10-K405 1 l93194ae10-k405.txt CERES GROUP, INC. FORM 10-K405 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, 2001 COMM FILE NO. 0-8483 CERES GROUP, INC. (Exact Name of Registrant as Specified in its Charter) DELAWARE 34-1017531 --------------------------- ------------------------------------ (State of Other Jurisdiction of (I.R.S. Employer Identification Number) 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 led 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] The aggregate market value of the voting stock held by non-affiliates of the Registrant was $65,516,420 computed based on the closing price of the common stock on March 1, 2002. (The Registrant considers affiliates to be directors, executive officers, and those persons subject to the Voting and Stockholders' Agreements.) The number of shares of common stock, par value $0.001 per share, outstanding as of March 1, 2002 was 33,901,112. -------------------------------------------------------------------------------- DOCUMENTS INCORPORATED BY REFERENCE: Portions of the Registrant's Definitive Proxy Statement for the Annual Meeting of Stockholders to be held May 15, 2002 are incorporated by reference into Part III of this Form 10-K. -------------------------------------------------------------------------------- CERES GROUP, INC. INDEX TO ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2001
PAGE ---- PART I Item 1 Business.................................................... 1 Item 2 Properties.................................................. 20 Item 3 Legal Proceedings........................................... 20 Item 4 Submission of Matters to a Vote of Security Holders......... 20 PART II Item 5 Market for Registrant's Common Equity and Related Stockholder Matters......................................... 21 Item 6 Selected Financial Data..................................... 23 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 25 Item 7A Quantitative and Qualitative Disclosures about Market Risk........................................................ 42 Item 8 Financial Statements and Supplemental Data.................. 43 Schedule II - Condensed Financial Information of Registrant.................................................. 79 Schedule III - Supplemental Insurance Information........... 82 Schedule IV - Reinsurance................................... 83 Item 9 Changes in and Disagreement with Accountants on Accounting and Financial Disclosure.................................... 84 PART III Item 10 Directors and Executive Officers of the Registrant.......... 84 Item 11 Executive Compensation...................................... 84 Item 12 Security Ownership of Certain Beneficial Owners and Management.................................................. 84 Item 13 Certain Relationships and Related Transactions.............. 84 PART IV Item 14 Exhibits, Financial Statements, Financial Statement Schedules, and Reports on Form 8-K.......................... 84 Signatures................................................................ 90
PART I ITEM 1. BUSINESS OVERVIEW Ceres provides a wide array of health and life insurance products to approximately 535,000 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 major medical health insurance for individuals, 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 48,000 independent and exclusive agents and QQLink, our proprietary, patent pending electronic distribution system. In 1998, a new management team led by Peter W. Nauert took control of Ceres and its then only insurance subsidiary, Central Reserve Life Insurance Company. The management team implemented a complete restructuring of the company and its operations by initiating a series of remedial actions designed to stabilize our operating performance, including repricing and eliminating unprofitable products, improving underwriting and reducing administrative expenses. Throughout the restructuring, we added experienced management personnel to our financial, actuarial, underwriting, claims, marketing and operations areas. We also initiated a growth strategy that included expanded distribution channels and product offerings and a series of strategic acquisitions, which included our entry into the senior market. 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. 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, and Pyramid Life Insurance Company, a company primarily in the senior market. The strategic acquisitions completed since 1998 have given us sufficient size and scope to compete in our markets. Since 1998, we increased our distribution channels from one to five, expanded our agent force from 16,000 to approximately 48,000 and increased our product offerings from five to approximately 40 in our major medical and senior markets. Assets increased from $135.8 million at December 31, 1997 to $946.0 million at December 31, 2001, and our gross premiums increased from $253.0 million for 1997 to $828.7 million for the year ended 2001. Our operating results have been negatively impacted by the results of United Benefit Life and Provident American Life. These companies have not met our expectations due to significantly higher than anticipated claims and benefit utilization and losses from unanticipated litigation. However, we limited our losses by reinsuring portions of these businesses under various reinsurance agreements and by halting new sales in these subsidiaries in July 2000. In addition, in July 2001, we implemented a program to mitigate future losses of these subsidiaries by notifying policyholders that their policies would be terminated or replaced. The business in these two subsidiaries will be substantially wound down by the early part of 2002. In addition, our operating results have been adversely impacted by industry-wide and historically high medical inflation. This environment has caused us to enhance and accelerate a number of programs to lessen the inflationary impact, including: - premium rate increases; - modified product lines for new sales; - target marketing; - proactive medical cost management; and - lowered administrative and sales expenses. 1 Our senior segment continued to produce increasing profits for 2001, totaling $25.9 million in pre-tax segment profits for the year ended 2001. Our medical segment improved from the first half of 2001, and without the losses attributable to United Benefit Life and Provident American Life, this segment would have shown a pre-tax gain of $4.7 million. However, our acquisitions and internal growth have strained our capital levels. We have shifted our focus to achieving internal growth while controlling our costs, although we will still be open to selected strategic acquisitions. On December 27, 2001, we completed a follow-on public offering of 16,100,000 shares of our common stock, including the exercise of the underwriters' over-allotment option, at $3.20 per share for net proceeds of $46.5 million. The proceeds of the offering were used as follows: - $28.0 million contributed to the capital of our insurance subsidiaries; - $12.5 million to repay a portion of our bank debt; - $5.0 million to repurchase our convertible voting preferred stock; and - $1.0 million for working capital and general corporate purposes. The offering significantly strengthened our balance sheet. We believe our focus on internal growth, along with increased capital, will lead to more predictable earnings, enhanced profitability and higher financial agency ratings of our insurance subsidiaries, which in turn will support greater internal growth capacity and enable us to enter into more favorable reinsurance agreements. OUR CORE BUSINESSES SENIOR HEALTH, LIFE AND ANNUITY PRODUCTS. We increasingly 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. In 2001, new sales of our senior health and life products rose 12.6% to $82.4 million of new annualized sales premiums from $73.2 million in 2000. 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 Health Care Financing Administration (HCFA), the number of Medicare enrollees, age 65 and over, nearly doubled between 1967 and 1999, growing to 33.9 million from 19.5 million. By 2007, the Medicare population is expected to exceed 44 million. CATASTROPHIC AND 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 major medical segment includes insurance for individuals under age 65, associations and small businesses. With increasingly stringent federal and state restrictions on small group insurance, we now 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 the current premium level of our medical segment by continuing the targeted market that we implemented in 2000 and 2001, 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. Approximately 40% of U.S. workers have PPO coverage, providing them with 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 2 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. At the end of 2001, we restructured our management organization to increase the responsibility and accountability of key senior officers and improve our overall efficiency. We established three strategic business units: senior, individual medical and group medical. Each unit has its own separate business plans, goals, profit expectations and budgets. Individual medical and group medical are both part of our medical segment but each has different marketing, product development, underwriting, claims and administrative support needs. We believe that managing these as separate business and administrative units provides a greater opportunity to enhance the service we provide to our insureds and agents. BUSINESS STRATEGY Principal elements of our business strategy include: INCREASING SENIOR MARKET FOCUS. Because of favorable demographics and higher profit potential in the senior segment, we are focusing more of our capital and 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 designed to generate higher profit margins and are not as sensitive to medical inflation as major medical products. With the July 2000 acquisition of Pyramid Life, we significantly increased our senior business. We have been concentrating more of 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, 2001, our senior segment comprised 36% of our total net premium revenues compared to 27% for 2000, and 33% of total new sales in 2001 compared to 25% in 2000. With our growing focus on the senior market, we have expanded our marketing for this segment. In addition, in October, we consolidated all administrative service functions for our senior segment into our Kansas City facility to enhance service as well as help reduce administrative expenses in 2002. Previously, part of our senior business was administered at our Omaha facility. 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 $41.0 billion, or $205 per capita, in 1965 to $1.1 trillion, or $4,164 per capita, in 1998, according to statistics compiled by HCFA. 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 (which have increased almost 19% in 2000 to nearly $132 billion nationwide) and the aging of the population. 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; 3 - strengthening of our program to detect fraud and abuse by medical providers, policyholders or agents; - limitation of medical fees to reasonable and customary standards; - per diem arrangements through some networks; - 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. 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 "Personal Healthcare Management" 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. In 2000, we also developed new medical provider network discount programs to help our insureds maximize their insurance benefits. Since the beginning of 2001, we reduced our PPO networks from 51 to 23, without significantly reducing the number of insureds. We expect this reduction to result in network access fee savings and additional provider discounts, along with quicker claims processing for our insureds. IMPROVING UNDERWRITING AND PRODUCT DESIGN. 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. We actively pursue product redesign and curtailment of unprofitable product offerings, where necessary. In 2001, we made material changes to our underwriting process to improve quality, timeliness and customer service. Changes in risk selection have been made to improve profitability. 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, the Act requires guaranteed issuance of major medical insurance for small groups that meet continuing coverage and participation guidelines. The act 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 2001, our major medical certificates included 70.6% for individual and association products and 29.4% for small group products compared to 68.2% and 31.8%, respectively, in the year ended December 31, 2000. 4 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. We have developed "Ceres Standards," a guideline of our best practices for underwriting of new business. These standards were 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 for specific products. 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 routine and elective cases. 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 and consolidation of corporate services, such as accounting, marketing, and distribution. Administrative changes in 2002 will involve 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 was implemented in 2000 to provide 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 outsource all information and telephone systems at our Cleveland headquarters, the claims processing for our Central Reserve Life Ohio insureds, and the 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; - freeing our capital to be used for other aspects of growth strategy; - efficiency and economies of scale; and - system consolidation and integration. We began implementing a strong expense reduction program in the fourth quarter of 2001. For 2002, we expect to further streamline operations and reduce our general and administrative expenses through efficiency improvements and elimination of functions that do not support our core businesses. In 2001, our selling, general and administrative expenses as a percentage of consolidated revenue decreased to 31.4% compared to 32.3% in 2000. EXPANDING DISTRIBUTION CHANNELS. We have five distribution channels with approximately 48,000 independent agents. We believe that multiple distribution channels provide the greatest sales opportunities for our products. We are continuing to expand our marketing reach by recruiting new agents for our existing distribution systems. Beginning in 2001, we initiated a systematic program to focus our marketing expenses on more productive agents. We have also implemented tighter controls of agent sales activities which are designed to enhance the quality of business they generate for us. 5 Our five distribution channels are: - senior career; - senior brokerage; - medical career; - medical brokerage; and - QQLink electronic distribution. Our distribution channels are discussed in greater detail in "Marketing and Sales." Through compensation incentives, we encourage our agents to cross-sell our complementary, supplemental and non-insurance products and services that typically have higher profit margins. We believe that health and other insurance products increasingly will be marketed on the Internet. Other companies have launched a number of insurance e-commerce initiatives, including health insurance, with and without agent involvement in sales. Due to the complexity of health insurance and some life insurance products, we believe agent involvement is critical to the success of these ventures both for consumers and the insurance company. We believe our proprietary, patent pending QQLink electronic distribution system, which includes an agent interface to explain the complexity of many health and life products, should be favorably positioned for this emerging trend. In addition, in this challenging business environment, we believe our marketing and administrative structure provides us with competitive advantages in the medical market, including distribution strength, selective marketing programs, product design and cost management programs. We target our marketing on products, geographic areas and marketing organizations that offer the best opportunity for profitable growth. We have reduced our activities in a number of strengths and focused product support in states that provide greater profit potential. INCREASING FEE REVENUE. We enhance our revenue by charging fees for services such as: - medical care coordination programs; - claims processing on certain products; - administration for direct billing; - reinsurance management; and - management services for associations. Our fee revenue generates higher margins because fees are not generally subject to premium tax or commission payments. In 2001, our fee and other income increased 10.5% to $36.2 million from $32.7 million in 2000. Fee and other income from our non-regulated subsidiaries accounted for $11.4 million in 2001. Fees from our non-regulated subsidiaries, such as medical care coordination and management services, are used by Ceres to meet our debt obligations. In addition, QQLink generates revenue from fees and is expected to generate revenue from sales commissions. Fee income for QQLink includes: - monthly website hosting fees charged to participating agents for use of QQlink; - agent support service fees for training and certification programs; and - marketing fees from unaffiliated vendor companies. PRODUCTS AND SERVICES We primarily market health, life and annuity insurance products tailored to meet the needs of individuals, 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 6 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. In July 1999, we also implemented a program to reduce 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 new Simplicity Series catastrophic products, released in the fourth quarter of 2001, 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 enable 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 new 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 a major medical plan 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, including coverage for vision care, dental, critical illness coverage or supplemental life insurance. LIFE AND ANNUITY. We also market group life insurance and annuity plans. We offer term life insurance as an ancillary product to our major medical insureds. We also offer various single premium deferred annuities. SENIOR HEALTH INSURANCE PRODUCTS. Our senior market products include a wide range of comprehensive and supplemental major medical benefit products. In 2000, we began releasing our new "Senior Power Portfolio," featuring 12 health, life and annuity products for Americans age 55 and over. The medical benefit products in this package include 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 long-term care insurance and Medicare Select products. Long-term care products provide needed benefits to supplement Medicare and Medicare Supplement coverage for nursing home and home healthcare expenses. Medicare Select is a specific type of Medicare Supplement plan that provides lower premiums for consumers through hospitals that have agreed to waive the Medicare Part A deductible amount. 7 SENIOR LIFE INSURANCE AND ANNUITIES. The life insurance and annuity products in our "Senior Power Portfolio" 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. SPECIALTY AND SUPPLEMENTAL INSURANCE PRODUCTS. We enhance our base medical insurance products with a select group of complementary supplemental products. These products provide increased protection for our insureds and additional commission income for our agents, and are designed with higher profit margins for us. We provide compensation and marketing support programs to encourage our agents to use these products for cross-selling purposes. These supplemental products include: - dental coverage; - critical illness coverage which provides a one-time cash payment when an insured is diagnosed with a specified illness or when undergoing a specified surgery; - first diagnosis cancer coverage which provides a one-time cash payment when an insured is diagnosed with cancer; - accidental injury coverage which provides replacement income when an insured becomes disabled due to a covered off-the-job accident; and - accidental death benefit which provides payment directly to the insured's beneficiary in the event of accidental death. SERVICES AND NON-INSURANCE PRODUCTS. In 1999, we developed the Ceres Savers Plan as a non-insurance annual fee benefit package that provides discounts on travel, prescription medicine, hearing aids and other health-related products and services. In 2000, this product was changed to 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 Personal Healthcare Management Services program to most of our major medical products to provide service enhancements for our insureds. MARKETING AND SALES Our distribution channels are critical for our continued growth. We market our products through approximately 48,000 agents in 49 states, the District of Columbia and the U.S. Virgin Islands. In 2001, we recruited approximately 14,200 new agents. Our total number of agents has remained approximately the same as at the beginning of 2001 because we initiated a systematic program to focus our marketing expenses on more productive agents by reducing 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. Through training and incentive programs, we encourage our agents to cross-sell our select group of complementary, supplemental and non-insurance products. In addition, we have implemented compensation structures that are designed to reward agents for multi-product sales. We believe that these products and programs combine to enhance the value and productivity of our agents. DISTRIBUTION CHANNELS. We use a variety of distribution systems in marketing our products, including independent agents, exclusive agents and electronic distribution. Because product lines vary among many of these distribution systems, we have some overlap of agents between channels. Some of our agents are licensed and contracted with more than one of our distribution channels. We base our five distribution channels on organization of the agents and specific markets or products: 1. SENIOR CAREER. With our acquisition of Pyramid Life, we gained a distribution system of agents who sell primarily for Pyramid Life. This distribution channel targets the 59 million Americans age 55 and over, with a product line including Medicare supplement, long-term care, home healthcare, convalescent and acute recovery care, and senior life and annuities. We are initiating a program to expand our senior marketing reach into new areas, including the Western and Mountain States and several Midwestern States. 8 2. SENIOR BROKERAGE. Agents in this distribution channel target the 59 million Americans age 55 and over with a comprehensive product line, similar to the career channel. However, these agents may represent multiple insurance carriers. 3. MEDICAL CAREER. This channel is comprised of well-established marketing organizations and our newly-developed exclusive agent agency, HealthMark Sales, LLC. This operation concentrates on individual catastrophic health insurance and supplemental health insurance sales of specially designed products primarily in rural markets. At December 31, 2001, HealthMark had approximately 500 dedicated agents. 4. MEDICAL BROKERAGE. This distribution system concentrates on individuals, associations and small business owners. The product portfolio creates cross-selling and package-selling opportunities and includes catastrophic medical coverage, individual medical plans, small group medical plans, medical savings account plans, basic medical coverage, short-term major medical, dental and supplemental products, including life insurance and annuities. These agents may represent multiple insurance carriers. 5. QQLINK ELECTRONIC DISTRIBUTION. In addition to the traditional agent distribution channels, in the fall of 2000, we began enrolling agents to participate in our proprietary, patent pending electronic distribution system, QQLink. QQLink is 94% owned by Ceres with most of the remaining 6% primarily owned by 16 of our agents. QQLink combines a traditional agent distribution system with direct online sales of insurance and other financial service products. 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. QQLink has established marketing alliances with unaffiliated insurance, financial service and other vendors of products and services. We are continuing to pursue additional alliances in order to position QQLink as a distributor of many products from a growing number of companies. MARKETING SUPPORT. We compete with other insurance companies and other sales operations for our agents. In addition, we compete with other companies that our independent agents represent. Our marketing systems concentrate on broad product portfolios and sales support to agents. Our strategy is to provide the tools and resources needed by the sales force, so that our agents can devote their time to selling. We provide comprehensive support programs to attract and retain agents, including: - competitive products and commission structures; - advanced commissions on selected products for agents who qualify; - lead generation programs; - ongoing product development; - cross-selling opportunities; - 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 400,000 certificates and individual policies in force as of December 31, 2001, representing approximately 535,000 insureds. One association, Eagle Association, had approximately 44,000 9 certificate holders, or 11.0% of all our certificates and individual policies in force as of December 31, 2001. 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, 2001 and 2000.
