10-Q 1 l87897ae10-q.txt CERES GROUP, INC. FORM 10-Q 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2001 -------------- OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ________ TO _________ Commission file number 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 incorporation or organization) Identification No.) 17800 Royalton Road Cleveland, Ohio 44136 --------------------- (Address of principal executive offices) (Zip Code) (440) 572-2400 -------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Common Stock, $.001 Par Value - 17,451,884 shares as of April 30, 2001. 2 CERES GROUP, INC. AND SUBSIDIARIES INDEX
PART I. FINANCIAL INFORMATION PAGE ---- Item 1. Financial Statements - Unaudited Condensed Consolidated Balance Sheets - March 31, 2001 and December 31, 2000 3 Condensed Consolidated Statements of Income - Three months ended March 31, 2001 and 2000 4 Condensed Consolidated Statements of Stockholders' Equity - Three months ended March 31, 2001 5 Condensed Consolidated Statements of Cash Flows - Three months ended March 31, 2001 and 2000 6 Notes to Condensed Consolidated Financial Statements - March 31, 2001 7 Item 2. Management's Discussion and Analysis of Financial Condition and 16 Results of Operations Item 3. Quantitative and Qualitative Disclosure of Market Risk 26 PART II. OTHER INFORMATION Item 1. Legal Proceedings 27 Item 2. Changes in Securities 29 Item 6. Exhibits and Reports on Form 8-K 29 SIGNATURES 30 EXHIBITS 31
2 3 PART I. FINANCIAL INFORMATION ----------------------------- ITEM 1. FINANCIAL STATEMENTS - UNAUDITED ---------------------------------------- CERES GROUP, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS)
MARCH 31, DECEMBER 31, 2001 2000 --------- --------- (UNAUDITED) (NOTE A) ASSETS Investments Fixed maturities available-for-sale, at fair value $ 441,461 $ 415,287 Surplus notes 4,992 4,995 Policy and mortgage loans 5,798 5,829 --------- --------- Total investments 452,251 426,111 Cash and cash equivalents (of which $11,388 and $9,397 is restricted, respectively) 46,995 59,512 Accrued investment income 6,540 7,496 Premiums receivable 6,069 5,852 Reinsurance receivable 229,313 238,185 Property and equipment, net 17,165 17,531 Deferred federal income taxes 7,084 3,797 Deferred acquisition costs 59,335 55,989 Value of business acquired 33,147 32,254 Goodwill 25,274 25,425 Other assets 7,473 8,377 --------- --------- Total assets $ 890,646 $ 880,529 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Policy liabilities and accrual Future policy benefits, losses and claims $ 413,310 $ 408,169 Unearned premiums 47,950 42,751 Other policy claims and benefits payable 180,753 176,236 --------- --------- 642,013 627,156 Deferred reinsurance gain 17,580 18,839 Other policyholders' funds 28,325 24,246 Federal income taxes payable 1,621 1,464 Mortgage note payable 7,981 8,018 Debt 48,000 49,000 Other liabilities 40,810 48,523 --------- --------- Total liabilities 786,330 777,246 --------- --------- Stockholders' equity Non-voting preferred stock, $.001 par value, 1,900,000 shares authorized, none issued -- -- Convertible voting preferred stock, $.001 par value, at stated value, 100,000 shares authorized, 75,000 shares issued and outstanding 7,500 7,500 Common stock, $.001 par value, 50,000,000 shares authorized, 17,322,679 and 17,278,704 shares issued and outstanding, respectively 17 17 Additional paid-in capital 83,278 82,943 Dividends distributable, convertible voting preferred stock 512 327 Retained earnings 11,390 18,672 Accumulated other comprehensive income (loss) 1,619 (6,176) --------- --------- Total stockholders' equity 104,316 103,283 --------- --------- Total liabilities and stockholders' equity $ 890,646 $ 880,529 ========= =========
The accompanying notes are an integral part of these condensed consolidated financial statements. 3 4 CERES GROUP, INC AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME UNAUDITED (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED MARCH 31, ---------------------- 2001 2000 REVENUES Premiums, net Medical $ 101,426 $ 80,837 Senior and other 51,786 23,887 --------- --------- Total premiums, net 153,212 104,724 Net investment income 7,670 5,731 Net realized gains (losses) 648 (73) Fee and other income 8,396 6,929 Amortization of deferred reinsurance gain 1,259 1,398 --------- --------- 171,185 118,709 --------- --------- BENEFITS, LOSSES AND EXPENSES Benefits, claims, losses and settlement expenses Medical 86,144 62,667 Senior and other 43,052 18,891 --------- --------- Total benefits, claims, losses and settlement expenses 129,196 81,558 Selling, general and administrative expenses 53,848 37,699 Net (deferral) amortization and change in acquisition costs and value of business acquired (10,924) (7,774) Amortization of goodwill 275 239 Interest expense and financing costs 1,485 1,186 Special charges - Note D 7,097 -- --------- --------- 180,977 112,908 --------- --------- Income (loss) before federal income taxes, minority interest, and preferred stock dividends (9,792) 5,801 Federal income tax expense (benefit) (2,680) 2,030 --------- --------- Income (loss) after tax, before minority interest and preferred stock dividends (7,112) 3,771 Minority interest (15) -- --------- --------- NET INCOME (LOSS) (7,097) 3,771 Convertible voting preferred stock dividends 185 -- --------- --------- NET INCOME (LOSS) ATTRIBUTABLE TO COMMON STOCKHOLDERS $ (7,282) $ 3,771 ========= ========= NET INCOME (LOSS) PER SHARE ATTRIBUTABLE TO COMMON STOCKHOLDERS Basic $ (0.42) $ 0.28 Diluted (0.42) 0.26
The accompanying notes are an integral part of these condensed consolidated financial statements. 4 5 CERES GROUP, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE THREE MONTHS ENDED MARCH 31, 2001 (DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS) UNAUDITED CONVERTIBLE VOTING PREFERRED STOCK Balance at March 31, 2001 $ 7,500 ============ COMMON STOCK Balance at March 31, 2001 $ 17 ============ ADDITIONAL PAID-IN CAPITAL Balance at beginning of year $ 82,943 Issuance of stock: Employee benefit plans 335 ------------ Balance at March 31, 2001 $ 83,278 ============ DIVIDENDS DISTRIBUTABLE, CONVERTIBLE VOTING PREFERRED STOCK Balance at beginning of year $ 327 Dividends distributable 185 ------------ Balance at March 31, 2001 $ 512 ============ RETAINED EARNINGS Balance at beginning of year $ 18,672 Net loss (7,097) Dividends distributable, convertible voting preferred stock (185) ------------ Balance at March 31, 2001 $ 11,390 ============ ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at beginning of year $ (6,176) Unrealized gain on securities, net of tax of $813 8,326 Other (531) ------------ Balance at March 31, 2001 $ 1,619 ============ TOTAL STOCKHOLDERS' EQUITY $ 104,316 ============ NUMBER OF SHARES OF CONVERTIBLE VOTING PREFERRED STOCK Balance at March 31, 2001 75,000 ============ NUMBER OF SHARES OF COMMON STOCK Balance at beginning of year 17,278,704 Issuance of stock: Employee benefit plans 43,975 ------------ Balance at March 31, 2001 17,322,679 ============ The accompanying notes are an integral part of these condensed consolidated financial statements. 5 6 CERES GROUP, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS UNAUDITED (DOLLARS IN THOUSANDS)
