10-Q 1 l03427ae10vq.txt CERES GROUP, INC. | FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003 COMMISSION FILE NUMBER 0-8483 CERES GROUP, INC. (Exact name of registrant as specified in its charter) DELAWARE 34-1017531 --------------------------------- ------------------------------------ (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 17800 ROYALTON ROAD, CLEVELAND, OHIO 44136 --------------------------------------------- ----------- (Address of principal executive offices) (Zip Code) (440) 572-2400 ---------------------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No ( ) Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes (X) No ( ) The number of shares of common stock, par value $0.001 per share, outstanding as of October 31, 2003 was 34,344,434. CERES GROUP, INC. AND SUBSIDIARIES INDEX
PAGE ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets - September 30, 2003 (Unaudited) and December 31, 2002 1 Condensed Consolidated Statements of Operations - Three and nine months ended September 30, 2003 and 2002 (Unaudited) 2 Condensed Consolidated Statement of Stockholders' Equity - Nine months ended September 30, 2003 (Unaudited) 3 Condensed Consolidated Statements of Cash Flows - Nine months ended September 30, 2003 and 2002 (Unaudited) 4 Notes to Condensed Consolidated Financial Statements - September 30, 2003 (Unaudited) 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 17 Item 3. Quantitative and Qualitative Disclosure about Market Risk 32 Item 4. Controls and Procedures 32 PART II. OTHER INFORMATION Item 1. Legal Proceedings 33 Item 2. Changes in Securities and Use of Proceeds 33 Item 3. Defaults Upon Senior Securities 33 Item 4. Submission of Matters to a Vote of Security Holders 33 Item 5. Other Information 33 Item 6. Exhibits and Reports on Form 8-K 33 SIGNATURES 35
PART I. FINANCIAL INFORMATION ----------------------------- ITEM 1. FINANCIAL STATEMENTS ---------------------------- CERES GROUP, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS)
SEPTEMBER 30, DECEMBER 31, 2003 2002 ------------- ------------- (UNAUDITED) (NOTE A) ASSETS Investments Fixed maturities available-for-sale, at fair value $ 469,592 $ 388,057 Surplus notes 4,036 5,151 Policy and mortgage loans 4,040 3,895 ------------- ------------- Total investments 477,668 397,103 Cash and cash equivalents (of which $6,116 and $7,703 is restricted, respectively) 40,518 32,118 Accrued investment income 4,874 5,236 Premiums receivable 4,660 4,810 Reinsurance receivable 144,342 170,075 Property and equipment, net 5,728 5,387 Assets of Pyramid Life -- 157,774 Deferred acquisition costs 70,254 74,891 Value of business acquired 13,085 16,084 Goodwill 10,657 10,657 Licenses 3,440 3,586 Other assets 5,358 9,760 ------------- ------------- TOTAL ASSETS $ 780,584 $ 887,481 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY Policy liabilities and benefits accrued Future policy benefits, losses and claims $ 341,947 $ 327,385 Unearned premiums 36,137 36,680 Other policy claims and benefits payable 131,784 147,938 ------------- ------------- 509,868 512,003 Deferred reinsurance gain 9,760 11,037 Other policyholders' funds 19,073 23,610 Federal income taxes payable 1,298 -- Debt 12,192 25,003 Liabilities of Pyramid Life -- 102,457 Deferred federal income taxes 10,988 11,746 Other liabilities 34,531 34,101 ------------- ------------- TOTAL LIABILITIES 597,710 719,957 ------------- ------------- Stockholders' equity Non-voting preferred stock, $0.001 par value, 1,900,000 shares authorized, none issued -- -- Convertible voting preferred stock, $0.001 par value, at stated value, 100,000 shares authorized, none issued -- -- Common stock, $0.001 par value, 50,000,000 shares authorized, 34,340,299 and 34,232,610 shares issued and outstanding, respectively 34 34 Additional paid-in capital 133,266 133,052 Retained earnings 39,921 21,430 Accumulated other comprehensive income 9,653 13,008 ------------- ------------- TOTAL STOCKHOLDERS' EQUITY 182,874 167,524 ------------- ------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 780,584 $ 887,481 ============= =============
The accompanying notes are an integral part of these condensed consolidated financial statements. 1 CERES GROUP, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS UNAUDITED (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------------ ------------------------------ 2003 2002 2003 2002 ------------ ------------ ------------ ------------ REVENUES Premiums, net Medical $ 72,593 $ 90,702 $ 236,754 $ 277,793 Senior and other 43,439 42,102 128,698 127,462 ------------ ------------ ------------ ------------ Total premiums, net 116,032 132,804 365,452 405,255 Net investment income 6,588 5,779 18,572 18,544 Net realized gains 184 2,102 1,330 1,657 Fee and other income 6,758 7,311 20,496 23,474 Amortization of deferred reinsurance gain 355 478 1,431 2,354 ------------ ------------ ------------ ------------ 129,917 148,474 407,281 451,284 ------------ ------------ ------------ ------------ BENEFITS, LOSSES AND EXPENSES Benefits, claims, losses and settlement expenses Medical 53,327 66,315 174,632 222,909 Senior and other 32,200 31,163 96,604 95,434 ------------ ------------ ------------ ------------ Total benefits, claims, losses and settlement expenses 85,527 97,478 271,236 318,343 Selling, general and administrative expenses 35,663 42,106 111,071 133,481 Net (deferral) amortization and change in acquisition costs and value of business acquired 1,756 1,938 4,813 (4,312) Interest expense and financing costs 291 490 1,026 1,536 Special charge -- -- -- 2,381 ------------ ------------ ------------ ------------ 123,237 142,012 388,146 451,429 ------------ ------------ ------------ ------------ Income (loss) from continuing operations before federal income taxes and minority interest 6,680 6,462 19,135 (145) Federal income tax expense 2,430 2,253 4,197 102 ------------ ------------ ------------ ------------ Income (loss) from continuing operations after tax and before minority interest 4,250 4,209 14,938 (247) Minority interest 50 (10) 30 (37) ------------ ------------ ------------ ------------ INCOME (LOSS) FROM CONTINUING OPERATIONS 4,200 4,219 14,908 (210) ------------ ------------ ------------ ------------ Discontinued operations Income from operations of Pyramid Life (less tax expense of $0, $1,674, $3,223 and $2,867, respectively) -- 3,078 5,732 5,244 Loss on sale of Pyramid Life (less tax benefit of $0 and $79, respectively) -- -- (2,149) -- ------------ ------------ ------------ ------------ INCOME FROM DISCONTINUED OPERATIONS -- 3,078 3,583 5,244 ------------ ------------ ------------ ------------ NET INCOME $ 4,200 $ 7,297 $ 18,491 $ 5,034 ============ ============ ============ ============ BASIC EARNINGS PER SHARE Continuing operations $ 0.12 $ 0.12 $ 0.43 $ -- Discontinued operations -- 0.09 0.11 0.15 ------------ ------------ ------------ ------------ Net income $ 0.12 $ 0.21 $ 0.54 $ 0.15 ============ ============ ============ ============ DILUTED EARNINGS PER SHARE Continuing operations $ 0.12 $ 0.12 $ 0.43 $ -- Discontinued operations -- 0.09 0.11 0.15 ------------ ------------ ------------ ------------ Net income $ 0.12 $ 0.21 $ 0.54 $ 0.15 ============ ============ ============ ============
The accompanying notes are an integral part of these condensed consolidated financial statements. 2 CERES GROUP, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 UNAUDITED (DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS) COMMON STOCK Balance at September 30, 2003 $ 34 ============== ADDITIONAL PAID-IN CAPITAL Balance at beginning of year $ 133,052 Issuance of stock: Employee benefit plans 214 -------------- Balance at September 30, 2003 $ 133,266 ============== RETAINED EARNINGS Balance at beginning of year $ 21,430 Net income 18,491 -------------- Balance at September 30, 2003 $ 39,921 ============== ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at beginning of year $ 13,008 Unrealized gain on securities, net of tax expense of $207 389 Realized gains due to the sale of Pyramid Life, net of tax of $2,016 (3,744) -------------- Balance at September 30, 2003 $ 9,653 ============== TOTAL STOCKHOLDERS' EQUITY $ 182,874 ============== NUMBER OF SHARES OF COMMON STOCK Balance at beginning of year 34,232,610 Issuance of stock: Employee benefit plans 107,689 -------------- Balance at September 30, 2003 34,340,299 ==============
The accompanying notes are an integral part of these condensed consolidated financial statements. 3 CERES GROUP, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS UNAUDITED (DOLLARS IN THOUSANDS)
NINE MONTHS ENDED SEPTEMBER 30, ----------------------------------- 2003 2002 ------------- ------------ OPERATING ACTIVITIES Net income $ 18,491 $ 5,034 Adjustments to reconcile net income to cash provided by (used in) operating activities: Net income from discontinued operations (3,583) (5,244) Depreciation and amortization 2,725 2,160 Net realized gains (1,330) (1,657) Deferred federal income taxes (910) 2,147 Impairment of intangible asset, licenses 146 -- Changes in assets and liabilities: Accrued investment income 362 1,262 Reinsurance and premiums receivable 25,883 31,466 Deferred acquisition costs 3,301 (5,774) Value of business acquired 1,512 1,462 Other assets 2,243 (1,146) Future policy benefits, claims and funds payable (3,182) (44,825) Unearned premium (543) 1,399 Deferred reinsurance gain (1,277) (2,354) Federal income taxes payable/recoverable 3,458 (2,029) Other liabilities 756 (19,058) ------------- ------------ Net cash provided by (used in) operating activities 48,052 (37,157) ------------- ------------ INVESTING ACTIVITIES Net purchases of furniture and equipment (1,524) (308) Purchase of fixed maturities available-for-sale (188,631) (143,472) Increase in policy and mortgage loans, net (145) (136) Proceeds from sales of fixed maturities available-for-sale 38,099 119,688 Proceeds from calls and maturities of fixed maturities available-for-sale 72,832 37,759 Net proceeds from sale of Pyramid Life 55,261 -- ------------- ------------ Net cash provided by (used in) investing activities (24,108) 13,531 ------------- ------------ FINANCING ACTIVITIES Increase in annuity account balances 10,680 5,555 Decrease in annuity account balances (13,627) (15,540) Principal payments on debt (12,811) (4,915) Proceeds from issuance of common stock related to employee benefit plans 214 739 ------------- ------------ Net cash used in financing activities (15,544) (14,161) ------------- ------------ NET INCREASE (DECREASE) IN CASH 8,400 (37,787) Cash and cash equivalents at beginning of year 32,118 68,506 ------------- ------------ CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 40,518 $ 30,719 ============= ============ SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the period for interest $ 745 $ 1,698 Cash paid during the period for federal income taxes 1,892 --