DECEMBER 31, 2001 DECEMBER 31, 2000 ------------------- ------------------- INDEMNITY PPO INDEMNITY PPO --------- ------- --------- ------- Major Medical................................. 30,960 137,224 45,539 174,982 Senior and Supplemental Products.............. 168,643 -- 173,137 -- ------- ------- ------- ------- Total Health............................. 199,603 137,224 218,676 174,982 Life and Annuity Products..................... 63,530 -- 68,703 -- ------- ------- ------- ------- Total.................................... 263,133 137,224 287,379 174,982 ======= ======= ======= =======
The geographic distribution of direct and assumed premiums, before reinsurance ceded, on a statutory basis of all of our subsidiaries in 2001 and 2000, including only five months for Pyramid Life in 2000, 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.
DECEMBER 31, 2001 DECEMBER 31, 2000 (IN THOUSANDS) (IN THOUSANDS) --------------------------------------------- ---------------------------------------------- PERCENT PERCENT STATE AMOUNT OF TOTAL STATE AMOUNT OF TOTAL ----- -------- -------- ----- -------- -------- Ohio.................... $101,868 11.7% Ohio.................... $104,179 13.0% Texas................... 92,341 10.6 Florida................. 77,490 9.7 Florida................. 73,522 8.4 Texas................... 67,306 8.4 Indiana................. 56,831 6.5 Indiana................. 54,555 6.8 Pennsylvania............ 44,250 5.1 Georgia................. 35,576 4.5 Tennessee............... 34,471 3.9 North Carolina.......... 34,988 4.4 Georgia................. 34,429 3.9 Tennessee............... 29,896 3.7 Missouri................ 30,755 3.5 Missouri................ 28,424 3.6 Illinois................ 28,721 3.3 South Carolina.......... 28,356 3.6 Nebraska................ 26,844 3.1 Kansas.................. 27,711 3.5 Other................... 349,753 40.0 Other................... 310,082 38.8 -------- ----- -------- ----- Total......... $873,785 100.0% Total................... $798,563 100.0% ======== ===== ======== =====
PRICING AND UNDERWRITING Effective, consistent and accurate underwriting is an important 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 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. 10 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. 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 Life Ohio insureds and claims processing and other administrative services for the Chambers 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 Provident American Life and United Benefit Life policies prior to their termination or replacement to HealthPlan Services Corporation. In 2001, as part of the termination or replacement of United Benefit Life's and Provident American Life's policies, we also outsource claims processing for the replacement product, HealthEdge, to Antares. 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. In 2001, we also expanded our claims review process by establishing a unit that focuses on potential cases of fraud or abuse, including investigating fraud or misrepresentation by medical providers, policyholders or agents. Claims that exceed a certain dollar amount or fit a certain profile based on diagnosis or time period following policy issuance are subject to detailed review. 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. Although from time-to-time we experience backlogs in claims inventory, we, together with our vendors, actively work to meet our goals relating to turnaround time, accuracy and call response. 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 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 11 information processing technology, evolving industry and regulatory standards, and changing customer preferences. A significant portion of our systems is obtained through 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 Life Ohio insureds. In addition, we outsource claims processing and other administrative services for the Chambers 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. In 2001, as part of the termination or replacement of United Benefit Life's and Provident American Life's policies, we also outsource claims processing for the replacement product, HealthEdge, to Antares. 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, 2001, approximately 98.8% of our invested assets were fixed maturity securities, including surplus notes. At December 31, 2001, 94.8% of our fixed maturity securities were of investment grade quality with 80.6% in securities rated A or better (typically National Association of Insurance Commissioners (NAIC I) and 14.2% in securities rated BBB (typically NAIC II). We do not invest in derivatives, such as futures, forwards, swaps, option contracts or other financial instruments with similar characteristics. At December 31, 2001, our investments in mortgage-backed securities totaled $138.0 million, or 28.6% 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 10.5% 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 18.1% 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. 12 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.................... $ 29,051 $ 611 $ (5) $ 29,657 U.S. Agencies............................... 10,323 347 (11) 10,659 State and political subdivisions............ 1,083 -- (11) 1,072 Corporate bonds............................. 273,915 4,049 (5,137) 272,827 Mortgage- and asset-backed securities....... 154,309 2,569 (1,303) 155,575 Preferred stock............................. 1,520 182 (7) 1,695 -------- ------ ------- -------- Total available-for-sale................. 470,201 7,758 (6,474) 471,485 Surplus notes................................. 5,045 166 -- 5,211 Mortgage loans................................ 57 -- -- 57 Policy notes.................................. 5,869 -- -- 5,869 -------- ------ ------- -------- Total investments........................ $481,172 $7,924 $(6,474) $482,622 ======== ====== ======= ========
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 worsening, or improvement, of the medical cost trend or changes in claims payment patterns from the trends and patterns assumed in estimating reserves would trigger a change. The majority of Central Reserve's, Provident American Life's and United Benefit Life's reserves and liabilities for claims are for the health insurance business. The majority of Continental General's and Pyramid Life's reserves and liabilities for claims are for the life and annuity 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 extensive estimates and prior years' statistics. 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 13 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 estimates. For example, in 2001, we increased claims reserves for our medical segment to provide for an increase in medical benefit utilization and increased medical inflation which emerged during the first quarter. 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, Pyramid Life's maximum retention is $100,000, 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 J, 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 94.4% of the total premiums ceded by our subsidiaries. Hannover has entered into reinsurance agreements with several of our subsidiaries, including Central Reserve Life, Provident American Life, United Benefit Life and Continental General. Our reinsurance agreements with Hannover are not cancelable or terminable by Hannover. In recent years, we have reduced our reliance on reinsurance. Our arrangements are generally for closed blocks of business which means that Hannover, since we discontinued sales activities of United Benefit Life and Provident American Life in July 2000, is not reinsuring any new sales or business of any of our subsidiaries under these reinsurance agreements, except for the new HealthEdge product as explained below. Hannover is reinsuring the business under the reinsurance agreements until those policies lapse or are terminated by us. 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. Hannover reinsures the HealthEdge product on the same basis as 14 the reinsurance under the old policy. United Benefit Life has no sales activities, and, other than the HealthEdge replacement product, Provident American Life has no sales activities. The business of United Benefit Life and Provident American Life, other than HealthEdge, should be substantially wound down by the early part of 2002. To evaluate the claims paying ability and financial strength of Hannover, we review financial information provided to us by Hannover, and hold quarterly 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 2001 to unaffiliated reinsurers amounted to $193.7 million, of which Hannover represented approximately 94.4%. Our gross reinsurance receivables from unaffiliated reinsurers amounted to $223.3 million as of December 31, 2001, of which approximately 86.0% was attributable to Hannover. Hannover is a subsidiary of Hannover Rueckversicherungs, a German corporation, which had assets of $22.1 billion and total stockholders' equity of $1.5 billion at December 31, 2000. Moody's has assigned Hannover Rueckversicherungs a financial strength rating of A2 (good). Hannover maintains an A (excellent) rating from A.M. Best Company, Inc. Other rating agencies have maintained similar ratings of Hannover. At December 31, 2001, Standard & Poor's has assigned Hannover a financial strength rating of AA (rated very strong). There can be no assurance that Hannover will continue to pay in full and in a timely manner the claims made against them in accordance with terms of our reinsurance agreements. 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 seek out 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 experience competition with other companies for the marketing focus of each agent. RATINGS Our ratings assigned by A.M. Best Company, Inc. and other nationally recognized rating agencies are important in evaluating our competitive position. 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 August 2001, the Best ratings of our insurance subsidiaries were downgraded, all with negative outlooks, due primarily to the losses of United Benefit Life and our need to raise capital. Central 15 Reserve's rating is a B (fair) rating. Continental General's and Pyramid Life's ratings are 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 August 2001, Fitch also downgraded Continental General to BBB (good credit quality) with "rating watch evolving" and downgraded Central Reserve to BB (speculative credit quality) with a negative outlook. In addition, Standard & Poor recently downgraded the ratings of Provident American Life, Continental General and Pyramid Life. In light of our recent capitalization and strengthened balance sheet, we are hopeful that the major rating agencies will give favorable consideration to our financial ratings in 2002. 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 occasionally make changes 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, claim 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 and Pyramid Life, the examinations were performed by the States of Nebraska and Kansas, respectively, as of December 31, 1997. Continental General is currently being examined by the State of Nebraska for the three year period ended December 31, 2000. The State of Kansas has indicated it will perform an examination of Pyramid Life for the two year period ending 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 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 16 statements. The impact of these changes to statutory-basis capital and surplus of Ceres 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, 2001, using the applicable RBC formula. Based on these calculations, our risk-based capital levels for each of our subsidiaries exceeded the levels required by regulatory authorities. Dividends paid by our insurance subsidiaries to Ceres are limited by state insurance regulations. The insurance regulator in the insurer's state of domicile may disapprove any dividend which, together with other dividends paid by an insurance company in the prior 12 months, exceeds the regulatory maximum as computed for the insurance company based on its statutory surplus and net income. As of December 31, 2001, none of our insurance subsidiaries could 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, 17 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. For example, recently enacted Texas statutes require insurance companies, with insureds in the state, to pay at least 85% of "clean claims," as defined in the statutes, within 45 days of receipt. Failure to comply with the prompt payment laws and clean claims rules may require the insurer to pay restitution, such as the full amount of the billed charges or the contracted penalty rate, and/or an administrative penalty that may not exceed $1,000 for each day each claim remained unpaid. The Texas Department of Insurance recently requested information from health maintenance organizations and insurers operating in the state, including Central Reserve, Provident American Life and Continental General, with respect to their respective claims payment practices. Based on our evaluation of our Texas claims payment practices and in conjunction with the review by the Texas Department of Insurance, we have made, and are continuing to make, restitution payments to providers where we may not have complied with the prompt pay laws. In addition, the Texas Department of Insurance has recently notified us that they intend to impose a fine based on our alleged failure to comply with the prompt pay laws. Texas has imposed similar fines on HMOs and other insurance companies operating in the state. Management does not believe that the final outcome of the Texas matter, including the assessment of a fine, will have a material adverse impact on us. 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 18 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; - 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. We are evaluating the effect of HIPAA and have formed a HIPAA task force to begin systematic implementation of HIPAA's requirements and to ensure compliance. The new federal and state regulations promulgated under HIPAA are currently unsettled, making certainty of compliance impossible at this time. Due to the uncertainty surrounding the regulatory requirements, we cannot be sure that the systems and programs that we plan to implement will comply adequately with the regulations that are ultimately approved. Implementation of additional systems and programs may be required, the cost of which is unknown to us at this time. Further, compliance with these regulations would require changes to many of the procedures we currently use to conduct our business, which may lead to additional costs that we have not yet identified. We do not know whether, or the extent to which, we will be able to recover our costs of complying with these new 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, and limitations on rate increases and guaranteed renewability for small business plans and policies for individuals. 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, 2001, 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 administra- 19 tive 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 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 healthcare delivery system, including medical providers, PPOs, exclusive provider organizations, community-based healthcare organizations and indemnity insurance plans. This pending federal legislation: - requires a more stringent timeframe for claims review and processing, utilization review and internal and external appeals processes; - provides that insureds have greater access to non-formulary drugs, clinical trials, physicians, specialists and emergency care; and - allows insureds to bring suit after exhaustion of the appeals process. 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 1,081 employees at December 31, 2001. We consider our employee relations to be good. Our approximately 48,000 agents are independent contractors and not employees. ITEM 2. PROPERTIES Since August 1, 2001, we have leased our headquarters building in Cleveland, Ohio, consisting of 121,625 square feet. Since April 11, 2000, we have leased a 19,484 square foot facility in Cleveland, Ohio that houses our new business underwriting operations. Continental General owns and occupies a building in Omaha, Nebraska, consisting of approximately 61,400 square feet. Pyramid Life owns and occupies a building in Mission, Kansas, consisting of approximately 45,000 square feet. Since August 1, 2000, we have also leased a 3,605 square foot office in Chicago, Illinois. Since January 10, 2001, we have also leased a 4,365 square foot office in Dallas, Texas. ITEM 3. LEGAL PROCEEDINGS We are involved in litigation arising in the ordinary course of business. In our opinion, the effects, if any, of such litigation are not expected to be material to our consolidated financial condition. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 20 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) 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, 2002, our common stock closed at $4.43 per share.