THREE MONTHS ENDED MARCH 31, -------------------- 2001 2000 -------- -------- OPERATING ACTIVITIES Net income (loss) $ (7,097) $ 3,771 Adjustments to reconcile net income (loss) to cash provided by (used in) operating activities: Depreciation and amortization 808 611 Net realized (gains) losses (648) 73 Deferred federal income tax benefit (2,908) (39) Changes in assets and liabilities: Reinsurance and premiums receivable 8,655 (7,716) Value of business acquired (893) (336) Goodwill 151 239 Federal income taxes payable/recoverable 157 2,638 Accrued investment income 956 268 Other assets 904 (11,555) Future policy benefits, claims and funds payable 12,481 11,965 Unearned premium 5,199 869 Reinsurance payable 682 2,408 Other liabilities (8,396) 875 Deferred acquisition costs (4,162) (7,439) Deferred reinsurance gain (1,259) (1,398) -------- -------- Net cash provided by (used in) operating activities 4,630 (4,766) -------- -------- INVESTING ACTIVITIES Net purchases of furniture and equipment (86) (412) Purchase of fixed maturities available-for-sale (55,339) (12,514) Decrease in surplus notes -- 236 Decrease (increase) in mortgage and policy loans, net 31 (10) Proceeds from sales of fixed maturities available-for-sale 15,447 991 Proceeds from calls and maturities of fixed maturities available-for sale 22,246 2,393 Proceeds from sale of property held for sale -- 1,954 -------- -------- Net cash used in investing activities (17,701) (7,362) ======== ======== FINANCING ACTIVITIES Increase in annuity account balances 11,336 4,204 Decrease in annuity account balances (10,080) (6,690) Principal payments on mortgage note payable (37) (33) Increase in debt borrowings 10,000 2,000 Principal payments on debt (11,000) (3,000) Proceeds from issuance of common stock related to employee benefit plans 335 -- -------- -------- Net cash provided by (used in) financing activities 554 (3,519) -------- -------- NET DECREASE IN CASH (12,517) (15,647) Cash and cash equivalents at beginning of year 59,512 42,921 -------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 46,995 $ 27,274 ======== ======== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the period for interest $ 1,466 $ 2,088 Cash paid during the period for federal income taxes 500 1,000
The accompanying notes are an integral part of these condensed consolidated financial statements. 6 7 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2001 (UNAUDITED) ================================================================================ A. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements of Ceres Group, Inc. and subsidiaries included herein have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three month period ended March 31, 2001 are not necessarily indicative of the results that may be expected for the year ended December 31, 2001. The condensed consolidated financial statements for March 31, 2001 include the accounts of Central Reserve Life Insurance Company, Provident American Life & Health Insurance Company, Continental General Corporation and its wholly-owned subsidiary Continental General Insurance Company, United Benefit Life Insurance Company, and Pyramid Life Insurance Company acquired on July 26, 2000. The balance sheet at December 31, 2000 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in Ceres' Annual Report on Form 10-K/A for the year ended December 31, 2000. RECLASSIFICATIONS Certain prior period amounts have been reclassified to conform to the current year presentation. CASH AND CASH EQUIVALENTS Cash and cash equivalents include cash and all liquid securities with maturities of 90 days or less when purchased. At March 31, 2001 and December 31, 2000, the Company had approximately $11.4 million and $9.4 million, respectively, in cash and cash equivalents that were not available due to restrictions on the cash held for self-funded accident and health accounts. The Company is entitled to investment income from these funds. A corresponding liability is included in the accompanying condensed consolidated financial statements. INVESTMENTS The Company's insurance subsidiaries had certificates of deposit and fixed maturity securities on deposit with various state insurance departments to satisfy regulatory requirements. 7 8 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED MARCH 31, 2001 (UNAUDITED) ================================================================================ NEW ACCOUNTING PRONOUNCEMENTS In September 2000, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities which replaces FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This standard revises the methods for accounting for securitizations and other transfers of financial assets and collateral as outlined in FASB Statement No. 125, and requires certain additional disclosures. For transfers and servicing of financial assets and extinguishments of liabilities, this standard will be effective for the Company's June 30, 2001 financial statements. However, for disclosures regarding securitizations and collateral, as well as the accounting for recognition and reclassification of collateral, this standard is effective for our December 31, 2000 financial statements. The adoption of this standard did not have a material effect on our financial position or results of operations as of December 31, 2000. In addition the provisions that will be effective June 30, 2001, are not expected to have a material effect on our financial position or results of operations. In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities as amended by FASB Statement No. 137, Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133. We adopted the new statement effective January 1, 2001. If in the future we have derivative instruments, this Statement will require us to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If a derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will either be offset against the change in fair value of the hedged asset, liability, or firm commitment through earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value will be immediately recognized in earnings. The adoption of FASB Statement No. 133 did not have a significant effect on our results of operations or financial position. B. DEBT MARCH 31, DECEMBER 31, 2001 2000 ------- ------- (dollars in thousands) Mortgage note payable $ 7,981 $ 8,018 ======= ======= Bank credit facility $43,000 $34,000 Revolver 5,000 15,000 ------- ------- $48,000 $49,000 ======= ======= The mortgage note payable on our Cleveland headquarters bears interest at 9.5% per annum. The mortgage note is collateralized by the home office building and by an assignment of the tenant lease for the building. Principal payments are due monthly with the final payment of 8 9 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED MARCH 31, 2001 (UNAUDITED) ================================================================================ $7.7 million due on January 1, 2003. The Company has a right to prepay the loan with a 1.0% prepayment fee. To provide funds for the acquisition of Continental General in February 1999, we incurred debt of $40.0 million under a credit agreement. Under the terms of the credit agreement, dated as of February 17, 1999, among Ceres, various lending institutions and The Chase Manhattan Bank, as Administrative Agent, quarterly principal payments are due through February 2005. Interest on the outstanding balance will be 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% in excess of a federal funds rate and (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 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 must be repaid on February 17, 2002. The revolver bears interest at the same rate choices as the $40.0 million loan. At March 31, 2001, the interest rate on the revolver was 10.5% on the outstanding balance of $5.0 million. On March 