997 Treaty, Central Reserve cedes 50% of the premiums of the eligible policies, and in return receives reimbursement for 50% of the claims paid, plus a commission and expense allowance. In connection with the 1997 Treaty, Central Reserve transferred $24.5 million of reserves to Hannover, and received an initial ceding allowance of $10.0 million, resulting in a net cash transfer of $14.5 million to Hannover. The initial ceding allowance was reported as a deferred reinsurance gain, and is being amortized into income over the duration of the underlying block of business. CONTINENTAL GENERAL LIFE INSURANCE COMPANY In December 2001, Continental General entered into a reinsurance transaction with London Life International Reinsurance Corporation, or London, for a 75% quota share of certain health policies issued after February 1, 1999. Under the provisions of the treaty, effective January 1, 2001, Continental General cedes 75% of the premiums of the eligible policies, and in return receives reimbursement for 75% of the claims paid, plus a commission and expense allowance. If the combined loss ratio (defined as benefits plus expense allowances divided by premium) is less than 100%, an experience refund will be paid from London to Continental General. The expense and profit charge is 200 basis points and 85 basis points of reinsurance premium for 2002 and 2001, respectively. Beginning January 1, 2002, London retroceded any losses on these policies in excess of a combined ratio of 110% to Central Reserve. In exchange for coverage on this business, Central Reserve received 100 basis points of reinsurance premium in 2002 from London. On June 2, 2002, these reinsurance agreements were terminated. The Company has determined that this contract does not transfer risk in accordance with generally accepted accounting principles and has reflected this agreement as a deposit. In February 1999, Continental General entered into a reinsurance agreement with Hannover, under which Hannover reinsured 50% of all insurance business in force at Continental General for a ceding allowance of $13.0 million. The ceding allowance is being accounted for as a deferred reinsurance gain in the accompanying consolidated financial statements and will be amortized into income over the duration of the underlying block of business. Various assets, primarily comprised of fixed income securities with a market value of $188.4 million, were transferred from Continental General to Hannover for the policy liabilities assumed by Hannover. PROVIDENT AMERICAN LIFE & HEALTH INSURANCE COMPANY Prior to the acquisition of Provident American Life, all of the insurance business of Provident American Life in force at December 31, 1998 was ceded to Provident Indemnity. Hannover reinsured all the individual and small group health insurance in force at December 31, 1998, of Provident Indemnity for a ceding 66 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- allowance of approximately $10.0 million. On January 1, 1999, Hannover ceded 10% of this insurance in force to Central Reserve and Central Reserve paid a $1.0 million ceding commission. Effective January 1, 1999, Provident American Life entered into a reinsurance agreement with Provident Indemnity, whereby Provident American Life reinsured 100% of Provident Indemnity's business written after December 31, 1998. In a separate reinsurance agreement, Provident American Life ceded to Hannover 50% of its direct business written after December 31, 1998 and 50% of the business reinsured from Provident Indemnity. On December 31, 2002, Provident American Life and Hannover entered into an agreement, which amended the reinsurance arrangement relative to the policies of Provident American Life and Provident Indemnity. For claims incurred June 30, 2002 and prior, Hannover continues to be responsible for its quota share percentage. For premiums earned and claims incurred July 1, 2002 and subsequent, Provident American Life retains 100% of the business and risk on the remaining closed block of policies. UNITED BENEFIT LIFE INSURANCE COMPANY Effective August 1, 1998, Central Reserve entered into a reinsurance treaty with United Benefit Life, a life and accident and health insurer in Texas. Under the terms of the treaty, Central Reserve agreed to assume 100% of United Benefit Life's block of business, until such time as profits earned by Central Reserve on the assumed block reach a contractual threshold, which approximates $20.0 million of pre-tax income. Central Reserve paid to United Benefit Life a $20.0 million ceding allowance in connection with this transaction. In connection with the United Benefit Life reinsurance treaty, Central Reserve ceded 80% of the business in force on August 1, 1998 to Hannover, thereby retaining a net risk of 20%. Additionally, Central Reserve ceded 50% of the policies written by United Benefit Life subsequent to August 1, 1998 and reinsured by Central Reserve to Hannover. This treaty provided Central Reserve an initial ceding allowance of $20.0 million, which was being accounted for as a deferred reinsurance gain in the accompanying consolidated financial statements, and was amortized into income over the duration of the underlying block of business. In 1999, Central Reserve acquired through foreclosure the stock of United Benefit Life. On December 31, 2002, United Benefit Life and Hannover entered into an agreement which amended these reinsurance arrangements. For claims incurred June 30, 2002 and prior, Hannover continues to be responsible for its quota share percentage. For claims incurred July 1, 2002 and subsequent, Central Reserve retains 100% of the risk. In the ordinary course of business, the Company maintains other reinsurance arrangements with other insurers. These arrangements are designed to limit the maximum amount of exposure that the Company retains on a given policy. For ordinary and group life claims, Continental'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. 67 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The following table summarizes the net impact of reinsurance arrangements on premiums and benefits, claims, losses and settlement expenses, and selling, general and administrative expenses:
YEAR ENDED DECEMBER 31, --------------------------------- 2002 2001 2000 --------- --------- --------- (DOLLARS IN THOUSANDS) PREMIUMS, NET Direct.......................................... $ 652,967 $ 739,190 $ 722,170 Assumed......................................... 122 7,432 16,817 Ceded........................................... (112,953) (191,100) (256,605) --------- --------- --------- Total premiums, net.......................... $ 540,136 $ 555,522 $ 482,382 ========= ========= ========= BENEFITS, CLAIMS, LOSSES, AND SETTLEMENT EXPENSES........................................ $ 498,130 $ 600,529 $ 576,072 Reinsurance recoveries............................ (77,106) (156,686) (205,511) --------- --------- --------- Total benefits, claims, losses and settlement expenses................................... $ 421,024 $ 443,843 $ 370,561 ========= ========= ========= SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES Commissions..................................... $ 97,655 $ 117,572 $ 122,980 Salaries and benefits........................... 34,140 40,951 36,231 Taxes, licenses, and fees....................... 17,258 19,764 17,278 Other operating expenses........................ 39,974 38,149 38,587 Administrative and IS services.................. 9,874 20,463 21,486 Reinsurance expenses............................ 457 1,728 1,973 Reinsurance allowances.......................... (24,126) (41,619) (62,101) --------- --------- --------- Total selling, general and administrative expenses................................... $ 175,232 $ 197,008 $ 176,434 ========= ========= =========
The insurance companies remain obligated for amounts ceded in the event that the reinsurers do not meet their obligations. Initial ceding allowances received from reinsurers are accounted for as deferred reinsurance gain and are amortized into income over the estimated remaining life of the underlying policies reinsured, except for interest sensitive products that are amortized over the expected profit stream of the in force business. The above table does not include the amortization of initial ceding allowances received from reinsurers. Amortization of deferred reinsurance gain for the years ended December 31, 2002, 2001 and 2000 was $2.8 million, $5.0 million, and $6.1 million, respectively. N. CONTINGENCIES We are involved in various legal and regulatory actions occurring in the normal course of business. Based on current information, we believe any ultimate liability that may arise from these actions would not materially affect our consolidated financial position or results of operations. However, our evaluation of the likely impact of these actions could change in the future and an unfavorable outcome could have a material adverse effect on our consolidated financial position, results of operations or cash flow of a future period. 68 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- O. DEBT
DECEMBER 31, ----------------------- 2002 2001 ---------- ---------- (DOLLARS IN THOUSANDS) Bank credit facility........................................ $25,003 $28,500 Revolver.................................................... -- 2,500 ------- ------- $25,003 $31,000 ======= =======
To provide funds for the acquisition of Continental General, on February 17, 1999, we entered into a credit agreement among Ceres, various lending institutions, and JPMorgan Chase (formerly the Chase Manhattan Bank) as Administrative Agent. Under the agreement, we borrowed $40.0 million under a tranche A term loan and secured a $10.0 million revolver. The credit agreement was amended on July 25, 2000 to increase the revolver from $10.0 million to $15.0 million in connection with the acquisition of Pyramid Life. Any amount outstanding on the revolver had to be repaid on February 17, 2002. The revolver bore interest at the same rate choices as the tranche A term loan. On February 17, 2002, the balance of the revolver was permanently repaid from proceeds of our December 2001 public offering. On March 30, 2001, this credit agreement was amended to enter into a new $10.0 million term loan with CIT Equipment Financing, Inc. The proceeds of this term loan, the tranche B term loan, were used to permanently pay down $10.0 million of our then fully-drawn $15.0 million revolver agreement. The terms of this amendment provide for CIT Group to participate equally with the syndicate of banks and Chase under the credit agreement. Interest on the outstanding balance of the term loans is determined based on our selection each quarter of either a Base Rate Loan or a Eurodollar Loan. Under the Base Rate Loan, the interest rate will be 2.5% per annum plus the higher of (a) the rate which is 0.50% of 1.0% in excess of a federal funds rate or (b) Chase's prime rate as in effect from time to time. Under the Eurodollar Loan, the interest rate will be 3.5% per annum plus a Eurodollar rate, which is the arithmetic average of the offered quotation to first-class banks in the interbank Eurodollar market by Chase, adjusted for certain reserve requirements. The interest rate of the tranche B term loan is 0.5% per annum higher than the above rates. At December 31, 2002, the interest rate on our tranche A term loan balance of $16.0 million was 4.9% per annum and our $9.0 million CIT tranche B term loan was 5.4% per annum. The credit agreement, as amended, contains financial and other covenants that among other things: - prohibit the payment of cash dividends on, or the repurchase of, shares of our common stock; - restrict the creation of liens and sales of assets; - requires us to repay the term loans with 25% of the net cash proceeds from any future sale or issuance of our equity, excluding warrants and compensation awards or plans; and - require that we, at a minimum, maintain: - a leverage ratio (consolidated debt to consolidated total capital) of 0.30 to 1.00; - an interest coverage ratio (consolidated earnings before interest, income taxes, depreciation, and amortization to consolidated interest expense) of 3.00 to 1.00; - a risk-based capital (RBC) ratio at year end for any of our regulated insurance company subsidiaries of not less than 125.0% of the RBC Company Action level; 69 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - consolidated net worth, excluding goodwill, of no less than the sum of (i) $85.0 million plus (ii) 80% of the net proceeds from the equity offering excluding the $5.0 million repurchase of our convertible voting preferred stock plus (iii) 50% of our aggregate consolidated net income calculated quarterly; and - a fixed charge coverage ratio of not less than 1.05 to 1.00 through June 30, 2003, and 1.10 to 1.00 thereafter. Effective March 31, 2003, the credit agreement was amended in connection with the sale of Pyramid Life. The amendment: - permits the sale of Pyramid Life; - requires $10.0 million of sale proceeds to be used as a partial pay down of bank debt; - waives the minimum risk-based capital ratio requirement of 125% for Continental General at December 31, 2002; - excludes intercompany tax sharing payments in the calculation of the fixed charge coverage ratio at December 31, 2002; - increases the interest rate on the tranche A and tranche B term loans for the Base Rate Loans to Base Rate plus 3.0% and 3.5%, respectively, and for the Eurodollar Loans to LIBOR plus 4.0% and 4.5%, respectively; - restructured the tranche A term loan debt payments as follows: quarterly principal payments of $547,000 through November 17, 2003, $509,000 through November 17, 2004, and a payment of approximately $5,040,000 on February 17, 2005; and - restructured the tranche B term loan debt payments as follows: quarterly principal payments of $223,000 through December 17, 2003, $216,000 on March 17, 2004, $412,000 through December 17, 2004, $434,000 on March 17, 2005, and $820,000 through December 17, 2005. We do not have transactions or relationships with "special purpose" entities, and we do not have any off balance sheet financing other than normal operating leases. In addition, the common stock of Central Reserve, Continental General, and most of our non-regulated subsidiaries are pledged as security for the credit agreement. At December 31, 2002, we were in compliance with our credit agreement, as amended and waived. We believe that cash flow from operating activities will be sufficient to meet the currently anticipated operating and capital expenditure requirements of our subsidiaries over the next 12 months. Funds to meet our debt obligations are generated from fee income from our non-regulated subsidiaries. Our ability to make scheduled payments of the principal and interest on our indebtedness depends on our future performance and the future performance of our non-regulated subsidiaries, which are subject to economic, financial, competitive and other factors beyond our control. Fee income is derived from fees primarily in connection with our major medical business. As that business declines, fee income declines. Dividends from the regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. In 2003, none of the insurance subsidiaries (Central Reserve Life and Continental General) can pay a dividend to Ceres Group, the parent company, without prior approval of their respective state regulators as a result of their respective statutory levels of unassigned surplus. 70 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- P. SPECIAL CHARGES 2002 On April 15, 2002, Peter W. Nauert announced his retirement from his position as our Chief Executive Officer effective June 1, 2002. He will remain as Chairman of the Board of Directors through June 2003. In the first quarter of 2002, we reported a pre-tax non-recurring special charge to operations of approximately $2.7 million ($2.4 million in continuing operations and $0.3 million in discontinued operations) related to the early termination of his employment agreement and the payment of certain benefits through June 2003. 2001 We reported special charges of $7.1 million in the first quarter of 2001 related to: - the elimination of $5.9 million deferred acquisition cost (DAC) asset on all products of United Benefit Life and Provident American Life; and - $1.2 million loss on United Benefit Life. From 1998 to 2001, we experienced excessive losses at United Benefit Life and Provident American Life due to high benefit utilization and higher-than-anticipated claims costs. In July 2001, we implemented a program to mitigate future losses of United Benefit Life and Provident American Life by notifying policyholders that their policies would be terminated or replaced with a different Provident American Life product. The business was substantially wound down by the end of 2002. As a result of the termination of the business in these subsidiaries, these blocks had a $2.5 million pre-tax loss in 2002 compared to $17.9 million pre-tax loss in 2001 including special charges and legal expenses. Q. STOCK PLANS STOCK OPTION PLANS In 1999, 373 employees each received 1,000 common stock options under the 1998 Employee Stock Option Plan. A second grant was made for new employees hired from January 1, 1999 through September 30, 1999, and still employed as of December 31, 1999. Under this second grant in 2000, 75 employees received 1,000 common stock options. Each grant vests after three years and expires ten years from the date of the grant, with accelerated vesting upon an event of a change in control. The Company terminated this plan in December 2000. At December 31, 2002, there were options outstanding under the plan to purchase 243,000 shares. In 1998, pursuant to the 1998 Key Employee Share Incentive Plan, the Company granted common stock options to certain key employees. In 1999 through 2002, the Company granted additional common stock options to certain employees under the 1998 Key Employee Share Incentive Plan. In general, such grants vest over three years and expire ten years from the date of the grant. In the event of a change in control, all options granted immediately vest and become exercisable in full. There are 2,000,000 shares of our common stock reserved for issuance under this plan. At December 31, 2002, there were options outstanding under the plan to purchase 1,483,628 shares. In 1998 and 1999, pursuant to various individual employment agreements, the Company granted non-qualified options to purchase 815,000 shares of our common stock to certain key employees. Such grants generally vest over three years. At December 31, 2002, there were options outstanding under the plan to purchase 815,000 shares. In 1999, pursuant to the 1999 Special Agents' Stocks Option Plan, the Company granted 78,706 common stock options to certain Regional Sales Directors and Managing General Agents. Each grant vested 71 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- immediately and expires ten years from the date of grant. The Company terminated this plan at the end of 2000. At December 31, 2002, there were options outstanding under the plan to purchase 78,706 shares. A summary of the Company's stock option activity is presented below:
YEAR ENDED DECEMBER 31, ------------------------------------------------------------------ 2002 2001 2000 -------------------- -------------------- -------------------- WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE EXERCISE EXERCISE EXERCISE OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE --------- -------- --------- -------- --------- -------- Outstanding at beginning of year......................... 2,878,632 $7.12 2,130,890 $7.45 1,606,000 $7.81 Options granted, with exercise prices: Greater than fair value at grant date................ 40,000 6.25 633,333 6.73 -- -- Equal to fair value at grant date...................... 140,000 4.11 275,000 5.19 644,977 6.68 Less than fair value at grant date...................... -- -- -- -- 78,706 5.94 Forfeited...................... (438,298) 6.78 (160,591) 6.76 (198,793) 7.22 --------- --------- --------- Outstanding at end of year..... 2,620,334 7.00 2,878,632 7.12 2,130,890 7.45 ========= ========= ========= Exercisable at end of year..... 1,927,834 7.29 1,128,653 7.52 548,706 7.60 ========= ========= ========= Shares available for future grants....................... 516,372 =========
Exercise prices for options outstanding at December 31, 2002 ranged from $3.90 to $10.50. While some options have no expiration date, management estimates the remaining average contractual life of options awarded is 5 years. A summary of the options by range of exercise price is as follows:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------------------------- ------------------------------------- NUMBER OUTSTANDING WEIGHTED AVERAGE NUMBER EXERCISABLE WEIGHTED AVERAGE RANGE OF EXERCISE PRICE DECEMBER 31, 2002 EXERCISE PRICE DECEMBER 31, 2002 EXERCISE PRICE - ----------------------- ------------------ ---------------- ------------------ ---------------- $3.90 to $5.99........ 523,706 $5.10 363,706 $5.30 $6.00 to $6.99........ 877,500 6.40 455,000 6.49 $7.00 to $7.99........ 371,128 7.20 371,128 7.20 $8.00 to $10.50....... 848,000 8.70 738,000 8.80 --------- --------- 2,620,334 7.00 1,927,834 7.29 ========= =========
WARRANTS The Company also had outstanding at December 31, 2002, 3,657,743 warrants at $5.41, expiring in 2005. STOCK PURCHASE PLAN Our 2000 Employee Stock Purchase Plan was adopted by our stockholders on June 27, 2000. Under the plan, employees may purchase shares of our common stock at a 15% discount from fair value. All of our full time employees, including officers, are eligible to participate in the employee stock purchase plan, subject to limited exceptions. Eligible employees participate voluntarily, and may withdraw from an offering at any time before the stock is purchased. Participation terminates automatically upon termination of employment other than for death, disability or retirement. Six-month offerings are made available beginning May 1 and November 1 of each year. The purchase price per share in an offering will not be less than 85% of the lesser of 72 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- the stock's fair value at the beginning of the offering period or on the applicable exercise date and may be paid through payroll deductions. As of December 31, 2002 and 2001, 63,954 and 62,761 shares, respectively, had been issued under the employee plan. AGENT STOCK PURCHASE PLAN We also have a 2000 Agent Stock Purchase Plan similar to the employee plan under which certain of our agents may purchase shares of our common stock at the same discount from fair value. The agent stock purchase plan does not qualify as an employee stock purchase plan within the meaning of Section 423 of the Code. As of December 31, 2002 and 2001, 164,164 and 76,621 shares, respectively, had been issued under the agent plan. There are 1,000,000 shares of common stock reserved for issuance in the aggregate under both plans. Both of the plans will terminate when all of the shares reserved for issuance under the plans have been purchased unless sooner terminated by the Board of Directors. STOCK AWARD Also, pursuant to employment contracts, the Company provided an award of common shares to Peter W. Nauert. The number of shares awarded was contingent upon the weighted average fair value of the common shares over specified periods, but is based on a stock award equal to $1.0 million per year through July 1, 2001 and $0.5 million per year through May 31, 2002, which was revised from July 1, 2003 due to his retirement as Chief Executive Officer. For the year ended December 31, 2002, 88,661 shares were awarded. STOCK-BASED COMPENSATION The Company recognized stock compensation expense of $0.2 million, $0.9 million, and $1.1 million in 2002, 2001 and 2000, respectively. As required by FASB Statement 123, Accounting for Stock-Based Compensation, the Company has estimated the pro forma impact on net income and earnings per share of stock-based compensation under the fair value method, using the Black-Scholes option valuation model. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. Significant underlying assumptions made are summarized as follows:
YEAR ENDED DECEMBER 31, --------------------------- 2002 2001 2000 ------- ------- ------- Risk-free rate of return.................................. 2.73% 4.33% 4.98% Dividend yield............................................ 0% 0% 0% Volatility factor......................................... 0.433 0.275 0.226 Expected life of award.................................... 5 YEARS 5 years 5 years
Based on the methodology and assumptions delineated above, the weighted average fair value of options was $1.39, $1.18 and $1.25 per share for 2002, 2001 and 2000, respectively. The pro forma impact would be to decrease net income by $0.4 million, $0.8 million and $0.7 million and decrease net income per share by $0.01, $0.05 and $0.04 for basic and for diluted for the years ended December 31, 2002, 2001 and 2000, respectively. 73 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- R. PREFERRED SHARES The Company has authorized 1,900,000 Non-Voting Preferred Shares, $.001 par value. The Company has never issued any Non-Voting Preferred Shares. However, the Board of Directors is authorized at any time to provide for the issuance of, such shares in one or more series, and to determine the designations, preferences, limitations and other rights of the shares issued, including but not limited to the dividend rate, liquidation preference, redemption rights and price, sinking fund requirements, conversion rights and restrictions on the issuance of such shares. Holders of non-voting preferred shares shall have no voting rights except as required by law. The Company has authorized 100,000 Convertible Voting Preferred Shares, $.001 par value, of which none are outstanding at December 31, 2002. On December 27, 2001, the Company repurchased its convertible voting preferred stock for $5.0 million from the proceeds of the public offering. The carrying value of the convertible voting preferred stock was $8.2 million and the related dividends distributable was $0.4 million. The resulting gain from repurchase of the convertible voting preferred stock was $3.6 million. The gain was recorded in retained earnings and was reflected as a component of net income attributable to common stockholders. For more information regarding our convertible voting preferred stock, see Note B. Equity Transactions and Note C. Business Combinations for further information. S. 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 use of such permitted practices by Ceres and its insurance subsidiaries did not have a material effect on their statutory equity at December 31, 2002 and 2001. Statutory accounting practices prescribed or permitted by regulatory authorities for Ceres' insurance subsidiaries differ from generally accepted accounting principles. Shareholders' equity and net income, unaudited, as determined in accordance with statutory accounting practices, for Ceres and its subsidiaries are summarized as follows:
STATUTORY CAPITAL AND STATUTORY NET GAIN (LOSS) SURPLUS YEAR ENDED DECEMBER 31, DECEMBER 31, ------------------------------- --------------------- 2002 2001 2000 2002 2001 -------- -------- --------- --------- --------- UNAUDITED (DOLLARS IN THOUSANDS) Central Reserve(1)................. $ 6,767 $(17,968) $(1,046) $30,584 $27,399 Provident American Life(1)......... (1,329) (5,085) (419) 3,215 3,947 Continental General(2)............. (13,684) (6,411) (2,831) 33,755 48,072 United Benefit Life(1)............. (187) (2,391) (1,564) 3,378 3,004 Pyramid Life(2).................... (105) 1,008 2,874 22,299 22,320
- --------------- (1) Statutory capital and surplus for Central Reserve includes Provident American Life and United Benefit Life. Central Reserve's statutory net gain (loss) for the years ended December 31, 2002 and 2001 includes losses of Provident American Life and United Benefit Life. (2) Statutory capital and surplus for Continental General includes Pyramid Life. Generally, the capital and surplus of Ceres' insurance subsidiaries available for transfer to the parent company are limited to the amounts that the insurance subsidiaries' capital and surplus, as determined in accordance with statutory accounting practices, exceed minimum statutory capital requirements. However, 74 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- payments of the amounts as dividends may be subject to approval by regulatory authorities. Ceres' insurance subsidiaries cannot pay any dividends in 2003 without prior regulatory approval. The National Association of Insurance Commissioners revised the Accounting Practices and Procedures Manual in a process referred to as Codification. The revised manual was effective January 1, 2001. The domiciliary states of Ceres and its insurance subsidiaries have adopted the provisions of the revised manual. The revised manual has changed, to some extent, prescribed statutory accounting practices and has resulted in changes to the accounting practices that Ceres and its subsidiaries use to prepare their statutory-basis financial statements. The impact of these changes to statutory-basis capital and surplus of Ceres insurance subsidiaries was not significant. The NAIC also 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. The Company calculated the risk-based capital for its insurance subsidiaries as of December 31, 2002 using the applicable RBC formula. Based on these calculations, the RBC levels of each of the insurance subsidiaries, except Continental General, exceeded the levels required by regulatory authorities. Continental General's statutory capital level was below "Company Action Level" at December 31, 2002. However, after the addition of the statutory capital generated from the sale of Pyramid Life, Continental General's RBC level will exceed the levels required by regulatory authorities. T. COMPREHENSIVE INCOME Comprehensive income is as follows:
YEAR ENDED DECEMBER 31, -------------------------- 2002 2001 2000 ------- ------ ------- (DOLLARS IN THOUSANDS) Net income (loss)........................................ $(2,401) $2,332 $16,450 Other comprehensive income, net of tax: Unrealized gain on securities, net of tax of $5,885, $37 and $0, respectively (1)........................ 12,173 7,280 11,806 Other.................................................. 186 (455) 210 ------- ------ ------- Comprehensive income................................ $ 9,958 $9,157 $28,466 ======= ====== =======
- --------------- (1) Net of reclassification adjustments for net gains (losses) included in net income. U. COMPUTATION OF NET INCOME PER COMMON SHARE Basic and diluted earnings per share are calculated in accordance with SFAS No. 128, Earnings per Share. Basic earnings per common share is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of shares outstanding during the period. Diluted earnings per common share is computed by dividing net income (loss) by the weighted average number of shares outstanding during the period including the effect of the assumed exercise of dilutive stock options under the treasury stock method. In 2001, the diluted earnings per share calculation was adjusted for a one time net gain on repurchase of the convertible voting preferred stock. All stock options and warrants were antidilutive for the 75 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- year ended December 31, 2002 and therefore are excluded from the calculation of diluted earnings per share. Basic and diluted weighted average shares of common stock are as follows:
YEAR ENDED DECEMBER 31, ------------------------------------ 2002 2001 2000 ---------- ---------- ---------- Weighted average shares: BASIC.......................................... 34,019,063 17,751,919 15,260,160 Convertible voting preferred stock............. -- -- 535,851 Stock awards and incremental shares from assumed exercise of stock options........... -- 38,226 629,344 ---------- ---------- ---------- DILUTED........................................ 34,019,063 17,790,145 16,425,355 ========== ========== ==========
V. EMPLOYEE BENEFIT PLAN The Company sponsors the Ceres Group, Inc. 401(k) Plan, a defined contribution 401(k) savings plan (the Plan). Effective January 1, 2001, the Plan was amended to increase the employer match (Company Match Contribution) to 50% of the first 6% of each participant's salary deferrals. Effective June 1, 2002, the Plan was amended so that participants can elect to make pre-tax contributions from 1% to 25% of their compensation and after-tax contributions were no longer permitted. In addition to the Company Match Contribution, Ceres will match 100% of each participant's contributions (Stock Match Contribution) to the Ceres Group, Inc. Stock Fund, up to maximum of $1,000 per year provided the participant agrees that the pre-tax contributions will not be transferred out of the fund for a minimum of one year. In addition, Ceres may contribute a Profit Sharing Contribution to the Plan, as determined by the Board of Directors. All eligible, active employees who have worked over 1,000 hours during the plan year and who are employed on the last day of the plan year share in this contribution. Participants who leave employment during the plan year due to retirement, death or disability will also share in the contribution. There were no Profit Sharing Contributions made for the 2002, 2001 and 2000 plan years, respectively. A participant's interest in the Company Match Contribution, Stock Match Contribution and Profit Sharing Contribution allocated to the participant's account becomes vested over a five-year graded vesting schedule with 100% vesting over five years. Total matching contributions by the Company were approximately $642,000 for 2002, $768,000 for 2001, and $376,000 for 2000. W. OPERATING SEGMENTS We apply SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, which requires us to report information about our operating segments according to the management approach for determining reportable segments. This approach is based on the way management organizes segments within a company for making operating decisions and assessing performance. We have three distinct operating segments based upon product types: medical, senior and other, and corporate and other. Products included in the medical segment include catastrophic and comprehensive medical plans. Significant products in the senior and other segment include Medicare supplement, long-term care, dental, life insurance, and annuities. The corporate and other segment encompasses all other activities, including investment income, interest expense, and corporate expenses of the parent company. 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) 76 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- allocated by industry segment. Revenues from each segment are primarily generated from premiums charged to external policyholders and interest earned on cash and investments.