HIGH LOW ------ ----- 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 2000 First Quarter.......................................... $ 7.25 $6.00 Second Quarter......................................... 6.63 5.75 Third Quarter.......................................... 7.25 5.81 Fourth Quarter......................................... 7.00 5.50 1999 First Quarter.......................................... $11.50 $8.25 Second Quarter......................................... 11.00 8.50 Third Quarter.......................................... 10.25 6.56 Fourth Quarter......................................... 8.00 5.94
(b) As of March 25, 2002, we had 2,174 record holders. (c) 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 Chase Manhattan Bank, 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 2001, 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, 2001. In 2002, Central Reserve, United Benefit Life and Provident American Life cannot pay any dividends without the prior approval of the Ohio Insurance Commissioner as a result of their respective statutory levels of unassigned surplus at December 31, 2001. As of December 31, 2001, Continental General cannot pay any dividends in 2002, without the prior approval of the Nebraska Insurance Commissioner. By agreement with the Kansas Department of Insurance, Pyramid Life can pay dividends to its parent Continental General Insurance only from net underwriting profits of Pyramid Life, and, therefore, as of December 31, 2001, Pyramid Life could pay approximately $1.0 million in dividends in 2002, without the prior approval of the Kansas Insurance Commissioner. 21 (d) On October 11, 2001, we issued 28,403 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 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. (e) On December 27, 2001, we completed a follow-on public offering of 16,100,000 shares of our common stock, including the exercise of the underwriters' over-allotment option, at $3.20 per share for gross proceeds of $51.5 million, or $46.5 million net of fees and expenses. The Form S-1 registration statement (Reg. No. 333-59784) was declared effective by the SEC on December 20, 2001. The offering was lead managed by Friedman, Billings, Ramsey & Co., Inc. and Sandler O'Neill & Partners, L.P. and Stifel, Nicolaus & Company, Incorporated was co-manager. The net proceeds of the offering were used as follows: - $28.0 million contributed to the capital of our insurance subsidiaries; - $12.5 million to repay a portion of our bank debt; - $5.0 million to repurchase our convertible voting preferred stock; and - $1.0 million for working capital and general corporate purposes. 22 ITEM 6. SELECTED FINANCIAL DATA The selected consolidated financial data presented below as of and for each of the five years ended December 31, 2001, 2000, 1999, 1998, and 1997 have been derived from our audited consolidated financial statements. The acquisitions of Provident American Life, Continental General and Pyramid Life occurred on December 31, 1998, February 17, 1999 and July 26, 2000, 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, and the financial information for the year ended December 31, 2000 includes the operations of Pyramid Life since July 26, 2000. The financial information for the year ended December 31, 2001 includes the operations of all our subsidiaries for the entire year. 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, ---------------------------------------------------------------- 2001 2000 1999 1998 1997 -------- -------- -------- -------- -------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Premiums (net of reinsurance)....... $635,039 $511,542 $327,746 $154,188 $249,707 Net investment income............... 31,999 26,871 21,362 7,454 6,528 Net realized gains (losses)......... 4,953 (98) 107 211 146 Fee and other income................ 36,155 32,718 17,410 7,694 9,152 Amortization of deferred reinsurance gain.............................. 4,958 6,093 5,468 600 -- -------- -------- -------- -------- -------- Total revenues................. $713,104 $577,126 $372,093 $170,147 $265,533 ======== ======== ======== ======== ======== Income (loss) before federal income taxes, minority interest, and preferred stock repurchase and dividends......................... $ 4,980 $ 24,804 $ 18,006 $ (2,769) $(21,089) Federal income tax expense (benefit)......................... 2,703 8,380 6,302 1,067 (133) -------- -------- -------- -------- -------- Income (loss) after tax, before minority interest and preferred stock repurchase and dividends.... 2,277 16,424 11,704 (3,836) (20,956) Minority interest................... (55) (26) -- -- -- -------- -------- -------- -------- -------- Net income (loss)................... 2,332 16,450 11,704 (3,836) (20,956) Gain on repurchase of the convertible voting preferred stock, net of dividends........... 2,827 (327) -- -- -- -------- -------- -------- -------- -------- Net income (loss) attributable to common stockholders............ $ 5,159 $ 16,123 $ 11,704 $ (3,836) $(20,956) ======== ======== ======== ======== ======== Basic earnings (loss) per share(1).......................... $ 0.29 $ 1.06 $ 0.88 $ (0.49) $ (5.01) Diluted earnings (loss) per share(1).......................... 0.29 1.00 0.77 (0.49)(2) (5.01)(2) Cash dividends per share............ -- -- -- -- --
23
DECEMBER 31, -------------------------------------------------------- 2001 2000 1999 1998 1997 -------- -------- -------- -------- -------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Investments......................... $482,622 $426,111 $309,952 $ 89,826 $ 79,957 Reinsurance receivable.............. 223,330 238,185 263,289 41,417 26,216 Total assets........................ 946,016 880,529 717,868 180,233 135,804 Debt................................ 31,000 57,018 48,157 8,284 8,399 Note payable........................ -- -- -- -- 20,000 Future policy benefits and claims payable........................... 654,553 627,877 538,732 97,113 81,090 Retained earnings (accumulated deficit).......................... 23,831 18,672 2,549 (9,155) (5,319) Stockholders' equity(4)............. 156,575 103,283 44,661 35,836 1,512 Equity per share: After accumulated other comprehensive income (loss)(3)...................... 4.62 5.52 3.26 3.12 0.36 Before accumulated other comprehensive income (loss)(3)...................... 4.61 5.88 4.59 3.02 0.21
--------------- (1) Loss per share amounts for 1997 and 1996 have been restated to comply with Statement of Financial Accounting Standard No. 128 "Earnings Per Share." (2) The exercise of options and warrants is not assumed when a loss from operations is reported and the result would be antidilutive. (3) "Accumulated other comprehensive income (loss)" relates primarily to the net unrealized gain (loss) on available-for-sale securities. (4) We received proceeds from our 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. 24 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 Since January 1, 1998, we: - restructured the company and its operations and initiated a growth strategy that included expanded distribution channels and product offerings and a series of strategic acquisitions, including our entry into the senior market; - entered into a quota share reinsurance agreement with Hannover, effective January 1, 1997, under which Hannover reinsured 50% of certain group health policies in force at Central Reserve and written during 1997; - underwent a change of control in July 1998; - completed a private placement of our common stock in July 1998 in which we issued and sold 7,300,000 shares of common stock at $5.50 per share and warrants to purchase an additional 3,650,000 shares of common stock at an exercise price of $5.50 per share for total proceeds of approximately $40.2 million, or $37.7 million net of expenses; - entered into an agreement with United Benefit Life Insurance Company as of August 1, 1998 to reinsure 100% of the major medical policies of United Benefit Life and entered into a reinsurance agreement with Hannover in which we ceded 80% of the risk for United Benefit Life policies in force before August 1, 1998 and 50% of the risk for United Benefit Life policies in force after August 1, 1998; - acquired Provident American Life and Health Insurance Company from Provident American Corporation on December 31, 1998 for $5.5 million in cash and, immediately prior to the sale, Provident American Life ceded 100% of its policies in force to Provident Indemnity Life Insurance Company while in turn Hannover assumed from Provident Indemnity 100% of its health block of business with Central Reserve assuming 10% from Hannover; - entered into a reinsurance agreement with Hannover, in which Hannover reinsured 50% of Provident American Life's direct business written after December 31, 1998 and 50% of the business reinsured from Provident Indemnity; - acquired Continental General Insurance Company from The Western & Southern Life Insurance Company of Cincinnati, Ohio, on February 17, 1999 for $84.5 million including $40.0 million from a credit facility with Chase, $15.0 million from a private placement of 2,000,000 shares of our common stock, $22.5 million from a special pre-closing dividend to Western & Southern from Continental General, and the balance in cash; - entered into a reinsurance agreement with Hannover, under which Hannover reinsured 50% of all insurance business in force at Continental General on February 1, 1999; - acquired United Benefit Life in July 1999 through foreclosure in order to satisfy, in part, a $19.4 million reserve shortfall at December 31, 1999, of which $17.8 million was recovered and $1.6 million was expensed by us; - acquired selected major medical insureds of Central Benefits Mutual Insurance Company beginning in January 2000; 25 - discontinued new sales activities for United Benefit Life and Provident American Life, except for Internet sales of Provident American Life, in July 2000; - acquired a block of individual and small group health insurance written by American Chambers Life Insurance Company effective May 1, 2000; - acquired Pyramid Life Insurance Company from United Insurance Company of America, a subsidiary of Unitrin, Inc., on July 26, 2000 for $67.5 million including $25.0 million from a special pre-closing dividend from Pyramid Life to Unitrin, $20.0 million from a private placement offering of 3,333,334 shares of our common stock, $15.0 million from cash at Continental General and financing provided by Chase, and $7.5 million from the sale of our convertible voting preferred stock to United Insurance Company; - implemented a program in July 2001 to mitigate losses at United Benefit Life and Provident American Life by notifying their policyholders that their policies would be terminated or replaced and the business in these two subsidiaries will be substantially wound down in the early part of 2002; and - sold 16.1 million shares of our common stock, including the exercise of the underwriters' over-allotment option, on December 27, 2001 for $3.20 per share in a follow-on public offering for net proceeds of $46.5 million. 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, 2000 and 2001 includes the operations of Pyramid Life subsequent to its acquisition on July 26, 2000. The financial information for the year ended December 31, 2001 includes the operations of all our subsidiaries for the entire period. Our results of operations are affected by the following accounting and insurance business factors: Level of required reserves for policies in force. The amount of reserves relating to reported and unreported claims incurred is determined by periodically evaluating historical claims experience and statistical information with respect to the probable number and nature of such claims. Claim reserves reflect actual experience through the most recent time period and policy reserves reflect expectations of claims related to a block of business over its entire life. We compare actual experience with estimates and adjust our reserves on the basis of such comparisons. Revisions to reserves are reflected in our current results of operations through benefits, claims, losses and settlement expenses. In addition to the reserves discussed above, we also maintain reserves for policies that are not currently in claims based upon actuarial expectations that a policy may become a claim in the future. These reserves are calculated based on factors that include estimates for mortality, morbidity, interest rates and persistency. Factor components generally include assumptions that are consistent with both our experience and industry practices. 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. 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 26 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. Amortized deferred acquisition costs are affected by unanticipated termination of policies because, upon such unanticipated termination, we expense fully the unamortized deferred acquisition costs associated with the terminated policy. Value of business acquired. A portion of the purchase price paid for Pyramid Life and 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 6.0% for Continental General and 7.0% for Pyramid Life 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 and 7.0% for Pyramid Life, 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. 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 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 also believe that we enjoy a favorable reputation with our insureds for providing desirable policy benefits and efficient claims processing. 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 the payment of 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 deferred acquisition cost amortization and anti-selection of higher-risk insureds. Reinsurance. Consistent with the general practice of the insurance industry, we reinsure portions of the coverage provided by our insurance products to unaffiliated insurance companies under reinsurance agreements. Reinsurance provides a greater diversification of underwriting risk, minimizes our aggregate exposure 27 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. RECENT EVENTS As previously reported, 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 sale was subject to approval by the State of Ohio Department of Insurance and other customary terms and conditions. Based on recent discussions with the Ohio Department of Insurance, we believe that approval of this transaction is unlikely. The parties mutually terminated the stock purchase agreement on January 14, 2002. On December 27, 2001, we sold 16.1 million shares of common stock at $3.20 per share, which included the exercise of the underwriters' over-allotment option of 2.1 million shares, in a follow-on 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; - 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; - contribute $28.0 million to the capital of our insurance subsidiaries; and - $1.0 million for general corporate purposes and working capital. RESULTS OF OPERATIONS Year-to-year financial results must be viewed in light of the change in control, reinsurance, acquisitions, changes to our equity and debt and the other factors described above. We have three reportable segments: - medical -- includes 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. 28 2001 COMPARED TO 2000
INCREASE (DECREASE) FROM % OF % OF PREVIOUS YEAR CONSOLIDATED CONSOLIDATED ----------------- 2001 REVENUES 2000 REVENUES DOLLARS % -------- ------------ -------- ------------ -------- ------ (DOLLARS IN THOUSANDS) Premiums, net Medical.................... $408,215 57.2% $375,804 65.1% $ 32,411 8.6% Senior and other........... 226,824 31.8% 135,738 23.5% 91,086 67.1% -------- ----- -------- ----- -------- Total................. 635,039 89.0% 511,542 88.6% 123,497 24.1% Net investment income........ 31,999 4.5% 26,871 4.7% 5,128 19.1% Net realized gains (losses)................... 4,953 0.7% (98) -- 5,051 N/M Fee and other income......... 36,155 5.1% 32,718 5.7% 3,437 10.5% Amortization of deferred reinsurance gain........... 4,958 0.7% 6,093 1.0% (1,135) (18.6)% -------- ----- -------- ----- -------- Consolidated revenues........... 713,104 100.0% 577,126 100.0% 135,978 23.6% -------- ----- -------- ----- -------- Benefits, claims, losses and settlement expenses Medical.................... 333,740 46.8% 288,260 49.9% 45,480 15.8% Senior and other........... 166,735 23.4% 101,551 17.6% 65,184 64.2% -------- ----- -------- ----- -------- Total................. 500,475 70.2% 389,811 67.5% 110,664 28.4% Selling, general and administrative expenses.... 223,941 31.4% 186,389 32.3% 37,552 20.1% Net (deferral) amortization and change in acquisition costs and value of business acquired................... (29,172) (4.1)% (30,513) (5.3)% 1,341 4.4% Amortization of goodwill..... 1,104 0.2% 1,069 0.2% 35 3.3% Interest expense and financing costs............ 4,679 0.6% 5,566 1.0% (887) (15.9)% Special charges.............. 7,097 1.0% -- -- 7,097 -- Federal income tax expense... 2,703 0.4% 8,380 1.4% (5,677) (67.7)% Minority interest............ (55) -- (26) -- (29) (111.5)% -------- ----- -------- ----- -------- Net income................... 2,332 0.3% 16,450 2.9% (14,118) (85.8)% Gain on repurchase of the convertible voting preferred stock, net of dividends.................. 2,827 0.4% (327) (0.1)% 3,154 N/M -------- ----- -------- ----- -------- Net income attributable to common stockholders........ $ 5,159 0.7% $ 16,123 2.8% $(10,964) (68.0)% ======== ===== ======== ===== ======== Net income per share attributable to common stockholders Basic................... $ 0.29 $ 1.06 Diluted................. 0.29 1.00
--------------- N/M = not meaningful 29 NET PREMIUMS (NET OF REINSURANCE CEDED) For the year ended December 31, 2001, total net premiums were $635.0 million, an increase of 24.1%, from $511.5 million for 2000. Medical premiums for 2001 were $408.2 million compared to $375.8 million for 2000, an increase of 8.6%. 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 $226.8 million for 2001 compared to $135.7 million for 2000, an increase of 67.1%. The increase in senior and other premiums was primarily the result of $47.3 million attributable to a full year of Pyramid Life premiums, increased new sales and premium rate increases. OTHER REVENUES Net investment income increased to $32.0 million for 2001 from $26.9 million for 2000, an increase of 19.1%, due primarily to an increased investment base from the addition of Pyramid Life. Net realized gains increased to $5.0 million for 2001 from zero 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 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 $32.7 million for 2000, an increase of 10.5%. 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 $500.5 million for 2001 compared to $389.8 million for 2000, an increase of 28.4%. Medical benefits, claims, losses and settlement expenses were $333.7 million for 2001 compared to $288.3 million for 2000, an increase of 15.8%. 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, a larger volume of business in force at Continental General, and $3.1 million attributable to a full year of Pyramid Life. Additionally, for these same reasons, a $12.4 million deficiency in 2000 reserves emerged in 2001. The medical loss ratio was 81.8% for 2001 compared to 76.7% for 2000. The medical loss ratio without United Benefit Life and Provident American Life was 79.1% compared to 76.6% for 2001 and 2000, respectively. The increase was due to the above mentioned items. Senior and other benefits, claims, losses and settlement expenses were $166.7 million for 2001 compared to $101.6 million for 2000, an increase of 64.2%. The increase was a result of $34.3 million attributable to 30 Pyramid Life being included for a full year in 2001 and claims and benefits paid on a larger volume of business in force. The senior and other loss ratio decreased to 73.5% for 2001 compared to 74.8% for 2000, primarily attributable to increased volume of new premiums and lower benefit utilization. OTHER EXPENSES AND NET INCOME Selling, general and administrative expenses increased to $223.9 million in 2001 compared to $186.4 million in 2000, an increase of 20.1%. The increase in selling, general and administrative expenses represented a $3.0 million increase in commissions, a $14.3 million increase in other operating and reinsurance expenses attributable to our increased business base, and reduced reinsurance allowances of $20.2 million resulting from a lower volume of ceded premiums. The inclusion of Pyramid Life for a full year accounted for $17.0 million of the $37.5 million increase. As a percentage of revenues, selling, general and administrative expenses have decreased to 31.4% in 2001 compared to 32.3% in 2000. The net (deferral) amortization and change in acquisition costs and value of business acquired resulted in a net deferral of $29.2 million for 2001 compared to a net deferral of $30.5 million for 2000. Pyramid Life accounted for $4.9 million of the net deferral. The decrease was primarily attributable to the write-off of Central Reserve's deferred acquisition costs (DAC) asset of approximately $6.7 million in six states due to the continuing unprofitability of the 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 M, Special Charges for further information). The DAC asset was written off due to the planned termination of the business. A federal income tax expense of $2.7 million, or 54.3% of the income before federal taxes, was established for 2001. The 2000 effective rate was 33.8%. The increase in the effective tax rate resulted from permanent tax differences, which are proportionately higher compared to income in 2001 versus 2000. 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, 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. 31 2000 COMPARED TO 1999
INCREASE (DECREASE) FROM % OF % OF PREVIOUS YEAR CONSOLIDATED CONSOLIDATED ---------------- 2000 REVENUES 1999 REVENUES DOLLARS % -------- ------------ -------- ------------ -------- ----- (DOLLARS IN THOUSANDS) Premiums, net Medical..................... $375,804 65.1% $251,876 67.7% $123,928 49.2% Senior and other............ 135,738 23.5% 75,870 20.4% 59,868 78.9% -------- ----- -------- ----- -------- Total.................. 511,542 88.6% 327,746 88.1% 183,796 56.1% Net investment income......... 26,871 4.7% 21,362 5.7% 5,509 25.8% Net realized gains (losses)... (98) -- 107 -- (205) N/M Fee and other income.......... 32,718 5.7% 17,410 4.7% 15,308 87.9% Amortization of deferred reinsurance gain............ 6,093 1.0% 5,468 1.5% 625 11.4% -------- ----- -------- ----- -------- Consolidated revenues............ 577,126 100.0% 372,093 100.0% 205,033 55.1% -------- ----- -------- ----- -------- Benefits, claims, losses and settlement expenses Medical..................... 288,260 49.9% 176,531 47.5% 111,729 63.3% Senior and other............ 101,551 17.6% 56,572 15.2% 44,979 79.5% -------- ----- -------- ----- -------- Total.................. 389,811 67.5% 233,103 62.7% 156,708 67.2% Selling, general and administrative expenses..... 186,389 32.3% 137,932 37.1% 48,457 35.1% Net (deferral) amortization and change in acquisition costs and value of business acquired.................... (30,513) (5.3)% (21,892) (5.9)% (8,621) (39.4)% Amortization of goodwill...... 1,069 0.2% 854 0.2% 215 25.2% Interest expense and financing costs....................... 5,566 1.0% 4,090 1.1% 1,476 36.1% Federal income tax expense.... 8,380 1.4% 6,302 1.7% 2,078 33.0% Minority interest............. (26) -- -- -- (26) N/M -------- ----- -------- ----- -------- Net income.................... 16,450 2.9% 11,704 3.1% 4,746 40.6% Convertible voting preferred stock dividends............. (327) (0.1) -- -- (327) N/M -------- ----- -------- ----- -------- Net income attributable to common stockholders......... $ 16,123 2.8% $ 11,704 3.1% $ 4,419 37.8% ======== ===== ======== ===== ======== Net income per share attributable to common stockholders Basic.................... $ 1.06 $ 0.88 Diluted.................. 1.00 0.77