The accompanying notes are an integral part of these condensed consolidated financial statements. 4 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2003 UNAUDITED ================================================================================ A. SUMMARY OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES SUMMARY OF BUSINESS The accompanying unaudited condensed consolidated financial statements of Ceres Group, Inc. and subsidiaries, included herein, have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003. The condensed consolidated financial statements for September 30, 2003 include the continuing operations of Central Reserve Life Insurance Company, Provident American Life and Health Insurance Company, Continental General Corporation and its wholly-owned subsidiary, Continental General Insurance Company, United Benefit Life Insurance Company, and the discontinued operations of Pyramid Life Insurance Company. On March 31, 2003, we sold the stock of Pyramid Life. See Note D. Discontinued Operations for further information. As a result of the sale of Pyramid Life, our previously reported condensed consolidated financial statements for the three and nine months ended September 30, 2002 have been reclassified to present the discontinued operations of Pyramid Life separate from continuing operations to conform to the current period's presentation. The condensed consolidated balance sheet presented at December 31, 2002 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2002. Unless the context indicates otherwise, "we," "our" and "us" refers to Ceres Group, Inc. and its subsidiaries on a consolidated basis. SIGNIFICANT ACCOUNTING POLICIES USE OF ESTIMATES The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. 5 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED SEPTEMBER 30, 2003 UNAUDITED ================================================================================ CASH AND CASH EQUIVALENTS Cash and cash equivalents include cash and all liquid securities with maturities of 90 days or less when purchased. At September 30, 2003 and December 31, 2002, restricted cash was $6.1 million and $7.7 million, respectively. Restricted cash primarily represents cash held related to fully insured employer shared risk plans, which is restricted from any other use. We are entitled to the investment income from these funds. A corresponding liability is included in the accompanying condensed consolidated balance sheets. INVESTMENTS Our insurance subsidiaries had certificates of deposit and fixed maturity securities on deposit with various state insurance departments to satisfy regulatory requirements. 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 35 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 three to 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. STOCK-BASED COMPENSATION Stock-based compensation plans are accounted for using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB Opinion 25"). In accordance with the intrinsic value method, compensation cost is measured as the excess, if any, of the quoted market price of the equity instrument awarded at the measurement date over the amount an employee must pay to acquire the equity instrument. Stock-based compensation costs are recognized over the period in which employees render services associated with the awards. We adopted Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation ("SFAS 123"), which permits entities to continue to apply the provisions of APB Opinion 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants as if the fair-value-based method, as defined in SFAS 123, had been applied. Additionally, in December 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 148, Accounting For Stock-Based Compensation-Transition and Disclosure ("SFAS 148"). SFAS 148 amends SFAS 123, to provide alternative methods of transition to SFAS 123's fair value method of accounting for stock-based employee compensation, but does not require companies to account for employee stock options using the fair value method. SFAS 148 also amends the disclosure provisions of SFAS 123 and APB Opinion No. 28, Interim Financial Reporting ("APB Opinion 28"). We elected to continue to 6 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED SEPTEMBER 30, 2003 UNAUDITED ================================================================================ apply provisions of APB Opinion 25 and provide the pro forma disclosure required by SFAS 123 and the amended disclosures required by SFAS 148. No stock-based employee compensation cost is reflected in net income, as all options granted under our plan generally had an exercise price equal to or higher than the fair value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS 123.
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------- ------------------------------- 2003 2002 2003 2002 ------------ ------------ ------------ ------------ (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Net income, as reported $ 4,200 $ 7,297 $ 18,491 $ 5,034 Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax -- (139) -- (378) ------------ ------------ ------------ ------------ PRO FORMA NET INCOME $ 4,200 $ 7,158 $ 18,491 $ 4,656 ============ ============ ============ ============ Earnings per share Basic-as reported $ 0.12 $ 0.21 $ 0.54 $ 0.15 BASIC-PRO FORMA $ 0.12 $ 0.21 $ 0.54 $ 0.14 Diluted-as reported $ 0.12 $ 0.21 $ 0.54 $ 0.15 DILUTED-PRO FORMA $ 0.12 $ 0.21 $ 0.54 $ 0.14
RECLASSIFICATIONS Certain prior period amounts have been reclassified to conform to the current period presentation. NEW ACCOUNTING PRONOUNCEMENTS In July 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts ("SOP 03-1"). SOP 03-1 addresses a number of topics, the most significant of which is the accounting for contracts with guaranteed minimum death benefits. SOP 03-1 requires companies to evaluate the significance of guaranteed minimum death benefits to determine whether the contract should be accounted for as an investment or insurance contract. If the contract is determined to be an insurance contract, companies are required to establish a reserve to recognize a portion of the assessment (revenue) that compensates the insurance company for benefits to be provided in future periods. SOP 03-1 also provides guidance on separate account presentation, interest in separate accounts, gains and losses on the transfer of assets from the general account to a separate account, liability valuation, return based on a contractually referenced pool of assets or index, annuitization options and sales inducements to contract holders. The effective date of SOP 03-1 is for fiscal years beginning 7 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED SEPTEMBER 30, 2003 UNAUDITED ================================================================================ after December 15, 2003, with earlier adoption encouraged. If adopted early, the provisions of SOP 03-1 must be applied as of the beginning of the fiscal year. We are currently evaluating the impact that SOP 03-1 will have on our consolidated results of operations, cash flows and financial position. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity ("SFAS 150"). SFAS 150 establishes standards for how an issuer classifies and measures three classes of freestanding financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. The FASB deferred indefinitely, the application of various provisions as it related to mandatorily redeemable financial instruments of nonpublic entities. We have not entered into any financial instruments within the scope of SFAS 150 since May 31, 2003, nor do we currently hold any significant financial instruments as defined within the scope of this pronouncement. In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities ("SFAS 149"). SFAS 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"). SFAS 149 is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of SFAS 149 on July 1, 2003 did not have a material impact on our consolidated results of operations, cash flows or financial position. In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 ("FIN 46"). FIN 46 addresses consolidation by business enterprises of variable interest entities which have certain characteristics by requiring that if a business enterprise has a controlling interest in a variable interest entity (as defined by FIN 46), the assets, liabilities, and results of activities of the variable interest entity be included in the consolidated financial statements with those of the business enterprise. FIN 46 applies to variable interest entities created after January 31, 2003 and to variable interest entities in which an enterprise obtains an interest after that date. For variable interests acquired before February 1, 2003, FIN 46 applies in the first fiscal year or interim period beginning after June 15, 2003. We have, and will continue to, adopt the various provisions of FIN 46 as indicated above, but presently do not have any variable interest entities that would be required to be included in our consolidated results of operations, cash flows or financial position. We previously reported that we would adopt FIN 46 for variable interests acquired before February 1, 2003 on July 1, 2003; however, the FASB staff has delayed the implementation date for these provisions until the fourth quarter of 2003. 8 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED SEPTEMBER 30, 2003 UNAUDITED ================================================================================ In June 2002, the FASB, issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities ("SFAS 146"), which supercedes Emerging Issues Task Force, or EITF, Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring) ("EITF Issue 94-3"). The provisions of this Statement are effective for exit or disposal activities initiated after December 31, 2002. SFAS 146 requires recognition of a liability for costs associated with an exit or disposal activity when the liability is incurred, rather than when the entity commits to an exit plan under EITF Issue 94-3. This Statement applies to costs associated with an exit activity that does not involve an entity newly acquired in a business combination or with a disposal activity covered by SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS 144"). Additionally, this Statement does not apply to costs associated with the retirement of a long-lived asset covered by SFAS No. 143, Accounting for Asset Retirement Obligations ("SFAS 143"). The adoption of this Standard did not have a material effect on our consolidated results of operations, cash flows, or financial position. B. DEBT