30, 2001, our credit agreement with Chase was amended to enter into a new $10.0 million term loan with CIT Equipment Financing, Inc. The proceeds of this term loan were used to permanently pay down $10.0 million of our then fully-drawn $15.0 million revolver under the credit agreement. The terms of the amendment provide for CIT to participate equally with the syndicate of banks and Chase under the credit agreement. The $10.0 million CIT term loan bears interest at the same rate choices, as our $40.0 million term loan. At March 31, 2001, the interest rate on our $40.0 million term loan was 8.9% and the interest rate on our $10.0 million CIT term loan was 10.5%. The first principal payment on the CIT term loan of $0.3 million will be due on June 17, 2002. Quarterly principal payments will be due thereafter as follows: $0.3 million through March 17, 2004; $0.6 million thereafter through March 17, 2005; and $1.2 million thereafter through March 17, 2006. In addition, we pledged the common stock of Central Reserve, Continental General Corporation, Provident American Life, Pyramid Life, United Benefit Life and other subsidiaries as security for the credit agreement. In conjunction with the special charges taken in the first quarter of 2001, our credit agreement was amended to provide for a waiver of certain financial covenant requirements. The covenants of minimum interest coverage ratio and minimum net worth were waived as a result of the adverse effect of the special charges. At March 31, 2001, we were in compliance with our credit agreement, as amended. 9 10 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED MARCH 31, 2001 (UNAUDITED) ================================================================================ C. REINSURANCE The Company has entered into several quota-share reinsurance treaties with Hannover Life Reassurance Company of America on various blocks of business of its subsidiaries. Under the provisions of the treaties, the Company cedes between 50% and 100% of the premiums for these policies and in return receives reimbursement, for the same percentage, of the claims. In addition, the Company receives a commission and expense allowance. In another reinsurance arrangement, the Company also assumes certain policies, in which it paid certain commission and expense allowances, which are classified as reinsurance expenses below. The following table summarizes the net impact of reinsurance arrangements on premiums and benefits, claims, losses and settlement expenses, commissions, and other operating expenses:
THREE MONTHS ENDED MARCH 31, -------------------------- 2001 2000 --------- --------- (dollars in thousands) Premiums Direct $ 206,463 $ 169,957 Assumed 1,965 2,776 Ceded (55,216) (68,009) --------- --------- Net premiums $ 153,212 $ 104,724 ========= ========= Benefits, claims, losses, and settlement expenses $ 178,186 $ 134,841 Reinsurance recoveries (48,990) (53,283) --------- --------- $ 129,196 $ 81,558 ========= ========= Selling, general, and administrative expenses Commissions $ 33,638 $ 29,685 Other operating expenses 32,765 25,589 Reinsurance expenses 504 1,040 Reinsurance allowances (13,059) (18,615) --------- --------- $ 53,848 $ 37,699 ========= =========
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. We have reclassified certain prior period amounts in accordance with current year treatment. 10 11 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED MARCH 31, 2001 (UNAUDITED) ================================================================================ D. SPECIAL CHARGES The Company 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 the sale of United Benefit Life. The Company has experienced excessive losses on United Benefit Life and Provident American Life due to high benefit utilization. These blocks had a $4.2 million pre-tax loss, including legal expenses, for the first quarter of 2001 compared to a $1.2 million pre-tax loss for these blocks for the first quarter of 2000. In addition to the special charges, the Company has taken the following actions to mitigate these losses: - entered into a written agreement to sell the stock of United Benefit Life, including United Benefit Life's licenses and certain liabilities, to Pelagian, LLC.; and - begun to implement a planned policyholder conversion program. E. COMPREHENSIVE INCOME Comprehensive income is as follows: THREE MONTHS ENDED MARCH 31, ----------------------- 2001 2000 ------- -------- (dollars in thousands) Net income (loss) $(7,097) $ 3,771 Other comprehensive income, net Unrealized gain (loss) on securities, net of tax of $813 and $0 8,326 (869) Other (531) (266) ------- ------- Comprehensive income $ 698 $ 2,636 ======= ======= F. EARNINGS PER SHARE Basic and diluted earnings per share are calculated in accordance with SFAS No. 128, Earnings per Share. Basic earnings per common share are computed by dividing net income (loss) attributable to common stockholders by the weighted average number of shares 11 12 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED MARCH 31, 2001 (UNAUDITED) ================================================================================ outstanding during the period. Diluted earnings per common share are 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. Stock options are antidilutive for the three months ended March 31, 2001 and therefore are excluded from the calculation of diluted earnings per share. Basic and diluted weighted average shares of common stock are as follows: THREE MONTHS ENDED MARCH 31, ------------------------- 2001 2000 ---------- ---------- Weighted average shares: BASIC 17,321,702 13,706,726 Incremental shares from assumed exercise of stock options -- 840,264 ---------- ---------- DILUTED 17,321,702 14,546,990 ========== ========== G. CONTINGENT MATTERS We are defendants in a lawsuit filed on August 14, 2000, Insurance Advisors of America, Inc., Transcend Group, Inc., and Jimmy K. Walker vs. Ceres Group, Inc., Ceres Financial Services, Inc., Peter W. Nauert, Central Reserve Life Insurance Company, Hannover Life Reassurance Company of America (f/k/a Reassurance Company of Hannover), Provident American Life and Health Insurance Company and Health Plan Services, Inc., United Benefit Life Insurance Company and Billy B. Hill, Jr., case no. 17-184-65-00, in State District Court of Tarrant County, Texas. The lawsuit involves a number of agreements between Insurance Advisors of America and its affiliates, Transcend Group and Mr. Walker, Ceres, Ceres Financial and United Benefit Life in which, among other things, we reinsured United Benefit Life's policies, Insurance Advisors entered into a non-compete agreement which prohibited them from selling insurance products not provided by us, and Insurance Advisors signed a $10.0 million promissory note payable to us. Pursuant to these agreements and to satisfy, in part, a $19.4 million reserve shortfall, we acquired through foreclosure the stock of United Benefit Life on July 21, 1999. Plaintiffs assert claims for, among other things, fraud, breach of contract and negligence relating to unfair competition. Plaintiffs allege that we engaged in a scheme to eliminate plaintiffs from the competitive market, retain Insurance Advisors' renewal commissions and "steal" their subagents by, among other things, "locking" plaintiffs into exclusive agreements and non-compete agreements and "improperly" increasing premiums and reducing commissions. Plaintiffs further assert, among other things, that our actions and inactions "unilaterally and unfairly" effectively