--------------- N/M = not meaningful 32 NET PREMIUMS (NET OF REINSURANCE CEDED) For the year ended December 31, 2000, total net premiums were $511.5 million, an increase of 56.1%, from $327.7 million for 1999. Medical premiums for 2000 were $375.8 million compared to $251.9 million for 1999, an increase of 49.2%. The increase in medical premiums was primarily the result of increased new sales including sales arising from the selected major medical insureds of Central Benefits, premium rate increases, additional reinsurance assumed from American Chambers and the inclusion of Continental General's results for twelve months in 2000 compared to eleven months in 1999. Senior and other premiums were $135.7 million for 2000 compared to $75.9 million for 1999, an increase of 78.9%. The increase in senior and other premiums was primarily the result of increased Medicare supplement sales, premium rate increases, $26.2 million attributable to Pyramid Life, and the inclusion of Continental General's results for twelve months in 2000 compared to eleven months in 1999. OTHER REVENUES Net investment income increased to $26.9 million for 2000 from $21.4 million for 1999, an increase of 25.8%, due primarily to an increased investment base from the addition of Pyramid Life and the inclusion of Continental General's results for twelve months in 2000 compared to eleven months in 1999. Fee and other income increased to $32.7 million for 2000 compared to $17.4 million for 1999, an increase of 87.9%, primarily attributable to additional fees charged for new services, such as care coordination fees, as well as fees received on a larger volume of business. Fee and other income from non-regulated subsidiaries accounted for $10.4 million in 2000. The amortization of deferred reinsurance gain of $6.1 million for 2000 represented the recognition and amortization of the ceding commission allowances received on our reinsurance agreements. The unamortized amount of $18.8 million at December 31, 2000 was accounted for as a deferred reinsurance gain on our consolidated balance sheet. BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES Total benefits, claims, losses and settlement expenses increased to $389.8 million for 2000 compared to $233.1 million for 1999, an increase of 67.2%. Medical benefits, claims, losses and settlement expenses were $288.3 million for 2000 compared to $176.5 million for 1999, an increase of 63.3%. The increase was primarily a result of higher benefit utilization in 2000 versus 1999 on a larger volume of business and increased medical costs. The medical loss ratio was 76.7% for the year ended December 31, 2000 compared to 70.1% for 1999. Our loss ratios are defined as policy benefits, claims, losses and settlement expenses as a percentage of net premiums for each segment. Senior and other benefits, claims, losses and settlement expenses were $101.6 million for 2000 compared to $56.6 million for 1999, an increase of 79.5%. The increase was a result of $17.4 million attributable to Pyramid Life for five months, claims and benefits paid on a larger volume of business and the inclusion of Continental General's results for twelve months in 2000 compared to eleven months in 1999. The senior loss ratio was 74.8% for 2000 compared to 74.6% for 1999. OTHER EXPENSES AND NET INCOME Selling, general and administrative expenses increased $48.5 million to $186.4 million in 2000 compared to $137.9 million in 1999, an increase of 35.1%. The increase in selling, general and administrative expenses resulted from a $42.6 million increase in commissions and a $13.8 million increase in other operating expenses and a $5.4 million increase in premium taxes, licenses and fees attributable to our increased business base. This increase was partially offset by a net change in reinsurance expenses and allowances of $13.3 million. The addition of Pyramid Life accounted for $10.0 million of the $48.5 million increase. As a percentage of 33 consolidated revenues, selling, general and administrative expenses decreased to 32.3% in 2000 compared to 37.1% in 1999. The net amortization and change in deferral of acquisition costs and value of business acquired resulted in a net deferral of $30.5 million for 2000 compared to a net deferral of $21.9 million for 1999. Pyramid Life accounted for $2.5 million of the net deferral in 2000. The remaining increase in the deferral was a result of capitalized acquisition expenses on new business, including Continental General's new business for twelve months in 2000 versus eleven months in 1999. Interest expense and financing costs increased to $5.6 million in 2000 compared to $4.1 million in 1999 as a result of the interest expense incurred under our credit agreement for twelve months in 2000 compared to interest expense for 1999 which did not begin to accrue until February 17, 1999, the closing date of the purchase of Continental General, and a higher outstanding balance. Interest rates charged under the credit agreement in 2000 were also higher than those charged in 1999. For the year ended December 31, 2000, the provision for federal income taxes was $8.4 million, or 33.8% of income before federal income taxes of $24.8 million. The 1999 effective rate was 35.0%. Net income for the year ended December 31, 2000 was $16.5 million, or $1.06 basic earnings per share and $1.00 diluted earnings per share, compared to $11.7 million, or $0.88 basic earnings per share and $0.77 diluted earnings per share, for 1999. Our net income for 2000 was adversely affected by a net loss of $4.9 million at United Benefit Life due to high benefit and claims loss ratios and other related expenses. New sales activities for United Benefit Life were discontinued in July 2000. We have taken a number of actions to mitigate future adverse results, but future losses at United Benefit Life could continue to have a material adverse effect on our financial performance. In addition, new sales activities for Provident American Life, except for Internet sales, also were discontinued in July 2000. 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 increased 7.4% to $946.0 million at December 31, 2001 from $880.5 million at December 31, 2000. Assets of $482.6 million, or 51.0% of the total assets, were in investments at December 31, 2001. Fixed maturities, our primary investment, were $471.5 million, or 97.7% of total investments, at December 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 December 31, 2001. Approximately 94.8% of our bonds were of investment grade quality at December 31, 2001. In addition to the fixed maturities, we also had $74.6 million in cash and cash equivalents, and a $2.5 million revolver, at December 31, 2001. At December 31, 2001, there was no amount available for additional borrowings under the revolver. On February 17, 2002, the revolver balance of $2.5 million was paid in full with proceeds from our December 2001 public offering. The total reinsurance receivable was $223.3 million at December 31, 2001. Of this amount, $185.5 million represents reserves held by our reinsurers under our various reinsurance treaties in place. Hannover holds most of these reserves. The total policy liabilities and accruals (reserves) were 82.9% of the total liabilities at December 31, 2001 compared to 80.8% at December 31, 2000. On May 25, 2001, we entered into an agreement with Royalton Investors, LLC and Big T Investments, LLC to sell our Cleveland headquarters. The transaction was effective July 31, 2001. The building was sold to 34 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. Monthly rent payments began in August 2001 and annually total $1.7 million through July 2003, $1.8 million through July 2006, $2.0 million through July 2011, and $2.1 million through July 2016. The net proceeds were used to: - prepay in full the outstanding $7.9 million mortgage note on the building on August 3, 2001; - permanently reduce our revolving line of credit by $2.5 million on August 6, 2001; and - contribute $5.0 million to the capital of Central Reserve. 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, Ceres borrowed $40.0 million under a tranche A term loan and secured a $10.0 million revolver. Interest on the outstanding balance of the term loan and revolver are 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 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 $40.0 million tranche A term loan. At December 31, 2001, the interest rate on the revolver was 5.7% on the outstanding balance of $2.5 million. On February 17, 2002, the balance of the revolver was repaid from proceeds of our December 2001 public offering. On March 30, 2001, our credit agreement was again 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 under the credit agreement. The terms of the amendment provide for CIT Group to participate equally with the syndicate of banks and Chase under the credit agreement. At December 31, 2001, the interest rate on our tranche A term loan balance of $18.5 million was 6.0% per annum and our $10.0 million CIT tranche B term loan was 6.5% per annum. The first principal payment on the CIT tranche B 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. On December 27, 2001, our credit agreement again was amended in connection with the stock offering. The credit agreement, as amended, contains financial and other covenants that among other things: - 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, and beginning in 2002, 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 35 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. In addition, the amended agreement required us to: - repay a portion of our tranche A term loan with $10.0 million of the proceeds from the December 2001 equity offering; - 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; - set aside $2.5 million of the proceeds from the equity offering for the permanent repayment of the balance of our revolver due February 17, 2002; and - increase the interest rate of the tranche B term loan by 0.5% per annum. Finally, the credit agreement, as amended: - restructured our scheduled tranche A term loan debt payments as follows: quarterly principal payments of $0.5 million through May 17, 2002, $0.8 million through November 17, 2002, $0.9 million through November 17, 2004, and a payment of $8.5 million on February 17, 2005; - allowed repurchase of all of our convertible voting preferred stock with $5.0 million of the proceeds from the equity offering; and - allowed capital contributions to our insurance subsidiaries with proceeds from the equity offering after the repayments to the banks and repurchase of our convertible voting preferred stock. At December 31, 2001, the balance of our fully drawn revolver was $2.5 million. The pay-off and final maturity of this revolver was February 17, 2002. The following schedule summarizes current and future contractual obligations as of December 31, 2001:
PAYMENTS DUE BY YEAR ----------------------------------------------------- LESS THAN AFTER CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR 1-3 YEARS 4-5 YEARS 5 YEARS ----------------------- ------- --------- --------- --------- ------- (IN THOUSANDS) Long-Term Debt............................... $28,500 $3,497 $11,068 $13,935 $ -- Operating Leases............................. 32,581 3,383 5,500 4,351 19,347 Bank Revolver................................ 2,500 2,500 -- -- -- ------- ------ ------- ------- ------- Total Contractual Obligations.............. $63,581 $9,380 $16,568 $18,286 $19,347 ======= ====== ======= ======= =======
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, 2001, we were in compliance with our credit agreement, as amended. 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. Due to the equity offering and the amendment to our credit agreement, we believe that funds should be sufficient to meet all our debt obligations over the next 12 months. Funds to meet our debt obligations are generated from fee income from our non-regulated subsidiaries and from dividends of our insurance subsidiaries, if available. 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. Dividends from our regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. As of December 31, 2001, none of our direct insurance subsidiaries (Central Reserve and Continental General) could pay a dividend to Ceres Group, the parent company, without prior approval of their respective state regulators as a result of their 36 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, 2001, we had a tax net operating loss, or NOL, carryforward of approximately $26.6 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. The December 2001 public offering resulted in an "ownership change" of our company, 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 $26.6 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, 2001 and 2000, estimates were made as to the potential financial impact of recent NOLs and our financial condition. Management believes that we will generate sufficient future taxable income to realize the $1.1 million net deferred tax asset, recorded as of December 31, 2001, prior to the expiration of any NOLs. 37 FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The following tables present the revenues, expenses and profit (loss) before federal income taxes, for the last three years attributable to our industry segments. We do not separately allocate investment assets or other identifiable assets by industry segment, nor are income tax (benefit) expenses allocated by industry segment.
YEAR ENDED DECEMBER 31, ------------------------------ 2001 2000 1999 -------- -------- -------- (DOLLARS IN THOUSANDS) MEDICAL Revenues Net premiums........................................... $408,215 $375,804 $251,876 Investment income, realized gains...................... 11,984 9,101 6,985 Other income........................................... 37,772 36,103 21,307 -------- -------- -------- 457,971 421,008 280,168 -------- -------- -------- Expenses Benefits and claims.................................... 333,740 288,260 176,531 Other operating expenses............................... 130,306 122,483 96,357 Special charges........................................ 7,097 -- -- -------- -------- -------- 471,143 410,743 272,888 -------- -------- -------- Segment profit (loss) before federal income taxes, minority interest and preferred stock transactions..... $(13,172) $ 10,265 $ 7,280 ======== ======== ======== SENIOR AND OTHER Revenues Net premiums........................................... $226,824 $135,738 $ 75,870 Investment income, realized gains...................... 24,345 16,615 14,233 Other income........................................... 3,341 2,686 1,364 -------- -------- -------- 254,510 155,039 91,467 -------- -------- -------- Expenses Benefits and claims.................................... 166,735 101,551 56,572 Other operating expenses............................... 61,871 32,265 18,510 -------- -------- -------- 228,606 133,816 75,082 -------- -------- -------- Segment profit before federal income taxes, minority interest and preferred stock transactions.............. $ 25,904 $ 21,223 $ 16,385 ======== ======== ======== CORPORATE AND OTHER Revenues Investment income, realized gains...................... $ 623 $ 1,057 $ 251 Other income........................................... -- 22 207 -------- -------- -------- 623 1,079 458 -------- -------- -------- Expenses Interest and financing expenses........................ 4,679 5,566 4,090 Other operating expenses............................... 3,696 2,197 2,027 -------- -------- -------- 8,375 7,763 6,117 -------- -------- -------- Segment loss before federal income taxes, minority interest and preferred stock transactions.............. $ (7,752) $ (6,684) $ (5,659) ======== ======== ======== INCOME BEFORE FEDERAL INCOME TAXES, MINORITY INTEREST AND PREFERRED STOCK TRANSACTIONS................................ $ 4,980 $ 24,804 $ 18,006 ======== ======== ========
38 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. Recent increased medical inflation and higher than anticipated utilization had the effect in the year ended December 31, 2001 of exceeding premium rate increases. Any negative fluctuation in our estimates of the effect of continued medical inflation and high benefit utilization could have a material adverse impact on our results of operations. Legal/Regulatory Risk is the risk that changes in the legal or regulatory environment in which an insurer operates will create additional expenses not anticipated by the insurer in pricing its products. For example, regulatory initiatives designed to reduce insurer profits or otherwise affecting the industry in which the insurer operates, new legal theories or insurance company insolvencies through guaranty fund assessments, may create costs for the insurer beyond those recorded in the financial statements. We attempt to mitigate this risk by offering a wide range of products and by operating in many states, thus reducing our exposure to any single product and by employing underwriting practices that identify and minimize the adverse impact of this risk. In addition, insurance companies are subject to extensive federal and state regulation and compliance with these regulations could increase the insurance companies' operating costs. In some circumstances, failure to comply with certain insurance regulations could subject an insurance company to regulatory actions by such insurance company's state of domicile. For example, states have statutory risk-based capital, 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, 2001, our risk-based capital levels for each of our insurance subsidiaries exceeded the levels required by regulatory authorities. 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 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 $19.7 million after-tax at December 31, 2001. This amount represents approximately 12.6% of our stockholders' equity at such date. We also have long-term debt that bears interest at variable rates. Therefore, our results of operations would be affected by interest rate changes. We do not expect a significant rate change in the near future that would have a material effect on our near-term results of operations. Seasonality is the risk of fluctuations of revenues and operating results. Historically, our revenues and operating results have varied from quarter to quarter and are expected to continue to fluctuate in the future. These fluctuations have been due to a number of factors, including higher benefit utilization by our insureds 39 during the winter months and the use of deductibles. More specifically, our senior segment 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, as evidenced by the year ended December 31, 2001, 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: - 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 implement increases in premium rates and to develop, distribute and administer competitive products and services in a timely, cost-effective manner; - our ability to maintain our current PPO network arrangements; - 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; - our ability to meet risk-based capital requirements; - the adequacy of funds, including fee income, received from our non-regulated subsidiaries to meet Ceres' debt obligations; 40 - the risk of material adverse outcomes in litigation; - dependence on senior management and key personnel; - the failure to successfully manage our expanding operations and integrate future acquisitions, if any, including the failure to achieve cost savings; - our financial and claims paying ratings, including any potential downgrades; - 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 failure to comply with financial and other covenants in our loan agreements; - payments to state assessment funds; - business conditions and competition in the healthcare industry; - changes in tax laws; - 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; - 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 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 August 2001, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. This Statement will supersede, effective January 1, 2002, 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 required 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 by broadening the presentation of discontinued operations to include more disposal transactions. The provisions of this Statement generally are to be applied prospectively. The adoption of SFAS No. 144 on January 1, 2002 is not expected to have a significant 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. We anticipate that the adoption of this standard will not have a significant effect on our results of operations, financial position or liquidity. In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets, which replaces APB Opinion No. 17, Intangible Assets. This Statement addressed how intangible assets that are acquired 41 individually or with a group of other assets (but not those acquired in a business combination) should be accounted for in financial statements upon their acquisition. Additionally, this Statement discussed how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements. This Statement: - specifies that goodwill and intangible assets that have indefinite useful lives will not be amortized but rather will be tested at least annually for impairment; - provides specific guidance for testing goodwill for impairment; and - requires additional disclosures not previously required. The provisions of SFAS No. 142 were adopted by the Company as required effective January 1, 2002. Application of the nonamortization provisions of this Statement is expected to reduce annual expense by approximately $1.1 million, which is projected to result in an increase in net income of approximately $0.7 million, or $0.02 per diluted share, in 2002 and subsequent periods, subject to the impairment test described herein. SFAS No. 142, as part of its adoption provisions, requires a transitional impairment test to be applied to all goodwill and other indefinite-lived intangible assets within the first half of 2002 and any resulting impairment loss be reported as a change in accounting principle. The Company is in the process of evaluating the potential impact of this Statement on its results of operations, financial position, and liquidity. In general, application of the new provisions for goodwill and other indefinite-lived intangible assets may result in more income statement volatility due to the potential for periodic recognition of impairment losses, which could vary in amount and regularity versus reducing those assets through systematic amortization over a finite period of time. In June 2001, the FASB issued SFAS No. 141, Business Combinations, which addressed the accounting and reporting for business combinations and expanded the criteria for recording intangible assets separate from goodwill. On July 1, 2001, we adopted this Statement which requires us to use the purchase method of accounting for all business combinations initiated after June 30, 2001. In September 2000, the FASB issued SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which replaces SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This Statement revised the methods for accounting for securitizations and other transfers of financial assets and collateral as outlined in SFAS No. 125, and required certain additional disclosures. The adoption of this Statement did not have a material effect on our results of operations, financial position or liquidity. In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities and SFAS 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 SFAS No. 133 did not have a significant 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. 42 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA CERES GROUP, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