YEAR ENDED DECEMBER 31, ------------------------------ 2002 2001 2000 -------- -------- -------- (DOLLARS IN THOUSANDS) MEDICAL Revenues Net premiums.................................... $370,029 $402,214 $372,816 Investment income, realized gains (losses)...... 8,511 11,644 9,014 Other income.................................... 30,481 37,772 36,086 -------- -------- -------- 409,021 451,630 417,916 -------- -------- -------- Expenses Benefits and claims............................. 291,789 328,803 286,387 Other operating expenses........................ 123,183 129,382 121,991 Special charges................................. -- 7,097 -- -------- -------- -------- 414,972 465,282 408,378 -------- -------- -------- Segment profit (loss) before federal income taxes, minority interest and preferred stock transactions.................................... $ (5,951) $(13,652) $ 9,538 ======== ======== ======== SENIOR AND OTHER Revenues Net premiums.................................... $170,107 $153,308 $109,566 Investment income, realized gains (losses)...... 17,566 15,285 14,508 Other income.................................... 3,067 3,341 2,597 -------- -------- -------- 190,740 171,934 126,671 -------- -------- -------- Expenses Benefits and claims............................. 129,235 115,040 84,174 Other operating expenses........................ 46,637 43,316 25,324 -------- -------- -------- 175,872 158,356 109,498 -------- -------- -------- Segment profit before federal income taxes, minority interest and preferred stock transactions.................................... $ 14,868 $ 13,578 $ 17,173 ======== ======== ========
77 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, ------------------------------ 2002 2001 2000 -------- -------- -------- (DOLLARS IN THOUSANDS) CORPORATE AND OTHER Revenues Investment income, realized gains (losses)...... $ 443 $ 623 $ 521 -------- -------- -------- Expenses Interest and financing expenses................. 2,001 4,679 5,566 Other operating expenses........................ 1,567 3,264 2,019 Special charges................................. 2,381 -- -- -------- -------- -------- 5,949 7,943 7,585 -------- -------- -------- Segment loss before federal income taxes, minority interest and preferred stock transactions....... $ (5,506) $ (7,320) $ (7,064) ======== ======== ======== INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE FEDERAL INCOME TAXES, MINORITY INTEREST AND PREFERRED STOCK TRANSACTIONS....................... $ 3,411 $ (7,394) $ 19,647 ======== ======== ========
We do not separately allocate investments or other identifiable assets by industry segment, nor are income tax expenses (benefits) allocated by industry segment. The Company also expanded the detail of its disclosures for 2002, 2001 and 2000, which included certain reclassifications. X. FAIR VALUES OF FINANCIAL INSTRUMENTS Fair values of financial instruments are based upon quoted market prices, where available, or on values obtained from independent pricing services. In cases where quoted market prices are not available, fair value is based on estimates using present value or other valuation techniques. These techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Although fair value estimates are calculated using assumptions that management believes are appropriate, differences between estimated and actual outcomes or changes in the underlying assumptions could cause these values to vary materially. Consequently, calculated fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized by the immediate settlement of the instruments. The tax ramifications of the related unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates. The following methods and assumptions were used by the Company in estimating its fair value disclosures: INVESTMENT SECURITIES -- Fair value for fixed maturity securities is based on quoted market prices, where available. For fixed maturity securities not actively traded, fair value is estimated using values obtained from independent pricing services. CASH, CASH EQUIVALENTS, PREMIUMS RECEIVABLE, REINSURANCE RECEIVABLE, SURPLUS NOTES, MORTGAGE LOANS AND POLICY NOTES -- The carrying amounts reported in the consolidated balance sheets for these instruments approximate their fair value. ANNUITY CONTRACTS -- The fair value for the annuity reserves included in the liability for future policy benefit, losses, and claims is the amount payable on demand. 78 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- OTHER POLICYHOLDERS' FUNDS -- The carrying amount reported in the consolidated balance sheets for these instruments approximate their fair value. MORTGAGE NOTE PAYABLE, DEBT AND REINSURANCE PAYABLE -- The carrying amounts reported in the consolidated balance sheets for the mortgage note payable and long-term debt approximates their fair value. Carrying amounts and estimated fair values of financial instruments at December 31, 2002 and 2001, are summarized as follows:
DECEMBER 31, --------------------------------------------- 2002 2001 --------------------- --------------------- CARRYING ESTIMATED CARRYING ESTIMATED AMOUNT FAIR VALUE AMOUNT FAIR VALUE -------- ---------- -------- ---------- (DOLLARS IN THOUSANDS) ASSETS Investments Fixed maturities available for sale...... $388,057 $388,057 $376,969 $376,969 Surplus notes............................ 5,151 5,151 5,211 5,211 Policy notes............................. 3,843 3,843 3,678 3,678 Mortgage loans........................... 52 52 57 57 Cash and cash equivalents.................. 32,118 32,118 68,506 68,506 Premiums receivable........................ 4,810 4,810 4,986 4,986 Reinsurance receivable..................... 170,075 170,075 217,360 217,360 LIABILITIES Annuity reserves........................... 160,388 156,218 179,369 174,313 Other policyholders' funds................. 23,610 23,610 28,659 28,659 Debt....................................... 25,003 25,003 31,000 31,000
Y. CONCENTRATIONS OF CREDIT RISK Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of fixed maturity investments, cash, cash equivalents, and reinsurance receivable. The Company maintains cash and short-term investments with various financial institutions, and performs periodic evaluations of the relative credit standings of those financial institutions. Substantially all of the Company's reinsurance recoverable is due from a single reinsurer, Hannover. At December 31, 2002, Hannover maintained an "A" rating from the A.M. Best Company. The Company performs periodic evaluations of this reinsurer's credit standing. 79 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2002, 2001 AND 2000 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Z. QUARTERLY RESULTS OF OPERATIONS - (UNAUDITED) The following is a summary of quarterly results of operations for the years ended December 31, 2002 and 2001. All prior quarters have been reclassed to reflect the pending sale of Pyramid Life:
FIRST SECOND THIRD FOURTH ---------- ---------- ---------- ---------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 2002 Revenues......................................... $153,127 $149,683 $148,474 $148,920 Benefits, claims, losses and settlement expenses...................................... 107,662 113,203 97,478 102,681 Selling, general and administrative and other expenses...................................... 45,369 46,006 42,106 41,751 Special charges.................................. 2,381 -- -- -- Income (loss) from continuing operations......... 1,011 (5,440) 4,219 2,327 Discontinued operations: Income from operations of Pyramid Life, net of tax......................................... 517 1,649 3,078 1,865 Loss on sale of Pyramid Life, net of tax...... -- -- -- (11,627) Income (loss) from discontinued operations....... 517 1,649 3,078 (9,762) Net income (loss)................................ 1,528 (3,791) 7,297 (7,435) Net income (loss) attributable to common stockholders.................................. 1,528 (3,791) 7,297 (7,435) Basic earnings (loss) per share: Continuing operations......................... 0.03 (0.16) 0.12 0.07 Discontinued operations....................... 0.02 0.05 0.09 (0.29) Net income.................................... 0.05 (0.11) 0.21 (0.22) Diluted earnings (loss) per share: Continuing operations......................... 0.03 (0.16) 0.12 0.07 Discontinued operations....................... 0.02 0.05 0.09 (0.29) Net income.................................... 0.05 (0.11) 0.21 (0.22) 2001 Revenues......................................... $150,365 $154,451 $160,673 $158,698 Benefits, claims, losses and settlement expenses...................................... 114,276 109,227 108,785 111,555 Selling, general and administrative and other expenses...................................... 47,254 50,732 47,598 51,424 Special charges.................................. 7,097 -- -- -- Income (loss) from continuing operations......... (7,626) (1,047) 1,830 1,314 Income (loss) from discontinued operations....... 529 1,758 3,728 1,846 Net income (loss)................................ (7,097) 711 5,558 3,160 Gain on repurchase of the convertible voting preferred stock, net of dividends............. (185) (187) (207) 3,406 Net income (loss) attributable to common stockholders.................................. (7,282) 524 5,351 6,566 Basic earnings (loss) per share Continuing operations......................... (0.45) (0.07) 0.09 0.25 Discontinued operations....................... 0.03 0.10 0.21 0.10 Net income.................................... (0.42) 0.03 0.30 0.35 Diluted earnings (loss) per share Continuing operations......................... (0.45) (0.07) 0.09 0.25 Discontinued operations....................... 0.03 0.10 0.20 0.10 Net income.................................... (0.42) 0.03 0.29 0.35
80 SCHEDULE II CERES GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CERES GROUP, INC. (PARENT ONLY) BALANCE SHEETS DECEMBER 31, 2002 AND 2001 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
2002 2001 -------- -------- ASSETS Investment in subsidiaries(1)............................... $199,774 $193,901 Cash and cash equivalents................................... 138 14,021 Property and equipment, net................................. 272 381 Other assets................................................ 9,665 4,725 -------- -------- Total assets...................................... $209,849 $213,028 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Debt...................................................... $ 25,003 $ 31,000 Other liabilities(2)...................................... 17,322 25,453 -------- -------- Total liabilities.................................... 42,325 56,453 -------- -------- Stockholders' equity Non-voting preferred stock................................ -- -- Convertible voting preferred stock........................ -- -- Common stock.............................................. 34 34 Additional paid-in capital................................ 133,052 132,061 Retained earnings......................................... 21,430 23,831 Accumulated other comprehensive income.................... 13,008 649 -------- -------- Total stockholders' equity........................ 167,524 156,575 -------- -------- Total liabilities and stockholders' equity........ $209,849 $213,028 ======== ========
- --------------- (1) Eliminated in consolidation. (2) Includes $9.5 million and $8.0 million in advances from non-regulated subsidiaries in 2002 and 2001, respectively. See accompanying independent auditors' report. 81 SCHEDULE II CERES GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CERES GROUP, INC. (PARENT ONLY) STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
2002 2001 2000 ------- ------- ------- REVENUES Dividend income(1).......................................... $ 6,300 $11,200 $ -- Rental income(2)............................................ 1,736 1,406 1,170 Net realized gains.......................................... 434 180 -- Net investment income....................................... 9 26 97 ------- ------- ------- 8,479 12,812 1,267 EXPENSES Selling, general and administrative expenses................ 5,580 8,097 4,015 ------- ------- ------- Income (loss) before income tax benefit and equity in undistributed income (loss) of subsidiaries............... 2,899 4,715 (2,748) Income tax benefit.......................................... (1,186) (2,270) (962) ------- ------- ------- Income (loss) before equity in undistributed income (loss) of subsidiaries........................................... 4,085 6,985 (1,786) Equity in undistributed (loss) income of subsidiaries(3).... (6,486) (4,653) 18,236 ------- ------- ------- NET INCOME (LOSS)........................................... (2,401) 2,332 16,450 Gain on repurchase of preferred stock, net of dividends..... -- 2,827 (327) ------- ------- ------- NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCKHOLDERS....... $(2,401) $ 5,159 $16,123 ======= ======= =======
- --------------- (1) Represents dividend income from non-regulated subsidiaries, which is eliminated in consolidation. (2) Eliminated in consolidation. (3) Includes the parent company's equity of regulated and non-regulated subsidiaries, which is eliminated in consolidation. See accompanying independent auditors' report. 82 SCHEDULE II CERES GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CERES GROUP, INC. (PARENT ONLY) STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