eliminated plaintiffs' ability to conduct business and made it "impossible" for agents and their managers to remain with Insurance Advisors and "make a living." Actual damages sought by plaintiffs in the original complaint filed on August 14 are in excess of $50.0 million. Hannover has now been dismissed from this action. Additionally, plaintiffs voluntarily dismissed our general counsel, Billy B. Hill, Jr., from the lawsuit. On March 5, 2001, plaintiffs amended their complaint to again include Billy Hill; to add additional defendants, including Rhonda Immoos (a paralegal at Ceres), Pyramid Life and 12 13 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED MARCH 31, 2001 (UNAUDITED) ================================================================================ Continental General; to add additional allegations of civil conspiracy, tortious interference with business and existing and future contractual relationships towards Nauert, Hill and Immoos; and to demand a jury trial. Plaintiffs now seek monetary damages in excess of $100.0 million, including damages for lost profits, unpaid commissions and unpaid administrative fees. In addition, plaintiffs now seek punitive damages in excess of $100.0 million. On September 5, 2000, we filed a claim, Ceres Group, Inc., Central Reserve Life Insurance Company, Provident American Life and Health Insurance Company, and United Benefit Life Insurance Company vs. Insurance Advisors of America, Inc., Robert H. Merrill, Private Business Management, Inc., Transcend Group, Inc. and Jimmy K. Walker, in the Court of Common Pleas of Cuyahoga County, Ohio, relating to the foreclosure on the United Benefit Life stock and Insurance Advisors' failure to make payments under the promissory note. On September 15, 2000, the Court of Common Pleas entered a temporary restraining order in our favor, prohibiting defendants from making any false statements regarding us and prohibiting them from inducing our insureds to lapse coverage. This order was superceded by an agreed order dated October 2, 2000, which made permanent the temporary order and required defendants to send a mailing to the agents of Insurance Advisors advising them of the same. On October 25, 2000, we filed a counterclaim in Tarrant County, Texas, asserting that the plaintiffs failed to make payments under the various lending agreements entered into by Insurance Advisors, breach of fiduciary duties, misrepresentation of financial condition, breach of contract and certain other claims. Contractual and tort damages sought are in excess of $25.0 million. On January 23, 2001, we sought leave of the court to file a supplemental complaint and to deposit certain funds with the court pending the final outcome of the litigation. On February 22, 2001, the Court of Common Pleas of Cuyahoga County granted the defendants' Motion to Dismiss on Jurisdictional Priority Grounds. We plan to appeal the court's decision to dismiss the case. We have denied liability to plaintiffs in the Texas action and we intend to vigorously contest plaintiffs' claims in that action, as well as pursue the claims we have against Insurance Advisors, Jimmy Walker and their affiliates both in the litigation we initiated in Ohio and in our counterclaim in the Texas action. Management believes the allegations in the Texas action to be groundless and does not believe that the outcome of this matter, after consideration of the provision in our financial statements, will have a material adverse impact on us. However, because litigation and jury trials are inherently unpredictable and the amounts sought by plaintiffs are large, there can be no assurance that the litigation will not have a material adverse effect on our business, financial condition or results of operations. In addition to the above litigation, we have recently been sued for compensatory damages and, in some cases, unspecified punitive damages in a number of actions pertaining to the insureds of United Benefit Life arising from claims payment issues. While we do not believe that United Benefit Life has harmed any of the plaintiffs in these lawsuits and we believe our reserves are adequate, we cannot predict the outcome of the lawsuits, including the award of 13 14 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED MARCH 31, 2001 (UNAUDITED) ================================================================================ punitive damages and, therefore, we cannot predict the financial impact on us. We intend to vigorously contest these actions. Other than the above matters, neither Ceres nor any of our subsidiaries is party to, or the subject of, any material legal proceeding. The company is also involved in litigation arising in the ordinary course of business. In the opinion of management, the effects, if any, of such litigation are not expected to be material to the Company's consolidated financial condition. H. SEGMENT INFORMATION In conjunction with the Company's continued growth and refinement of a organization structure, the Company expanded its operating segments to the following three distinct operating segments based upon product types: medical, senior and other, and corporate and other. Products included in the medical segment include comprehensive major medical plans. Significant products in the senior and other include Medicare supplement, long-term care, dental, life insurance, and annuities. 14 15 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED MARCH 31, 2001 (UNAUDITED) ================================================================================ The corporate and other segment encompasses all other activities of the Company, including interest income, interest expense, and corporate expenses of the parent company. Revenues from each segment are primarily generated from premiums charged to policyholders and interest earned on cash and investments, and are summarized in the following table:
THREE MONTHS ENDED MARCH 31, 2001 2000 --------- -------- (dollars in thousands) MEDICAL Revenues Net premiums $ 101,426 $ 80,837 Investment income, realized gains (losses) 2,383 1,799 Other income 9,201 7,957 --------- -------- 113,010 90,593 --------- -------- Expenses Benefits and claims 86,144 62,667 Other operating expenses 29,169 23,505 Special charges 7,097 -- --------- -------- 122,410 86,172 --------- -------- Segment profit (loss) before federal income taxes, minority interest and preferred stock dividends $ (9,400) $ 4,421 ========= ======== SENIOR AND OTHER Revenues Net premiums $ 51,786 $ 23,887 Investment income, realized gains (losses) 5,760 3,793 Other income 454 370 --------- -------- 58,000 28,050 --------- -------- Expenses Benefits and claims 43,052 18,891 Other operating expenses 13,108 5,873 --------- -------- 56,160 24,764 --------- -------- Segment profit before federal income taxes, minority interest and preferred stock dividends $ 1,840 $ 3,286 ========= ======== CORPORATE AND OTHER Revenues Investment income, realized gains (losses) $ 175 $ 66 --------- -------- Expenses Interest and financing costs 1,485 1,186 Other operating expenses 922 786 --------- -------- 2,407 1,972 --------- -------- Segment loss before federal income taxes, minority interest and preferred stock dividends $ (2,232) $ (1,906) ========= ======== INCOME (LOSS) BEFORE FEDERAL INCOME TAXES, MINORITY INTEREST AND PREFERRED STOCK DIVIDENDS $ (9,792) $ 5,801 ========= ========