PAGE ---- Report of Independent Auditors.............................. 44 CONSOLIDATED FINANCIAL STATEMENTS Consolidated Balance Sheets as of December 31, 2001 and 2000...................................................... 45 Consolidated Statements of Income for the years ended December 31, 2001, 2000 and 1999.......................... 46 Consolidated Statements of Stockholders' Equity for the years ended December 31, 2001, 2000 and 1999.............. 47 Consolidated Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999.......................... 48 Notes to Consolidated Financial Statements for the years ended December 31, 2001, 2000 and 1999.................... 49 FINANCIAL STATEMENT SCHEDULES Schedule II -- Condensed Financial Information of Registrant - Ceres Group, Inc. (Parent Only)......................... 79 Schedule III -- Supplemental Insurance Information.......... 82 Schedule IV -- Reinsurance.................................. 83
43 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, 2001 and 2000, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2001. We have also audited the information presented in the financial statement schedules listed in the Index at Item 14(a). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with 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, 2001 and 2000, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, 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. Ernst & Young LLP Cleveland, Ohio March 11, 2002 44 CERES GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2001 AND 2000 (DOLLARS IN THOUSANDS) -------------------------------------------------------------------------------- --------------------------------------------------------------------------------
2001 2000 -------- -------- ASSETS Investments Fixed maturities available-for-sale, at fair value........ $471,485 $415,287 Surplus notes............................................. 5,211 4,995 Policy and mortgage loans................................. 5,926 5,829 -------- -------- Total investments -- Note D............................ 482,622 426,111 Cash and cash equivalents (of which $9,881 and $9,397 is restricted, respectively) -- Note D....................... 74,573 59,512 Accrued investment income................................... 7,200 7,496 Premiums receivable......................................... 5,230 5,852 Reinsurance receivable -- Note J............................ 223,330 238,185 Property and equipment, net -- Note E....................... 8,100 17,531 Deferred federal income taxes -- Note H..................... 1,112 3,797 Deferred acquisition costs -- Note F........................ 77,377 55,989 Value of business acquired -- Note G........................ 33,470 32,254 Goodwill.................................................... 24,443 25,425 Other assets................................................ 8,559 8,377 -------- -------- Total assets........................................... $946,016 $880,529 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Policy liabilities and accrual Future policy benefits, losses and claims................. $408,918 $408,890 Unearned premiums......................................... 47,339 42,751 Other policy claims and benefits payable -- Note I........ 198,296 176,236 -------- -------- 654,553 627,877 Deferred reinsurance gain -- Note J......................... 13,881 18,839 Other policyholders' funds.................................. 28,659 24,246 Federal income taxes payable -- Note H...................... 1,259 1,464 Mortgage note payable -- Note L............................. -- 8,018 Debt -- Note L.............................................. 31,000 49,000 Other liabilities........................................... 60,089 47,802 -------- -------- Total liabilities...................................... 789,441 777,246 -------- -------- Stockholders' equity Non-voting preferred stock, $.001 par value, 1,900,000 shares authorized, none issued -- Note O............... -- -- Convertible voting preferred stock, $.001 par value, at stated value, 100,000 shares authorized, 0 and 75,000 shares issued and outstanding, respectively -- Notes B and O.................................................. -- 7,500 Common stock, $.001 par value, 50,000,000 shares authorized, 33,857,895 and 17,278,704 shares issued and outstanding, respectively -- Note B.................... 34 17 Additional paid-in capital................................ 132,061 82,943 Dividends distributable, convertible voting preferred stock -- Note B........................................ -- 327 Retained earnings......................................... 23,831 18,672 Accumulated other comprehensive income (loss)............. 649 (6,176) -------- -------- Total stockholders' equity........................... 156,575 103,283 -------- -------- Total liabilities and stockholders' equity........... $946,016 $880,529 ======== ========
The accompanying notes are an integral part of these consolidated financial statements. 45 CERES GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) -------------------------------------------------------------------------------- --------------------------------------------------------------------------------
2001 2000 1999 -------- -------- -------- REVENUES Premiums, net -- Note J Medical................................................... $408,215 $375,804 $251,876 Senior and other.......................................... 226,824 135,738 75,870 -------- -------- -------- Total premiums, net.................................... 635,039 511,542 327,746 Net investment income -- Note D............................. 31,999 26,871 21,362 Net realized gains (losses)................................. 4,953 (98) 107 Fee and other income........................................ 36,155 32,718 17,410 Amortization of deferred reinsurance gain -- Note J......... 4,958 6,093 5,468 -------- -------- -------- 713,104 577,126 372,093 -------- -------- -------- BENEFITS, LOSSES AND EXPENSES Benefits, claims, losses and settlement expenses -- Note J Medical................................................... 333,740 288,260 176,531 Senior and other.......................................... 166,735 101,551 56,572 -------- -------- -------- Total benefits, claims, losses and settlement expenses............................................. 500,475 389,811 233,103 Selling, general and administrative expenses -- Note J...... 223,941 186,389 137,932 Net (deferral) amortization and change in acquisition costs and value of business acquired -- Notes F and G........... (29,172) (30,513) (21,892) Amortization of goodwill.................................... 1,104 1,069 854 Interest expense and financing costs........................ 4,679 5,566 4,090 Special charges -- Note M................................... 7,097 -- -- -------- -------- -------- 708,124 552,322 354,087 -------- -------- -------- Income before federal income taxes, minority interest, and preferred stock repurchase and dividends.................. 4,980 24,804 18,006 Federal income tax expense -- Note H........................ 2,703 8,380 6,302 -------- -------- -------- Income after tax, before minority interest and preferred stock repurchase and dividends............................ 2,277 16,424 11,704 Minority interest........................................... (55) (26) -- -------- -------- -------- NET INCOME.................................................. 2,332 16,450 11,704 Gain on repurchase of the convertible voting preferred stock, net of dividends -- Notes B and O.................. 2,827 (327) -- -------- -------- -------- NET INCOME ATTRIBUTABLE TO COMMON STOCKHOLDERS.............. $ 5,159 $ 16,123 $ 11,704 ======== ======== ======== NET INCOME PER SHARE ATTRIBUTABLE TO COMMON STOCKHOLDERS Basic..................................................... $ 0.29 $ 1.06 $ 0.88 Diluted................................................... 0.29 1.00 0.77
The accompanying notes are an integral part of these consolidated financial statements. 46 CERES GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) -------------------------------------------------------------------------------- --------------------------------------------------------------------------------
2001 2000 1999 ---------- ---------- ---------- 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................................ $ 17 $ 14 $ 12 Issuance of common stock: Public equity offering.................................... 16 -- -- Employee benefit plans and private placement.............. 1 3 2 ---------- ---------- ---------- Balance at end of year................................ $ 34 $ 17 $ 14 ========== ========== ========== ADDITIONAL PAID-IN CAPITAL Balance at beginning of year................................ $ 82,943 $ 60,290 $ 43,883 Issuance of stock: Public equity offering.................................... 46,495 -- -- Private placement......................................... -- 21,093 14,998 Employee benefit plans.................................... 2,623 1,560 1,409 ---------- ---------- ---------- Balance at end of year................................ $ 132,061 $ 82,943 $ 60,290 ========== ========== ========== 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................................ $ 18,672 $ 2,549 $ (9,155) Net income.................................................. 2,332 16,450 11,704 Dividends distributable, convertible voting preferred stock..................................................... (774) (327) -- Repurchase of convertible voting preferred stock............ 3,601 -- -- ---------- ---------- ---------- Balance at end of year................................ $ 23,831 $ 18,672 $ 2,549 ========== ========== ========== ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) Balance at beginning of year................................ $ (6,176) $ (18,192) $ 1,096 Unrealized gain (loss) on securities, net of tax of $37, $0 and $0, respectively...................................... 7,280 11,806 (19,650) Other....................................................... (455) 210 362 ---------- ---------- ---------- Balance at end of year................................ $ 649 $ (6,176) $ (18,192) ========== ========== ========== TOTAL STOCKHOLDERS' EQUITY.................................. $ 156,575 $ 103,283 $ 44,661 ========== ========== ========== 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................................ 17,278,704 13,706,726 11,495,172 Issuance of stock: Public equity offering.................................... 16,100,000 -- -- Private placement......................................... -- 3,333,334 2,000,000 Employee benefit plans.................................... 479,191 238,644 211,554 ---------- ---------- ---------- Balance at end of year................................ 33,857,895 17,278,704 13,706,726 ========== ========== ==========
The accompanying notes are an integral part of these consolidated financial statements. 47 CERES GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999 (DOLLARS IN THOUSANDS) -------------------------------------------------------------------------------- --------------------------------------------------------------------------------
2001 2000 1999 --------- -------- --------- OPERATING ACTIVITIES Net income................................................ $ 2,332 $ 16,450 $ 11,704 Adjustments to reconcile net income to cash provided by operating activities: Depreciation and amortization......................... 3,660 2,418 2,395 Net realized (gains) losses........................... (4,953) 98 (107) Deferred federal income tax expense................... 2,893 1,573 5,587 Changes in assets and liabilities: Premiums receivable................................ 622 (724) 85 Reinsurance receivable............................. 14,855 28,350 (221,744) Value of business acquired......................... (1,216) (2,841) (902) Goodwill........................................... 982 6,495 (423) Federal income taxes payable/recoverable........... (205) 15 (6,256) Accrued investment income.......................... 296 (350) 250 Other assets....................................... (182) 627 (1,376) Future policy benefits, claims and funds payable... 26,813 11,998 248,382 Unearned premium................................... 4,588 9,530 17,525 Other liabilities.................................. 5,219 4,861 8,454 Deferred acquisition costs......................... (22,088) (27,672) (22,283) Deferred reinsurance gain.......................... (4,958) (2,093) (5,468) --------- -------- --------- Net cash provided by operating activities................... 28,658 48,735 35,823 --------- -------- --------- INVESTING ACTIVITIES Net purchases of furniture and equipment.................. (766) (1,909) (739) Purchase of fixed maturities available-for-sale........... (232,594) (66,337) (30,323) Proceeds from sale of Cleveland headquarters.............. 15,586 -- -- Acquisition of Continental General Corporation, net of $2,212 cash acquired.................................... -- -- (59,788) Acquisition of Pyramid Life Insurance Company, net of $7,159 cash acquired.................................... -- (37,339) -- Increase in surplus notes................................. -- -- (5,042) Decrease (increase) in mortgage and policy loans, net..... (97) 366 (20) Proceeds from sales of fixed maturities available-for-sale...................................... 117,129 11,569 29,811 Proceeds from calls and maturities of fixed maturities available-for-sale...................................... 69,340 31,258 12,991 Proceeds from sales, calls and maturities of fixed maturities held-to-maturity............................. -- -- 3,923 Proceeds from sale of property held for sale.............. -- 2,115 -- --------- -------- --------- Net cash used in investing activities....................... (31,402) (60,277) (49,187) --------- -------- --------- FINANCING ACTIVITIES Increase in annuity account balances...................... 23,367 23,223 18,446 Decrease in annuity account balances...................... (23,679) (34,107) (37,819) Principal payments on mortgage note payable............... (8,018) (139) (127) Increase in debt borrowings............................... 10,000 15,000 40,000 Principal payments on debt................................ (28,000) (6,000) -- Proceeds from public equity offering...................... 46,511 -- -- Proceeds from issuance of common stock related to employee benefit plans........................................... 2,624 1,560 1,409 Proceeds from private placement of common stock, net of acquisition costs....................................... -- 21,096 15,000 Proceeds from private placement of convertible voting preferred stock......................................... -- 7,500 -- Repurchase of convertible voting preferred stock.......... (5,000) -- -- --------- -------- --------- Net cash provided by financing activities................... 17,805 28,133 36,909 --------- -------- --------- NET INCREASE IN CASH........................................ 15,061 16,591 23,545 Cash and cash equivalents at beginning of year.............. 59,512 42,921 19,376 --------- -------- --------- CASH AND CASH EQUIVALENTS AT END OF YEAR.................... $ 74,573 $ 59,512 $ 42,921 ========= ======== ========= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the year for interest.................... $ 4,193 $ 6,051 $ 2,940 Cash paid during the year for federal income taxes........ 450 1,100 2,078
The accompanying notes are an integral part of these consolidated financial statements. 48 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- A. SUMMARY OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES SUMMARY OF BUSINESS Ceres Group, Inc. and its subsidiaries operated in 1998 and prior periods primarily through its wholly owned subsidiary, Central Reserve Life Insurance Company. As of December 31, 2000, the Company's consolidated statements also include the accounts 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, United Benefit Life Insurance Company under a reinsurance arrangement effective August 1, 1998 and acquired on July 21, 1999 (through foreclosure), and Pyramid Life Insurance Company acquired on July 26, 2000. As of December 31, 2001, the Company's consolidated statements include the operations of all these subsidiaries for the entire year. These acquisitions are discussed further in Note C, Business Combinations and Note J, Reinsurance Arrangements. The Company provides through its wholly-owned subsidiaries a wide array of health and life insurance products to over 535,000 insureds. While the Company through its subsidiaries is licensed in 49 states, the District of Columbia and the U.S. Virgin Islands, approximately 60.0% of premium volume is generated from ten states: Ohio, Texas, Florida, Indiana, Pennsylvania, Tennessee, Georgia, Missouri, Illinois and Nebraska. SIGNIFICANT ACCOUNTING POLICIES The accompanying consolidated financial statements include the accounts of Ceres and its wholly-owned subsidiaries. The consolidated statement of income for the year ended December 31, 2000 reflects the results of operations for Pyramid Life for the period subsequent to its acquisition on July 26, 2000. The consolidated statement of income for the year ended December 31, 1999 reflects the results of operations for Continental General Corporation for the period subsequent to its acquisition on February 17, 1999 and United Benefit Life for the period subsequent to its acquisition on July 21, 1999. All intercompany transactions have been eliminated in consolidation. The accompanying financial statements have been prepared in accordance with generally accepted accounting principles, which differ from accounting practices prescribed or permitted by the various state departments of insurance in which the insurance subsidiaries are domiciled. See Note P, Statutory Financial Information for further information. A summary of significant accounting policies is as follows: 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 reported at fair value, with unrealized holding gains and losses reported in accumulated other comprehensive income (losses), net of deferred federal income taxes. All investments as of December 31, 2001 are designated as available-for-sale. Investments in policy notes and mortgage loans are reported at cost which approximates fair value. 49 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 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. Deferred Acquisition Costs Certain excess first year 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 determined that these amounts are recoverable. Goodwill Goodwill represents the excess of cost over the fair value of net assets acquired. Goodwill is being amortized on a straight-line basis over periods of 25 years or less. On a periodic basis, management reviews goodwill to determine if events or changes in circumstances indicate the carrying value of such assets is not recoverable, in which case an impairment charge would be recorded in current operations. Management believes that no impairment of goodwill exists at December 31, 2001. See New Accounting Pronouncements for further information. 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. Management periodically reviews the carrying value of property and equipment for impairment. Any impaired property and equipment is valued using an undiscounted cash flow methodology. 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 50 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 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 4.5%. At December 31, 2001, credited rates ranged from 4.0% to 6.0%. 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 4.0% to 7.0%. 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 interest rates ranging from 3.0% to 6.0%. 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. The adoption of this statement effective January 1, 1999 resulted in a $0.2 million charge to general operating expenses. Comprehensive Income Comprehensive income in 2001, 2000 and 1999 includes a change in unrealized gains or losses on available-for-sale securities, in addition to reported net income. See Note Q, Comprehensive Income (Loss) 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. Fee and Other Income Fee and other income consist of association, collection, management, and administrative fees, and are recognized when earned. 51 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 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 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 The intrinsic value method of accounting is used for stock-based compensation plans. 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. 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 R, Computation of Net Income Per Common Share for further information. Related Party Transactions 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 and network access for our Central Reserve Ohio insureds. Antares is a division of Medical Mutual Services, which is a subsidiary of Medical Mutual of Ohio, a 2.0% stockholder of the Company on a diluted basis and a party to the Company's voting agreement. Under the administrative services agreement, we have paid $18.4 million in 2001, $21.4 million in 2000 and $18.8 million in 1999. Use of Estimates The consolidated financial statements reflect estimates and judgments made by management that affect the amounts reported herein and the disclosure of contingent assets and liabilities. Actual results could differ significantly from those estimates. Reclassification Certain amounts presented in the prior years' financial statements have been reclassified to conform to the current year's method of presentation. 