2002 2001 2000 -------- -------- -------- OPERATING ACTIVITIES Net income (loss)........................................... $ (2,401) $ 2,332 $ 16,450 Adjustments to reconcile net income (loss) to cash provided by (used in) operating activities: Equity in undistributed loss (income) of subsidiaries (1)..................................................... 6,486 4,653 (18,236) Depreciation.............................................. 109 352 470 Net realized gains........................................ (434) (180) -- Decrease (increase) in other assets....................... (4,940) (1,612) 1,303 Increase (decrease) in other liabilities.................. (1,160) (5,067) (1,915) Increase in net advances from non-regulated subsidiaries (1)..................................................... 1,463 1,685 6,336 -------- -------- -------- Net cash provided by (used in) operating activities......... (877) 2,163 4,408 -------- -------- -------- INVESTING ACTIVITIES Capital contributions to regulated subsidiaries (1)....... (8,000) (26,500) (3,500) Capital contribution to Continental General for the acquisition of Pyramid Life Insurance Company (1)....... -- -- (33,272) Increase in investment in subsidiaries (1)................ -- (141) (2,877) Proceeds from sale of Cleveland headquarters.............. -- 15,586 -- Purchase of property and equipment........................ -- (36) (618) -------- -------- -------- Net cash used in investing activities....................... (8,000) (11,091) (40,267) -------- -------- -------- FINANCING ACTIVITIES Increase in debt borrowings............................... -- 10,000 15,000 Principal payments on debt................................ (5,997) (28,000) (6,000) Principal payments on mortgage note payable............... -- (8,018) (139) Proceeds from public equity offering...................... -- 46,511 -- Proceeds from private placement of common stock, net of acquisition costs....................................... -- -- 21,096 Proceeds from issuance of common stock related to employee benefit plans........................................... 991 2,624 1,560 Repurchase of convertible voting preferred stock.......... -- (5,000) -- Proceeds from private placement of preferred stock........ -- -- 7,500 -------- -------- -------- Net cash provided by (used in) financing activities......... (5,006) 18,117 39,017 -------- -------- -------- NET INCREASE (DECREASE) IN CASH............................. (13,883) 9,189 3,158 Cash and cash equivalents at beginning of year.............. 14,021 4,832 1,674 -------- -------- -------- CASH AND CASH EQUIVALENTS AT END OF YEAR.................... $ 138 $ 14,021 $ 4,832 ======== ======== ========
- --------------- (1) Eliminated in consolidation. See accompanying independent auditors' report. 83 SCHEDULE III CERES GROUP, INC. AND SUBSIDIARIES SUPPLEMENTAL INSURANCE INFORMATION (DOLLARS IN THOUSANDS)
BENEFITS, FUTURE POLICY OTHER POLICY CLAIMS, DEFERRED BENEFITS, CLAIMS AND NET LOSSES AND ACQUISITION LOSSES AND UNEARNED BENEFITS PREMIUM INVESTMENT SETTLEMENT COSTS CLAIMS PREMIUMS PAYABLE REVENUE INCOME EXPENSES ----------- ------------- -------- ------------ -------- ---------- ----------- YEAR ENDED DECEMBER 31, 2002 Medical.......................... $41,869 $ 9,281 $10,535 $ 97,050 $370,029 $ 7,317 $291,789 Senior and other................. 33,022 318,104 26,145 50,888 170,107 16,932 129,235 Corporate and other.............. -- -- -- -- -- 9 -- ------- -------- ------- -------- -------- ------- -------- Total..................... $74,891 $327,385 $36,680 $147,938 $540,136 $24,258 $421,024 ======= ======== ======= ======== ======== ======= ======== YEAR ENDED DECEMBER 31, 2001 Medical.......................... $39,202 $ 11,258 $10,591 $144,064 $402,214 $ 9,634 $328,803 Senior and other................. 29,732 331,499 26,477 42,719 153,308 15,210 115,040 Corporate and other.............. -- -- -- -- -- 443 -- ------- -------- ------- -------- -------- ------- -------- Total..................... $68,934 $342,757 $37,068 $186,783 $555,522 $25,287 $443,843 ======= ======== ======= ======== ======== ======= ======== YEAR ENDED DECEMBER 31, 2000 Medical.......................... $33,187 $ 9,221 $ 8,621 $130,709 $372,816 $ 9,164 $286,387 Senior and other................. 20,038 337,746 25,005 34,037 109,566 14,486 84,174 Corporate and other.............. -- -- -- -- -- 521 -- ------- -------- ------- -------- -------- ------- -------- Total..................... $53,225 $346,967 $33,626 $164,746 $482,382 $24,171 $370,561 ======= ======== ======= ======== ======== ======= ======== NET (DEFERRAL) AMORTIZATION AND CHANGE IN ACQUISITION COSTS AND VALUE OTHER OF BUSINESS OPERATING ACQUIRED EXPENSES ---------------- --------- YEAR ENDED DECEMBER 31, 2002 Medical.......................... $ (2,450) $125,633 Senior and other................. (1,395) 48,032 Corporate and other.............. -- 5,949 -------- -------- Total..................... $ (3,845) $179,614 ======== ======== YEAR ENDED DECEMBER 31, 2001 Medical.......................... $(11,687) $148,166 Senior and other................. (10,031) 53,347 Corporate and other.............. -- 7,943 -------- -------- Total..................... $(21,718) $209,456 ======== ======== YEAR ENDED DECEMBER 31, 2000 Medical.......................... $(14,129) $136,120 Senior and other................. (13,862) 39,186 Corporate and other.............. -- 7,585 -------- -------- Total..................... $(27,991) $182,891 ======== ========
See accompanying independent auditors' report. 84 SCHEDULE IV CERES GROUP, INC. AND SUBSIDIARIES REINSURANCE (DOLLARS IN THOUSANDS) - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
PERCENTAGE OF CEDED TO ASSUMED AMOUNT GROSS OTHER FROM OTHER NET ASSUMED TO AMOUNT COMPANIES COMPANIES AMOUNT NET ---------- ---------- ---------- ---------- ---------- YEAR ENDED DECEMBER 31, 2002 Life insurance in force............ $3,296,906 $1,603,135 $ -- $1,693,771 N/M ========== ========== ======= ========== Premiums Life insurance................... $ 18,742 $ 8,301 $ 135 $ 10,576 1.3% Accident and health insurance.... 634,225 104,652 (13) 529,560 N/M ---------- ---------- ------- ---------- $ 652,967 $ 112,953 $ 122 $ 540,136 N/M ========== ========== ======= ========== YEAR ENDED DECEMBER 31, 2001 Life insurance in force............ $3,913,107 $2,077,299 $40,670 $1,876,478 2.2% ========== ========== ======= ========== Premiums Life insurance................... $ 19,268 $ 10,543 $ 570 $ 9,295 6.1% Accident and health insurance.... 719,922 180,557 6,862 546,227 1.3% ---------- ---------- ------- ---------- $ 739,190 $ 191,100 $ 7,432 $ 555,522 1.3% ========== ========== ======= ========== YEAR ENDED DECEMBER 31, 2000 Life insurance in force............ $4,042,892 $2,183,516 $80,178 $1,939,554 4.1% ========== ========== ======= ========== Premiums Life insurance................... $ 19,999 $ 5,711 $ 999 $ 15,287 6.5% Accident and health insurance.... 702,171 250,894 15,818 467,095 3.4% ---------- ---------- ------- ---------- $ 722,170 $ 256,605 $16,817 $ 482,382 3.5% ========== ========== ======= ==========
- --------------- N/M = not meaningful See accompanying independent auditors' report. 85 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 is incorporated by reference to our Proxy Statement in connection with our 2003 Annual Meeting of Stockholders to be held on May 20, 2003. We expect to file the Proxy Statement on or about April 10, 2003. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated by reference to our Proxy Statement in connection with our 2003 Annual Meeting of Stockholders to be held on May 20, 2003. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS EQUITY COMPENSATION PLAN INFORMATION As of December 31, 2002, the following table presents information regarding all of the company's option plans or awards with respect to Equity Compensation Plans approved by our stockholders:
NUMBER OF SHARES OF NUMBER OF SHARES OF OUR COMMON STOCK OUR COMMON STOCK WEIGHTED-AVERAGE- REMAINING AVAILABLE TO BE ISSUED UPON EXERCISE PRICE OF FOR FUTURE ISSUANCE EXERCISE OF OUTSTANDING UNDER EACH PLAN NAME OUTSTANDING OPTIONS OPTIONS PLAN/AWARD - --------- ------------------- ----------------- ------------------- 1998 Key Employee Share Incentive Plan........ 1,483,628 shares $6.39 516,372 shares Peter W. Nauert Employee Agreement (7/3/98)... 500,000 shares 8.50 -0- shares Total....................................... 1,983,628 shares 516,372 shares
As of December 31, 2002, the following table presents information regarding all of the Company's option plans or awards with respect to Equity Compensation Plans not previously approved by our stockholders:
NUMBER OF SHARES OF NUMBER OF SHARES OF OUR COMMON STOCK OUR COMMON STOCK TO BE ISSUED UPON WEIGHTED-AVERAGE REMAINING AVAILABLE FOR EXERCISE OF EXERCISE PRICE OF FUTURE ISSUANCE UNDER PLAN NAME OUTSTANDING OPTIONS OUTSTANDING OPTIONS EACH PLAN/AWARD - --------- ------------------- ------------------- ----------------------- 1998 Employee Stock Option Plan................. 243,000 shares $7.96 -0- shares* 1999 Special Agents' Stock Option Plan.......... 78,706 shares 5.94 -0- shares* Employment Agreement for Val Rajic (8/10/99).... 75,000 shares 6.50 -0- shares Employment Agreement for Charles E. Miller, Jr. (10/1/98).............. 100,000 shares 6.50 -0- shares Retainer Agreement for Billy B. Hill, Jr. (7/3/98)...................................... 125,000 shares 7.50 -0- shares Andrew A. Boemi................................. 15,000 shares 8.25 -0- shares Total......................................... 636,706 shares -0- shares
86 - --------------- * Plan terminated by Board of Directors and no future grants will be made. The outstanding grants under the plan were not affected by the termination. For additional information regarding our equity compensation plans, see "Note Q -- Stock Plans" in the accompanying consolidated financial statements in this Form 10-K. Additional information required by Item 12 is incorporated by reference to our Proxy Statement in connection with our 2003 Annual Meeting of Stockholders to be held on May 20, 2003. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is incorporated by reference to our Proxy Statement in connection with our 2003 annual meeting of stockholders to be held on May 20, 2003. ITEM 14. CONTROLS AND PROCEDURES Within the 90 days prior to the date of this report, we carried out an evaluation, under the supervision and with the participation of management, including our President and Chief Executive Officer along with our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-14(c)). Based upon that evaluation, our President and Chief Executive Officer along with our Chief Financial Officer concluded that our disclosure controls and procedures are effective. There have been no significant changes in our internal controls or in other factors, which could significantly affect internal controls subsequent to the date we carried out our evaluation. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Filed documents. The following documents are filed as part of this report: 1. Financial Statements. Ceres Group, Inc. and Subsidiaries: Audit Report. Consolidated Balance Sheets -- December 31, 2002 and 2001. Consolidated Statements of Operations -- Years ended December 31, 2002, 2001 and 2000. Consolidated Statements of Stockholders' Equity -- Years ended December 31, 2002, 2001 and 2000. Consolidated Statements of Cash Flows -- Years ended December 31, 2002, 2001 and 2000. Notes to Consolidated Financial Statements. 2. Financial Statement Schedules. Ceres Group, Inc.: II. Condensed Financial Information of Registrant -- Ceres Group, Inc. (parent only). III. Supplementary Insurance Information. IV. Reinsurance. Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the consolidated financial statements or notes thereto. 87 (b) Reports on Form 8-K: Form 8-K report filed on December 26, 2002 disclosing the announcement of definitive agreement to sell Pyramid Life to a subsidiary of Universal American Financial Corp. (c) Exhibits.
INCORPORATED BY REFERENCE TO REGISTRATION OR FORM OR EXHIBIT EXHIBITS FILE NUMBER REPORT DATE NUMBER -------- --------------- ------- --------- ------- Plan of acquisition, reorganization, arrangement, liquidation, or succession Amended and Restated Stock Purchase 0-8483 10-K Mar. 1998 2.2 Agreement, dated March 30, 1998, by and among Strategic Partners, Insurance Partners, L.P., Insurance Partners Offshore (Bermuda), L.P., and Central Reserve. Merger Agreement and Plan of Reorganization 0-8483 8-K Dec. 1998 2.1 dated December 8, 1998 between Central Reserve Life Corporation and Ceres Group, Inc. Stock Purchase Agreement dated as of 0-8483 8-K Feb. 1999 2.2 November 4, 1998 between The Western & Southern Life Insurance Company and Ceres Group, Inc. Purchase Agreement dated October 7, 1999, 0-8483 8-K Aug. 2000 2.1 by and between United Insurance Company of America and Ceres Group, Inc. Amendment of Purchase Agreement by and 0-8483 8-K Aug. 2000 2.2 between United Insurance Company of America and Ceres Group, Inc. dated as of April 17, 2000. Amendment No. 2 to Purchase Agreement by 0-8483 8-K Aug. 2000 2.3 and between United Insurance Company of America and Ceres Group, Inc. dated as of July 5, 2000. Purchase Agreement, dated December 20, 0-8483 8-K Dec. 2002 2.4 2002, by and among Continental General Insurance Company, Ceres Group, Inc., Pennsylvania Life Insurance Company, and Universal American Financial Corp. Articles of Incorporation and By-laws Certificate of Incorporation of Ceres 0-8483 8-K Dec. 1998 3.1 Group, Inc. as filed with Secretary of Delaware on October 22, 1998. Certificate of Amendment of the Certificate 0-8483 8-K Aug. 2000 3.1 of Incorporation of Ceres Group, Inc. dated July 25, 2000. Amended and Restated Bylaws of Ceres Group, 0-8483 10-Q Aug. 2002 3.2 Inc.
88
INCORPORATED BY REFERENCE TO REGISTRATION OR FORM OR EXHIBIT EXHIBITS FILE NUMBER REPORT DATE NUMBER -------- --------------- ------- --------- ------- Instruments defining the rights of security holders, including indentures Stockholders Agreement, dated as of July 1, 0-8483 8-K Feb. 1999 4.2 1998 by and among Ceres Group, Inc. (as successor-in-interest to Central Reserve Life Corporation) and the security holders listed on the signature pages thereof. Amended and Restated Registration Rights 0-8483 8-K Aug. 2000 4.1 Agreement dated as of July 25, 2000 between Ceres Group, Inc. (as successor-in-interest to Central Reserve Life Corporation) and the persons and entities set forth on the signature pages attached thereto. Form of Stockholders Agreement between 0-8483 S-1 Apr. 2001 4.5 QQLink.com, Inc., Ceres Group, Inc. and the persons and entities listed on the signature pages thereto. Material Contracts Reinsurance Agreement between Central 0-8483 10-K Mar. 1998 10.10 Reserve Life Insurance Company and Hannover Life Reassurance Company of America (f/k/a Reassurance Company of Hannover). Administrative Services Agreement, dated 0-8483 10-K/A Mar. 1998 10.12 March 25, 1998 by and between Mutual Management Company, Inc. and Central Reserve Life Insurance Company. Employment Agreement, dated October 1, 0-8483 10-K Mar. 1999 10.20 1998, by and between Charles E. Miller, Jr. and Ceres Group, Inc. Reinsurance Agreement dated February 1, 0-8483 10-K Mar. 1999 10.21 1999, between Continental General Life Insurance Company and Hannover Life Reassurance Company of America (f/k/a Reassurance Company of Hannover). Credit Agreement dated February 17, 1999, 0-8483 8-K Feb. 1999 10.22 among Ceres Group, Inc., the lending institutions and the Chase Manhattan Bank, as Administrative Agent. First Amendment to the Credit Agreement, 0-8483 8-K Aug. 2000 10.2 dated as of May 3, 1999, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and the Chase Manhattan Bank, as Administrative Agent.