The Company does not separately allocate investments or other identifiable assets by industry segment, nor are income tax (benefit) expenses allocated by industry segment. 15 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ------------------------------------------------------------------------ RESULTS OF OPERATIONS --------------------- This discussion should be read in conjunction with our condensed consolidated financial statements, notes and tables included elsewhere in this report. Management's discussion and analysis may contain forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. However, future performance involves risks and uncertainties which may cause actual results to differ materially from those expressed in the forward-looking statements. See "Forward-Looking Statements." OVERVIEW We provide a wide array of health and life insurance products to over 700,000 insureds. Our core businesses are major medical health insurance for individuals, associations and small businesses, and senior health, life and annuity products for Americans age 55 and over. To help control medical costs, we also provide medical cost management services to our insureds. Our nationwide distribution channels include approximately 48,000 independent and exclusive agents and QQLink.com, our new web-based service. The financial information for the quarter ended March 31, 2000 included the operations of Central Reserve, Continental General, United Benefit Life and Provident American Life for the entire period. The financial information for the quarter ended March 31, 2001 also included the operations of Pyramid Life for the entire period. RECENT EVENTS On May 8, 2001, Central Reserve entered into an agreement to sell the stock of United Benefit Life, including United Benefit Life's licenses and certain liabilities, to Pelagian, LLC, a Texas limited liability company. The purchase price will be equal to the statutory capital and surplus of United Benefit Life as of the closing date. The sale is subject to approval by the State of Ohio Department of Insurance and other customary terms and conditions. We expect that the transaction will close in the third quarter of 2001. In the first quarter of 2001, we recorded a $1.2 million loss on the sale of United Benefit Life. 16 17 RESULTS OF OPERATIONS QUARTER ENDED MARCH 31, 2001 COMPARED TO QUARTER ENDED MARCH 31, 2000
INCREASE THREE MONTHS THREE MONTHS (DECREASE) FROM ENDED % OF ENDED % OF PREVIOUS YEAR MARCH 31, CONSOLIDATED MARCH 31, CONSOLIDATED --------------- 2001 REVENUES 2000 REVENUES DOLLARS % --------- ---- --------- ---- -------- ---- (dollars in thousands) Premiums, net Medical $ 101,426 59.2% $ 80,837 68.1% $ 20,589 25.5% Senior and other 51,786 30.3% 23,887 20.1% 27,899 116.8% --------- ---- --------- ---- -------- Total 153,212 89.5% 104,724 88.2% 48,488 46.3% Net investment income 7,670 4.5% 5,731 4.8% 1,939 33.8% Net realized gains (losses) 648 0.4% (73) -- 721 N/M Fee and other income 8,396 4.9% 6,929 5.8% 1,467 21.2% Amortization of deferred reinsurance gain 1,259 0.7% 1,398 1.2% (139) (9.9)% --------- ---- --------- ---- -------- Consolidated Revenues 171,185 100.0% 118,709 100.0% 52,476 44.2% --------- ---- --------- ---- -------- Benefits, claims, losses and settlement expenses Medical 86,144 50.3% 62,667 52.8% 23,477 37.5% Senior and other 43,052 25.2% 18,891 15.9% 24,161 127.9% --------- ---- --------- ---- -------- Total 129,196 75.5% 81,558 68.7% 47,638 58.4% Selling, general and administrative expenses 53,848 31.5% 37,699 31.8% 16,149 42.8% Net (deferral) amortization and change in acquisition costs and value of business acquired (10,924) (6.4)% (7,774) (6.6)% (3,150) (40.5)% Amortization of goodwill 275 0.2% 239 0.2% 36 15.1% Interest expense and financing costs 1,485 0.9% 1,186 1.0% 299 25.2% Special charges 7,097 4.1% -- -- 7,097 -- Federal income tax expense (benefit) (2,680) (1.6)% 2,030 1.7% (4,710) N/M Minority interest (15) -- -- -- (15) -- --------- ---- --------- ---- -------- Net income (loss) (7,097) (4.2)% 3,771 3.2% (10,868) N/M Convertible voting preferred stock dividends 185 0.1% -- -- 185 -- --------- ---- --------- ---- -------- Net income (loss) attributable to common stockholders $ (7,282) (4.3)% $ 3,771 3.2% $(11,053) N/M ========= ==== ========= ==== ======== Net income (loss) per share attributable to common stockholders Basic $ (0.42) $ 0.28 $ (0.70) N/M Diluted (0.42) 0.26 (0.68) N/M
------------------------------------------- N/M = not meaningful 17 18 1. NET PREMIUMS (NET OF REINSURANCE CEDED) For the quarter ended March 31, 2001, total net premiums were $153.2 million, an increase of 46.3%, from $104.7 million for the same quarter in 2000. Medical premiums for the quarter ended March 31, 2001 were $101.4 million compared to $80.8 million for the quarter ended March 31, 2000, an increase of 25.5%. The increase in medical premiums was primarily the result of increased new sales, premium rate increases and the acquisition of Pyramid Life in July 2000. Senior and other premiums were $51.8 million for the quarter ended March 31, 2001 compared to $23.9 million for the quarter ended March 31, 2000, an increase of 116.8%. The increase in senior and other premiums was primarily the result of $17.0 million attributable to Pyramid, increased new sales and premium rate increases. 2. OTHER REVENUES Net investment income increased to $7.7 million for the first quarter of 2001 from $5.7 million for the first quarter of 2000, an increase of 33.8%, due primarily to an increased investment base from the addition of Pyramid. Fee and other income increased to $8.4 million for the quarter ended March 31, 2001 compared to $6.9 million for the same quarter of 2000, an increase of 21.2%. This increase was attributable to new administrative fees introduced at Continental General after the first quarter of 2000 and fees received on a larger volume of business in force. The amortization of deferred reinsurance gain of $1.3 million for the quarter ended March 31, 2001 represented the recognition of the ceding commission allowances received under our reinsurance agreements. The unamortized amount of $17.6 million at March 31, 2001 was accounted for as a deferred reinsurance gain on the consolidated condensed balance sheet. 3. BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES Total benefits, claims and settlement expenses increased to $129.2 million for the quarter ended March 31, 2001 compared to $81.6 million for the same quarter in 2000, an increase of 58.4%. Medical benefits, claims, losses and settlement expenses were $86.1 million for the quarter ended March 31, 2001 compared to $62.7 million for the same quarter in 2000, an increase of 37.5%. The increase was a result of higher than anticipated benefit utilization in the first quarter of 2001 versus the same quarter of 2000 on a larger volume of business in force, particularly with respect to United Benefit Life and Provident American Life, increased medical costs, and $1.2 million attributable to Pyramid Life. The medical loss ratio was 84.9% for the quarter ended March 31, 2001 compared to 77.5% for the same quarter of 2000. The increase was due to increased medical inflation 18 19 CERES GROUP, INC. AND SUBSIDIARIES MARCH 31, 2001 ============================================================== and higher than anticipated medical benefit utilization, particularly with respect to United Benefit Life and Provident American Life, as well as higher claims utilization in selected states on specific product lines that were terminated in 2000. As a result of these developments, claims reserves at Central Reserve increased by $7.5 million at March 31, 2001. Senior and other benefits, claims, losses and settlement expenses were $43.1 million for the quarter ended March 31, 2001 compared to $18.9 million for the same quarter of 2000, an increase of 127.9%. The increase was a result of $13.7 million attributable to Pyramid Life, seasonality in the Medicare supplement business, and claims and benefits paid on a larger volume of business in force. The senior and other loss ratio increased to 83.1% for the first quarter of 2001 compared to 79.1% for the first quarter of 2000, primarily attributable to increased claims on Medicare supplement due to seasonality. This seasonality had a larger impact this year due to the addition of Pyramid Life in July 2000 and increased sales of Medicare supplement policies. Medicare deductible amounts are typically submitted as claims on these supplemental policies during the first quarter, leading to a higher benefit and claims loss ratio during the period. 