SEPTEMBER 30, DECEMBER 31, 2003 2002 ------------- ------------ (DOLLARS IN THOUSANDS) Bank credit facility $ 12,192 $ 25,003 ============= ============
We maintain a bank credit facility consisting of a tranche A term loan that expires February 17, 2005 and a tranche B term loan that expires December 17, 2005. The term loans bear interest at either a fixed rate based on the prime rate plus a spread or a floating rate based on LIBOR plus a spread. The applicable rate for the tranche A term loan is the prime rate plus 3.0% or LIBOR plus 4.0%. The applicable rate for the tranche B term loan is the prime rate plus 3.5% or LIBOR plus 4.5%. At September 30, 2003, the interest rate on our $7.6 million tranche A term loan was 5.1% and the interest rate on our $4.6 million tranche B term loan was 5.6%. The credit agreement, as amended, contains customary covenants which, among other matters, require us to achieve certain minimum financial results, prohibit us from paying future cash dividends and restrict or limit our ability to incur additional debt and dispose of assets outside the ordinary course of business. At September 30, 2003, we were in compliance with all such covenants. Our obligations under the credit agreement are secured by pledges of the common stock of Central Reserve Life, Continental General, and most of our non-regulated subsidiaries. We do not have transactions or relationships with "special purpose" entities and we do not have any off balance sheet financing other than operating leases. 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 9 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED SEPTEMBER 30, 2003 UNAUDITED ================================================================================ 12 months. Funds to meet our debt obligations are generated from fee income from our non-regulated subsidiaries. Our ability to make scheduled payments of the principal and interest on our indebtedness depends on our future performance and the future performance of our non-regulated subsidiaries, which are subject to economic, financial, competitive and other factors beyond our control. Fee income is derived from fees primarily in connection with our major medical business. As that business declines, fee income declines. Dividends from the regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. In 2003, none of the insurance subsidiaries (Central Reserve and Continental General) can pay a dividend to Ceres Group, the parent company, without prior approval of their respective state regulators as a result of their respective statutory levels of unassigned surplus. C. 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 on major risks and limits our potential losses on reinsured business. Reinsurance involves one or more insurance companies participating in the liabilities or risks of another insurance company in exchange for a portion of the premiums. Although the effect of reinsurance is to lessen our risks, it may lower net income. We have entered into a variety of reinsurance arrangements under which we cede business to other insurance companies to mitigate risk. A significant portion of our risks are reinsured with a single reinsurance company, Hannover Life Reassurance Company of America, a health and life reinsurance company. 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. 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. 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, which are amortized over the expected profit stream of the in force business. 10 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED SEPTEMBER 30, 2003 UNAUDITED ================================================================================ The following table summarizes the net impact of our reinsurance arrangements on premiums and benefits, claims, losses and settlement expenses, commissions, and other operating expenses:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------------ --------------------------------- 2003 2002 2003 2002 ----------- ------------ ------------- -------------- (DOLLARS IN THOUSANDS) PREMIUMS, NET Direct $ 139,970 $ 161,455 $ 437,178 $ 497,132 Assumed -- 28 -- 73 Ceded (23,938) (28,679) (71,726) (91,950) ----------- ------------ ------------- -------------- Total premiums, net $ 116,032 $ 132,804 $ 365,452 $ 405,255 =========== ============ ============= ============== BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES, NET Benefits, claims, losses and settlement expenses $ 100,432 $ 113,471 $ 316,215 $ 381,474 Reinsurance recoveries (14,905) (15,993) (44,979) (63,131) ----------- ------------ ------------- -------------- Total benefits, claims, losses and settlement expenses, net $ 85,527 $ 97,478 $ 271,236 $ 318,343 =========== ============ ============= ============== SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Commissions $ 17,204 $ 23,528 $ 56,330 $ 75,285 Other operating expenses 22,985 24,458 69,341 77,046 Reinsurance expenses -- -- -- 440 Reinsurance allowances (4,526) (5,880) (14,600) (19,290) ----------- ------------ ------------- -------------- Total selling, general and administrative expenses $ 35,663 $ 42,106 $ 111,071 $ 133,481 =========== ============ ============= ==============
D. DISCONTINUED OPERATIONS On March 31, 2003, we sold the stock of our indirect subsidiary, Pyramid Life, which was primarily included in our Senior and Other segment, to the Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. Net proceeds from the sale were used to strengthen Continental General's statutory capital and repay $10.0 million of our bank debt. Additionally, we continue to process Pyramid Life's business through an administrative services agreement until December 31, 2003. The total loss from the sale (net of taxes and expenses incurred) was $13.8 million. Accordingly, we adjusted the carrying value of Pyramid Life's assets held for sale to fair market value at December 31, 2002, which resulted in a charge of $11.6 million. In addition, we recorded a $2.2 million loss on the sale in 2003. As a result of the sale, Pyramid Life's operations were classified as discontinued operations and prior years' financial information has been reclassified. 11 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED SEPTEMBER 30, 2003 UNAUDITED ================================================================================ Summarized financial data for Pyramid Life's operations are as follows: STATEMENTS OF OPERATIONS
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------------- ------------------------------ 2003 2002 2003 2002 ----------- ------------ ------------ ------------ (DOLLARS IN THOUSANDS) REVENUES Premiums, net $ -- $ 25,144 $ 27,964 $ 71,852 Net investment income -- 1,695 1,568 5,080 Net realized gains -- 976 5,965 131 ----------- ------------ ------------ ------------ -- 27,815 35,497 77,063 ----------- ------------ ------------ ------------ BENEFITS, LOSSES AND EXPENSES Benefits, claims, losses and settlement expenses -- 17,640 20,285 53,280 Selling, general and administrative expenses -- 7,512 8,702 21,612 Net (deferral) amortization and change in acquisition costs and value of business acquired -- (2,089) (2,445) (6,227) Special charge -- -- -- 287 ----------- ------------ ------------ ------------ -- 23,063 26,542 68,952 ----------- ------------ ------------ ------------ Income from operations before federal income taxes -- 4,752 8,955 8,111 Federal income tax expense -- 1,674 3,223 2,867 ----------- ------------ ------------ ------------ INCOME FROM OPERATIONS -- 3,078 5,732 5,244 ----------- ------------ ------------ ------------ Loss on sale of Pyramid Life -- -- (2,228) -- Federal income tax benefit -- -- (79) -- ----------- ------------ ------------ ------------ LOSS ON SALE OF PYRAMID LIFE, NET -- -- (2,149) -- ----------- ------------ ------------ ------------ INCOME FROM DISCONTINUED OPERATIONS $ -- $ 3,078 $ 3,583 $ 5,244 =========== ============ ============ ============
12 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED SEPTEMBER 30, 2003 UNAUDITED ================================================================================ BALANCE SHEET
DECEMBER 31, 2002 --------------- (DOLLARS IN THOUSANDS) ASSETS Investments $ 106,231 Cash and cash equivalents 6,411 Accrued investment income 1,391 Premiums receivable 312 Reinsurance receivable 7,808 Property and equipment, net 1,000 Deferred acquisition costs 16,150 Value of business acquired 15,067 Other assets 3,404 --------------- TOTAL ASSETS 157,774 --------------- LIABILITIES AND STOCKHOLDERS' EQUITY Policy liabilities and benefits accrued 96,866 Intercompany payable 1,797 Other liabilities 3,794 --------------- TOTAL LIABILITIES 102,457 --------------- NET ASSETS OF DISCONTINUED OPERATIONS $ 55,317 ===============
E. SPECIAL CHARGE On April 15, 2002, Peter W. Nauert announced his retirement from his position as our Chief Executive Officer effective June 1, 2002. He remained Chairman of the Board of Directors through June 2003. In the first quarter of 2002, we reported a pre-tax non-recurring special charge to operations of approximately $2.7 million ($2.4 million in continuing operations and $0.3 million in discontinued operations) related to the early termination of his employment agreement and the payment of certain benefits through June 2003. 13 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED SEPTEMBER 30, 2003 UNAUDITED ================================================================================ F. COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) is as follows:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------------- ------------------------------ 2003 2002 2003 2002 ------------ ----------- ----------- ----------- (DOLLARS IN THOUSANDS) Net income $ 4,200 $ 7,297 $ 18,491 $ 5,034 Other comprehensive income (loss), net of tax: Unrealized gain on securities, net of tax expense (benefit) of $(3,177), $3,839, $207 and $5,666, respectively (1) (5,896) 7,128 389 11,767 Realized gain due to the sale of Pyramid Life, net of tax of $2,016 -- -- (3,744) -- ------------ ----------- ----------- ----------- Comprehensive income (loss) $ (1,696) $ 14,425 $ 15,136 $ 16,801 ============ ============ =========== =========== ----------- (1) Net of reclassification adjustments for net gains (losses) included in net income.