89
INCORPORATED BY REFERENCE TO REGISTRATION OR FORM OR EXHIBIT EXHIBITS FILE NUMBER REPORT DATE NUMBER -------- --------------- ------- --------- ------- Second Amendment to Credit Agreement, dated 0-8483 8-K Aug. 2000 10.3 as of July 25, 2000, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and the Chase Manhattan Bank, as Administrative Agent. Employment Agreement, dated October 1, 0-8483 10-K Apr. 2001 10.3 1999, by and between Anthony J. Pino and Ceres Group, Inc. Third Amendment to Credit Agreement, dated 0-8483 10-Q Nov. 2000 10.1 as of September 22, 2000, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and the Chase Manhattan Bank, as Administrative Agent. Fourth Amendment to Credit Agreement, dated 0-8483 10-K Apr. 2001 10.4 as of December 13, 2000, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and the Chase Manhattan Bank, as Administrative Agent. Fifth Amendment to Credit Agreement, dated 0-8483 10-K Apr. 2001 10.5 as of February 16, 2001, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and the Chase Manhattan Bank, as Administrative Agent. Sixth Amendment to Credit Agreement, dated 0-8483 S-1 Apr. 2001 10.25 as of March 30, 2001, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and the Chase Manhattan Bank, as Administrative Agent. Ceres Group, Inc. 1998 Key Employee Share 0-8483 S-1 Apr. 2001 10.26 Incentive Plan. Ceres Group, Inc. 1998 Employee Stock 0-8483 S-1 Apr. 2001 10.27 Option Plan. Ceres Group, Inc. 1999 Special Agent's 0-8483 S-1 Apr. 2001 10.28 Stock Option Plan. Ceres Group, Inc. 2000 Employee Stock 0-8483 S-8 Apr. 2001 4.1 Purchase Plan. Ceres Group, Inc. 2000 Agent Stock Purchase 0-8483 S-8 Apr. 2001 4.2 Plan. Employment Agreement dated April 10, 2001, 333-59784 S-1 Apr. 2001 10.30 by and between Bruce M. Henry and Ceres Group, Inc. Amendment No. 1 to Employment Agreement 333-59784 S-1 Apr. 2001 10.31 dated April 10, 2001, by and between Anthony J. Pino and Ceres Group, Inc.
90
INCORPORATED BY REFERENCE TO REGISTRATION OR FORM OR EXHIBIT EXHIBITS FILE NUMBER REPORT DATE NUMBER -------- --------------- ------- --------- ------- Amendment No. 1 to Employment Agreement 0-8483 S-1 Apr. 2001 10.32 dated April 10, 2001, by and between Charles E. Miller. Employment Agreement, dated April 10, 2001, 333-59784 S-1/A Nov. 2001 10.29 by and between Peter W. Nauert and Ceres Group, Inc. Seventh Amendment to Credit Agreement, 0-8483 10-Q May 2001 10.35 dated as of May 17, 2001, among Ceres Group, Inc., the lending institutions party to the Credit Agreement referred to therein and the Chase Manhattan Bank, as Administrative Agent. Lease Agreement, dated as of July 31, 2001, 0-8483 10-Q Aug. 2001 10.37 between Royalton Investors, LLC and Big T Investments, LLC and Ceres Group, Inc. Eighth Amendment to the Credit Agreement, 0-8483 8-K Jan. 2002 10.38 dated as of December 18, 2001, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and JPMorgan Chase, as Administrative Agent. Transition Agreement, dated as of April 15, 0-8483 10-Q May 2002 10.38 2002, between Ceres Group, Inc. and Peter W. Nauert. Employment Agreement, dated as of July 9, 0-8483 10-Q Aug. 2002 10.39 2002, between Ceres Group, Inc. and Thomas J. Kilian. Employment Agreement, effective as of * 10.40 December 17, 2002 between Ceres Group, Inc. and David I. Vickers. Ninth Amendment to the Credit Agreement, * 10.41 dated as of March 31, 2003, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and JPMorgan Chase, as Administrative Agent. Subsidiaries of the registrant Subsidiaries. * 21.1 Consents of expert and counsel. Consent of Ernst & Young LLP. * 23.1 Certification pursuant to 18 U.S.C. Section * 99.1 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
- --------------- * Filed herewith. 91 SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, THE COMPANY HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. CERES GROUP, INC. Date: March 31, 2003 By: /s/ THOMAS J. KILIAN ----------------------------------------------------- Thomas J. Kilian, President and Chief Executive Officer
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE COMPANY AND IN THE CAPACITIES AND ON THE DATES INDICATED.
DATE SIGNATURE AND CAPACITY ---- ---------------------- March 31, 2003 By: /s/ THOMAS J. KILIAN ------------------------------------------------------- Thomas J. Kilian, President, Chief Executive Officer, and Director (principal executive officer) March 31, 2003 By: /s/ DAVID I. VICKERS ------------------------------------------------------- David I. Vickers, Executive Vice President and Chief Financial Officer (principal financial and accounting officer) March 31, 2003 By: /s/ ANDREW A. BOEMI ------------------------------------------------------- Andrew A. Boemi, Director March 31, 2003 By: /s/ MICHAEL A. CAVATAIO ------------------------------------------------------- Michael A. Cavataio, Director March 31, 2003 By: /s/ BRADLEY E. COOPER ------------------------------------------------------- Bradley E. Cooper, Director March 31, 2003 By: /s/ SUSAN S. FLEMING ------------------------------------------------------- Susan S. Fleming, Director March 31, 2003 By: /s/ ROBERT J. LUNN ------------------------------------------------------- Robert J. Lunn, Director March 31, 2003 By: /s/ PETER W. NAUERT ------------------------------------------------------- Peter W. Nauert, Director March 31, 2003 By: /s/ WILLIAM J. RUH ------------------------------------------------------- William J. Ruh, Director March 31, 2003 By: /s/ ROBERT A. SPASS ------------------------------------------------------- Robert A. Spass, Director
92 CERTIFICATIONS PURSUANT TO 17 CFR SECTION 240.13a-14 I, Thomas J. Kilian, President and Chief Executive Officer of Ceres Group, Inc., certify that: 1. I have reviewed this annual report on Form 10-K of Ceres Group, Inc. 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 31, 2003 /s/ THOMAS J. KILIAN - ------------------------------------ Thomas J. Kilian President and Chief Executive Officer (Principal Executive Officer) 93 I, David I. Vickers, Executive Vice President and Chief Financial Officer of Ceres Group, Inc., certify that: 1. I have reviewed this annual report on Form 10-K of Ceres Group, Inc. 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 31, 2003 /s/ DAVID I. VICKERS - ------------------------------------ David I. Vickers Executive Vice President and Chief Financial Officer (Principal Financial Officer) Simultaneously with the filing of this annual report on Form 10-K, the Company submitted to the Securities and Exchange Commission the certification of this report by its chief executive and chief financial officer required by 18 U.S.C. sec. 1350 as adopted pursuant to sec. 906 of the Sarbanes-Oxley Act of 2002. 94 EXHIBIT INDEX
INCORPORATED BY REFERENCE TO REGISTRATION OR FORM OR EXHIBIT EXHIBITS FILE NUMBER REPORT DATE NUMBER -------- --------------- ------- --------- ------- Plan of acquisition, reorganization, arrangement, liquidation, or succession. Amended and Restated Stock Purchase 0-8483 10-K Mar. 1998 2.2 Agreement, dated March 30, 1998, by and among Strategic Partners, Insurance Partners, L.P., Insurance Partners Offshore (Bermuda), L.P., and Central Reserve. Merger Agreement and Plan of 0-8483 8-K Dec. 1998 2.1 Reorganization dated December 8, 1998 between Central Reserve Life Corporation and Ceres Group, Inc. Stock Purchase Agreement dated as of 0-8483 8-K Feb. 1999 2.2 November 4, 1998 between The Western & Southern Life Insurance Company and Ceres Group, Inc. Purchase Agreement dated October 7, 0-8483 8-K Aug. 2000 2.1 1999, by and between United Insurance Company of America and Ceres Group, Inc. Amendment of Purchase Agreement by 0-8483 8-K Aug. 2000 2.2 and between United Insurance Company of America and Ceres Group, Inc. dated as of April 17, 2000. Amendment No. 2 to Purchase 0-8483 8-K Aug. 2000 2.3 Agreement by and between United Insurance Company of America and Ceres Group, Inc. dated as of July 5, 2000. Purchase Agreement, dated December 0-8483 8-K Dec. 2002 2.4 20, 2002, by and among Continental General Insurance Company, Ceres Group, Inc., Pennsylvania Life Insurance Company, and Universal American Financial Corp. Articles of Incorporation and By-laws Certificate of Incorporation of 0-8483 8-K Dec. 1998 3.1 Ceres Group, Inc. as filed with Secretary of Delaware on October 22, 1998. Certificate of Amendment of the 0-8483 8-K Aug. 2000 3.1 Certificate of Incorporation of Ceres Group, Inc. dated July 25, 2000. Amended and Restated Bylaws of Ceres 0-8483 10-Q Aug. 2002 3.2 Group, Inc.
95
INCORPORATED BY REFERENCE TO REGISTRATION OR FORM OR EXHIBIT EXHIBITS FILE NUMBER REPORT DATE NUMBER -------- --------------- ------- --------- ------- Instruments defining the rights of security holders, including indentures Stockholders Agreement, dated as of 0-8483 8-K Feb. 1999 4.2 July 1, 1998 by and among Ceres Group, Inc. (as successor-in-interest to Central Reserve Life Corporation) and the security holders listed on the signature pages thereof. Amended and Restated Registration 0-8483 8-K Aug. 2000 4.1 Rights Agreement dated as of July 25, 2000 between Ceres Group, Inc. (as successor-in-interest to Central Reserve Life Corporation) and the persons and entities set forth on the signature pages attached thereto. Form of Stockholders Agreement 0-8483 S-1 Apr. 2001 4.5 between QQLink.com, Inc., Ceres Group, Inc. and the persons and entities listed on the signature pages thereto. Material Contracts Reinsurance Agreement between 0-8483 10-K Mar. 1998 10.10 Central Reserve Life Insurance Company and Hannover Life Reassurance Company of America (f/k/a Reassurance Company of Hannover). Administrative Services Agreement, 0-8483 10-K/A Mar. 1998 10.12 dated March 25, 1998 by and between Mutual Management Company, Inc. and Central Reserve Life Insurance Company. Employment Agreement, dated October 0-8483 10-K Mar. 1999 10.20 1, 1998, by and between Charles E. Miller, Jr. and Ceres Group, Inc. Reinsurance Agreement dated February 0-8483 10-K Mar. 1999 10.21 1, 1999, between Continental General Life Insurance Company and Hannover Life Reassurance Company of America (f/k/a Reassurance Company of Hannover). Credit Agreement dated February 17, 0-8483 8-K Feb. 1999 10.22 1999, among Ceres Group, Inc., the lending institutions and the Chase Manhattan Bank, as Administrative Agent. First Amendment to the Credit 0-8483 8-K Aug. 2000 10.2 Agreement, dated as of May 3, 1999, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and the Chase Manhattan Bank, as Administrative Agent.
96
INCORPORATED BY REFERENCE TO REGISTRATION OR FORM OR EXHIBIT EXHIBITS FILE NUMBER REPORT DATE NUMBER -------- --------------- ------- --------- ------- Second Amendment to Credit 0-8483 8-K Aug. 2000 10.3 Agreement, dated as of July 25, 2000, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and the Chase Manhattan Bank, as Administrative Agent. Employment Agreement, dated October 0-8483 10-K Apr. 2001 10.3 1, 1999, by and between Anthony J. Pino and Ceres Group, Inc. Third Amendment to Credit Agreement, 0-8483 10-Q Nov. 2000 10.1 dated as of September 22, 2000, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and the Chase Manhattan Bank, as Administrative Agent. Fourth Amendment to Credit 0-8483 10-K Apr. 2001 10.4 Agreement, dated as of December 13, 2000, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and the Chase Manhattan Bank, as Administrative Agent. Fifth Amendment to Credit Agreement, 0-8483 10-K Apr. 2001 10.5 dated as of February 16, 2001, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and the Chase Manhattan Bank, as Administrative Agent. Sixth Amendment to Credit Agreement, 0-8483 S-1 Apr. 2001 10.25 dated as of March 30, 2001, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and the Chase Manhattan Bank, as Administrative Agent. Ceres Group, Inc. 1998 Key Employee 0-8483 S-1 Apr. 2001 10.26 Share Incentive Plan. Ceres Group, Inc. 1998 Employee 0-8483 S-1 Apr. 2001 10.27 Stock Option Plan. Ceres Group, Inc. 1999 Special 0-8483 S-1 Apr. 2001 10.28 Agent's Stock Option Plan. Ceres Group, Inc. 2000 Employee 0-8483 S-8 Apr. 2001 4.1 Stock Purchase Plan. Ceres Group, Inc. 2000 Agent Stock 0-8483 S-8 Apr. 2001 4.2 Purchase Plan. Employment Agreement dated April 10, 333-59784 S-1 Apr. 2001 10.30 2001, by and between Bruce M. Henry and Ceres Group, Inc. Amendment No. 1 to Employment 333-59784 S-1 Apr. 2001 10.31 Agreement dated April 10, 2001, by and between Anthony J. Pino and Ceres Group, Inc.