52 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- New Accounting Pronouncements In August 2001, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. This Statement will supersede, effective January 1, 2002, 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 required 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 by broadening the presentation of discontinued operations to include more disposal transactions. The provisions of this Statement generally are to be applied prospectively. The adoption of SFAS No. 144 on January 1, 2002 is not expected to have a significant 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. We anticipate that the adoption of this standard will not have a significant effect on our results of operations, financial position or liquidity. In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets, which replaces APB Opinion No. 17, Intangible Assets. This Statement addressed how intangible assets that are acquired individually or with a group of other assets (but not those acquired in a business combination) should be accounted for in financial statements upon their acquisition. Additionally, this Statement discussed how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements. This Statement: - specifies that goodwill and intangible assets that have indefinite useful lives will not be amortized but rather will be tested at least annually for impairment; - provides specific guidance for testing goodwill for impairment; and - requires additional disclosures not previously required. The provisions of SFAS No. 142 were adopted by the Company as required effective January 1, 2002. Application of the nonamortization provisions of this Statement is expected to reduce annual expense by approximately $1.1 million, which is projected to result in an increase in net income of approximately $0.7 million, or $0.02 per diluted share, in 2002 and subsequent periods, subject to the impairment test described herein. SFAS No. 142, as part of its adoption provisions, requires a transitional impairment test to be applied to all goodwill and other indefinite-lived intangible assets within the first half of 2002 and any resulting impairment loss be reported as a change in accounting principle. The Company is in the process of evaluating the potential impact of this Statement on its results of operations, financial position, and liquidity. In general, application of the new provisions for goodwill and other indefinite-lived intangible assets may result in more income statement volatility due to the potential for periodic recognition of impairment losses, which could vary in amount and regularity versus reducing those assets through systematic amortization over a finite period of time. In June 2001, the FASB issued SFAS No. 141, Business Combinations, which addressed the accounting and reporting for business combinations and expanded the criteria for recording intangible assets separate from 53 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- goodwill. On July 1, 2001, we adopted this Statement which requires us to use the purchase method of accounting for all business combinations initiated after June 30, 2001. In September 2000, the FASB issued SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which replaces SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This Statement revised the methods for accounting for securitizations and other transfers of financial assets and collateral as outlined in SFAS No. 125, and required certain additional disclosures. The adoption of this Statement did not have a material effect on our results of operations, financial position or liquidity. In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and certain Hedging Activities and SFAS 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 SFAS No. 133 did not have a significant 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 or 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 L, 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 O, Preferred Shares, for more 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 O, Preferred Shares, for further information. On February 17, 1999, the Company entered into a series of stock subscription agreements with a group of investors, principally Peter W. Nauert and Insurance Partners, wherein the Company issued 2,000,000 common shares at $7.50 per share for $15.0 million. The $15.0 million proceeds from these sales were used for the purchase of Continental General Corporation from the Western & Southern Life Insurance Company. See Note C, Business Combinations, for further information. In November 1997, the Company entered into a stock purchase agreement, or Original Stock Purchase Agreement, with Strategic Acquisition Partners, LLC, or Strategic, wherein the Company agreed to issue and 54 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- sell 5,000,000 common shares and warrants to purchase an additional 2,500,000 common shares at an exercise price of $6.50 per share, for aggregate proceeds of $27.5 million. On March 30, 1998, the Company entered into an amended and restated Stock Purchase Agreement, or New Stock Purchase Agreement, with Strategic and two additional investors: Insurance Partners, L.P. and Insurance Partners Offshore (Bermuda), L.P., collectively, Insurance Partners. The New Stock Purchase Agreement was subsequently approved by stockholders, and accordingly, in July 1998 the Company issued and sold 7,300,000 common shares at $5.50 per share and warrants to purchase an additional 3,650,000 common shares at an exercise price of $5.50 per share, which expire July 2, 2005, and received proceeds of $37.7 million, which are net of transaction expenses. In connection with the Original Stock Purchase Agreement, Strategic arranged an interim loan, or the Bridge Loan of $20.0 million to the Company. The Bridge Loan was due June 30, 1998, and bore interest at the prime rate of a major commercial bank. As consideration for the arrangement, the Company issued Strategic and Richard M. Osborne warrants to purchase 800,000 common shares at $6.00 per share in December 1997, which expire December 17, 2002, and additional warrants to purchase 200,000 common shares at $6.00 per share on July 3, 1998, which expire on December 17, 2002. Proceeds from the Bridge Loan were used as follows: - $5.2 million was used to repay outstanding bank debt; - $14.0 million was used by the Company to invest in the statutory surplus of Central Reserve, and was evidenced by a surplus note in favor of the Company from Central Reserve; and - $0.8 million was used to establish an interest reserve at the Company and to pay transaction expenses. The Bridge Loan was repaid in full by the Company in July 1998 from the proceeds received in accordance with the New Stock Purchase Agreement. C. BUSINESS COMBINATIONS The Pyramid Life Insurance Company Acquisition On July 26, 2000, the Company, through Continental General Corporation, 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. At June 30, 2000 (prior to payment of the $25.0 million pre-closing dividend), Pyramid Life had assets of $140.9 million and total revenues of $37.0 million for the first six months of 2000. 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, which shares (1) are entitled to vote on all matters presented to stockholders as if conversion has occurred, (2) are convertible into common stock by dividing the $100.00 per share purchase price, plus any accrued and unpaid dividends, by the initial conversion price of $6.145 (the average market price of our common stock at the time of issuance), (3) receive cumulative stock dividends of 10% per annum in additional shares of convertible voting preferred stock, (4) prohibit the payment of dividends on shares of common stock unless all previous dividends on the convertible voting preferred stock have been paid, and (5) as of December 31, 2000, $0.3 million in dividends were accrued or $4.36 per convertible voting preferred share; 55 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- - $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. Continental General Corporation Effective February 1, 1999, the Company acquired 100% of the outstanding common stock of Continental General Corporation from The Western & Southern Life Insurance Company. Continental General Corporation is a holding company that primarily conducts business through its wholly-owned subsidiary, Continental General, a life and accident and health insurer domiciled in Nebraska, which is licensed in 49 states, the District of Columbia, and the U.S. Virgin Islands. Continental General offers Medicare supplement and individual major medical products, distributed through independent agents. Continental General also offers long-term care, Medicare supplement, ordinary life, universal life, and annuity policies. Total consideration paid by the Company for the common stock was $84.5 million, and was financed through reinsurance, debt, cash, an equity offering as described further below and a pre-closing dividend of $22.5 million paid to Western & Southern. This transaction was accounted for in accordance with the purchase method, and accordingly, the purchase price was allocated to assets and liabilities acquired based upon estimates of their fair value. The acquisition was partially funded by a reinsurance treaty with Hannover Life Reassurance Company of America (formerly Reassurance Company of Hannover), whereby Continental General ceded 50% of its in force life, accident and health, and annuity policies to Hannover, and retained the remaining risk. The treaty provided an initial ceding allowance of $13.0 million, which was accounted for as a deferred reinsurance gain. Other fundings were provided by a $40.0 million credit facility with a syndicate of major commercial banks led by The Chase Manhattan Bank. The Company has pledged the common stock of Continental General Corporation and Central Reserve as security for the loan. See Note M, Debt for further discussion of the credit facility. Provident American Life & Health Insurance Company On December 31, 1998, Central Reserve acquired 100% of the outstanding common stock of Provident American Life from Provident American Corporation for $5.5 million. Provident American Life is a life and accident and health insurer, domiciled in Ohio, licensed in 40 states and the District of Columbia, that markets managed care health insurance products to individuals and small businesses, and critical illness coverage. Funds for the acquisition were provided from Central Reserve's working capital. This transaction was accounted for in the accompanying consolidated financial statements in accordance with the purchase method and accordingly, the purchase price was allocated to assets and liabilities acquired based upon estimates of their fair values. There was no impact on the accompanying consolidated statement of operations for 1998 as a result of this transaction. Immediately prior to the completion of this transaction, Provident American Life ceded 100% of its insurance in force to Provident Indemnity Life Insurance Company, a subsidiary of Provident American Corporation. Effective January 1, 1999, Hannover assumed from Provident Indemnity 100% of its accident and health block of business. As of January 1, 1999, Central Reserve entered into a separate reinsurance agreement with Hannover, wherein Central Reserve assumed from Hannover 10% of the block acquired by Hannover from 56 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- Provident Indemnity. Also, at January 1, 1999, Provident American Life ceded 50% of all business written after December 31, 1998 to Hannover. D. CASH AND INVESTMENTS 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.................... $ 29,051 $ 611 $ (5) $ 29,657 U.S. Agencies............................... 10,323 347 (11) 10,659 State and political subdivisions............ 1,083 -- (11) 1,072 Corporate bonds............................. 273,915 4,049 (5,137) 272,827 Mortgage- and asset-backed securities....... 154,309 2,569 (1,303) 155,575 Preferred stock............................. 1,520 182 (7) 1,695 -------- ------ ------- -------- Total available-for-sale................. 470,201 7,758 (6,474) 471,485 Surplus notes................................. 5,045 166 -- 5,211 Mortgage loans................................ 57 -- -- 57 Policy notes.................................. 5,869 -- -- 5,869 -------- ------ ------- -------- Total investments........................ $481,172 $7,924 $(6,474) $482,622 ======== ====== ======= ========
The amortized cost and estimated fair value of invested assets as of December 31, 2000 were as follows:
GROSS UNREALIZED AMORTIZED ----------------- ESTIMATED COST GAINS LOSSES FAIR VALUE --------- ------ -------- ---------- (DOLLARS IN THOUSANDS) Available-for-sale U.S. Treasury securities................... $ 35,996 $ 347 $ (37) $ 36,306 U.S. Agencies.............................. 37,619 1,634 (7) 39,246 State and political subdivisions........... 3,672 20 (16) 3,676 Corporate bonds............................ 268,239 2,652 (10,746) 260,145 Mortgage- and asset-backed securities...... 72,082 847 (533) 72,396 Preferred stock............................ 3,470 135 (87) 3,518 -------- ------ -------- -------- Total available-for-sale................ 421,078 5,635 (11,426) 415,287 Surplus notes................................ 5,071 -- (76) 4,995 Mortgage loans............................... 89 -- -- 89 Policy notes................................. 5,740 -- -- 5,740 -------- ------ -------- -------- Total investments....................... $431,978 $5,635 $(11,502) $426,111 ======== ====== ======== ========
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, 2001 and 2000. 57 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- The amortized cost and estimated fair value of invested assets as of December 31, 2001 by contractual maturity were as follows:
AMORTIZED ESTIMATED COST FAIR VALUE --------- ---------- (DOLLARS IN THOUSANDS) Fixed maturities Due in one year or less................................... $ 20,427 $ 20,709 Due after one year through five years..................... 140,782 142,877 Due after five years through ten years.................... 75,929 75,455 Due after ten years....................................... 83,799 82,080 Mortgage- and asset-backed securities..................... 154,309 155,575 -------- -------- Total fixed maturities................................. 475,246 476,696 Mortgage loans.............................................. 57 57 Policy notes................................................ 5,869 5,869 -------- -------- Total invested assets.................................. $481,172 $482,622 ======== ========
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalties. 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, ---------------------------- 2001 2000 1999 -------- ------- ------- (DOLLARS IN THOUSANDS) Proceeds............................................... $117,129 $11,569 $29,811 Gross realized gains................................... 5,774 161 27 Gross realized losses.................................. 998 80 74
The following is a summary of net investment income by category of investment:
YEAR ENDED DECEMBER 31, --------------------------- 2001 2000 1999 ------- ------- ------- (DOLLARS IN THOUSANDS) Fixed maturities........................................ $29,995 $23,390 $19,359 Policy loans............................................ 399 356 244 Cash equivalents........................................ 2,339 3,378 1,637 Other................................................... 346 831 1,345 ------- ------- ------- Investment income..................................... 33,079 27,955 22,585 Investment expenses..................................... (1,080) (1,084) (1,223) ------- ------- ------- Net investment income................................. $31,999 $26,871 $21,362 ======= ======= =======
At December 31, 2001 and 2000, the Company's insurance subsidiaries had certificates of deposit and fixed maturity securities with a carrying value of $39.3 million and $32.6 million, respectively, on deposit with various state insurance departments to satisfy regulatory requirements. 58 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- At December 31, 2001 and 2000, $7.4 million and $9.4 million, respectively, of cash was held for fully insured employer shared risk plans, which is restricted to use. Ceres Group is entitled to investment income from these funds. Additionally, at December 31, 2001, $2.5 million of cash was held in escrow for the permanent repayment of the balance of the revolver due February 17, 2002. A corresponding liability is included in the accompanying consolidated financial statements. At December 31, 2001, the Company held no unrated bonds and 5.2% of fixed maturity investments were in less-than-investment grade securities. Corporate bonds representing approximately 1.1% of fixed maturities were downgraded by rating agencies. Approximately 4.1% 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. The Company has, however, taken a $0.8 million write-down for other than temporary impairment on securities backed by 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, which represent less than 0.1% of total invested assets. 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. E. PROPERTY AND EQUIPMENT Property and equipment are stated at cost and are summarized by category as follows:
DECEMBER 31, ----------------------- 2001 2000 --------- ---------- (DOLLARS IN THOUSANDS) Home office building........................................ $4,825 $16,153 Land........................................................ 1,261 2,871 Furniture and fixtures...................................... 2,538 2,499 Information technology equipment............................ 3,902 3,705 Other property and equipment................................ 3,738 3,229 ------ ------- 16,264 28,457 Accumulated depreciation.................................... (8,164) (10,926) ------ ------- Total..................................................... $8,100 $17,531 ====== =======
Other property and equipment consists principally of software, leasehold improvements and office equipment. Depreciation expense for the years ended December 31, 2001, 2000 and 1999 was $1.9 million, $1.5 million, and $1.1 million, respectively. 59 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- F. DEFERRED ACQUISITION COSTS Unamortized deferred policy acquisition costs are summarized as follows:
YEAR ENDED DECEMBER 31, --------------------------- 2001 2000 1999 ------- ------- ------- (DOLLARS IN THOUSANDS) Balance at beginning of year............................ $55,989 $26,650 $ 3,810 Current year's costs deferred........................... 50,062 46,171 27,379 ------- ------- ------- 106,051 72,821 31,189 Amortization for the year............................... (22,806) (16,832) (4,539) Write-off of deferred acquisition costs related to United Benefit Life and Provident American Life(1).... (5,868) -- -- ------- ------- ------- Balance at end of the year.............................. $77,377 $55,989 $26,650 ======= ======= =======
--------------- (1) See Note M, Special Charges for further information. G. VALUE OF BUSINESS ACQUIRED A portion of the purchase price paid by the Company for Pyramid Life and 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 6.0% and 7.0% is credited to the unamortized balance for Continental General Corporation and Pyramid Life, respectively. 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 and 7.0% for Pyramid Life which was the market rate at the time of acquisition. The value of business acquired is summarized as follows:
YEAR ENDED DECEMBER 31, --------------------------- 2001 2000 1999 ------- ------- ------- (DOLLARS IN THOUSANDS) Balance at beginning of year............................ $32,254 $16,731 $ -- Additions from acquisitions............................. -- 12,683 14,182 Amortization............................................ (3,626) (2,263) (1,901) Additional expense reserve.............................. 4,842 5,103 4,450 ------- ------- ------- Balance at end of the year.............................. $33,470 $32,254 $16,731 ======= ======= =======
60 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 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 ------------ 2002........................................................ $ 549 2003........................................................ 1,885 2004........................................................ 2,715 2005........................................................ 3,228 2006........................................................ 3,541
H. FEDERAL INCOME TAXES The Company files a consolidated federal income tax return with its subsidiaries, except for Continental General and Pyramid Life, which are required to file separate returns through fiscal years 2003 and 2004, respectively. Federal income tax expense is composed of the following:
YEAR ENDED DECEMBER 31, ------------------------ 2001 2000 1999 ------ ------ ------ (DOLLARS IN THOUSANDS) Current.................................................... $1,642 $1,022 $ 715 Deferred................................................... 1,061 7,358 5,587 ------ ------ ------ Total................................................. $2,703 $8,380 $6,302 ====== ====== ======
Income tax expense attributable to income from 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, ------------------------ 2001 2000 1999 ------ ------ ------ (DOLLARS IN THOUSANDS) Expected tax expense at 35%................................ $1,743 $8,681 $6,302 Tax exempt interest........................................ (8) (4) (135) Valuation allowance for deferred tax assets................ -- -- (158) Meals and entertainment.................................... 381 -- -- Non deductible goodwill.................................... 416 318 -- Alternative minimum tax.................................... -- -- 332 Other...................................................... 171 (615) (39) ------ ------ ------ $2,703 $8,380 $6,302 ====== ====== ======
The federal income tax returns for the Company and its subsidiaries have been examined by the Internal Revenue Service through 1997. 61 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2001 and 2000 are presented below:
DECEMBER 31, ---------------------- 2001 2000 --------- --------- (DOLLARS IN THOUSANDS) Deferred tax assets Ceding commission......................................... $ 2,475 $ 4,257 Reinsurance transactions.................................. 2,792 5,262 Depreciation.............................................. 2,607 -- Severance pay............................................. 7 266 Alternative minimum tax................................... 624 624 Reserves.................................................. 10,489 12,094 Net operating loss carryforward........................... 9,124 5,506 Advance premium........................................... 854 636 Other..................................................... 8,317 1,469 ------- ------- 37,289 30,114 ------- ------- Deferred tax liabilities Value of business acquired................................ 11,715 11,289 Deferred acquisition costs................................ 12,803 5,283 Unrealized gain adjustment................................ 349 359 Other..................................................... 2,922 557 ------- ------- 27,789 17,488 Less: Valuation allowance................................... 8,388 8,829 ------- ------- Net deferred tax assets..................................... $ 1,112 $ 3,797 ======= =======