G. EARNINGS PER SHARE Basic and diluted earnings per common share are calculated in accordance with SFAS No. 128, Earnings per Share. Basic earnings per common share is computed by dividing net income (loss) 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. Basic and diluted weighted average shares of common stock are as follows:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------------ ----------------------------- 2003 2002 2003 2002 ---------- ---------- ---------- ---------- Weighted average shares: BASIC 34,339,582 34,034,196 34,291,416 33,967,712 Stock awards and incremental shares from assumed exercise of stock options 55,714 -- 19,021 -- ---------- ---------- ---------- ---------- DILUTED 34,395,296 34,034,196 34,310,437 33,967,712 ========== ========== ========== ==========
H. CONTINGENCIES We are involved in various legal and regulatory actions occurring in the normal course of business, which could result in significant liabilities and costs. Based on current information, including consultation with outside counsel, we believe any ultimate liability that may arise from these actions would not materially affect our consolidated financial position or results of operations. However, we cannot predict with certainty the outcome of lawsuits against the Company or the potential costs involved. Our evaluation of the likely impact of these actions could change in the future and an unfavorable outcome could have a material adverse effect on our consolidated financial position, results of operations or cash flow of a future period. 14 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED SEPTEMBER 30, 2003 UNAUDITED ================================================================================ I. OPERATING SEGMENTS We apply SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, which requires us to report information about our operating segments according to the management approach for determining reportable segments. This approach is based on the way management organizes segments within a company for making operating decisions and assessing performance. We have three distinct operating segments based upon product types: Medical, Senior and Other, and Corporate and Other. Products included in the Medical segment include catastrophic and comprehensive 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, including investment income, interest expense, and corporate expenses, of the parent company. For all periods presented, the segment results exclude the operations of Pyramid Life, which was sold March 31, 2003. 15 CERES GROUP, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED SEPTEMBER 30, 2003 UNAUDITED ================================================================================ The following table presents the revenues, expenses and profit (loss) from continuing operations before federal income taxes, for the three and nine months ended September 30, 2003 and 2002 attributable to our industry segments. We do not separately allocate investments or other identifiable assets by industry segment, nor are income tax expenses (benefits) allocated by industry segment. Revenues from each segment are primarily generated from premiums charged to external policyholders and interest earned on cash and investments.
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, --------------------------------- ------------------------------- 2003 2002 2003 2002 -------------- ------------- ------------- ------------ (DOLLARS IN THOUSANDS) MEDICAL Revenues Net premiums $ 72,593 $ 90,702 $ 236,754 $ 277,793 Investment income, realized gains 1,312 2,460 4,591 6,263 Other income 4,934 7,446 16,956 23,974 -------------- ------------- ------------- ------------ 78,839 100,608 258,301 308,030 -------------- ------------- ------------- ------------ Expenses Benefits and claims 53,327 66,315 174,632 222,909 Other operating expenses 23,180 31,677 75,918 93,412 -------------- ------------- ------------- ------------ 76,507 97,992 250,550 316,321 -------------- ------------- ------------- ------------ Segment profit (loss) before federal income taxes and minority interest $ 2,332 $ 2,616 $ 7,751 $ (8,291) ============== ============= ============= ============ SENIOR AND OTHER Revenues Net premiums $ 43,439 $ 42,102 $ 128,698 $ 127,462 Investment income, realized gains 5,345 5,311 14,980 13,606 Other income 2,173 343 4,965 1,854 -------------- ------------- ------------- ------------ 50,957 47,756 148,643 142,922 -------------- ------------- ------------- ------------ Expenses Benefits and claims 32,200 31,163 96,604 95,434 Other operating expenses 13,885 11,905 38,801 34,578 -------------- ------------- ------------- ------------ 46,085 43,068 135,405 130,012 -------------- ------------- ------------- ------------ Segment profit before federal income taxes and minority interest $ 4,872 $ 4,688 $ 13,238 $ 12,910 ============== ============= ============= ============ CORPORATE AND OTHER Revenues Investment income, realized gains $ 115 $ 110 $ 331 $ 332 Other income 6 -- 6 -- -------------- ------------- ------------- ------------ 121 110 337 332 -------------- ------------- ------------- ------------ Expenses Interest and financing costs 291 490 1,026 1,536 Other operating expenses 354 462 1,165 1,179 Special charge -- -- -- 2,381 -------------- ------------- ------------- ------------ 645 952 2,191 5,096 -------------- ------------- ------------- ------------ Segment loss before federal income taxes and minority interest $ (524) $ (842) $ (1,854) $ (4,764) ============== ============= ============= ============ INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE FEDERAL INCOME TAXES AND MINORITY INTEREST $ 6,680 $ 6,462 $ 19,135 $ (145) ============== ============= ============= ============
16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS -------------------------------------------------------------------------------- OF OPERATIONS ------------- This discussion should be read in conjunction with our condensed consolidated financial statements, notes and tables included elsewhere in this report, as well as, the Management's Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, contained in our 2002 Annual Report on Form 10-K. MD&A may contain forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. However, future performance involves risks and uncertainties, which may cause actual results to differ materially from those expressed in the forward-looking statements. See "Forward-Looking Statements" for further information. OVERVIEW Ceres Group, through its insurance subsidiaries, provides a wide array of health and life insurance products through two primary business segments. The Senior segment includes senior health, life and annuity products for Americans age 55 and over. The Medical segment includes major medical health insurance for individuals, families, associations and small businesses. Our insurance subsidiaries include Central Reserve Life Insurance Company, Provident American Life & Health Insurance Company, United Benefit Life Insurance Company and Continental General Insurance Company. Central Reserve markets and sells major medical health insurance to individuals, families, associations and small employer groups and in late 2003, will market and sell senior products. Continental General markets and sells both major medical and senior health and life products to individuals, families, associations, and Americans age 55 and over. United Benefit Life discontinued new sales activities in July 2000 and terminated all of its existing business at the end of 2001. United Benefit Life has no active policyholders and its business was substantially wound down at December 31, 2002. Provident American Life also discontinued new sales activities and currently has approximately 1,600 active policyholders. CRITICAL ACCOUNTING POLICIES Refer to Critical Accounting Policies in our 2002 Annual Report on Form 10-K for information on accounting policies that we consider critical in preparing our consolidated financial statements. These policies include significant estimates made by management using information available at the time the estimates were made. However, these estimates could change materially if different information or assumptions were used. RESULTS OF OPERATIONS On March 31, 2003, we sold our indirect subsidiary, Pyramid Life Insurance Company, to the Pennsylvania Life Insurance Company, a subsidiary of Universal American Financial Corp., for approximately $57.5 million in cash. Results of continuing operations for the three and nine months ended September 30, 2003 and 2002 include the operations of all our subsidiaries for the entire period with the exception of Pyramid Life. Consistent with Statement of Financial Accounting Standards, or SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, Pyramid Life was classified as held for sale at December 31, 2002, and was measured at its fair value less cost to sell. Therefore, the financial information excludes the operations of Pyramid Life for the periods presented. Financial data for the three and nine months ended September 30, 2002 was reclassified to reflect the sale of Pyramid Life. The net 17 assets, results of operations, and cash flows of Pyramid Life were reported separately as discontinued operations of a subsidiary in our condensed consolidated financial statements for the periods presented. See Note D. Discontinued Operations to our condensed consolidated financial statements for further information. 18 QUARTER ENDED SEPTEMBER 30, 2003 COMPARED TO QUARTER ENDED SEPTEMBER 30, 2002