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INCORPORATED BY REFERENCE TO REGISTRATION OR FORM OR EXHIBIT EXHIBITS FILE NUMBER REPORT DATE NUMBER -------- --------------- ------- --------- ------- Amendment No. 1 to Employment 0-8483 S-1 Apr. 2001 10.32 Agreement dated April 10, 2001, by and between Charles E. Miller. Employment Agreement, dated April 333-59784 S-1/A Nov. 2001 10.29 10, 2001, by and between Peter W. Nauert and Ceres Group, Inc. Seventh Amendment to Credit 0-8483 10-Q May 2001 10.35 Agreement, dated as of May 17, 2001, among Ceres Group, Inc., the lending institutions party to the Credit Agreement referred to therein and the Chase Manhattan Bank, as Administrative Agent. Lease Agreement, dated as of July 0-8483 10-Q Aug. 2001 10.37 31, 2001, between Royalton Investors, LLC and Big T Investments, LLC and Ceres Group, Inc. Eighth Amendment to the Credit 0-8483 8-K Jan. 2002 10.38 Agreement, dated as of December 18, 2001, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and JPMorgan Chase, as Administrative Agent. Transition Agreement, dated as of 0-8483 10-Q May 2002 10.38 April 15, 2002, between Ceres Group, Inc. and Peter W. Nauert. Employment Agreement, dated as of 0-8483 10-Q Aug. 2002 10.39 July 9, 2002, between Ceres Group, Inc. and Thomas J. Kilian. Employment Agreement, effective as * 10.40 of December 17, 2002 between Ceres Group, Inc. and David I. Vickers. Ninth Amendment to the Credit * 10.41 Agreement, dated as of March 31, 2003, among Ceres Group, Inc., the lending institutions party to the Credit Agreement and JPMorgan Chase, as Administrative Agent. Subsidiaries of the registrant. Subsidiaries. * 21.1 Consents of expert and counsel. Consent of Ernst & Young LLP. * 23.1 Certification pursuant to 18 U.S.C. * 99.1 Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
- --------------- * Filed herewith. 98 EX-10.40 3 l99084aexv10w40.txt EX-10.40 EMPLOYMENT AGREEMENT EXHIBIT 10.40 EMPLOYMENT AGREEMENT THIS EMPLOYMENT AGREEMENT is effective this 17th day of December, 2002, by and between CERES GROUP, INC., a Delaware corporation, referred to in this Agreement as "Employer," and DAVID I. VICKERS, referred to in this Agreement as "Employee." RECITALS: Employer is engaged in the insurance business and maintains its corporate office in the City of Strongsville, Ohio; and Employer wished to employ Employee, and Employee wishes to be employed by Employer on the terms, covenants and conditions set forth in this Agreement. For good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, the parties agree as follows: Employer hereby employs Employee and Employee hereby accepts such employment upon the terms, covenants and conditions hereinafter set forth. 1. SERVICES. Employer shall employ Employee as Chief Financial Officer, solely subject to the supervision and pursuant to the assignments, advices and directions of Employer. Employee's duties and responsibilities shall include duties and responsibilities as are customarily performed by one holding such a position for Employer and/or other similar businesses or enterprises." Employee shall devote all Employee's time, attention, knowledge, and skill solely and exclusively to the business and interest of Employer, and Employer shall be entitled to all of the benefits, emoluments, profits or other issues arising from or incident to any and all work, services and advice of Employee, and Employee expressly agrees that during the term of this Agreement, Employee will not be interested, directly or indirectly, in any form, fashion or manner, as partner, officer, director, stockholder, advisor, employee or in any other form or capacity, in any other business similar to Employer's business or any allied trade. Employee represents and warrants to Employer that his employment hereunder and compliance with the terms and conditions of this Agreement will not conflict with or result in the breach of any agreement or obligation to which he is a party or may be bound. 2. TERM AND TERMINATION. The duration of employment pursuant to this Agreement shall be for a period of two (2) years, commencing on December 17, 2002 through December 16, 2004; provided, however, that this Agreement shall automatically renew for succeeding one (1) year terms, unless the Employer provides Employee with at least sixty (60) days' advance written notice that this Agreement and Employee's employment shall terminate as of the close of business on December 16 of the then-current original or renewal termination date (as the case may be). Termination without cause. Regardless of any provisions of this Agreement to the contrary, or which could be construed to the contrary, in the event that (a) Employer chooses to terminate this Agreement upon sixty (60) days' advance written notice prior to the end of the initial term or then-current renewal term, (b) Employee's annual salary is reduced, or (c) Employee shall leave the employment of Employer at any time other than as a voluntary quit or for "cause" (as defined below) or Employee's employment is terminated in connection with a "change of control" (as defined below), this Agreement shall terminate and Employee shall be entitled to severance pay equal to eighteen (18) months of Employee's then-current annual salary (less normal administrative deductions), payable in eighteen (18) equal monthly installments. Such payments shall be in lieu of any other payments from Employer, including, without limitation, severance or termination payments contained herein or otherwise and Employer shall have no further liability or obligation to Employee for compensation or benefits. "Change of Control." In the event that Employee's employment is terminated in connection with a "change of control" of Employer, Employee shall be entitled to receive cash compensation equal to two (2) years of Employee's then-current annual salary (less normal administrative deductions), payable in lump sum within thirty (30) days of such "change of control." Such payment shall be in lieu of any other payments from Employer, including, without limitation, severance or termination payments contained herein or otherwise and Employer shall have no further liability or obligation to Employee for compensation or benefits. "Change of control" shall mean the occurrence of any of the following events: (i) a tender offer shall be made and consummated for the ownership of 50.1% or more of the outstanding voting securities of Employer; (ii) Employer shall be merged or consolidated with another corporation and, as a result of such merger or consolidation, less than 50.1% of the outstanding voting securities of the surviving or continuing corporation shall be owned in the aggregate by the former stockholders of Employer as the same shall have existed immediately prior to such merger or consolidation; or (iii) Employer shall sell substantially all of its operating assets to another corporation which is not a wholly-owned subsidiary; (iv) a person, within the meaning of Section 3(a)(9) or of Section 13(d)(3) (as in effect on the date hereof) of the Exchange Act shall acquire, other than by reason of inheritance, (50.1%) or more of the outstanding voting securities of Employer (whether directly, indirectly, beneficially or of record). In determining whether a Change of Control has occurred, gratuitous transfers made by a person to an affiliate of such person (as determined by the Board of Directors of Employer), whether by gift, devise or otherwise, shall not be taken into account. For purposes of this Agreement, 2 ownership of voting securities shall take into account and shall include ownership as determined by applying the provisions of Rule 13d-3(d)(1)(i) as in effect on the date hereof pursuant to the Exchange Act." Termination for "cause." Notwithstanding any other provisions of this Agreement to the contrary, Employee's employment and this Agreement may be terminated by the Employer at any time without further compensation or severance pay or fringe benefits for "cause." For purposes of this paragraph, "cause" shall mean if Employee (1) has refused, failed or neglected to perform duties or render services hereunder or has performed or rendered them incompetently; (2) has been dishonest or committed a fraud or breach of trust or engaged in illegal or wrongful conduct substantially detrimental to the business or reputation of Employer; (3) has developed or pursued interests substantially adverse to Employer; (4) has been charged with, indicted for, or convicted of, a crime that constitutes a felony; or (5) has otherwise materially breached this Agreement. If, in the opinion of the Board of Employer, Employee's employment shall become subject to termination for "cause," the Board shall give Employee written notice to that effect which notice shall describe the matter or matters constituting such "cause." In the case of clauses (b) and (d) above, such notice shall constitute notice of termination of Employee's employment and Employee's employment will terminate immediately. In the case of clauses (a), (c) and (e) above, if, within 15 days of receipt of such notice, Employee has not substantially eliminated, resolved or cured each such matter or matters to the satisfaction of the Board in its sole discretion, then Employer shall have the right to give Employee notice that Employee's employment will terminate immediately. Voluntary Quit. Notwithstanding any other provision of this Agreement, Employee shall have the right to voluntarily quit Employee's employment and terminate this Agreement by giving sixty (60) days' advance written notice to Employer at the address provided herein. Notwithstanding any other provision of this Agreement, if Employee shall so voluntarily quit and terminate this Agreement, Employer shall have no further obligations pursuant to the terms of this Agreement, except to pay to Employee accrued salary to the date of termination. 3. COMPENSATION. Base Compensation. During this Agreement, Employer shall pay Employee (according to Employer's normal payroll procedures) and Employee agrees to accept from Employer, in full payment for services under this Agreement, a salary set by the Board of Directors and Employee shall receive annual reviews and merit increases. Employee's initial salary shall be $250,000 which shall be increased to $290,000 effective April 1, 2003. Bonuses. Employee shall also participate in Employer's bonus plan for officers or such other incentive compensation or plans as may be established by the Board 3 of Directors of Employer (the "Officer Bonus Plan"). Employee's bonus shall be payable as soon as it reasonably can be determined. Notwithstanding the foregoing, Employee shall be entitled to defer the receipt of his salary and/or bonus pursuant to procedures adopted or plans maintained by Employer. Expenses. During the first ninety (90) days of the initial term of this Agreement (unless extended by the Board in its sole discretion), Employee is authorized to incur reasonable expenses for travel between his current home in Chicago, Illinois and Employer's headquarters in Strongsville, Ohio. Employer shall reimburse Employee for such expenses after receipt of a written statement from Employee that itemizes such expenses in reasonable detail, together with all receipts related to such expenses. If, at the direction of the Board, Employee relocates and moves his home near Employer's headquarters, Employer would reimburse Employee for the costs of such relocation in accordance with Employer's existing relocation policy. In addition, Employer agrees that it will reimburse Employee for any and all necessary, customary and usual business expenses incurred by Employee, subject to Employer's then-current policies regarding such expenses. Benefits. In addition to the above salary and reimbursement, Employee shall be provided all fringe benefits on the same basis that Employer normally provides to a regular full-time employee holding Employee's position with Employer, including, but not limited to, health/dental insurance, life insurance, holidays, vacations (etc.)." Options. Upon approval by the Compensation Committee, Employer shall grant to Employee a nonqualified option to purchase one hundred thousand (100,000) shares of Employer's common stock pursuant to Employer's 1998 Key Employee Share Incentive Plan ("Share Option"). The Share Option shall have an exercise price equal to $1.95 per share. All of the shares underlying the Share Option shall vest on the third anniversary of the effective date of this Agreement if Employee is still employed by Employer on such date; provided, however, the shares shall also vest in full upon a "change of control" of Employer as that term is defined in Section 2 above. The Share Option shall expire ten (10) years from the date of this Agreement. The Share Option shall be on the terms and conditions contained in a Nonqualified Stock Option Agreement in the form attached hereto as Annex A. 4. COVENANTS. Non-Disclosure. Employee further specifically agrees that Employee will not, at any time during the term of this Agreement and for three (3) years following the termination of this Agreement for any reason, in any manner, either directly or indirectly, communicate to any person, firm or corporation any information of any kind concerning any matters affecting or relating to the business of Employer, including, without the limiting the generality of the foregoing, the lists or names of any of its policyholders or customers or agents, the prices it obtains or has 4 obtained or at which it sells or has sold its products, or any other information of, about or concerning the business of Employer, its manner of operation, its plans, processes or other data of any kind, nature or description without regard to whether any or all of the foregoing matters would be deemed confidential, material, proprietary or important, and significantly affect the effective and successful conduct of the business of Employer, and its goodwill, and that any breach of the terms of this paragraph is a material breach of this Agreement. Non-Competition. During Employee's employment hereunder and, in the event of a change of control or termination of Employee's employment for any reason other than for "cause" (under Section 2) or a voluntary quit, for a period of one (1) year, Employee shall not engage, directly or indirectly, whether as an owner, partner, employee, officer, director, agent, consultant or otherwise, in any location where Employer or any of its subsidiaries is engaged in business after the date hereof and prior to the termination of Employee's employment, in a business the same or similar to, any business now, or at any time after the date hereof and prior to Employee's termination, conducted by Employer or any of its subsidiaries, provided, however, that the mere ownership of 5% or less of the stock of a company whose shares are traded on a national securities exchange or are quoted on the National Association of Securities Dealers Automated Quotation System shall not be deemed ownership which is prohibited hereunder. Non-Solicitation. Employee agrees that regardless of any termination of this Agreement, during or at the end of this Agreement or any renewal thereof, Employee will not, for a period of one (1) year thereafter, (i) hire, retain or recruit any of Employer's insurance agents for the purpose of performing services for Employee or another insurance company, or (ii) contact or solicit, directly or indirectly, any person, firm or entity connected with Employer, including its customers or clients, for the purpose of diverting work or business from the Employer. No termination of this Agreement shall terminate the rights and obligations of the parties under this Section, but such rights and obligations shall serve such termination in accordance with the terms of this Section. 