At December 31, 2001, the Company had a tax net operating loss carryforward, or NOL, of approximately $26.6 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. The December 2001 public offering resulted in an "ownership change" of our company, 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 $26.6 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, 2001 and 2000, estimates were made as to the potential financial impact on the Company of recent NOLs and our financial condition. Additionally, the Company reduced its valuation allowance by $5.9 million during 2000 through a reduction of goodwill related to the acquisition of Continental General. Management reviewed the Company's projections for taxable income of Continental General to be generated in future periods and concluded a greater amount of the deferred tax asset will be realized. 62 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 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, 2001, the accumulated untaxed policyholders' surplus for the Company, all of which relates to Central Reserve, is $2.9 million. I. 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, ------------------------------ 2001 2000 1999 -------- -------- -------- (DOLLARS IN THOUSANDS) Gross balance at beginning of year................... $176,236 $149,538 $ 74,395 Reserves on blocks of business acquired.............. -- 11,176 39,173 -------- -------- -------- Adjusted gross beginning balance..................... 176,236 160,714 113,568 Less: Reserves ceded................................. 67,227 85,347 54,340 -------- -------- -------- Adjusted net beginning balance....................... 109,009 75,367 59,228 -------- -------- -------- Paid claims and claims adjustments expenses, net of reinsurance, for Current year....................................... 330,686 263,587 176,387 Prior years........................................ 120,347 70,299 57,875 -------- -------- -------- Total paid.................................... 451,033 333,886 234,262 -------- -------- -------- Incurred claims and claims adjustment expenses, net of reinsurance, for Current year....................................... 474,994 362,495 226,202 Prior years........................................ 12,414 5,437 (1,487) -------- -------- -------- Total incurred................................ 487,408 367,932 224,715 -------- -------- -------- Net reserve balance at end of year................... 145,384 109,413 49,681 Plus: Reserves ceded at end of year.................. 58,078 67,227 85,347 -------- -------- -------- Balance before reinsurance recoveries on paid claims............................................. 203,462 176,640 135,028 Plus: Increase (decrease) in reinsurance recoveries on paid claims..................................... (5,166) (404) 14,510 -------- -------- -------- Gross balance at end of year......................... $198,296 $176,236 $149,538 ======== ======== ========
The foregoing indicates that a $12.4 million deficiency in the 2000 reserves emerged in 2001 as a result of higher than expected benefit utilization in the medical segment related to increased costs of services, greater utilization of medical services and greatly increased expenditures on prescription drugs. In 2000, a $5.4 million deficiency in the 1999 reserves emerged as a result of higher utilization in all segments, and in 1999, a $1.5 million redundancy in the 1998 reserves emerged. 63 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- J. 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. Due to the structure of this transaction, no assets will be transferred relating to the ceding allowance or policy liabilities assumed by Lincoln. 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. 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 85 basis points of reinsurance premium for calendar year 2001. 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. 64 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 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 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. 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 addition, Central Reserve entered into an agency arrangement with respect to the marketing of United Benefit Life policies with Insurance Advisors of America, Inc., or IAA, a subsidiary of United Benefit Managed Care Corporation and an affiliate of United Benefit Life, in exchange for a $7.0 million note receivable. Central Reserve recorded a full valuation allowance against such note receivable at December 31, 1998. Reserve liabilities assumed by Central Reserve under the United Benefit Life agreement on August 1, 1998 exceeded the cash transferred to Central Reserve by United Benefit Life as reimbursement for this assumption by $3.0 million, which was reflected in a note receivable. Subsequent to August 1, 1998, the balance of the note receivable was increased as a result of adverse developments in the assumed policy liabilities, net of amounts ceded to Hannover, and net of an allowance for uncollectability. The note receivable was secured by the outstanding common stock and assets of United Benefit Life. The assets included real estate, bonds and reinsurance receivables from an unrelated party, and commissions due IAA. 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 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. On March 18, 1999, Central Reserve announced the execution of an agreement with United Benefit Managed Care Corporation, to purchase all of the outstanding shares of its subsidiary, United Benefit Life. On June 14, 1999, Central Reserve terminated this agreement due to a reserve shortfall at United Benefit Life in excess of amounts projected. Pursuant to the "true up" provision in the agreements between United Benefit Life, IAA and Central Reserve, the reserve shortfall on the business assumed from United Benefit Life by Central Reserve at December 31, 1999, was approximately $19.4 million. On July 21, 1999, following receipt of approval from the Department of Insurance of the State of Indiana, Central Reserve foreclosed on the stock of United Benefit Life and the renewal commissions due IAA in partial payment of the $19.4 million reserve shortfall accounted for under purchase accounting rules. 65 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- As of December 31, 1999, Central Reserve had recovered approximately $17.8 million of the $19.4 million reserve shortfall through real and personal property of United Benefit Life totaling $4.6 million, commissions due IAA of $5.3 million, and $7.9 million from the Hannover reinsurance agreement. As a result, the remaining reserve shortfall was $1.6 million. An expense of $0.7 million was recorded in 1998, and the balance of $0.9 million was recorded in 1999. 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, Pyramid Life's maximum retention is $100,000, 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. 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, --------------------------------- 2001 2000 1999 --------- --------- --------- (DOLLARS IN THOUSANDS) Premiums Direct.......................................... $ 821,257 $ 752,281 $ 551,553 Assumed......................................... 7,432 16,817 81,493 Ceded........................................... (193,650) (257,556) (305,300) --------- --------- --------- Net premiums.................................... $ 635,039 $ 511,542 $ 327,746 ========= ========= ========= Benefits, claims, losses, and settlement expenses........................................ $ 658,637 $ 596,086 $ 485,717 Reinsurance recoverable........................... (158,162) (206,275) (252,614) --------- --------- --------- $ 500,475 $ 389,811 $ 233,103 ========= ========= ========= Selling, general, and administrative expenses Commissions..................................... $ 130,646 $ 127,692 $ 85,104 Salaries and benefits........................... 47,888 38,409 25,678 Taxes, licenses, and fees....................... 22,169 18,439 13,024 Other operating expenses........................ 38,817 40,580 46,579 Administrative and IS services.................. 24,589 21,486 14,513 Reinsurance expenses............................ 1,728 1,973 44,096 Reinsurance allowances.......................... (41,896) (62,190) (91,062) --------- --------- --------- $ 223,941 $ 186,389 $ 137,932 ========= ========= =========
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. Amortization of deferred reinsurance gain for the years ended December 31, 2001, 2000 and 1999 was $5.0 million, $6.1 million, and $5.5 million, respectively. The above table does not include the amortization of initial ceding allowances received from reinsurers. 66 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- K. COMMITMENTS AND CONTINGENCIES The Company is 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. L. DEBT
DECEMBER 31, ----------------------- 2001 2000 ---------- ---------- (DOLLARS IN THOUSANDS) Mortgage note payable....................................... $ -- $ 8,018 ======= ======= Bank credit facility........................................ $28,500 $34,000 Revolver.................................................... 2,500 15,000 ------- ------- $31,000 $49,000 ======= =======
On May 25, 2001, we entered into an agreement with Royalton Investors, LLC and Big T Investments, LLC 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. Monthly rent payments began in August 2001 and annually total $1.7 million through July 2003, $1.8 million through July 2006, $2.0 million through July 2011, and $2.1 million through July 2016. The net proceeds were used to: - prepay in full the outstanding $7.9 million mortgage note on the building on August 3, 2001; - permanently reduce our revolving line of credit by $2.5 million on August 6, 2001; and - contribute $5.0 million to the capital of Central Reserve. 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, Ceres borrowed $40.0 million under a tranche A term loan and secured a $10.0 million revolver. Interest on the outstanding balance of the term loan and revolver are 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 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 $40.0 million tranche A term loan. At December 31, 2001, the interest rate on the revolver was 5.7% on the outstanding balance of $2.5 million. On February 17, 2002, the balance of the revolver was repaid from proceeds of our December 2001 public offering. On March 30, 2001, our credit agreement again 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 under the credit agreement. The terms of the amendment provide for CIT Group to participate equally with the syndicate of 67 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- banks and Chase under the credit agreement. At December 31, 2001, the interest rate on our tranche A term loan balance of $18.5 million was 6.0% per annum and our $10.0 million CIT tranche B term loan was 6.5% per annum. The first principal payment on the CIT tranche B 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. On December 27, 2001, our credit agreement was again amended in connection with the stock offering. The credit agreement, as amended, contains financial and other covenants that among other things: - 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, and beginning in 2002, 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. In addition, the amended agreement required us to: - repay a portion of our tranche A term loan with $10.0 million of the proceeds from the December 2001 equity offering; - 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; - set aside $2.5 million of the proceeds from the equity offering for the permanent repayment of the balance of our revolver due February 17, 2002; and - increase the interest rate of the tranche B term loan by 0.5% per annum. Finally, the credit agreement, as amended: - restructured our scheduled tranche A term loan debt payments as follows: quarterly principal payments of $0.5 million through May 17, 2002, $0.8 million through November 17, 2002, $0.9 million through November 17, 2004, and a payment of $8.5 million on February 17, 2005; - allowed repurchase of all of our convertible voting preferred stock with $5.0 million of the proceeds from the equity offering; and - allowed capital contributions to our insurance subsidiaries with proceeds from the equity offering after the repayments to the banks and repurchase of our convertible voting preferred stock. 68 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- At December 31, 2001, the balance of our fully drawn revolver was $2.5 million. The pay-off and final maturity of this revolver was February 17, 2002. 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, 2001, we were in compliance with our credit agreement, as amended. 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. Due to the equity offering and the amendment to our credit agreement, we believe that funds should be sufficient to meet all our debt obligations over the next 12 months. Funds to meet our debt obligations are generated from fee income from our non-regulated subsidiaries and from dividends of our insurance subsidiaries, if available. 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. Dividends from the regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. As of December 31, 2001, none of the direct insurance subsidiaries (Central Reserve Life and Continental General) could 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. M. 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 United Benefit Life. The Company has experienced excessive losses at United Benefit Life and Provident American Life due to high benefit utilization and higher than anticipated claims costs. These blocks had a $17.9 million pre-tax loss in 2001 compared to a $7.6 million pre-tax loss in 2000, including special charges and legal expenses. 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 should be substantially wound down by the early part of 2002. N. STOCK-BASED COMPENSATION 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, 2001, there were options outstanding under the plan to purchase 325,000 shares. In 1998, pursuant to the 1998 Key Employee Share Incentive Plan, the Company granted common stock options to certain key employees. In 2000 and 1999, the Company granted additional common stock options to certain employees under the 1998 Key Employee Share Incentive Plan. Such grants generally 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 69 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- issuance under this plan, pending stockholder approval. At December 31, 2001, there were options outstanding under the plan to purchase 1,659,926 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, 2001 there were options outstanding under the plan to purchase 815,000 shares. Also, pursuant to employment contracts, the Company provided an award of shares of common stock to Peter Nauert. The number of shares awarded is 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 July 1, 2003. Management currently estimates that 269,881 shares (including 28,403 shares issued in 2001, 139,852 shares issued in 2002 and 101,626 shares issued in 2003) will be issued pursuant to the employment contract, based upon the fair value of the Company's shares at December 31, 2001. A summary of the Company's stock option activity is presented below:
YEAR ENDED DECEMBER 31, ------------------------------------------------------- 2001 2000 -------------------------- -------------------------- WEIGHTED WEIGHTED AVERAGE AVERAGE OPTIONS EXERCISE PRICE OPTIONS EXERCISE PRICE --------- -------------- --------- -------------- Outstanding at beginning of year..... 2,052,184 $7.51 1,606,000 $7.81 Options granted, with exercise Prices: Greater than fair value at grant date............................ 633,333 6.73 -- -- Equal to fair value at grant date............................ 275,000 5.19 644,977 6.68 Forfeited............................ (160,591) 6.76 (198,793) 7.22 --------- --------- Outstanding at end of year........... 2,799,926 7.15 2,052,184 7.51 ========= ========= Exercisable at end of year........... 1,049,947 7.64 470,000 7.88 ========= =========
Exercise prices for options outstanding at December 31, 2001 ranged from $5.12 to $10.50, of which 51% were between $5.12 and $6.99, 14% between $7.00 and $7.99, 27% between $8.00 and $8.99, and 8% between $9.00 and $10.50. While some options have no expiration date, management estimates the remaining average contractual life of options awarded is 5 years. At December 31, 2001, there were 1,049,947 options exercisable ranging from $5.50 to $10.50. Approximately 47% were between $5.50 and $6.99, 17% between $7.00 and $7.99, 14% between $8.00 and $8.99, and 22% between $9.00 and $10.50. The Company also had outstanding at December 31, 2001 3,657,743 warrants at $5.41, expiring in 2005, 770,000 warrants at $6.00, expiring in 2002, and 130,000 warrants at $6.00, expiring in 2003. 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 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 the stock's fair 70 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 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, 2001 and 2000, 62,761 and 18,807 shares, respectively, had been issued under the employee 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, 2001 and 2000, 76,621 and 10,603 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. The Company recognized stock compensation expense of $0.9 million, $1.1 million, and $0.8 million in 2001, 2000 and 1999, 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:
2001 2000 1999 ------- ------- ------- Risk-free rate of return.................................. 4.33% 4.98% 6.34% Dividend yield............................................ 0% 0% 0% Volatility factor......................................... 0.275 0.226 0.287 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 $1.17, $1.26 and $2.10 per share for 2001, 2000 and 1999, respectively. The pro forma impact would be to decrease net income by $0.8 million, $0.6 million and $0.9 million and decrease net income per share by $0.05, $0.04 and $0.07 for basic and $0.05, $0.04 and $0.06 for fully diluted for the years ended December 31, 2001, 2000 and 1999, respectively. O. 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, 2001. On December 27, 2001, the Company repurchased our 71 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 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. P. 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, 2001 and 2000. 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, ---------------------------- --------------------- 2001 2000 1999 2001 2000 -------- ------- ------- --------- --------- UNAUDITED (DOLLARS IN THOUSANDS) Central Reserve(1).................. $(10,492) $(1,046) $(1,994) $27,399 $26,164 Provident American Life(1).......... (5,085) (419) (983) 3,947 6,551 Continental General(2).............. (6,411) (2,831) 13,591 48,072 42,478 United Benefit Life(1).............. (2,392) (1,564) 421 3,004 4,182 Pyramid Life(2)..................... 1,008 2,874 -- 22,320 20,814 -------- ------- ------- Total............................. $(23,372) $(2,986) $11,035 ======== ======= =======
--------------- (1) Statutory capital and surplus for Central Reserve includes 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, payments of the amounts as dividends may be subject to approval by regulatory authorities. In 2002, Central Reserve, United Benefit Life and Provident American Life cannot pay any dividends without the prior approval of the Ohio Insurance Commissioner as a result of their respective statutory levels of unassigned surplus at December 31, 2001. As of December 31, 2001, Continental General cannot pay any dividends in 2002, without the prior approval of the Nebraska Insurance Commissioner. By agreement with the Kansas Department of Insurance, Pyramid Life can pay dividends to its parent Continental General Insurance only from net underwriting profits of Pyramid Life, and, therefore, as of December 31, 2001, Pyramid Life could pay approximately $1.0 million in dividends in 2002, without the prior approval of the Kansas Insurance Commissioner. 72 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 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. Q. COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) is as follows:
YEAR ENDED DECEMBER 31, ----------------------------- 2001 2000 1999 -------- ------- -------- (DOLLARS IN THOUSANDS) Net income............................................ $ 2,332 $16,450 $ 11,704 Other comprehensive income (loss), net of tax: Unrealized gain (loss) on securities, net of tax of $37, $0 and $0, respectively(1).................. 7,280 11,806 (19,650) Other............................................... (455) 210 362 -------- ------- -------- Comprehensive income (loss)...................... $ 9,157 $28,466 $ (7,584) ======== ======= ========
--------------- (1) Net of reclassification adjustments for net gains (losses) included in net income. R. 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 are antidilutive for the year ended December 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:
YEAR ENDED DECEMBER 31, ------------------------------------ 2001 2000 1999 ---------- ---------- ---------- (DOLLARS IN THOUSANDS) Weighted average shares: BASIC.......................................... 17,751,919 15,260,160 13,328,339 Convertible voting preferred stock............. -- 535,851 -- Stock awards and incremental shares from assumed exercise of stock options........... 38,226 629,344 1,905,560 ---------- ---------- ---------- DILUTED........................................ 17,790,145 16,425,355 15,233,899 ========== ========== ==========
73 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- S. EMPLOYEE BENEFIT PLAN The Company sponsors the Ceres Group, Inc. 401(k) Plan, a defined contribution 401(k) savings plan, or 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. Based on provisions of the Plan, participants can elect to make pre-tax contributions from 1% to 15% of their compensation and can elect to make after-tax contributions up to 15% of their compensation. 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 a maximum of $1,000 per 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 2001, 2000 and 1999 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 $768,000 for 2001, $376,000 for 2000, and $133,000 for 1999. T. OPERATING SEGMENTS In conjunction with the Company's continued growth and refinement of its 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 segment include Medicare supplement, long-term care, dental, life insurance, and annuities. The corporate and other segment encompasses all other activities of the Company, including interest income, interest expense, or corporate expenses of the parent company. Revenues from each segment are primarily generated from premiums charged to external policyholders and interest earned on cash and investments and are summarized in the following tables: 74 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- --------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, ------------------------------ 2001 2000 1999 -------- -------- -------- (DOLLARS IN THOUSANDS) MEDICAL Revenues Net premiums.................................... $408,215 $375,804 $251,876 Investment income, realized gains............... 11,984 9,101 6,985 Other income.................................... 37,772 36,103 21,307 -------- -------- -------- 457,971 421,008 280,168 -------- -------- -------- Expenses Benefits and claims............................. 333,740 288,260 176,531 Other operating expenses........................ 130,306 122,483 96,357 Special charges................................. 7,097 -- -- -------- -------- -------- 471,143 410,743 272,888 -------- -------- -------- Segment profit (loss) before federal income taxes, minority interest and preferred stock transactions.................................... $(13,172) $ 10,265 $ 7,280 ======== ======== ======== SENIOR AND OTHER Revenues Net premiums.................................... $226,824 $135,738 $ 75,870 Investment income, realized gains............... 24,345 16,615 14,233 Other income.................................... 3,341 2,686 1,364 -------- -------- -------- 254,510 155,039 91,467 -------- -------- -------- Expenses Benefits and claims............................. 166,735 101,551 56,572 Other operating expenses........................ 61,871 32,265 18,510 -------- -------- -------- 228,606 133,816 75,082 -------- -------- -------- Segment profit before federal income taxes, minority interest and preferred stock transactions.................................... $ 25,904 $ 21,223 $ 16,385 ======== ======== ======== CORPORATE AND OTHER Revenues Investment income, realized gains............... $ 623 $ 1,057 $ 251 Other income.................................... -- 22 207 -------- -------- -------- 623 1,079 458 -------- -------- -------- Expenses Interest and financing expenses................. 4,679 5,566 4,090 Other operating expenses........................ 3,696 2,197 2,027 -------- -------- -------- 8,375 7,763 6,117 -------- -------- -------- Segment loss before federal income taxes, minority interest and preferred stock transactions....... $ (7,752) $ (6,684) $ (5,659) ======== ======== ======== INCOME BEFORE FEDERAL INCOME TAXES, MINORITY INTEREST AND PREFERRED STOCK TRANSACTIONS................... $ 4,980 $ 24,804 $ 18,006 ======== ======== ========