4. OTHER EXPENSES AND NET INCOME Selling, general and administrative expenses increased to $53.8 million in the first quarter of 2001 compared to $37.7 million in the first quarter of 2000, an increase of 42.8%. The increase in selling, general and administrative expenses represented a $4.0 million increase in commissions and a $12.1 million increase in other operating expenses and reinsurance charges and allowances attributable to our increased business base. Pyramid Life accounted for $6.6 million of the $16.1 million increase. As a percentage of revenues, selling, general and administrative expenses decreased to 31.5% in the first quarter of 2001 compared to 31.8% in the first quarter of 2000. The net amortization and change in deferral of acquisition costs and value of business acquired resulted in a net deferral of $10.9 million for the first quarter of 2001 compared to a net deferral of $7.8 million for the first quarter of 2000. Pyramid Life accounted for $1.7 million of the net deferral. The remaining increase in the deferral was a result of capitalized acquisition expenses on new business. Interest expense and financing costs increased to $1.5 million in the first quarter of 2001 compared to $1.2 million in the first quarter of 2000 as a result of a higher outstanding balance and increased interest rates under our credit agreement. Special charges of $7.1 million represented a $5.9 million write-off of the deferred acquisition cost (DAC) asset for United Benefit Life and Provident American Life and a $1.2 million write-off of costs associated with the loss on the sale of United Benefit Life, including the write-off of United Benefit Life's deferred tax costs. Due to higher than anticipated benefit utilization and the planned policyholder conversion program, the DAC asset was written-off because it was believed to no longer be recoverable. A federal income tax benefit of $2.7 million, or 34.0% of the loss before federal taxes (excluding losses at United Benefit Life where no federal income tax benefit was realized due to the sale) was established for the first quarter of 2001. A similar effective rate was used for 2000. 19 20 As a result of the foregoing, for the first quarter of 2001, the net loss was $7.1 million and the net loss attributable to common stockholders was $7.3 million, or $(0.42) basic and diluted earnings per share of common stock, compared to net income of $3.8 million, or $0.28 basic and $0.26 diluted earnings per share of common stock, for the first quarter of 2000. Net income attributable to common stockholders excluding the United Benefit Life and Provident American Life operating losses of $4.2 million (including legal expenses) and the special charges of $7.1 million was $0.8 million, or $.05 per diluted share. 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. Assets of $452.3 million, or 50.8% of the total assets, were in investments at March 31, 2001. Fixed maturities, our primary investment, were $441.5 million or 97.6% of total investments, at March 31, 2001. 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 March 31, 2001. We hold few high-yield type securities, with 97.2% of our bonds being investment grade quality at March 31, 2001. In addition to the fixed maturities, we also had $47.0 million in cash and cash equivalents, and a $5.0 million revolver, that was fully drawn, at March 31, 2001. At March 31, 2001, there was no amount available for additional borrowings under the revolver. The total reinsurance receivable was $229.3 million at March 31, 2001. Of this amount, $211.5 million represents reserves held by our reinsurers under our various reinsurance treaties in place. Hannover holds most of these reserves. Assets increased 1.1% to $890.6 million at March 31, 2001 from $880.5 million at December 31, 2000. The increase was primarily due to an increase in new business. The total policy liabilities and accruals (reserves) were 81.6% of the total liabilities at March 31, 2001 compared to 80.7% at December 31, 2000. To provide funds for the acquisition of Continental General in February 1999, we incurred debt of $40.0 million under a credit agreement. Under the terms of the credit agreement, dated as of February 17, 1999, among Ceres, various lending institutions and The Chase Manhattan Bank, as Administrative Agent, quarterly principal payments of $1.5 million through February 17, 2002 and $2.25 million thereafter are due through February 2005. 20 21 Interest on the outstanding balance will be 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% in excess of a federal funds rate and (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 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 must be repaid on February 17, 2002. The revolver bears interest at the same rate choices as the $40.0 million loan. At March 31, 2001, the interest rate was 10.5% on the outstanding balance of $5.0 million. On March 30, 2001, our 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 were used to permanently pay down $10.0 million of our then fully-drawn $15.0 million revolver under the credit agreement. The terms of the amendment provide for CIT to participate equally with the syndicate of banks and Chase under the credit agreement. The $10.0 million CIT term loan bears interest at the same rate choices, as our $40.0 million term loan. On March 31, 2001, the interest rate on our $40.0 million term loan was 8.9% and the interest rate on our $10.0 million CIT term loan was 10.5%. The first principal payment on the CIT term loan of $0.3 million will be due on June 17, 2002. Quarterly principal payments will be due thereafter as follows: $0.3 million through March 17, 2004; $0.6 million thereafter through March 17, 2005; and $1.2 million thereafter through March 17, 2006. Our credit agreement, as amended, contains financial and other covenants that, among other matters: - prohibit the payment of cash dividends on our shares of common stock; - restrict the creation of liens and sales of assets; and - require that we, at a minimum, maintain: - a leverage ratio (consolidated debt to consolidated total capital) of 0.35 to 1.00 through December 31, 2001, and 0.30 to 1.00 thereafter; - 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 for any of our regulated insurance company subsidiaries of not less than 125.0% of the RBC Company Action Level; - consolidated net worth of $110.0 million through December 31, 2001, $160.0 million thereafter through December 31, 2002, and $200.0 million thereafter; and 21 22 - a fixed charge coverage ratio (borrower cash flow to the sum of consolidated interest expense and scheduled