5. NON-DISPARAGEMENT. Following the termination of this Agreement for any reason, Employee hereby agrees and acknowledges that Employee will continue to have a duty of loyalty to Employer, and to the officers, directors, shareholders and employees of Employer, and in recognition of that duty of loyalty, Employee agrees that Employee shall not indulge in any conduct which may reflects adversely upon, nor make any statements disparaging of, Employer, or the officers, directors, shareholders or employees of Employer. 6. REMEDIES. Employee agrees that the remedy at law for any violation or threatened violation by Employee of Sections 4 and 5 will be inadequate and that, accordingly, Employer shall be entitled to injunctive relief in the event of a violation or threatened violation without being required to post bond or other surety. The foregoing remedies shall be in addition to, and not in limitation of, 5 any other rights or remedies to which Employer is or may be entitled at law, or in equity, or under this Agreement. 7. DEATH. Notwithstanding any other provisions of this Agreement, this Agreement shall be deemed automatically terminated upon death. In such event, Employer shall pay to Employee's personal representative or executor any compensation accrued but unpaid as of such date. Upon the payment of such accrued compensation, Employer shall have no further obligations under this Agreement, including, but not limited to, an obligation to pay a salary, severance or termination pay or any other form of compensation, or to provide any further fringe benefits of any kind or nature. 8. ENTIRE AGREEMENT. This written Agreement contains the sole and entire agreement between the parties and shall supersede any and all other agreements, whether oral or written, between the parties. The parties acknowledge and agree that neither of them has made any representation with respect to the subject matter of this Agreement or any representations inducing its execution and delivery, except such representations as are specifically set forth in this writing, and the parties acknowledge that they have relied on their own judgment in entering into the same. The parties further acknowledge that any statements or representations that may have been made by either of them to the other are void and of no effect and that neither of them has relied on such statements or representations in connection with its dealings with the other. 9. CONFIDENTIALITY. The terms of this Agreement are to be confidential, and Employee shall disclose its terms only to Employee's attorney, tax advisor and/or spouse, if any, subject to disclosure that may be necessary to comply with applicable law or in the event of a dispute leading to mediation and/or arbitration. 10. WAIVER/MODIFICATION. It is agreed that no waiver or modification of this Agreement or of any covenant, condition or limitation contained in it shall be valid unless it is in writing and duly executed by the party to be charged with it, and that no evidence of any waiver or modification shall be offered or received in evidence in any proceeding, arbitration or litigation between the parties arising out of or affecting this Agreement, or the rights or obligations of any party under it, unless such waiver or modification is in writing, duly executed as above. The parties agree that the provisions of this paragraph may not be waived, except by a duly executed writing. 11. ARBITRATION. If a dispute of any kind arises from or relates in any manner to this Agreement or the breach thereof, and if such dispute cannot be settled through direct discussions, the parties agree to endeavor to first settle the dispute in an amicable manner by mediation administered by and through the American Arbitration Association in accordance with its Commercial Mediation Rules before resorting to arbitration. Thereafter, any unresolved controversy or claim arising from or relating to this Agreement or breach thereof shall be settled by arbitration administered by and through the American Arbitration Association in accordance with its Commercial Arbitration Rules, provided however that only one arbitrator shall be appointed, which arbitrator shall be an attorney licensed in 6 the State of Ohio or an active or retired judge, having experience in employment contracts, and judgment on the award rendered by the arbitrator may be entered in any court having jurisdiction thereof. 12. GOVERNING LAW. The parties agree that it is their intention and covenant that this Agreement be construed in accordance with and under and pursuant to the laws of the State of Ohio. 13. SUCCESSORS AND ASSIGNS. Employee may not assign any rights or obligations under this Agreement without the prior written consent of Employer. This Agreement shall be binding upon and inure to the benefit of Employee and his lawful heirs, guardians, executors, administrators, and permitted successors and assigns. Employer may not assign any rights or obligations under this Agreement without the prior written consent of Employee except to the surviving corporation in connection with a merger or consolidation involving Employer or to the purchaser of assets in connection with a sale of all or substantially all of its assets, so long as the assignee expressly assumes Employer's rights or obligations. This Agreement shall be binding upon and inure to the benefit of Employer and its permitted successors and assigns. This Agreement does not create, and shall not be construed as creating, any rights enforceable by any person not a party to this Agreement, except as provided in this Section 13. 14. RETURN OF PROPERTY. Upon termination of this Agreement for any reason, Employee shall immediately return any property of Employer, including, but not limited to, any equipment, credit cards, advertising materials, booklets, training guides or any other such similar information, materials or documents that Employee has in Employee's possession or control. 15. COUNTERPARTS. This Agreement may be executed in one or more counterparts, each of which shall be deemed to constitute an original but all of which together will constitute one and the same instrument. 16. SEVERABILITY. If any clause, paragraph, or section of this Agreement be held invalid or unenforceable, the remaining provisions of this Agreement shall not be affected thereby and shall be valid and remain enforceable to the extent permitted by law. Moreover, if any one or more of the provisions in this Agreement shall for any reason by held to be excessively broad as to duration, geographical scope, activity, or subject, it shall be construed by limiting and reducing it, so as to be enforceable to the extent compatible with then applicable law. 17. NOTICES: All notices required to be provided under the terms of this Agreement shall be sent by United States mail, certified, return receipt requested, and to the following addresses: 7 TO EMPLOYER: Ceres Group, Inc. 17800 Royalton Road Strongsville, Ohio 44136 TO EMPLOYEE: David I. Vickers 197 Lawndale Avenue Elmhurst, Illinois 60126 ACKNOWLEDGMENT BY EMPLOYEE: BY SIGNING THIS AGREEMENT, I AFFIRM THAT I HAVE CAREFULLY READ AND CONSIDERED ALL OF THE TERMS AND CONDITIONS OF THIS AGREEMENT AND THAT SUCH TERMS AND CONDITIONS ARE UNDERSTOOD, ACCEPTED AND AGREED. IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first above written. EMPLOYER: EMPLOYEE: CERES GROUP, INC. DAVID I. VICKERS By: /s/ Thomas J. Kilian /s/ David I. Vickers ------------------------------- ----------------------------- Its: CEO and President 8 ANNEX A NON-QUALIFIED STOCK OPTION AGREEMENT UNDER THE CERES GROUP, INC. 1998 KEY EMPLOYEE SHARE INCENTIVE PLAN This Non-Qualified Stock Option Agreement ("Agreement") is made on March 4, 2003, by and between Ceres Group, Inc., a Delaware corporation ("Ceres" or the "Company"), and David I. Vickers ("Optionee"). Ceres and Optionee agree that the option granted by this Agreement does not qualify as an "incentive stock option" ("ISO") within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"). Ceres makes this grant of an option pursuant to the Ceres Group, Inc., 1998 Key Employee Share Incentive Plan ("Plan"). The option granted by this Agreement shall be subject to all the provisions of the Plan, which are incorporated herein by reference, and shall be subject to the following provisions of this Agreement: 1. NUMBER OF COMMON SHARES AND OPTION PRICE. Ceres hereby grants Optionee an option ("Option") to purchase 100,000 shares of the Company's $0.001 par value common stock ("Common Shares") for a purchase price ("Option Price") of $1.95 (One dollar and Ninety-five cents) per Common Share. 2. GENERAL TERMS, PERIOD, VESTING AND EXERCISABILITY. (a) The term of the Option and the term of this Agreement shall commence on the date hereof ("Date of Grant") and shall terminate upon the expiration of ten (10) years from the Date of Grant ("Maximum Term") if not terminated or extinguished earlier by operation of this Agreement or the terms of the Plan. Upon termination of the Optionee's employment (regardless of reason) with Ceres or one of its subsidiary corporations, as the case may be, all Options evidenced by this Agreement that remain outstanding but are not then vested and exercisable shall terminate and expire. Upon termination of the Optionee's employment with Ceres or a subsidiary company other than by death or permanent and total disability and more than three (3) months prior to the end of the Maximum Term, those Options evidenced by this Agreement that are vested and exercisable shall terminate and expire three (3) months following the date such employment terminates. Upon termination of the Optionee's employment with Ceres or a subsidiary company, by death or permanent and total disability and more than one (1) year prior to the end of the Maximum Term, those Options evidenced by this Agreement that are vested and exercisable shall terminate and expire one (1) year following the date of such death or permanent and total disability (as determined by the Compensation Committee of the Board of Directors of Ceres). Options that terminate, expire or lapse on a given date shall do so on such date at 5:00 p.m., Cleveland, Ohio time. (b) The Option shall vest and first become exercisable on December 17, 2005 and shall terminate on December 17, 2012. (c) Notwithstanding any contrary provisions of this Agreement and subject only to the terms of the Plan, the Compensation Committee of the Board of Directors of Ceres ("Committee") in its sole discretion may cancel and extinguish this Agreement, incident to or as a result of any reorganization, merger, consolidation, recapitalization, dissolution or similar restructuring or corporate event involving Ceres, by paying to the Optionee (or other party then in rightful possession of the Option) the value of said Option (to the extent then vested and exercisable), determined as of the date of such restructuring or corporate event and based on the excess, if any, of the fair market value of Common Shares over the Option Price. 3. METHOD OF EXERCISE: The Option shall be exercisable from time to time by written notice (in substantially the form attached hereto as Exhibit A) to the Company that shall: (a) state that the Option is thereby being exercised, the number of Common Shares with respect to which the Option is being exercised, each person in whose name any certificates for the Common Shares should be registered and his or her address and social security number; (b) be signed by the person or persons entitled to exercise the Option and, if the Option is being exercised by anyone other than the Optionee, be accompanied by proof satisfactory to counsel for Ceres of the right of such person or persons to exercise the Option under the Plan and all applicable laws and regulations; and (c) be accompanied by such representations, warranties or agreements with respect to the investment intent of such person or persons exercising the Option as Ceres may reasonably request in form and substance satisfactory to counsel for Ceres. 4. PAYMENT OF OPTION PRICE. Upon exercise of the Option, Ceres shall deliver a certificate or certificates for such Common Shares to the specified person or persons at the specified time upon receipt of the full purchase price for such Common Shares by any method of payment authorized by the Plan. 5. TRANSFERABILITY. The Option shall not be transferable or assignable by the Optionee except as expressly provided by the Plan. The Option shall be exercisable (subject to any other applicable restrictions on exercise) only by the Optionee for his or her own account, except that (a) in the event of the death of the Optionee, the Option shall be exercisable (subject to any other applicable restrictions on exercise) only by the Optionee's estate (acting through its fiduciary) or by the Optionee's duly authorized legal representative; (b) in the event of the permanent and total disability of the Optionee, the Option shall be exercisable by the Optionee's authorized representative (unless the Optionee has legal capacity); and (c) in the event of a divorce or other marriage dissolution resulting in a change in ownership of some or all of the Options covered by this Agreement, the Option shall be exercisable only by the ex-spouse of the Optionee within the three (3) month period ending on the date of such change in ownership. 6. RESTRICTIONS ON EXERCISE. The Option is subject to all restrictions in this Agreement or in the Plan. As a condition of any exercise of the Option, Ceres may require the Optionee or his successor to make any representation and warranty to comply with any applicable law or regulation or to confirm any factual matters reasonably requested by counsel for Ceres. 2 7. TAXES. The Optionee hereby agrees to pay to Ceres, in accordance with the terms of the Plan, any federal, state or local taxes of any kind required by law to be withheld with respect to the Option granted hereunder. If the Optionee does not make such payment, Ceres shall have the right to deduct from any payment of any kind otherwise due to the Optionee from Ceres, any federal, state or local taxes of any kind required by law to be withheld with respect to the Option or the Common Shares to be purchased by the Optionee under this Agreement. 8. NO CONTRACT OF EMPLOYMENT. Neither the Plan nor this Agreement, nor any other action taken by Ceres or any committee or representative thereof, shall constitute or otherwise evidence a contract of employment, regardless whether express or implied, between the Optionee and Ceres. 