INCREASE THREE MONTHS THREE MONTHS (DECREASE) FROM ENDED % OF ENDED % OF PREVIOUS YEAR SEPTEMBER 30, CONSOLIDATED SEPTEMBER 30, CONSOLIDATED ------------------- 2003 REVENUES 2002 REVENUES DOLLARS % ------------- ------------ ------------- ------------ ------- ------ (dollars in thousands, except per share amounts) Premiums, net Medical $ 72,593 55.9% $ 90,702 61.1% $ (18,109) (20.0)% Senior and other 43,439 33.4 42,102 28.4 1,337 3.2 ---------- ------- ---------- ------- --------- Total 116,032 89.3 132,804 89.5 (16,772) (12.6) Net investment income 6,588 5.1 5,779 3.9 809 14.0 Net realized gains 184 0.1 2,102 1.4 (1,918) (91.2) Fee and other income 6,758 5.2 7,311 4.9 (553) (7.6) Amortization of deferred reinsurance gain 355 0.3 478 0.3 (123) (25.7) ---------- ------- ---------- ------- --------- Consolidated revenues 129,917 100.0 148,474 100.0 (18,557) (12.5) ---------- ------- ---------- ------- --------- Benefits, claims, losses and settlement expenses Medical 53,327 41.0 66,315 44.7 (12,988) (19.6) Senior and other 32,200 24.8 31,163 21.0 1,037 3.3 ---------- ------- ---------- ------- --------- Total 85,527 65.8 97,478 65.7 (11,951) (12.3) Selling, general and administrative expenses 35,663 27.5 42,106 28.3 (6,443) (15.3) Net (deferral) amortization and change in acquisition costs and value of business acquired 1,756 1.4 1,938 1.3 (182) (9.4) Interest expense and financing costs 291 0.2 490 0.3 (199) (40.6) ---------- ------- ---------- ------- --------- 123,237 94.9 142,012 95.6 (18,775) (13.2) ---------- ------- ---------- ------- --------- Income from continuing operations before federal income taxes and minority interest 6,680 5.1 6,462 4.4 218 3.4 Federal income tax expense 2,430 1.9 2,253 1.6 177 7.9 ---------- ------- ---------- ------- --------- Income from continuing operations after tax and before minority interest 4,250 3.2 4,209 2.8 41 1.0 Minority interest 50 -- (10) -- 60 N/M ---------- ------- ---------- ------- --------- INCOME FROM CONTINUING OPERATIONS 4,200 3.2 4,219 2.8 (19) (0.5) ---------- ------- ---------- ------- --------- Discontinued operations: Income from operations of Pyramid Life, net of tax -- -- 3,078 2.1 (3,078) (100.0) Loss on sale of Pyramid Life, net of tax -- -- -- -- -- -- ---------- ------- ---------- ------- --------- INCOME FROM DISCONTINUED OPERATIONS -- -- 3,078 2.1 (3,078) (100.0) ---------- ------- ---------- ------- --------- NET INCOME $ 4,200 3.2% $ 7,297 4.9% $ (3,097) (42.4) ========== ======= ========== ======= ========= Basic earnings per share $ 0.12 $ 0.21 $ (0.09) (42.9) Diluted earnings per share 0.12 0.21 (0.09) (42.9) ----------- N/M = not meaningful
19 NET PREMIUMS (NET OF REINSURANCE CEDED) For the quarter ended September 30, 2003, total net premiums decreased 12.6% to $116.0 million, compared to $132.8 million for the same quarter in 2002. MEDICAL Medical premiums for the quarter ended September 30, 2003 were $72.6 million compared to $90.7 million for the quarter ended September 30, 2002, a decrease of 20.0%. The decrease in medical premiums was primarily the result of a decrease in major medical certificates in force due to the cancellation of medical business in unprofitable states, higher than anticipated policy lapse rates, and a 66% decline in new business production offset by a lower level of reinsurance and renewal premium increases averaging 20% to 30%. SENIOR AND OTHER Senior and other premiums increased $1.3 million to $43.4 million for the quarter ended September 30, 2003 compared to $42.1 million for the same quarter in 2002. The increase in senior and other premiums was primarily the result of premium rate increases and an increase in Medicare supplement new business production. OTHER REVENUES Net investment income was $6.6 million for the third quarter of 2003 compared to $5.8 million for the third quarter of 2002, an increase of 14.0%, due primarily to an increase in invested assets from the proceeds of the sale of Pyramid Life. Net realized gains decreased to $0.2 million for the third quarter of 2003 compared to $2.1 million for the third quarter of 2002. The prior year quarter reflected a partial redistribution of our investment portfolio, which resulted in the realization of capital gains. Fee and other income decreased to $6.8 million for the quarter ended September 30, 2003 compared to $7.3 million for the same quarter of 2002, a decrease of 7.6%. This decrease was primarily attributable to the cancellation of medical business in certain unprofitable states and the decline in new business in the Medical segment, and was partially offset by $1.9 million of third party administrator ("TPA") fees in the Senior and Other segment related to the processing of senior business for Pyramid Life. This TPA agreement is expected to terminate at December 31, 2003. The amortization of deferred reinsurance gain of $0.4 million for the quarter ended September 30, 2003 represented the recognition of the ceding commission allowances received under our reinsurance agreements. The unamortized amount of $9.8 million at September 30, 2003 was accounted for as a deferred reinsurance gain on the condensed consolidated balance sheet. The amortization of deferred reinsurance gain decreased from $0.5 million for the quarter ended September 30, 2002 as a result of lower amortization due to diminishing levels of in force certificates. 20 BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES Total benefits, claims, losses and settlement expenses decreased to $85.5 million for the quarter ended September 30, 2003 compared to $97.5 million for the same quarter in 2002, a decrease of 12.3%. MEDICAL Medical benefits, claims, losses and settlement expenses were $53.3 million for the quarter ended September 30, 2003 compared to $66.3 million for the same quarter in 2002, a decrease of 19.6%. The decrease was primarily a result of a smaller volume of business in force due to the cancellation of medical business in certain unprofitable states and higher than anticipated policy lapse rates. The medical loss ratio was 73.5% for the quarter ended September 30, 2003 compared to 73.1% for the same quarter of 2002. SENIOR AND OTHER Senior and other benefits, claims, losses and settlement expenses increased to $32.2 million for the quarter ended September 30, 2003 compared to $31.2 million for the same quarter of 2002. The senior and other loss ratio was 74.1% for the third quarter of 2003 compared to 74.0% for the third quarter of 2002 primarily due to higher claims experience on the long-term care business. OTHER EXPENSES AND NET INCOME Selling, general and administrative expenses decreased to $35.7 million in the third quarter of 2003 compared to $42.1 million in the third quarter of 2002, a decrease of 15.3%. Commissions decreased $6.3 million and other operating expenses decreased $1.5 million as a direct result of the decline in medical premiums. As a percentage of revenues, selling, general and administrative expenses decreased to 27.5% in the third quarter of 2003 compared to 28.3% in the third quarter of 2002 primarily due to the decrease in the overall commissions rate as a result of lower new sales, a reduced workforce at our Cleveland facility, offset by the decrease in reinsurance allowances due to a lower volume of ceded premiums as a result of our cancelled business. The net (deferral) amortization and change in acquisition costs (DAC) and value of business acquired (VOBA) resulted in net amortization of $1.8 million for the third quarter of 2003 which was comparable to net amortization of $1.9 million for the third quarter of 2002. Interest expense and financing costs decreased to $0.3 million in the third quarter of 2003 compared to $0.5 million in the third quarter of 2002 as a result of a decrease in outstanding debt. A federal income tax expense of $2.4 million was recorded for the third quarter of 2003, or 36.4% of the income from continuing operations before federal taxes. In the third quarter of 2002, a federal income tax expense of $2.3 million was recorded, or 34.9% of the income from continuing operations before federal taxes. 21 Income from continuing operations was $4.2 million, or $0.12 per share, for the third quarter of 2003, which was comparable to the third quarter of 2002. For the third quarter of 2003, net income was $4.2 million, or $0.12 per share, compared to $7.3 million, or $0.21 per share, for the third quarter of 2002. 22 NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2002