repayments) of not less than 1.05 to 1.00 through June 30, 2001, 1.10 to 1.00 thereafter through June 30, 2002, 1.20 to 1.00 thereafter through June 30, 2003, and 1.30 to 1.00 thereafter. In addition, we pledged the common stock of Central Reserve, Continental General, Provident American Life, Pyramid Life, United Benefit Life and other subsidiaries as security for the credit agreement. In conjunction with the special charges taken in the first quarter of 2001, our credit agreement was amended to provide for a waiver of certain financial covenant requirements. The covenants of minimum interest coverage ratio and minimum net worth were waived as a result of the adverse effect of the special charges. At March 31, 2001, we were in compliance with our credit agreement, as amended. The mortgage note on our Cleveland headquarters bears interest at 9.5% per annum. Principal payments are due monthly with the final payment of $7.7 million due on January 1, 2003. We believe that cash flow from operating activities will be sufficient to meet our currently anticipated operating and capital expenditure requirements over the next 12 months. In addition, we believe that funds from our non-regulated subsidiaries will be sufficient to meet our debt obligations over the next 12 months. In the future, we intend to rely primarily on dividends from our non-regulated subsidiaries to meet our outstanding debt obligations. Dividends from our non-regulated, non-insurance subsidiaries may be derived from their retained earnings, which are generated by fees paid by unaffiliated and affiliated companies under various agreements of these 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 these non-regulated subsidiaries. Dividends from our regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. If additional funds become necessary, additional financing may not be available on terms favorable to us or at all. If adequate funds are not available on acceptable terms, we may not be able to continue to fund our growth or make any additional acquisitions. Our inability to raise capital could adversely affect our business. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS We have three segments: medical, which includes comprehensive major medical plans, senior and other, which includes Medicare supplement, long-term care, dental, life insurance and annuities, and corporate and other, which includes interest income, interest expense, and corporate expenses of the parent company. See Note H, Segment Information to the Notes to our Condensed Consolidated Financial Statements for further information. 22 23 MARKET RISK AND MANAGEMENT POLICIES The following is a description of certain risks facing health and life insurers and how we mitigate those risks: 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. 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. Credit Risk is the risk that issuers of securities owned by us will default or that other parties, including reinsurers that have obligations to us, will not pay or perform. We attempt to minimize this risk by adhering to a conservative investment strategy and by maintaining sound reinsurance and credit and 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 its assets with the expected payouts of its liabilities. To the extent that liabilities come due more quickly than assets mature, an insurer 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 $18.3 million after-tax at March 31, 2001. This amount represents approximately 17.5% of our stockholders' equity. We also have long-term debt that bears interest at variable rates. Therefore, our results of operations would be affected by interest rate changes. We do not expect a significant rate change in the near future that would have a material effect on our near-term results of operations. Seasonality is the risk of fluctuations in 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. 23 24 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. The Health Insurance Association of America reported, in an Issue Brief dated March 2000, that prescription drug costs are increasing more than 16% a year. 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 both historical and forward-looking statements. Forward-looking statements are statements other than historical information or statements of current condition. The forward-looking statements relate to our plans and objectives for future operations. In addition to statements, which are forward-looking by reason of context, the words "believe," "expect," "anticipate," "intend," "designed," "goal," "objective," "optimistic," "will" and other similar expressions identify forward-looking statements. In light of risks and uncertainties inherent in all future projections, the inclusion of forward-looking statements should not be regarded as a representation by Ceres or any other person that our objectives or plans will be achieved. Many 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: - rising healthcare costs, especially the rising costs of prescription drug costs that are rising faster than other medical costs, and rising utilization rates; - 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; - 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 develop, distribute and administer competitive products and services in a timely, cost effective manner; 24 25 - the performance of others on whom we rely for reinsurance, particularly Hannover upon whom we have relied for substantially all of our reinsurance; - the risk of material adverse outcomes in litigation; - a new and untested business plan; - dependence on senior management and key personnel; - the failure to successfully manage our growth and integrate future acquisitions, including the failure to achieve cost savings; - our financial and claims paying ratings; - the performance of others on whom we rely for administrative and operations services; - restrictions on our insurance subsidiaries' ability to pay dividends to Ceres; - the adequacy of funds received from our non-regulated subsidiaries to meet Ceres' debt obligations; - payments to state assessment funds; - business conditions and competition in the healthcare industry; - the risk of selling investments to meet liquidity requirements; - the risk that issuers of securities owned by Ceres will default or that other parties will not pay or perform; - the failure to comply with financial and other covenants in our loan agreements; - changes in accounting and reporting practices; - our ability to fully collect all agent advances; and - our ability to obtain additional debt or equity financing on terms favorable to us to facilitate our long-term growth. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included in this report, including the risks detailed under "Market Risk and Management Policies." We undertake no obligation to update forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. 25 26 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK The information called for by this item is provided under the caption "Market Risk and Management Policies" under Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations. 