9. DEFINITIONS. Unless otherwise defined in this Agreement, capitalized terms will have the same meanings given them in the Plan. 10. AMENDMENT AND CONTROLLING LAW. This Agreement may be amended or modified at any time, but only by a written instrument signed by the parties hereto (or their successors and assigns). This Agreement is to be governed and construed according to the laws of the state of incorporation of Ceres, without regard to its conflicts of law principles or statutes. CERES GROUP, INC. DATE OF GRANT: MARCH 4, 2003 By: /s/ Kathleen L. Mesel ------------------------------------- Kathleen L. Mesel Secretary - - - - - - - - - - - - - (Return signed page 3 only)- - - - - - - - - - - - - ACCEPTANCE OF AGREEMENT The Optionee hereby: (a) acknowledges receiving a copy of the Plan, which is attached to this Non-Qualified Stock Option Agreement, and represents that he/she is familiar with all provisions of the Plan; (b) accepts this Non-Qualified Stock Option Agreement and the Option granted under this Agreement subject to all provisions of the Plan and this Agreement; and (c) agrees to accept as binding, conclusive and final all decisions or interpretations of Ceres. Date: ------------------------- ----------------------------------- Signature ----------------------------------- Printed Name Optionee 3 EXHIBIT A Exercise of Non-Qualified Stock Option TO: Secretary Ceres Group, Inc. 17800 Royalton Road Strongsville, Ohio 44136 Dear Secretary: The undersigned Optionee hereby exercises the Non-qualified Stock Option granted to him/her pursuant to the Non-Qualified Stock Option Agreement dated May 1, 2001, between Ceres Group, Inc. and the Optionee with respect to ________________ Common Shares covered by said Option, and tenders herewith $__________________________ in payment of the purchase price thereof by delivery of - -------------------------------------------------------. The name and registered address on such certificate should be: ---------------------------- ---------------------------- ---------------------------- The Optionee's social security number is: ______-_____-______. Dated: ---------------------------- ----------------------------------- Optionee 4 EX-10.41 4 l99084aexv10w41.txt EX-10.41 9TH AMENDMENT TO THE CREDIT AGREEMENT EXHIBIT 10.41 NINTH AMENDMENT, WAIVER AND CONSENT NINTH AMENDMENT, WAIVER AND CONSENT (this "Amendment"), dated as of March __, 2003, among CERES GROUP, Inc., a Delaware corporation (the "Borrower"), the lending institutions party to the Credit Agreement referred to below (each a "Bank" and, collectively, the "Banks"), and JPMORGAN CHASE BANK, as Administrative Agent (the "Administrative Agent"). All capitalized terms used herein and not otherwise defined herein shall have the respective meanings provided such terms in the Credit Agreement referred to below. W I T N E S S E T H : - - - - - - - - - - WHEREAS, the Borrower, the Banks and the Administrative Agent are party to a Credit Agreement, dated as of February 17, 1999 (as amended, modified and supplemented prior to the date hereof, the "Credit Agreement"); WHEREAS, the Borrower and its indirect Wholly-Owned Subsidiary, Continental General Insurance Company, a Nebraska insurance company ("Continental"), have decided to sell 100% of the capital stock of the Pyramid Life Insurance Company, a Kansas stock insurance company ("Pyramid") and a direct Wholly-Owned Subsidiary of Continental (the "Pyramid Sale"); WHEREAS, to effectuate the Pyramid Sale, Continental, the Borrower, Pennsylvania Life Insurance Company, a Pennsylvania insurance company and a Wholly-Owned Subsidiary of American Exchange Life Insurance Company, a Texas corporation ("American Exchange"), and Universal American Financial Corp. have heretofore entered into a Purchase Agreement, dated as of December 20, 2002 (the "Pyramid Purchase Agreement"); WHEREAS, the Borrower has requested that the Banks consent to the Pyramid Sale as provided herein; WHEREAS, the Borrower has also requested certain other amendments and waivers to the Credit Agreement as provided herein; and WHEREAS, subject to the terms and conditions of this Amendment, the Banks hereby agree to grant the consents, amendments and waivers under the Credit Agreement as herein provided; NOW, THEREFORE, it is agreed: 1. The Banks hereby waive any Default or Event of Default that may have arisen solely as a result of the Borrower's failure to comply with (a) Section 7.12 of the Credit Agreement solely to the extent such Default or Event of Default was caused by the failure of Continental to comply with the minimum Risk-Based Capital Ratio set forth in such Section 7.12 of the Credit Agreement during the period commencing on December 31, 2002 and ending on the Ninth Amendment Effective Date and (b) Section 7.17 of the Credit Agreement for the Test Period ended on December 31, 2002, solely to the extent such Default or Event of Default would not have occurred had the Borrower been permitted to exclude the amount of intercompany tax sharing payments made during such Test Period in calculating Borrower Cash Flow for such Test Period. 2. Notwithstanding anything to the contrary contained in the Credit Agreement, the Banks hereby consent to the Pyramid Sale on the terms and conditions substantially the same as those set forth in the Pyramid Purchase Agreement, so long as (i) no Default or Event of Default exists at the time of consummation of such sale or would result therefrom, (ii) such sale shall be for an amount at least equal to the fair market value thereof (as determined in good faith by senior management of the Borrower), (iii) the total consideration received therefrom by Continental is 100% cash and is paid at the time of closing of such sale, (iv) the aggregate sale proceeds therefrom shall be at least $56,000,000, subject to an adjustment equal to the change (if any) in the aggregate statutory capital and surplus of Pyramid as of the closing of such sale as compared to the aggregate statutory capital and surplus of Pyramid at June 30, 2002, each as determined in accordance with the accounting practices prescribed or permitted by the State of Kansas (the "Pyramid Sale Price"), (v) upon receipt by Continental of such sale proceeds, Dividends in an amount equal to at least $10,000,000 are paid in cash by Continental to Continental General Corporation ("Continental Corporation"), (vi) upon receipt by Continental Corporation of such Dividends, further Dividends in an amount equal to at least $10,000,000 are paid in cash by Continental Corporation to the Borrower and are applied upon receipt thereof as a mandatory repayment of principal of outstanding (x) A-1 Term Loans in an amount equal to no less than $6,300,000 and (y) A-2 Term Loans in an amount equal to no less than $3,600,000, and (vii) any material amendments and/or modifications to the Pyramid Purchase Agreement after the Ninth Amendment Effective Date are reasonably satisfactory to the Administrative Agent. 3. Section 3.02(i)(a)(x) of the Credit Agreement is hereby amended by deleting the table appearing therein in its entirety and inserting the following new table in lieu thereof: "Scheduled Repayment Date Amount ------------------------- ------ May 17, 2003 $ 547,368.78 August 17, 2003 $ 547,368.78 November 17, 2003 $ 547,368.77 February 17, 2004 $ 508,509.34 May 17, 2004 $ 508,509.34 August 17, 2004 $ 508,509.33 November 17, 2004 $ 508,509.33 February 17, 2005 $5,039,574.49" 4. Section 3.02(i)(a)(y)(ii) of the Credit Agreement is hereby amended by deleting the table appearing therein and inserting the following new table in lieu thereof: "A-2 Term Loan Scheduled Repayment Date Amount ------------------------ ------ June 17, 2003 $222,631.23 September 17, 2003 $222,631.22 December 17, 2003 $222,631.22 March 17, 2004 $215,992.06 June 17, 2004 $412,490.20 September 17, 2004 $412,490.20 December 17, 2004 $412,490.20 March 17, 2005 $434,231.27 June 17, 2005 $820,398.08 September 17, 2005 $820,398.08 December 17, 2005 $820,398.08" 5. Section 3.02(i) of the Credit Agreement is hereby further amended by inserting the following new sub-clause (g) immediately after sub-clause (f) appearing therein: "(g) In addition to any of the mandatory repayments pursuant to this Section 3.02(i), in the event that (i) the aggregate sale proceeds from the Pyramid Sale are greater than $56,000,000, (ii) Continental has Dividends available for distribution as of December 31, 2003 and (iii) Continental has obtained from the Nebraska Department of Insurance (the "Nebraska Department") approval to distribute Dividends to Continental Corporation, upon the receipt of such approval (A) Continental shall pay Dividends in cash to Continental Corporation in an the amount equal to the excess of the aggregate sale proceeds from the Pyramid Sale over $56,000,000 (or, if less, in the amount permitted by the Nebraska Department), (B) upon the receipt thereof, Continental Corporation shall pay Dividends in cash to the Borrower in an amount equal to no less than the amount of Dividends received from Continental pursuant to clause (A) above and (C) upon receipt thereof, the Borrower shall apply such amount received from Continental Corporation pursuant to clause (B) above as a mandatory repayment of principal of outstanding Term Loans. Notwithstanding anything to the contrary contained in Section 3.02(ii)(b), all mandatory repayments of principal made pursuant to this Section 3.02(i)(g) shall be applied to the A-1 Term Loans and A-2 Term Loans on a pro rata basis (based upon the then outstanding principal amount of A-1 Term Loans and A-2 Term Loans)." 6. Section 3.02(ii)(a) of the Credit Agreement is hereby amended by deleting the text "Section 3.02(i)(b)" appearing therein and inserting the new text "Sections 3.02(i)(b) and 3.02(i)(g)" in lieu thereof. 7. Section 6 of the Credit Agreement is hereby amended by inserting the following new Section 6.15 at the end of said Section: "Section 6.15 Payment of Dividends by Continental. In the event that Continental has Dividends available for distribution as of December 31, 2003, the Borrower will, and will cause Continental, to promptly request approval from the Nebraska Department to pay Dividends in cash in an amount equal to the excess of the aggregate sale proceeds from the Pyramid Sale over $56,000,000." 8. Section 9 of the Credit Agreement is hereby amended by (x) deleting the definition of "Applicable Percentage" appearing therein and (y) inserting therein the following new definitions in the appropriate alphabetical order: "Applicable Percentage" shall mean (a) with respect to Base Rate Loans, 3.00% and (ii) with respect to Eurodollar Loans, 4.00%, "; provided that for the purposes of the A-2 Term Loans, "Applicable Percentage" shall mean (a) with respect to Base Rate Loans, 3.50%, and (b) with respect to Eurodollar Loans, 4.50%. 9. Section 9 of the Credit Agreement is hereby further amended by inserting in the appropriate alphabetical order the following new definitions: "Nebraska Department" shall have the meaning provided in Section 3.02(g). 10. In order to induce the Banks to enter into this Amendment, the Borrower represents and warrants that (i) all of the representations and warranties contained in the Credit Agreement or in the other Credit Documents are true and correct in all material respects on and as of the Ninth Amendment Effective Date, both before and after giving effect to this Amendment unless any such representation and warranty expressly indicates that it is being made as of any other specific date in which case such representation and warranty shall be true and correct in all material respects as of such other specified date, (ii) there exists no Default or Event of Default on the Ninth Amendment Effective Date after giving effect to this Amendment. 11. This Amendment shall become effective as of the date (the "Ninth Amendment Effective Date") when the following conditions are satisfied: (i) the Borrower and Required Banks shall have signed a counterpart hereof (whether the same or different counterparts) and shall have delivered (including by way of facsimile transmission) the same to the Administrative Agent at its Notice Office (such date, the "Signing Date"), provided that the Borrower shall have paid on or prior to such Signing Date all reasonable out-of-pocket costs and expenses of the Banks incurred prior to the Signing Date (including, without limitation, the fees and disbursements of White & Case LLP); (ii) the Borrower shall have consummated the Pyramid Sale on the terms described in Section 2 above; and (iii) the Borrower shall have paid to the Administrative Agent for the benefit of the Banks an amendment fee equal to 0.25% of the aggregate principal amount of such Bank's outstanding Term Loans as of the Ninth Amendment Effective Date after giving effect to the payment required by Section 2 above. 12. From and after the Ninth Amendment Effective Date, all references in the Credit Agreement and each of the Credit Documents to the Credit Agreement shall be deemed to be references to the Credit Agreement as amended hereby. 13. This Amendment is limited as specified and shall not constitute a modification, acceptance or waiver of any other provision of the Credit Agreement or any other Credit Document. 14. This Amendment may be executed in any number of counterparts and by the different parties hereto on separate counterparts, each of which counterparts when executed and delivered shall be an original, but all of which counterparts shall together constitute one and the same instrument. A complete set of counterparts shall be lodged with the Borrower and the Administrative Agent. THIS AMENDMENT AND THE RIGHTS AND OBLIGATIONS OF THE PARTIES HEREUNDER SHALL BE GOVERNED BY AND CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE OF NEW YORK. * * * IN WITNESS WHEREOF, each of the parties hereto has caused a counterpart of this Amendment to be duly executed and delivered as of the date hereof. CERES GROUP, INC. By: /s/ Larry E. Wharton ----------------------------------- Title: Treasurer JPMORGAN CHASE BANK, Individually and as Administrative Agent By: /s/ Helen L. Newcomb ----------------------------------- Title: Vice President DRESDNER BANK AG, NEW YORK BRANCH AND GRAND CAYMAN BRANCH By: /s/ James M. Gallagher ----------------------------------- Title: Director By: /s/ Erika P. Walters-Engemann ----------------------------------- Title: Director KEYBANK NATIONAL ASSOCIATION By: /s/ Mary K. Young ----------------------------------- Title: Vice President FIRSTAR BANK MILWAUKEE, N.A. By: /s/ Jeffrey P. Googins ----------------------------------- Title: Relationship Manager FLEET NATIONAL BANK By: /s/ Stephen E. Burse ----------------------------------- Title: Vice President THE CIT GROUP/EQUIPMENT FINANCING, INC. By: /s/ Katie J. Sanders ----------------------------------- Title: Senior Credit Analyst EX-21.1 5 l99084aexv21w1.txt EX-21.1 SUBSIDIARIES . . . Exhibit 21.1
JURISDICTION OF PERCENT OF PARENT SUBSIDIARIES ORGANIZATION OWNERSHIP Ceres Group, Inc. Central Reserve Life Insurance Company Ohio 100% Ceres Administrators, L.L.C. Delaware 100% Ceres Financial Services, Inc. Ohio 100% Ceres Health Care, Inc. Delaware 100% Ceres Marketing, LLC Delaware 100% Ceres Net, Inc. Delaware 100% Ceres Sales, LLC Delaware 100% Ceres Sales of Ohio, LLC Ohio 100% Ceres Savers Plan, Inc. Delaware 100% Continental General Corporation Nebraska 100% QQLink.com, Inc. Delaware 94% Senior Savers Plus, Inc. Delaware 100% Western Reserve Administrative Ohio 100% Services, Inc. Continental General Corporation Continental General Insurance Company Nebraska 100% Continental Agency Services, Inc. Nebraska 100% Continental Print & Photo Company Nebraska 100% Central Reserve Life Insurance Company Provident American Life & Health Ohio 100% Insurance Company United Benefit Life Insurance Company Ohio 100% Ceres Administrators, L.L.C. Continental Association Management Corp. Delaware 100% Ceres Sales, LLC HealthMark Sales, LLC Delaware 100% HealthMark Sales, LLC HealthMark Sales of Ohio, LLC Ohio 100% QQAgency, Inc. QQAgency of Massachusetts, Inc. Massachusetts 100% QQAgency of Ohio, Inc. Ohio 100% QQAgency of Texas, Inc. Texas 100% QQLink.com, Inc. QQAgency, Inc. Delaware 100% QQBiz.com, Inc. Delaware 100%
EX-23.1 6 l99084aexv23w1.txt EX-23.1 CONSENT OF INDEPENDENT AUDITORS Exhibit 23.1 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 33-62657) pertaining to the Ceres Group, Inc. 401(k) Plan of our report dated March 4, 2003, except for Notes A, F and O as to which the date is March 31, 2003, with respect to the consolidated financial statements and schedules of Ceres Group, Inc. included in this Annual Report (Form 10-K) for the year ended December 31, 2002. Cleveland, Ohio March 31, 2003 EX-99.1 7 l99084aexv99w1.txt EX-99.1 CERTIFCATION OF CEO AND CFO CERES GROUP, INC. CERTIFICATION OF PERIODIC FINANCIAL REPORT PURSUANT TO 18 U.S.C. SECTION 1350 Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, each of the undersigned officers of Ceres Group, Inc. (the "Company") certifies that the Annual Report on Form 10-K of the Company for the annual ended December 31, 2002 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and information contained in that Form 10-K fairly presents, in all material respects, the financial condition and results of operations of the Company. Dated: March 31, 2003 /s/ Thomas J. Kilian ------------------------------------- Thomas J. Kilian Chief Executive Officer Dated: March 31, 2003 /s/ David I. Vickers ------------------------------------- David I. Vickers Chief Financial Officer This certification is made solely for purpose of 18 U.S.C. Section 1350, subject to the knowledge standard contained therein, and not for any other purpose. -----END PRIVACY-ENHANCED MESSAGE-----