INCREASE NINE MONTHS NINE MONTHS (DECREASE) FROM ENDED % OF ENDED % OF PREVIOUS YEAR SEPTEMBER 30, CONSOLIDATED SEPTEMBER 30, CONSOLIDATED ---------------------- 2003 REVENUES 2002 REVENUES DOLLARS % ---------- ------------ ---------- ------------ ---------- ------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Premiums, net Medical $ 236,754 58.1% $ 277,793 61.6% $ (41,039) (14.8)% Senior and other 128,698 31.6 127,462 28.2 1,236 1.0 ---------- ----- ---------- ----- ---------- Total 365,452 89.7 405,255 89.8 (39,803) (9.8) Net investment income 18,572 4.6 18,544 4.1 28 0.2 Net realized gains 1,330 0.3 1,657 0.4 (327) (19.7) Fee and other income 20,496 5.0 23,474 5.2 (2,978) (12.7) Amortization of deferred reinsurance gain 1,431 0.4 2,354 0.5 (923) (39.2) ---------- ----- ---------- ----- ---------- Consolidated revenues 407,281 100.0 451,284 100.0 (44,003) (9.8) ---------- ----- ---------- ----- ---------- Benefits, claims, losses and settlement expenses Medical 174,632 42.9 222,909 49.4 (48,277) (21.7) Senior and other 96,604 23.7 95,434 21.1 1,170 1.2 ---------- ----- ---------- ----- ---------- Total 271,236 66.6 318,343 70.5 (47,107) (14.8) Selling, general and administrative expenses 111,071 27.3 133,481 29.6 (22,410) (16.8) Net (deferral) amortization and change in acquisition costs and value of business acquired 4,813 1.2 (4,312) (0.9) 9,125 N/M Interest expense and financing costs 1,026 0.2 1,536 0.4 (510) (33.2) Special charge -- -- 2,381 0.5 (2,381) (100.0) ---------- ----- ---------- ----- ---------- 388,146 95.3 451,429 100.1 (63,283) (14.0) ---------- ----- ---------- ----- ---------- Income (loss) from continuing operations before federal income taxes and minority interest 19,135 4.7 (145) (0.1) 19,280 N/M Federal income tax expense 4,197 1.1 102 -- 4,095 N/M ---------- ----- ---------- ----- ---------- Income (loss) from continuing operations after tax and before minority interest 14,938 3.6 (247) (0.1) 15,185 N/M Minority interest 30 -- (37) -- 67 181.1 ---------- ----- ---------- ----- ---------- INCOME (LOSS) FROM CONTINUING OPERATIONS 14,908 3.6 (210) (0.1) 15,118 N/M ---------- ----- ---------- ----- ---------- Discontinued operations: Income from operations of Pyramid Life, net of tax 5,732 1.4 5,244 1.2 488 9.3 Loss on sale of Pyramid Life, net of tax (2,149) (0.5) -- -- (2,149) N/M ---------- ----- ---------- ----- ---------- INCOME FROM DISCONTINUED OPERATIONS 3,583 0.9 5,244 1.2 (1,661) (31.7) ---------- ----- ---------- ---- ---------- NET INCOME $ 18,491 4.5% $ 5,034 1.1% $ 13,457 N/M ========== ===== ========== ===== ========== Basic earnings per share $ 0.54 $ 0.15 $ 0.39 N/M Diluted earnings per share 0.54 0.15 0.39 N/M ----------- N/M = not meaningful
23 NET PREMIUMS (NET OF REINSURANCE CEDED) For the nine months ended September 30, 2003, total net premiums decreased 9.8% to $365.5 million, compared to $405.3 million for the same period in 2002. MEDICAL Medical premiums for the nine months ended September 30, 2003 were $236.8 million compared to $277.8 million for the nine months ended September 30, 2002, a decrease of 14.8%. The decrease in medical premiums was primarily the result of a decrease in major medical certificates in force due to the cancellation of medical business in unprofitable states and a 65% decline in new business production offset by a lower level of reinsurance and renewal premium increases averaging 20% to 30%. SENIOR AND OTHER Senior and other premiums were $128.7 million for the nine months ended September 30, 2003 compared to $127.5 million for the same period in 2002. The increase in senior and other premiums was primarily the result of premium rate increases and an increase in Medicare supplement new business production. OTHER REVENUES Net investment income was $18.6 million for the first nine months of 2003 compared to $18.5 million for the first nine months of 2002, an increase of 0.2%. The decline in the overall portfolio yield to 5.5% was offset by the increase in average invested assets. Net realized gains decreased to $1.3 million for the first nine months of 2003 compared to $1.7 million for the first nine months of 2002. The prior year period reflected a partial redistribution of our investment portfolio, which resulted in the realization of capital gains, offset by the write-down for other-than-temporary impairment on bonds held in WorldCom of $0.9 million. Fee and other income decreased to $20.5 million for the nine months ended September 30, 2003 compared to $23.5 million for the same nine months of 2002, a decrease of 12.7%. This decrease was primarily attributable to the cancellation of medical business in certain unprofitable states and a decline in new business and was partially offset by $3.8 million of TPA fees in the Senior and Other segment related to the processing of senior business for Pyramid Life. This TPA agreement is expected to terminate at December 31, 2003. The amortization of deferred reinsurance gain of $1.4 million for the nine months ended September 30, 2003 represented the recognition of the ceding commission allowances received under our reinsurance agreements. The unamortized amount of $9.8 million at September 30, 2003 was accounted for as a deferred reinsurance gain on the condensed consolidated balance sheet. The amortization of deferred reinsurance gain decreased from $2.4 million for the nine months ended September 30, 2002 as a result of lower amortization due to diminishing levels of in force certificates. 24 BENEFITS, CLAIMS, LOSSES AND SETTLEMENT EXPENSES Total benefits, claims, losses and settlement expenses decreased to $271.2 million for the nine months ended September 30, 2003 compared to $318.3 million for the nine months ended September 30, 2002, a decrease of 14.8%. MEDICAL Medical benefits, claims, losses and settlement expenses were $174.6 million for the nine months ended September 30, 2003 compared to $222.9 million for the same period in 2002, a decrease of 21.7%. The decrease was primarily a result of a smaller volume of business in force due to the cancellation of medical business in certain unprofitable states. The medical loss ratio was 73.8% for the nine months ended September 30, 2003 compared to 80.2% for the same period of 2002. The medical loss ratio decreased due to the cancellation of business in poor performing markets, rate increases, and a higher severity of claims than anticipated in the December 31, 2001 claim inventory, which adversely impacted 2002 loss ratios. SENIOR AND OTHER Senior and other benefits, claims, losses and settlement expenses increased to $96.6 million for the nine months ended September 30, 2003 compared to $95.4 million for the same period of 2002. The senior and other loss ratio was 75.1% for the first nine months of 2003 compared to 74.9% for the first nine months of 2002. The higher loss ratio in the current period was primarily due to higher claims experience on the long-term care and senior life business, which was partially offset in part by improved Medicare supplement experience. OTHER EXPENSES AND NET INCOME Selling, general and administrative expenses decreased to $111.1 million for the first nine months of 2003 compared to $133.5 million in the first nine months of 2002, a decrease of 16.8%. Commissions decreased $19.0 million and other operating expenses decreased $8.1 million as a direct result of our cancelled or replaced business offset by reduced reinsurance allowances of $4.7 million as a result of a lower volume of ceded premiums. As a percentage of revenues, selling, general and administrative expenses decreased to 27.3% in the first nine months of 2003 compared to 29.6% in the first nine months of 2002 primarily due to the decrease in the overall commissions rate as a result of lower new sales, a reduced workforce at our Cleveland facility and economies of scale achieved from the conversion of the senior business to our Kansas City facility in 2002, offset by the decrease in reinsurance allowances due to a lower volume of ceded premiums as a result of our cancelled business. The net (deferral) amortization and change in acquisition costs (DAC) and value of business acquired (VOBA) resulted in net amortization of $4.8 million for the first nine months of 2003 compared to a net deferral of $4.3 million for the first nine months of 2002. The decrease in the net deferral was primarily attributable to the lower capitalization of DAC due to decreases in new business sales. Interest expense and financing costs decreased to $1.0 million in the first nine months of 2003 compared to $1.5 million in the first nine months of 2002 as a result of a decrease in outstanding debt. 25 The special charge for the nine months ended September 30, 2002 represented a pre-tax non-recurring charge of $2.7 million ($2.4 million in continuing operations and $0.3 million in discontinued operations) related to the retirement of Peter W. Nauert, our former CEO. See Note E. Special Charge to our condensed consolidated financial statements for further information. A federal income tax expense of $4.2 million was recorded for the first nine months of 2003, which included a $2.7 million reduction to the deferred tax valuation allowance as a result of the improved profitability of certain subsidiaries in the Medical segment. The effective tax rate, including the deferred tax valuation allowance adjustment of $2.7 million, was 21.9% for the nine months ended September 30, 2003. In the first nine months of 2002, a federal income tax expense of $0.1 million was recorded, which included a $0.2 million adjustment for permanent differences related to penalties and meals and entertainment. Income from continuing operations was $14.9 million, or $0.43 per share, for the first nine months of 2003 compared to a loss of $0.2 million for the first nine months of 2002. Income from the operations of Pyramid Life (classified as discontinued operations) was $3.6 million, or $0.11 per share, (which included $3.9 million of net realized investment gains, $1.8 million of operating income and a loss on the sale of $2.1 million) for the first nine months of 2003 compared to $5.2 million, or $0.15 per share, for the first nine months of 2002. For the first nine months of 2003, net income was $18.5 million, or $0.54 per share, compared to $5.0 million, or $0.15 per share, for the same period of 2002. LIQUIDITY AND CAPITAL RESOURCES Liquidity is our ability to generate adequate amounts of cash to meet our financial commitments. Our major needs for cash are to enable our insurance subsidiaries to pay claims and expenses as they come due and for Ceres to pay interest on, and to repay principal of, its indebtedness. The primary sources of cash are premiums, investment income, fee income, equity, and debt financings, and reimbursements from reinsurers. Payments consist of current claim payments to insureds, medical cost management expenses, operating expenses such as rent, salaries, employee benefits, commissions, taxes, and interest on debts. Net cash provided by operating activities for the period ended September 30, 2003 was $48.1 million compared to net cash used in operating activities of $37.2 million at September 30, 2002. The increase was primarily attributable to an improvement in earnings and the current year settlements of our reinsurance receivables. Assets decreased 12.0% to $780.6 million at September 30, 2003 from $887.5 million at December 31, 2002 due primarily to the sale of Pyramid Life. Assets of $477.7 million, or 61.2% of the total assets, were in investments at September 30, 2003. Fixed maturities, our primary investment, were $469.6 million, or 98.3% of total investments, at September 30, 2003. 