The Company does not separately allocate investments or other identifiable assets by industry segment, nor are income tax (benefits) expenses allocated by industry segment. The Company also expanded the detail of its disclosures for 2001, 2000 and 1999, which included certain reclassifications. 75 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- U. 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 the present value of future cash flows 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. 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. 76 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- Carrying amounts and estimated fair values of financial instruments at December 31, 2001 and 2000, are summarized as follows:
DECEMBER 31, --------------------------------------------- 2001 2000 --------------------- --------------------- CARRYING ESTIMATED CARRYING ESTIMATED AMOUNT FAIR VALUE AMOUNT FAIR VALUE -------- ---------- -------- ---------- (DOLLARS IN THOUSANDS) ASSETS Investments Fixed maturities available for sale.............. $471,485 $471,485 $415,287 $415,287 Surplus notes.................................... 5,211 5,211 4,995 4,995 Policy notes..................................... 5,869 5,869 5,740 5,740 Mortgage loans................................... 57 57 89 89 Cash and cash equivalents.......................... 74,573 74,573 59,512 59,512 Premiums receivable................................ 5,230 5,230 5,852 5,852 Reinsurance receivable............................. 223,330 223,330 238,185 238,185 LIABILITIES Annuity reserves................................... 182,526 177,381 194,369 186,786 Other policyholders' funds......................... 28,659 28,659 24,246 24,246 Mortgage note payable.............................. -- -- 8,018 8,018 Debt............................................... 31,000 31,000 49,000 49,000
V. 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, 2001, Hannover maintained an "A" rating from the A.M. Best Company. The Company performs periodic evaluations of this reinsurer's credit standing. 77 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED DECEMBER 31, 2001, 2000 AND 1999 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- W. QUARTERLY RESULTS OF OPERATIONS - (UNAUDITED) The following is a summary of quarterly results of operations for the years ended December 31, 2001 and 2000:
FIRST SECOND THIRD FOURTH ---------- ---------- ---------- ---------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 2001 Revenues......................................... $171,185 $175,667 $184,826 $181,426 Benefits and claims.............................. 129,196 123,062 122,331 125,886 Selling, general and administrative and other expenses...................................... 44,684 51,279 53,772 50,817 Special charges.................................. 7,097 -- -- -- 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 Net income (loss) per share attributable to common stockholders Basic............................................ (0.42) 0.03 0.30 0.35 Diluted.......................................... (0.42) 0.03 0.29 0.35 2000 Revenues......................................... $118,709 $135,043 $158,021 $165,353 Benefits and claims.............................. 81,558 90,023 104,018 114,212 Selling, general and administrative and other expenses...................................... 31,350 37,965 47,893 45,303 Net income....................................... 3,771 4,585 3,972 4,122 Net income attributable to common stockholders... 3,771 4,585 3,834 3,933 Net income per share attributable to common stockholders Basic............................................ 0.28 0.33 0.23 0.23 Diluted.......................................... 0.26 0.32 0.21 0.22
78 SCHEDULE II CERES GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CERES GROUP, INC. (PARENT ONLY) BALANCE SHEETS DECEMBER 31, 2001 AND 2000 (DOLLARS IN THOUSANDS) -------------------------------------------------------------------------------- --------------------------------------------------------------------------------
2001 2000 -------- -------- ASSETS Investment in subsidiaries(1)............................... $193,901 $157,088 Cash and cash equivalents................................... 14,021 4,832 Property and equipment, net................................. 381 9,035 Other assets................................................ 4,725 3,113 -------- -------- Total assets...................................... $213,028 $174,068 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Debt...................................................... $ 31,000 $ 57,018 Other liabilities(2)...................................... 25,453 13,767 -------- -------- Total liabilities................................. 56,453 70,785 -------- -------- Stockholders' equity Non-voting preferred stock................................ -- -- Convertible voting preferred stock........................ -- 7,500 Common stock.............................................. 34 17 Additional paid-in capital................................ 132,061 82,943 Dividends distributable, convertible voting preferred stock.................................................. -- 327 Retained earnings......................................... 23,831 18,672 Accumulated other comprehensive income (loss)............. 649 (6,176) -------- -------- Total stockholders' equity........................ 156,575 103,283 -------- -------- Total liabilities and stockholders' equity........ $213,028 $174,068 ======== ========
--------------- (1) Eliminated in consolidation. (2) Includes $8.0 million and $6.3 million in advances from non-regulated subsidiaries in 2001 and 2000, respectively. See accompanying independent auditors' report. 79 SCHEDULE II CERES GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CERES GROUP, INC. (PARENT ONLY) STATEMENT OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999 (DOLLARS IN THOUSANDS) -------------------------------------------------------------------------------- --------------------------------------------------------------------------------
2001 2000 1999 ------- ------- ------- REVENUES Dividend income(1).......................................... $11,200 $ -- $ -- Rental income(2)............................................ 1,406 1,170 1,410 Net realized gains.......................................... 180 -- -- Net investment income....................................... 26 97 72 ------- ------- ------- 12,812 1,267 1,482 EXPENSES Selling, general and administrative expenses................ 8,097 4,015 10,103 ------- ------- ------- Income (loss) before income tax benefit and equity in undistributed income (loss) of subsidiaries............... 4,715 (2,748) (8,621) Income tax benefit.......................................... (2,270) (962) (3,017) ------- ------- ------- Income (loss) before equity in undistributed income (loss) of subsidiaries........................................... 6,985 (1,786) (5,604) Equity in undistributed (loss) income of subsidiaries(3).... (4,653) 18,236 17,308 ------- ------- ------- Net income.................................................. 2,332 16,450 11,704 Gain on repurchase of preferred stock, net of dividends..... 2,827 (327) -- ------- ------- ------- NET INCOME ATTRIBUTABLE TO COMMON STOCKHOLDERS.............. $ 5,159 $16,123 $11,704 ======= ======= =======
--------------- (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. 80 SCHEDULE II CERES GROUP, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT CERES GROUP, INC. (PARENT ONLY) STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999 (DOLLARS IN THOUSANDS) -------------------------------------------------------------------------------- --------------------------------------------------------------------------------
2001 2000 1999 -------- -------- -------- OPERATING ACTIVITIES Net income.................................................. $ 2,332 $ 16,450 $ 11,704 Adjustments to reconcile net income (loss) to cash provided by operating activities: Equity in undistributed loss (income) of subsidiaries (1)..................................................... 4,653 (18,236) (17,308) Depreciation.............................................. 352 470 380 Net realized gains........................................ (180) -- -- Decrease (increase) in other assets....................... (1,612) 1,303 (3,682) Increase (decrease) in other liabilities.................. 2,933 (1,915) 7,137 Increase in net advances from non-regulated subsidiaries (1)..................................................... 1,685 6,336 -- -------- -------- -------- Net cash provided by (used in) operating activities......... 10,163 4,408 (1,769) -------- -------- -------- INVESTING ACTIVITIES Capital contributions to regulated subsidiaries (1)....... (34,500) (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) (4,035) Acquisition of Continental General Corporation, net of $2,212 cash acquired (1)................................ -- -- (59,788) Proceeds from sale of Cleveland headquarters.............. 15,586 -- -- Purchase of property and equipment........................ (36) (618) (191) -------- -------- -------- Net cash used in investing activities....................... (19,091) (40,267) (64,014) -------- -------- -------- FINANCING ACTIVITIES Increase in debt borrowings............................... 10,000 15,000 40,000 Principal payments on debt................................ (28,000) (6,000) -- Principal payments on mortgage note payable............... (8,018) (139) (127) Proceeds from public equity offering...................... 46,511 -- -- Proceeds from private placement of common stock, net of acquisition costs....................................... -- 21,096 15,000 Proceeds from issuance of common stock related to employee benefit plans........................................... 2,624 1,560 1,409 Repurchase of convertible voting preferred stock.......... (5,000) -- -- Proceeds from private placement of preferred stock........ -- 7,500 -- -------- -------- -------- Net cash provided by financing activities................... 18,117 39,017 56,282 -------- -------- -------- NET INCREASE (DECREASE) IN CASH............................. 9,189 3,158 (9,501) Cash and cash equivalents at beginning of year.............. 4,832 1,674 11,175 -------- -------- -------- CASH AND CASH EQUIVALENTS AT END OF YEAR.................... $ 14,021 $ 4,832 $ 1,674 ======== ======== ========
--------------- (1) Eliminated in consolidation. See accompanying independent auditors' report. 81 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, 2001 Medical.......................... $39,202 $ 12,120 $11,284 $145,951 $408,215 $ 9,877 $333,740 Senior and other................. 38,175 396,798 36,055 52,345 226,824 21,679 166,735 Corporate and other.............. -- -- -- -- -- 443 -- ------- -------- ------- -------- -------- ------- -------- Total..................... $77,377 $408,918 $47,339 $198,296 $635,039 $31,999 $500,475 ======= ======== ======= ======== ======== ======= ======== Year ended December 31, 2000 Medical.......................... $33,187 $ 10,113 $ 9,493 $132,453 $375,804 $ 9,250 $288,260 Senior and other................. 22,802 398,777 33,258 43,783 135,738 16,570 101,551 Corporate and other.............. -- -- -- -- -- 1,051 -- ------- -------- ------- -------- -------- ------- -------- Total..................... $55,989 $408,890 $42,751 $176,236 $511,542 $26,871 $389,811 ======= ======== ======= ======== ======== ======= ======== Year ended December 31, 1999 Medical.......................... $18,758 $ 6,839 $ 8,613 $120,081 $251,876 $ 7,027 $176,531 Senior and other................. 7,892 350,310 23,432 29,457 75,870 14,084 56,572 Corporate and other.............. -- -- -- -- -- 251 -- ------- -------- ------- -------- -------- ------- -------- Total..................... $26,650 $357,149 $32,045 $149,538 $327,746 $21,362 $233,103 ======= ======== ======= ======== ======== ======= ======== NET (DEFERRAL) AMORTIZATION AND CHANGE IN ACQUISITION COSTS AND VALUE OTHER OF BUSINESS OPERATING ACQUIRED EXPENSES --------------------------------------------------------------------------- Year ended December 31, 2001 Medical.......................... $(11,687) $149,090 Senior and other................. (17,485) 79,356 Corporate and other.............. -- 8,375 -------- -------- Total..................... $(29,172) $236,821 ======== ======== Year ended December 31, 2000 Medical.......................... $(14,295) $136,778 Senior and other................. (16,218) 48,483 Corporate and other.............. -- 7,763 -------- -------- Total..................... $(30,513) $193,024 ======== ======== Year ended December 31, 1999 Medical.......................... $(13,210) $109,567 Senior and other................. (8,682) 27,192 Corporate and other.............. -- 6,117 -------- -------- Total..................... $(21,892) $142,876 ======== ========
See accompanying independent auditors' report. 82 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, 2001 Life insurance in force............ $4,422,807 $2,138,147 $ 40,670 $2,325,330 1.7% ========== ========== ======== ========== Premiums Life insurance................... $ 25,074 $ 11,108 $ 1,183 $ 15,149 7.8% Accident and health insurance.... 796,183 182,542 6,249 619,890 1.0% ---------- ---------- -------- ---------- $ 821,257 $ 193,650 $ 7,432 $ 635,039 1.2% ========== ========== ======== ========== YEAR ENDED DECEMBER 31, 2000 Life insurance in force............ $4,566,816 $2,247,235 $ 80,178 $2,399,759 3.3% ========== ========== ======== ========== Premiums Life insurance................... $ 25,765 $ 6,207 $ 1,671 $ 21,229 7.9% Accident and health insurance.... 726,516 251,349 15,146 490,313 3.1% ---------- ---------- -------- ---------- $ 752,281 $ 257,556 $ 16,817 $ 511,542 3.3% ========== ========== ======== ========== YEAR ENDED DECEMBER 31, 1999 Life insurance in force............ $3,863,690 $1,165,579 $129,428 $2,827,539 4.6% ========== ========== ======== ========== Premiums Life insurance................... $ 17,735 $ 5,757 $ 1,958 $ 13,936 14.0% Accident and health insurance.... 533,818 299,543 79,535 313,810 25.3% ---------- ---------- -------- ---------- $ 551,553 $ 305,300 $ 81,493 $ 327,746 24.9% ========== ========== ======== ==========
See accompanying independent auditors' report. 83 ITEM 9. CHANGES IN AND DISAGREEMENT 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 annual meeting of stockholders to be held on May 15, 2002. We expect to file the Proxy Statement by April 1, 2002. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated by reference to our Proxy Statement in connection with our annual meeting of stockholders to be held on May 15, 2002. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is incorporated by reference to our Proxy Statement in connection with our annual meeting of stockholders to be held on May 15, 2002. 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 annual meeting of stockholders to be held on May 15, 2002. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, 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, 2001 and 2000. Consolidated Statements of Operations -- Years ended December 31, 2001, 2000 and 1999. Consolidated Statements of Stockholders' Equity -- Years ended December 31, 2001, 2000 and 1999. Consolidated Statements of Cash Flows -- Years ended December 31, 2001, 2000 and 1999. 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. 84 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. (b) Reports on Form 8-K: None. (c) Exhibits.
INCORPORATED BY REFERENCE TO REGISTRATION OR FORM OR EXHIBIT EXHIBITS FILE NUMBER REPORT DATE NUMBER -------- --------------- ------- ---------- ------- (2) Plan of acquisition, reorganization, arrangement, liquidation, or succession. (1) 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. (2) 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. (3) Stock Purchase Agreement dated as of 0-8483 8-K Feb. 1999 2.2 November 4, 1998 between The Western and Southern Life Insurance Company and Ceres Group, Inc. (4) 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. (5) 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. (6) Amendment No. 2 to Purchase Agreement 0-8483 8-K Aug. 2000 2.3 by and between United Insurance Company of America and Ceres Group, Inc. dated as of July 5, 2000. (3) Articles of Incorporation and By-laws. (1) 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. (2) Certificate of Amendment of the 0-8483 8-K Aug. 2000 3.1 Certificate of Incorporation of Ceres Group, Inc. dated July 25, 2000. (3) Bylaws of Ceres Group, Inc. 0-8483 8-K Dec. 1998 3.2 (4) Instruments defining the rights of security holders, including indentures.
85
INCORPORATED BY REFERENCE TO REGISTRATION OR FORM OR EXHIBIT EXHIBITS FILE NUMBER REPORT DATE NUMBER -------- --------------- ------- ---------- ------- (1) Amended and Restated Voting Agreement 0-8483 8-K Aug. 2000 4.2 dated as of July 25, 2000 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. (2) 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. (3) 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. (5) 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. (6) Amendment No. 1 to Amended and * 4.6 Restated Voting Agreement, dated November 30, 2001, by and among Ceres Group, Inc. and the persons and entities set forth on the signature page attached thereto. (10) Material Contracts (6) Warrant to purchase Common Shares, 0-8483 8-K Dec. 1997 10.4 dated December 16, 1997 by Central Reserve Life Corporation in favor of Peter W. Nauert. (7) Warrant to purchase Common Shares, 0-8483 8-K Dec. 1997 10.5 dated December 16, 1997, by Central Reserve Life Corporation in favor of the Turkey Vulture Fund XIII, Ltd. (8) Reinsurance Agreement between Central 0-8483 10-K Mar. 1998 10.10 Reserve Life Insurance Company and Reassurance Company of Hannover. (9) 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. (10) Amendment No. 1 to Warrant to 0-8483 10-K Mar. 1998 10.13 purchase Common Shares, dated March 30, 1998 by Central Reserve Life Corporation in favor of Peter W. Nauert.
86
INCORPORATED BY REFERENCE TO REGISTRATION OR FORM OR EXHIBIT EXHIBITS FILE NUMBER REPORT DATE NUMBER -------- --------------- ------- ---------- ------- (11) Amendment No. 1 to Warrant to 0-8483 10-K Mar. 1998 10.14 purchase Common Shares, dated March 30, 1998 by Central Reserve in favor of the Turkey Vulture Fund XIII, Ltd. (12) Employment Agreement dated June 30, 0-8483 10-Q Sept. 1998 10.17 1998, by and between Peter W. Nauert and Central Reserve Life Corporation. (13) Employment Agreement dated October 0-8483 10-K Mar. 1999 10.20 1, 1998, by and between Charles E. Miller and Central Reserve Life Corporation. (14) Reinsurance Agreement dated February 0-8483 10-K Mar. 1999 10.21 1, 1999, between Continental General Life Insurance Company and Reassurance Company of Hannover. (15) 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. (16) 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. (17) 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. (18) First Amendment to Employment 0-8483 10-K Mar. 2000 10.23 Agreement between Peter W. Nauert and Ceres Group, Inc. dated March 18, 1999. (19) Second Amendment to Employment 0-8483 10-K Mar. 2000 10.24 Agreement between Peter W. Nauert and Ceres Group, Inc. dated June 15, 1999. (20) Third Amendment to Employment 0-8483 10-K Mar. 2000 10.25 Agreement between Peter W. Nauert and Ceres Group, Inc. dated December 19, 1999. (21) 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.
87
INCORPORATED BY REFERENCE TO REGISTRATION OR FORM OR EXHIBIT EXHIBITS FILE NUMBER REPORT DATE NUMBER -------- --------------- ------- ---------- ------- (22) Employment Agreement, dated October 0-8483 10-K Apr. 2001 10.3 1, 1999, by and between Anthony J. Pino and Ceres Group, Inc. (23) 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. (24) 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. (25) 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. (26) Ceres Group, Inc. 1998 Key Employee 0-8483 S-1 Apr. 2001 10.26 Share Incentive Plan. (27) Ceres Group, Inc. 1998 Employee 0-8483 S-1 Apr. 2001 10.27 Stock Option Plan. (28) Ceres Group, Inc. 1999 Special 0-8483 S-1 Apr. 2001 10.28 Agent's Stock Option Plan. (29) Ceres Group, Inc. 2000 Employee 0-8483 S-8 Apr. 2001 4.1 Stock Purchase Plan. (30) Ceres Group, Inc. 2000 Agent Stock 0-8483 S-8 Apr. 2001 4.2 Purchase Plan. (31) Employment Agreement dated April 10, 0-8483 S-1 Apr. 2001 10.30 2001, by and between Bruce M. Henry and Ceres Group, Inc. (32) Amendment No. 1 to Employment 0-8483 S-1 Apr. 2001 10.31 Agreement dated April 10, 2001, by and between Anthony J. Pino and Ceres Group, Inc. (33) Amendment No. 1 to Employment 0-8483 S-1 Apr. 2001 10.32 Agreement dated April 10, 2001, by and between Charles E. Miller. (34) 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.
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INCORPORATED BY REFERENCE TO REGISTRATION OR FORM OR EXHIBIT EXHIBITS FILE NUMBER REPORT DATE NUMBER -------- --------------- ------- ---------- ------- (35) 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. (36) 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. (37) 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. (21) Subsidiaries of the registrant. (1) Subsidiaries. * 21.1 (23) Consents of expert and counsel. (1) Consent of Ernst & Young LLP. * 23.1
--------------- * Filed herewith. 89 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 25, 2002 By: /s/ PETER W. NAUERT ----------------------------------------------------- Peter W. Nauert, Chairman
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 25, 2002 By: /s/ PETER W. NAUERT ------------------------------------------------------- Peter W. Nauert, Chairman, President and Chief Executive Officer (principal executive officer) March 25, 2002 By: /s/ CHARLES E. MILLER, JR. ------------------------------------------------------- Charles E. Miller, Jr., Executive Vice President, Chief Financial Officer (principal financial and accounting officer) March 25, 2002 By: /s/ ANDREW A. BOEMI ------------------------------------------------------- Andrew A. Boemi, Director March 25, 2002 By: /s/ MICHAEL A. CAVATAIO ------------------------------------------------------- Michael A. Cavataio, Director March 25, 2002 By: /s/ BRADLEY E. COOPER ------------------------------------------------------- Bradley E. Cooper, Director March 25, 2002 By: /s/ SUSAN S. FLEMING ------------------------------------------------------- Susan S. Fleming, Director March 25, 2002 By: /s/ RODNEY L. HALE ------------------------------------------------------- Rodney L. Hale, Director March 25, 2002 By: /s/ ROBERT J. LUNN ------------------------------------------------------- Robert J. Lunn, Director March 25, 2002 By: /s/ WILLIAM J. RUH ------------------------------------------------------- William J. Ruh, Director March 25, 2002 By: /s/ ROBERT A. SPASS ------------------------------------------------------- Robert A. Spass, Director
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