26 27 PART II. FINANCIAL INFORMATION All items of Part II other than Items 1, 2 and 6 are either inapplicable to Ceres, would not require a response, or have been previously reported. ITEM 1. LEGAL PROCEEDINGS We are defendants in a lawsuit filed on August 14, 2000, Insurance Advisors of America, Inc., Transcend Group, Inc., and Jimmy K. Walker vs. Ceres Group, Inc., Ceres Financial Services, Inc., Peter W. Nauert, Central Reserve Life Insurance Company, Hannover Life Reassurance Company of America (f/k/a Reassurance Company of Hannover), Provident American Life and Health Insurance Company and Health Plan Services, Inc., United Benefit Life Insurance Company and Billy B. Hill, Jr., case no. 17-184-65-00, in State District Court of Tarrant County, Texas. The lawsuit involves a number of agreements between Insurance Advisors of America and its affiliates, Transcend Group and Mr. Walker, Ceres, Ceres Financial and United Benefit Life in which, among other things, we reinsured United Benefit Life's policies, Insurance Advisors entered into a non-compete agreement which prohibited them from selling insurance products not provided by us, and Insurance Advisors signed a $10.0 million promissory note payable to us. Pursuant to these agreements and to satisfy, in part, a $19.4 million reserve shortfall, we acquired through foreclosure the stock of United Benefit Life on July 21, 1999. Plaintiffs assert claims for, among other things, fraud, breach of contract and negligence relating to unfair competition. Plaintiffs allege that we engaged in a scheme to eliminate plaintiffs from the competitive market, retain Insurance Advisors' renewal commissions and "steal" their subagents by, among other things, "locking" plaintiffs into exclusive agreements and non-compete agreements and "improperly" increasing premiums and reducing commissions. Plaintiffs further assert, among other things, that our actions and inactions "unilaterally and unfairly" effectively eliminated plaintiffs' ability to conduct business and made it "impossible" for agents and their managers to remain with Insurance Advisors and "make a living." Actual damages sought by plaintiffs in the original complaint filed on August 14 are in excess of $50.0 million. Hannover has now been dismissed from this action. Additionally, plaintiffs voluntarily dismissed our general counsel, Billy B. Hill, Jr., from the lawsuit. On March 5, 2001, plaintiffs amended their complaint to again include Billy Hill; to add additional defendants, including Rhonda Immoos (a paralegal at Ceres), Pyramid Life and Continental General; to add additional allegations of civil conspiracy, tortious interference with business and existing and future contractual relationships toward Nauert, Hill and Immoos; and to demand a jury trial. Plaintiffs now seek monetary damages in excess of $100.0 million, including damages for lost profits, unpaid commissions and unpaid administrative fees. In addition, plaintiffs now seek punitive damages in excess of $100.0 million. On September 5, 2000, we filed a claim, Ceres Group, Inc., Central Reserve Life Insurance Company, Provident American Life and Health Insurance Company, and United Benefit Life Insurance Company vs. Insurance Advisors of America, Inc., Robert H. Merrill, Private Business Management, Inc., Transcend Group, Inc. and Jimmy K. Walker, in the Court of Common Pleas of Cuyahoga County, Ohio, relating to the foreclosure on the United Benefit Life stock and 27 28 ITEM 1. LEGAL PROCEEDINGS - CONTINUED Insurance Advisors' failure to make payments under the promissory note. On September 15, 2000, the Court of Common Pleas entered a temporary restraining order in our favor, prohibiting defendants from making any false statements regarding us and prohibiting them from inducing our insureds to lapse coverage. This order was superceded by an agreed order dated October 2, 2000, which made permanent the temporary order and required defendants to send a mailing to the agents of Insurance Advisors advising them of the same. On October 25, 2000, we filed a counterclaim in Tarrant County, Texas, asserting that the plaintiffs failed to make payments under the various lending agreements entered into by Insurance Advisors, breach of fiduciary duties, misrepresentation of financial condition, breach of contract and certain other claims. Contractual and tort damages sought are in excess of $25.0 million. On January 23, 2001, we sought leave of the court to file a supplemental complaint and to deposit certain funds with the court pending the final outcome of the litigation. On February 22, 2001, the Court of Common Pleas of Cuyahoga County granted the defendants' Motion to Dismiss on Jurisdictional Priority Grounds. We plan to appeal the court's decision to dismiss the case. We have denied liability to plaintiffs in the Texas action and we intend to vigorously contest plaintiffs' claims in that action, as well as pursue the claims we have against Insurance Advisors, Jimmy Walker and their affiliates both in the litigation we initiated in Ohio and in our counterclaim in the Texas action. Management believes the allegations in the Texas action to be groundless and does not believe that the outcome of this matter, after consideration of the provision in our financial statements, will have a material adverse impact on us. However, because litigation and jury trials are inherently unpredictable and the amounts sought by plaintiffs are large, there can be no assurance that the litigation will not have a material adverse effect on our business, financial condition or results of operations. In addition to the above litigation, we have recently been sued for compensatory damages and, in some cases, unspecified punitive damages in a number of actions pertaining to the insureds of United Benefit Life arising from claims payment issues. While we do not believe that United Benefit Life has harmed any of the plaintiffs in these lawsuits and we believe our reserves are adequate, we cannot predict the outcome of the lawsuits, including the award of punitive damages and, therefore, we cannot predict the financial impact on us. We intend to vigorously contest these actions. Other than the above matters, neither Ceres nor any of our subsidiaries is party to, or the subject of, any material pending legal proceeding. 28 29 ITEM 2. CHANGES IN SECURITIES On January 2, 2001, we issued 34,626 shares of our common stock to Peter W. Nauert, our Chairman of the Board, President and Chief Executive Officer, pursuant to the stock award provision of his current employment agreement, as amended. This issuance was exempt from registration in accordance with Section 4(2) of the Securities Act of 1933, as amended, and exemptions available under applicable state securities laws. Also on January 2, 2001, we issued 3,847 shares of our common stock to Billy B. Hill, Jr., our General Counsel, pursuant to his retainer agreement. This issuance was exempt from registration in accordance with Section 4(2) of the Securities Act of 1933, as amended, and exemptions available under applicable state securities laws. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits. (10) Seventh Amendment to Credit 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. Stock Purchase Agreement, dated as of May 8, 2001, between Central Reserve Life Insurance Company and Pelagian, LLC. (b) Reports on Form 8-K: None. 29 30 SIGNATURES ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CERES GROUP, INC. Date: May 21, 2001 By: /s/ Charles E. Miller, Jr. ------------------- -------------------------------------- Charles E. Miller, Jr. Executive Vice President and Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer) 30 31 EXHIBITS -------- 10.35 Seventh Amendment to Credit 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. 10.36 Stock Purchase Agreement, dated as May 8, 2001, between Central Reserve Life Insurance Company and Pelagian, LLC. 31