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 September 30, 2003. Approximately 95.5% of our bonds were of investment grade quality at September 30, 2003. In addition to the fixed maturities, we also had $40.5 million in cash and cash equivalents of which $6.1 million was restricted at September 30, 2003. 26 The total reinsurance receivable was $144.3 million at September 30, 2003. Of this amount, $144.1 million represents reserves held by our reinsurers under our various reinsurance treaties in place. Hannover holds substantially all of these reserves. The total policy liabilities and benefits accrued were 85.3% of the total liabilities at September 30, 2003 compared to 71.1% at December 31, 2002. This increase was primarily due to the sale of Pyramid Life. CREDIT AGREEMENT. We maintain a bank credit facility consisting of a tranche A term loan that expires February 17, 2005 and a tranche B term loan that expires December 17, 2005. The term loans bear interest at either a fixed rate based on the prime rate plus a spread or a floating rate based on LIBOR plus a spread. The applicable rate for the tranche A term loan is the prime rate plus 3.0% or LIBOR plus 4.0%. The applicable rate for the tranche B term loan is the prime rate plus 3.5% or LIBOR plus 4.5%. At September 30, 2003, the interest rate on our $7.6 million tranche A term loan was 5.1% and the interest rate on our $4.6 million tranche B term loan was 5.6%. The credit agreement, as amended, contains customary covenants which, among other matters, require us to achieve certain minimum financial results, prohibit us from paying future cash dividends and restrict or limit our ability to incur additional debt and dispose of assets outside the ordinary course of business. At September 30, 2003, we were in compliance with all such covenants. Our obligations under the credit agreement are secured by pledges of the common stock of Central Reserve Life, Continental General, and most of our non-regulated subsidiaries. We do not have transactions or relationships with "special purpose" entities, and we do not have any off balance sheet financing other than operating leases. The following schedule summarizes current and future contractual obligations as of September 30, 2003:
PAYMENTS DUE BY YEAR --------------------------------------------------------------------------------- LESS THAN CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR 1-3 YEARS 4-5 YEARS AFTER 5 YEARS ------------------------------------------ ------------ ------------ ------------ ---------- ------------- (DOLLARS IN THOUSANDS) Long-term debt $ 12,192 $ 3,336 $ 8,856 $ -- $ -- Operating leases 27,392 2,807 4,692 3,976 15,917 ------------ ------------ ------------ --------- ------------ Total contractual obligations $ 39,584 $ 6,143 $ 13,548 $ 3,976 $ 15,917 ============ ============ ============ ========= ============
We believe that cash flow from operating activities will be sufficient to meet the currently anticipated operating and capital expenditure requirements of our subsidiaries over the next 12 months. Funds to meet our debt obligations are generated from fee income from our non-regulated subsidiaries. Our ability to make scheduled payments of the principal and interest on our indebtedness depends on our future performance and the future performance of our non-regulated subsidiaries, which are subject to economic, financial, competitive, and other factors beyond our control. Fee income is derived from fees primarily in connection with our major medical business. As that business declines, fee income declines. Dividends from our regulated insurance subsidiaries are subject to, and limited by, state insurance regulations. In 2003, none of our insurance subsidiaries (Central Reserve and Continental General) can pay a 27 dividend to Ceres Group, the parent company, without prior approval of their respective state regulators as a result of their respective statutory levels of unassigned surplus. If our non-regulated subsidiaries do not generate sufficient fee income to service all of our debt obligations, there may be a material adverse effect on our business, financial condition and results of operations, and a significant adverse effect on the market value of our common stock. In addition, if necessary, additional financing may not be available on terms favorable to us or at all. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS We have three segments: Medical, which includes catastrophic and comprehensive major medical plans; Senior and Other, which includes Medicare supplement, long-term care, dental, life insurance and annuities; and Corporate and Other, which includes interest income, interest expense, and corporate expenses of the parent company. See Note I. Operating Segments, to the Notes to our Condensed Consolidated Financial Statements for further information. MARKET RISK AND MANAGEMENT POLICIES The following is a description of certain risks facing health and life insurers and how we mitigate those risks: Inadequate Pricing Risk is the risk that the premium charged for insurance and insurance related products is insufficient to cover the costs associated with the distribution of such products, including benefits, claims and losses, settlement expenses, acquisition expenses and other corporate expenses. We utilize a variety of actuarial and qualitative methods to set such pricing levels. Any negative fluctuation in our estimates of the effect of continued medical inflation and high benefit utilization could have a material adverse impact on our results of operations. Legal/Regulatory Risk is the risk that changes in the legal or regulatory environment in which an insurer operates will create additional expenses not anticipated by the insurer in pricing its products. For example, regulatory initiatives designed to reduce insurer profits or otherwise affecting the industry in which the insurer operates, new legal theories or insurance company insolvencies through guaranty fund assessments, may create costs for the insurer beyond those recorded in the financial statements. We attempt to mitigate this risk by offering a wide range of products and by operating in many states, thus reducing our exposure to any single product and by employing underwriting practices that identify and minimize the adverse impact of this risk. In addition, insurance companies are subject to extensive federal and state regulation and compliance with these regulations could increase 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 28 December 31, 2002, our risk-based capital levels for each of our insurance subsidiaries, except for Continental General, exceeded the levels required by regulatory authorities. Continental General's statutory capital level was below "Company Action Level" at December 31, 2002. However, after the addition of the capital generated from the sale of Pyramid Life on March 31, 2003, Continental General's risk-based capital level exceeded the levels required by regulatory authorities. Investment Impairment Risk is the risk that all amounts due (both principal and interest) on our fixed maturity investments will not be collected according to the security's contractual terms. We attempt to minimize this risk by adhering to a conservative investment strategy. With the exception of short-term investments and securities on deposit with various state regulators, investment responsibilities have been delegated to external investment managers within the investment parameters established by the Company. Our external investment managers prepare a monthly investment surveillance list to analyze our fixed maturity portfolio for potential other-than-temporary impairment. The following factors are reviewed for inclusion on our surveillance list: - debt downgrades or other events that adversely affects an investee's access to, or cost of, financing; - negative economic factors and conditions specific to the issuers industry; - adverse changes in the regulatory environment specific to the issuers industry; - all spread changes exceeding 50 basis points; or - corporate bond prices that move more than 10% over the past week, 20% over the past month, or 30% over the past three months. All of our fixed maturity investments are reported at fair market value at September 30, 2003. The amortized cost and estimated fair value of fixed maturities on our investment surveillance list at September 30, 2003 were $5.4 million and $4.9 million, respectively. Credit Risk is the risk that parties, including reinsurers that have obligations to us, will not pay or perform. We attempt to minimize this risk by maintaining sound reinsurance and credit collection policies. Interest Rate Risk is the risk that interest rates will change and cause a decrease in the value of an insurer's investments. This change in rates may cause certain interest-sensitive products to become uncompetitive or may cause disintermediation if we attempt to mitigate this risk by charging fees for non-conformance with certain policy provisions and/or by attempting to match the maturity schedule of our assets with the expected payouts of its liabilities. To the extent that liabilities come due more quickly than assets mature, we would have to sell assets prior to maturity and recognize a gain or loss. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical decline in fair value of stockholders' equity is estimated to be $13.1 million after-tax at September 30, 2003. This amount represents approximately 7.2% of our stockholders' equity at such date. 29 We also have long-term debt that bears interest at variable rates. Therefore, our results of operations would be affected by interest rate changes. We do not expect a significant rate change in the near future that would have a material effect on our near-term results of operations. Seasonality is the risk of fluctuations of revenues and operating results. Historically, our revenues and operating results have varied from quarter to quarter and are expected to continue to fluctuate in the future. These fluctuations have been due to a number of factors, including higher benefit utilization by our insureds during the winter months and the use of deductibles. More specifically, our Senior segment's seasonality is the opposite of our Medical segment's, meaning that earnings in the Senior segment are generally lower in the first quarter and higher later in the year. This is mainly a factor of our Medicare Supplement products that pay the Medicare deductible for our insureds generally during the early months of the year. IMPACT OF INFLATION Inflation rates impact our financial condition and operating results in several areas. Changes in inflation rates impact the market value of the investment portfolio and yields on new investments. Inflation has had an impact on claim costs and overall operating costs and although it has been lower in the last few years, hospital and medical costs have still increased at a higher rate than general inflation, especially prescription drug costs. New, more expensive and wider use of pharmaceuticals is inflating health care costs. We will continue to establish premium rates in accordance with trends in hospital and medical costs along with concentrating on various cost containment programs. However, there can be no assurance that these efforts by us will fully offset the impact of inflation or that premiums will equal or exceed increasing healthcare costs. FORWARD-LOOKING STATEMENTS This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are necessarily based on estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, us. In particular, forward-looking statements can be identified by the use of words such as "may," "will," "should," "expect," "anticipate," "estimate," "continue" or similar words. In light of the risks and uncertainties inherent in all future projections, the inclusion of forward-looking statements in this report should not be considered as a representation by us or any other person that our objectives or plans will be achieved. Numerous factors could cause our actual results to differ materially and adversely from those in the forward-looking statements, including those risks outlined above in "Market Risk and Management Policies," and the following: - unforeseen losses with respect to loss and settlement expense reserves for unreported and reported claims or adverse changes in persistency or profitability of insurance contracts that would accelerate the amortization of our deferred acquisition costs; 30 - our ability to implement increases in premium rates and to develop, distribute and administer competitive products and services in a timely, cost-effective manner; - rising healthcare costs, especially the rising costs of prescription drug costs that are rising faster than other medical costs, and rising utilization rates; - developments in healthcare reform and other regulatory issues, including the Health Insurance Portability and Accountability Act of 1996, increased privacy regulation, and changes in laws and regulations in key states in which we operate; - our ability to meet risk-based or statutory capital requirements; - our ability to continue to meet the terms of our debt obligations under our credit agreement which contains a number of significant financial and other covenants; - the adequacy of funds, including fee income, received from our non-regulated subsidiaries, and the restrictions on our insurance subsidiaries' ability to pay dividends to Ceres, to meet our debt obligations; - the performance of others on whom we rely for reinsurance, particularly Hannover Life Reassurance Company of America upon whom we have relied for substantially all of our reinsurance; - the risk of material adverse outcomes in litigation; - the risk of selling investments to meet liquidity requirements; - our ability to obtain additional debt or equity financing on terms favorable to us to facilitate our long-term growth; - the risk that issuers of securities owned by Ceres will default or that other parties will not pay or perform; - our financial and claims paying ratings, including any potential downgrades; - our ability to maintain our current PPO network arrangements; - dependence on senior management and key personnel; - the performance of others on whom we rely for administrative and operations services; - changes in accounting and reporting practices; - the failure to successfully manage our operations and integrate future acquisitions, if any, including the failure to achieve cost savings; - payments to state assessment funds; - business conditions and competition in the healthcare industry; 31 - changes in tax laws; and - our ability to fully collect all agent advances. The factors listed above should not be construed as exhaustive. We undertake no obligation to publicly release 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. NEW ACCOUNTING PRONOUNCEMENTS See Note A. Summary of Business and Significant Accounting Policies, to the notes to our condensed consolidated financial statements for a discussion of recently issued Accounting Standards. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK ------------------------------------------------------------------ The information called for by this item is provided under the caption "Market Risk and Management Policies" under Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations. ITEM 4. CONTROLS AND PROCEDURES -------------------------------- We carried out an evaluation, under the supervision and with the participation of management, including our President and Chief Executive Officer along with our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15 (e)) as of September 30, 2003. Based upon that evaluation, our President and Chief Executive Officer along with our Chief Financial Officer concluded that our disclosure controls and procedures are effective. There have been no changes in our internal control over financial reporting that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 32 PART II. OTHER INFORMATION -------------------------- ITEM 1. LEGAL PROCEEDINGS -------------------------- We are involved in various legal and regulatory actions occurring in the normal course of business, which could result in significant liabilities and costs. Based on current information, including consultation with outside counsel, we believe any ultimate liability that may arise from these actions would not materially affect our consolidated financial position or results of operations. However, we cannot predict with certainty the outcome of lawsuits against the Company or the potential costs involved. Our evaluation of the likely impact of these actions could change in the future and an unfavorable outcome could have a material adverse effect on our consolidated financial position, results of operations or cash flow of a future period. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS -------------------------------------------------- None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES ---------------------------------------- None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ------------------------------------------------------------ None. ITEM 5. OTHER INFORMATION -------------------------- None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K ----------------------------------------- a) Exhibits: 10.42 Employment Agreement dated, August 18, 2003, between Bradley A. Wolfram and Ceres Group, Inc. 31.1 CEO certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002. 31.2 CFO certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002. 32 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. b) Reports on Form 8-K: On August 7, 2003, we filed a current report on Form 8-K to disclose our earnings for the second quarter of 2003. On August 20, 2003, we amended our current report on Form 8-K, dated June 26, 2003, to disclose that the client-auditor relationship between the Company and Ernst & Young, LLP ceased upon the completion of second quarter review procedures on August 14, 2003. 33 On September 15, 2003, we filed a current report on Form 8-K to disclose that we engaged KPMG, LLP as our independent accountants. 34 SIGNATURES ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CERES GROUP, INC. Date: November 14, 2003 By: /s/ David I. Vickers ----------------- ---------------------------------- David I. Vickers Executive Vice President and Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer) 35